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10-K-1024tk-2020

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Velocity Financial, Inc.

2020-04-07

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 “Item 6. Selected Financial Data” and the consolidated financial statements and related notes and the other financial information included elsewhere in the Annual Report on Form 10-K. This discussion contains forward-looking statements, as described under the heading “Forward-Looking Statements” that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this prospectus, particularly under “Item 1A. Risk Factors.” Business We are a vertically integrated real estate finance company founded in 2004. We primarily originate and manage investor loans secured by 1-4 unit residential rental and small commercial properties, which we refer to collectively as investor real estate loans. We originate loans nationwide across our extensive network of independent mortgage brokers which we have built and refined over the 15 years since our inception. Our objective is to be the preferred and one of the most recognized brands in our core market, particularly within our network of mortgage brokers. We operate in a large and highly fragmented market with substantial demand for financing and limited supply of institutional financing alternatives. We have developed the highly-specialized skill set required to effectively compete in this market, which we believe has afforded us a durable business model capable of generating compelling risk-adjusted returns for our stockholders throughout various business cycles. We offer competitive pricing to our borrowers by pursuing low-cost financing strategies and by driving front- end process efficiencies through customized technology designed to control the cost of originating a loan. Furthermore, by originating loans through our efficient and scalable network of approved mortgage brokers, we are able to maintain a wide geographical presence and nimble operating infrastructure capable of reacting quickly to changing market environments. Our growth strategy is predicated on continuing to serve and build loyalty within our network of mortgage brokers, while also expanding our network with new mortgage brokers through targeted marketing, improved brand awareness, and the growth and development of our team of account executives. We believe our reputation and 15-year history within our core market position us well to capture future growth opportunities. Our primary source of revenue is interest income earned on our loan portfolio. Our typical loan is secured by a first lien on the underlying property with a personal guarantee and, based on all loans in our portfolio as of December 31, 2019, has an average balance of approximately $323,000. As of December 31, 2019, our loan portfolio, including both loans held for investment and loans held for sale, totaled $2.1 billion of UPB on properties in 45 states and the District of Columbia. The total portfolio had a weighted average loan-to-value ratio, or LTV at origination, of 65.8%, and was concentrated in 1-4 unit residential rental loans, which we refer to as investor 1-4 loans, representing 52.2% of the UPB. During the year ended December 31, 2019, the yield on our total portfolio was 8.84%. We fund our portfolio primarily through a combination of committed and uncommitted secured warehouse repurchase facilities, securitizations, corporate debt and equity. The securitization market is our primary source of long-term financing. We have successfully executed twelve securitizations, resulting in a total of over $2.5 billion in gross debt proceeds from May 2011 through October 2019. In January 2020, we repaid $75.0 million of our existing corporate debt with a portion of the net proceeds from our IPO. In February 2020, we completed the securitization of $261.9 million of investor real estate loans, measured by UPB as of the January 1, 2020 cut-off date, issuing $248.7million of non-recourse notes payable through the Velocity Commercial Capital Loan Trust 2020-1, or 2020-1. We are the sole beneficial interest holder of 2020-1, a variable interest entity that will be included in our consolidated financial statements. We refer to this transaction as the “February 2020 Securitization.” One of our core profitably measurements is our portfolio related net interest margin, which measures the difference between interest income earned on our loan portfolio and interest expense paid on our portfolio-related debt, relative to the amount of loans outstanding over the period. Our portfolio-related debt consists of our warehouse repurchase facilities and securitizations and excludes our corporate debt. For the year ended December 31, 2019, our portfolio related net interest margin was 4.13%. We generate profits to the extent that our portfolio related net interest income exceeds our interest expense on corporate debt, provision for loan losses and operating expenses. For the year ended December 31, 2019, we generated income before income taxes and net income of $25.4 million and $17.3 million, respectively, and earned a pre-tax return on equity and return on equity of 17.4% and 11.8%, respectively. Items Affecting Comparability of Results Due to a number of factors, our historical financial results may not be comparable, either from period to period, or to our financial results in future periods. We have summarized the key factors affecting the comparability of our financial results below. Income Taxes Prior to our initial public offering, the Company operated as Velocity Financial, LLC, which was formed as a Delaware Limited Liability Company, or LLC, in 2012. Until January 1, 2018, as an LLC, we had elected to be treated as a partnership for U.S. federal and state income tax purposes, and as such, had generally not been subject to federal and state income taxes prior to January 1, 2018. Accordingly, the results of operations presented for the years prior to January 1, 2018 do not include any provision for federal or state income taxes. As part of our initial public offering, we converted Velocity Financial, LLC into a Delaware corporation and changed our name to Velocity Financial, Inc., a transaction that we refer to as the “conversion” in this Annual Report Form 10-K. The conversion is accounted for in accordance with ASC 805-50 -Business Combinations, as a transaction between entities under common control. The conversion is not expected to impact our provision for income taxes or our deferred tax assets and liabilities. Effective January 1, 2018, we elected to be treated as a corporation for U.S. federal and state income tax purposes. Accordingly, the results of operations for the year ended December 31, 2018 include the impacts of income taxes. As a result, the historical net income reported for any period prior to January 1, 2018, is not comparable to the net income reported for the year ended December 31, 2018 or the net income anticipated in future periods. Furthermore, in connection with the new tax treatment, we began recognizing, and will continue to recognize, deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of our existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the statements of operations in the period that included the enactment date, as applicable. Interest Expense on Corporate Debt In 2014, we entered into a five-year, $100.0 million corporate debt agreement with the owners of our Class C preferred units, pursuant to which we issued at par senior secured notes, the 2014 Senior Secured Notes, that mature on December 16, 2019. The 2014 Senior Secured Notes bear interest, at our election, at either 10% annually paid in cash or 11% annually paid in kind. In August 2019, we entered into a five-year $153.0 million corporate debt agreement with Owl Rock Capital Corporation (“2019 Term Loans”). The 2019 Term Loans under this agreement bear interest at a rate equal to one-month LIBOR plus 7.50% and mature in August 2024. A portion of the net proceeds from the 2019 Term Loans was used to redeem all of the outstanding 2014 Senior Secured Notes in August 2019. Another portion of the net proceeds from the 2019 Term Loans, together with cash on hand, was used to repurchase our outstanding Class C preferred units. As of December 31, 2018, including paid-in-kind interest, the 2014 Senior Secured Notes balance was $127.6 million, and is presented as secured financing, net of debt issuance costs, on the consolidated statement of financial condition. The 2019 Term Loans balance was $153.0 million as of December 31, 2019. During the year ended December 31, 2019, we incurred $14.6 million of interest expense related to the 2014 Senior Secured Notes and the 2019 Term Loans. We used $75.7 million of the net proceeds from our IPO to lower our interest expense through the repayment of the $75.0 million outstanding principal amount on the 2019 Term Loans. Recent Developments January 2020 IPO On January 16, 2020, Velocity Financial, LLC converted from a Delaware limited liability company to a Delaware corporation and changed its name to Velocity Financial, Inc. The Conversion was accounted for in accordance with ASC 805-50 -Business Combinations, as a transaction between entities under common control. All assets and liabilities of Velocity Financial, LLC were contributed to Velocity Financial, Inc. at their carrying value. The Conversion had no impact on our provision for income taxes or our deferred tax assets and liabilities. Upon completion of the Conversion, Velocity Financial, LLC’s Class A equity units of 97,513,533 and Class D equity units of 60,193,989 were converted to 11,749,994 shares of Velocity Financial, Inc. common stock. On January 22, 2020, we completed our initial public offering (“IPO”). The net proceeds received from the sale of our common stock in the IPO was $100.7 million, including $13.1 million from the underwriters fully exercising their over-allotment option to purchase an additional 1,087,500 shares of our common stock. The proceeds were net of underwriting discounts and commissions and offering expenses payable by us. We used $75.7 million of the net proceeds from our IPO to repay $75.0 million principal amount of our outstanding 2019 Term Loans described below (plus $0.7 million for related prepayment penalties and accrued interest), and the remainder for general corporate purposes, including originating or acquiring investor real estate loans. The 2019 Term Loans bear interest at a rate equal to one-month LIBOR plus 7.50% and mature in August 2024. Strategies to Address Uncertainties Caused by COVID-19 The COVID-19 outbreak has caused significant disruption in business activity and the financial markets both globally and in the United States. As a result of the spread of COVID-19, economic uncertainties have arisen which are likely to negatively impact our financial condition, results of operations and cash flows. 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 and impact on our customers, employees and vendors, all of which is uncertain at this time and cannot be predicted. The extent to which COVID-19 may impact our financial condition or results of operations cannot be reasonably estimated at this time. For more information on the potential impacts of the COVID-19 outbreak on our business see “Item 1A. Risk Factors-The outbreak of the recent coronavirus, COVID-19, or an outbreak of another highly infectious or contagious disease, could adversely affect our business, financial condition, results of operations and cash flow, and limit our ability to obtain additional financing.” We have proactively executed a number of business initiatives to strengthen our liquidity position and re-focus our business strategies in light of the effects of the COVID-19 pandemic, including the following: • On April 5, 2020, we issued and sold 45,000 shares of our newly designated Series A Convertible Preferred Stock, par value $0.01 per share (the “Preferred Stock”), in a private placement to affiliates of Snow Phipps and TOBI (the “Purchasers”), our two largest common stockholders, at a price per share of Preferred Stock of $1,000. In addition, as part of that private placement, we issued and sold to the Purchasers warrants (the “Warrants”) to purchase an aggregate of 3,013,125 shares of our common stock. This private placement offering resulted in gross proceeds to us of $45.0 million, before expenses payable by us of approximately $1.0 million. We intend to use the net proceeds from this private placement to pay down our existing warehouse repurchase facilities and general corporate purposes. See “Note 24 - Subsequent Events” in the consolidated financial statements included in this Annual Report for information about the Preferred Stock and the Warrants. We will evaluate the Preferred Stock and the Warrants for liability or equity classification in accordance with the provisions of ASC 480, Distinguishing Liabilities from Equity. • On April 6, 2020, we entered into amendments to the master repurchase agreements on both of our warehouse repurchase agreements with the lenders under such agreements. We believe that the amended warehouse repurchase agreements provide us with a flexible and more stabilized financing solution that will allow us to better operate our business under the current market conditions. For more information about the amended warehouse repurchase agreements see “-Liquidity and Capital Resources-Warehouse Repurchase Facilities” below. • During this economic crisis, we will consider the benefits of originating commercial mortgage loans along with opportunistically acquiring commercial mortgage loans that comply with our credit guidelines. If we are able to prudently originate or acquire mortgage loans, they will be added to our held for investment loan portfolio and supplement our current earnings profile generated by our $1.9 billion of portfolio loans, which are primarily fixed rate loans financed with fixed rate securitizations. We will continue to evaluate our business strategy in light of rapidly changing market conditions. Critical Accounting Policies and Use of Estimates The preparation of financial statements in accordance with U.S. GAAP requires certain judgments and assumptions, based on information available at the time of preparation of the consolidated financial statements, in determining accounting estimates used in preparation of the consolidated financial statements. The following discussion addresses the accounting policies that we believe apply to us based on the nature of our operations. Our most critical accounting policies involve decisions and assessments that could affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments used to prepare the company’s financial statements are based upon reasonable assumptions given the information available at that time. We believe the following are critical accounting policies that require the most significant judgments and estimates used in the preparation of the consolidated financial statements. The summary below should be read in conjunction with the disclosure of our accounting policies and use of estimates in Note 2 to the consolidated financial statements. Allowance for Loan Losses The allowance for loan and lease losses, or ALLL, on loans held for investment is maintained at a level deemed adequate by management to provide for probable and inherent losses in the portfolio at the balance sheet date. The ALLL has a general reserve component for loans with no credit impairment and a specific reserve component for loans determined to be impaired. The allowance methodology for the general reserve component includes both quantitative and qualitative loss factors which are applied to the population of unimpaired loans to estimate the general reserves. The quantitative loss factors include loan type, age of the loan, borrower FICO score, past loan loss experience, historical default rates, and delinquencies. The qualitative loss factors consider, among other things, the loan portfolio composition and risk, current economic conditions that may affect the borrower’s ability to pay, and the underlying collateral value. While our management uses available information to estimate its required ALLL, future additions to the ALLL may be necessary based on changes in estimates resulting from economic and other conditions. The provision for loan losses and recoveries of previously recognized charge-offs are added to the ALLL, while charge-offs on loans are recorded as a reduction to ALLL. Loans are considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal and interest according to the contractual terms of the loan agreements. Impairment is measured on a loan-by-loan basis by comparing the estimated fair value of the underlying collateral, net of estimated selling costs (net realizable value) against the recorded investment of the loan. To the extent the recorded investment of the loan exceeds the estimated fair value, a specific reserve or charge-off is recorded depending upon either the certainty of the estimate of loss or the fair value of the loan’s collateral. Deferred Income Tax Assets and Liabilities Our deferred income tax assets and liabilities arise from 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. We determine whether a deferred tax asset is realizable based on facts and circumstances, including our current and projected future tax position, the historical level of our taxable income, and estimates of our future taxable income. In most cases, the realization of deferred tax assets is based on our future profitability. If we were to experience either reduced profitability or operating losses in a future period, the realization of our deferred tax assets may no longer be considered more likely than not and, accordingly, we could be required to record a valuation allowance on our deferred tax assets by charging earnings. How We Assess Our Business Performance Net income is the primary metric by which we assess our business performance. Accordingly, we closely monitor the primary drivers of net income which consist of the following: Net Interest Income Net interest income is the largest contributor to our net income and is monitored on both an absolute basis and relative to provisions for loan losses and operating expenses. We generate net interest income to the extent that the rate at which we lend in our portfolio exceeds the cost of financing our portfolio, which we primarily achieve through long-term securitizations. Accordingly, we closely monitor the financing markets and maintain consistent dialogue with investors and financial institutions as we evaluate our financing sources and cost of funds. To evaluate net interest income, we measure and monitor: (1) the yields on our loans, (2) the costs of our funding sources, (3) our net interest spread and (4) our net interest margin. Net interest spread measures the difference between the rates earned on our loans and the rates paid on our funding sources. Net interest margin measures the difference between our annualized interest income and annualized interest expense, or net interest income, as a percentage of average loans outstanding over the specified time period. Periodic changes in net interest income are primarily driven by: (1) origination volume and changes in average outstanding loan balances and (2) interest rates and changes in interest earned on our portfolio or paid on our debt. Historically, origination volume and portfolio size have been the largest contributors to the growth in our net interest income. We measure net interest income before and after interest expense related to our corporate debt and before and after our provisions for loan losses. Credit Losses We strive to minimize actual credit losses through our rigorous screening and underwriting process and life of loan portfolio management and special servicing practices. We closely monitor the credit performance of our loan portfolio, including delinquency rates and expected and actual credit losses, as a key factor in assessing our overall business performance. Operating Expenses We incur operating expenses from compensation and benefits related to our employee base, rent and other occupancy costs associated with our leased facilities, our third-party primary loan servicing vendors, professional fees to the extent we utilize third-party legal, consulting and advisory firms, and costs associated with the resolution and disposition of real estate owned, among other items. We monitor and strive to prudently manage operating expenses and to balance current period profitability with investment in the continued development of our platform. Because volume and portfolio size determine the magnitude of the impact of each of the above factors on our earnings, we also closely monitor origination volume along with all key terms of new loan originations, such as interest rates, loan-to-value ratios, estimated credit losses and expected duration. Factors Affecting Our Results of Operations We believe there are a number of factors that impact our business, including those discussed below and in this Form 10K titled “Item 1A Risk Factors.” Our results of operations depend on, among other things, the level of our net interest income, the credit performance of our loan portfolio and the efficiency of our operating platform. These measures are affected by a number of factors, including the demand for investor real estate loans, the competitiveness of the market for originating or acquiring investor real estate loans, the cost of financing our portfolio, the availability of funding sources and the underlying performance of the collateral supporting our loans. While we have been successful at managing these elements in the past, there are certain circumstances beyond our control, including the current disruption caused by the COVID-19 pandemic, macroeconomic conditions and market fundamentals, which can affect each of these factors and potentially impact our business performance. Origination Volume Portfolio related net interest income is the largest contributor to our net income. We have grown our portfolio related net interest income by $11.5 million or 18.5% from $62.1 million for the year ended December 31, 2018 to $73.6 million for the year ended December 31, 2019. Our portfolio related net interest income grew by $11.9 million or 23.8% from $50.2 million for the year ended December 31, 2018 to $62.1 million for the year ended December 31, 2018. The growth in net interest income is largely attributable to our growth in loan originations which we have achieved by executing our principal strategies of expanding our broker network and further penetrating our network of existing brokers. We anticipate that our future performance will continue to depend on growing our origination volume and believe that the large and highly fragmented nature of our core market provides meaningful opportunity to achieve this. We intend to grow originations by continuing to serve and build loyalty within our existing network of brokers while expanding our network with new brokers through targeted marketing and improved brand awareness. Our future performance could be impacted to the extent that our origination volumes decline as we rely on new loans to offset maturities and prepayments in our existing portfolio. To augment our core origination business, we continually assess opportunities to acquire portfolios of loans that meet our investment criteria. In our experience, portfolio acquisition opportunities have generally been more attractive and plentiful during market conditions when origination opportunities are less favorable. Accordingly, we believe our acquisition strategy not only expands our core business, but also provides a counter-cyclical benefit. Competition The investor real estate loan market is highly competitive which could affect our profitability and growth. We believe we compete favorably through diversified borrower access driven by our extensive network of mortgage brokers and by emphasizing a high level of real estate and financial expertise, customer service, and flexibility in structuring transactions, as well as by attracting and retaining experienced managerial and marketing personnel. However, some of our competitors may be better positioned to market their services and financing programs because of their ability to offer more favorable rates and terms and other services. Availability and Cost of Funding Our primary funding sources have historically included cash from operations, warehouse repurchase facilities, term securitizations, corporate debt and equity. We believe we have an established brand in the term securitization market and that this market will continue to support our portfolio growth with long-term financing. Changes in macroeconomic conditions can adversely impact our ability to issue securitizations and, thereby, limit our options for long-term financing. In consideration of this potential risk, we have entered into a credit facility for longer-term financing that will provide us with capital resources to fund loan growth in the event we are not able to issue securitizations. We used $75.7 million of the net proceeds from our IPO to lower our interest expense through the repayment of $75.0 million in outstanding principal amount on the 2019 Term Loans. Loan Performance We underwrite and structure our loans to minimize potential losses. We believe our fully amortizing loan structures and avoidance of large balloon payments, coupled with meaningful borrower equity in properties, limit the probability of losses and that our proven in-house asset management capability allows us to minimize potential losses in situations where there is insufficient equity in the property. Our income is highly dependent upon borrowers making their payments and resolving delinquent loans as favorably as possible. Macroeconomic conditions can, however, impact credit trends in our core market and have an adverse impact on financial results. Macroeconomic Conditions The investor real estate loan market may be impacted by a wide range of macroeconomic factors such as interest rates, residential and commercial real estate prices, home ownership and unemployment rates, and availability of credit, among others. We believe our prudent underwriting, conservative loan structures and interest rate protections, and proven in-house asset management capability leave us well positioned to manage changing macroeconomic conditions. Operating Efficiency We generate positive operating leverage to the extent that our revenue grows at a faster rate than our expenses. We believe our platform is highly scalable and that we can generate positive operating leverage in future periods, primarily due to the technology and other investments we have made in our platform to date and our focus on a scalable, cost-effective mortgage broker network to generate new loan originations. Portfolio and Asset Quality Key Portfolio Statistics Total Loans. Total loans reflects the aggregate UPB at the end of the period. It excludes deferred origination costs, acquisition discounts, fair value adjustments and allowance for loan losses. Loan Count. Loan count reflects the number of loans at the end of the period. It includes all loans with an outstanding principal balance. Average Loan Balance. Average loan balance reflects the average UPB at the end of the period (i.e., total loans divided by loan count). Weighted Average Loan-to-Value. Loan-to-value, or LTV, reflects the ratio of the original loan amount to the appraised value of the underlying property at the time of origination. In instances where the LTV at origination is not available for an acquired loan, the LTV reflects our best estimate of value at the time of acquisition. Weighted average LTV is calculated for the population of loans outstanding at the end of each specified period using the original loan amounts and appraised LTVs at the time of origination of each loan. LTV is a key statistic because requiring the borrower to invest more equity in the collateral minimizes our exposure for future credit losses. Nonperforming Loans. Loans that are 90 or more days past due, in bankruptcy, or in foreclosure are not accruing interest and are considered nonperforming loans. The dollar amount of nonperforming loans presented in the table above reflects the UPB of all loans that meet this definition. Originations and Acquisitions The following table presents new loan originations and acquisitions and includes average loan size, weighted average coupon and weighted average loan-to-value for the periods indicated: Over the periods shown, we have increased our origination volume by executing our strategy of continuing to serve and build loyalty within our network of mortgage brokers, while also expanding our network with new mortgage brokers through improved brand recognition. For the year ended December 31, 2019, we originated $1.0 billion of loans, which was an increase of $275.4 million, or 37.4% from $737.3 million for the year ended December 31, 2018. For the year ended December 31, 2018, we originated $737.3 million of loans, which was an increase of $182.6 million, or 32.9%, from $554.7 million for the year ended December 31, 2017. Loans Held for Investment Our total portfolio of loans held for investment consists of both loans held for investment at cost, which are presented in the consolidated financial statements as loans held for investment, net, and loans held for investment at fair value, which are presented in the financial statements as loans held for investment at fair value. The following tables show the various components of loans held for investment as of the dates indicated: The following table illustrates the contractual maturities for our loans held for investment in aggregate UPB and as a percentage of our total held for investment loan portfolio as of December 31, 2019: Allowance for Loan Losses Our allowance for loan losses increased to $2.2 million as of December 31, 2019, compared to $1.7 million as of December 31, 2018. The increase in allowance is primarily due to the increase in our loan portfolio from December 31, 2018 to December 31, 2019. Our allowance decreased to $1.7 million as of December 31, 2018, compared to $1.9 million as of December 31, 2017. The decrease in the allowance for loan losses is based on an analysis of historical loan loss data from January 1, 2012 through December 31, 2019. We strive to minimize actual credit losses through our rigorous screening and underwriting process, life of loan portfolio management and special servicing practices. Additionally, we believe borrower equity of 25% to 40% provides significant protection against credit losses should a loan become impaired. To estimate the allowance for loan losses in our loans held for investment portfolio, we follow a detailed internal process, considering a number of different factors including, but not limited to, our ongoing analyses of loans, historical loss rates, relevant environmental factors, relevant market research, trends in delinquencies, effects and changes in credit concentrations, and ongoing evaluation of fair values. The following table illustrates the activity in our allowance for loan losses over the periods indicated: Credit Quality - Loans Held for Investment The following table provides delinquency information on our held for investment loan portfolio as of the dates indicated: Loans that are 90+ days past due, in bankruptcy, or in foreclosure are not accruing interest and are considered nonperforming loans. Nonperforming loans were $112.2 million, or 6.1% of our held for investment loan portfolio as of December 31, 2019, compared to $91.1 million, or 5.9% as of December 31, 2018, and $73.3 million, or 5.7% of the loan portfolio as of December 31, 2017. We believe the significant equity cushion at origination and the active management of loans will continue to minimize credit losses on the resolution of defaulted loans and disposition of REO properties. Historically, most loans that become nonperforming resolve prior to converting to REO. This is due to low LTVs at origination and our active management of the portfolio. The following table summarizes the cumulative number and UPB of all loans originated since January 1, 2013 that became nonperforming at some point through December 31, 2019. We classify a loan as nonperforming when it becomes 90 days delinquent or when it enters bankruptcy or foreclosure. Of the 899 loans totaling $334.6 million in UPB that became nonperforming over the specified period, we have resolved 493 loans totaling $183.8 million in UPB, or 54.9% of the cumulative nonperforming loans. We realized a net gain of $6.0 million, or 3.3% of the resolved principal balance, on these resolutions, which is largely the result of collecting default interest and prepayment penalties in excess of the contractual interest due and collected. (1) Reflects the unpaid principal balance at time of delinquency. (2) Reflects all loans originated since 2013 that became nonperforming at some point on or prior to December 31, 2019. Our actual losses incurred are very small as a percentage of all loans that have ever become nonperforming. The table below shows our actual loan losses from January 1, 2013 through December 31, 2019, and through the years ended December 31, 2018, 2017 and 2016. Our average annual charge-off percentage since January 1, 2013 is approximately 0.02%. The table includes all loans originated over those periods, the year-end UPB amounts, the amount of loans that were ever nonperforming during those periods, and the actual losses for all loans that were either liquidated or converted to REO (life of loan) during the periods. (1) Reflects UPB of all loans originated since January 1, 2013 that became nonperforming at some point during the period indicated. (2) Reflects the total charge-offs on loans that were nonperforming and have been liquidated or converted to REO from January 1, 2013 through the date indicated. (3) Reflects the average annual charge-offs on loans that were nonperforming and have been liquidated or converted to REO from January 1, 2013 through the date indicated. (4) Reflects the cumulative charge-offs as a percent of the end of period UPB. (5) Reflects the average annual charge-offs as a percent of the end of period UPB. Concentrations - Loans Held for Investment As of December 31, 2019, our held for investment loan portfolio was concentrated in investor 1-4 loans, representing 46.6% of the UPB. Mixed used properties represented 13.6% of the UPB and multifamily properties represented 10.7% of the UPB. No other property type represented more than 10.0% of our held for investment loan portfolio. By geography, the principal balance of our loans held for investment were concentrated 23.7% in New York, 22.2% in California, 12.1% in Florida, and 8.1% in New Jersey. (1) All other properties individually comprise less than 5.0% of the total unpaid principal balance. (1) All other states individually comprise less than 5.0% of the total unpaid principal balance. Loans Held for Sale We started originating short-term, interest-only loans in March 2017, which we have historically aggregated and sold at a premium to par to institutional investors. During the year ended December 31, 2019 and 2018, we originated $338.8 million and $150.1 million of loans held for sale and sold $179.6 million and $72.9 million of held for sale loans, respectively. Given our increased experience providing these loans, we are currently evaluating long-term financing alternatives for these short-term, interest-only loans, and may elect to retain these loans in the future to be more consistent with our investment strategy of holding loans in our portfolio and earning a longer-term spread. As of December 31, 2019, our portfolio of loans held for sale, which were carried at the lower of cost or estimated fair value consisted of 733 loans with an aggregate UPB of $216.1 million, and carried a weighted average original loan term of 17.7 months, a weighted average coupon of 10.0%, and a weighted average LTV at origination of 68.6%. The following tables show the various components of loans held for sale as of the dates indicated: Concentrations - Loans Held for Sale As of December 31, 2019, our held for sale loan portfolio was entirely concentrated in investor 1-4 loans, representing 100.0% of the UPB. By geography, the principal balance of our loans held for sale were concentrated 25.2% in California, 11.5% in New York, 9.1% in Florida, 8.2% in New Jersey, and 5.2% in Massachusetts. (1) All other states individually comprise less than 5.0% of the total UPB. Real Estate Owned (REO) REO includes real estate we acquire through foreclosure or by deed-in-lieu of foreclosure. REO assets are initially recorded at fair value, less estimated costs to sell, on the date of foreclosure. Adjustments that reduce the carrying value of the loan to the fair value of the real estate at the time of foreclosure are recognized as charge-offs in the allowance for loan losses. Positive adjustments at the time of foreclosure are recognized in other operating income. After foreclosure, we periodically obtain new valuations and any subsequent changes to fair value, less estimated costs to sell, are reflected as valuation adjustments. As of December 31, 2019, our REO included 24 properties with an estimated fair value of $13.1 million compared to 12 properties with an estimated fair value of $7.2 million as of December 31, 2018. Key Performance Metrics Average Loans Average loans reflects the daily average of total outstanding loans, including both loans held for investment and loans held for sale, as measured by UPB, over the specified time period. Portfolio Yield Portfolio yield is an annualized measure of the total interest income earned on our loan portfolio as a percentage of average loans over the given period. Interest income includes interest earned on performing loans, cash interest received on nonperforming loans, default interest and prepayment fees. The increase in our portfolio yield over the periods shown was driven by higher collections of contractual and default interest on nonperforming loans due to the efficiency and expertise of our asset management area, and, to a lesser extent, an increase in the weighted average coupon on the loans in our portfolio. Average Debt - Portfolio Related and Total Company Portfolio-related debt consists of borrowings related directly to financing our loan portfolio, which includes our warehouse repurchase facilities and securitizations. Total company debt consists of portfolio- related debt and corporate debt. The measures presented here reflects the monthly average of all portfolio- related and total company debt, as measured by outstanding principal balance, over the specified time period. Cost of Funds - Portfolio Related and Total Company Portfolio related cost of funds is an annualized measure of the interest expense incurred on our portfolio-related debt as a percentage of average portfolio-related debt outstanding over the given period. Total company cost of funds is an annualized measure of the interest expense incurred on our portfolio-related debt and corporate debt outstanding over the given period. Interest expense includes the amortization of expenses incurred in connection with our portfolio related financing activities and corporate debt. Through the issuance of long-term securitizations, we have been able to fix a significant portion of our borrowing costs over time. The strong credit performance on our securitizations has allowed us to issue debt at attractive rates. Our portfolio related cost of funds increased to 5.23% for the year ended December 31, 2019 from 5.07% and 4.93% for the years ended December 31, 2018 and 2017, respectively. The increase in portfolio related cost of funds was the result of the seasoning of older, more costly securitizations, and to a lesser extent, the increasing LIBOR index rates, partially offset by lower spreads paid to investors in our more recent securitizations. As we have continued to add more of the lower-cost securitizations, our interest cost has started to decrease, averaging 5.00% for the fourth quarter of 2019. Net Interest Margin - Portfolio Related and Total Company Portfolio related net interest margin measures the difference between the interest income earned on our loan portfolio and the interest expense paid on our portfolio-related debt as a percentage of average loans over the specified time period. Total company net interest margin measures the difference between the interest income earned on our loan portfolio and the interest expense paid on our portfolio-related debt and corporate debt as a percentage of average loans over the specified time period. Over the periods shown, our portfolio related net interest margin decreased as a result of the seasoning of older, more costly securitizations and, to a lesser extent, the increasing LIBOR index rates, partially offset by higher portfolio yields and lower spreads paid to investors in our more recent securitizations. In addition to achieving lower spreads in our more recent securitizations, we have also been able to utilize more favorable structures that will result in a lower and more stable cost of funds over the life of the securities. The following tables show the average outstanding balance of our loan portfolio and portfolio-related debt, together with interest income and the corresponding yield earned on our portfolio, and interest expense and the corresponding rate paid on our portfolio-related debt for the periods indicated: (1) Net interest spread - portfolio related is the difference between the rate earned on our loan portfolio and the interest rates paid on our portfolio-related debt. (2) Net interest spread - total company is the difference between the rate earned on our loan portfolio and the interest rates paid on our total debt. Charge-Offs The charge-offs ratio reflects charge-offs as a percentage of average loans held for investment over the specified time period. We do not record charge-offs on our loans held for sale which are carried at the lower of cost or estimated fair value. Pre-Tax Return on Equity and Return on Equity Pre-tax return on equity and return on equity reflect income before income taxes and net income, respectively, as a percentage of the monthly average of members’ equity over the specified time period. The Company was not subject to income tax prior to January 1, 2018 because prior to that time it elected to be treated as a partnership for U.S. federal income tax purposes. Components of Results of Operations Interest Income We accrue interest on the UPB of our loans in accordance with the individual terms and conditions of each loan, discontinuing interest and reversing previously accrued interest once a loan becomes 90 days or more past due (nonaccrual status). When a loan is placed on nonaccrual status, the accrued and unpaid interest is reversed as a reduction to interest income and accrued interest receivable. Interest income is subsequently recognized only to the extent that cash payments are received or when the loan has returned to accrual status. Payments received on nonaccrual loans are first applied to interest due, then principal. Interest accrual resumes once a borrower has made all principal and interest payments due, bringing the loan back to current status. Interest income on loans held for investment is comprised of interest income on loans and prepayment fees less the amortization of deferred net costs related to the origination of loans. Interest income on loans held for sale is comprised of interest income earned on loans prior to their sale. The net fees and costs associated with loans held for sale are deferred as part of the carrying value of the loan and recognized as a gain or loss on the sale of the loan. Interest Expense - Portfolio Related Portfolio related interest expense is incurred on the debt we incur to fund our loan origination and portfolio activities and consists of our warehouse repurchase facilities and securitizations. Portfolio related interest expense also includes the amortization of expenses incurred as a result of issuing the debt, which are amortized using the level yield method. Key drivers of interest expense include the debt amounts outstanding, interest rates, and the mix of our securitizations and warehouse liabilities. Net Interest Income - Portfolio Related Portfolio related net interest income represents the difference between interest income and portfolio related interest expense. Interest Expense - Corporate Debt Through December 31, 2019, interest expense on corporate debt primarily consists of interest expense paid with respect to the 2014 Senior Secured Notes and the 2019 Term Loans, as reflected on our consolidated statement of financial condition, and the related amortization of deferred debt issuance costs. In August 2019, we redeemed the 2014 Senior Secured Notes and repurchased our outstanding Class C preferred units with the proceeds of the 2019 Term Loans, which bear interest at a rate equal to the one-month LIBOR plus 7.50% and mature in August 2024, together with cash on hand. We used $75.7 million of the net proceeds from our IPO to repay $75.0 million in outstanding principal amount on the 2019 Term Loans. Net Interest Income Net interest income represents the difference between portfolio related net interest income and interest expense on corporate debt. Provision for Loan Losses Provision for loan losses consists of amounts charged to income during the period to maintain an estimated allowance for loan and lease losses, or ALLL, to provide for probable credit losses inherent in our existing portfolio of loans held for investment (excluding those loans which we have elected to carry at fair value). The ALLL consists of a specific valuation allowance on those loans that are 90 days or more delinquent, in bankruptcy, or in foreclosure, and a general reserve allowance for all other loans in our existing portfolio. Other Operating Income Gain on Disposition of Loans. When we sell a loan held for sale, we record a gain or loss that reflects the difference between the proceeds received for the sale of the loans and their respective carrying values. The gain or loss that we ultimately realize on the sale of our loans held for sale is primarily determined by the terms of the originated loans, current market interest rates and the sales price of the loans. In addition, when we transfer a loan to REO, we record the REO at its fair value at the time of the transfer. The difference between the fair value of the real estate and the carrying value of the loan is recorded as a gain or loss. Lastly, when our acquired loans, which were purchased at a discount, pay off, we record a gain related the write-off of the remaining purchase discount. Unrealized Gain/(Loss) on Fair Value Loans. We have elected to account for certain purchased distressed loans at fair value using FASB ASC Topic 825, Financial Instruments (ASC 825). We regularly estimate the fair value of these loans as discussed more fully in the notes to our consolidated financial statements included elsewhere in this prospectus. Changes in fair value are reported as a component of other operating income within our consolidated statements of operations. Other Income. Other income includes the following: Unrealized Gains/(Losses) on Retained Interest Only Securities. As part of the proceeds received for the sale of our held for sale loans, we may receive an interest only security that we mark to fair value at the end of each period. Fee Income. In certain situations, we collect fee income by originating loans and realizing miscellaneous fees such as late fees. Operating Expenses Compensation and Employee Benefits. Costs related to employee compensation, commissions and related employee benefits, such as health, retirement, and payroll taxes. Rent and Occupancy. Costs related to occupying our locations, including rent, maintenance and property taxes. Loan Servicing. Costs related to our third-party servicers. Professional Fees. Costs related to professional services, such as external audits, legal fees, tax, compliance and outside consultants. Real Estate Owned, Net. Costs related to our real estate owned, net, including gains/(losses) on disposition of REO, maintenance of REO properties, and taxes and insurance. Other Operating Expenses. Other operating expenses consist of general and administrative costs such as, travel and entertainment, marketing, data processing, insurance and office equipment. Provision for Income Taxes The provision for income taxes consists of the current and deferred U.S. federal and state income taxes we expect to pay, currently and in future years, with respect to the net income for the year. The amount of the provision is derived by adjusting our reported net income with various permanent differences. The tax- adjusted net income amount is then multiplied by the applicable federal and state income tax rates to arrive at the provision for income taxes. Prior to January 1, 2018, we had elected to be treated as a partnership for U.S. federal income tax purposes and were, therefore, not required to pay income taxes because of our treatment as a pass-through entity. Effective January 1, 2018, we changed our election to be taxed as a corporation for U.S. federal income tax purposes and are now recording provisions for income taxes. Consolidated Results of Operations The following table summarizes our consolidated results of operations for the periods indicated: Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Our earnings increase is mainly attributable to significant growth in our loan originations of 37.4% and the corresponding income earned from a higher balance of loans under management. Net interest income increased 20.9% partially offset by an increase in operating costs of 9.2%. Our net income increased 126.6% from $7.6 million for the year ended December 31, 2018 to $17.3 million for the year ended December 31, 2019. Net Interest Income - Portfolio Related Interest Income. Interest income increased by $32.8 million, or 26.3%, to $157.5 million during the year ended December 31, 2019, compared to $124.7 million during the year ended December 31, 2018. The increase is primarily attributable to an increase in average loans (volume), which increased $352.7 million, or 24.7%, from $1.4 billion for the year ended December 31, 2018 to $1.8 billion for the year ended December 31, 2019. The average yield (rate) over those same periods increased from 8.72% to 8.84%. The following table distinguishes between the change in interest income attributable to change in volume and the change in interest income attributable to change in rate. The effect of changes in volume is determined by multiplying the change in volume (i.e., $352.7 million) by the previous period’s average rate (i.e., 8.72%). Similarly, the effect of rate changes is calculated by multiplying the change in average rate (i.e., 0.12%) by the current period’s volume (i.e., $1.8 billion). Interest Expense - Portfolio Related. Interest expense related to our warehouse repurchase facilities increased $4.4 million to approximately $13.6 million during the year ended December 31, 2019, compared to approximately $9.2 million during the year ended December 31, 2018. Interest expense related to our securitizations increased by $16.9 million to approximately $70.3 million during the year ended December 31, 2019, compared to approximately $53.4 million during the year ended December 31, 2018. Our cost of funds increased to 5.23% during the year ended December 31, 2019 from 5.07% during the year ended December 31, 2018. The increase in interest expense - portfolio related was primarily due to the increase in borrowings for loan originations, as well as the impact of increased seasoning of older securitizations. As we have continued to add more of the lower-cost securitizations, our interest cost has started to decrease, averaging 5.00% for the fourth quarter of 2019. The following table presents information regarding the increase in portfolio related interest expense and distinguishes between the dollar amount of change in interest expense attributable to changes in the average outstanding debt balance (volume) versus changes in cost of funds (rate). (1)Includes securitizations and warehouse repurchase agreements. Net Interest Income After Provision for Loan Losses Interest Expense - Corporate Debt. Corporate debt interest expense increased by $1.3 million from $13.3 million for the year ended December 31, 2018 to $14.6 million for the year ended December 31, 2019 primarily due to the increase in the corporate debt balance. In August 2019, we refinanced the 2014 Senior Secured Notes with a portion of the net proceeds from the 2019 Term Loans - a five-year $153.0 million corporate debt agreement with a new lender. The corporate debt balance was $153.0 million as of December 31, 2019 compared to $127.6 million as of December 31, 2018. Provision for Loan Losses. Our provision for loan losses increased by $0.9 million from $0.2 million during the year ended December 31, 2018 to $1.1 million during the year ended December 31, 2019 primarily due to the increase in the loan portfolio. Other Operating Income The table below presents the various components of other operating income for the year ended December 31, 2019 compared to the year ended December 31, 2018. The $0.2 million net decrease is primarily due to the increase in gain on disposition of loans, offset by the valuation adjustments on interest-only strips included within other (expense) income. Operating Expenses Total operating expenses increased by $3.0 million, or 9.2%, to $35.1 million during the year ended December 31, 2019 from $32.2 million during the year ended December 31, 2018. This increase is primarily the result of loan servicing costs associated with higher loan origination volumes and the increase in REO expense. Compensation and Employee Benefits. Compensation and employee benefits increased from $15.1 million during the year ended December 31, 2018 to $15.5 million during year ended December 31, 2019, mainly due to higher commission expenses and increased operations and sales staff to support our growth in loan origination volume. Rent and Occupancy. Rent and occupancy expenses increased from $1.3 million during the year ended December 31, 2018 to $1.5 million during the year ended December 31, 2019, due to the increase in office space. Loan Servicing. Loan servicing expenses increased from $6.0 million during the year ended December 31, 2018 to $7.4 million during the year ended December 31, 2019. The $1.4 million increase during the year ended December 31, 2019 is mainly due to the increase in our loan portfolio. Professional Fees. Professional fees decreased from $3.0 million for the year ended December 31, 2018 to $2.1 million for the year ended December 31, 2019, mainly due to the timing of legal and external audit services rendered related to our public offering initiative. Net Expenses of Real Estate Owned. Net expenses of real estate owned increased from $1.3 million during the year ended December 31, 2018 to $2.6 million during the year ended December 31, 2019, mainly due to the increase in valuation adjustment expense during the year ended December 31, 2019. Other Operating Expenses. Other operating expenses increased from $5.3 million for the year ended December 31, 2018 to $6.0 million for the year ended December 31, 2019, mainly due to increased data processing costs related to technology investments. Income Tax Expense. Income tax expense was $8.1 million for the year ended December 31, 2019, compared to $11.6 million for the year ended December 31, 2018. Our consolidated effective tax rate as a percentage of pre-tax income for 2019 was 31.9%, compared to 60.4% for 2018. The 2019 effective tax rate differed from the federal statutory rate of 21.0% principally because of state taxes. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Our income before income taxes increased 37.6% from $14.0 million for the year ended December 31, 2017 to $19.2 million for the year ended December 31, 2018. Our strong earnings growth is mainly attributable to significant growth in our loan originations and a slight increase in our net interest margin. Net interest margin expansion was attributable to an increase in portfolio yield, partially offset by increasing portfolio related cost of funds. Net Interest Income - Portfolio Related Interest Income. Interest income increased by $26.9 million, or 27.5%, to $124.7 million during the year ended December 31, 2018, compared to $97.8 million during the year ended December 31, 2017. The increase is attributable to a combination of an increase in average loans (volume) and an increase in average yield (rate). Average loans increased $261.9 million, or 22.4%, from $1.2 billion during the year ended December 31, 2017 to $1.4 billion during the year ended December 31, 2018. The average yield over those same periods increased from 8.38% to 8.72%. The following table distinguishes between the change in interest income attributable to change in volume and the change in interest income attributable to change in rate. The effect of changes in volume is determined by multiplying the change in volume (i.e., $261.9 million) by the previous period’s average rate (i.e., 8.38%). Similarly, the effect of rate changes is calculated by multiplying the change in average rate (i.e., 0.34%) by the current period’s volume (i.e., $1.4 billion). Interest Expense - Portfolio Related. Interest expense related to our warehouse repurchase facilities increased $2.0 million, or 28.2%, to approximately $9.2 million during the year ended December 31, 2018, compared to approximately $7.2 million during the year ended December 31, 2017. Interest expense related to our securitizations increased by $12.9 million to approximately $53.4 million during the year ended December 31, 2018, compared to approximately $40.5 million during the year ended December 31, 2017. The increase in interest expense - portfolio related was primarily due to the increase in borrowings for loan originations. Our average cost of funds increased slightly to 5.07% during the year ended December 31, 2018 from 4.93% during the year ended December 31, 2017. The following table presents information regarding the increase in portfolio related interest expense and distinguishes between the dollar amount of change in interest expense attributable to changes in the average outstanding debt balance (volume) versus changes in cost of funds (rate). (1) Includes securitizations and warehouse repurchase agreements. Net Interest Income After Provision for Loan Losses Interest Expense - Corporate Debt. Under the 2014 Senior Secured Notes, interest paid-in-kind accrues at an 11.0% interest rate and interest paid in cash accrues at a 10.0% interest rate. During the first half of 2017, the interest due on the 2014 Senior Secured Notes was paid-in-kind. During the second half of 2017, and during the year ended 2018, the interest due was paid in cash. The change in interest payments resulted in a 2.4% decrease in corporate debt interest expense from $13.7 million during the year ended December 31, 2017 to $13.3 million during the year ended December 31, 2018. We used $75.7 million of the net proceeds from our IPO to reduce interest expense through the repayment of $75.0 million in outstanding principal amount on the 2019 Term Loans, which refinanced the 2014 Senior Secured Notes in August 2019. Provision for Loan Losses. Our provision for loan losses decreased $0.2 million from $0.4 million during the year ended December 31, 2017 to $0.2 million during the year ended December 31, 2018 as a result of an improvement in incurred losses, as the Company experienced fewer losses in 2018. Other Operating Income The table below presents the various components of other operating income for the year ended December 31, 2018 compared to the year ended December 31, 2017. The $0.8 million increase is primarily the result of the increased gain on sale of loans. Operating Expenses Total operating expenses increased $8.0 million, or 33.2%, to $32.2 million during the year ended December 31, 2018 from $24.1 million during the year ended December 31, 2017. This increase is primarily the result of additional personnel and loan servicing costs associated with higher loan origination volumes. Compensation and Employee Benefits. Compensation and employee benefits increased from $11.9 million during the year ended December 31, 2017 to $15.1 million during the year ended December 31, 2018 mainly due to higher commission expenses and increased operations and sales staff to support our growth in loan origination volume. Rent and Occupancy. Rent and occupancy expenses increased from $1.1 million during the year ended December 31, 2017 to $1.3 million during the year ended December 31, 2018 due to the opening of two new sales offices. Loan Servicing. Loan servicing expenses increased from $4.9 million during the year ended December 31, 2017 to $6.0 million during the year ended December 31, 2018. The $1.1 million increase during 2018 is primarily related to the increase in our loan portfolio. Professional Fees. Professional fees increased from $1.7 million for the year ended December 31, 2017 to $3.0 million for the year ended December 31, 2018 mainly due to increased legal and external audit fees related to our public offering initiative. Net Expenses of Real Estate Owned. Net expenses of real estate owned increased from $0.6 million during the year ended December 31, 2017 to $1.4 million during the year ended December 31, 2018, mainly as a result of a $0.7 million increase in REO valuation adjustments. Other Operating Expenses. Other operating expenses increased from $3.9 million for the year ended December 31, 2017 to $5.3 million for the year ended December 31, 2018 mainly due to increased data processing costs related to technology investments. Income Tax Expense. Income tax expense was $11.6 million, and our consolidated effective tax rate was 60.4% for the year ended December 31, 2018. The Company elected to be treated as a corporation for U.S. federal and state income tax purposes effective January 1, 2018. Prior to January 1, 2018, the Company was a limited liability company and it was not subject to U.S. federal and state income tax. Liquidity and Capital Resources Sources and Uses of Liquidity We fund our lending activities primarily through borrowings under our warehouse repurchase facilities, securitizations, members’ equity and other corporate-level debt, equity and debt securities, and net cash provided by operating activities to manage our business. We use cash to originate and acquire investor real estate loans, repay principal and interest on our borrowings, fund our operations and meet other general business needs. As a result of the spread of the COVID-19, economic uncertainties have arisen which are likely to negatively impact our financial condition, results of operations and cash flows. We have recently executed a number of business initiatives to strengthen our liquidity and capital resources position in light of the impact of COVID-19. As part of these initiatives, on April 6, 2020, we entered into amendments to our warehouse repurchase agreements and issued and sold $45.0 million in gross proceeds of Preferred Stock and Warrants. See below under “-Warehouse Repurchase Facilities” and “-April 2020 Preferred Stock and Warrants.” Cash and Cash Equivalents As of December 31, 2019, we had liquidity of approximately $26.4 million in cash and eligible collateral borrowings under our warehouse facilities. Cash comprised $21.5 million of our liquidity and eligible collateral borrowings under our warehouse facilities comprised $4.9 million of our liquidity. As of December 31, 2019, we had $80.3 million of uncommitted available capacity under our warehouse facilities. As of December 31, 2018, we had liquidity of approximately $60.0 million in cash and eligible collateral borrowings under our warehouse facilities. Cash comprised $15.0 million of our liquidity and eligible collateral borrowings under our warehouse facilities comprised $45.0 million of our liquidity. As of December 31, 2018, we had $283.3 million of uncommitted available capacity under our warehouse facilities. During the year ended December 31, 2019, we generated approximately $10.9 million of net cash and cash equivalents from operations, investing and financing activities. During the year ended December 31, 2018, we generated approximately $1.0 million of net cash and cash equivalents from operations, investing and financing activities. Warehouse Repurchase Facilities As of December 31, 2019, we had two warehouse repurchase agreements to support our loan origination and acquisition activities. Both agreements are short-term borrowing facilities. The borrowings are collateralized by pools of primarily performing loans, bearing interest at one-month LIBOR plus a margin that ranges from 2.75% to 3.00%. As of December 31, 2019, these two agreements had an aggregated maximum borrowing capacity of $450.0 million, of which $200.0 million were committed amounts and $250.0 million were uncommitted amounts. The maximum capacity increased from $450.0 million to $500.0 million effective March 11, 2020. Borrowings under these repurchase facilities as of December 31, 2019 were $417.2 million. As of December 31, 2018, we had two warehouse repurchase agreements to support our loan origination and acquisition activities. Both agreements are short-term borrowing facilities. The borrowings are collateralized by pools of primarily performing loans, bearing interest at one-month LIBOR plus a margin that ranges from 2.75% to 3.00%. As of December 31, 2018, these two agreements had an aggregated maximum borrowing capacity of $450.0 million, of which $200.0 million were committed amounts and $250.0 million were uncommitted amounts. Borrowings under these repurchase facilities as of December 31, 2018 were $216.4 million. In addition to the two warehouse repurchase agreements, we also have a longer term warehouse agreement, which was added in September 2018. The borrowings are collateralized by pools of primarily performing loans, with a maximum borrowing capacity of $50 million, bearing interest at one-month LIBOR plus a margin of 3.50%. The warehouse repurchase facility has a maturity date of September 12, 2021 and allows loans to be financed for a period of up to three years. Borrowings under this warehouse agreement as of December 31, 2019 were $2.5 million. All warehouse repurchase facilities fund less than 100% of the principal balance of the mortgage loans we own requiring us to use working capital to fund the remaining portion. We may need to use additional working capital if loans become delinquent, because the amount permitted to be financed by the facilities may change based on the delinquency performance of the pledged collateral. All borrower payments on loans financed under the warehouse agreements are segregated into pledged accounts with the loan servicer. All principal amounts in excess of the interest due are applied to reduce the outstanding borrowings under the warehouse repurchase facilities, which then allows us to draw additional funds on a revolving basis under the facilities. The revolving warehouse repurchase facilities also contain customary covenants, including financial covenants that require us to maintain a minimum net worth, a maximum debt-to- net worth ratio and a ratio of a minimum earnings before interest, taxes, depreciation and amortization to interest expense. If we fail to meet any of the covenants or otherwise default under the facilities, the lenders have the right to terminate their facility and require immediate repayment, which may require us to sell our loans at less than optimal terms. As of December 31, 2019, we were in compliance with these covenants. In response to the dislocations in the markets related to the COVID-19 pandemic and its unknown future impact on the value of our financed collateral, on April 6, 2020, we entered into amendments to the master repurchase agreements on both of our warehouse repurchase agreements with the lenders under such agreements. We believe that the amended warehouse repurchase agreements provide us with a flexible and more stabilized financing solution that will allow us to better operate our business under the current market conditions. Pursuant to the terms of the warehouse repurchase amendments, (i) we must maintain unrestricted cash and cash equivalents of at least $7.5 million, (ii) we were required to make aggregate payments of $20.0 million to reduce our obligations under the warehouse repurchase agreements on April 6, 2020, and (iii) we must ensure that payments of at least $3.0 million per month are made to each lender, from the cash flow of the underlying financed loans and/or corporate cash each month from April 6 through August 3, 2020, in reduction of its obligations thereunder. In addition, the interest rate under each warehouse repurchase facility was increased by 25 basis points, effective as of April 6, 2020. Securitizations From May 2011 through October 2019, we have completed twelve securitizations of $2.7 billion of investor real estate loans, issuing $2.5 billion in principal amount of securities to third parties through twelve respective transactions. In February 2020, we completed our thirteenth securitization issuing $248.7million in principal amount of securities for $261.9 million of mortgage loans. All borrower payments are segregated into remittance accounts at the primary servicer and remitted to the trustee of each trust monthly. We are the sole beneficial interest holder of the applicable trusts, which are variable interest entities included in our consolidated financial statements. The transactions are accounted for as a secured borrowings under U.S. GAAP. Table summarizing the investor real estate loans securitized, securities issued, securities retained by the Company at the time of the securitization, and as of December 31, 2019 and 2018, the stated maturity for each securitization, the outstanding bond balances, and the weighted average on the securities for the Trusts as of December 31, 2019 and 2018, are included in Item 15. Exhibits, Financial Statement Schedules. The securities are callable by us when the stated principal balance is less than a certain percentage, ranging from 5%-30%, of the original stated principal balance of loans at issuance. As a result, the actual maturity date of the securities issued will likely be earlier than their respective stated maturity date. Our intent is to use the proceeds from the issuance of new securities primarily to repay our warehouse borrowings and originate new investor real estate loans in accordance with our underwriting guidelines, as well as for general corporate purposes. Our financing sources may include borrowings in the form of additional bank credit facilities (including term loans and revolving credit facilities), repurchase agreements, warehouse repurchase facilities and other sources of private financing. We also plan to continue using securitization as long-term financing for our portfolio, and we do not plan to structure any securitizations as sales or utilize off-balance-sheet vehicles. We believe any financing of assets and/or securitizations we may undertake will be sufficient to fund our working capital requirements. Cash Flows The following table summarizes the net cash provided by (used in) operating activities, investing activities and financing activities as of the periods indicated: Operating Activities Cash flows from operating activities primarily includes net income adjusted for (1) cash used for origination of held for sale loans and the related cash proceeds from the sales of such loans, (2) non-cash items including depreciation, provision for loan loss, discount accretion, and valuation changes, and (3) changes in the balances of operating assets and liabilities. For the year ended December 31, 2019, our net cash used in operating activities of $105.3 million consisted mainly of $336.9 million cash used to originate held for sale loans, offset by $179.6 million proceeds from sale of loans held for sale, $25.1 million in repayments on loans held for sale, and net income of $17.3 million. For the year ended December 31, 2018, our net cash used in operating activities of $72.5 million consisted mainly of net income of $7.6 million, offset by $148.8 million in cash used to originate held for sale loans, less proceeds from the sale and repayments of loans held for sale of $72.9 million and $3.5 million, respectively. Changes in operating assets and liabilities resulted in cash used of $18.9 million, mainly as a result of a $16.2 million increase in interest receivable due to portfolio growth. For the year ended December 31, 2017, our net cash provided by operating activities of $37.6 million consisted mainly of net income of $14.0 million, offset by $42.9 million in cash used to originate held for sale loans, less proceeds from the sale of such loans of $46.3 million. Changes in operating assets and liabilities resulted in cash provided of $4.8 million. Interest paid in kind on our corporate debt resulted in a positive non-cash adjustment to net income of $6.7 million. Investing Activities For the year ended December 31, 2019, our net cash used in investing activities of $305.9 million consisted mainly of $682.9 million in cash used to originate held for investment loans, offset by $379.3 million in cash received in payments on held for investment loans. We also used cash to purchase $9.3 million of loans for investment. We also received cash of $4.5 million from proceeds of the sale of REO. For the year ended December 31, 2018, our net cash used in investing activities of $270.2 million consisted mainly of $595.7 million in cash used to originate held for investment loans, less $334.7 million in cash received in payments on held for investment loans. We also received cash of $6.2 million from proceeds of the sale of REO. For the year ended December 31, 2017, our net cash used in investing activities of $274.8 million consisted mainly of $518.9 million in cash used to originate held for investment loans, less $240.9 million in cash received in payments on held for investment loans. We also received cash of $6.3 million from proceeds of the sale of loans and $2.5 million from proceeds on the sale of REO. Financing Activities For the year ended December 31, 2019, our net cash provided by financing activities of $422.1 million consisted mainly of $961.7 million and $608.1 million in cash from borrowings from our warehouse repurchase facilities and securitizations issued, respectively. This cash generated was partially offset by payments we made of $756.0 million and $371.4 million on our warehouse repurchase facilities and securitizations issued, respectively. The 2019 Term Loans generated $153.0 million of cash, of which $127.6 million was used to redeem the 2014 Secured Notes, and $27.7 million was used to repurchase the Class C preferred units as return of capital. We used cash of $17.9 million for debt issuance costs. For the year ended December 31, 2018, our net cash provided by financing activities of $343.6 million consisted mainly of $658.5 million and $535.5 million in cash from borrowings from our warehouse repurchase facilities and securitizations issued, respectively. This cash generated was partially offset by payments we made of $527.9 million and $314.7 million on our warehouse repurchase facilities and securitizations issued, respectively. We used cash of $7.8 million for debt issuance costs. For the year ended December 31, 2017, our net cash provided by financing activities of $201.1 million consisted mainly of $420.5 million and $455.3 million in cash from borrowings from our warehouse repurchase facilities and securitizations issued, respectively. This cash generated was partially offset by payments we made of $445.7 million and $214.4 million on our warehouse repurchase facilities and securitizations issued, respectively. We used cash of $7.8 million for debt issuance costs and $6.9 million for tax distributions. April 2020 Preferred Stocks and Warrants On April 5, 2020, we sold 45,000 shares of Preferred Stock and Warrants to purchase 3,013,125 shares of our common stock in a private placement to two of our largest stockholders. These offerings resulted in aggregate gross proceeds of $45.0 million, before expenses payable by us of approximately $1.0 million. The proceeds will be used for general corporate purposes and to strengthen our liquidity position during this current economic crisis. Beginning on October 5, 2022, but in no event later than November 28, 2024, each holder of Preferred Stock has the option to cause us to repurchase all or a portion of such holder’s shares of Preferred Stock, for an amount in cash equal to the liquidation preference of each share repurchased. The Preferred Stock has a liquidation preference equal to the greater of (i) $2,000 per share from April 5, 2020 through October 5, 2022, which amount increases ratably to $3,000 per share between October 6, 2022 and November 28, 2024 and to $3,000 per share from and after November 28, 2024 and (ii) the amount such Preferred Stock holder would have received if the Preferred Stock had converted into common stock immediately prior to such liquidation. We also have an obligation to repurchase the Preferred Stock for cash at a price per share equal to the liquidation preference in the event of a change of control (as defined in the certificate of designation governing the Preferred Stock). The Warrants are exercisable at the warrantholder’s option at any time and from time to time, in whole or in part, until April 5, 2025 at an exercise price of $2.96 per share of common stock with respect to 2,008,750 of the Warrants, and at an exercise price of $4.94 per share of common stock with respect to 1,004,374 of the Warrants. For more information about the Preferred Stock and the Warrants, see “Note 24 - Subsequent Events” in the footnotes to the consolidated financial statements included in this Annual Report. Contractual Obligations and Commitments In 2014, we entered into a five-year, $100.0 million corporate debt agreement with the owners of the Class C preferred units, pursuant to which we issued at par senior secured notes that mature on December 16, 2019, the 2014 Senior Secured Notes. The 2014 Senior Secured Notes bear interest at either 10% annually paid in cash or 11% annually paid-in-kind on June 15 and December 15 of each year. All principal and paid-in-kind interests are due at maturity. In August 2019, we entered into a five-year $153.0 million corporate debt agreement with Owl Rock Capital Corporation. The 2019 Term Loans under this agreement bear interest a rate equal to one-month LIBOR plus 7.50% and mature in August 2024. A portion of the net proceeds from the 2019 Term Loans was used to redeem the 2014 Senior Secured Notes. As of December 31, 2019, 2018, and 2017, including paid-in-kind interest, the aggregate outstanding principal amount of the 2014 Senior Secured Notes was zero, $127.6 million and$127.6 million, respectively. As of December 31, 2019, the outstanding principal amount of the 2019 Term Notes was $153.0 million. Another portion of the net proceeds from the 2019 Term Loans, together with cash on hand, was used to repurchase our outstanding Class C preferred units. The 2019 Term Loans mature in August 2024 and are subject to a 0.25% quarterly amortization beginning on the fifth full fiscal quarter after August 2019. Velocity Commercial Capital, LLC is the borrower of the 2019 Term Loans, which are secured by substantially all of the borrower’s non-warehoused assets, with a guarantee from Velocity Financial, Inc., formerly Velocity Financial LLC, that is secured by the equity interests of the borrower. The corporate debt agreement contains customary affirmative and negative covenants, including financial maintenance covenants and limitations on dividends by the borrower. As of December 31, 2019, we maintained warehouse and repurchase facilities to finance our investor real estate loans and had approximately $417.2 million in outstanding borrowings with $80.3 million of available capacity under our warehouse and repurchase facilities. The following table illustrates our contractual obligations existing as of December 31, 2019: (1) Amount represents gross warehouse and repurchase borrowing. Balance of $421.5 million in the consolidated statement of financial condition as of December 31, 2019 is net of $1.1 million debt issuance costs. In August 2019, the Citibank Repurchase Agreement was amended to be due in August 2020. In October 2019, the Barclays Repurchase Agreement was amended to be due in October 2020. In April 2020, the Barclays Repurchase Agreement was further amended to be due August 2020. (2) In August 2019, we entered into a five-year $153.0 million corporate debt agreement and a portion of the proceeds of the 2019 Term Loans under this agreement were used to redeem the then outstanding corporate debt. The 2019 Term Loans mature in August 2024 and are subject to a 0.25% quarterly amortization beginning on the fifth full fiscal quarter after August 2019. In January 2020, we repaid $75.0 million of our existing corporate debt with a portion of the net proceeds from our IPO. Off-Balance-Sheet Arrangements At no time have we maintained any relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance, or special-purpose or variable interest entities, established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. Further, we have never guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities. New Accounting Standards In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments, which significantly changes the way entities recognize credit losses and impairment of financial assets recorded at amortized cost. Currently, the credit loss and impairment model for loans and leases is based on incurred losses, and investments are recognized as impaired when there is no longer an assumption that future cash flows will be collected in full under the originally contracted terms. Under the new current expected credit loss (“CECL”) model, the standard requires immediate recognition of estimated credit losses expected to occur over the remaining life of the asset. This standard also expands the disclosure requirements regarding an entity’s assumptions, models and methods for estimating the allowance for loan and lease losses, and requires disclosure of the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination (i.e., by vintage year). ASU 2016-13 is effective for interim and annual periods in fiscal years beginning after December 15, 2019, with earlier adoption permitted. Entities are required to use a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted (modified-retrospective approach). The Company has developed a detailed implementation plan, selected a new software solution, reached accounting decisions on various matters, developed econometric models for our reasonable and supportable forecast period, selected key assumptions used in the model, and performed preliminary calculations. The Company continues to test and refine the CECL models, including its qualitative methodology to estimate losses that are not expected to be captured in the quantitative models. The Company is in the final stage of the independent third-party model validation. Based on multiple parallel testing performed using the Company’s portfolio data, we expect the impact from the adoption of this standard to be immaterial to the Company’s consolidated financial statements. In August 2018, the FASB issued ASU 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, which aligns the requirements for capitalizing implementation costs in a cloud computing arrangement service contract with the requirements for capitalizing implementation costs incurred for an internal-use software license. Specifically, if a cloud computing arrangement is deemed to be a service contract, certain implementation costs are eligible for capitalization. The new guidance prescribes the balance sheet and income statement presentation and cash flow classification for the capitalized costs and related amortization expense. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The Company adopted this standard on a prospective basis on January 1, 2020. The adoption of ASU 2018-15 did not have a material impact on the Company’s consolidated financial statements. In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework - Changes to Disclosure Requirements for Fair Value Measurements”, which modified the disclosure requirements in ASC Topic 820 to add disclosures regarding changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements and the narrative description of measurement uncertainty. Certain disclosure requirements in ASC Topic 820 are also removed or modified. Certain disclosures in ASU 2018-13 would need to be applied on a retrospective basis and others on a prospective basis and early adoption is permitted. The Company has early adopted those provisions of the standard that permitted the removal or modification of certain disclosures effective January 1, 2019 but deferred adoption of the additional new disclosures until January 1, 2020. The adoption of this standard will modify disclosures in 2020 but will not have an impact on the Company’s consolidated financial statements. In April 2019, the FASB issued ASU No. 2019-04, “Codification Improvements to Topic 326, Financial Instruments Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments,” which clarifies and improves areas of guidance related to the recently issued standards on credit losses (ASU 2016-13), hedging (ASU 2017-12), and recognition of financial instruments (ASU 2016-01). The amendments generally have the same effective dates as their related standards. Impacts from the adoption of 2019-04 have been considered in the Company's overall CECL implementation and will be adopted concurrent with the adoption of ASU 2016-13. ASU 2017-12 and ASU 2016-01 are not applicable to the Company and therefore had no impact on the Company’s consolidated financial statements.

<s>[INST] Business We are a vertically integrated real estate finance company founded in 2004. We primarily originate and manage investor loans secured by 14 unit residential rental and small commercial properties, which we refer to collectively as investor real estate loans. We originate loans nationwide across our extensive network of independent mortgage brokers which we have built and refined over the 15 years since our inception. Our objective is to be the preferred and one of the most recognized brands in our core market, particularly within our network of mortgage brokers. We operate in a large and highly fragmented market with substantial demand for financing and limited supply of institutional financing alternatives. We have developed the highlyspecialized skill set required to effectively compete in this market, which we believe has afforded us a durable business model capable of generating compelling riskadjusted returns for our stockholders throughout various business cycles. We offer competitive pricing to our borrowers by pursuing lowcost financing strategies and by driving front end process efficiencies through customized technology designed to control the cost of originating a loan. Furthermore, by originating loans through our efficient and scalable network of approved mortgage brokers, we are able to maintain a wide geographical presence and nimble operating infrastructure capable of reacting quickly to changing market environments. Our growth strategy is predicated on continuing to serve and build loyalty within our network of mortgage brokers, while also expanding our network with new mortgage brokers through targeted marketing, improved brand awareness, and the growth and development of our team of account executives. We believe our reputation and 15year history within our core market position us well to capture future growth opportunities. Our primary source of revenue is interest income earned on our loan portfolio. Our typical loan is secured by a first lien on the underlying property with a personal guarantee and, based on all loans in our portfolio as of December 31, 2019, has an average balance of approximately $323,000. As of December 31, 2019, our loan portfolio, including both loans held for investment and loans held for sale, totaled $2.1 billion of UPB on properties in 45 states and the District of Columbia. The total portfolio had a weighted average loantovalue ratio, or LTV at origination, of 65.8%, and was concentrated in 14 unit residential rental loans, which we refer to as investor 14 loans, representing 52.2% of the UPB. During the year ended December 31, 2019, the yield on our total portfolio was 8.84%. We fund our portfolio primarily through a combination of committed and uncommitted secured warehouse repurchase facilities, securitizations, corporate debt and equity. The securitization market is our primary source of longterm financing. We have successfully executed twelve securitizations, resulting in a total of over $2.5 billion in gross debt proceeds from May 2011 through October 2019. In January 2020, we repaid $75.0 million of our existing corporate debt with a portion of the net proceeds from our IPO. In February 2020, we completed the securitization of $261.9 million of investor real estate loans, measured by UPB as of the January 1, 2020 cutoff date, issuing $248.7million of nonrecourse notes payable through the Velocity Commercial Capital Loan Trust 20201, or 20201. We are the sole beneficial interest holder of 20201, a variable interest entity that will be included in our consolidated financial statements. We refer to this transaction as the “February 2020 Securitization.” One of our core profitably measurements is our portfolio related net interest margin, which measures the difference between interest income earned on our loan portfolio and interest expense paid on our portfoliorelated debt, relative to the amount of loans outstanding over the period. Our portfoliorelated debt consists of our warehouse repurchase facilities and securitizations and excludes our corporate debt. For the year ended December 31, 2019, our portfolio related net [/INST] Positive. </s>

Milestone Pharmaceuticals Inc.

2020-03-06

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 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 expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed in “Risk Factors” and in other parts of this Annual Report on Form 10-K. Overview We are a biopharmaceutical company focused on the development and commercialization of innovative cardiovascular medicines. Our lead product candidate etripamil is a novel, potent and short-acting calcium channel blocker that we designed as a rapid-onset nasal spray to be self-administered by patients. We are developing etripamil to treat paroxysmal supraventricular tachycardia, or PSVT, atrial fibrillation, and other cardiovascular indications. PSVT is a rapid heart rate condition characterized by episodes of supraventricular tachycardia, or SVT, that start and stop without warning. Episodes of SVT are often experienced by patients with symptoms including palpitations, sweating, chest pressure or pain, shortness of breath, sudden onset of fatigue, lightheadedness or dizziness, fainting and anxiety. Calcium channel blockers have long been approved for the treatment of PSVT as well as other cardiac conditions. Calcium channel blockers available in oral form are frequently used prophylactically to control the frequency and duration of future episodes of SVT. For treatment of episodes of SVT, approved calcium channel blockers are administered intravenously under medical supervision, usually in the emergency department. The combination of convenient nasal-spray delivery, rapid-onset and short duration of action of etripamil has the potential to shift the current treatment paradigm for episodes of SVT away from the burdensome and costly emergency department setting. If approved, we believe that etripamil will be the first self-administered therapy for the rapid termination of episodes of SVT wherever and whenever they occur. Our development program for etripamil for the treatment of PSVT consists of three Phase 3 clinical trials, one Phase 2 trial, and Phase 1 trials. We believe this clinical trial program, if successful, will be sufficient to support approval in the United States and the European Union. NODE-301 is our ongoing, placebo-controlled Phase 3 safety and efficacy trial, which is being conducted in North America. NODE-301 may serve as a single pivotal efficacy trial required for approval by the US Food and Drug Administration, or FDA. The trial is being conducted in two parts. NODE-301A will continue until the trial’s adjudication committee has evaluated data from the treatment of 150 SVT events with blinded study drug (etripamil or placebo). All pivotal efficacy analyses will be conducted on data from NODE-301A. NODE-301B will follow patients already enrolled in NODE-301 who did not take the study drug in NODE-301A. Data from NODE-301B will be analyzed as a pivotal safety and supportive efficacy data set, and will contribute to potentially valuable sub-population analyses and pharmaco-economic assessments. Following consultation with the FDA in 2019, we confirmed the two-part design, along with an increase in the sample size of NODE-301A from 100 to 150 adjudicated SVT events. The upsize of the trial satisfies a request from the European Medicines Agency, or EMA. NODE-302 is our ongoing Phase 3 open-label safety extension trial. Patients who complete NODE-301 may enroll in NODE-302 and receive up to an additional 11 doses of etripamil. We designed NODE-302 to evaluate the safety of etripamil when self-administered without medical supervision and to monitor the safety and efficacy of etripamil for the treatment of multiple episodes of SVT. All patients randomized in NODE-301 will be eligible for NODE-302. Patients who have successfully dosed with the study drug and completed a study closure visit will be eligible to enroll in NODE-302 to manage any subsequent episodes of SVT. Eligibility will also be contingent on satisfying all inclusion and exclusion criteria, including not experiencing a serious adverse event related to the study drug or the study procedure that precludes the self-administration of etripamil. We initiated NODE-302 in December 2018 and the trial is ongoing. Trial safety results will contribute to the etripamil safety database. NODE-303 is our ongoing Phase 3 open label safety trial, which is being conducted primarily in North America, Europe and Latin America. We designed NODE-303 to evaluate the safety of etripamil when self-administered without medical supervision, and to evaluate the treatment safety and efficacy of etripamil on multiple SVT episodes. The trial is designed to enroll up to 3,000 patients in order to collect data on approximately 1,000 patients taking etripamil in an at-home setting. A more accurate sizing of the trial will be determined once an overall size of the safety dataset is determined for NDA filing following future discussions with the FDA and other regulatory authorities. Based on a review of the NODE-301 safety data available in June 2019, the FDA and multiple European and Latin American regulatory authorities have agreed to allow patient enrollment in NODE-303 without an in-office safety test dose, which is a safeguard required in the NODE-301 trial, and in a broad patient population including patients taking concomitant beta-blockers and calcium channel blockers. We completed our Phase 2 clinical trial of etripamil for the treatment of PSVT in the United States and Canada, with results published in the Journal of the American College of Cardiology. Investigators reported an 87% termination rate of episodes of SVT within 15 minutes at the dose selected for our Phase 3 trials versus a 35% termination rate for placebo. We have also completed two Phase 1 clinical trials in healthy volunteers, characterizing the pharmacokinetics and pharmacodynamic effect of etripamil. As with PSVT, calcium channel blockers are also approved for use in intravenous form for the treatment of some episodes of atrial fibrillation in which patients experience rapid ventricular rates. We plan to initiate in 2020 a Phase 2 proof-of-concept clinical trial in a controlled setting to evaluate the potential effectiveness of etripamil to reduce ventricular rate in atrial fibrillation patients who present to the clinic with rapid ventricular rate. The trial will enroll approximately 50 patients, randomized to etripamil 70 mg versus placebo, with a primary endpoint of reduction in ventricular rate. As we generate more data on the safety and efficacy profile of etripamil in PSVT and atrial fibrillation with rapid ventricular rate, we will continue to assess whether etripamil could be developed to potentially fulfill other areas of unmet medical need. Since the commencement of our operations in 2003, we have devoted substantially all of our resources to performing research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities, providing general and administrative support for these operations and, more recently preparing for commercialization. We operate our business utilizing a significant outsourcing model. As such, our team is composed of a relatively smaller core of employees who direct a significantly larger number of team members who are outsourced in the forms of vendors and consultants to enable execution of our operational plans. We do not currently have any products approved for sale, and we continue to incur significant research and development and general administrative expenses related to our operations. Since inception, we have incurred significant operating losses. For the years ended December 31, 2019 and 2018, we recorded net losses of $53.7 million and $23.2 million, respectively. As of December 31, 2019, we had an accumulated deficit of $111.8 million. We expect to continue to incur significant losses for the foreseeable future. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on completing the necessary development activities required for obtaining regulatory approval and preparing for potential commercialization of our product candidates. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: · continue our ongoing and planned development of etripamil, including our Phase 3 clinical trials of etripamil for the treatment of PSVT; · seek marketing approvals for etripamil for the treatment of PSVT and other cardiovascular indications; · establish a sales, marketing, manufacturing and distribution capability, either directly or indirectly through third parties, to commercialize etripamil or any future product candidate for which we may obtain marketing approval; · build a portfolio of product candidates through development, or the acquisition or in-license of drugs, product candidates or technologies; · initiate preclinical studies and clinical trials for etripamil for any additional indications we may pursue, including the clinical trials for the treatment of atrial fibrillation with rapid ventricular rate and angina, and for any additional product candidates that we may pursue in the future; · maintain, protect and expand our intellectual property portfolio; · hire additional clinical, regulatory and scientific personnel; · add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts; and · incur additional legal, accounting and other expenses associated with operating as a public company. Reverse Share Split On April 26, 2019, in connection with our initial public offering, or IPO, our Board of Directors approved an amendment to our articles of incorporation to effect a 1-for-5.3193 reverse share split of our common shares, convertible preferred shares and the share options of the Company. Accordingly, all common shares, convertible preferred shares, share options and per share amounts in the consolidated financial statements and MD&A have been retroactively adjusted for all periods presented to give effect to the reverse share split. The reverse share split was effected on April 26, 2019. Initial Public Offering On May 13, 2019, we completed our IPO, whereby we issued 5,500,000 common shares at a public offering price of $15.00 per share. The shares began trading on The Nasdaq Global Select Market on May 9, 2019. On May 15, 2019, the underwriters fully exercised their option to purchase an additional 825,000 common shares at the public offering price of $15.00 per share. We received net proceeds from the IPO and the over-allotment exercise of $85.4 million, after deducting underwriting discounts and commissions and other offering expenses. Upon the closing of the IPO, 24,490,742 common shares were outstanding, which included all outstanding shares of our preferred shares that converted into 17,550,802 common shares. Components of Results of Operations Research and Development Expenses Research and development expenses consist primarily of salaries and fees paid to external service providers and also include personnel costs, including share-based compensation expense and other related compensation expenses. We expense 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. To date, substantially all of our research and development expenses have been related to the preclinical and clinical development of etripamil. Historically, we have incurred research and development expenses that primarily relate to the development of etripamil for the treatment of PSVT. As we advance etripamil or other product candidates for other indications, we expect to allocate our direct external research and development costs across each of the indications or product candidates. Further, while we expect our research and development costs for the development of etripamil in atrial fibrillation with rapid ventricular rate and angina to increase in preparation for each of their respective Phase 2 clinical trials, we expect our research and development expenses related to the development of etripamil for PSVT to remain a large majority of our research and development expenses. The following table shows our research and development expenses by type of activity for the years ended December 31, 2019 and 2018. We expect our research and development expenses to increase substantially as we increase personnel costs, including share-based compensation, and as we continue the development of etripamil and pursue regulatory approval. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming. 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, if at all. We recognize the benefit of Canadian research and development tax credits as a reduction of research and development costs for fully refundable investment tax credits. General and Administrative Expenses General and administrative expenses include personnel and related compensation costs, expenses for outside professional services, rent expense and other general administrative expenses. Personnel costs consist of salaries, bonuses, benefits, related payroll taxes and share-based compensation. Outside professional services consist of legal, accounting and audit services and other consulting fees. We expect to increase our administrative headcount significantly as we advance etripamil and any future product candidates through clinical development, which will also increase our general and administrative expenses. Commercial Expenses Commercial expenses consist primarily of personnel and related compensation costs, market and health economic research, and market development activities for PSVT and, to a much lesser extent, atrial fibrillation with rapid ventricular rate and angina. The focus of these expenses is three-fold: first, we want to leverage rigorous primary and secondary research to fully understand our target disease states from the perspective of the patient, healthcare provider, and payer; second, we want to understand and document the burden of disease posed by PSVT from an epidemiology, healthcare resource use, and cost perspective; and third, we want to engage our target patient, physician, and payor stakeholders with evidence-based and compliant educational materials that serve to increase the awareness and understanding of the impact of PSVT on patients and the overall healthcare system. Starting approximately one year before we file our new drug application, or NDA with the FDA, we anticipate our commercial expenses will increase substantially as we invest in the infrastructure and personnel required to launch our first product in the United States. Interest Income Interest income primarily consists of interest income from our cash equivalents and short-term investments. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations: Research and Development Expenses Research and development,or R&D expenses increased by $25.1 million, or 149%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. Spending during 2019 was primarily related to advancing our Phase 3 efficacy and safety trials in etripamil for the treatment of PSVT and increases in headcount related expenses to support the trials and activities important for regulatory approvals. We spent $28.8 million on these programs in 2019 and $9.1 million in 2018. We recorded personnel and related R&D costs of $13.5 million for 2019 and $8.0 million in 2018. We also recognized $0.4 million and $0.3 million of R&D investment tax credits provided by the provincial government of Québec for the years ended December 31, 2019 and December 31, 2018, respectively. Tax credits are recorded as a reduction of our R&D expenses. General and Administrative Expenses General and administrative expenses increased by $4.0 million, or 129% for the year ended December 31, 2019 compared to the year ended December 31, 2018. During 2019, we increased our administrative headcount and, as a result, compensation and related personnel costs increased when compared to 2018. In addition, we incurred increased spending for consulting fees, recruiting fees and professional fees, including legal and accounting services incurred to support our IPO. Following the IPO, insurance costs increased in the second quarter of 2019 to support risk management activities as a public company. Commercial Expenses Commercial expenses increased by $5.0 million, or 127%, for the year ended December 31, 2019 when compared to 2018. During this period, commercial expenses reflect increased commercial headcount and related costs, increase in additional commercial and market research, increases in the scope of our patient engagement activities, and costs of a medical affairs team focused on engaging key opinion leaders’ and raising disease awareness. Interest Income, Net Interest income, net of bank charges was $2.6 million and $0.7 million for the years ended December 31, 2019 and 2018, respectively. The increase in 2019 reflects increased earnings on cash and cash equivalents to the proceeds from the October 2018 Series D preferred share financing and the net cash proceeds from the IPO and over-allotment exercised in May 2019. Net Loss For the foregoing reasons, we had net losses of $55.2 million and $23.2 million for the years ended December 31, 2019 and 2018, respectively. Liquidity and Capital Resources Sources of Liquidity Prior to our IPO, we financed our operations primarily through sales of our convertible preferred shares to accredited investors generating net proceeds of $138.8 million. In May 2019, we received net proceeds of $85.4 million from our IPO. We have incurred operating losses and experienced negative operating cash flows since our inception and anticipate that we will continue to incur losses for at least the next several years. As of December 31, 2019, we had $119.8 million cash & cash equivalents and short-term investments of NIL and an accumulated deficit of $113.5 million. Based on our current operating plan, we expect our existing cash, cash equivalents and short-term investments will be sufficient to fund our operations for at least the next 12 months based on our most recent forecast. Funding Requirements We use our cash primarily to fund research and development expenditures. We expect to incur an increase in research and development expenses as well as general and administrative expenses and commercial activities as our R&D progresses. We expect to incur increasing operating losses for the foreseeable future as we continue the clinical development of our product candidate. At this time, due to the inherently unpredictable nature of clinical development, we cannot reasonably estimate the costs we will incur and the timelines that will be required to complete development, obtain marketing approval, and commercialize etripamil or any future product candidates, if at all. For the same reasons, we are also unable to predict when, if ever, we will generate revenue from product sales or whether, or when, if ever, we may achieve profitability. Clinical and preclinical development timelines, the probability of success, and development costs can differ materially from expectations. In addition, we have exclusive development and commercialization rights for etripamil for all indications that we may pursue and as such have the potential to license development and or commercialization rights for etripamil to a potential partner. We plan to establish commercialization and marketing capabilities using a direct sales force to commercialize etripamil in the United States. Outside of the United States, we are considering commercialization strategies that may include collaborations with other companies. For other new product candidates, our efforts are focused on licensing development and/or commercialization rights from potential partners. In the case of either in-licensing or out-licensing, we cannot forecast when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development and commercialization plans and capital requirements. The timing and amount of our operating expenditures will depend largely on: · the timing, progress and results of our ongoing and planned clinical trials and other development activities of etripamil in PSVT and in other cardiovascular indications; · the scope, progress, results and costs of preclinical development, laboratory testing and clinical trials of etripamil for additional indications or any future product candidates that we may pursue; · our ability to establish collaborations on favorable terms, if at all; · the ability of vendors and third-party service providers to accurately forecast expenses and deliver on expectations; · the costs, timing and outcome of regulatory review of etripamil and any future product candidates; · the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for etripamil and any future product candidates for which we receive marketing approval; · the revenue, if any, received from commercial sales of etripamil and any future product candidates for which we receive marketing approval; · the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims; and · the extent to which we acquire or in-license other product candidates and technologies. Until such time, if ever, as we can generate substantial revenue from product sales, we expect to fund our operations and capital funding needs through equity and/or debt financing. We may also consider entering into collaboration arrangements or selectively partnering for clinical development and commercialization. The sale of additional equity would result in additional dilution to our shareholders. The incurrence of debt financing would result in debt service obligations and the instruments governing such debt could provide for operating and financing covenants that restrict our operations or our ability to incur additional indebtedness or pay dividends, among other items. 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 and adversely affect our business, financial condition, results of operations and prospects. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities In 2019, we used $51.2 million of cash in operating activities, which consisted of a net loss of $55.2 million offset by a net change of $2.9 million in our net operating assets and non-cash charges of $1.2 million. The non-cash charges primarily consist of share-based compensation expense for grants to employees. The change in our net operating assets and liabilities was primarily due to a net increase of $3.5 million for accounts payable, a net decrease of $0.2 million for research and development tax credits, interest and sales tax receivable and offset by an increase of $0.5 million for prepaid expenses. In 2018, we used $21.0 million of cash in operating activities, which consisted of a net loss of $23.2 million offset by a net change of $1.5 million in our net operating assets and non-cash charges of $0.6 million. The non-cash charges primarily consist of share-based compensation expense for grants to employees. The change in our net operating assets and liabilities was primarily due to a net increase of $2.9 million for accounts payable and accrued liabilities offset by an increase of $1.3 million for prepaid expenses and a net increase of $0.1 million for research and development tax credits, interest and sales tax receivable. Investing Activities For the year ended December 31, 2019, there was a net use of cash of $0.4 million mainly related to cash used for the acquisition of property and equipment. Short-term investment acquisitions used $35.0 million in cash and provided the same amount of redemptions leaving a balance of nil in short-term investments. For the year ended December 31, 2018, our investing activities provided $16.0 million of cash due to the redemption of approximately net $16.0 million of short-term investments that we had acquired during the year ended December 31, 2017. Financing Activities In 2019, the IPO and the exercise by the underwriters of their option to purchase additional common shares provided a net cash consideration of $85.4 million. In 2018, our financing activities provided $80.1 million of cash, primarily consisting of the proceeds from the issuance of Class D1 and Class D2 preferred shares in October 2018. Additionally, in the years ended December 31, 2019 and 2018, exercise of share options provided $44 thousand and $461 thousand, respectively. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements, as defined in the rules and regulations of the Securities and Exchange Commission. Contractual Obligations We enter into contracts in the normal course of business with clinical research organizations (CRO), contract manufacturing organizations (CMO) and other third parties for clinical trials, preclinical research studies and testing and manufacturing services. These contracts are generally cancelable at our option with various notice requirements as defined in the contract. Payments due upon cancellation consist of payments for services provided or expenses incurred, including noncancelable obligations of our service providers, up to and through the date of cancellation. These payments are not included as the amount and timing of these payments are not known. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our audited consolidated financial statements as at December 31, 2019, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP and on a basis consistent with those accounting principles followed by us. The preparation of these audited consolidated financial statements requires our management to make judgments and estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Significant estimates and judgments include, but are not limited to, research and development tax credits recoverable, research and development expenses, and share-based compensation. Accordingly, actual results may differ from these judgments and estimates under different assumptions or conditions and any such differences may be material. 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. Effective January 1, 2019, the company adopted ASC Topic 842, and changed the manner in which it accounts for leases under the new standard. For a description of this critical accounting policy and the impact of the change, see Note 3 of the consolidated financial statements. a) Research & Development Expenses - Accruals and Tax Credits Research and development costs are charged against income in the period of expenditure. Our research and development costs consist primarily of salaries and fees paid to contract research organizations, CROs, and to contract manufacturing organizations, or CMOs. Clinical trial expenses include direct costs associated with CROs, direct CMO costs for the formulation and packaging of clinical trial material, as well as investigator and patient-related costs at sites at which our trials are being conducted. Direct costs associated with our CROs and CMOs are generally payable on a time-and-materials basis, or when milestones are achieved. The invoicing from clinical trial sites can lag several months. We record expenses for our clinical trial activities performed by third parties based upon estimates of the percentage of work completed of the total work over the life of the individual trial in accordance with agreements established with CROs and clinical trial sites. We determine the estimates through discussions with internal clinical personnel, CROs and CMOs as to the progress or stage of completion of trials or services and the agreed-upon fee to be paid for such services based on facts and circumstances known to us as of each consolidated balance sheet date. The actual costs and timing of clinical trials are highly uncertain, subject to risks and may change depending upon a number of factors, including our clinical development plan. If the actual timing of the performance of services of the level of effort varies from the estimate, we will adjust the accrual accordingly. Adjustments to prior period estimates have not been material. We recognize the benefit of Canadian research and development tax credits as a reduction of research and development costs for fully refundable investment tax credits and as a reduction of income taxes for investment tax credits that can only be claimed against income taxes payable when there is reasonable assurance that the claim will be recovered. b) Leases Effective January 1, 2019, the Company adopted ASC 842, Leases (ASC 842), using the required modified retrospective approach and utilizing the effective date as its date of initial application. As a result, prior periods are presented in accordance with the previous guidance in ASC 840, Leases (“ASC 840”). At the inception of an arrangement, the Company determines whether the arrangement is or contains a lease based on the unique facts and circumstances present in the arrangement. Leases with a term greater than one year are recognized on the balance sheet as right-of-use assets and short-term and long-term lease liabilities, as applicable. The Company does not have financing leases. Operating lease liabilities and their corresponding right-of-use assets are initially recorded based on the present value of lease payments over the expected remaining lease term. Certain adjustments to the right-of-use asset may be required for items such as incentives received. The interest rate implicit in lease contracts is typically not readily determinable. As a result, the Company utilizes its incremental borrowing rate to discount lease payments, which reflects the fixed rate at which the Company could borrow on a collateralized basis the amount of the lease payments in the same currency, for a similar term, in a similar economic environment. Prospectively, the Company will adjust the right-of-use assets for straight-line rent expense or any incentives received and remeasure the lease liability at the net present value using the same incremental borrowing rate that was in effect as of the lease commencement or transition date. The Company has elected not to recognize leases with an original term of one year or less on the balance sheet. The Company typically only includes an initial lease term in its assessment of a lease arrangement. Options to renew a lease are not included in the Company’s assessment unless there is reasonable certainty that the Company will renew. c) Share-Based Compensation We recognize compensation costs related to share options granted to employees, consultants and directors based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting share-based compensation expense, using the Black-Scholes option-pricing model. This Black-Scholes option pricing model uses various inputs to measure fair value, including estimated fair value of our underlying common shares at the grant date, expected term, estimated volatility, risk-free interest rate and expected dividend yields of our common shares. The grant date fair value of the share-based awards is recognized on a straight-line basis over the requisite service periods, which are generally the vesting period of the respective awards. Forfeitures are accounted for as they occur. As there had been no public market for our common shares prior to May 13, 2019, the estimated fair value of our common shares has been 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 shares as well as our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent third-party valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. 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. Following the completion of our initial public offering on May 13, 2019, we have determined the per share fair value of our common shares based on the closing price of our common shares as reported by The Nasdaq Stock Market on the date of grant. The following table summarizes, by grant date, the number of underlying common shares and the associated per-share exercise price, which was the fair value per share as determined by our board of directors on the applicable grant date, for share options granted during the years ended December 31, 2018 and 2019: The intrinsic value of all outstanding options as of December 31, 2019 was $32.7 million, based on the fair value of our common shares of $16.01 per share at December 31, 2019, of which approximately $17.4 million related to vested options and approximately $15.5 million related to unvested options. Recent Accounting Prononcements Refer to Note 2, “Summary of Significant Accounting Policies,” in the accompanying notes to our audited consolidated financial statements for a discussion of recent accounting pronouncements. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we 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 biopharmaceutical company focused on the development and commercialization of innovative cardiovascular medicines. Our lead product candidate etripamil is a novel, potent and shortacting calcium channel blocker that we designed as a rapidonset nasal spray to be selfadministered by patients. We are developing etripamil to treat paroxysmal supraventricular tachycardia, or PSVT, atrial fibrillation, and other cardiovascular indications. PSVT is a rapid heart rate condition characterized by episodes of supraventricular tachycardia, or SVT, that start and stop without warning. Episodes of SVT are often experienced by patients with symptoms including palpitations, sweating, chest pressure or pain, shortness of breath, sudden onset of fatigue, lightheadedness or dizziness, fainting and anxiety. Calcium channel blockers have long been approved for the treatment of PSVT as well as other cardiac conditions. Calcium channel blockers available in oral form are frequently used prophylactically to control the frequency and duration of future episodes of SVT. For treatment of episodes of SVT, approved calcium channel blockers are administered intravenously under medical supervision, usually in the emergency department. The combination of convenient nasalspray delivery, rapidonset and short duration of action of etripamil has the potential to shift the current treatment paradigm for episodes of SVT away from the burdensome and costly emergency department setting. If approved, we believe that etripamil will be the first selfadministered therapy for the rapid termination of episodes of SVT wherever and whenever they occur. Our development program for etripamil for the treatment of PSVT consists of three Phase 3 clinical trials, one Phase 2 trial, and Phase 1 trials. We believe this clinical trial program, if successful, will be sufficient to support approval in the United States and the European Union. NODE301 is our ongoing, placebocontrolled Phase 3 safety and efficacy trial, which is being conducted in North America. NODE301 may serve as a single pivotal efficacy trial required for approval by the US Food and Drug Administration, or FDA. The trial is being conducted in two parts. NODE301A will continue until the trial’s adjudication committee has evaluated data from the treatment of 150 SVT events with blinded study drug (etripamil or placebo). All pivotal efficacy analyses will be conducted on data from NODE301A. NODE301B will follow patients already enrolled in NODE301 who did not take the study drug in NODE301A. Data from NODE301B will be analyzed as a pivotal safety and supportive efficacy data set, and will contribute to potentially valuable subpopulation analyses and pharmacoeconomic assessments. Following consultation with the FDA in 2019, we confirmed the twopart design, along with an increase in the sample size of NODE301A from 100 to 150 adjudicated SVT events. The upsize of the trial satisfies a request from the European Medicines Agency, or EMA. NODE302 is our ongoing Phase 3 openlabel safety extension trial. Patients who complete NODE301 may enroll in NODE302 and receive up to an additional 11 doses of etripamil. We designed NODE302 to evaluate the safety of etripamil when selfadministered without medical supervision and to monitor the safety and efficacy of etripamil for the treatment of multiple episodes of SVT. All patients randomized in NODE301 will be eligible for NODE302. Patients who have successfully dosed with the study drug and completed a study closure visit will be eligible to enroll in NODE302 to manage any subsequent episodes of SVT. Eligibility will also be contingent on satisfying all inclusion and exclusion criteria, including not experiencing a serious adverse event related to the study drug or the study procedure that precludes the selfadministration of etripamil. We initiated NODE302 in December 2018 and the trial is ongoing. Trial safety results will contribute to the etripamil safety database. NODE303 [/INST] Positive. </s>

Richmond Mutual Bancorporation, Inc.

2020-03-30

2019-12-31

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Cautionary Note Regarding Forward-Looking Statements Certain matters in this Form 10-K may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical fact, are based on certain assumptions and are generally identified by use of words such as “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would,” and “could.” These forward-looking statements include, but are not limited to: · statements of our goals, intentions and expectations; · statements regarding our business plans, prospects, growth and operating strategies; · statements regarding the quality of our loan and investment portfolios; and · estimates of our risks and future costs and benefits. You are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date made. These forward-looking statements are based on our current beliefs and expectations and, by their nature, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Important factors that could cause our actual results to differ materially from the results anticipated or projected, include, but are not limited to, the following: · general economic conditions, either nationally or in our market areas, that are worse than expected; · changes in the level and direction of loan or lease delinquencies and write-offs and changes in estimates of the adequacy of the allowance for loan and lease losses; · our ability to access cost-effective funding; · fluctuations in real estate values and both residential and commercial real estate market conditions; · risks associated with the relatively unseasoned nature of a significant portion of our loan portfolio; · demand for loans and deposits in our market area; · our ability to implement and change our business strategies; · competition among depository and other financial institutions and equipment financing companies; · inflation and changes in the interest rate environment that reduce our margins and yields, our mortgage banking revenues, the fair value of financial instruments or our level of loan originations, or increase the level of defaults, losses and prepayments on loans and leases we have made and make; · adverse changes in the securities or secondary mortgage markets; · changes in the quality or composition of our loan, lease or investment portfolios; · technological changes that may be more difficult or expensive than expected; · the inability of third-party providers to perform as expected; · our ability to manage market risk, credit risk and operational risk in the current economic environment; · our ability to enter new markets successfully and capitalize on growth opportunities; · our ability to retain key employees; · our compensation expense associated with equity allocated or awarded to our employees; · changes in the financial condition, results of operations or future prospects of issuers of securities that we own; · our ability to successfully integrate into our operations any assets, liabilities, customers, systems and management personnel we may acquire and our ability to realize related revenue synergies and cost savings within expected time frames, and any goodwill charges related thereto; · changes in consumer spending, borrowing and savings habits; · changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board, the Securities and Exchange Commission or the Public Company Accounting Oversight Board; · changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory fees and capital requirements, including as a result of Basel III; · the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the implementing regulations; and · other economic, competitive, governmental, regulatory, and technical factors affecting our operations, pricing, products and services including the potential effects of coronavirus on local and international trade (including supply chains and export levels), and other risks described elsewhere in this Form 10 K and our other reports filed with the U.S. Securities and Exchange Commission (“SEC”). We undertake no obligation to publicly update or revise any forward-looking statements included in this report or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking statements discussed in this report might not occur and you should not put undue reliance on any forward-looking statements. Additional factors that may affect our results are discussed under Part I, Item 1A in this document under the heading “Risk Factors.” General Our principal business consists of attracting deposits from the general public, as well as brokered deposits, and investing those funds primarily in loans secured by first mortgages on owner-occupied, one- to four-family residences, a variety of consumer loans, direct financing leases, commercial and industrial loans, and loans secured by commercial and multi-family real estate. We also obtain funds by utilizing FHLB advances. Funds not invested in loans generally are invested in investment securities, including mortgage-backed and mortgage-related securities and agency and municipal bonds. Our results of operations are primarily dependent on net interest income. Net interest income is the difference between interest income, which is the income that is earned on loans and investments, and interest expense, which is the interest that is paid on deposits and borrowings. Other significant sources of pre-tax income are service charges (mostly from service charges on deposit accounts and loan servicing fees), and fees from sale of residential mortgage loans originated for sale in the secondary market. We also recognize income from the sale of investment securities. At December 31, 2019, on a consolidated basis, we had $986.0 million in assets, $687.3 million in loans, $617.2 million in deposits and $187.8 million in stockholders’ equity. First Bank Richmond’s risk-based capital ratio at December 31, 2019 was 19.5%, exceeding the 10.0% requirement for a well-capitalized institution. For the year ended December 31, 2019, we reported a net loss of $14.1 million, compared with net income of $5.7 million for 2018. Critical Accounting Policies Certain accounting policies are important to the portrayal of our financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management believes that its critical accounting policies include determining the allowance for loan and lease losses, the valuation of foreclosed assets, mortgage servicing rights, valuation of intangible assets and securities, deferred tax asset and income tax accounting. Allowance for Loan and Lease Losses. We maintain an allowance for loan and lease losses to cover probable incurred credit losses at the balance sheet date. Loan and lease 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. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. A provision for loan and lease losses is charged to operations based on our periodic evaluation of the necessary allowance balance. We have an established process to determine the adequacy of the allowance for loan and lease losses. The determination of the allowance is inherently subjective, as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on other classified loans and pools of homogeneous loans, and consideration of 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, all of which may be susceptible to significant change. Foreclosed Assets. Foreclosed assets are carried at the lower of cost or fair value less estimated selling costs. Management estimates the fair value of the properties based on current appraisal information. Fair value estimates are particularly susceptible to significant changes in the economic environment, market conditions, and real estate market. A worsening or protracted economic decline would increase the likelihood of a decline in property values and could create the need to write down the properties through current operations. Mortgage Servicing Rights. Mortgage servicing rights, or MSRs, associated with loans originated and sold, where servicing is retained, are capitalized and included in the consolidated balance sheet. The value of the capitalized servicing rights represents the fair value of the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as a reduction in loan servicing fee income. Securities. Under FASB Codification Topic 320 (ASC 320), Investments-Debt, investment securities must be classified as held to maturity, available for sale or trading. Management determines the appropriate classification at the time of purchase. The classification of securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and the Company has the ability to hold the securities to maturity. Securities not classified as held to maturity are classified as available for sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not affect earnings until realized. The fair values of our securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of our fair values of securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the securities. These models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third party pricing services, management judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics and implied volatilities. We evaluate all securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if any other-than-temporary-impairments (“OTTI”) exist pursuant to guidelines established in ASC 320. In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and our ability and intent to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. If management determines that an investment experienced an OTTI, we must then determine the amount of the OTTI to be recognized in earnings. If we do not intend to sell the security and it is more likely than not that we will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If management intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Any recoveries related to the value of these securities are recorded as an unrealized gain (as accumulated other comprehensive income (loss) in stockholders’ equity) and not recognized in income until the security is ultimately sold. From time to time we may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time. Deferred Tax Asset. We have evaluated our deferred tax asset to determine if it is more likely than not that the asset will be utilized in the future. Our most recent evaluation has determined that we will more likely than not be able to utilize our remaining deferred tax asset. Income Tax Accounting. We file a consolidated federal income tax return. The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for 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. The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date. Management Strategy We are a community-oriented financial institution dedicated to serving the needs of customers in our primary market area. Our commitment is to offer a full array of consumer and commercial banking products and services to meet the needs of our customers. We offer mortgage lending products to qualified borrowers to give them the broadest access to home ownership in our markets. We offer commercial lending products and services tailored to complement their businesses. Our goal is to maintain asset quality while continuing to build our strong capital position while looking for growth opportunities in the markets we serve. To achieve these goals, we will focus on the following strategies: Lending. We believe that commercial lending offers an opportunity to enhance our profitability while managing credit, interest rate and operational risk. We seek quality commercial loan opportunities in our existing markets and purchase loan participations that complement our existing portfolios. We will continue to focus our efforts on our existing markets as well as to further develop the Columbus, Ohio market through our loan production office. We anticipate that the majority of our commercial and multi-family real estate and commercial construction loan originations will range in size from $1.0 million to $8.0 million, while the majority of our commercial and industrial loan originations will range in size from $250,000 to $1.5 million. At December 31, 2019, our commercial loan portfolio, which includes commercial and multi-family real estate loans, commercial and industrial loans and construction loans, totaled $433.4 million, or 62.4% of total loans and leases, with approximately $97.4 million of these loans, or 14.2% of our total loans and leases, located in the Columbus, Ohio market. A large portion of our commercial loan portfolio is unseasoned, meaning they were originated recently. Our limited experience with these borrowers does not provide us with a significant payment history pattern with which to judge future collectability. Further, these loans have not been subjected to unfavorable economic conditions. As a result, it is difficult to predict the future performance of this part of our loan portfolio. These loans may have delinquency or charge-off levels above our historical experience, which could adversely affect our future performance. Deposit Services. Deposits are our primary source of funds for lending and investment. We intend to continue to focus on increasing core deposits (which we define as all deposits except for certificates of deposit greater than $250,000 and brokered certificates of deposit) in our primary market area, with a particular emphasis on non-interest bearing deposits. We will continue to enhance our offering of retail deposit products to maintain and increase our market share, while continuing to build our product offering of commercial deposit products to strengthen our relationships with our business customers. Core deposits represented 84.0% of our total deposits as of December 31, 2019. Balance Sheet Growth. As a result of our efforts to build our management and infrastructure, we believe we are well-positioned to increase the size of our balance sheet without a proportional increase in overhead expense or operating risk. Accordingly, we intend to increase, on a managed basis, our assets and liabilities, particularly loans and deposits. Asset Quality. We believe that strong asset quality is a key to long-term financial success. Our strategy for credit risk management focuses on an experienced team of credit professionals, well-defined credit policies and procedures, appropriate loan underwriting criteria and active credit monitoring. Our non-performing loans to total loans ratio was 0.55% at December 31, 2019. Capital Position. Our policy has always been to protect the safety and soundness of First Bank Richmond through credit and operational risk management, balance sheet strength, and sound operations. The end result of these activities has been a capital ratio in excess of the well-capitalized standards set by our regulators. We believe that maintaining a strong capital position safeguards the long-term interests of First Bank Richmond. Interest Rate Risk Management. Changes in interest rates are our primary market risk as our balance sheet is almost entirely comprised of interest-earning assets and interest-bearing liabilities. As such, fluctuations in interest rates have a significant impact not only upon our net income but also upon the cash flows related to those assets and liabilities and the market value of our assets and liabilities. In order to maintain what we believe to be acceptable levels of net interest income in varying interest rate environments, we actively manage our interest rate risk and assume a moderate amount of interest rate risk consistent with board policies. Financial Condition at December 31, 2019 Compared to December 31, 2018 General. Total assets increased $136.4 million, or 16.1%, to $986.0 million at December 31, 2019 from $849.6 million at December 31, 2018. This increase was driven by a $32.5 million, or 5.0%, increase in the loan and lease portfolio, net of allowance for loan and lease losses, a $74.1 million, or 51.6%, increase in investment securities and a $25.6 million, or 171.1%, increase in cash and cash equivalents. The increase in assets was funded with the proceeds received by the Company in connection with the initial public offering. Most of the growth in the loan portfolio occurred in the commercial and multi-family real estate and commercial and industrial loan portfolios. Loans and Leases. Our loan and lease portfolio, net of allowance for loan and lease losses, increased $32.5 million, or 5.0%, to $687.3 million at December 31, 2019 from $654.8 million at December 31, 2018. The majority of the growth occurred in the commercial and multi-family real estate portfolios, which in the aggregate increased $40.4 million, or 15.8%. We also experienced a $12.7 million, or 17.7%, increase in our commercial and industrial loan portfolio. These increases were partially offset by a $19.5 million, or 26.8%, decrease in our construction and development loan portfolio. Most of the growth in the loan portfolio took place in the Richmond, Indiana market area. Allowance for Loan and Lease Losses. Our allowance for loan and lease losses increased $1.5 million, or 26.8%, to $7.1 million at December 31, 2019 from $5.6 million at December 31, 2018, primarily as a result of the growth in commercial and multi-family real estate loans. At December 31, 2019, the allowance for loan and lease losses totaled 1.02% of total loans and leases outstanding compared to 0.85% at December 31, 2018. Net charge-offs during the year ended 2019 were $1.1 million or 0.16% of average loans and leases outstanding compared to $880,000 or 0.14% of average loans and leases outstanding during 2018.. Deposits. Total deposits decreased $3.4 million, or 0.6%, to $617.2 million at December 31, 2019 from $620.6 million at December 31, 2018. This decrease in deposits was due to brokered deposits decreasing $67.8 million, or 54.5%, during 2019. At December 31, 2019, our brokered deposits totaled $56.7 million, or 9.2% of total deposits. This decrease was partially offset by an increase in retail certificates of deposit of $40.8 million from December 31, 2018 to December 31, 2019. Borrowings. Total borrowings, consisting solely of FHLB advances, increased $17.9 million, or 13.2%, to $154.0 million at December 31, 2019 from $136.1 million at December 31, 2018. The increase in borrowings was used to primarily fund loan growth during the period. Stockholders’ Equity. Stockholders’ equity totaled $187.8 million as of December 31, 2019, an increase of $101.9 million, or 118.6%, from December 31, 2018. The increase in stockholders’ equity was the result of the completion of the Company’s initial public offering and a $3.7 million reduction in the accumulated other comprehensive loss, partially offset by a net loss of $14.1 million. First Bank Richmond’s tangible common equity ratio and its risk-based capital ratios exceeded “well-capitalized” levels as defined by all regulatory standards as of December 31, 2019. Comparison of Results of Operations for the Years Ended December 31, 2019 and 2018 General. We reported a net loss for 2019 of $14.1 million compared to net income of $5.7 million in 2018. The net loss for the 2019 was affected by the estimated $14.3 million after-tax charge associated with the planned termination of the DB Plan, an after-tax charge of $4.9 million associated with the Company’s contribution to the Foundation which was formed in connection with our reorganization and stock offering completed on July 1, 2019, and an after-tax charge of $1.3 million related to the adoption of a nonqualified deferred compensation plan in the second quarter of 2019 Interest Income. Total interest income for 2019 increased $6.4 million or 18.2% over 2018. The increase primarily was a result of the $73.4 million increase in the average balance of loans and leases outstanding year-over-year and a 18 basis point increase in average yield on loans and leases resulting in a $5.0 million increase in interest income. Interest on investment securities increased $294,000 during 2019 primarily due to a $18.7 million increase in the average balance of the portfolio, partially offset by an eight basis point decrease in the average yield on investment securities. Interest Expense. Total interest expense increased $3.4 million, or 43.6% to $11.2 million during 2019 compared to $7.8 million during 2018. The primary reason for this increase was an increase in the average rate paid and the average balance of certificates of deposit and borrowings. The average rate paid on certificates of deposit increased 48 basis points in 2019 compared to 2018, partially due to a 34 basis point increase in the average rate paid on brokered certificates of deposit. The rate paid on borrowings was 2.18% in 2019, an increase of 36 basis points over the average rate of 1.82% in 2018. The primary reason for these increases was a higher average market rate of interest during 2019, despite three 25 basis point decreases in the Federal Funds Rate during the months of August, September and October. The average balance of certificates of deposit and borrowings in 2019 increased by $23.9 million and $28.6 million, respectively, compared to those in 2018. The primary reason for these increases was to fund loan growth during 2019. Net Interest Income. Net interest income before provision for loan and lease losses increased $3.0 million, or 10.8%, to $30.4 million in 2019 compared to $27.4 million in 2018, primarily due to the increase in average earning assets. Our net interest margin in 2019 was 3.34%, a decrease of 23 basis points compared to 2018. The decrease in net interest margin mostly reflects slightly lower overall yield on average interest-earning assets largely as a result of three 25 basis point decreases in the targeted Fed Funds Rate in the third and fourth quarters of 2019. Provision for Loan and Lease Losses. The provision for loan and lease losses in 2019 was $2.6 million, a $920,000 increase over the $1.7 million provision in 2018. The increase in the provision was due to the growth of the loan and lease portfolio during 2019, and slightly higher net charge-offs than were experienced in 2018. Net charge-offs in 2019 were $231,000 more than 2018. Due to the increased provision expense, the allowance increased as a percentage of the total loan and lease portfolio to 1.02% at year-end 2019. Net charge-offs in 2019 equaled 0.16% of total average loans and leases outstanding compared to 0.14% of total average loans and leases outstanding in 2018. The increase in net charge-offs was primarily due to three moderately-sized loan charge-offs in 2019 with no similar charge-offs during 2018. Non-Interest Income. Total non-interest income decreased $434,000, or 10.1%, to 39.0 million for 2019 compared to $4.3 million for 2018. The decrease in total noninterest income was primarily driven by the recognition of impairment of mortgage servicing rights of $202,000 and a $510,000 decrease in other income primarily due to gains recorded on prepayment of below market rate FHLB advances recorded in 2018. These decreases were partially offset by an $83,000 increase in the gain on sale of securities in 2019 compared to 2018. Non-Interest Expenses. Total noninterest expense increased $27.9 million, or 120.8%, to $51.0 million during 2019 compared to 2018. The increase primarily was the result of the $19.3 million estimated DB Plan expense, the $6.25 million expense attributable to the contribution to the Foundation and the $1.7 million expense related to the adoption of a nonqualified deferred compensation plan during the year. Excluding these three non-recurring expenses, noninterest expenses increased $700,000 in 2019 compared to 2018. Salaries and employee benefits increased $21.2 million, or 153.6%, in 2019 compared to 2018, primarily due to the estimated DB Plan expense and expense related to the adoption of the nonqualified deferred compensation plan. Excluding the cost of those two non-recurring expenses, salaries and employee benefits increased $300,000, or 2.25, due to merit increases. Data processing fees increased $267,000, primarily attributable to higher transaction volume and additional services utilized from the Company’s IT provider. FDIC assessments decreased $329,000, or 54.8%, during 2019 compared to 2018. This was the result of the Deposit Insurance Fund achieving a specified ratio of eligible deposits and banks with less than $10 billion assets receiving credit for previous assessments paid. Legal and professional fees increased $133,000, or 15.2%, in 2019 compared to 2018, primarily as a result of our reorganization and stock offering and operating as a public company. Advertising expense increased $280,000, or 51.5%, year-over-year due to sponsorships of various community organizations and events. Loan tax and insurance expense decreased by $274,000, or 46.7%, during 2019 compared to 2018 due to a recovery of $84,000 in property taxes during 2019 that were advanced in 2018 and lower expenses in 2019 on loans sold but still serviced by the Bank. Other expenses increased $4,259,000, or 9.0%, in 2019 compared to 2018, primarily driven by a $62,000 increase in loan closing expenses and a $46,000 increase in charitable contributions. Income Tax Expense. Income tax expense decreased in 2019 by $6.6 million compared to 2018, reflecting a tax benefit of $5.3 million for 2019. This decrease in income tax expense was due to pre-tax income decreasing during 2019 compared to 2018 for the reasons discussed above. Average Balances, Interest and Average Yields/Cost The following tables set forth for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Average balances have been calculated using quarterly balances. Non-accruing loans have been included in the table as loans carrying a zero yield. Loan fees are included in interest income on loans and are not material. Years Ended December 31, Average Balance Outstanding Interest Earned/ Paid Yield/ Rate Average Balance Outstanding Interest Earned/ Paid Yield/ Rate Average Balance Outstanding Interest Earned/ Paid Yield/ Rate (Dollars in thousands) Interest-earning assets: Loans and leases receivable $ 686,949 $ 36,560 5.32 % $ 613,569 $ 31,559 5.14 % $ 513,129 $ 25,523 4.97 % Securities 160,812 3,461 2.15 % 142,140 3,167 2.23 % 155,250 3,177 2.05 % Federal Reserve Bank and FHLB stock 7,256 5.32 % 6,686 5.10 % 6,631 4.03 % Other 55,316 1,151 2.08 % 5,771 2.29 % 11,250 1.22 % Total interest-earning assets 910,333 41,558 4.57 % 768,166 35,199 4.58 % 686,261 29,104 4.24 % Interest-bearing liabilities: Savings and money market accounts 169,941 1,227 0.72 % 161,111 0.55 % 157,926 0.50 % Interest-bearing checking accounts 102,521 0.36 % 100,958 0.20 % 92,698 0.18 % Certificate accounts 302,735 6,419 2.12 % 278,810 4,559 1.64 % 223,060 2,843 1.27 % Borrowings 144,201 3,138 2.18 % 115,620 2,104 1.82 % 97,240 1,454 1.50 % Total interest-bearing liabilities 719,398 11,156 1.55 % 656,499 7,752 1.18 % 570,924 5,250 0.92 % Net interest income $ 30,402 $ 27,447 $ 23,854 Net earning assets $ 190,935 $ 111,667 $ 115,337 Net interest rate spread(1) 3.02 % 3.40 % 3.32 % Net interest margin(2) 3.34 % 3.57 % 3.48 % Average interest-earning assets to average interest-bearing liabilities 126.54 % 117.01 % 120.20 % (1) Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average rate of interest-bearing liabilities. (2) Net interest margin represents net interest income divided by average total interest-earning assets. Rate/Volume Analysis The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate. Years Ended December 31, Years Ended December 31, 2019 vs. 2018 2018 vs. 2017 Increase/ (decrease) due to Total increase/ Increase/ (decrease) due to Total increase/ Volume Rate (decrease) Volume Rate (decrease) (In thousands) Interest-earning assets: Loans and leases receivable $ 3,766 $ 1,235 $ 5,001 $ 5,142 $ $ 6,036 Securities (132 ) (280 ) (10 ) FHLB stock Other 1,135 (116 ) 1,019 (88 ) (5 ) Total interest-earning assets $ 5,356 $ 1,003 $ 6,359 $ 4,776 $ 1,318 $ 6,095 Interest-bearing liabilities: Savings and money market accounts $ $ $ $ (152 ) $ $ Interest-bearing checking accounts Certificate accounts 1,465 1,860 1,716 Borrowings 1,034 Total interest-bearing liabilities $ $ 2,439 $ 3,404 $ $ 1,531 $ 2,502 Change in net interest income $ 2,955 $ 3,593 Off-Balance Sheet Activities In the normal course of operations, we engage in a variety of financial transactions that are not recorded in our financial statements, including commitments to extend credit and unused lines of credit. These transactions involve varying degrees of off-balance sheet risks. While these contractual obligations represent our potential future cash requirements, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans we make. At December 31, 2019, we had $112.7 million in loan commitments and unused lines of credit. Liquidity We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure safe and sound operations. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Historically, liquid assets have been maintained above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. Liquidity management involves the matching of cash flow requirements of customers, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and the ability of the Company to manage those requirements. We strive to maintain an adequate liquidity position by managing the balances and maturities of interest-earning assets and interest-bearing liabilities so that the balance in short-term investments at any given time will cover adequately any reasonably anticipated, immediate need for funds. Additionally, First Bank Richmond maintains a relationship with the FHLB of Indianapolis which could provide funds on short-term notice if needed. Liquidity management is both a daily and long-term function of the management of our business. It is overseen by the Asset and Liability Management Committee. Excess liquidity is generally invested in short-term investments, such as overnight deposits and holding excess funds at the Federal Reserve Board. On a long term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed and municipal securities. First Bank Richmond uses its sources of funds primarily to meet its ongoing commitments, pay maturing deposits, fund deposit withdrawals and fund loan commitments. First Bank Richmond can also generate funds from borrowings, primarily FHLB advances. In addition, we have historically sold eligible long-term, fixed-rate residential mortgage loans in the secondary market in order to reduce interest rate risk and to create another source of liquidity. Liquidity, represented by cash, cash equivalents, and investment securities, is a product of our operating, investing and financing activities. Primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-backed securities, maturities of investment securities and other short-term investments and funds provided from operations. While scheduled payments from the amortization of loans and mortgage-backed securities and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. In addition, excess funds are invested in short-term interest-earning assets, which provide liquidity to meet lending requirements. Cash is also generated through borrowings. FHLB advances are utilized to leverage our capital base and provide funds for lending and investment activities, as well as to enhance interest rate risk management. Funds are used primarily to meet ongoing commitments, pay maturing deposits, fund withdrawals, and to fund loan commitments. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, we believe that a majority of maturing deposits will remain with us. Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations. Further, management is not aware of any current recommendations by regulatory agencies, which, if they were to be implemented, would have this effect. Capital Resources First Bank Richmond is subject to minimum capital requirements imposed by the FDIC. The FDIC may require us to have additional capital above the specific regulatory levels if it believes we are subject to increased risk due to asset problems, high interest rate risk and other risks. At December 31, 2019, First Bank Richmond’s regulatory capital exceeded the FDIC regulatory requirements, and First Bank Richmond was well-capitalized under regulatory prompt corrective action standards. Consistent with our goals to operate a sound and profitable organization, our policy is for First Bank Richmond to maintain well-capitalized status. Required for To Be Well Actual Adequate Capital Capitalized Amount Ratio Amount Ratio Amount Ratio At December 31, 2019 (Dollars in thousands) Total risk-based capital (to risk weighted assets) $149,137 19.5 % $61,304 8.0 % $76,629 10.0 % Tier 1 risk-based capital (to risk weighted assets) 142,048 18.5 45,978 6.0 61,304 8.0 Common equity tier 1 capital (to risk weighted assets) 142,048 18.5 34,483 4.5 49,809 6.5 Tier 1 leverage (core) capital (to adjusted tangible assets) 142,048 14.6 39,027 4.0 48,784 5.0 As of December 31, 2018 Total risk-based capital (to risk weighted assets) $89,850 12.3 % $58,640 8.0 % $73,300 10.0 % Tier 1 risk-based capital (to risk weighted assets) 84,250 11.5 43,980 6.0 58,640 8.0 Common equity tier 1 capital (to risk weighted assets) 84,250 11.5 32,985 4.5 47,645 6.5 Tier 1 leverage (core) capital (to adjusted tangible assets) 84,250 10.1 33,511 4.0 41,888 5.0 Pursuant to the capital regulations of the FDIC and the other federal banking agencies, First Bank Richmond must maintain a capital conservation buffer consisting of additional common equity tier 1 (“CET1”) capital greater than 2.5% of risk-weighted assets above the required minimum levels of risk-based CET1 capital, tier 1 capital and total capital in order to avoid limitations on paying dividends, repurchasing shares, and paying discretionary bonuses. At December 31, 2019, the Bank’s CET1 capital exceeded the required capital conservation buffer. For a bank holding company with less than $3.0 billion in assets, the capital guidelines apply on a bank only basis and the Federal Reserve Board expects the holding company’s subsidiary banks to be well capitalized under the prompt corrective action regulations. If Richmond Mutual Bancorporation was subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets, at December 31, 2019, it would have exceeded all regulatory capital requirements. Impact of Inflation The effects of price changes and inflation can vary substantially for most financial institutions. While management believes that inflation affects the economic value of total assets, it believes that it is difficult to assess the overall impact. Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of inflationary changes in the economy coincides with changes in interest rates. Since virtually all of our assets and liabilities are monetary in nature, interest rates generally have a more significant impact on our performance than does inflation.

<s>[INST] Certain matters in this Form 10K may constitute forwardlooking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forwardlooking statements are not statements of historical fact, are based on certain assumptions and are generally identified by use of words such as “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would,” and “could.” These forwardlooking statements include, but are not limited to: · statements of our goals, intentions and expectations; · statements regarding our business plans, prospects, growth and operating strategies; · statements regarding the quality of our loan and investment portfolios; and · estimates of our risks and future costs and benefits. You are cautioned not to place undue reliance on any forwardlooking statements, which speak only as of the date made. These forwardlooking statements are based on our current beliefs and expectations and, by their nature, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forwardlooking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Important factors that could cause our actual results to differ materially from the results anticipated or projected, include, but are not limited to, the following: · general economic conditions, either nationally or in our market areas, that are worse than expected; · changes in the level and direction of loan or lease delinquencies and writeoffs and changes in estimates of the adequacy of the allowance for loan and lease losses; · our ability to access costeffective funding; · fluctuations in real estate values and both residential and commercial real estate market conditions; · risks associated with the relatively unseasoned nature of a significant portion of our loan portfolio; · demand for loans and deposits in our market area; · our ability to implement and change our business strategies; · competition among depository and other financial institutions and equipment financing companies; · inflation and changes in the interest rate environment that reduce our margins and yields, our mortgage banking revenues, the fair value of financial instruments or our level of loan originations, or increase the level of defaults, losses and prepayments on loans and leases we have made and make; · adverse changes in the securities or secondary mortgage markets; · changes in the quality or composition of our loan, lease or investment portfolios; · technological changes that may be more difficult or expensive than expected; · the inability of thirdparty providers to perform as expected; · our ability to manage market risk, credit risk and operational risk in the current economic environment; · our ability to enter new markets successfully and capitalize on growth opportunities; · our ability to retain key employees; · our compensation expense associated with equity allocated or awarded to our employees; · changes in the financial condition, results of operations or future prospects of issuers of securities that we own; · our ability to successfully integrate into our operations any assets, liabilities, customers, systems and management personnel we may acquire and our ability to realize related revenue synergies and cost savings within expected time frames, and any goodwill charges related thereto; · changes in consumer spending, borrowing and savings habits; · changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board, the Securities and Exchange Commission or the Public Company Accounting Oversight Board; · changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory fees and capital requirements, including as a result of Basel III; · the impact of the DoddFrank Wall Street Reform and Consumer Protection Act and the implementing regulations; and · other economic, competitive, governmental, regulatory, and technical factors affecting our operations, pricing, products and services including the potential effects of coronavirus on local and international trade (including supply chains and export levels), and other ris [/INST] Negative. </s>

Avantor, Inc.

2020-02-14

2019-12-31

Item 7. Management’s discussion and analysis of financial condition and results of operations This discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results may differ materially from those contained in or implied by any forward-looking statements. See “Cautionary factors regarding forward-looking statements.” Overview We are a leading global provider of mission critical products and services to customers in the biopharmaceutical, healthcare, education & government and advanced technologies & applied materials industries. We have global operations and an extensive product portfolio. We strive to enable customer success through innovation, cGMP manufacturing and comprehensive service offerings. The depth and breadth of our portfolio provides our customers a comprehensive range of products and services and allows us to create customized and integrated solutions for our customers. In 2019, we recorded net sales of $6,040.3 million, net income of $37.8 million and Adjusted EBITDA of $1,031.2 million. We also generated net sales growth of 3.0% and organic net sales growth of 5.1%, each compared to the same period in 2018. See “Reconciliations of non-GAAP measures” for a reconciliation of net income to Adjusted EBITDA and “Results of operations” for a reconciliation of net sales growth to organic net sales growth. Trends affecting our business and results of operations The following trends have affected our recent operating results, and they may also continue to affect our performance and financial condition in future periods. Our IPO generated significant proceeds and certain costs In the second quarter of 2019, we completed our IPO. The IPO generated net proceeds of $4,235.6 million after deducting underwriting discounts, commissions and other offering costs of $132.1 million. The IPO also satisfied a performance condition for certain of our stock options, which caused us to immediately recognize of $26.9 million of expense. We simplified our capital structure and reduced our borrowings Proceeds from the IPO, supplemented by operating cash flows, enabled us to simplify our equity capitalization, reduce debt levels and ultimately enabled us to lower the interest rates on our indebtedness. These actions reduced our interest burden and improved our operating cash flows and earnings in 2019, and we expect those improvements to continue into future periods. We redeemed all of our outstanding series A preferred stock for $2,630.9 million using proceeds from the IPO. Furthermore, all shares of junior convertible preferred stock automatically converted into shares of our common stock. The redemption of series A preferred stock eliminated the accumulation of yield thereon, which has positively impacted our income available to common stockholders and will continue to do so in future periods. We used the remaining net proceeds from the IPO and operating cash flows to repay $1.9 billion of outstanding indebtedness. This reduction in borrowings improved our credit profile, which enabled us to amend our debt in June 2019 and January 2020 to reduce the interest rate margins under the senior secured credit facilities. This has reduced our interest expense and cash paid for interest and will continue to do so in future periods. We reduced our expenses through a global restructuring program We have generated significant cost and commercial synergies across our business from the global restructuring program we initiated in the fourth quarter of 2017. Under that program, we are permitted to spend up to $215 million over a three-year period to optimize our sales, gross margins and operating costs. As a result of the program, we have combined sales and marketing resources, eliminated redundant corporate functions, optimized procurement and our manufacturing footprint, and implemented best practices throughout the organization. From inception of the program through December 31, 2019, we have recognized $118.8 million of charges and have spent $8.3 million on capital projects. Through December 31, 2019, we believe that we have generated over $180 million of annualized cost synergies, which we believe will favorably impact our results in 2020 and beyond. Our AMEA region is experiencing significant growth In 2019, net sales grew by nearly 15% in the AMEA region. Our largest customers in this region are in the biopharma and advanced technologies & applied materials industries. We believe that local demand for our products and solutions in these regions is being driven by the expansion of our customers’ presence, an inadequate local supplier base and a significant increase in local government investment to support innovation in the industries we serve. We expect that the AMEA region will continue to generate significant growth for us in future periods. We are investing in a differentiated innovation model We are engaging with our customers early in their product development cycles to advance their programs from research and discovery through development and commercialization. These projects include enhancing product purity and performance characteristics, improving product packaging and streamlining workflows. We are also developing new products in emerging areas of science such as cell and gene therapy. Changes in foreign currency exchange rates are impacting our financial condition and results of operations We have substantial operations overseas whose financial condition and results of operations have been and will continue to be impacted by changes in the exchange rate of the U.S. dollar into other currencies. See Item 7A, “Quantitative and qualitative disclosures about market risk.” Key indicators of performance and financial condition To evaluate our performance, we monitor a number of key indicators. As appropriate, we supplement our results of operations determined in accordance with GAAP with certain non-GAAP measures that we believe are useful to investors, creditors and others in assessing our performance. These measurements should not be considered in isolation or as a substitute for reported GAAP results because they may include or exclude certain items as compared to similar GAAP-based measurements, and such measurements may not be comparable to similarly-titled measurements reported by other companies. Rather, these measurements should be considered as an additional way of viewing aspects of our operations that provide a more complete understanding of our business. The key indicators that we monitor are as follows: • Net sales, gross margin, operating income and net income or loss. These measures are discussed in the section entitled “Results of operations;” • Organic net sales growth, which is a non-GAAP measure discussed in the section entitled “Results of operations.” Organic net sales growth eliminates from our reported net sales the impacts of earnings from any acquired or disposed businesses and changes in foreign currency exchange rates. We believe that this measurement is useful to investors as a way to measure and evaluate our underlying commercial operating performance consistently across our segments and the periods presented. This measurement is used by our management for the same reason. Reconciliations to the change in reported net sales, the most directly comparable GAAP financial measure, are included in the section entitled “Results of operations.” • Adjusted EBITDA and Adjusted EBITDA margin, which are non-GAAP measures discussed in the section entitled “Results of operations.” Adjusted EBITDA is used by investors to measure and evaluate our operating performance exclusive of interest expense, income tax expense, depreciation, amortization and certain infrequently occurring items. Adjusted EBITDA margin is Adjusted EBITDA divided by net sales as determined under GAAP. We believe that these measurements are useful to investors as a way to analyze the underlying trends in our core business consistently across the periods presented. A reconciliation of net income or loss, the most directly comparable GAAP financial measure, to Adjusted EBITDA is included in the section entitled “Reconciliations of non-GAAP measures;” • Management EBITDA, which is a non-GAAP measure discussed in the section entitled “Results of operations.” Management EBITDA is used by our management to measure and evaluate the internal operating performance of our business segments. It is also the basis for calculating management incentive compensation programs. Management EBITDA is our Adjusted EBITDA further adjusted for other items that are not used to measure internal operating performance. We believe that this measurement is useful to investors as a way to analyze the underlying trends in our core business, including at the segment level, consistently across the periods presented and also to evaluate performance under management incentive compensation programs. A reconciliation of net income or loss, the most directly comparable GAAP financial measure, to Management EBITDA is included in the section entitled “Reconciliations of non-GAAP measures;” and • Cash flows from operating activities, which we discuss in the section entitled “Liquidity and capital resources-Historical cash flows.” Results of operations We present results of operations in the same way that we manage our business, evaluate our performance and allocate our resources. We also provide discussion of net sales and Management EBITDA by geographic segment based on customer location: Americas, Europe and AMEA. Corporate costs are managed on a standalone basis and not allocated to segments. Years ended December 31, 2019 and 2018 Executive summary Net sales growth, gross margin improvement, reduced operating costs, lower interest expense and an improved tax rate each contributed to strong performance in 2019 compared to 2018. The net sales growth was driven by strength in biopharma, which contributed to the mid single-digit organic net sales growth in Americas and Europe and to the low double-digit organic net sales growth in AMEA. These factors were partially offset by unfavorable foreign currency translation. The gross margin improvement reflected increased volume, better prices relative to cost inflation and the absence of one-time factors related to 2018. This was offset by unfavorable manufacturing variances and lower supplier rebates. In addition to these factors, the growth in operating income included net operating expense reductions that were the result of productivity improvements partially offset by strategic spending in the AMEA region. The change from net loss to net income and the improvements in Adjusted EBITDA and Adjusted EBITDA margin were for reasons similar to the growth in operating income. Net sales Net sales increased $176.0 million or 3.0%, which included $123.3 million or 2.1% of unfavorable foreign currency impact. Organic net sales growth was $299.3 million or 5.1% and was caused by more favorable pricing and volume growth. In Americas, net sales increased $123.9 million or 3.6%, which included $6.5 million or 0.2% of unfavorable foreign currency impact. Organic net sales growth was $130.4 million or 3.8% and was caused by more favorable pricing and volume growth. Additional information by end market (with approximate percentage of total net sales) is as follows: • Biopharma (50%) - Sales grew in the high-single digits. We gained new customers and experienced low double-digit volume growth from customer spending on research and development, as well as mid-single-digit growth from biopharma production. • Healthcare (10%) - We experienced low single-digit contraction due to a less favorable mix of product sales and a challenging comparison to the prior year driven by our proprietary materials. • Education and government (15%) - We experienced low single-digit growth driven by new customer wins, partially offset by a normalization of customized inventory production after a significant ramp-up in 2018 related to a key customer win. • Advanced technologies & applied materials (25%) - Sales were flat year over year, with strength in the aerospace and defense and microelectronics industries that did not overcome the generally flat industrial sector. In Europe, net sales increased $6.7 million or 0.3%, which included $113.9 million or 5.4% of unfavorable foreign currency impact. Organic net sales growth was $120.6 million or 5.7%, due nearly in equal parts to volume growth and favorable pricing. Additional information by end market (with approximate percentage of total net sales) is as follows: • Biopharma (40%) - We experienced low double-digit growth broadly across strategic customer accounts and new customer wins. This was driven by lab chemicals, which continued to be a strong driver of growth, our biopharma production capabilities and specialty procurement. • Healthcare (10%) - We experienced mid single-digit growth due to strong sales of proprietary materials. This was partially offset by a contraction in equipment & instrumentation. • Education & government (15%) - Sales were essentially flat due to fewer growth opportunities and increased competitive pressure in the market, specifically in our chemicals offerings. • Advanced technologies & applied materials (35%) - We experienced mid single-digit growth due to growth in third-party chemicals and consumables, which was partially offset by softness in equipment & instrumentation. In AMEA, net sales increased $45.4 million or 14.7% due to strong volume growth in the biopharma end market. Additional information by end market (with approximate percentage of total net sales) is as follows: • Biopharma (45%) - We experienced over 30% growth driven by our chromatography resin products as well as strong growth with key biopharma production customers in Korea, China and India. • Advanced technologies & applied materials (40%) - We experienced mid single-digit growth driven by higher sales of third-party materials & consumables, which was partially offset by a reduction in electronic materials due to a significant order in 2018 that did not repeat. Gross margin The increase in gross margin included 50 basis points from more favorable prices relative to cost inflation and 10 basis points of favorable product mix, reflecting sales of our higher margin proprietary materials. The increase also included 50 basis points due to the absence of higher product costs in 2018 for (i) the step-up of VWR inventory in purchase accounting, and (ii) restructuring of a discontinued product line that resulted in $20.2 million of inventory adjustments. These factors were partially offset by 30 basis points from unfavorable manufacturing absorption due to system integration initiatives at our manufacturing facilities and lower supplier rebates due to increased thresholds in certain rebate agreements. The global restructuring program contributed a total of $85.1 million to 2019 gross profit and included more favorable prices relative to cost inflation, product cost reductions and productivity improvements from leaner footprints and operating practices. Operating income Operating income increased primarily from higher gross profit, as previously discussed, as well as a reduction of operating expenses from lower restructuring charges, realized cost synergies from the global restructuring program, favorable foreign currency translation and lower annual incentive compensation expense. These decreases were partially offset by additional stock-based compensation expense triggered by the completion of our IPO, investments in AMEA, incremental public company expenses and inflationary impacts. Our investments in AMEA are designed to support long-term growth and were made in sales and marketing, supply chain facilities and a new innovation center in China. Net income or loss Net loss changed to net income primarily due to higher operating income, as previously discussed, and lower interest expense, which were partially offset by a loss on extinguishment of debt and a change from income tax benefit to expense. Interest expense declined with the application of IPO proceeds and operating cash flows to reduce outstanding borrowings, as well as interest rate margin reductions from the repricing of our term loans in June 2019. This was substantially offset by the non-cash loss on extinguishment of debt. The income tax benefit changed to expense following the change from pre-tax loss to pre-tax income. Adjusted EBITDA and Management EBITDA For reconciliations of Adjusted EBITDA and Management EBITDA to net income or loss, see “Reconciliations of non-GAAP measures.” Adjusted EBITDA increased $85.9 million, or 9.1%, which included an unfavorable foreign currency translation impact of $18.1 million, or 1.9%. The remaining growth of $104.0 million, or 11.0%, was for reasons similar to the Management EBITDA growth discussed below. In the Americas, the growth in Management EBITDA was driven by the improvements to net sales previously discussed, more favorable prices relative to cost inflation, productivity improvements and cost reductions. In Europe, the growth in Management EBITDA was driven by volume growth and more favorable prices relative to cost inflation in our biopharma and other proprietary offerings, partially offset by relatively lower sales of equipment & instrumentation. The growth in Management EBITDA also reflected operating expense savings primarily related to headcount reduction and facility footprint optimization. These factors were substantially offset by an unfavorable foreign currency translation impact. In AMEA, Management EBITDA was favorably impacted by an increase in gross profit driven by sales growth, which was offset by an increase to operating expenses due to targeted investments in customer facing sales and marketing functions to support the growth in this strategic region, new supply chain facilities and an innovation center in China to better serve our markets. In Corporate, Management EBITDA was reduced primarily related to increases in public company compliance as a result of our IPO and investments into our global business center as we continue to grow our offshore capabilities. Year ended December 31, 2017 A discussion and analysis covering the year ended December 31, 2017 is included in the Registration Statement. Reconciliations of non-GAAP measures The following table presents the reconciliation of net income or loss to non-GAAP measures: (1) Represents amounts as determined under GAAP. (2) See note 5 to our consolidated financial statements beginning on page of this report. (3) See note 21 to our consolidated financial statements beginning on page of this report. (4) Represents expenses primarily related to remeasuring SARs at fair value on a recurring basis, the vesting of performance stock options with the completion of our IPO and the modification of stock-based awards caused by the legal entity restructuring in November 2017. (5) See note 11 to our consolidated financial statements beginning on page of this report. (6) Represents reversals of the short-term impact of purchase accounting adjustments on earnings. The most significant adjustment in 2019 was a normalization of expense for prepaid customer rebates that were derecognized in purchase accounting. The most significant adjustment in 2017 was an increase to cost of sales that resulted from valuing VWR’s inventory at fair value in purchase accounting. (7) See note 13 to our consolidated financial statements beginning on page of this report. (8) See note 23 to our consolidated financial statements beginning on page of this report. (9) Represents direct expenses incurred to consummate the acquisition of VWR and other expenses incurred related to the planning and integration of VWR. (10) The following table presents the components of other adjustments to Adjusted EBITDA: (11) Primarily represents expense related to stock options, RSUs and optionholder awards that vest based on continuing employee service. (12) Substantially represents the reduction of inventory to net realizable value in accordance with GAAP, but also includes immaterial write-offs of trade accounts receivable and property, plant and equipment. (13) Represents cost of cash-based compensation programs awarded to key employees that vest at the end of three-year periods through December 31, 2020 with continuing service. (14) Represents expenses related to business performance improvement programs, non-recurring tax payments, customer rebates, non-cash pension charges, consulting projects, advisory fees and other immaterial items. Liquidity and capital resources We fund short-term cash requirements primarily from operating cash flows and unused availability under our credit facilities. Most of our long-term financing is from indebtedness. Our most significant contractual obligations are scheduled principal and interest payments for indebtedness. We also have obligations to make payments under operating leases, to purchase certain products and services and to fund defined benefit plan obligations primarily outside of the United States. In addition to contractual obligations, we use cash to fund capital expenditures, taxes and dividends on MCPS. We have also used significant amounts of cash to pay debt refinancing fees and to fund distributions in 2017. We do not anticipate such significant distributions going forward due to new restrictions imposed by our indebtedness. Changes in working capital may be a source or a use of cash depending on our operations during the period. We expect to fund our long-term capital needs with cash generated by operations and availability under our credit facilities. Although we believe that these sources will provide sufficient liquidity for us to meet our long-term capital needs, our ability to fund these needs will depend to a significant extent on our future financial performance, which will be subject in part to general economic, competitive, financial, regulatory and other factors that are beyond our control. We believe that cash generated by operations, together with available liquidity under our credit facilities, will be adequate to meet our current and expected needs for cash prior to the maturity of our debt, although no assurance can be given in this regard. Liquidity The following table presents our primary sources of liquidity: Our liquidity needs change daily. We manage liquidity needs by utilizing our credit line availability and also by monitoring working capital levels. Some of our credit line availability also depends upon maintaining a sufficient borrowing base of eligible accounts receivable. We believe that we have sufficient capital resources to meet our daily liquidity needs. As of December 31, 2019, we were in compliance with all of our debt covenants. At December 31, 2019, $161.4 million or 86% of our cash and cash equivalents was held by our non-U.S. subsidiaries and may be subject to certain taxes upon repatriation, primarily where foreign withholding taxes apply. Historical cash flows The following table presents a summary of cash provided by (used in) various activities: * Working capital includes accounts receivable, inventory and accounts payable. Cash flows from operating activities increased $153.5 million in 2019 primarily due to an increase of operating income and a reduction in cash for paid interest. This was partially offset by growth in working capital and an increase in cash paid for taxes. Investing activities used $18.9 million of additional cash in 2019, reflecting an increase in capital spending and fewer proceeds from the sale of capital assets. Financing activities used $137.5 million of additional cash in 2019 due to significant offsetting factors. The $2,630.9 million redemption of our series A preferred stock and $1,878.6 million repayment of debt was substantially offset by $4,235.6 million of IPO proceeds. Of our debt repayments, we funded $1,606.2 million with proceeds from the IPO and $272.4 million with operating cash flows. A discussion and analysis of historical cash flows covering the year ended December 31, 2017 is included in the Registration Statement. Indebtedness A significant portion of our long-term financing is from indebtedness. The purpose of this section is to disclose how certain features of our indebtedness influence our liquidity and capital resources. Additional detail about the terms of our indebtedness may be found in note 13 to our consolidated financial statements beginning on page of this report. Our credit facilities provide us access to up to $500 million of additional cash We have entered into a receivables facility and a revolving credit facility that provide us access to cash to fund short-term business needs. See the section entitled “Liquidity” for additional information. Our indebtedness restricts us from paying dividends to common stockholders The acquisition of VWR was partially funded by the issuance of debt by Avantor Inc.’s wholly-owned subsidiary, Avantor Funding, Inc. Certain of those debt agreements prevent Avantor Funding, Inc. from paying dividends or making other payments to Avantor, Inc., subject to limited exceptions. At December 31, 2019 and 2018, substantially all of Avantor, Inc.’s net assets were subject to those restrictions. Our senior secured credit facilities require or may require us to make certain principal repayments prior to maturity We began repaying the term loans on March 31, 2018 in required quarterly installments of €1.0 million for the euro portion and $2.0 million for the U.S dollar portion, with the balance due on the maturity date. We have generated sufficient cash flow to make all required historical payments, and we expect that our cash flows will continue to be sufficient to make future payments. We are required to make additional prepayments if: (i) we generate excess cash flows, as defined, at specified percentages that decline if certain net leverage ratios are achieved; or (ii) we receive cash proceeds from certain types of asset sales or debt issuances. No additional required prepayments have become due since the inception of the credit facilities. We are subject to certain financial covenants that, if not met, could put us in default of our debt agreements The receivables facility and our senior secured credit facilities contain certain other customary covenants, including a financial covenant. That covenant becomes applicable in periods when we have drawn more than 35% of our revolving credit facility. When applicable, we may not have total borrowings in excess of a pro forma net leverage ratio, as defined. This covenant was not applicable at December 31, 2019, and our historical net leverage has been well in excess of the covenant requirement. Contractual obligations The following table presents our contractual obligations at December 31, 2019: (1) Includes finance lease liabilities. To calculate payments for principal and interest, we assumed that variable interest rates, foreign currency exchange rates and outstanding borrowings under credit facilities were unchanged from December 31, 2019 through maturity. For the variable interest rates and principal amounts used, see note 13 to our consolidated financial statements beginning on page of this report. (2) Our senior secured credit facilities would require us to accelerate our principal repayments should we generate excess cash flows, as defined, in future periods. (3) Purchase obligations for certain products and services are made in the normal course of business to meet operating needs. (4) Represents our obligation to fund defined benefit plans with obligations in excess of plan assets. The total obligation is equal to the aggregate excess of the discounted benefit obligation over the fair value of plan assets for all underfunded plans. The payments due in less than one year are estimated using actuarial methods. The payments due for all other years are estimated by distributing the remaining funding status to future periods in the same way as benefit payments are expected to be made by the plans following actuarial methods. (5) Represents our transition tax obligation due over eight years to transition to the modified territorial tax system under new U.S. income tax legislation. Off-balance sheet arrangements We do not use special purpose entities or have any other material off-balance sheet financing arrangements except for our receivables facility and letters of credit. We enter into these arrangements for ordinary business reasons and believe that they are governed by ordinary commercial terms. For more information, see note 13 to our consolidated financial statements beginning on page of this report. Critical accounting policies and estimates The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported throughout the financial statements. Those estimates and assumptions are based on our best estimates and judgment. We evaluate our estimates and assumptions on an ongoing basis using historical experience and known facts and circumstances. We adjust our estimates and assumptions when we believe the facts and circumstances warrant an adjustment. As future events and their effects cannot be determined with precision, actual results could differ significantly from those estimates. We consider the policies and estimates discussed below to be critical to an understanding of our financial statements because their application places the most significant demands on our judgment. Specific risks for these critical accounting policies are described in the following sections. For all of these policies, we caution that future events rarely develop exactly as forecast, and such estimates naturally require adjustment. Our discussion of critical accounting policies and estimates is intended to supplement, not duplicate, our summary of significant accounting policies so that readers will have greater insight into the uncertainties involved in these areas. For a summary of all of our significant accounting policies, see note 2 to our consolidated financial statements beginning on page of this report. Testing goodwill and other intangible assets for impairment As a result of the VWR acquisition, we carry significant amounts of goodwill and other intangible assets on our consolidated balance sheet. At December 31, 2019, the combined carrying value of goodwill and other intangible assets, net of accumulated amortization and impairment charges, was $7.0 billion or 72% of our total assets. Required annual assessment On October 1 of each year, we perform annual impairment testing of our goodwill and indefinite-lived intangible assets, or more frequently whenever an event or change in circumstance occurs that would require reassessment of the recoverability of those assets. The impairment analysis for goodwill and indefinite-lived intangible assets consists of an optional qualitative test potentially followed by a quantitative analysis. These measurements rely upon significant judgment from management described as follows: • The qualitative analysis for goodwill and indefinite-lived intangible assets requires us to identify potential factors that may result in an impairment and estimate whether they would warrant performance of a quantitative test; • The quantitative goodwill impairment test requires us to estimate the fair value of our reporting units. We estimate the fair value of each reporting unit using a weighted average of three valuation methods based on discounted cash flows, market multiples and market references. These valuation methods require management to make various assumptions, including, but not limited to, future profitability, cash flows, discount rates, weighting of valuation methods and the selection of comparable publicly traded companies; and • The quantitative test for indefinite-lived intangible assets is determined using a discounted cash flow method that incorporates an estimated royalty rate, an estimated discount rate and certain other assumptions. Our estimates are based on historical trends, management’s knowledge and experience and overall economic factors, including projections of future earnings potential. Developing future cash flows in applying the income approach requires us to evaluate our intermediate to longer-term strategies, including, but not limited to, estimates about net sales growth, operating margins, capital requirements, inflation and working capital management. The development of appropriate rates to discount the estimated future cash flows requires the selection of risk premiums, which can materially impact the present value of future cash flows. Selection of an appropriate peer group under the market approach involves judgment, and an alternative selection of guideline companies could yield materially different market multiples. Weighing the different value indications involves judgment about their relative usefulness and comparability to the reporting unit. We did not record any impairment charges as a result of our October 1, 2019 impairment testing. Each reporting unit had a fair value that was substantially in excess of the carrying value. Determination of operating segments and reporting units Prior to October 1, 2018, we determined that we had three operating segments aligned to product groups. On October 1, 2018, following the acquisition of VWR, we reorganized our management team and implemented new processes to report three geographic operating segments to our chief operating decision maker: Americas, Europe and AMEA. Our operating segments were considered reporting units for the purpose of performing our October 1, 2018 annual impairment test. We have since developed additional reporting processes for our segment managers and accordingly, on October 1, 2019, determined that the Americas operating segment should be divided into two reporting units: Americas sciences and Americas silicones. The determination of operating segments and reporting units requires us to exercise significant judgment, especially in determining (i) the basis of segmentation used by our Chief Executive Officer and segment management at various points in time across the reporting periods; and (ii) whether components of operating segments are economically similar and therefore aggregated. Determining one basis of segmentation versus another fundamentally changes the way economic and other changes will impact individual reporting units; an impairment could be recognized under one basis but not another, or the impairment could be of different magnitudes. If we make a judgment that reporting units are economically dissimilar, we will establish more reporting units which could put us at a greater risk of recognizing a goodwill impairment. Accounting for changes to income tax laws Income tax laws change from time to time. The effect of a change in tax law on deferred tax assets and liabilities is recognized as a cumulative adjustment to income tax expense or benefit in the period of enactment. The effect of a change in tax law on the income tax expense or benefit itself is recognized prospectively for the applicable tax years. In December 2017, tax reform legislation was enacted in the United States. The new legislation included a broad range of corporate tax reforms, some of which were very complex. The new legislation caused us to recognize a provisional income tax benefit of $126.7 million for 2017 and an additional benefit of $29.5 million when we finalized our accounting for tax reform in 2018. Additional details are included in note 19 to the consolidated financial statements beginning on page of this report. Estimating valuation allowances on deferred tax assets We are required to estimate the degree to which tax assets and loss carryforwards will result in a future income tax benefit, based on our expectations of future profitability by tax jurisdiction. We provide a valuation allowance for deferred tax assets that we believe will more likely than not go unutilized. If it becomes more likely than not that a deferred tax asset will be realized, we reverse the related valuation allowance and recognize an income tax benefit for the amount of the reversal. At December 31, 2019, our valuation allowance on deferred tax assets was $193.9 million, $160.0 million of which relates to foreign net operating loss carry forwards that are not expected to be realized. We must make assumptions and judgments to estimate the amount of valuation allowance to be recorded against our deferred tax assets, which take into account current tax laws and estimates of the amount of future taxable income, if any. Changes to any of the assumptions or judgments could cause our actual income tax obligations to differ from our estimates. Accounting for uncertain tax positions In the ordinary course of business, there is inherent uncertainty in quantifying our income tax positions. We assess income tax positions for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded an amount having greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority assumed to have full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. Our reserve for uncertain tax positions was $83.6 million at December 31, 2019, exclusive of penalties and interest. Where applicable, associated interest expense has also been recognized as a component of the provision for income taxes. We operate in numerous countries under many legal forms and, as a result, we are subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or our level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence our net income. We file tax returns in each tax jurisdiction that requires us to do so. Should tax return positions not be sustained upon audit, we could be required to record an income tax provision. Should previously unrecognized tax benefits ultimately be sustained, we could be required to record an income tax benefit. Calculating expense for long-term compensation arrangements Our employees have received various long-term compensation awards, including stock options, RSUs, SARs and cash-based awards. We calculate expense for some of those awards using fair value estimates based on unobservable inputs. Additionally, some of those awards contain performance conditions. We assess the probability of achieving those performance conditions, and in cases where partial or exceptional performance affects the size of the award, we also estimate the projected achievement level. Expense for stock options is determined on the grant date and recognized ratably over their vesting term. We estimate the grant date fair value of stock options using the Black-Scholes model. This model requires us to make various assumptions, with the most significant assumption currently being the volatility of our stock price. A public quotation was first established for our common stock in May 2019, which does not provide adequate historical basis to reasonably estimate the expected volatility of our common stock over their more than six-year expected life. Instead, we estimate volatility based on historical stock price trends of a peer company set. The fair value of our awards would have differed had we selected different peer companies or used a different technique to estimate volatility. Increasing our expected volatility assumption by 5% for all stock options at the date of grant would have increased our 2019 stock-based compensation expense by $4.9 million. Prior to the IPO, we were also required to estimate the fair value of our common stock, which was another critical accounting policy and estimate discussed further below. Expense for some of our awards is impacted by performance conditions related to future earnings or achieving a company milestone such as an IPO. For these awards, we must assess whether the condition is probable of being achieved and, in some cases, estimate the relative performance level. If we change our assessments or estimates, or if actual earnings differ from our estimates, we will be required to recognize a cumulative adjustment in that period to remeasure all of the expense recognized to-date. During 2019, we recognized $26.9 million of expense upon achievement of our IPO, which was not considered probable prior to its consummation. At December 31, 2019, we also had outstanding unvested awards with performance conditions based on future earnings achievement. A $10 million increase or decrease to our estimate of future earnings would have caused us to recognize an additional $0.2 million of expense or $9.7 million of benefit during 2019, respectively. Expense for SARs was adjusted each period based on changes in their fair value until their settlement in November 2019. Prior to the IPO, this calculation depended upon estimating the fair value of our common stock, another critical accounting policy and estimate discussed further below. From the IPO through November 2019, the value of our common stock was determined by reference to quoted stock prices and was not subject to any significant judgment. Estimating the fair value of our common stock prior to the IPO Prior to the IPO, we were required to estimate the fair value of our common stock to determine, among other things, the expense associated with our stock-based compensation awards. The fair value of our common stock was determined by management using input from an independent third-party valuation analysis. The assumptions we used in the valuation models were based on future expectations combined with our judgment about applicable assumptions. We estimated the fair value of our common stock using a weighted average of three valuation methods in the same way as described for the critical accounting policy and estimate entitled “Testing goodwill and other intangible assets for impairment.” Changes to the estimates and assumptions used would have changed the amount of stock-based compensation recognized in each of the periods presented. For example, a 10% increase to the valuation of our common stock used from November 21, 2017 to the date of our IPO would have increased 2019 stock-based compensation expense by $6.2 million. Estimating the net realizable value of inventories We value our inventories at the lower of cost or net realizable value. We regularly review quantities of inventories on hand and compare these amounts to the expected use of each product or product line, which can require us to make significant judgments. If our judgments prove to be incorrect, we may be required to record a charge to cost of sales to reduce the carrying amount of inventory on hand to net realizable value. As with any significant estimate, we cannot be certain of future events which may cause us to change our judgments. In December 2018, we determined that market conditions had deteriorated for a specialty product line we formerly manufactured and divested as part of our global restructuring program. As a result, we no longer believed that we would be able to recover any of the cost of the manufactured inventory still on hand. We recorded a non-cash restructuring loss of $20.2 million in the fourth quarter of 2018 to reduce the value of those inventories to zero. Estimating the fair value of assets acquired from VWR In November 2017, we acquired VWR for a purchase price of $6.6 billion. To account for the acquisition, we were required to allocate the purchase price to the assets acquired and liabilities assumed based on their individual fair values with the excess allocated to goodwill. Estimating those fair values required the use of significant unobservable inputs, or level 3 measurements. Determining these inputs required us to make significant assumptions and judgments. Those estimates have impacted nearly all captions on our consolidated balance sheets and the amount of net sales, cost of sales, depreciation, amortization and income tax expense on our statements of operations. Using different estimates or assumptions would have materially affected our results in 2017 and subsequent periods. For example: • A one percent decrease to the rate we used to discount future cash flows would have increased the fair value of finite-lived intangible assets by $580 million and increased annual amortization by $25 million; and • An overall one-year decrease to our estimates of remaining useful lives would have increased annual amortization of our customer relationships by $11 million and annual depreciation of our property, plant and equipment by $17 million. All purchase accounting estimates were determined as of the acquisition date and are not adjusted for future developments. However, any differences between acquisition-date estimates and actual future results could impact other subsequent accounting under GAAP, such as the results of future impairment tests.

<s>[INST] This discussion contains forwardlooking statements that reflect our plans, estimates and beliefs. Our actual results may differ materially from those contained in or implied by any forwardlooking statements. See “Cautionary factors regarding forwardlooking statements.” Overview We are a leading global provider of mission critical products and services to customers in the biopharmaceutical, healthcare, education & government and advanced technologies & applied materials industries. We have global operations and an extensive product portfolio. We strive to enable customer success through innovation, cGMP manufacturing and comprehensive service offerings. The depth and breadth of our portfolio provides our customers a comprehensive range of products and services and allows us to create customized and integrated solutions for our customers. In 2019, we recorded net sales of $6,040.3 million, net income of $37.8 million and Adjusted EBITDA of $1,031.2 million. We also generated net sales growth of 3.0% and organic net sales growth of 5.1%, each compared to the same period in 2018. See “Reconciliations of nonGAAP measures” for a reconciliation of net income to Adjusted EBITDA and “Results of operations” for a reconciliation of net sales growth to organic net sales growth. Trends affecting our business and results of operations The following trends have affected our recent operating results, and they may also continue to affect our performance and financial condition in future periods. Our IPO generated significant proceeds and certain costs In the second quarter of 2019, we completed our IPO. The IPO generated net proceeds of $4,235.6 million after deducting underwriting discounts, commissions and other offering costs of $132.1 million. The IPO also satisfied a performance condition for certain of our stock options, which caused us to immediately recognize of $26.9 million of expense. We simplified our capital structure and reduced our borrowings Proceeds from the IPO, supplemented by operating cash flows, enabled us to simplify our equity capitalization, reduce debt levels and ultimately enabled us to lower the interest rates on our indebtedness. These actions reduced our interest burden and improved our operating cash flows and earnings in 2019, and we expect those improvements to continue into future periods. We redeemed all of our outstanding series A preferred stock for $2,630.9 million using proceeds from the IPO. Furthermore, all shares of junior convertible preferred stock automatically converted into shares of our common stock. The redemption of series A preferred stock eliminated the accumulation of yield thereon, which has positively impacted our income available to common stockholders and will continue to do so in future periods. We used the remaining net proceeds from the IPO and operating cash flows to repay $1.9 billion of outstanding indebtedness. This reduction in borrowings improved our credit profile, which enabled us to amend our debt in June 2019 and January 2020 to reduce the interest rate margins under the senior secured credit facilities. This has reduced our interest expense and cash paid for interest and will continue to do so in future periods. We reduced our expenses through a global restructuring program We have generated significant cost and commercial synergies across our business from the global restructuring program we initiated in the fourth quarter of 2017. Under that program, we are permitted to spend up to $215 million over a threeyear period to optimize our sales, gross margins and operating costs. As a result of the program, we have combined sales and marketing resources, eliminated redundant corporate functions, optimized procurement and our manufacturing footprint, and implemented best practices throughout the organization. From inception of the program through December 31, 2019, we have recognized $118.8 million of charges and have spent $8.3 million on capital projects. Through December 31, 2019, we believe that we have generated over $180 million of annualized cost synergies, which we believe will favorably impact our results in 2020 and beyond. Our AMEA region is experiencing significant growth In 2019, net sales grew by nearly 15% in the AMEA region. Our largest customers in this region are in the biopharma and advanced technologies & applied materials industries. We [/INST] Negative. </s>

TELA Bio, 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 together with the section titled “Selected Consolidated Financial Data” and the consolidated financial statements and the related notes included elsewhere in this Annual Report. In addition to historical financial information, the following discussion contains forward-looking statements based upon our current plans, expectations and beliefs that involve risks, uncertainties and assumptions. Our actual results may differ materially from those described in or implied by these forward-looking statements as a result of many factors, including those set forth under the section titled “Risk Factors” and in other parts of this Annual Report. Overview We are a commercial stage medical technology company focused on designing, developing and marketing a new category of tissue reinforcement materials to address unmet needs in soft tissue reconstruction. We offer a portfolio of advanced reinforced tissue matrices that improve clinical outcomes and reduce overall costs of care in hernia repair, abdominal wall reconstruction and plastic and reconstructive surgery. Our products are an innovative solution that integrate multiple layers of minimally-processed biologic material with interwoven polymers in a unique embroidered pattern, which we refer to as a reinforced tissue matrix. Our first portfolio of products, OviTex, addresses unmet needs in hernia repair and abdominal wall reconstruction by combining the benefits of biologic matrices and polymer materials while minimizing their shortcomings, at a cost-effective price. Our OviTex products have received 510(k) clearance from the FDA, which clearance was obtained and is currently held by Aroa and have demonstrated safety and clinical effectiveness in our BRAVO study. The first 32 patients who reached one year follow-up in the BRAVO study had experienced no ventral hernia recurrences, no explantations and no surgical site occurrences requiring follow-up surgery. Our second portfolio of products, OviTex PRS, addresses unmet needs in plastic and reconstructive surgery. We began commercialization of our OviTex products in the U.S. in July 2016 and they are now sold to more than 250 hospital accounts. In the first half of 2017, we began scaling our U.S. direct commercial presence and we initiated our BRAVO study in April 2017. Our OviTex portfolio consists of multiple products for hernia repair and abdominal wall reconstruction, inguinal hernia repair and hiatal hernia repair. In addition, to address the significant increase in the number of robotic-assisted hernia repairs over the last several years we have designed an OviTex product for use in laparoscopic and robotic-assisted surgery called OviTex LPR which we began commercializing in November 2018. We introduced additional sizes of our OviTex products in both 25 × 30 cm and 25 × 40 cm sizes in January 2019. In April 2019, our OviTex PRS products received 510(k) clearance from the FDA for plastic and reconstructive surgery, which clearance was obtained by Aroa and is currently held by us. We commenced a limited launch in May 2019 and expect to continue commercializing in a controlled manner to gradually expand our surgeon network throughout 2020. Our commercial efforts are predominantly focused on the U.S. market where we have established strong relationships in the U.S. with key constituencies, including hospitals, ambulatory surgery centers, GPOs, IDN, third-party payors and other key clinical and economic decision makers by offering a unique high quality, cost-effective product. We market our products through a single direct sales force, predominantly in the U.S. We plan to continue to invest in our commercial organization by adding account managers, clinical development specialists, business managers and administrative support staff in order to cover the highest potential of accounts for soft tissue reconstruction procedures. We plan to continue to contract with GPOs and IDNs to increase access to and penetration of hospital accounts. We plan to adjust our commercial expansion plan as appropriate as we continue to better understand the effects of COVID-19 pandemic on our sales and marketing efforts, which could be negatively impacted by a potential decrease in the number of patients seeking procedures which utilize our products and by restrictions on the ability of our sales professionals to effectively market to physicians, as hospitals defer elective surgeries, reduce and divert staffing, divert resources to patients suffering from the infectious disease and limit hospital access for non-patients. Prior to obtaining FDA clearance for our first OviTex product, we devoted substantially all of our resources to the design and development of our reinforced tissue matrices. Our development efforts to date have included an extensive non- human primate preclinical research data set for OviTex. In addition to our current portfolio, we are developing new product features and designs for both our OviTex and OviTex PRS portfolios. We intend to continue to make investments in research and development efforts to develop improvements and enhancements. Substantially all of our revenue to date has been generated by the sale of our OviTex products. Our revenue for the years ended December 31, 2019 and 2018 was $15.4 million and $8.3 million, respectively, an increase of $7.2 million, or 87% in the year ended December 31, 2019 as compared to the year ended December 31, 2018. Net loss increased from $21.1 million in the year ended December 31, 2018 to $22.4 million in the year ended December 31, 2019. We have not been profitable since inception and as of December 31, 2019, we had an accumulated deficit of $167.9 million. We expect to incur losses for the foreseeable future. During 2019, we received net proceeds of $14.4 million from the issuance of Series B preferred stock and then, in November 2019, we closed our IPO and received net proceeds of $50.6 million after deducting underwriting discounts, commissions and other offering expenses. Our products are manufactured by Aroa at their FDA registered and ISO 13485 facility in Auckland, New Zealand. We maintain our Aroa License for the exclusive supply of ovine rumen and manufacture of our reinforced tissue matrices under which we purchase product from Aroa at a fixed cost equal to 27% of our net sales of licensed products. This revenue sharing arrangement allows us to competitively price our products and pass along cost-savings to our customers. Components of Our Results of Operations Revenue Substantially all of our revenue consists of direct sales of our products to hospital accounts in the U.S. Depending on the terms of our agreements with our customers, we recognize revenue related to product sales either when control transfers, which generally occurs when the product is shipped to the customer, or when the product is utilized in a surgical procedure in the case of consignment agreements. Fees charged to customers for shipping are recognized as revenue. Recent revenue growth has been driven by, and we expect continued growth as a result of, increasing revenue from product sales due to our expanding customer base. Cost of Revenue Cost of revenue primarily consists of the costs of licensed products purchased from Aroa, charges related to excess and obsolete inventory adjustments, and costs related to shipping. We purchase product from Aroa at a fixed cost equal to 27% of our net sales of licensed products. The initial term of our Aroa License terminates on the later of (i) August 3, 2022, or (ii) the expiration of the last patent covering bovine and ovine products, with an option to extend for an additional ten year period. We expect our cost of revenue to increase in absolute dollars as, and to the extent, our sales volume grows. Amortization of Intangible Assets Amortization of intangible assets relates to the amortization of capitalized milestone amounts paid or probable to be paid to Aroa related to license fees or commercialization rights after future economic benefit has been established for a product. These capitalized milestone amounts relate to regulatory clearances, the receipt of certain supply quantities of product, and amounts based upon aggregate net sales thresholds within a specified territory, and are amortized over the remaining useful life of the intellectual property. Gross Profit and Gross Margin Our gross profit is calculated by subtracting our cost of revenue and amortization of intangible assets from our revenue. We calculate our gross margin percentage as our gross profit divided by our revenue. Our gross margin has been, and we expect it will continue to be, affected by a variety of factors, including sales volume and excess and inventory obsolescence costs. Our gross profit may increase to the extent our revenue grows. Sales and Marketing Expenses Sales and marketing expenses consist of market research and commercial activities related to the sale of OviTex and OviTex PRS and salaries and related benefits, sales commissions and stock-based compensation for employees focused on these efforts. Other significant sales and marketing expenses include costs incurred with post-market clinical studies, conferences and trade shows, promotional and marketing activities, as well as travel and training expenses. Over time we expect our sales and marketing expenses to increase in absolute dollars as we continue to expand our commercial organization to both drive and support our planned growth in revenue. We expect our sales and marketing expenses to continue to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related benefits, including stock-based compensation for personnel in executive, finance, information technology and administrative functions. General and administrative expenses also include professional service fees for legal, accounting, consulting, investor and public relations, insurance costs and direct and allocated facility-related costs. We expect that our general and administrative expenses will increase in absolute dollars as we expand our headcount to support our growth and incur additional expenses related to operating as a public company, including director and officer insurance coverage, legal costs, accounting costs, costs related to exchange listing and costs related to SEC compliance and investor relations. We expect our general and administrative expenses to continue to decrease as a percentage of revenue primarily as, and to the extent, our revenue grows. Research and Development Expenses Research and development expenses consist primarily of product research, engineering, product development, regulatory compliance and clinical development. These expenses include salaries and related benefits, stock-based compensation, consulting services, costs associated with our preclinical studies, costs incurred with our manufacturing partner under development agreements related to technology transfer, laboratory materials and supplies and an allocation of related facilities costs. We expense research and development costs as they are incurred. We expect research and development expenses in absolute dollars to increase in the future as we develop new products and enhance existing products. We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of new product development initiatives. Interest Expense Interest expense consists of cash interest under our credit facilities, non-cash interest attributable to the accrual of final payment fees and the amortization of deferred financing costs related to our indebtedness. Loss on Extinguishment of Debt Loss on extinguishment of debt consists of the excess consideration paid over the net carrying value of our debt at the time of extinguishment. Change in Fair Value of Preferred Stock Warrant Liability Prior to our IPO, our outstanding warrants to purchase shares of our preferred stock were classified as liabilities, recorded at fair value and were subject to remeasurement at each balance sheet date until they were exercised, expired or were otherwise settled. The change in fair value of our preferred stock warrant liability reflected a non-cash charge primarily driven by changes in the fair value of our underlying Series B preferred stock. All outstanding warrants to purchase shares of our preferred stock were converted into warrants to purchase shares of our common stock after our IPO. Other Income Other income consists primarily of income earned on our cash, cash equivalents and short-term investments. Results of Operations Comparison of the Year Ended December 31, 2019 and 2018 Revenue Revenue increased by $7.2 million, or 87%, to $15.4 million for the year ended December 31, 2019 from $8.3 million for the year ended December 31, 2018. The increase in revenue was primarily driven by an increase in unit sales of our products due to the expansion of our commercial organization with increased penetration within existing customer accounts as well as the introduction of larger sizes of OviTex during 2019. During the year ended December 31, 2019, we sold 3,779 units of OviTex compared to 2,110 units of OviTex during the year ended December 31, 2018, a 79% increase in unit sales volume. We commenced a limited launch of OviTex PRS in May 2019, selling 240 units during the year ended December 31, 2019. Cost of Revenue Cost of revenue (excluding amortization of intangible assets) increased by $1.3 million to $5.9 million for the year ended December 31, 2019 from $4.5 million for the year ended December 31, 2018. The increase in cost of revenue was primarily the result of higher revenue due to the growth in the number of OviTex and OviTex PRS units sold offset by a lower charge to excess and obsolete inventory of $0.7 million during the year ended December 31, 2019 compared to the prior year. The larger reserve expense recognized during the year ended December 31, 2018 was primarily due to Aroa reducing the shelf life of a certain product line during the year. Amortization of Intangible Assets Amortization of intangible assets was $0.3 million for the year ended December 31, 2019 as compared to $0.8 million for the year ended December 31, 2018. In May 2018, we achieved one of our regulatory milestones, and we determined that certain commercial sales milestone targets under our licensing agreement with Aroa became probable of being met. As a result, we recorded these milestone payments as intangible assets that required a cumulative amortization charge during 2018. Gross Margin Gross margin increased to 60% for the year ended December 31, 2019 from 36% for the year ended December 31, 2018. The increase was primarily due to a lower expense recognized for excess and obsolete inventory adjustments as a percentage of revenue during the year ended December 31, 2019 as compared to the prior year and the $0.4 million cumulative amortization charge recognized during the year ended December 31, 2018. Sales and Marketing Sales and marketing expenses increased by $4.4 million, or 32%, to $18.1 million for the year ended December 31, 2019 from $13.6 million for the year ended December 31, 2018. The increase was primarily due to higher salary, benefits and commission costs of $4.4 million due to our sales expansion activities, including the hiring of additional sales personnel. General and Administrative General and administrative expenses increased by $1.3 million, or 27%, to $6.2 million for the year ended December 31, 2019 from $4.9 million for the year ended December 31, 2018. The increase was primarily due to higher salary and benefits costs of $0.7 million, increased insurance costs of $0.4 million and higher professional fees of $0.1 million. Research and Development Research and development expenses decreased by $0.2 million, or 4%, to $4.2 million for the year ended December 31, 2019 from $4.3 million for the year ended December 31, 2018. The decrease in research and development expense primarily relates to a decrease in external development and testing. Gain on Litigation Settlement In 2018, we recognized a gain on litigation settlement of $2.2 million related to a litigation claim that we had brought against the former carrier for our directors and officer and employment practices liability insurance for breach of contract and failure to reimburse us for defense costs incurred in litigation against LifeCell that was fully settled in 2016. Interest Expense Interest expense increased by $1.8 million, or 100%, to $3.6 million for the year ended December 31, 2019 from $1.8 million for the year ended December 31, 2018. The increase was primarily due to having a larger principal balance outstanding with a higher interest rate during the year ended December 31, 2019 compared to the prior year. Loss on Extinguishment of Debt We recorded a loss on the extinguishment of debt of $1.8 million during the year ended December 31, 2018 related to the repayment of borrowings and cancellation of refinancing of our credit facilities with Hercules and MidCap Financial Trust (“MidCap”) in April and November, respectively. The losses were primarily comprised of the write-off of unamortized debt discounts and prepayment penalties at the time of extinguishment. Change in Fair Value of Preferred Stock Warrant Liability We recognized a loss on the change in the fair value of our preferred stock warrant liability of $5,000 during the year ended December 31, 2019. All outstanding warrants to purchase shares of our preferred stock were converted into warrants to purchase shares of our common stock and the liability was reclassed to additional paid-in capital in the accompanying consolidated balance sheet. Other Income Other income increased by $0.3 million, which was primarily attributable to having larger cash, cash equivalents and short-term investment balances, which earned more interest income during the year ended December 31, 2019 as compared to the prior year. Comparison of the Years Ended December 31, 2018 and 2017 Revenue Revenue increased by $4.0 million, or 95%, to $8.3 million for the year ended December 31, 2018 from $4.2 million for the year ended December 31, 2017. The increase in revenue was primarily driven by an increase in unit sales of our products due to the expansion of our commercial organization and increased penetration within the market. During 2018, we sold 2,110 units of OviTex as compared to 1,027 units of OviTex during 2017, a 105% increase in unit sales volume. Cost of Revenue Cost of revenue (excluding amortization of intangible assets) increased by $2.8 million, or 165%, to $4.5 million for the year ended December 31, 2018 from $1.7 million for the year ended December 31, 2017. The increase in cost of revenue was primarily the result of an increase in revenue as well as a $1.8 million increase in our excess and obsolete inventory reserve recognized during the year ended December 31, 2018 as compared to the prior year, primarily due to Aroa reducing the shelf life of a certain product line. Amortization of Intangible Assets Amortization of intangible assets was $0.8 million for the year ended December 31, 2018. In May 2018, we determined that certain milestone targets under our licensing agreement with Aroa became probable of being met and recorded the payment obligation as an intangible asset. There were no intangible assets or related amortization expense during the year ended December 31, 2017. Gross Margin Gross margin decreased to 36% for the year ended December 31, 2018 from 60% for the year ended December 31, 2017. The decrease was primarily due to a $1.8 million increase in excess and obsolete inventory adjustments recognized during 2018 as compared to the prior year, primarily due to Aroa reducing the shelf life of a certain product line during 2018. We also recognized $0.8 million in amortization of intangible assets in 2018. There was no such expense in 2017. Sales and Marketing Sales and marketing expenses increased by $4.9 million, or 57%, to $13.6 million for the year ended December 31, 2018 from $8.7 million for the year ended December 31, 2017. The increase was primarily due to higher salary and commission costs of $2.6 million as a result of our sales expansion activities, including hiring of additional sales personnel and expansion of marketing activity costs of $2.3 million, consistent with our growth in revenue. General and Administrative General and administrative expenses remained flat for the year ended December 31, 2018 compared to the year ended December 31, 2017. Research and Development Research and development expenses decreased by $1.4 million, or 25%, to $4.3 million for the year ended December 31, 2018 from $5.8 million for the year ended December 31, 2017. The decrease in research and development expense was primarily attributable to a decrease in licensing payments of $0.5 million, a decrease in external testing and analysis costs of $0.2 million and a decrease of $0.7 million in overall research and development efforts as we shifted our focus to the commercialization of our approved products. Gain on Litigation Settlement In 2018, we recognized a gain on litigation settlement of $2.2 million related to a litigation claim that we had brought against the former carrier for our directors and officer and employment practices liability insurance for breach of contract and failure to reimburse us for defense costs incurred in litigation against LifeCell that was fully settled in 2016. Interest Expense Interest expense decreased by $2.8 million, or 60%, to $1.8 million for the year ended December 31, 2018 from $4.6 million for the year ended December 31, 2017. The decrease was primarily due to a decrease of $1.4 million related to non-cash accretion expense, and a decrease of $1.4 million related to the recognition of a beneficial conversion feature recognized in 2017. Loss on Extinguishment of Debt We recorded a loss on the extinguishment of debt of $1.8 million during the year ended December 31, 2018 related to the repayment of borrowings and cancellation of refinancing of our credit facilities with Hercules and MidCap, in April and November, respectively. The losses were primarily comprised of the write-off of unamortized debt discounts and prepayment penalties at the time of extinguishment. Change in Fair Value of Preferred Stock Warrant Liability The fair value of our preferred stock warrant liability decreased during both of the years ended December 31, 2018 and 2017, primarily attributable to the decrease in the remaining contractual term of the outstanding warrants. As a result, we recognized a gain on the change in the fair value of our preferred stock warrant liability of $0.2 million and $54,000 during the years ended December 31, 2018 and 2017, respectively. Liquidity and Capital Resources Overview As of December 31, 2019, we had cash, cash equivalents and short-term investments of $54.6 million, working capital of $57.6 and an accumulated deficit of $167.9 million. As of December 31, 2018, we had cash and cash equivalents of $17.3 million, working capital of $13.7 million and an accumulated deficit of $137.9 million as of December 31, 2018. On November 13, 2019, we closed our IPO in which we issued and sold 4,398,700 shares of our common stock at a public offering price of $13.00 per share, which included 398,700 shares of our common stock sold pursuant to the underwriters’ option to purchase additional shares. We received net proceeds of $50.6 million after deducting underwriting discounts and commissions and other expenses. We have incurred operating losses since our inception, and we anticipate that our operating losses will continue in the near term as we seek to expand our sales and marketing initiatives to support our growth in existing and new markets and invest funds in additional research and development activities. We will also incur additional costs of operating as a public company. As of December 31, 2019, we had $30.0 million of borrowings outstanding under our credit facility (the “OrbiMed Credit Facility”). This credit facility matures in November 2023 and had $5.0 million of additional capacity through December 31, 2019, which we did not borrow. This facility requires that we maintain a minimum cash balance of $2.0 million. Based on our current business plan, we believe that our existing cash resources and short-term investments will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months from the issuance of this Annual Report. If these sources are insufficient to satisfy our liquidity requirements, we may seek to sell additional common or preferred equity or debt securities, or enter into a new credit facility. If we raise additional funds by issuing equity or equity-linked securities, our stockholders would experience dilution and any new equity securities could have rights, preferences and privileges superior to those of holders of our common stock. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. We cannot be assured that additional equity, equity-linked or debt financing will be available on terms favorable to us or our stockholders, or at all, including as a result of market volatility following the COVID-19 outbreak. If we are unable to obtain adequate financing we may be required to delay the development, commercialization and marketing of our products. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating Activities During the year ended December 31, 2019, we used $25.5 million of cash in operating activities, resulting from our net loss of $22.4 million and the change in operating assets and liabilities of $6.3 million, offset by non-cash charges of $3.2 million. Our non-cash charges were primarily comprised of our excess and obsolete inventory charge of $1.6 million, stock-based compensation expense of $0.5 million, interest expense of $0.5 million, depreciation of $0.3 million and amortization of intangibles of $0.3 million. The change in our operating assets was primarily related to increases in accounts receivable, inventory and prepaid expenses and other assets. During the year ended December 31, 2018, we used $19.9 million of cash in operating activities, resulting from our net loss of $21.1 million and the change in operating assets and liabilities of $4.5 million offset by non-cash charges of $5.6 million. Our non-cash charges were comprised of depreciation of $0.5 million, the amortization of intangibles of $0.8 million, interest expense of $0.7 million, the recognition of a loss on extinguishment of debt of $1.8 million, and our excess and obsolete inventory charge of $2.2 million. We also had stock-based compensation expense of $0.2 million and a change in the fair value of our warrants of $0.2 million. The change in our operating assets was primarily related to a $4.8 million increase in inventory, a $0.5 million increase in accounts receivable, and a decrease in accrued expenses and other liabilities of $1.2 million. These amounts were slightly offset by a $1.9 million increase in accounts payable. Investing Activities During the year ended December 31, 2019, cash used in investing activities was $12.0 million, consisting of purchases of short-term investments of $9.3 million, payments made for our intangible assets of $2.5 million and purchases of property and equipment of $0.2 million. During the year ended December 31, 2018, cash used in investing activities was $1.6 million, consisting of payments made for our intangible assets of $1.5 million, and purchases of property and equipment of $0.1 million. Financing Activities During the year ended December 31, 2019, cash provided by financing activities was $65.5 million, consisting primarily from the net proceeds received from our IPO and the net proceeds from the issuance of our Series B preferred stock. During the year ended December 31, 2018, cash provided by financing activities was $27.4 million, consisting primarily of $30.0 million in proceeds received from the issuance of long-term related party debt with OrbiMed, $8.0 million in proceeds from the issuance of long-term debt with MidCap, $4.0 million in net proceeds received from the issuance of our Series B preferred stock, partially offset by $13.0 million in repayments made on our long-term debt with MidCap and Hercules and $1.6 million in payments of issuance costs related to our debt financings. Indebtedness In November 2018, we entered into the OrbiMed Credit Facility, which consists of up to $35.0 million in term loans (the “OrbiMed Term Loans”). The OrbiMed Term Loans consist of two tranches, a $30.0 million Tranche 1 (“Tranche 1”) and a $5.0 million Tranche 2 (“Tranche 2”). Upon closing, we borrowed $30.0 million of Tranche 1 and used a portion of the proceeds to repay borrowings under our credit facility with MidCap and intend to use the remaining proceeds to fund operations and capital expenditures. We elected not to borrow Tranche 2 prior to its expiration on December 31, 2019. Pursuant to the OrbiMed Credit Facility, we provided a first priority security interest in all existing and future acquired assets, excluding intellectual property and certain other assets, owned by us. The OrbiMed Credit Facility contains a negative pledge on intellectual property owned by us. The OrbiMed Credit Facility also contains customary indemnification obligations and customary events of default, including, among other things, (i) non-payment, (ii) breach of warranty, (iii) non-performance of covenants and obligations, (iv) default on other indebtedness, (v) judgments, (iv) change of control, (vii) bankruptcy and insolvency, (viii) impairment of security, (ix) key permit events, (x) key person event, (xi) regulatory matters, (xii) and key contracts. In addition, we must maintain a minimum cash balance of $2.0 million. In the event of default under the OrbiMed Credit Facility, we would be required to pay interest on principal and all other due and unpaid obligations at the current rate in effect plus 3%. The OrbiMed Term Loans mature on November 16, 2023 and bear interest at a rate equal to 7.75% plus the greater of one-month LIBOR or 2.0%. We are required to make 60 monthly interest payments beginning on November 30, 2018 with the entire principal payment due at maturity. The OrbiMed Term Loans have a prepayment penalty equal to 10.0% of the prepaid principal amount prior to the second anniversary of the OrbiMed Term Loans, 5.0% of the prepaid principal amount after the second anniversary but prior to the third anniversary and 2.5% of the prepaid principal amount after the third anniversary. We are also required to pay an administration fee equal to $10,000 on the last day of each quarter until all obligations have been paid in full and an exit fee at the time of maturity or prepayment event equal to $3.0 million. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1) Interest payable reflects the rate in effect as of December 31, 2019. The interest rate on borrowings under the OrbiMed Credit Facility is variable and resets monthly. End of term fee reflects final payment fee due at maturity. (2) Reflects payments due for our lease of office and laboratory space in Malvern, Pennsylvania under an operating lease agreement that expires in 2021. (3) This table does not include (a) any milestone payments that are not deemed probable under license agreements as the timing and likelihood of such payments are not known with certainty and (b) contracts that are entered into in the ordinary course of business that are not material in the aggregate in any period presented above. Excluded amounts primarily consist of a $1,000 milestone payment due to Aroa when certain sales milestones are met.

<s>[INST] Overview We are a commercial stage medical technology company focused on designing, developing and marketing a new category of tissue reinforcement materials to address unmet needs in soft tissue reconstruction. We offer a portfolio of advanced reinforced tissue matrices that improve clinical outcomes and reduce overall costs of care in hernia repair, abdominal wall reconstruction and plastic and reconstructive surgery. Our products are an innovative solution that integrate multiple layers of minimallyprocessed biologic material with interwoven polymers in a unique embroidered pattern, which we refer to as a reinforced tissue matrix. Our first portfolio of products, OviTex, addresses unmet needs in hernia repair and abdominal wall reconstruction by combining the benefits of biologic matrices and polymer materials while minimizing their shortcomings, at a costeffective price. Our OviTex products have received 510(k) clearance from the FDA, which clearance was obtained and is currently held by Aroa and have demonstrated safety and clinical effectiveness in our BRAVO study. The first 32 patients who reached one year followup in the BRAVO study had experienced no ventral hernia recurrences, no explantations and no surgical site occurrences requiring followup surgery. Our second portfolio of products, OviTex PRS, addresses unmet needs in plastic and reconstructive surgery. We began commercialization of our OviTex products in the U.S. in July 2016 and they are now sold to more than 250 hospital accounts. In the first half of 2017, we began scaling our U.S. direct commercial presence and we initiated our BRAVO study in April 2017. Our OviTex portfolio consists of multiple products for hernia repair and abdominal wall reconstruction, inguinal hernia repair and hiatal hernia repair. In addition, to address the significant increase in the number of roboticassisted hernia repairs over the last several years we have designed an OviTex product for use in laparoscopic and roboticassisted surgery called OviTex LPR which we began commercializing in November 2018. We introduced additional sizes of our OviTex products in both 25 × 30 cm and 25 × 40 cm sizes in January 2019. In April 2019, our OviTex PRS products received 510(k) clearance from the FDA for plastic and reconstructive surgery, which clearance was obtained by Aroa and is currently held by us. We commenced a limited launch in May 2019 and expect to continue commercializing in a controlled manner to gradually expand our surgeon network throughout 2020. Our commercial efforts are predominantly focused on the U.S. market where we have established strong relationships in the U.S. with key constituencies, including hospitals, ambulatory surgery centers, GPOs, IDN, thirdparty payors and other key clinical and economic decision makers by offering a unique high quality, costeffective product. We market our products through a single direct sales force, predominantly in the U.S. We plan to continue to invest in our commercial organization by adding account managers, clinical development specialists, business managers and administrative support staff in order to cover the highest potential of accounts for soft tissue reconstruction procedures. We plan to continue to contract with GPOs and IDNs to increase access to and penetration of hospital accounts. We plan to adjust our commercial expansion plan as appropriate as we continue to better understand the effects of COVID19 pandemic on our sales and marketing efforts, which could be negatively impacted by a potential decrease in the number of patients seeking procedures which utilize our products and by restrictions on the ability of our sales professionals to effectively market to physicians, as hospitals defer elective surgeries, reduce and divert staffing, divert resources to patients suffering from the infectious disease and limit hospital access for nonpatients. Prior to obtaining FDA clearance for our first OviTex product, we devoted substantially all of our resources to the design and development of our reinforced tissue matrices. Our development efforts to date have included an extensive non human primate preclinical research data set for OviTex. In addition to our current portfolio, we are developing new product features and designs for both our OviTex and OviTex PR [/INST] Negative. </s>

Kaleido Biosciences, 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 our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, the forward-looking statements contained in the following discussion and analysis. Overview We are a clinical-stage healthcare company with a differentiated, chemistry-driven approach focused on leveraging the potential of the microbiome organ to treat disease and improve human health. We have built a human-centric proprietary product platform for discovery and development that we believe will enable the rapid advancement of a broad portfolio of novel product candidates into clinical studies under regulations supporting research with food. Our product candidates are MMTs, which are designed to modulate the metabolic output and profile of the microbiome by driving the function and distribution of the organ’s existing microbes. We have an industrialized approach to the discovery and development of MMTs, and our initial MMTs are targeted glycans. Each targeted glycan is an ensemble of complex carbohydrates that is intended to modulate microbial metabolism to drive a specific biological response. We believe our MMTs have the potential to be novel treatments across a variety of diseases and conditions. The human microbiome is generally a community of more than 30 trillion microbes, organisms that include bacteria, viruses, archaea and fungi, which reside on and inside the human body. By evolving together over thousands of years, microbes and humans have developed an intricate and mutually beneficial relationship. Given the profound impact that microbes have on human health, this highly complex microbial ecosystem has been referred to as a “newly discovered organ.” There is a growing body of research that links a healthy microbiome with overall human health, while dysbiosis, or imbalance, in the microbiome has been correlated with numerous human conditions, including those that can cause significant morbidity and mortality. Some of these conditions include irritable bowel syndrome, Parkinson’s disease, diabetes, metabolic syndrome, cancer, allergies and ulcerative colitis. The microbiome organ remains a largely untapped frontier in healthcare, and we believe that we are uniquely positioned to succeed in translating its promise into solutions for human health. Since our inception in 2015, we have devoted substantially all of our resources to building our proprietary product platform, developing our pipeline of MMT candidates, building our intellectual property portfolio and process development and manufacturing function, business planning, raising capital and providing general and administrative support for these operations. To date, we have primarily financed our operations through public offering of our equity securities, private placement of our convertible preferred stock and borrowings of long-term debt. We have incurred significant net losses since inception and expect to continue to incur net operating losses for the foreseeable future. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: • conduct preclinical studies, clinical studies and clinical trials for our product candidates; • advance the development of our product candidate pipeline; • continue to discover and develop additional product candidates; • continue to build out our proprietary product platform and to increase its throughput for the discovery and nomination of product candidates; • develop, acquire or in-license other product candidates and technologies; • maintain, expand and protect our intellectual property portfolio; • hire additional clinical, scientific and commercial personnel; • expand manufacturing capabilities, including in-house and third-party commercial manufacturing, through the purchase, renovation, customization and operation of a manufacturing facility and securing supply chain capacity sufficient to provide clinical study and clinical trial materials and commercial quantities of any product candidates which we may commercialize; • seek regulatory approvals for any product candidates for therapeutic indications that successfully complete clinical trials; • establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain regulatory approval or identify alternate commercial pathways for such products; and • add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to support our transition to a public reporting company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for or identify alternate non-drug pathways for our product candidates. If we obtain regulatory approval for or otherwise commercialize 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 of December 31, 2019, we had $71.2 million in cash and cash equivalents and an accumulated deficit of $192.6 million. Based on our current operating plans, we have sufficient cash and cash equivalents to fund our operating expenses and capital expenditures into the first quarter of 2021. We will require additional capital to sustain our operations, including the development of our MMT candidates. We may implement cost reduction strategies, which may include amending, delaying, limiting, reducing or terminating one or more of our ongoing or planned clinical trials of our product candidates. These factors raise substantial doubt about our ability to continue as a going concern. For more information, refer to “-Liquidity and Capital Resources” below and Note 1 to our condensed consolidated financial statements included elsewhere in this Annual Report. 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 equity or 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. Financial Overview 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 our current product candidates or additional product candidates that we may develop in the future are successful and can be commercialized, 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. Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. These expenses include: • development and operation of our proprietary product platform; • employee-related expenses, including salaries, related benefits and stock-based compensation expense, for employees engaged in research and development functions; • expenses incurred in connection with the preclinical and clinical development of our product candidates, including under agreements with third parties, such as consultants and contract research organizations, or CROs; • the cost of laboratory supplies and acquiring, developing and manufacturing products for use in our preclinical studies, clinical studies and clinical trials, including under agreements with third parties, such as consultants and contract manufacturing organizations, or CMOs; • facilities, depreciation and other expenses, which include direct or allocated expenses for rent and maintenance of facilities and insurance; and • costs related to compliance with regulatory requirements. We expense research and development costs as incurred. Advance payments that we make for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. Our direct external research and development expenses are tracked on a program-by-program basis and consist of costs that include fees, reimbursed materials and other costs paid to consultants, contractors, CMOs and CROs in connection with our preclinical and clinical development and manufacturing activities. We do not allocate employee costs, costs associated with our discovery efforts, laboratory supplies and facilities expenses, including depreciation or other indirect costs, to specific product development programs because these costs are deployed across multiple programs and our platform technology and, as such, are not separately classified. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect that our research and development expenses will increase substantially in connection with our planned preclinical and clinical development activities in the near term and in the future. At this time, we cannot accurately estimate or know the nature, timing and costs of the efforts that will be necessary to complete the preclinical and clinical development of any of our product candidates. The successful development and commercialization of our product candidates is highly uncertain. This is due to the numerous risks and uncertainties associated with product development and commercialization, including the following: • the timing and progress of preclinical and clinical development activities; • the number and scope of programs we decide to pursue and their regulatory paths to market; • raising additional funds necessary to complete preclinical and clinical development of and commercialize our product candidates; • the progress of the development efforts of parties with whom we have entered into and may enter into collaboration arrangements; • our ability to maintain our current research and development programs and to establish new ones; • our ability to maintain existing and 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 for any product candidates for therapeutic indications; • the availability of specialty raw materials for use in production of our product candidates; • establishing agreements with third-party manufacturers for clinical supply for our clinical trials and commercial manufacturing, if any of our product candidates is approved or commercialized on an alternate regulatory pathway; • meeting demand in a timely fashion with sufficient supply at appropriate quality levels; • 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 if approval to market is required; • obtaining and maintaining third-party insurance coverage and adequate reimbursement; • the acceptance of our product candidates, if commercialized, by patients, consumers, the medical community and third-party payors; • competition with other products; and • a continued acceptable safety profile of our therapies following commercialization. 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 or commercialization for any of our product candidates. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related costs, including stock-based compensation, for personnel in executive, finance, 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; and facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. 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. 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: Research and Development Expenses The increase in direct costs related to our KB195 program of $5,585 was primarily due to continued costs incurred with external CROs and external CMOs and associated with our preclinical and clinical development activities. The increase in personnel-related costs of $5,975 and stock-based compensation expense of $1,936 was due to increased headcount in our research and development function. The increase in external manufacturing and research costs of $5,951 was primarily due to an increase in production of study material used in preclinical studies, clinical studies and clinical trials, as well as increased clinical and preclinical CRO activities. The increase in professional and consulting fees of $2,209 was primarily due to higher consulting fees within our regulatory affairs, quality, and clinical development functions as our pipeline programs have continued to advance. General and Administrative Expenses The decrease in personnel-related costs of $1,032 was primarily due to the reduced salary and bonus expenses resulting from headcount reductions in the fourth quarter of 2019. The increase in stock-based compensation expense of $1,168 was primarily due to an increase in the number of shares outstanding and a higher fair value per share which increased the fair value of these awards. The increase in facility-related and other expenses of $3,893 was primarily due to increased facility related expenses associated with the build out of our new corporate headquarters that were attributed to general and administrative functions. Interest Income Interest income for the year ended December 31, 2019 was $1,693 compared to $1,118 in the year ended December 31, 2018. Interest income increased primarily as a result of higher invested balances due to cash proceeds received from our IPO in February 2019. Interest income in future periods will fluctuate based upon the amount of invested cash available. Interest expense Interest expense for the year ended December 31, 2019 was $977, compared to $1,005 for the year ended December 31, 2018. The interest expense is related to interest paid on our term loan. Interest expense is expected to increase in 2020 due to increased borrowings and the interest rate which increased under the new debt facility. 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 primarily financed our operations through the public offering of our equity securities, private placement of our convertible preferred stock and borrowings of long-term debt. As of December 31, 2019, $22.5 million was outstanding under the debt facility and $12.5 million was available for borrowing contingent upon successful completion of financing and operational milestones. In March 2019, we completed our IPO, pursuant to which we issued and sold 5,000,000 shares of common stock. We received aggregate net proceeds of $69.8 million, after deducting underwriting discounts and commissions, but before deducting offering costs totaling $3.8 million. As of December 31, 2019, we had $71.2 million in cash and cash equivalents and an accumulated deficit of $192.6 million. Based on our current operating plans, we have sufficient cash and cash equivalents or borrowing capacity to fund our operating expenses and capital expenditures into the first quarter of 2021. We will require additional capital to sustain our operations, including the development of our MMT candidates. We may implement cost reduction strategies, which may include amending, delaying, limiting, reducing or terminating one or more of our ongoing or planned clinical trials of our product candidates. These factors raise substantial doubt about our ability to continue as a going concern. For more information, refer to “-Liquidity and Capital Resources” below and Note 1 to our condensed consolidated financial statements included elsewhere in this Annual Report. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Net Cash Used in Operating Activities During the year ended December 31, 2019, operating activities used $75.8 million of cash, due to our net loss of $86.3 million, partially offset by non-cash charges of $11.8 million and net cash used by changes in our operating assets and liabilities of $1.2 million. Net cash used in our operating assets and liabilities primarily consisted of a $1.9 decrease in prepaid expenses and other assets and a $0.7 million increase in accounts payable and accrued expenses. During the year ended December 31, 2018, operating activities used $46.3 million of cash, due to our net loss of $61.7 million, partially offset by non-cash charges of $8.9 million and net cash provided by changes in our operating assets and liabilities of $6.5 million. Net cash provided by changes in our operating assets and liabilities primarily consisted of a $4.7 million increase in accrued expenses and a $1.8 million increase in accounts payable. Changes in prepaid expenses and other current assets, accounts payable and accrued expenses and other liabilities were generally due to growth in our business, the advancement of our research programs and the timing of vendor invoices and payments. Net Cash Used in Investing Activities During the years ended December 31, 2019 and 2018, net cash used in investing activities was $3.5 million and $3 million, respectively, due to purchases of property and equipment. Net Cash Provided by Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $74.6 million, consisting of $66.0 million in aggregate net proceeds from our IPO in March 2019, $6.6 million in net proceeds from debt refinancings, and $0.3 million in the settlement of our derivative liability. During the year ended December 31, 2018, net cash provided by financing activities was $98.9 million, consisting primarily of $100.7 million in proceeds from the sale of our convertible preferred stock. On December 31, 2019, we entered into a Credit Agreement (the “Credit Agreement”) with Hercules Capital, Inc. (the “Lender”). Under the Credit Agreement, the Lenders extended an initial $22.5 million to us, with the option to draw down an additional $12.5 million if certain milestones and conditions are met. The Credit Agreement replaced the existing debt. We incurred fees of $0.4 million related to a facility charge and legal fees, which was paid to the lender on the closing date. These amounts were recorded as a debt discount and are being amortized as interest expense using the effective interest method over the life of the Credit Agreement. The Credit Agreement also includes an end of term charge equal to 7.55% of the aggregate principal amount of all advances. The end of term charge is being accrued and recorded to interest expense over the life of the Loan using the effective interest method. The Credit Agreement contains customary representations and warranties, events of default and affirmative and negative covenants, including, among others, covenants that limit or restrict the Borrower’s ability to, among other things, incur additional indebtedness, merge or consolidate, make acquisitions, pay dividends or other distributions or repurchase equity, make investments, dispose of assets and enter into certain transactions with affiliates, in each case subject to certain exceptions. As security for its obligations under the Credit Agreement, the Borrowers granted the Lender a first priority security interest on substantially all of the Borrowers’ assets (other than intellectual property), subject to certain exceptions. The facility carries a 48-month term with interest only payments on the term loan for the first 15 months, which can be extended to up to 24 months, depending on the achievement of certain performance milestones. The Term Loan will mature in January 2024 and bears an interest rate of equal to the greater of (i) 8.95% plus the prime rate last quoted in The Wall Street Journal (or a comparable replacement rate if The Wall Street Journal ceases to quote such rate) minus 4.75% and (ii) 8.95%. The Term Loan is subject to mandatory prepayment provisions that require prepayment upon the occurrence of a Change in Control event (as defined in the Credit Agreement). Funding Requirements Over the next several quarters we are focusing our activities on key exploratory and clinical studies and clinical trials which we expect will reduce our overall expense rate. In the periods that follow, assuming the success of our clinical studies and clinical trials, we anticipate our expenses to increase as we progress towards larger and more pivotal clinical studies and clinical trials of our product candidates, with the potential for larger clinical studies, clinical trials and associated manufacturing. The timing and amount of our operating expenditures will depend largely on: • the commencement, enrollment or results of the planned clinical studies or clinical trials of our product candidates or any future clinical studies or clinical trials we may conduct, or changes in the development status of our product candidates; • the timing and outcome of regulatory review of our product candidates; • our decision to initiate a clinical trial, not to initiate a clinical trial or to terminate an existing clinical trial; • changes in laws or regulations applicable to our product candidates, including but not limited to clinical trial requirements for approvals; • developments concerning our CMOs; • our ability to obtain materials and to produce adequate cGMP compliant product supply for any approved or commercialized product or inability to do so at acceptable prices; • our ability to establish and maintain collaborations, if needed; • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we obtain marketing approval or identify an alternate regulatory pathway to market; • the costs involved in prosecuting patent applications and enforcing patent claims and other intellectual property claims; • additions or departures of key scientific or management personnel; • unanticipated serious safety concerns related to the use of our product candidates; and • the terms and timing of any collaboration, license or other arrangement, including the terms and timing of any milestone payments thereunder. We believe that our existing cash and cash equivalents will enable us to fund our operating expenses, capital expenditure requirements and debt service obligations into the first quarter of 2021. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. 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, 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 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. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements as defined under applicable SEC rules. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses, and the disclosure of contingent assets and liabilities in our 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. 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 preclinical development activities; • CROs and investigative sites in connection with preclinical, human clinical studies and clinical trials; and • CMOs in connection with the production of preclinical, human clinical studies and clinical trial materials. We measure the expense recognized based 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, human clinical 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 certain 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 changes in estimates that increase or decrease amounts recognized 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 fair value on the date of the grant using the Black-Scholes option-pricing model for options. Compensation expense for those awards is recognized over the requisite service period, which is generally the vesting period of the respective award. We use the straight-line method to record the expense of awards with service-based vesting conditions. We use the graded-vesting method to record the expense of awards with both service-based and performance-based vesting conditions, commencing when achievement of the performance condition becomes probable. The fair value of each stock option grant is estimated 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. 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. 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. Recent Accounting Pronouncements Refer to Note 2, “Summary of Significant Accounting Policies,” in the accompanying notes to the condensed consolidated financial statements for a discussion of recent accounting pronouncements. 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] Overview We are a clinicalstage healthcare company with a differentiated, chemistrydriven approach focused on leveraging the potential of the microbiome organ to treat disease and improve human health. We have built a humancentric proprietary product platform for discovery and development that we believe will enable the rapid advancement of a broad portfolio of novel product candidates into clinical studies under regulations supporting research with food. Our product candidates are MMTs, which are designed to modulate the metabolic output and profile of the microbiome by driving the function and distribution of the organ’s existing microbes. We have an industrialized approach to the discovery and development of MMTs, and our initial MMTs are targeted glycans. Each targeted glycan is an ensemble of complex carbohydrates that is intended to modulate microbial metabolism to drive a specific biological response. We believe our MMTs have the potential to be novel treatments across a variety of diseases and conditions. The human microbiome is generally a community of more than 30 trillion microbes, organisms that include bacteria, viruses, archaea and fungi, which reside on and inside the human body. By evolving together over thousands of years, microbes and humans have developed an intricate and mutually beneficial relationship. Given the profound impact that microbes have on human health, this highly complex microbial ecosystem has been referred to as a “newly discovered organ.” There is a growing body of research that links a healthy microbiome with overall human health, while dysbiosis, or imbalance, in the microbiome has been correlated with numerous human conditions, including those that can cause significant morbidity and mortality. Some of these conditions include irritable bowel syndrome, Parkinson’s disease, diabetes, metabolic syndrome, cancer, allergies and ulcerative colitis. The microbiome organ remains a largely untapped frontier in healthcare, and we believe that we are uniquely positioned to succeed in translating its promise into solutions for human health. Since our inception in 2015, we have devoted substantially all of our resources to building our proprietary product platform, developing our pipeline of MMT candidates, building our intellectual property portfolio and process development and manufacturing function, business planning, raising capital and providing general and administrative support for these operations. To date, we have primarily financed our operations through public offering of our equity securities, private placement of our convertible preferred stock and borrowings of longterm debt. We have incurred significant net losses since inception and expect to continue to incur net operating losses for the foreseeable future. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: conduct preclinical studies, clinical studies and clinical trials for our product candidates; advance the development of our product candidate pipeline; continue to discover and develop additional product candidates; continue to build out our proprietary product platform and to increase its throughput for the discovery and nomination of product candidates; develop, acquire or inlicense other product candidates and technologies; maintain, expand and protect our intellectual property portfolio; hire additional clinical, scientific and commercial personnel; expand manufacturing capabilities, including inhouse and thirdparty commercial manufacturing, through the purchase, renovation, customization and operation of a manufacturing facility and securing supply chain capacity sufficient to provide clinical study and clinical trial materials and commercial quantities of any product candidates which we may commercialize; seek regulatory approvals for any product candidates for therapeutic indications that successfully complete clinical trials; establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain regulatory approval or identify alternate commercial pathways for such products; and add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts, as well as to support our transition to a public reporting company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for or identify alternate nondrug pathways for our product candidates. If we obtain regulatory approval for or otherwise commercialize any of our product candidates, we expect to incur significant expenses related to developing our commercialization capability to support product sales, market [/INST] Positive. </s>

EXAGEN INC.

2020-03-25

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion of our financial condition and results of operations in conjunction with the 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 and financial performance, includes forward-looking statements that are based on current beliefs, plans and expectations and involve risks, uncertainties and assumptions. You should read the "Special note regarding forward-looking statements" and "Risk Factors" section of this Annual Report on Form 10-K 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. Overview We are dedicated to transforming the care continuum for patients suffering from debilitating and chronic autoimmune diseases by enabling timely differential diagnosis and optimizing therapeutic intervention. We have developed and are commercializing a portfolio of innovative testing products under our AVISE® brand, several of which are based on our proprietary CB-CAPs technology. Our goal is to enable rheumatologists to improve care for patients through the differential diagnosis, prognosis and monitoring of complex autoimmune and autoimmune-related diseases, including SLE and RA. Our strategy includes leveraging our portfolio of testing products to market therapeutics through our sales channel, targeting the approximately 5,000 rheumatologists across the United States. Our business model of integrating testing products and therapeutics positions us to offer targeted solutions to rheumatologists and, ultimately, better serve patients. We currently market nine testing products under our AVISE® brand that allow for the differential diagnosis, prognosis and monitoring of complex autoimmune and autoimmune-related diseases. Our lead testing product, AVISE® CTD, enables differential diagnosis for patients presenting with symptoms indicative of a wide variety of CTDs and other related diseases with overlapping symptoms. We commercially launched AVISE® CTD in 2012 and revenue from this product comprised 82% of our revenue for each of the years ended December 31, 2019 and 2018. There is an unmet need for rheumatologists to add clarity in their CTD clinical evaluation, and we believe there is a significant opportunity for our tests that enable the differential diagnosis of these diseases, particularly for potentially life-threatening diseases such as SLE. In order to advance our integrated testing and therapeutics strategy, in December 2018 we entered into the Janssen agreement to exclusively promote SIMPONI® in the United States for the treatment of adult patients with moderate to severe RA and for other indicated rheumatic diseases. We began direct promotion of SIMPONI® in January 2019 and in support of these promotion efforts we expanded our salesforce from 31 representatives as of December 31, 2018 to 50 representatives as of December 31, 2019. Our SIMPONI® promotion efforts contributed approximately $1.5 million in incremental revenue in 2019 with our quarterly tiered promotion fee based on the incremental increase in total prescribed units above a predetermined average baseline of approximately 29,000 prescribed units per quarter. We also have additional agreements with other leading pharmaceutical companies, including GSK and Horizon Therapeutics, that leverage our testing products and the information generated from such tests. We plan to pursue additional strategic partnerships with a focus on the commercialization of therapeutics that are synergistic with our testing products. We perform all of our AVISE® tests in our approximately 8,000 square foot clinical laboratory, which is certified by CLIA and accredited by CAP, and located in Vista, California. Our laboratory is certified for performance of high-complexity testing by CMS in accordance with CLIA. We are approved to offer our products in all 50 states. Our clinical laboratory reports all AVISE® testing product results within five business days. We market our AVISE® testing products using our specialized salesforce. Unlike many diagnostic salesforces that are trained only to understand the comparative benefits of their tests, the specialized backgrounds of our salesforce coupled with our comprehensive training enables our sales representatives to interpret results from our de-identified patient test reports and provide unique insights in a highly tailored discussion with rheumatologists. Our integrated testing and therapeutics strategy results in a unique opportunity to promote and sell targeted therapies in patient focused sales calls with rheumatologists, including those with whom we have a longstanding relationship and history using our portfolio of testing products. Reimbursement for our testing services comes from several sources, including commercial third-party payers, such as insurance companies and health maintenance organizations, government payers, such as Medicare, and patients. Reimbursement rates vary by product and payer. We continue to focus on expanding coverage among existing contracted rheumatologists and to achieve coverage with commercial payers, laboratory benefit managers and evidence review organizations. Since inception we have devoted substantially all our efforts developing and marketing products for the diagnosis, prognosis and monitoring of autoimmune diseases. Although our revenue has increased sequentially year over year, we have never been profitable and, as of December 31, 2019 we had an accumulated deficit of $164.6 million. We incurred net losses of $12.0 million and $8.0 million for the years ended December 31, 2019 and 2018, respectively. We expect to continue to incur operating losses in the near term as our operating expenses will increase to support the growth of our business, as well as additional costs associated with being a public company. We have funded our operations primarily through equity and debt financings and revenue from sales of our products. Through the date of our initial public offering (IPO) in September 2019, our operations were financed primarily from sales of our common and redeemable convertible preferred stock and borrowings under various debt financings. In September 2019, we completed our IPO of 4,140,000 shares of our common stock at a price to the public of $14.00 per share, including the exercise in full by the underwriters of their option to purchase 540,000 additional shares of our common stock. Including the option exercise, the aggregate net proceeds to us from the offering was approximately $50.4 million, net of underwriting discounts, commissions and other offering expenses, for aggregate expenses of approximately $7.5 million. As of December 31, 2019, we had $72.1 million of cash and cash equivalents. Factors Affecting Our Performance We believe there are several important factors that have impacted, and that we expect will impact, our operating performance and results of operations, including: ▪Continued Adoption of Our Testing Products. Since its launch in 2012, we have grown the number of our AVISE® CTD tests delivered at a compound annual growth rate of 81%, with limited incremental investment in our commercial infrastructure. Over 105,000 AVISE® CTD tests were delivered in 2019, representing 26% growth over 2018, and the number of ordering healthcare providers reached 1,707 in the fourth quarter of 2019, representing 34% growth over the same quarter in 2018. In the fourth quarter of 2019, we reached 572 adopting healthcare providers, which we classify as those who had previously prescribed at least 11 diagnostic tests in the corresponding period, compared to 506 in the same period in 2018. More than 387,000 AVISE® CTD tests have been delivered since launch. Revenue growth for our testing products will depend on our ability to continue to expand our base of ordering healthcare providers and increase our penetration with existing healthcare providers. ▪Reimbursement for Our Testing Products. Our revenue depends on achieving broad coverage and reimbursement for our tests from third-party payers, including both commercial and government payers such as Medicare. Payment from third-party payers differs depending on whether we have entered into a contract with the payers as a "participating provider" or do not have a contract and are considered a "non-participating provider." Payers will often reimburse non-participating providers, if at all, at a lower amount than participating providers. We have received a substantial portion of our revenue from a limited number of third-party commercial payers, most of which have not contracted with us to be a participating provider. Historically, we have experienced situations where commercial payers proactively reduced the amounts they were willing to reimburse for our tests, and in other situations, commercial payers have determined that the amounts they previously paid were too high and have sought to recover those perceived excess payments by deducting such amounts from payments otherwise being made. When we contract to serve as a participating provider, reimbursements are made pursuant to a negotiated fee schedule and are limited to only covered indications. If we are not able to obtain or maintain coverage and adequate reimbursement from third-party payers, we may not be able to effectively increase our testing volume and revenue as expected. Additionally, retrospective reimbursement adjustments can negatively impact our revenue and cause our financial results to fluctuate. ▪Promotion of SIMPONI®. In January 2019, we began promoting SIMPONI® in the United States under the Janssen agreement. Our SIMPONI® promotion efforts contributed approximately $1.5 million in incremental revenue in 2019 with our quarterly tiered promotion fee based on the incremental increase in total prescribed units above a predetermined average baseline of approximately 29,000 prescribed units per quarter. We may encounter difficulties in successfully promoting SIMPONI® and generating significant revenue under the agreement. Our ability to effectively promote SIMPONI® will require us to be successful in a range of activities, including training and deploying additional sales representatives and creating demand for SIMPONI® through our own sales activities as well as those of Janssen. Based on our estimate of the total U.S. addressable market for SIMPONI®'s approved indications of $28 billion, each incremental 1% market share we are able to capture for SIMPONI® above the predetermined baseline under the Janssen Agreement could result in incremental revenue to us of up to $84 million. In interest of supporting these efforts we expect to continue to expand our salesforce in 2020. However, it may take longer to generate meaningful revenue than we currently expect and we may not be successful in materially increasing market share, which would cause us to continue to rely on our existing testing products to drive revenue growth. ▪Development of Additional Testing Products. We rely on sales of our AVISE® CTD test to generate the significant majority of our revenue. We expect to continue to invest in research and development in order to develop additional testing products and expect these costs to increase. Our success in developing new testing products will be important in our efforts to grow our business by expanding the potential market for our testing products and diversifying our sources of revenue. ▪Margin Expansion. We believe growth in our promotion of therapeutics will meaningfully improve our margin profile and further support our goal of achieving profitability. We also expect an increase to our gross margins beginning in the first quarter of 2020 following the expiration of a 10% annual royalty on our CB-CAPs technology. In addition, we believe we are well positioned to drive further margin expansion through a continued focus on increasing operating leverage through the implementation of certain internal initiatives, such as conducting additional validation and reimbursement oriented clinical studies to facilitate payer coverage of our testing products, capitalizing on our growing reagent purchasing to negotiate improved volume-based pricing and automation in our clinical laboratory to reduce material and labor costs. However, these potential margin increases may be partially offset by expected decreases in Medicare reimbursement rates as a result of the Protecting Access to Medicare Act of 2014, or PAMA. ▪Timing of Our Research and Development Expenses. Our spending on experiments and clinical studies may vary substantially from quarter to quarter. We also expend funds to secure clinical samples that can be used in discovery, product development, clinical validation, utility and outcome studies. The timing of these research and development activities is difficult to predict. If a substantial number of clinical samples are obtained in a given quarter or if a high-cost experiment is conducted in one quarter versus the next, the timing of these expenses will affect our financial results. We conduct clinical studies to validate our new testing products, as well as ongoing clinical and outcome studies to further expand the published evidence to support our commercialized AVISE® testing products. Spending on research and development for both experiments and studies may vary significantly by quarter depending on the timing of these various expenses. ▪How We Recognize Revenue. We record revenue on an accrual basis based on our estimate of the amount that will be ultimately realized for each test upon delivery based on a historical analysis of amounts collected by test and by payer. Changes to such estimates may increase or decrease revenue recognized in future periods. While each of these areas present significant opportunities for us, they also pose significant risks and challenges that we must address. In addition, the recent COVID-19 outbreak may have a material adverse effect on our business, financial condition and results of operations, including as a result of shutdowns of our facilities and operations as well as those of our suppliers and courier services, disrupt the supply chain of material needed for our tests, interrupt our ability to receive specimens, impair our ability to perform or deliver the results from our genomic tests, impede patient movement or interrupt healthcare services causing a decrease in test volumes, delay coverage decisions from Medicare and third party payors, and delay ongoing and planned clinical trials involving our tests. We discuss many of these risks, uncertainties and other factors in the section entitled "Risk Factors." Janssen Promotion Agreement In December 2018, we entered into a co-promotion agreement with Janssen, under which we are responsible for the costs associated with our salesforce in promoting SIMPONI® in the United States. Janssen is responsible for all other costs associated with our promotion of SIMPONI® under the Janssen agreement. In exchange for our sales and co-promotional services, we are entitled to a quarterly tiered promotion fee ranging from $750 to $1,250 per prescription based on the incremental increase in total prescribed units of SIMPONI® for that quarter over a predetermined baseline. The predetermined average baseline for the initial term of 18 months is approximately 29,000 prescribed units per quarter, subject to adjustment under certain circumstances. In September 2019, we exercised our option to extend the term of the Janssen agreement to December 31, 2021. Janssen can terminate the agreement at any time for any reason upon 30 days' notice to us, and we can terminate the agreement for any reason at the end of any calendar quarter upon 30 days' notice to Janssen. Either party may terminate the agreement in the event of the other party's default of any of its material obligations under the agreement if such default remains uncured for a specified period of time following receipt of written notice of such default. We recognized co-promotional revenue of approximately $1.5 million during the year ended December 31, 2019 and expect to continue to recognize revenue as we perform co-promotional services based on the number of total prescribed units of SIMPONI® over the predetermined baseline. Financial Overview Revenue To date, we have derived nearly all of our revenue from the sale of our testing products, most of which is attributable to our AVISE® CTD test. We primarily market our testing products to rheumatologists in the United States. The rheumatologists who order our testing products and to whom results are reported are generally not responsible for payment for these products. The parties that pay for these services, or payers, consist of healthcare insurers, government payers (primarily Medicare and Medicaid), client payers (i.e. hospitals, other laboratories, etc.), and patient self-pay. Our service is completed upon the delivery of test results to the prescribing rheumatologists which triggers billing for the service. We recognize revenue in accordance with the provisions of ASC Topic 606, Revenue from Contracts with Customers. We record revenue on an accrual basis based on our estimate of the amount that will be ultimately realized for each test upon delivery based on a historical analysis of amounts collected by test and by payer. These assessments require significant judgment by management. Our ability to increase our revenue will depend on our ability to further penetrate the market for our current and future testing products, and increase our reimbursement and collection rates for tests delivered, as well as our ability to successfully promote SIMPONI®. Operating Expenses Costs of Revenue (Excluding Amortization of Purchased Technology) Costs of revenue represents the expenses associated with obtaining and testing patient specimens. The components of our costs of revenue include materials costs, direct labor, equipment and infrastructure expenses associated with testing specimens, shipping charges to transport specimens, blood specimen collections fees, royalties, depreciation and allocated overhead, including rent and utilities. Each payer, commercial third-party, government, or individual, reimburses us at different amounts. These differences can be significant. As a result, our costs of revenue as a percentage of revenue may vary significantly from period to period due to the composition of payers for each month's billings. We expect that our costs of revenue will increase in absolute dollars as the number of tests we perform increases. However, we expect that the cost per test will decrease over time due to volume discounts on materials and shipping costs and other volume efficiencies we may gain as the number of tests we perform increases. Selling, General and Administrative Expenses Selling, general and administrative expenses consist of personnel costs, including stock-based compensation expense, direct marketing expenses, accounting and legal expenses, consulting costs, and allocated overhead including rent, information technology, depreciation and utilities. We expect that our selling, general and administrative expenses will increase in absolute dollars in 2020 as we expand our sales and sales support functions, including expansion activities related to our promotion of SIMPONI®, and incur expenses from operating as a public company for the entire year, including expenses related to compliance with the rules and regulations of the SEC and Nasdaq, additional insurance, investor relations activities and other administrative and professional services such as accounting, legal, regulatory and tax. Research and Development Expenses Research and development expenses include costs incurred to develop our technology, testing products and product candidates, collect clinical specimens and conduct clinical studies to develop and support our testing products and product candidates. These costs consist of personnel costs, including stock-based compensation expense, materials, laboratory supplies, consulting costs, costs associated with setting up and conducting clinical studies and allocated overhead including rent and utilities. We expense all research and development costs in the periods in which they are incurred. We expect that our research and development expenses will increase in absolute dollars as we continue to invest in research and development activities related to our existing testing products and product candidates. Amortization of Intangible Assets Amortization of intangible assets represents the total amortization expense for our purchased technologies. The intangible assets recorded as of December 31, 2017 became fully amortized in 2018; accordingly, we do not expect any future amortization expense related to these assets. Interest Expense Interest expense consists of cash and non-cash interest expense associated with our financing arrangements, including the borrowings under our Amended Loan Agreement with Innovatus. We expect interest expense to decrease in the near term due to lower interest rates. Change in Fair Value of Financial Instruments Prior to the completion of our IPO, we classified our outstanding warrants to purchase shares of our redeemable convertible preferred stock as liabilities on our balance sheets at their estimated fair value since the underlying redeemable convertible preferred stock was classified as temporary equity. At the end of each reporting period, changes in the estimated fair value during the period were recorded as a component of other income (expense). In connection with the completion of our IPO, all outstanding warrants to purchase shares of our redeemable convertible preferred stock either terminated or were converted into warrants to purchase shares of our common stock and accordingly, will no longer be subject to measurement. Other Income, Net Other income, net, consists primarily of interest income earned on our cash and cash equivalents. Income Tax Expense Income taxes include federal and state income taxes in the United States. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018: Revenue Revenue increased $7.9 million, or 24.5%, for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to an increase in the number of diagnostic tests delivered. The number of AVISE® CTD tests, which accounted for 82% of revenue for the years ended December 31, 2019 and 2018, increased to 105,370 tests delivered in the year ended December 31, 2019 compared to 83,405 tests delivered in the same 2018 period. The increase is primarily due to the increased adoption of the AVISE® CTD test by rheumatologists as the number of ordering healthcare providers increased to 1,707 for the fourth quarter of 2019 as compared to 1,278 healthcare providers in the same 2018 period. In addition, we recognized approximately $1.5 million of revenue related to our SIMPONI® promotion efforts during the year ended December 31, 2019. Costs of Revenue (excluding amortization of purchased technology) Costs of revenue increased $3.4 million, or 22.3%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to increased direct costs such as materials and supplies, royalties, shipping and handling and labor associated with the increase in test volume in 2019 compared to 2018. Selling, General and Administrative Expenses Selling, general and administrative expenses increased $9.0 million, or 45.9%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to increased employee related expenses of $6.1 million as a result of increasing the size of our salesforce from 30 as of December 31, 2018 to 50 as of December 31, 2019. The remaining increase relates primarily to increased audit and professional services of $1.2 million, insurance expenses of $0.5 million and stock-based compensation expense of $0.4 million. Research and Development Expenses Research and development expenses remained relatively consistent for the year ended December 31, 2019 compared to the year ended December 31, 2018. Amortization of Intangible Assets Our purchased intangible assets were fully amortized at December 31, 2018, therefore there is no amortization expense recorded for the year ended December 31, 2019. Interest Expense Interest expense increased $0.6 million, or 21.7%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to higher principal amounts outstanding over the year ended December 31, 2019 compared to the prior year period, under our long-term borrowing arrangements. Change in Fair Value of Financial Instruments The change in fair value of financial instruments increased $0.6 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase resulted from changes in the valuation of our redeemable convertible preferred stock warrant liabilities. Other Income, Net Other income, net, increased $0.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was due to the higher cash balance in our money market funds account during the year ended December 31, 2019 compared to the prior year period. Income Tax Expense Income tax expense remained relatively consistent for the year ended December 31, 2019 compared to the year ended December 31, 2018. Liquidity and Capital Resources We have incurred net losses since our inception. For the years ended December 31, 2019 and 2018, we incurred a net loss of $12.0 million and $8.0 million, respectively, and we expect to incur additional losses and increased operating expenses in future periods. As of December 31, 2019, we had an accumulated deficit of $164.6 million. To date, we have generated only limited revenue, and we may never achieve revenue sufficient to offset our expenses. Through the date of our IPO in September 2019, our operations were financed primarily from sales of our common and redeemable convertible preferred stock and borrowings under various debt financings. In September 2019, we completed our IPO of 4,140,000 shares of its common stock at a price to the public of $14.00 per share, including the exercise in full by the underwriters of their option to purchase 540,000 additional shares of our common stock. Including the option exercise, the aggregate net proceeds to us from the offering was approximately $50.4 million, net of underwriting discounts, commissions and other offering expenses, for aggregate expenses of approximately $7.5 million. As of December 31, 2019, we had $72.1 million of cash and cash equivalents. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. Currently, our funds are held in cash and money market funds. In September 2017, we entered into the loan and security agreement with Innovatus, or the Loan Agreement, under which we immediately drew down $20.0 million. In December 2018, we borrowed an additional $5.0 million under the Loan Agreement. In November 2019, we executed the first amendment, or the Loan Amendment, to the Loan Agreement with Innovatus, which we collectively refer to as the Amended Loan Agreement. Pursuant to the Amended Loan Agreement, the loan term is for five years with a final maturity date of November 2024. The Amended Loan Agreement accrues interest at an annual rate of 8.5%, of which 2.0%, during the first 36 months, will be treated as paid in-kind interest. Paid in-kind interest is added to the principal balance each period. After the initial 36 months of the loan, the entire 8.5% will be paid in cash at the end of each period. On or after the first anniversary of the Loan Amendment, but before the second anniversary of the Loan Amendment, we may, at our option, prepay the term loan borrowings by paying the lender a prepayment premium. Prepayment before the second anniversary of the Loan Amendment may only occur for specified reasons in the Amended Loan Agreement. The prepayment premium decreases by 1% during each subsequent twelve-month period after the first anniversary of the Loan Amendment. Our obligations under the Amended Loan Agreement are secured by a security interest in substantially all of our assets, including our intellectual property. The Amended Loan Agreement contains customary conditions to borrowing, events of default, and covenants, including covenants requiring us to maintain certain levels of minimum liquidity of $2.0 million and achieve certain minimum amounts of revenue, and limiting our ability to dispose of assets, undergo a change in control, merge with or acquire other entities, incur debt, incur liens, pay dividends or other distributions to holders of our capital stock, repurchase stock and make investments, in each case subject to certain exceptions. In connection with the execution of the Loan Agreement, we issued the lender a seven-year warrant to purchase 15,384,615 shares of our Series F redeemable convertible preferred stock at an exercise price of $0.078 per share, and in December 2018, in connection with the additional $5.0 million borrowed under the Loan Agreement, we issued to the lender a seven-year warrant to purchase 3,846,154 shares of our Series F redeemable convertible preferred stock at an exercise price of $0.078 per share. In connection with the completion of our IPO in September 2019, the warrants were automatically converted into warrants exercisable for an aggregate of 104,722 shares of common stock at an exercise price of $14.32. Funding Requirements Our primary uses of cash are to fund our operations as we continue to grow our business. We expect to continue to incur operating losses in the near term as our operating expenses will be increased to support the growth of our business. We expect that our costs of revenue, selling, general and administrative expenses, and research and development expenses will continue to increase as we increase our test volume, expand our marketing efforts and increase our internal salesforce to drive increased adoption of and reimbursement for our AVISE® testing products, promote SIMPONI®, prepare to commercialize new testing products, continue our research and development efforts and further develop our product pipeline. We believe we have sufficient laboratory capacity to support increased test volume. Other than the addition of laboratory equipment, we expect that we will not need to make material capital expenditures in the near term related to our laboratory facilities. Cash used to fund operating expenses is impacted by the timing of when we pay expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. We expect that our near- and longer-term liquidity requirements will continue to consist of working capital and general corporate expenses associated with the growth of our business, including payments we may be required to make upon the achievement of previously negotiated milestones associated with intellectual property we have licensed. Based on our current business plan, we believe that our existing cash and cash equivalents and our anticipated future revenue, will be sufficient to meet our anticipated cash requirements for at least the next 12 months. Our estimate 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, and actual results could vary as a result of a number of factors, including: •our ability to maintain and grow sales of our AVISE® testing products, as well as the costs associated with conducting clinical studies to demonstrate the utility of our products and support reimbursement efforts; •the impact of the recent COVID-19 outbreak on our business, including challenges resulting from social distancing and stay-at home orders through a reduction in testing volumes; ▪fluctuations in working capital; ▪the costs associated with our promotion of SIMPONI®, including the expansion of our sales capabilities, and the extent and timing of generating revenue from such promotion; ▪the costs of developing our product pipeline, including the costs associated with conducting our ongoing and future validation studies; ▪our ability to achieve sufficient market acceptance, coverage and adequate reimbursement from third-party payers and adequate market share and revenue for our testing products; ▪the additional costs we may incur as a result of operating as a public company; and ▪the extent to which we establish additional partnerships or in-license, acquire or invest in complementary businesses or products. Until such time, if ever, as we can generate revenue to support our costs structure, we expect to finance our operations through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. 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. To the extent that we raise additional capital through the sale of equity or convertible debt securities, 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 common stockholders. If additional funding is required or desired, there can be no assurance that additional funds will be available to us on acceptable terms on a timely basis, if at all, or that we will generate sufficient cash from operations to adequately fund our operating needs or achieve or sustain profitability. If we are unable to raise additional capital or generate sufficient cash from operations to adequately fund our operations, we will need to delay, reduce or eliminate some or all of our research and development programs, product portfolio expansion plans or commercialization efforts. Doing so will likely have an unfavorable effect on our ability to execute on our business plan and could have a negative impact on our relationships with parties such as Janssen. If we cannot expand our operations or otherwise capitalize on our business opportunities because we lack sufficient capital, 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: Cash Flows from Operating Activities Net cash used in operating activities for the year ended December 31, 2019 was $9.7 million and primarily resulted from our net loss of $12.0 million adjusted for non-cash charges of $2.2 million related to depreciation, amortization, stock-based compensation, non-cash interest and the revaluation of our preferred stock liabilities. The net cash used in operating activities was partially offset by changes in our net operating assets of $0.2 million related to net increases in accounts payable and accrued liabilities, partially offset by decreases in prepaid expenses and other current assets. Net cash used in operating activities for the year ended December 31, 2018 was $9.3 million and primarily resulted from our net loss of $8.0 million adjusted for non-cash charges of $0.3 million for remeasurements of financial instruments and $1.8 million for depreciation, amortization and non-cash interest, partially offset by changes in our net operating assets consisting of $2.3 million increase in accounts receivable primarily due to the adoption of ASC 606 and $1.3 million related to net increases in prepaid expenses and other current assets, accounts payable, and accrued liabilities. Cash Flows from Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $0.1 million and was due to net purchases of property and equipment. Net cash used in investing activities for the year ended December 31, 2018 was $0.2 million and was primarily due to net purchases of property and equipment. Cash Flows from Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $68.7 million and primarily resulted from the net proceeds received from our IPO of $50.4 million, as well as net proceeds received from the issuance of our redeemable convertible preferred stock of $18.4 million. Net cash provided by financing activities for the year ended December 31, 2018 was $11.4 million and primarily resulted from $6.5 million of net proceeds received from the issuance of our redeemable convertible preferred stock and net proceeds of $5.0 million under our long-term borrowing arrangement with Innovatus. Critical Accounting Policies and Significant Management Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our audited financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP. The preparation of these audited 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 audited financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. 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 judgement and estimates. Revenue Recognition To date, substantially all of our revenue has been derived from sales of our testing products. We primarily market our testing products to rheumatologists and their physician assistants in the United States. The healthcare professionals who order our services and to whom test results are reported are generally not responsible for payment for these services. The parties that pay for these services consist of healthcare insurers, government payers (primarily Medicare and Medicaid), client payers (i.e. hospitals, other laboratories, etc.) and patient self-pays. Payers are billed at our list price. Net revenues recognized consist of amounts billed net of allowances for differences between amounts billed and the estimated consideration we expect to receive from such payers. We follow a standard process, which considers historical denial and collection experience, insurance reimbursement policies and other factors, to estimate allowances and implicit price concessions, recording adjustments in the current period as changes in estimates. Further adjustments to the allowances, based on actual receipts, is recorded upon settlement. The transaction price is estimated using an expected value method on a portfolio basis. Our portfolios are grouped per payer (i.e. each individual third party insurance, Medicare, client payers, patient self-pay, etc.) and per test basis. Collection of our net revenues from payers is normally a function of providing complete and correct billing information to the healthcare insurers and generally occurs within 30 to 90 days of billing. The process for estimating revenues and the ultimate collection of accounts receivable involves significant judgment and estimation by management. In December 2018, we entered into the Janssen agreement to co-promote SIMPONI® in the United States. Our obligations relating to sales and co-promotion services for SIMPONI® is a series of single performance obligations since Janssen simultaneously receives and consumes the benefits provided by our sales and co-promotional services. The method for measuring progress towards satisfying the performance obligations is based on prescribed units in excess of the contractual baseline at the contractual rate earned per unit since the agreement is cancelable. As of December 31, 2018, there were no performance obligations under the agreement and no consideration had been received. Long-Lived Assets Our long-lived assets are comprised principally of our property and equipment, finite lived intangible assets, and goodwill. We amortize all finite lived intangible assets over their respective estimated useful lives. In considering whether intangible assets are impaired, we combine our intangible assets and other long-lived assets (excluding goodwill), into groupings, a determination which we principally make on the basis of whether the assets are specific to a particular test offered by us or technology we are developing. If we identify events or circumstances indicate that the associated carrying amount of assets within a group may not be recoverable, we will consider the assets in the group impaired if the carrying value of the group’s assets and directly associated liabilities exceed the estimated cash flows expected to be generated over the estimated useful life of the assets in the group. Management’s estimates of future cash flows are impacted by projected levels of tests and levels of reimbursement, as well as expectations related to the future cost structure of the entity. Goodwill is not amortized but is tested for impairment at least annually or more frequently whenever a triggering event or change in circumstances occurs, at the reporting unit level. For our goodwill impairment analysis, we operate in a single reporting unit, and allocate all goodwill to this reporting unit. We are required to recognize an impairment charge if the carrying amount of the reporting unit exceeds its fair value. Management first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than the carrying amount as a basis for determining whether it is necessary to perform a quantitative assessment. If a quantitative assessment is deemed necessary, management uses all available information to make this fair value determination, including the present values of expected future cash flows using discount rates commensurate with the risks involved in the assets and observed market multiples of operating cash flows. The judgments and estimates involved in identifying and quantifying the impairment of long-lived assets or goodwill involve inherent uncertainties, and the measurement of the fair value is dependent on the accuracy of the assumptions used in making the estimates and how those estimates compare to our future operating performance. No goodwill impairments were recorded during the years ended December 31, 2019 and 2018. Following the completion of our IPO in September 2019, our stock price and associated market capitalization will also be considered in the determination of reporting unit fair value. A prolonged or significant decline in our share price could provide evidence of a need to record a material impairment to goodwill. Stock-Based Compensation We recognize compensation expense related to stock-based awards to employees and directors based on the estimated fair value of the awards on the date of grant over the requisite service period of the awards (usually the vesting period) on a straight-line basis. The grant date fair value, and the resulting stock-based compensation expense, is estimated using the Black-Scholes option pricing model. The grant date fair value of stock-based awards is expensed on a straight-line basis over the vesting period of the respective award. We recorded stock-based compensation expense of approximately $0.6 million and $0.1 million for the years ended December 31, 2019 and 2018, respectively. 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. The Black-Scholes option pricing model requires the use of highly subjective and complex assumptions, which determine the fair value of stock-based awards. If we had made different assumptions, our stock-based compensation expense, net loss and net loss per share attributable to common stockholders could have been significantly different. See Notes 2 and 10 to our audited financial statements included elsewhere in this Annual Report on Form 10-K for 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 granted in the years ended December 31, 2019 and 2018. Determination of the Fair Value of Our Common Stock Prior to the completion of our IPO in September 2019, our board of directors, with the assistance of management, determined the fair value of our common stock on each grant date. All options to purchase shares of our common stock are intended to be granted with an exercise price per share no less than the fair value per share of our common stock underlying those options on the date of grant, based on the information known to us on the date of grant. Following the closing of our initial public offering, our board of directors determines the fair value of our common stock based on its closing price as reported on the date of grant on the primary stock exchange on which our common stock is traded. Estimated Fair Value of Share Purchase Rights, Redeemable Convertible Preferred Stock Warrants and Other Financial Instruments Prior to the IPO, we entered into agreements with existing stockholders of our redeemable convertible preferred stock that contained future purchase obligations of redeemable convertible preferred stock at a fixed price. We evaluated these share purchase right agreements and assessed whether they meet the definition of a freestanding instrument and, if so, determined the fair value of the share purchase right liability and recorded it on the balance sheet. The share purchase right liability was revalued at each reporting period with changes in the fair value of the liability recorded as a component of other income (expense) in the statement of operations. The share purchase right liability was revalued at settlement and the resultant fair value was then reclassified to redeemable convertible preferred stock at that time. The estimated fair value of the share purchase right liability was determined using valuation models that consider the probability of achieving the requisite milestones, our cost of capital, the estimated time period the preferred stock right would be outstanding, consideration received for the convertible preferred stock, the number of shares to be issued to satisfy the preferred stock purchase right and at what price, and probability of the consummation of an initial public offering, as applicable. We accounted for our redeemable convertible preferred stock warrant liabilities as freestanding instruments for shares that were puttable or redeemable. These warrants were classified as liabilities on our balance sheet and were recorded at their estimated fair values. At the end of each reporting period, changes in estimated fair value during the period were recorded as a component of other income (expense), net in the accompanying statement of operations. We continued to re-measure the fair value of the warrant liabilities until: (i) exercise; (ii) expiration of the related warrant; or (iii) conversion of the preferred stock underlying the security into common stock, which occurred in connection with the completion of our IPO in September 2019. We estimated the fair values of our warrant liabilities using an option pricing model based on inputs as of the valuation measurement dates, including the fair value of our redeemable convertible preferred stock, the estimated volatility of the price of our redeemable convertible preferred stock, the expected term of the warrants and the risk-free interest rates. There were significant judgments and estimates inherent in the determination of the fair values of our preferred stock purchase right liabilities and redeemable convertible preferred stock warrant liabilities. If we had made different assumptions, the carrying value of these liabilities, net loss and net loss per share attributable to common stockholders could have been significantly different. Acquisition-Related Liabilities In connection with the acquisition of the medical diagnostics division of Cypress in 2010, we initially agreed to pay an additional amount not to exceed $9.0 million in the event specified revenue, contractual and product launch milestones are achieved. This contingent liability required the use of inputs which were not observable in the market to assess its fair value at the end of each reporting period. For this liability, fair value was determined based on probabilities assigned to the milestones being achieved, revenue projections, and interest rates. Changes in fair value were recorded in the statement of operations and comprehensive loss. In February 2017, we amended two of the remaining agreements for which a contingent payment amount had been originally agreed to. One contingent payment amount remains outstanding. Income Taxes We operate in, and are subject to tax authorities in, various tax jurisdictions in the United States. To date, we have not been audited by the Internal Revenue Service or any state income tax authority, however all tax years remain open for examination by federal tax authorities. At December 31, 2019, our deferred tax assets are primarily comprised of federal and state tax net operating loss carryforwards. We completed a formal study through the year ended December 31, 2019 and determined ownership changes within the meaning of Internal Revenue Code (IRC), Section 382 had occurred in 2003, 2008, 2012, 2017 and 2019. Therefore, our ability to utilize our net operating losses incurred prior to December 31, 2017 are limited. Our ability to utilize net operating loss carryforwards generated after December 31, 2017 will not expire under the Tax Cuts and Jobs Act of 2017. We are required to reduce our deferred tax assets by a valuation allowance if it is more likely than not that some or all of our deferred tax assets will not be realized. We must use judgment in assessing the potential need for a valuation allowance, which requires an evaluation of both negative and positive evidence. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. In determining the need for and amount of our valuation allowance, if any, we assess the likelihood that we will be able to recover our deferred tax assets using historical levels of income, estimates of future income and tax planning strategies. As a result of historical cumulative losses and uncertainties surrounding our ability to generate future taxable income and, based on all available evidence, we believe it is more likely than not that our recorded net deferred tax assets will not be realized. Accordingly, we have recorded a valuation allowance against all of our net deferred tax assets at December 31, 2019. We will continue to maintain a full valuation allowance on our deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of this allowance. The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP. There are also areas in which our management’s judgment in selecting any available alternative would not produce a materially different result. Please see our audited financial statements and notes thereto included elsewhere in this prospectus, which contain accounting policies and other disclosures required by GAAP. Recent Accounting Pronouncements See "Notes to the Financial Statements-Note 2-Recent Accounting Pronouncements" of our annual financial statements. Off-Balance Sheet Arrangements During the periods presented we did not have, nor do we currently have any off-balance sheet arrangements, as defined under the rules and regulations of the SEC. JOBS Act Accounting Election The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for an "emerging growth company." 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 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 audited 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 last day of our fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement under the Securities Act, which such fifth anniversary will occur in 2024. However, if certain events occur prior to the end of such five-year period, including if we become a "large accelerated filer" as defined in Rule 12b-2 under the Exchange Act, 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 dedicated to transforming the care continuum for patients suffering from debilitating and chronic autoimmune diseases by enabling timely differential diagnosis and optimizing therapeutic intervention. We have developed and are commercializing a portfolio of innovative testing products under our AVISE® brand, several of which are based on our proprietary CBCAPs technology. Our goal is to enable rheumatologists to improve care for patients through the differential diagnosis, prognosis and monitoring of complex autoimmune and autoimmunerelated diseases, including SLE and RA. Our strategy includes leveraging our portfolio of testing products to market therapeutics through our sales channel, targeting the approximately 5,000 rheumatologists across the United States. Our business model of integrating testing products and therapeutics positions us to offer targeted solutions to rheumatologists and, ultimately, better serve patients. We currently market nine testing products under our AVISE® brand that allow for the differential diagnosis, prognosis and monitoring of complex autoimmune and autoimmunerelated diseases. Our lead testing product, AVISE® CTD, enables differential diagnosis for patients presenting with symptoms indicative of a wide variety of CTDs and other related diseases with overlapping symptoms. We commercially launched AVISE® CTD in 2012 and revenue from this product comprised 82% of our revenue for each of the years ended December 31, 2019 and 2018. There is an unmet need for rheumatologists to add clarity in their CTD clinical evaluation, and we believe there is a significant opportunity for our tests that enable the differential diagnosis of these diseases, particularly for potentially lifethreatening diseases such as SLE. In order to advance our integrated testing and therapeutics strategy, in December 2018 we entered into the Janssen agreement to exclusively promote SIMPONI® in the United States for the treatment of adult patients with moderate to severe RA and for other indicated rheumatic diseases. We began direct promotion of SIMPONI® in January 2019 and in support of these promotion efforts we expanded our salesforce from 31 representatives as of December 31, 2018 to 50 representatives as of December 31, 2019. Our SIMPONI® promotion efforts contributed approximately $1.5 million in incremental revenue in 2019 with our quarterly tiered promotion fee based on the incremental increase in total prescribed units above a predetermined average baseline of approximately 29,000 prescribed units per quarter. We also have additional agreements with other leading pharmaceutical companies, including GSK and Horizon Therapeutics, that leverage our testing products and the information generated from such tests. We plan to pursue additional strategic partnerships with a focus on the commercialization of therapeutics that are synergistic with our testing products. We perform all of our AVISE® tests in our approximately 8,000 square foot clinical laboratory, which is certified by CLIA and accredited by CAP, and located in Vista, California. Our laboratory is certified for performance of highcomplexity testing by CMS in accordance with CLIA. We are approved to offer our products in all 50 states. Our clinical laboratory reports all AVISE® testing product results within five business days. We market our AVISE® testing products using our specialized salesforce. Unlike many diagnostic salesforces that are trained only to understand the comparative benefits of their tests, the specialized backgrounds of our salesforce coupled with our comprehensive training enables our sales representatives to interpret results from our deidentified patient test reports and provide unique insights in a highly tailored discussion with rheumatologists. Our integrated testing and therapeutics strategy results in a unique opportunity to promote and sell targeted therapies in patient focused sales calls with rheumatologists, including those with whom we have a longstanding relationship and history using our portfolio of testing products. Reimbursement for our testing services comes from several sources, including commercial thirdparty payers, such as insurance companies and health maintenance organizations, government payers, such as Medicare, and patients. Reimbursement rates vary by product and payer. We continue to [/INST] Positive. </s>

Oaktree Acquisition Corp.

2020-03-27

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 Oaktree Acquisition Corp. The following discussion and analysis of the company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Overview We are a blank check company incorporated on April 9, 2019 as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses that we have not yet identified. Although we are not limited to a particular industry or geographic region for purposes of consummating our Business Combination, we intend to capitalize on the ability of our management team to identify, acquire and manage a business in the industrial and consumer sectors. Our sponsor is Oaktree Acquisition Holdings, L.P., a Cayman Islands exempted limited partnership. Our registration statement for our initial public offering was declared effective on July 17, 2019. On July 22, 2019, we consummated our initial public offering of 20,125,000 units, including 2,625,000 additional units to cover over-allotments, at $10.00 per Unit, generating gross proceeds of $201.25 million, and incurring offering costs of approximately $11.9 million, inclusive of approximately $7.04 million in deferred underwriting commissions. Simultaneously with the closing of the initial public offering, we consummated the private placement of 4,016,667 private placement warrants at a price of $1.50 per private placement warrant with our sponsor, generating gross proceeds of approximately $6.03 million. Upon the closing of the initial public offering and the private placement, $201.25 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, located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee, and was invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund selected by the company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by the company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the assets held in the trust account as described below. If we are unable to complete a Business Combination within 24 months from the closing of our initial public offering, or July 22, 2021, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the funds held in the trust account and not previously released to us to fund our regulatory compliance requirements and other costs related thereto and/or to pay our income taxes, if any, (less up to $100,000 of interest to pay dissolution expenses) divided by the number of the then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any); and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining shareholders and our board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii), to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. 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 approximately $1.5 million 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 Our entire activity since inception through December 31, 2019 related to our formation, the preparation for the initial public offering, and since the closing of the initial public offering, the search for a prospective initial business combination. We have neither engaged in any operations nor generated any revenues to date. We will not generate any operating revenues until after completion of our initial business combination. We will generate non-operating income in the form of interest income on cash and cash equivalents. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from April 9, 2019 (inception) through December 31, 2019, we had net income of approximately $1.1 million, which consisted of approximately $1.9 million in interest earned on investments and marketable securities held in the trust account, offset by approximately $710,000 in general and administrative expenses. Liquidity and Capital Resources As of December 31, 2019, we had approximately $1.5 million in our operating bank account, working capital of approximately $678,000, and approximately $1.9 million of interest income available in the trust account for Regulatory Withdrawals (subject to an annual limit of $325,000) and for our tax obligations, if any. 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. Our liquidity needs to date have been satisfied prior to the completion of the initial public offering through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the Founder Shares to our sponsor, the advancement of funds by our sponsor of approximately $62,000 to us to cover for offering costs in connection with the initial public offering, and the proceeds from the consummation of the private placement not held in the trust account. On November 18, 2019, we repaid the advance in full to our sponsor. In addition, in order to finance transaction costs in connection with a business combination, our sponsor or an affiliate of our sponsor, or our officers and directors may, but are not obligated to, provide us working capital loans. As of December 31, 2019, there were no amounts outstanding under any working capital loan. Based on the foregoing, management believes that we will have sufficient working capital and borrowing capacity from our sponsor or an affiliate of our sponsor, or our officers and directors to meet our 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. Contractual Obligations We do not have any long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations or long-term liabilities, other than an agreement to pay our sponsor a monthly fee of $10,000 for office space, utilities and administrative support. Registration and Shareholder Rights The holders of founder shares, private placement warrants and warrants that may be issued upon conversion of working capital loans, if any, be issued warrants upon conversion of working capital loans. These holders will be entitled to registration rights (in the case of the founder shares, only after conversion of such shares into Class A ordinary shares) pursuant to a registration and shareholder rights agreement to be entered into upon consummation of the initial public offering. These holders will be entitled to certain demand and “piggyback” registration and shareholder rights. However, the registration and shareholder rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. We will bear the expenses incurred in connection with the filing of any such registration statements. Underwriting Agreement We granted the underwriters a 45-day option from the date of the final prospectus relating to the initial public offering to purchase up to 2,625,000 units to cover over-allotments, if any, at the initial public offering price less underwriting discounts and commissions. On July 22, 2019, the underwriters fully exercised their over-allotment option. The underwriters were entitled to underwriting discounts of $0.20 per unit, or $4.025 million in the aggregate, paid upon the closing of the initial public offering. In addition, $0.35 per unit, or approximately $7.04 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 the company completes a business combination, subject to the terms of the underwriting agreement. Critical Accounting Policies This management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with GAAP. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to fair value of financial instruments and accrued expenses. We base our estimates on historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The company has identified the following as its critical accounting policies: Class A Ordinary Shares Subject to Possible Redemption Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at December 31, 2019, 19,159,203 Class A ordinary shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ equity section of our balance sheet. Net Income Per Ordinary Share Net income per share is computed by dividing net income by the weighted-average number of ordinary shares outstanding during the period. We have not considered the effect of the warrants sold in the initial public offering and the private placement to purchase an aggregate of 10,725,000 of the company’s Class A ordinary shares in the calculation of diluted income per share, since their inclusion would be anti-dilutive under the treasury stock method. Our statement of operations includes a presentation of income per share for ordinary shares subject to redemption in a manner similar to the two-class method of income per share. Net income per ordinary share, basic and diluted for Class A ordinary shares are calculated by dividing the interest income earned on investments and marketable securities held in the trust account of approximately $1.9 million, net of $325,000 annual limit of Regulatory Withdrawal available to be withdrawn from the trust account, resulting in a total of approximately $1.5 million for the period from April 9, 2019 (inception) through December 31, 2019, by the weighted average number of Class A ordinary shares outstanding for the period. Net loss per ordinary share, basic and diluted for Class B ordinary shares is calculated by dividing the net income of approximately $1.1 million, less income attributable to Class A ordinary shares of approximately $1.5 million, resulted to a net loss of approximately $385,000, by the weighted average number of Class B ordinary shares outstanding for the period. Recent Accounting Pronouncements Our management does not believe that any recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying 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. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” under the JOBS Act and are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We elected 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. As an “emerging growth company”, we are not required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements This Annual Report on Form 10K includes forwardlooking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. We have based these forwardlooking statements on our current expectations and projections about future events. These forwardlooking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forwardlooking statements. In some cases, you can identify forwardlooking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Overview We are a blank check company incorporated on April 9, 2019 as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses that we have not yet identified. Although we are not limited to a particular industry or geographic region for purposes of consummating our Business Combination, we intend to capitalize on the ability of our management team to identify, acquire and manage a business in the industrial and consumer sectors. Our sponsor is Oaktree Acquisition Holdings, L.P., a Cayman Islands exempted limited partnership. Our registration statement for our initial public offering was declared effective on July 17, 2019. On July 22, 2019, we consummated our initial public offering of 20,125,000 units, including 2,625,000 additional units to cover overallotments, at $10.00 per Unit, generating gross proceeds of $201.25 million, and incurring offering costs of approximately $11.9 million, inclusive of approximately $7.04 million in deferred underwriting commissions. Simultaneously with the closing of the initial public offering, we consummated the private placement of 4,016,667 private placement warrants at a price of $1.50 per private placement warrant with our sponsor, generating gross proceeds of approximately $6.03 million. Upon the closing of the initial public offering and the private placement, $201.25 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, located in the United States at J.P. Morgan Chase Bank, N.A., with Continental Stock Transfer & Trust Company acting as trustee, and was invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less, or in any openended investment company that holds itself out as a money market fund selected by the company meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a7 of the Investment Company Act, as determined by the company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the assets held in the trust account as described below. If we are unable to complete a Business Combination within 24 months from the closing of our initial public offering, or July 22, 2021, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a pershare 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 fund our regulatory compliance requirements and other costs related thereto and/or to pay our income taxes, if any, (less up [/INST] Positive. </s>

BJ's Wholesale Club Holdings, Inc.

2019-03-25

2019-02-02

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis and the information in Part II. "Item 6. Selected Financial 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. The following discussion contains forward-looking statements that reflect our plans, estimates and assumptions. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause such differences are discussed in the sections of this Annual Report on Form 10-K in Part I. "Item 1A. Risk Factors." We report on the basis of a 52- or 53-week fiscal year, which ends on the Saturday closest to the last day of January. Accordingly, references herein to “fiscal year 2018” and "fiscal year 2016" relate to the 52 weeks ending February 2, 2019 and January 28, 2017, respectively, and references herein to “fiscal year 2017” relate to the 53 weeks ending February 3, 2018. Overview BJ’s Wholesale Club is a leading warehouse club operator on the east coast of the United States. We deliver significant value to our members, consistently offering 25% or more savings on a representative basket of manufacturer-branded groceries compared to traditional supermarket competitors. We provide a curated assortment focused on perishable products, continuously refreshed general merchandise, gasoline and other ancillary services to deliver a differentiated shopping experience, that is further enhanced by our omnichannel capabilities. Since pioneering the warehouse club model in New England in 1984, we have grown our footprint to 216 large-format, high volume warehouse clubs spanning 16 states. In our core New England markets, which have high population density and generate a disproportionate part of U.S. GDP, we operate almost three times the number of clubs compared to the next largest warehouse club competitor. In addition to shopping in our clubs, members are able to shop when and how they want through our website, www.bjs.com; our highly-rated mobile app and our integrated Instacart same-day delivery offering. Our goal is to offer our members significant value and a meaningful return, in savings, on their annual membership fee. We have approximately 5.5 million members paying annual fees to gain access to savings on groceries, consumables, general merchandise, gas and ancillary services. The annual membership fee for our Inner Circle® Membership is $55 per year, and our BJ’s Perks Rewards® Membership, which offers additional value-enhancing features, costs $110 annually. We believe that members can save over ten times their $55 Inner Circle membership fee versus what they would have paid at traditional supermarket competitors when they spend $2,500 or more per year at BJ’s on manufacturer-branded groceries. In addition to providing significant savings on a representative basket of manufacturer-branded groceries, we accept all manufacturer coupons and also carry our own exclusive brands that enable members to save on price without compromising on quality. Our two private label brands, Wellsley Farms® and Berkley Jensen®, represent over $2.0 billion in sales, and are the largest brands we sell. Our customers recognize the relevance of our value proposition across economic environments, as demonstrated by over 20 consecutive years of membership fee income growth. Our membership fee income was $282.9 million for fiscal year 2018 and represents approximately half of our Adjusted EBITDA. Our business is moderately seasonal in nature. Historically, our business has realized a slightly higher portion of net sales, operating income and cash flows from operations in the second and fourth fiscal quarters, attributable primarily to the impact of the summer and year-end holiday season, respectively. Factors Affecting Our Business 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 in our clubs, while economic weakness which generally results in a reduction of customer spending may have a different or more extreme effect on spending at our clubs. 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, tax rates and fuel and energy costs. In addition, during periods of low unemployment, we may experience higher labor costs. Size and loyalty of membership base. The membership model is a critical element of our business. Members drive our results of operations through their membership fee income and their purchases. The majority of members renew within six months following their renewal date. Therefore, our renewal rate is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date. We have grown our membership fee income each year over the past two decades. Our membership fee income totaled $282.9 million in fiscal year 2018. Our membership renewal rate, a key indicator of membership engagement, satisfaction and loyalty, reached an all-time high of 87% during fiscal year 2018. Consumer preferences and demand. Our ability to maintain our appeal to existing customers and attract new customers depends on our ability to originate, develop and offer a compelling product assortment responsive to customer preferences. If we misjudge the market for our products, we may be faced with excess inventories for some products and may be required to become more promotional in our selling activities, which would impact our net sales and gross profit. Infrastructure investment. Our historical operating results reflect the impact of our ongoing investments to support our growth. We have made significant investments in our business that we believe have laid the foundation for continued profitable growth. We believe that strengthening our management team and enhancing our information systems, including our distribution center management and point-of-sale systems, will enable us to replicate our profitable club format and provide a differentiated shopping experience. We expect these infrastructure investments to support our successful operating model across our club operations. Product mix. Changes in our product mix affect our performance. For example, we continue to add private label products to our assortment of product offerings at our clubs, which we generally price lower than the manufacturer branded products of comparable quality that we also offer. Accordingly, a shift in our sales mix in which we sell more units of our private label products and fewer units of our manufacturer branded products would generally have a positive impact on our profit margins but an adverse impact on our overall net sales. Changes in our revenues from gasoline sales may also negatively affect our performance. Since gasoline generates lower profit margins than the remainder of our business, we could expect to see our overall gross profit margin rates decline as sales of gasoline increase. Effective sourcing and distribution of products. Our net sales and gross profit are affected by our ability to purchase our products in sufficient quantities at competitive prices. While we believe our vendors have adequate capacity to meet our current and anticipated demand, our level of net sales could be adversely affected in the event of constraints in our supply chain, including our inability to procure and stock sufficient quantities of some merchandise in a manner that is able to match market demand from our customers, leading to lost sales. Gas prices. The market price of gasoline impacts our net sales and comparable club sales, and large fluctuations in the price of gasoline can produce a short-term impact on our margins. Retail gasoline prices are driven by daily crude oil and wholesale commodity market changes and are volatile, as they are influenced by factors that include changes in demand and supply of oil and refined products, global geopolitical events, regional market conditions and supply interruptions caused by severe weather conditions. Typically, the change in crude oil prices impacts the purchase price of wholesale petroleum fuel products, which in turn impacts retail gasoline prices at the pump. During times when prices are particularly volatile, differences in pricing and procurement strategies between the Company and its competitors may lead to temporary margin contraction or expansion depending on whether prices are rising or falling, and this impact could affect our overall results for a fiscal quarter. In addition, the relative level of gasoline prices from period to period can lead to differences in our net sales between those periods. Further, because we generally attempt to maintain a fairly stable gross profit per gallon, this variance in net sales, which may be substantial, may or may not have a significant impact on our operating income. Fluctuation in quarterly results. Our quarterly results have historically varied depending upon a variety of factors, including our product offerings, promotional events, club openings, weather related events and shifts in the timing of holidays, among other things. As a result of these factors, our working capital requirements and demands on our product distribution and delivery network may fluctuate during the year. Inflation and deflation trends. Our financial results can be expected to be directly impacted by substantial increases in product costs due to commodity cost increases or general inflation, which could lead to margin pressure as costs may not be able to be passed on to consumers. In response to increasing commodity prices or general inflation, we seek to minimize the impact of such events by sourcing our merchandise from different vendors, changing our product mix or increasing our pricing when necessary. Refinancings. We used the proceeds of the initial public offering ("IPO") to repay indebtedness under our Second Lien Facility, which reduced our cost of capital and debt service obligations. In addition we amended our ABL Facility and First Lien Facility, resulting in a reduction to the applicable interest rates. 53rd week. Our fiscal year 2017 consisted of 53 weeks and our fiscal years 2018 and 2016 each consisted of 52 weeks. Fiscal years in which there are 53 weeks will see increased net sales and expenses from the additional week. Adoption of Accounting Standards Codification No. 606, Revenue from Contracts with Customers, and related amendments (“ASC 606”). We adopted ASC 606 effective February 4, 2018 using the modified retrospective method. The amounts reported in the consolidated statement of operations for the fiscal year ended February 2, 2019 and the consolidated balance sheet as of February 2, 2019 reflect this adoption. According to the modified retrospective method, all financial information before February 4, 2018 was not restated. See Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information regarding our adoption of ASC 606. How We Assess the Performance of Our Business In assessing our performance, we consider a variety of performance and financial measures. The key GAAP measures include net sales; membership fee income; cost of sales; selling, general and administrative expenses; and net income. In addition, we also review other important metrics such as Adjusted EBITDA, comparable club sales and merchandise comparable club sales, which exclude gasoline sales. Net sales Net sales are derived from direct retail sales to customers in our clubs and online, net of merchandise returns and discounts. Growth in net sales is impacted by opening new clubs and increases in comparable club sales. Comparable club sales Comparable club sales, also known as same store sales, is an important measure throughout the retail industry. In determining comparable club sales, we include all clubs that were open for at least 13 months at the beginning of the period and were in operation during all of both periods being compared, including relocated clubs and expansions. There may be variations in the way in which some of our competitors and other retailers calculate comparable or same store sales. As a result, data in this Annual Report on Form 10-K, regarding our comparable club sales may not be comparable to similar data made available by other retailers. Comparable club sales allow us to evaluate how our club base is performing by measuring the change in period-over-period net sales in clubs that have been open for the applicable period. Various factors affect comparable club sales, including consumer preferences and trends, product sourcing, promotional offerings and pricing, customer experience and purchase amounts, weather and holiday shopping period timing and length. Merchandise comparable club sales Merchandise comparable club sales is calculated by excluding sales from our gasoline operations from comparable club sales for the applicable period. Membership fee income Membership fee income reflects the amount collected from our customers to be a member of our clubs. Membership fee income is recognized in revenue on a straight-line basis over the life of the membership, which is typically twelve months. Cost of sales Cost of sales consists primarily of the direct cost of merchandise and gasoline sold at our clubs, including the following: • costs associated with operating our distribution centers, including payroll, payroll benefits, occupancy costs and depreciation; • freight expenses associated with moving merchandise from vendors to our distribution centers and from our distribution centers to our clubs; and • vendor allowances, rebates and cash discounts. Selling, general and administrative expenses Selling, general and administrative expenses (“SG&A”) consist of various expenses related to supporting and facilitating the sale of merchandise in our clubs, including the following: • payroll and payroll benefits for club and corporate employees; • rent, depreciation and other occupancy costs for retail and corporate locations; • advertising expenses; • tender costs, including credit and debit card fees; • amortization of intangible assets; and • consulting, legal, insurance and other professional services expenses. SG&A includes both fixed and variable components and, therefore, is not directly correlated with net sales. In addition, the components of our SG&A expenses may not be comparable to those of other retailers. We expect that our SG&A expenses will increase in future periods due to investments to spur comparable club sales growth, our continuing club growth and in part due to additional legal, accounting, insurance and other expenses that we expect to incur as a result of being a public company, including compliance with the Sarbanes-Oxley Act. In addition, any increase in future stock option or other stock-based grants or modifications will increase our stock-based compensation expense included in SG&A. Net Income Net income reflects the Company's net sales, less cost of sales; selling, general and administrative expenses; operating expenses; depreciation; interest; taxes and other expenses. Adjusted EBITDA Adjusted EBITDA is defined as income from continuing operations before interest expense, net, provision (benefit) for income taxes and depreciation and amortization, adjusted for the impact of certain other items, including compensatory payments related to options, stock-based compensation expense, pre-opening expenses, management fees, non-cash rent, strategic consulting expenses, severance, offering costs and other adjustments. For a reconciliation of Adjusted EBITDA to income from continuing operations, the most directly comparable GAAP measure, see “Non-GAAP Financial Measures.” Non-GAAP Financial Measures Adjusted EBITDA We present Adjusted EBITDA, which is not a recognized financial measure under GAAP, because we believe it assists investors and analysts in comparing our operating performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance. We define Adjusted EBITDA as income (loss) from continuing operations before interest expense, net, provision (benefit) for income taxes and depreciation and amortization, adjusted for the impact of certain other items, including compensatory payments related to options, stock-based compensation expense, preopening expenses, management fees, non-cash rent, strategic consulting, severance, offering-related expenses, and other adjustments. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in our presentation of Adjusted EBITDA. Our presentation of Adjusted EBITDA should not be considered as alternative to any other performance measure derived in accordance with GAAP and should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. There can be no assurance that we will not modify the presentation of Adjusted EBITDA in the future, and any such modification may be material. In addition, Adjusted EBITDA may not be comparable to similarly titled measures used by other companies in our industry or across different industries. Additionally, Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for any analysis of our results as reported under GAAP. Management believes Adjusted EBITDA is helpful in highlighting trends in our core operating performance, while other measures can differ significantly depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments. We also use Adjusted EBITDA in connection with establishing discretionary annual incentive compensation; to supplement GAAP measures of performance in the evaluation of the effectiveness of our business strategies; to make budgeting decisions; and to compare our performance against that of other peer companies using similar measures. The following is a reconciliation of our income from continuing operations to Adjusted EBITDA and adjusted EBITDA as a percentage of sales for the periods presented: __________ (1) Represents payments to holders of our stock options made pursuant to antidilutive provisions in connection with dividends paid to our shareholders. (2) Represents total stock-based compensation expense and includes one-time expense related to certain restricted stock and stock option awards issued in connection with the our IPO. (3) Represents direct incremental costs of opening or relocating a facility that are charged to operations as incurred. (4) Represents management fees paid to our sponsors (or advisory affiliates thereof) in accordance with our management services agreement, which terminated upon closing of the IPO. (5) Consists of an adjustment to remove the non-cash portion of rent expense, which has been recorded on a straight-line basis in accordance with GAAP. (6) Represents fees paid to external consultants for strategic initiatives of limited duration. (7) Represents termination costs to a former executive and termination costs associated with our voluntary retirement packages issued in January 2018. (8) Represents one-time costs related to our IPO, 2018 secondary offering and other shareholder-related filings. (9) Other non-cash items, including amortization of a deferred gain from sale lease back transactions in 2013, non-cash accretion on asset retirement obligations, obligations associated with our post-retirement medical plan, impairment charges related to a club that was relocated in 2018 and a gain from a third party settlement. Free cash flow We present free cash flow, which is not a recognized financial measure under GAAP, because we use it to report to our board of directors, and we believe it assists investors and analysts in evaluating our liquidity. Free cash flow should not be considered as an alternative to cash flows from operations as a liquidity measure. We define free cash flow as net cash provided by operating activities net of capital expenditures. The following is a reconciliation of our net cash from operating activities to free cash flow for the periods presented: Results of Operations The following tables summarize key components of our results of operations for the periods indicated: Fiscal Year 2018 Compared to Fiscal Year 2017 53rd Week: The fourth quarter and full year of fiscal 2017 included one additional week ("53rd week") compared to the fourth quarter and full year of fiscal year 2018. Net sales and net income for the 53rd week of fiscal year 2017 were approximately $240 million and $7 million, respectively. Net Sales Net sales for fiscal year 2018 were $12.7 billion, a 1.8% increase from net sales reported for fiscal year 2017 of $12.5 billion. The increase was due primarily to a 3.7% increase in comparable club sales, which was partially offset by the 53rd week in the results of fiscal year 2017. Net sales in the 53rd week of fiscal year 2017 were approximately $240 million. Comparable club sales Comparable club sales excluding gasoline sales increased 2.2% in fiscal year 2018. The increase was driven by growth in general merchandise sales of approximately 3.0%, increases in sales of edible and non-edible groceries of approximately 2% and an increase in sales of perishables of approximately 1%. The increase in general merchandise sales was driven by strong sales of television, apparel and small appliances. Sales of edible groceries improved primarily due to growth in salty snacks, water and specialty beverages. Sales of non-edible groceries improved primarily due to growth in laundry care and health and beauty products. The sales increase of perishables was driven mainly by strong sales in bakery, fresh meat and produce categories. Membership fee income Membership fee income was $282.9 million in fiscal year 2018 compared to $258.6 million in fiscal year 2017, a 9.4% increase. The growth in membership fee income was due to a membership fee increase implemented in January 2018, the record renewal rate of 87% and successful member acquisition efforts. Cost of sales Costs of sales was $10.6 billion, or 83.7% of net sales, in fiscal year 2018, compared to $10.5 billion, or 84.1% of net sales, in fiscal year 2017. The 0.4% decrease as a percentage of net sales was driven primarily by merchandise margin gains from the continued progress in our category profitability improvement program, partially offset by higher penetration of gasoline sales which lowers our overall margin rate. The decrease was also due to our successful procurement efforts, assortment optimization and improved sales penetration of private label items. Private label penetration increased to 20% in fiscal year 2018 from 19% in fiscal year 2017. Selling, general and administrative expenses Selling, general and administrative expenses (“SG&A”) were $2.1 billion, or 16.1% of net sales, in fiscal year 2018, compared to $2.0 billion, or 16.2% of net sales, in fiscal year 2017. SG&A expenses in fiscal year 2018 included non-recurring charges of $48.9 million for stock compensation related to awards issued in conjunction with our IPO, $4.0 million of impairment charges on fixed assets for a club that was relocated, $3.8 million of offering costs related to our IPO and secondary offerings and $3.3 million of management fees paid to our sponsors. SG&A expenses in fiscal year 2017 included non-recurring charges of $78.0 million of compensatory payments to stock option holders pursuant to antidilution provisions in connection with dividends paid to our sponsors, $9.1 million of severance expense associated with a voluntary reduction in force and $8.0 million of management fees paid to our sponsors. Excluding these items in both periods, SG&A expense as a percent of net sales increased by approximately 0.1% due to investments in marketing and payroll to drive the Company’s sales and profitability growth. Preopening expenses Preopening expenses were $6.1 million in fiscal year 2018, compared to $3.0 million in fiscal year 2017. Preopening expenses for fiscal year 2018 include charges for one new club and five new gas stations that opened in fiscal year 2018 and several new club openings expected for fiscal year 2019. Interest expense Interest expense was $164.5 million for fiscal year 2018, compared to $196.7 million for fiscal year 2017. Interest expense for fiscal year 2018 includes interest expense of $128.6 million related to debt service on outstanding borrowings, $25.4 million of charges related to the repricing of our outstanding borrowings, $6.6 million of amortization expense on deferred financing costs and original issue discounts on our outstanding borrowings, and $3.9 million of other interest charges. Interest expense decreased in fiscal year 2018 due to the extinguishment of our Second Lien Term Loan and the benefit of repricing our First Lien Term Loan and ABL facilities in fiscal year 2018. Interest expense for fiscal year 2017 includes interest of $163.2 million related to debt service on outstanding borrowings, $8.5 million of amortization expense on deferred financing costs and original issue discounts on our outstanding borrowings, $21.1 million of charges related to debt refinancing loss on extinguishment of debt and $3.9 million of other interest charges. Provision for income taxes The Company’s effective income tax rate from continuing operations was 8.5% for fiscal year 2018 and (120.7)% for fiscal year 2017. The increase in the effective tax rate in fiscal year 2018 primarily resulted from a one-time benefit of $32.1 million in fiscal year 2017 for the revaluation of the Company’s net deferred tax liabilities due to the Tax Cuts and Jobs Act ( the “TCJA”), partially offset by stock option windfall tax benefit of $20.0 million and the benefit of a full year at the reduced federal tax rate of 21% in fiscal year 2018. Income and loss from discontinued operations Income and loss from discontinued operations (net of income tax) was $0.2 million and $1.7 million in fiscal years 2018 and 2017, respectively. The charges in both periods represent accretion expense on lease obligations. Charges for the period ended February 2, 2019, also includes income of $0.9 million for the reserve reversal associated with the lease termination of the Company's Austell, Georgia location. Fiscal Year Ended February 3, 2018 Compared to Fiscal Year Ended January 28, 2017 Net Sales Net sales for fiscal year 2017 were $12.5 billion, a 3.3% increase from net sales reported for fiscal year 2016 of $12.1 billion. The increase was due to a 0.8% increase in comparable club sales, incremental sales from two new clubs opened since the beginning of last year and the impact of the 53rd week in fiscal year 2017. Adjusting for the additional week, net sales increased by approximately 1.3% to $12.3 billion from fiscal year 2016 to fiscal year 2017. Comparable club sales The increase in comparable club sales includes a favorable contribution from gasoline sales of 1.7% primarily due mainly to price inflation. Comparable club sales excluding gasoline sales decreased 0.9% in fiscal year 2017 due to decreases in sales of edible grocery and perishables of approximately 2%, partially offset by an increase in sales of general merchandise of approximately 1%. The decline in edible grocery sales was driven by decreased sales of beverages, candy and breakfast foods partially offset by increases in specialty foods and water. The decrease in perishable sales was driven by lower sales of frozen meat and fresh produce, partially offset by increased sales in prepackaged meat and full-service deli. Non-edible grocery sales were flat due to better sales of household chemicals, offset by lower sales in pet care. Finally, the sales increase in general merchandise was driven by strong sales of apparel and home office supplies, slightly offset by lower sales in electronics. Membership fee income Membership fee income was $258.6 million in fiscal year 2017 versus $255.2 million in fiscal year 2016, a 1.3% increase. The growth was driven by a 5.8% increase in membership fee income on a cash basis, an increase in our renewal rate and incremental member acquisition efforts. The increase also reflects one month of our membership fee increase that became effective January 1, 2018. Cost of sales Costs of sales was $10.5 billion, or 84.1% of net sales, in fiscal year 2017, compared to $10.2 billion, or 84.5% of net sales, in fiscal year 2016. The decrease of 0.4% was due to successful procurement efforts, assortment optimization and better sales penetration of private label items. Private label penetration increased to 19% in fiscal year 2017 from 18% in fiscal year 2016. Selling, general and administrative expenses SG&A expenses were $2.0 billion or 16.2% of net sales in fiscal year 2017, compared to $1.9 billion or 15.8% in fiscal year 2016. The 0.4% increase was driven primarily by $78.0 million in compensatory payments to stock option holders pursuant to antidilution provisions in connection with dividends paid to our Sponsors and $9.1 million of severance expense associated with a voluntary reduction in force in February 2018. Excluding these items, SG&A expense as a percent of net sales decreased by approximately 0.3% due primarily to lower credit card related expenses of 0.1% and lower payroll benefits expense of 0.2% due mostly to lower medical and bonus expense. Preopening expenses Preopening expenses were $3.0 million in fiscal year 2017, compared to $2.7 million in fiscal year 2016. Preopening expenses for fiscal year 2017 include charges for one new club, two new gasoline stations and one club relocation that occurred in the first quarter of fiscal year 2018. Preopening expenses for fiscal 2016 includes expenses for one new club and three gasoline stations. Interest expense Interest expense was $196.7 million for fiscal year 2017, compared to $143.4 million for fiscal year 2016. Interest expense for fiscal year 2017 includes interest expense of $163.2 million related to debt service on outstanding borrowings, $8.5 million of amortization expense on deferred financing costs and original issue discounts on our outstanding borrowings, $21.1 million of charges related to debt refinancing loss on extinguishment of debt and $3.9 million of other interest charges. Interest expense for fiscal year 2016 includes interest of $122.2 million related to debt service on outstanding borrowings, $17.1 million of amortization expense on deferred financing costs and original issue discounts on our outstanding borrowings and $4.1 million of other interest charges. Provision for income taxes Our effective tax rate during the twelve months ended February 3, 2018 was impacted by the TCJA, which was enacted into law on December 22, 2017. The TCJA, among other things, contains significant changes to corporate taxation, including reduction of the corporate tax rate from a top marginal rate of 35% to a flat rate of 21%, effective as of January 1, 2018; limitation of the tax deduction for interest expense; limitation of the deduction for net operating losses to 80% of annual taxable income and elimination of net operating loss carrybacks (though any such tax losses may be carried forward indefinitely); and modifying or repealing many business deductions and credits. Income tax effects resulting from changes in tax laws are provisional and accounted for by the Company in accordance with the authoritative guidance, which requires that these tax effects be recognized in the period in which the law is enacted and the effects are recorded as a component of provision for income taxes from continuing operations. As a result, the effective tax rate from continuing operations was a benefit of (120.7%) in fiscal year 2017 compared to a rate of 38.5% in fiscal year 2016, primarily driven by a one-time adjustment of $32.1 million for the revaluation of the Company’s net deferred tax liabilities, and other non-recurring items in fiscal year 2017 including a solar tax credit net tax benefit of $3.1 million, and a stock option windfall tax benefit of $1.3 million. Further, our effective tax rate in future periods will be favorably impacted by the lower federal statutory corporate income tax rate of 21%. Loss from discontinued operations Loss from discontinued operations (net of income tax benefit) was $1.7 million and $0.5 million in fiscal years 2017 and 2016, respectively. The loss for both periods consists of post-tax accretion expense on lease obligations related to two closed locations. The loss in fiscal year 2017, includes a charge of $2.1 million to the reserve due to a change in our estimated sublease income for the locations. Seasonality Our business is moderately seasonal in nature. Historically, our business has realized a slightly higher portion of net sales, operating income and cash flows from operations in the second and fourth fiscal quarters, attributable primarily to the impact of the summer and year-end holiday season, respectively. Our quarterly results have been and will continue to be affected by the timing of new club openings and their associated preopening costs. As a result of these factors, our financial results for any single quarter or for periods of less than a year are not necessarily indicative of the results that may be achieved for a full fiscal year. Liquidity and Capital Resources Our primary sources of liquidity are cash flows generated from club operations and borrowings from our senior secured asset based revolving credit and term facility ("ABL Facility"). As of February 2, 2019 cash and cash equivalents totaled $27.1 million, and we had $545.6 million of borrowings available under our ABL Facility. We believe that our current resources, together with anticipated cash flows from operations and borrowing capacity under our ABL Facility will be sufficient to finance our operations, meet our current debt obligations, and fund anticipated capital expenditures. Summary of Cash Flows A summary of our cash flows from operating, investing and financing activities is presented in the following table: Net Cash from Operating Activities Net cash provided by operating activities was $427.1 million in fiscal year 2018, compared to $210.1 million in fiscal year 2017. The increase in operating cash flow was primarily due to higher operating income from improved margin rates and increased membership fee income, lower interest payments due to the paydown of the Second Lien Term Loan, and strong working capital management including better management of accounts payable. Additionally, fiscal 2018 operating cash flows increased due to non-recurring costs of $88.2 million related to the dividend transaction in February 2017, including the compensatory payments related to stock options and debt issuance costs that could not be deferred. Net cash provided by operating activities was $210.1 million in fiscal year 2017 versus $297.4 million in fiscal year 2016. The decrease in operating cash flow was primarily due to non-recurring costs of $88.2 million related to the dividend transaction in February 2017, including the compensatory payments related to stock options and debt issuance costs that could not be deferred. Excluding those items, operating cash flow increased by $0.9 million in fiscal year 2017. Net Cash from Investing Activities Cash used for capital expenditures was $145.9 million in fiscal year 2018, compared to $137.5 million in fiscal year 2017. The increase was due to more investments in technology and more spending on new and relocated clubs compared to the prior year. Cash used for capital expenditures was $137.5 million in fiscal year 2017 compared to $114.8 million in fiscal year 2016. The increase was due to more investment in club renovations and investments in technology. Net Cash from Financing Activities Cash used in financing activities in fiscal year 2018 was $289.0 million compared to $69.6 million in fiscal year 2017. The increase over last year is due mainly to the extinguishment of the Second Lien Term Loan in the second quarter and the partial paydown of the First Lien Term Loan in conjunction with its repricing in the third quarter. Net proceeds from the ABL Facility were $72.0 million in fiscal year 2018 and $162.0 million in fiscal year 2017. The increase in cash used for financing activities was also offset by net proceeds of $691.0 million from the IPO. Cash used in financing activities in fiscal year 2017 was $69.6 million and includes net borrowings of $162.0 million on the ABL Facility and net borrowings of $533.1 million on the Term Loan Facilities, partially offset by dividend payments of $735.5 million and debt issuance costs of $24.6 million. Financing Obligations On February 3, 2017, we entered into the ABL Facility and the Term Loan Facilities, in part to amend our Prior ABL Facility and refinance our Prior Term Loan Facilities. The Second Lien Term Loan was fully repaid on July 2, 2018 in connection with the closing of the IPO. On August 13, 2018, the Company refinanced its First Lien Term Loan and reduced the principal on the loan. The Company drew $350.0 million under its ABL Facility to fund the transaction. As amended, the First Lien Term Loan has an initial principal amount of $1,537.7 million and interest is calculated either at LIBOR plus 275 to 300 basis points or a base rate plus 175 to 200 basis points based on the Company achieving a net leverage ratio of 3.00 to 1.00. The Company paid debt costs of $1.8 million and accrued interest of $1.2 million at closing. On August 17, 2018, we amended the ABL Facility to extend the maturity date from February 3, 2022 to August 17, 2023 and reduce the applicable interest rates and letter of credit fees on the facility. As amended, interest on the revolving credit facility is calculated either at LIBOR plus a range of 125 to 175 basis points or a base rate plus a range of 25 to 75 basis points; and interest on the term loan is calculated at LIBOR plus a range of 200 to 250 basis points or a base rate plus a range of 100 to 150 basis points, in all cases based on excess availability. The applicable spread of LIBOR and base rate loans at all levels of excess availability steps down by 12.5 basis points upon achieving total net leverage of 3.00 to 1.00. The Company paid debt costs of approximately $1.0 million at closing. Contractual Obligations The following table summarizes our significant contractual obligations as of February 2, 2019: (1) Total interest payments associated with these borrowings are included within this amount and are estimated to be $461.8 million based on the LIBOR interest rate of 5.51% on the First Lien Term Loan and 3.76% on the ABL Facility. (2) Includes our significant contractual unconditional purchase obligations. For cancellable agreements, any penalty due upon cancellation is included. These commitments do not exceed our projected requirements and are in the normal course of business. Examples include firm commitments for merchandise purchase orders, gasoline and information technology. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our results of operations or financial position. We do enter into operating lease commitments, letters of credit and purchase obligations in the normal course of our operations. Critical Accounting Policies and Estimates The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We review our estimates on an ongoing basis and make judgments about the carrying value of assets and liabilities based on a number of factors. These factors include historical experience and assumptions made by management that are believed to be reasonable under the circumstances. Although management believes the judgment applied in preparing estimates is reasonable based on circumstances and information known at the time, actual results could vary materially from estimates based on assumptions used in the preparation of our consolidated financial statements. This section summarizes critical accounting policies and the related judgments involved in their application. The most significant accounting estimates involve a high degree of judgment or complexity. Management believes the estimates and judgments most critical to the preparation of our consolidated financial statements and to the understanding of our reported financial results include those made in connection with revenue recognition, estimating vendor rebates and allowances; estimating the value of inventory; impairment assessments for goodwill and other indefinite-lived intangible assets, and long-lived assets; self-insurance reserves, income taxes, estimating equity-based compensation expense and fair value of common stock. Our significant accounting policies related to these accounts in the preparation of our consolidated financial statements are described below. Revenue Recognition We recognize revenue from the sale of merchandise, net of estimated returns, at the time of purchase by the customer in the club. For sales of merchandise on our website, revenue is recognized when control of the merchandise is transferred to the customer, which is typically at the shipping point. Sales incentives redeemable only at BJ’s, such as coupons and instant rebates, are recorded as a reduction of net sales. Membership fee revenue is recognized on a straight-line basis over the life of the membership, which is typically twelve months. Consideration from manufacturers’ incentives (such as rebates or coupons) is recorded gross in net sales when the incentive is generic and can be tendered by a consumer at any reseller and the Company receives direct reimbursement from the manufacturer, or clearinghouse authorized by the manufacturer, based on the face value of the incentive. If these conditions are not met, such consideration is recorded as a decrease in cost of sales. The Company’s BJ’s Perks Rewards® members earn 2% cash back, up to a maximum of $500 per year, on all eligible purchases made at BJ’s. The Company’s My BJ’s Perks® Mastercard® credit card holders earn 3% or 5% cash back on all eligible purchases made at BJ’s and 1% to 2% cash back on purchases made with the card outside of BJ’s. Cash back is in the form of electronic awards issued in $20 increments that may be used at checkout at BJ's and expire six months from the date of issuance. Cash back may be requested in the form of a check before awards expire. The Company accounts for the Awards as a reduction in net sales, with the related liability being classified within other current liabilities. BJ’s gift cards are available for purchase at all of our clubs. We do not charge administrative fees on unused gift cards, and gift cards do not have an expiration date. Revenue from gift card sales is recognized upon redemption of the gift card. The Company recognizes breakage in proportion to its rate of gift cards redemptions. In the ordinary course of business, sales taxes are collected on items purchased by the members that are taxable in the jurisdictions when the purchases take place. These taxes are then remitted to the appropriate taxing authority. These taxes collected are excluded from revenues in the financial statements.At the beginning of fiscal year 2018, we adopted the provisions of ASC No. 606, Revenue from Contracts with Customers, and related amendments (“ASC 606”) using the modified retrospective method. As a result of the adoption, our revenue recognition policy as of February 4, 2018 reflects the following major changes: • Recognition of e-commerce sales when control is transferred to the customer • Recognition of royalty revenue in connection with our co-brand credit card program as variable consideration • Recognition of gift card breakage in proportion to gift card redemptions See Note 2 to our financial statements for further information. Vendor Rebates and Allowances We receive various types of cash consideration from vendors, principally in the form of rebates and allowances that typically do not exceed a one-year time period. We recognize such vendor rebates and allowances as a reduction of cost of sales based on a systematic and rational allocation of the cash consideration offered to the underlying transaction that results in progress by BJ’s toward earning the rebates and allowances, provided the amounts to be earned are probable and reasonably estimable. We review the status of all rebates and allowances at least once per quarter and update our estimates, if necessary, at that time. We believe that our review process has allowed us to avoid material adjustments in estimates of vendor rebates and allowances. Inventory Merchandise inventories are stated at the lower of cost, determined under the average cost method, or net realizable value. We recognize the write-down of slow-moving or obsolete inventory in cost of sales when such write-downs are probable and estimable. Records are maintained at the stock keeping unit (“SKU”) level. We utilize various reports that allow our merchandising staff to make timely markdown decisions to ensure rapid inventory turnover, which is essential in our business. The carrying value of any SKU for which the selling price is marked down to below cost is immediately reduced to that selling price. We take physical inventories of merchandise on a cycle basis at every location at least once every 24 months, relying on our weekly cycle counting programs in the intervening periods. A physical inventory is taken at the end of the year at selected locations that don’t meet our targeted accuracy rates or are experiencing unusual shrink activity. We write down inventory for estimated shrinkage for the period between physical inventories. This estimate is based on historical results of previous physical inventories, shrinkage trends or other judgments management believes to be reasonable under the circumstances. We have not had material adjustments between our estimated shrinkage percentages and actual results. Impairment of Goodwill, Indefinite-Lived and Long-Lived Assets Goodwill We evaluate goodwill annually to determine whether it is impaired. Goodwill is also tested more frequently if an event occurs or circumstances change that would indicate that the fair value of a reporting unit is less than its carrying amount. We have identified one reporting unit and selected the fourth fiscal quarter to perform our annual goodwill impairment testing. Goodwill impairment guidance provides entities an option to perform a qualitative assessment (commonly known as “step zero”) to determine whether further impairment testing is necessary before performing the two-step test. The qualitative assessment requires significant judgments by management about economic conditions including the entity’s operating environment, its industry and other market considerations, entity-specific events related to financial performance or loss of key personnel and other events that could impact the reporting unit. If management concludes, based on assessment of relevant events, facts and circumstances, that it is more likely than not that a reporting unit’s fair value is greater than its carrying value, no further impairment testing is required. If management’s assessment of qualitative factors indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then a two-step quantitative assessment is performed. We also have the option to bypass the qualitative assessment described above and proceed directly to the two-step quantitative assessment. In the first step, we compare the fair value of the reporting unit to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is considered not impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then we must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then we would record an impairment loss equal to the difference. To assess for impairment, we bypassed the qualitative assessment and performed a step-one test for fiscal year 2018. For fiscal years 2018 and 2017, we performed the qualitative step-zero assessment. Our tests for impairment of goodwill resulted in a determination that the fair value of the reporting unit exceeded the carrying value of our net assets and no impairment was recorded in fiscal years 2018, 2017 and 2016. The Company does not believe our reporting unit is considered at risk of failing the impairment test as the fair value of the reporting unit significantly exceeded the carrying value of the reporting unit. We do not anticipate any material impairment charges in the near term. Indefinite-Lived Intangible Assets We consider the BJ’s trade name to be an indefinite-lived intangible asset, as we currently anticipate that this trade name will contribute cash flows to us indefinitely. We evaluate whether the trade name continues to have an indefinite life on an annual basis. Our trade name is reviewed for impairment annually in the fourth fiscal quarter and may be reviewed more frequently if indicators of impairment are present. If the recorded carrying value of the intangible asset exceeds its estimated fair value, we record a charge to write the intangible asset down to its estimated fair value. Calculating the fair value requires significant judgment. We determine the fair value of our trade name using the relief from royalty method, a variation of the income approach. The use of different assumptions, estimates or judgments, such as the estimated future cash flows, the discount rate used to discount such cash flows or the estimated royalty rate, could significantly increase or decrease the estimated fair value of the intangible asset. We assessed the recoverability of the BJ’s trade name and determined that its estimated fair value exceeded its carrying value and that no impairment was recorded in fiscal years 2018, 2017 and 2016. Long-Lived Assets We review the realizability of our long-lived assets at the lowest level for which identifiable cash flows are present, our club level, periodically and whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. We monitor our club portfolio to identify clubs that are underperforming. When we identify an underperforming club, we perform a review to reassess the future cash flows of the club. Current and expected operating results and cash flows and other factors are considered in connection with our reviews. Significant judgments are made in projecting future cash flows and are based on a number of factors, including the maturity level of the club, historical experience of clubs with similar characteristics, recent sales, margin and other trends and general economic assumptions. Our estimates of future cash flows are based on our experience, knowledge and judgments. These estimates can be affected by factors that are difficult to predict including future revenue, operating results and economic conditions. While we believe our estimates are reasonable, different assumptions regarding future cash flows could affect our analysis and result in future impairment. Impairment losses are measured and recorded as the difference between the carrying amount and the fair value of the assets. In fiscal year 2018, we recorded an impairment loss of $4.0 million on the fixed assets at our club in Hooksett, New Hampshire to lower the carrying value of the fixed assets to its estimated fair value less cost to sell. No impairment charges were recorded in fiscal years 2017 and 2016. Self-Insurance Reserves We are primarily self-insured for workers’ compensation, general liability claims and medical claims. Reported reserves for these claims are derived from estimated ultimate costs based upon individual claim file reserves and estimates for incurred but not reported claims. Estimates are based on historical claims experience and other actuarial assumptions believed to be reasonable under the circumstances. Income Taxes We pay income taxes to federal, state and municipal taxing authorities. We are subject to audit by these jurisdictions and maintain reserves for those uncertain tax positions which we believe may be subject to challenge. Our reserves are based on our estimate of the likely outcome of these audits, and are revised periodically based on changes in tax law and court cases involving taxpayers with similar circumstances. We recognize the financial statement impact for uncertain income tax positions based on a two-step process. We recognize the financial statement impact of a tax position when it is more likely than not that the position will be sustained upon examination. If the tax position meets the more-likely-than-not recognition threshold, the tax effect is recognized at the largest amount of the benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Although we believe that we have adequately reserved for our uncertain tax positions, we can provide no assurance that the final tax outcome of these matters will not be materially different. In future periods, changes in facts, circumstances and new information may require us to change the recognition and measurement estimates with regard to individual tax positions. Changes in recognition and measurement estimates are recorded in income tax expense and liability in the period in which such changes occur. Share-Based Compensation We recognize compensation cost for employee stock options awards based on the estimated fair value of the awards on the grant date. Compensation cost is recognized over the period during which the employee is required to provide service in exchange for the awards, which is typically the vesting period. For awards that contain only a service vesting feature, we use straight-line attribution to recognize the cost of the awards. For awards with a performance condition feature, we recognize compensation cost ratably over the awards’ expected vesting periods when achievement of the performance condition is deemed probable. We estimate the fair value of our stock option awards using the Black-Scholes option pricing model, which uses as inputs the fair value of our common stock and subjective assumptions we make, including the expected stock price volatility, the expected term of the award, the risk-free interest rate and expected dividends. The risk free interest rate was based on United States Treasury yields in effect at the time of the grant for notes with terms comparable to the awards. Expected volatility was determined based on the historical volatilities of comparable companies. We use the simplified method to calculate the expected term for options granted to employees. The expected dividend yield is assumed to be zero as we do not have current plans to pay any dividends on common stock. Determination of Fair Value of Common Stock As there was no public market for our common stock prior to the IPO, the estimated fair value of our common stock was determined by our Board 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’s 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. In estimating the fair value of our common stock, we estimated the aggregate fair value of the Company and then allocate this aggregate value to our capital structure. In determining the fair value, we used a combination of the income approach and the market approach. Under the income approach, fair value is estimated based on the discounted present value of the cash flows that the business can be expected to generate in the future. The most significant estimates and assumptions inherent in this approach are based on the estimated present value of future net cash flows the business is expected to generate over a forecasted period and an estimate of the present value of cash flows beyond that period, which is referred to as the terminal value. The estimated present value is calculated using a discount rate, which is based on rates of return available from alternative investments of similar type and quality as of the date of value, which accounts for the time value of money and the appropriate degree of risks inherent in the business. Under the market approach, fair value is estimated using the guideline public company method. The guideline public company method uses a peer group of publicly traded companies and considers multiples of financial metrics to derive a range of indicated values. Determination of the peer group is based on factors including, but not limited to, the similarity of their industry, growth rate and stage of development, business model and financial risk. To derive our fair value we summed a 50% weighting of the fair value derived by the income approach and a 50% weighting of the market approach. After the IPO, the fair value of our common stock is determined based on the trading price on the NYSE. Recent Accounting Pronouncements See Note 2 to our audited financial statements for information regarding recently issued accounting pronouncements.

<s>[INST] We report on the basis of a 52 or 53week fiscal year, which ends on the Saturday closest to the last day of January. Accordingly, references herein to “fiscal year 2018” and "fiscal year 2016" relate to the 52 weeks ending February 2, 2019 and January 28, 2017, respectively, and references herein to “fiscal year 2017” relate to the 53 weeks ending February 3, 2018. Overview BJ’s Wholesale Club is a leading warehouse club operator on the east coast of the United States. We deliver significant value to our members, consistently offering 25% or more savings on a representative basket of manufacturerbranded groceries compared to traditional supermarket competitors. We provide a curated assortment focused on perishable products, continuously refreshed general merchandise, gasoline and other ancillary services to deliver a differentiated shopping experience, that is further enhanced by our omnichannel capabilities. Since pioneering the warehouse club model in New England in 1984, we have grown our footprint to 216 largeformat, high volume warehouse clubs spanning 16 states. In our core New England markets, which have high population density and generate a disproportionate part of U.S. GDP, we operate almost three times the number of clubs compared to the next largest warehouse club competitor. In addition to shopping in our clubs, members are able to shop when and how they want through our website, www.bjs.com; our highlyrated mobile app and our integrated Instacart sameday delivery offering. Our goal is to offer our members significant value and a meaningful return, in savings, on their annual membership fee. We have approximately 5.5 million members paying annual fees to gain access to savings on groceries, consumables, general merchandise, gas and ancillary services. The annual membership fee for our Inner Circle® Membership is $55 per year, and our BJ’s Perks Rewards® Membership, which offers additional valueenhancing features, costs $110 annually. We believe that members can save over ten times their $55 Inner Circle membership fee versus what they would have paid at traditional supermarket competitors when they spend $2,500 or more per year at BJ’s on manufacturerbranded groceries. In addition to providing significant savings on a representative basket of manufacturerbranded groceries, we accept all manufacturer coupons and also carry our own exclusive brands that enable members to save on price without compromising on quality. Our two private label brands, Wellsley Farms® and Berkley Jensen®, represent over $2.0 billion in sales, and are the largest brands we sell. Our customers recognize the relevance of our value proposition across economic environments, as demonstrated by over 20 consecutive years of membership fee income growth. Our membership fee income was $282.9 million for fiscal year 2018 and represents approximately half of our Adjusted EBITDA. Our business is moderately seasonal in nature. Historically, our business has realized a slightly higher portion of net sales, operating income and cash flows from operations in the second and fourth fiscal quarters, attributable primarily to the impact of the summer and yearend holiday season, respectively. Factors Affecting Our Business 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 in our clubs, while economic weakness which generally results in a reduction of customer spending may have a different or more extreme effect on spending at our clubs. 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, tax rates and fuel and energy costs. In addition, during periods of low unemployment, we may experience higher labor costs. Size and loyalty of membership base. The membership model is a critical element of our business. Members drive our results of operations through their membership fee income and their purchases. The majority of members renew within six months following their renewal date. Therefore, our renewal rate is a trailing calculation that captures renewals during the period seven to eighteen [/INST] Positive. </s>

Anaplan, Inc.

2019-03-29

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 included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties as discussed in “Cautionary Note Regarding Forward-Looking Statements” included in this Annual Report on Form 10-K. 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 “Risk Factors” under Part I, Item 1A in this Annual Report on Form 10-K. Our fiscal year ends January 31. Overview Anaplan is pioneering the category of Connected Planning, which allows organizations to transform their businesses by making better and faster decisions. We believe Connected Planning is the next essential cloud category. It fundamentally transforms planning by connecting all of the people, data, and plans needed to accelerate business value and enable real-time planning and decision-making in rapidly changing business environments. Connected Planning accelerates business value by transforming the way organizations make decisions and placing the power of planning in the hands of every individual at every level within and between organizations. Connected Planning represents a fundamental shift from the legacy approach to planning, which is typically confined to the finance department and uses a patchwork of outdated and disconnected tools and manual processes that are often overly complex, slow, inefficient, and static. Connected Planning enables dynamic, collaborative, and intelligent planning across all areas of an organization, including finance, sales, and supply chain, and other corporate functions such as marketing, human resources, and operations. We sell subscriptions to our cloud-based planning platform primarily through our direct sales team. We also have strategic partnerships that provide us with a significant source of lead generation and implementation leverage. Our global partners, including global strategic consulting firms and global systems integrators, often promote our platform as part of the large-scale transformation projects they drive by identifying opportunities in which our platform can help companies maximize the effectiveness of their business processes. We also partner with leading regional consulting firms and implementation partners. These highly skilled regional partners not only provide subject-matter expertise in the implementation of specific use cases, but they also act as an extension of our direct sales force by identifying and referring opportunities to us. We and our partners create pre-packaged applications that are available on our App Hub marketplace to further accelerate the adoption and expansion of our platform. We focus our selling efforts on executives of large enterprises, who are often making a strategic purchase of our platform with the potential for broad use throughout their organizations. We use a “land and expand” sales strategy to capitalize on this potential. Our platform is often initially adopted within a specific line of business, including in finance, sales, and supply chain, and other corporate functions such as marketing, human resources, and operations, for one or more planning use cases. Once customers see the benefits of our platform for their initial use cases, they often increase the number of users, add new use cases, and expand to additional lines of business, divisions, and geographies. We see a greenfield opportunity to help over 70 million knowledge workers around the world plan more efficiently using Anaplan. We derive the substantial majority of our revenue from subscriptions for users on our platform. Our initial subscription term is typically two to three years, although some customers commit for shorter periods. We generally bill our customers annually in advance. We also offer professional services, including consulting, implementation, and training, but are increasingly leveraging our partners to provide these services. During fiscal 2019, 2018, and 2017, subscription revenue was $208.6 million, $143.5 million and $91.4 million, respectively, representing a year-over-year subscription revenue growth rate of 45% and 57% in fiscal 2019 and 2018, respectively. During fiscal 2019, 2018, and 2017, services revenue was $32.0 million, $24.8 million and $29.1 million, respectively. Our subscription revenue as a percentage of total revenue was 87%, 85%, and 76% in fiscal 2019, 2018, and 2017, respectively. During fiscal 2019, 2018 and 2017, our revenue was $240.6 million, $168.3 million and $120.5 million, respectively. Approximately 43%, 41% and 38% of our revenue was generated from outside of the United States in fiscal 2019, 2018 and 2017, respectively. Our net loss was $131.0 million, $47.6 million and $40.2 million in fiscal 2019, 2018 and 2017, respectively. We believe that our focus on customer success allows us to retain and expand the subscription revenue generated from our existing customers, and is an indicator of the long-term value of our customer relationships for Anaplan as a whole. We track our performance in this area by measuring our dollar-based net expansion rate, which compares our annual recurring revenue from the same set of customers across comparable periods. The dollar-based net expansion rate was 123% and 122% as of January 31, 2019 and 2018, respectively. Our dollar-based net expansion rate equals the annual recurring revenue at the end of a period for a base set of customers from which we generated annual recurring revenue in the year prior to the date of calculation, divided by the annual recurring revenue one year prior to the date of the calculation for that same set of customers. Annual recurring revenue is calculated as subscription revenue already booked and in backlog that will be recorded over the next 12 months, assuming any contract expiring in those 12 months is renewed and continues on its existing terms and at its prevailing rate of utilization. Factors Affecting Our Performance We believe that our future performance will depend on many factors, including those described below. While these areas present significant opportunity, they also present risks that we must manage to achieve successful results. See the section titled “Risk Factors”. If we are unable to address these challenges, our business and operating results could be adversely affected. Market adoption of our platform. Even though we believe Connected Planning is a strategic imperative for enterprises in today’s rapidly changing business environment, it is at an early stage of adoption. Our long-term success will depend on widespread adoption of Connected Planning by enterprises for numerous planning applications with broad use of those applications within their organizations. While we believe that we are still in the early stages of penetrating our addressable market, we have benefited from rapid customer growth. Customer First strategy. We put the success of our customers at the center of our culture, strategy, and investments. We view our Customer First strategy as core to capturing our Connected Planning vision and driving the continued adoption and expansion in the use of our platform. By aligning our thought leadership, worldwide development and delivery capabilities, and local sales and service resources, our Customer First strategy drives exceptional value throughout our customers’ Connected Planning journeys. Our continued success depends in part on our ability to continue to put customers at the center of our strategy. Expansion of existing customers. We employ a “land and expand” approach, with many of our customers initially deploying our product for a specific use case and group of users, and, once they realize the benefits and wide applicability of our platform, subsequently renewing subscriptions and expanding the number of users or use cases within and across lines of business and geographies. As a result, we are able to generate a significant increase in revenue from the expanded use of our platform across the enterprise. Going forward we are focused on our large customers where the opportunity for expansion and need for our planning solutions are greatest. Our future revenue growth and our ability to achieve and maintain profitability is dependent upon our ability to maintain existing customer relationships and to continue to expand our customers’ use of our platform. Scaling our sales team. Our ability to achieve significant growth in revenue in the future will depend, in large part, upon the effectiveness of our sales efforts, both domestically and internationally. We have invested and intend to continue to invest aggressively in expanding our direct sales force, particularly in attracting and retaining sales personnel with experience selling to larger enterprises. A substantial portion of our sales force joined us over the last 12 months, and our ability to increase our revenue will depend on the new members of our sales force becoming fully productive. In the enterprise market, a customer’s decision to use our platform may be an enterprise-wide decision. These types of sales require us to provide greater levels of education regarding the use and benefits of our platform, which involves substantial time, effort, and costs. We anticipate that our headcount will continue to increase as a result of these investments. International sales. Our revenue generated outside of the United States during fiscal 2019, 2018 and 2017, was approximately 43%, 41% and 38%, respectively, of our total revenue. We believe global demand for our platform will continue to increase as organizations experience the benefits that our platform can provide to international enterprises with complex planning needs spanning multiple geographies. Accordingly, we believe there is significant opportunity to grow our international business. We have invested, and plan to continue to invest, ahead of this potential demand in personnel, marketing, and access to data center capacity to support our international growth. Partner ecosystem. Our partner ecosystem extends our geographic coverage, accelerates the usage and adoption of our platform, and enables more efficient delivery of service solutions. We intend to augment and deepen our partnerships with global and regional partners, which include consulting firms, systems integrators, and implementation partners. We believe our partners’ scale and route to market can significantly contribute to our ability to penetrate our addressable market, extend our geographic coverage, and extend usage and adoption of our platform. Product velocity. We have invested and intend to continue to invest significantly in research and development in an effort to enhance and expand the functionality of our platform, to attract and retain development personnel, and to protect our market-leading technology advantage. We have a well-defined technology roadmap to introduce new features and functionality to our platform that we believe will improve our ability to generate revenue by broadening the appeal of our platform to potential new customers as well as increasing the opportunities for further expanding the use of our platform by existing customers. We are also investing to further enhance the user interface, functionality, and usability of our platform, including in machine learning and other artificial intelligence technologies, to further enhance the predictive capabilities of our platform. We will need to continue to focus on bringing cutting-edge technology to market in order to remain competitive. Components of Results of Operations Revenue We offer subscriptions to our cloud-based planning platform. We derive our revenue primarily from subscription fees and, to a lesser degree, from professional services fees. Subscription revenue consists primarily of fees to provide our customers access to our cloud-based platform. Professional services revenue includes fees from assisting customers in implementing and optimizing the use of our cloud-based platform. These services include implementation, consulting, and training. Subscription Revenue Subscription revenue accounted for 87%, 85% and 76% for fiscal 2019, 2018 and 2017, respectively. Subscription revenue is driven primarily by the number of customers, the number of users at each customer, the price of user subscriptions, and renewal rates. Subscription fees are recognized ratably as revenue over the contract term beginning on the date the platform is made available to the customer. Our new business subscriptions typically have a term of two to three years. We generally invoice our customers in annual installments at the beginning of each year within the subscription period. Amounts that have been invoiced are initially recorded as deferred revenue and are recognized ratably over the subscription period. Most of our contracts are non-cancellable over the contract term. We had a remaining performance obligation, or backlog, in the amount of $440.0 million and $304.6 million as of January 31, 2019 and 2018, respectively, consisting of both billed and unbilled consideration. Because we recognize revenue from subscription fees ratably over the term of the contract, changes in our contracting activity in the near term may not impact our reported revenue until future periods. Professional Services Revenue Professional services revenue is generally recognized as the services are rendered for time and material contracts, or on a proportional performance basis for fixed price contracts. The substantial majority of our professional service contracts are on a time and materials basis. Implementations generally take one to six months to complete depending upon the scope of engagement with the customer. Our professional services revenue fluctuates from quarter to quarter as a result of the achievement of payment milestones in our professional services arrangements, and the requirements, complexity, and timing of our customers’ implementation projects. Cost of Revenue Cost of Subscription Revenue Cost of subscription revenue primarily consists of costs related to hosting our service. Significant expenses include data center capacity costs, personnel-related costs directly associated with our cloud infrastructure, including total compensation, customer support, equipment depreciation, and amortization of internal-use software. Cost of Professional Services Revenue Cost of professional services revenue primarily consists of costs related to providing implementation and configuration services, optimization services and training services, personnel-related costs directly associated with our professional services and training departments, including salaries and bonuses, benefits, and stock-based compensation, the costs of contracted third-party vendors, and travel. Professional services associated with the implementation and configuration of our subscription platform are performed directly by our services team, as well as by contracted third-party vendors. When third-party vendors invoice us for services performed for our customers, those fees are recognized as expense over the requisite service period. Operating Expenses Research and Development Research and development expenses consist primarily of personnel-related costs for our development team, including salaries and bonuses, benefits, stock-based compensation expense, and allocated overhead costs. We have invested, and intend to continue to invest, in developing technology to support our growth. We capitalize certain software development costs that are attributable to developing new features and adding incremental functionality to our platform, and amortize such costs as costs of subscription revenue over the estimated life of the new incremental functionality, which is three years. We plan to increase our investment in research and development for the foreseeable future as we focus on further developing our platform and enhancing its use cases. However, we expect our research and development expenses to decrease as a percentage of our total revenue over time, although they may fluctuate as a percentage of our total revenue from period to period. Sales and Marketing Sales and marketing expenses consist primarily of personnel-related costs directly associated with our sales and marketing staff, including salaries and bonuses, benefits, commissions, and stock-based compensation. Other sales and marketing costs include promotional events to promote our brand, including our Anaplan Connected Planning Xperience (CPX) user conference, previously known as our Hub conferences, advertising, and allocated overhead. We plan to increase our investment in sales and marketing over the foreseeable future, primarily stemming from increased headcount in sales and marketing, and investment in brand- and product-marketing efforts. However, we expect our sales and marketing expenses to decrease as a percentage of our total revenue over time, although they may fluctuate as a percentage of our total revenue from period to period. General and Administrative General and administrative expenses consist of personnel-related costs associated with our executive, finance, legal, and human resources personnel, including salaries and bonuses, benefits, and stock-based compensation expense, professional fees for external legal, accounting and other consulting services, and allocated overhead costs. We expect to increase the size of our general and administrative function to support the growth of our business and to take advantage of the large opportunity in front of us. We expect to incur 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 U.S. securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC. In addition, as a public company, we have incurred, and expect to continue to incur, increased expenses such as insurance, investor relations, and professional services. As a result, 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 our total revenue over time, although they may fluctuate as a percentage of our total revenue from period to period. Interest Income, Net Interest income, net consists primarily of interest income earned on our cash and cash equivalents. Other Expense, Net Other expense, net consists primarily of foreign exchange gains and losses. Provision for Income Taxes Provision for 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 and state 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 The following tables set forth selected consolidated statements of operations data for each of the periods indicated: Fiscal Year 2019 Compared to Fiscal Year 2018 Revenue Total revenue was $240.6 million in fiscal 2019 compared to $168.3 million in fiscal 2018, an increase of $72.3 million, or 43%. Subscription revenue was $208.6 million, or 87% of total revenue, in fiscal 2019, compared to $143.5 million, or 85% of total revenue, in fiscal 2018. The increase of $65.1 million, or 45%, in subscription revenue was primarily due to additional sales to existing customers, which accounted for approximately 77% of the increase, and a significant increase in sales to new customers, which accounted for approximately 23% of the increase. Professional services revenue was $32.0 million in fiscal 2019 compared to $24.8 million in fiscal 2018. The increase of $7.2 million, or 29%, in professional services revenue was primarily due to the higher revenue generated from partners and utilization of our professional services employees in fiscal 2019. This also represents a continued decline in professional services revenue as a percentage of total revenue from 15% to 13% primarily due to our strategy of shifting professional services revenue to our partners and a growing partner network. Cost of Revenue Total cost of revenue was $67.4 million in fiscal 2019 compared to $52.0 million in fiscal 2018, an increase of $15.4 million, or 30%. Cost of subscription revenue was $36.5 million in fiscal 2019 compared to $19.9 million in fiscal 2018, an increase of $16.6 million, or 83%. The increase in cost of subscription revenue was primarily due to an increase in salary and bonuses, and benefits costs related to an increase in headcount of $7.7 million, including stock-based compensation, an increase in amortization of capitalized software development costs and intangible assets of $1.7 million, an increase in software licenses to support data servers of $1.5 million, an increase in hosting fees of $1.5 million due primarily to additional servers, an increase in allocated facilities and IT of $1.2 million due to additional leases signed in fiscal 2019, and an increase in depreciation of our servers placed in service in fiscal 2019 of $1.1 million. Cost of professional services revenue was $30.9 million in fiscal 2019 compared to $32.1 million in fiscal 2018, a decrease of $1.2 million, or 4%. The decrease in cost of professional services revenue was primarily due to our strategy of shifting professional services to our partners. Gross Profit and Gross Margin Gross profit was $173.2 million in fiscal 2019 compared to $116.4 million in fiscal 2018, an increase of $56.9 million, or 49%. The increase in gross profit was the result of the increases in our subscription revenue primarily due to additional sales to existing customers and the addition of new customers in fiscal 2019. Gross margin was 72% in fiscal 2019 compared to 69% in fiscal 2018. The increase in gross margin was primarily due to the increase in subscription revenue, which generates a significantly higher gross margin than our professional services revenue, as a percentage of total revenue, and an increase in our professional services gross margins. Beginning in the fourth quarter of our fiscal 2018, we redeployed certain employees from our Customer Success team to the Sales and Marketing team as part of our overall strategy to transition more services to partners. Our gross margins can fluctuate from quarter to quarter as a result of the achievement of payment milestones in our professional services arrangements, and the requirements, complexity, and timing of our customers’ implementation projects that can vary significantly. Operating Expenses Research and Development Research and development expenses were $49.0 million in fiscal 2019 compared to $30.9 million in fiscal 2018, an increase of $18.1 million, or 59%. The increase was primarily due to an increase in salary and bonuses, and benefits costs related to an increase in headcount of $12.3 million, including an increase in stock-based compensation of $3.6 million mainly related to compensation expense related to our RSUs being recognized upon completion of our IPO, an increase in allocated facilities of $1.6 million due to additional leases signed in fiscal 2019, and an increase in consulting spend of $1.5 million to support our anticipated growth. Sales and Marketing Sales and marketing expenses were $176.3 million in fiscal 2019 compared to $100.7 million in fiscal 2018, an increase of $75.6 million, or 75%. The increase was primarily due to an increase in salary and bonuses, and benefits costs related to an increase in headcount of $53.3 million, including an increase in stock-based compensation of $12.0 million mainly related to compensation expense related to our RSUs being recognized upon completion of our IPO, an increase in allocated facilities and IT of $7.2 million due primarily to new facility leases in fiscal 2019, and an increase in commission expenses of $5.3 million. General and Administrative General and administrative expenses were $76.2 million in fiscal 2019 compared to $30.7 million in fiscal 2018, an increase of $45.5 million, or 148%. The increase was primarily due to an increase in salary and bonuses, and benefits costs related to an increase in headcount of $40.5 million, including an increase in stock-based compensation of $28.1 million mainly related to compensation expense related to our RSUs being recognized upon completion of our IPO, and an increase in software licenses of $2.9 million. Other Income and Expense, Net Interest Income, net Interest income, net increased by $1.8 million, or 1,679%, in fiscal 2019. The increase in interest income, net was primarily due to higher average cash and cash equivalents balances in fiscal 2019 compared to fiscal 2018. Other Expense, net Other expense, net was a loss of $1.5 million in fiscal 2019 compared to a loss of $0.5 million in fiscal 2018, an increase of $1.0 million, or 204%. The change was primarily due to foreign currencies decreasing in value compared to the U.S. dollar and the related remeasurements during the periods, primarily related to our U.K. operations. Provision for Income Taxes The provision for income taxes was $3.2 million in fiscal 2019 compared to $1.3 million in fiscal 2018, an increase of $1.9 million, or 154%. The increase in provision for income taxes was primarily related to increased income generated from intercompany cost plus arrangements in certain European and Asian countries. Fiscal Year 2018 Compared to Fiscal Year 2017 Revenue Total revenue was $168.3 million for fiscal 2018 compared to $120.5 million for fiscal 2017, an increase of $47.8 million, or 40%. Subscription revenue was $143.5 million, or 85% of total revenue, for fiscal 2018, compared to $91.4 million, or 76% of total revenue, for fiscal 2017. The increase of $52.1 million, or 57%, in subscription revenue was primarily due to additional sales to existing customers, which accounted for approximately 61% of the increase, and a significant increase in sales to new customers, which accounted for approximately 39% of the increase. Professional services revenue was $24.8 million for fiscal 2018 compared to $29.1 million for fiscal 2017. The decrease of $4.3 million, or 15%, in professional services revenue was primarily due to the lower utilization of our professional services employees in fiscal 2018. This also represents a decline in professional services revenue as a percentage of total revenue from 24% to 15% primarily due to increased utilization of a growing partner network and our strategy of shifting professional services revenue to our partners. Cost of Revenue Total cost of revenue was $52.0 million for fiscal 2018 compared to $39.4 million for fiscal 2017, an increase of $12.6 million, or 32%. Cost of subscription revenue was $19.9 million for fiscal 2018 compared to $9.1 million for fiscal 2017, an increase of $10.9 million, or 120%. The increase in cost of subscription revenue was primarily due to an increase in salary and benefits costs related to an increase in headcount of $4.4 million, including stock-based compensation, an increase in consulting and contractor spend of $1.2 million to support our anticipated growth, an increase in amortization of capitalized software development costs and intangible assets of $1.1 million and an increase in software licenses to produce additional functionality of our platform of $0.5 million, depreciation of our servers placed in service in fiscal 2018 of $0.7 million, and an increase in allocated facilities of $0.5 million due to additional leases signed in fiscal 2018. Cost of professional services revenue was $32.1 million for fiscal 2018 compared to $30.3 million for fiscal 2017, an increase of $1.7 million, or 6%. The relatively small increase in cost of professional services revenue was primarily due to an increase in partner implementation costs due to a growing partner network and the initial implementation of our strategy of shifting professional services to our partners. Gross Profit and Gross Margin Gross profit was $116.4 million for fiscal 2018 compared to $81.1 million for fiscal 2017, an increase of $35.3 million, or 43%. The increase in gross profit is the result of the increases in our subscription revenue due primarily to additional sales to existing customers and the addition of new customers in fiscal 2018. Gross margin was 69% for fiscal 2018 compared to 67% for fiscal 2017. The increase was due primarily to the increase in subscription revenue which generates a significantly higher gross margin than our professional services revenue. The effect on gross margin of the increase in subscription revenue was partially offset by an increase in the professional services gross loss and the negative gross margin related to the increase in cost of professional services revenue in fiscal 2018 and by a decrease in subscription gross margin. Our gross margins can fluctuate from quarter to quarter as a result of the achievement of payment milestones in our professional services arrangements, and the requirements, complexity, and timing of our customers’ implementation projects that can vary significantly. Operating Expenses Research and Development Research and development expenses were $30.9 million for fiscal 2018 compared to $23.9 million for fiscal 2017, an increase of $7.0 million, or 29%. The increase was primarily due to an increase in salary and benefits costs related to an increase in headcount of $4.4 million, including stock-based compensation, an increase in consulting and contractor spend of $3.0 million to support our anticipated growth, an increase in allocated facilities of $1.4 million due primarily to new facility leases entered into in fiscal 2018, an increase in hosting fees of $1.1 million for increased cloud services, and an increase of $0.6 million in recruiting costs. The increase in research and development costs was partially offset by an increase in capitalized software development costs of $3.5 million due to a significant increase in development of our core software and a one-time research and development credit in the amount of $1.4 million. Sales and Marketing Sales and marketing expenses were $100.7 million for fiscal 2018 compared to $73.7 million for fiscal 2017, an increase of $27.0 million, or 37%. The increase was primarily due to an increase in salary and benefits costs related to an increase in headcount of $14.9 million, including stock-based compensation, a $2.7 million increase in commission expenses recognized in fiscal 2018, an increase in travel related expenses of $2.2 million, and an increase in allocated facilities of $1.0 million due primarily to a new facility lease entered into in fiscal 2018. General and Administrative General and administrative expenses were $30.7 million for fiscal 2018 compared to $22.5 million for fiscal 2017, an increase of $8.2 million, or 37%. The increase was primarily due to an increase in salary and benefits costs related to an increase in headcount of $6.5 million, including stock-based compensation, an increase in consulting and contractor spend of $1.9 million, an increase in software licenses of $0.7 million, and an increase in recruiting costs of $0.7 million to support our anticipated growth. The increase was partially offset by restructuring charges of $3.3 million in fiscal 2017 related to severance and other related costs for employees terminated during that period. Other Income and Expenses Interest Income, net Interest income, net increased by $20,000, or 23%, in fiscal 2018 as there were no significant changes to income interest or expense activities during the respective periods. Other Expense, net Other expense, net was a loss of $0.5 million in fiscal 2018 compared to a loss of $0.8 million in fiscal 2017, a change of $0.4 million, or 42%. The change was primarily due to currency fluctuations and the related remeasurements during the periods, primarily related to our U.K. operations. Provision for Income Taxes The provision for income taxes was $1.3 million in fiscal 2018 compared to $0.5 million in fiscal 2017, an increase of $0.7 million, or 146%, primarily related to increased income generated from intercompany cost share arrangements in certain European and Asian countries. Quarterly Financial Data The following tables set forth selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in fiscal 2019 and 2018. The information for each of these eight quarters has been prepared on the same basis as the audited annual consolidated financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods in accordance with generally accepted accounting principles, or GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of our operating results for a full year or any future period. (1) Refer to “Immaterial Correction of Error” in Note 1 of the Notes to Consolidated Financial Statements. Liquidity and Capital Resources As of January 31, 2019, our principal sources of liquidity were cash and cash equivalents totaling $326.9 million, which were held for working capital purposes. Our cash equivalents are comprised primarily of bank deposits. In October 2018, we completed our IPO and received aggregate net proceeds of $281.8 million, after underwriting discounts and commissions, and before deducting offering costs of $6.5 million. We also received aggregate proceeds of $20.0 million related to a concurrent private placement, and did not pay any underwriting discounts or commissions with respect to the shares that were sold in this private placement. We believe our existing cash and cash equivalents will be sufficient to meet our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our pace of growth, subscription renewal activity, the timing and extent of spend to support research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced platform offerings, and the continuing market acceptance of the platform. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, and intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results, and financial condition would be adversely affected. After the IPO, all of our restricted stock units, or RSUs, vest upon the satisfaction of a service-based vesting condition. Vested RSUs are settled in shares of our common stock. The first settlement event for certain of our RSUs occurred in December 2018, at which time approximately 2.3 million RSUs were settled. We withheld approximately 1.2 million shares of common stock upon settlement in order to satisfy tax withholding obligations. At the time of settlement in December 2018, the value of our common stock was $24.63 per share. Based on an estimated withholding tax rate of approximately 50%, this December 2018 settlement resulted in aggregate withholding obligations of approximately $28.4 million paid by us from our working capital. An additional settlement event for our RSUs will occur no later than April 15, 2019, by which time approximately 0.5 million shares underlying RSUs held by our officers and employees will be vested and settled into shares of our common stock. We currently expect that the average withholding tax rate for the holders of these RSUs will be approximately 50%. Subject to the discretion of our board of directors and certain contractual obligations that require us to withhold shares of common stock in order to satisfy tax withholding obligations at RSU settlement, we have established a policy requiring individuals to sell-to-cover in order to satisfy our tax withholding obligations for such individuals due at settlement. Assuming that the holders of the 0.5 million RSUs sell-to-cover consistent with this policy, approximately 50%, or approximately 0.25 million, of the vested shares would need to be sold on the settlement date. Loan and Credit Facility Agreements In April 2018, we entered into a syndicated loan agreement with Wells Fargo to provide a secured revolving credit facility that allows us to borrow up to $40.0 million, subject to an accounts receivable borrowing base, for general corporate purposes through April 2020. Any advances drawn on the credit facility will incur interest at a rate equal to (i) the highest of (A) the prime rate, (B) the federal funds rate plus 0.5% and (C) one-month LIBOR plus 1% less (ii) 0.5%. Interest is payable monthly in arrears with the principal and any accrued and unpaid interest due on April 30, 2020. There was a $6.0 million reduction of the available credit facility in April 2018 related to letters of credit for certain of our facility leases, which resulted in the simultaneous release of $6.0 million in restricted cash. As of January 31, 2019, the Company had not drawn down any amounts under this agreement. We granted Wells Fargo a first priority lien in our accounts receivable, all of the issued shares of capital stock and equity interests of our subsidiaries, and other corporate assets and agreed not to pledge our intellectual property to other parties. The loan agreement includes affirmative and negative covenants, including financial covenants requiring: (i) maintenance at all times of minimum tangible net worth, defined as assets, excluding intangible assets, less liabilities of not less than $1; and (ii) maintenance at all times of a ratio of (A) the aggregate of our cash, cash equivalents and net accounts receivable to (B) total current liabilities less current deferred revenue plus revolving credit loans drawn under the loan agreement of not less than $1.50 to $1.00. This syndicated loan agreement was subsequently amended in September 2018. As of January 31, 2019, we were in compliance with all covenants associated with the credit facility. Cash Flows The following table summarizes our cash flows for the periods presented: Operating Activities Net cash used in operating activities of $45.9 million for fiscal 2019 was primarily due to a net loss of $131.0 million, partially offset by non-cash charges for stock-based compensation of $52.8 million, depreciation and amortization of $12.9 million, amortization of deferred commissions of $11.7 million, and loss on disposal of property and equipment of $0.6 million. Changes in working capital were favorable to cash flows from operations by $7.1 million primarily due to an increase in the deferred revenue balance of $52.6 million due to increases in sales, and an increase in accounts payable and accrued expenses of $15.5 million due to our growth, partially offset by an increase in deferred commissions of $32.8 million, and increases in accounts receivable, net of $28.5 million. Net cash used in operating activities of $14.5 million for fiscal 2018 was primarily due to a net loss of $47.6 million, partially offset by non-cash charges for stock-based compensation of $8.6 million, depreciation and amortization of $7.4 million, and amortization of deferred commissions of $7.4 million. Changes in working capital were favorable to cash flows from operations by $9.5 million primarily due to a change in the deferred revenue balance of $32.4 million from our increases in sales and increases in accounts payable and accrued expenses of $8.9 million due to our growth, partially offset by an increase in deferred commissions of $14.8 million and increases in accounts receivable, net of $10.0 million and in prepaid expenses and other current assets of $5.9 million also related to increases in our sales. Net cash used in operating activities of $26.2 million for fiscal 2017 was primarily due to a net loss of $40.2 million, partially offset by non-cash charges for stock-based compensation of $6.1 million, depreciation and amortization of $4.3 million, and amortization of deferred commissions of $4.8 million. Changes in working capital were unfavorable to cash flows from operations by $1.3 million primarily due to increases in our accounts receivable, net of $16.3 million and deferred commissions of $12.2 million due to increases in sales, partially offset by increases in deferred revenue of $24.2 million also due to increases in sales and an increase in accounts payable and accrued expenses of $5.4 million related to our growth. Investing Activities Net cash used in investing activities for fiscal 2019 of $22.5 million was related to purchases of property and equipment of $15.1 million related to our growth and the capitalization of internal-use software of $7.4 million as we expanded the platform and increased our development efforts. Net cash used in investing activities for fiscal 2018 of $15.4 million was related to purchases of property and equipment of $9.6 million related to our growth and the capitalization of internal use software of $5.8 million as we expanded the platform and increased our development efforts. Net cash used in investing activities for fiscal 2017 of $2.4 million was related to purchases of property and equipment of $2.8 million and the capitalization of internal use software of $2.2 million, partially offset by maturities in marketable securities of $3.0 million. Financing Activities Net cash provided by financing activities for fiscal 2019 of $279.9 million consisted primarily of proceeds of $301.8 million from our IPO and concurrent private placement, $6.2 million in proceeds from the exercise of stock options, and $1.9 million from the repayment of promissory notes, partially offset by $28.4 million taxes paid related to net share settlement of equity awards, and $1.6 million principal payment on capital lease obligations. Net cash provided by financing activities for fiscal 2018 of $64.7 million consisted of net proceeds of $59.9 million from the issuance of Series F convertible preferred stock, $3.3 million in proceeds from the exercise of stock options, and $1.5 million from the repayment of promissory notes. Net cash provided by financing activities for fiscal 2017 of $2.2 million consisted primarily of $1.9 million in proceeds from the exercise of stock options. Commitments and Contractual Obligations The following table summarizes our non-cancelable contractual obligations as of January 31, 2019: 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 these purchase orders represent authorizations to purchase rather than binding agreements and are generally fulfilled within short time periods. Off-Balance Sheet Arrangements Through 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. Critical Accounting Policies and Estimates Our consolidated financial statements have been 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, 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. Revenue Recognition We recognize revenue from contracts with customers using the five-step method described in Note 1 of the notes to our consolidated financial statements included elsewhere in this Form 10-K. 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 combine contracts entered into at or near the same time with the same customer if we determine that the contracts are negotiated as a package with a single commercial objective; the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or the services promised in the contracts are a single performance obligation. Our performance obligations consist of (i) subscription and support services and (ii) professional and other services. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on their relative standalone selling price. We determine standalone selling price, or SSP, for all our performance obligations using observable inputs, such as standalone sales and historical contract pricing. SSP is consistent with our overall pricing objectives, taking into consideration the type of subscription services and professional and other services. SSP also reflects the amount we would charge for that performance obligation if it were sold separately in a standalone sale, and the price we would sell to similar customers in similar circumstances. In general, we satisfy the majority of our performance obligations over time as we transfer the promised services to our customers. We review the contract terms and conditions to evaluate the timing and amount of revenue recognition; the related contract balances; and our remaining performance obligations. We also estimate the number of hours expected to be incurred based on an expected hours approach that considers historical hours incurred for similar projects based on the types and sizes of customers. These evaluations require significant judgment that could affect the timing and amount of revenue recognized. Deferred Commissions We capitalize sales commissions that are considered to be incremental to the acquisition of customer contracts, which are then amortized over an estimated period of benefit. To determine the period of benefit of our deferred commissions, we evaluate the type of costs incurred, the nature of the related benefit, and the specific facts and circumstances of our arrangements. We determine the period of benefit for commissions paid for the acquisition of the initial subscription contract by taking into consideration our initial estimated customer life and the technological life of the platform and related significant features. We determine the period of benefit for commissions on renewal subscription contracts by considering the average contractual term for renewal contracts. We evaluate these assumptions on a quarterly basis and periodically review whether events or changes in circumstances have occurred that could impact the period of benefit. Stock-Based Compensation Stock-based compensation expense is measured based on the fair value of the awards granted, and recognized in the consolidated financial statements over the requisite service period for stock options, restricted stock units (RSUs), and stock purchase rights (SPRs), and over the offering period for purchase rights issued under the ESPP. We 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. Stock Options The fair value of a stock option is estimated on the grant date using the Black-Scholes option-pricing model. Stock-based compensation expense is recognized, net of forfeitures, over the requisite service periods of the awards, 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 our underlying common stock, expected term of the option, 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 and estimates are as follows: • Fair Value of Common Stock. Prior to our IPO, our board of directors determined the fair value of our common stock using various valuation methodologies, including valuation analyses performed by third-party valuation firms. After our IPO, we use the publicly quoted market closing price as reported on the New York Stock Exchange as the fair value of our common stock. • Risk-Free Interest Rate. We base the risk-free interest rate for the expected term of the options on the U.S. Treasury yield curve in effect at the time of the grant. • Expected Term. We determine the expected term 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. • Expected Volatility. As there was no public market for our common stock prior to our IPO, we have limited information on the volatility of our common stock. Accordingly, the expected volatility for our common stock was estimated by taking the average historic price volatility for industry peers, consisting of several public companies in our industry which are either similar in size, stage of life cycle or financial leverage, over a period equivalent to the expected term of the awards. • Expected Dividend Yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. As a result, we use an expected dividend yield of zero. The Black-Scholes assumptions used in evaluating our awards are as follows: 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. Restricted Stock Units RSUs granted under the 2012 Stock Plan (2012 Plan) vest upon the satisfaction of both a service condition and a liquidity condition. Both the service and liquidity conditions must be met for the expense to be recognized. The liquidity condition was satisfied upon completion of our IPO, and we recognized an expense of $29.9 million in the three months ended October 31, 2018 for the portion of the RSUs that had met the service condition as of such date. Expense related to these RSUs is recognized using the tranche-by-tranche method. RSUs granted under the 2018 Equity Incentive Plan (2018 Plan) vest solely upon the satisfaction of a service condition. Expense related to these RSUs is recognized using the straight-line attribution method. As of January 31, 2019, unrecognized stock-based compensation cost related to outstanding unvested RSUs that are expected to vest was $78.1 million, which is expected to be recognized over a weighted-average period of 2.6 years. Stock Purchase Rights SPRs have been issued in exchange for recourse promissory notes that have been deemed to be non-substantive in nature. The rights are accounted for as option awards with the related stock-based compensation recognized over the vesting period of the awards. The related stock-based compensation is based on the fair value of the awards determined using the Black-Scholes option-pricing model and the assumptions are determined similarly to those noted in the option discussion above for each of the fair value of our underlying common stock, expected term of the option, expected volatility of the price of our common stock, risk-free interest rates, and the expected dividend yield of our common stock. We have not granted any SPRs since fiscal 2017. Recent Accounting Pronouncements See “Summary of Business and Significant Accounting Policies” in Note 1 of the notes to our consolidated financial statements included in Part II, Item 8 of this Form 10-K.

<s>[INST] Overview Anaplan is pioneering the category of Connected Planning, which allows organizations to transform their businesses by making better and faster decisions. We believe Connected Planning is the next essential cloud category. It fundamentally transforms planning by connecting all of the people, data, and plans needed to accelerate business value and enable realtime planning and decisionmaking in rapidly changing business environments. Connected Planning accelerates business value by transforming the way organizations make decisions and placing the power of planning in the hands of every individual at every level within and between organizations. Connected Planning represents a fundamental shift from the legacy approach to planning, which is typically confined to the finance department and uses a patchwork of outdated and disconnected tools and manual processes that are often overly complex, slow, inefficient, and static. Connected Planning enables dynamic, collaborative, and intelligent planning across all areas of an organization, including finance, sales, and supply chain, and other corporate functions such as marketing, human resources, and operations. We sell subscriptions to our cloudbased planning platform primarily through our direct sales team. We also have strategic partnerships that provide us with a significant source of lead generation and implementation leverage. Our global partners, including global strategic consulting firms and global systems integrators, often promote our platform as part of the largescale transformation projects they drive by identifying opportunities in which our platform can help companies maximize the effectiveness of their business processes. We also partner with leading regional consulting firms and implementation partners. These highly skilled regional partners not only provide subjectmatter expertise in the implementation of specific use cases, but they also act as an extension of our direct sales force by identifying and referring opportunities to us. We and our partners create prepackaged applications that are available on our App Hub marketplace to further accelerate the adoption and expansion of our platform. We focus our selling efforts on executives of large enterprises, who are often making a strategic purchase of our platform with the potential for broad use throughout their organizations. We use a “land and expand” sales strategy to capitalize on this potential. Our platform is often initially adopted within a specific line of business, including in finance, sales, and supply chain, and other corporate functions such as marketing, human resources, and operations, for one or more planning use cases. Once customers see the benefits of our platform for their initial use cases, they often increase the number of users, add new use cases, and expand to additional lines of business, divisions, and geographies. We see a greenfield opportunity to help over 70 million knowledge workers around the world plan more efficiently using Anaplan. We derive the substantial majority of our revenue from subscriptions for users on our platform. Our initial subscription term is typically two to three years, although some customers commit for shorter periods. We generally bill our customers annually in advance. We also offer professional services, including consulting, implementation, and training, but are increasingly leveraging our partners to provide these services. During fiscal 2019, 2018, and 2017, subscription revenue was $208.6 million, $143.5 million and $91.4 million, respectively, representing a yearoveryear subscription revenue growth rate of 45% and 57% in fiscal 2019 and 2018, respectively. During fiscal 2019, 2018, and 2017, services revenue was $32.0 million, $24.8 million and $29.1 million, respectively. Our subscription revenue as a percentage of total revenue was 87%, 85%, and 76% in fiscal 2019, 2018, and 2017, respectively. During fiscal 2019, 2018 and 2017, our revenue was $240.6 million, $168.3 million and $120.5 million, respectively. Approximately 43%, 41% and 38% of our revenue was generated from outside of the United States in fiscal 2019, 2018 and 2017, respectively. Our net loss was $131.0 million, $47.6 million and $40.2 million in fiscal 2019, 2018 and 2017, respectively. We believe that our focus on customer [/INST] Negative. </s>

Switchback Energy 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 the audited financial statements and the notes related thereto which are included in “Part II, 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,” “Part I, Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company incorporated in Delaware on May 10, 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. Although we are not limited to a particular industry or sector for purposes of consummating our initial business combination, we intend to focus our search for a target business in the energy industry in North America. Our Sponsor is NGP Switchback, LLC, a Delaware limited liability company. The Registration Statement for our Public Offering was declared effective on July 25, 2019. On July 30, 2019, we consummated the Public Offering of 30,000,000 Units at $10.00 per Unit, generating gross proceeds of $300.0 million, and incurring offering costs of approximately $17.0 million, inclusive of $10.43 million in deferred underwriting commissions. Certain of our officers and directors purchased 200,000 (the “Affiliated Units”) of the 30,000,000 Units sold in the Public Offering for an aggregate purchase price of $2.0 million. The underwriters were granted a 45-day option from the date of the final prospectus relating to the Public Offering to purchase up to 4,500,000 additional units to cover overallotments, if any, at $10.00 per unit, less underwriting discounts and commissions. On September 4, 2019, the underwriters partially exercised the overallotment option and, on September 6, 2019, the underwriters purchased 1,411,763 of the Overallotment Units, generating gross proceeds of approximately $14.1 million. The remaining overallotment option subsequently expired. Simultaneously with the closing of the Public Offering, we consummated the sale (the “Private Placement”) of 5,333,333 Private Placement Warrants at a price of $1.50 per Private Placement Warrant in a private placement to our Sponsor, generating gross proceeds of approximately $8.0 million. Simultaneously with the closing of the sale of the Overallotment Units, our Sponsor purchased an additional 188,235 Private Placement Warrants at a price of $1.50 per Private Placement Warrant, generating gross proceeds of approximately $282,000. Approximately $314.1 million ($10.00 per Unit) of the net proceeds of the Public Offering (including the Overallotment Units) and certain of the proceeds of the Private Placement was placed in a 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)(1), (d)(2), (d)(3) and (d)(4) of Rule 2a-7 under 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 our initial business combination and (ii) the distribution of the Trust Account as described below. If we are unable to complete an initial business combination within 24 months from the closing of the Public Offering, or July 30, 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 our remaining stockholders and its board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. Results of Operations Our only activities from inception through December 31, 2019 related to our formation and the Public Offering, and, since the closing of the Public Offering, the search for a prospective initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as costs in the pursuit of our acquisition plans. For the period from May 10, 2019 (inception) through December 31, 2019, we had net income of approximately $780,000, which consisted of approximately $2.3 million of gain on marketable securities, dividends and interest held in the Trust Account, offset by approximately $935,000 in general and administrative expenses, approximately $88,000 in franchise tax expense, and approximately $479,000 in income tax expense. Related Party Transactions Founder Shares On May 16, 2019, our Sponsor purchased 8,625,000 Founder Shares for an aggregate price of $25,000. Our Sponsor agreed to forfeit up to 1,125,000 Founder Shares to the extent that the overallotment option for our Public Offering was not exercised in full by the underwriters. On September 6, 2019, the underwriters purchased 1,411,763 Overallotment Units, and the remaining overallotment option subsequently expired. As a result, our Sponsor forfeited an aggregate of 772,059 Founder Shares. 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 date of the consummation of the initial business combination or earlier if, subsequent to the initial business combination, (i) the last sale price of the Company’s 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) the Company consummates a subsequent liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property. Private Placement Warrants Simultaneously with the closing of the Public Offering, our Sponsor purchased an aggregate of 5,333,333 Private Placement Warrants at a price of $1.50 per Private Placement Warrant, generating gross proceeds of approximately $8.0 million in the aggregate. Simultaneously with the closing of the sale of the Overallotment Units, our Sponsor purchased an additional 188,235 Private Placement Warrants at a price of $1.50 per Private Placement Warrant, generating gross proceeds of approximately $282,000. Each whole Private Placement Warrant is exercisable for one whole 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 to our Sponsor was added to the proceeds from the Public Offering held in the Trust Account. If the Company does not complete an initial business combination within the Combination Period, 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 our Sponsor or its permitted transferees. Our Sponsor and the Company’s officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their Private Placement Warrants until 30 days after the completion of our initial business combination. Related Party Loans On May 16, 2019, our Sponsor agreed to loan the Company an aggregate of up to $300,000 to cover organizational expenses and expenses related to the Public Offering pursuant to the Note. This loan is non-interest bearing and payable on the completion of the Public Offering. The Company borrowed approximately $251,000 under the Note, and then repaid the Note in full to our Sponsor on August 12, 2019. In addition, in order to finance transaction costs in connection with an initial business combination, our Sponsor or an affiliate of our Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, loan the Company funds as may be required. If the Company completes an initial business combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that an initial business combination does not close, the Company 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 an initial business combination, without interest, or, at the lender’s discretion, up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post business combination entity at a price of $1.50 per warrant. The warrants would be identical to the Private Placement Warrants. To date, the Company had no borrowings under the Working Capital Loans. Administrative Services Agreement Commencing on the date that our securities were first listed on the NYSE and continuing until the earlier of our consummation of an initial business combination or our liquidation, we have agreed to pay our Sponsor a total of $10,000 per month for office space, utilities, secretarial support and administrative services. We recorded an aggregate of $50,000 for the period from May 10, 2019 (inception) through December 31, 2019 in general and administrative expenses in connection with the related agreement in the accompanying statement of operations. Critical Accounting Policies and Estimates This management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with GAAP. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to fair value of financial instruments and accrued expenses. We base our estimates on historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company has identified the following as its critical accounting policies: Marketable Securities Held in Trust Account Our portfolio of marketable securities is 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 185 days or less, classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of these securities is included in gain on marketable securities (net), dividends and interest, held in Trust Account in the accompanying statement of operations. The estimated fair values of marketable securities held in Trust Account are determined using available market information. Class A Common Stock Subject to Possible Redemption Class A common stock subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A common stock (including Class A common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A common stock are classified as stockholders’ equity. Our Class A common stock feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at December 31, 2019, 30,047,981 shares of Class A common stock subject to possible redemption are presented as temporary equity, outside of the stockholders’ equity section of the Company’s 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 common stock outstanding during the periods. We have not considered the effect of the Warrants sold in the Public Offering (including the consummation of the overallotment) and Private Placement to purchase an aggregate of 15,992,155 shares of our 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 statement of operations includes a presentation of income per share for common stock subject to redemption in a manner similar to the two-class method of income per share. Net income per share, basic and diluted for Class A common stock is calculated by dividing the gain on marketable securities, dividends and interest held in the Trust Account of approximately $2.3 million, net of applicable taxes and funds available to be withdrawn from the Trust Account for tax obligations of approximately $567,000, resulted to an aggregate of approximately $1.7 million, by the weighted average number of Class A common stock outstanding for the period of 31,092,978 shares. Net loss per share, basic and diluted for Class B common stock is calculated by dividing the net income of approximately $780,000, less income attributable to Public Shares of approximately $1.7 million, resulted to a net loss of approximately $935,000, by the weighted average number of Class B common stock outstanding for the period of 7,852,941 shares. Recent Accounting Pronouncements In July 2017, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); 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. The ASU allows companies to exclude a down round feature when determining whether a financial instrument (or embedded conversion feature) is considered indexed to the entity’s own stock. As a result, financial instruments (or embedded conversion features) with down round features may no longer be required to be classified as liabilities. A company will recognize the value of a down round feature only when it is triggered and the strike price has been adjusted downward. For equity-classified freestanding financial instruments, such as warrants, an entity will treat the value of the effect of the down round, when triggered, as a dividend and a reduction of income available to common shareholders in computing basic earnings per share. For convertible instruments with embedded conversion features containing down round provisions, entities will recognize the value of the down round as a beneficial conversion discount to be amortized to earnings. The guidance in ASU 2017-11 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. We adopted this guidance at inception. As a result, the Warrants issued in connection with the Public Offering and the sale of the Private Placement Warrants to our Sponsor was equity-classified. 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. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” under the JOBS Act and are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We elected 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. As an “emerging growth company,” we are not required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our Public Offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Overview We are a blank check company incorporated in Delaware on May 10, 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. Although we are not limited to a particular industry or sector for purposes of consummating our initial business combination, we intend to focus our search for a target business in the energy industry in North America. Our Sponsor is NGP Switchback, LLC, a Delaware limited liability company. The Registration Statement for our Public Offering was declared effective on July 25, 2019. On July 30, 2019, we consummated the Public Offering of 30,000,000 Units at $10.00 per Unit, generating gross proceeds of $300.0 million, and incurring offering costs of approximately $17.0 million, inclusive of $10.43 million in deferred underwriting commissions. Certain of our officers and directors purchased 200,000 (the “Affiliated Units”) of the 30,000,000 Units sold in the Public Offering for an aggregate purchase price of $2.0 million. The underwriters were granted a 45day option from the date of the final prospectus relating to the Public Offering to purchase up to 4,500,000 additional units to cover overallotments, if any, at $10.00 per unit, less underwriting discounts and commissions. On September 4, 2019, the underwriters partially exercised the overallotment option and, on September 6, 2019, the underwriters purchased 1,411,763 of the Overallotment Units, generating gross proceeds of approximately $14.1 million. The remaining overallotment option subsequently expired. Simultaneously with the closing of the Public Offering, we consummated the sale (the “Private Placement”) of 5,333,333 Private Placement Warrants at a price of $1.50 per Private Placement Warrant in a private placement to our Sponsor, generating gross proceeds of approximately $8.0 million. Simultaneously with the closing of the sale of the Overallotment Units, our Sponsor purchased an additional 188,235 Private Placement Warrants at a price of $1.50 per Private Placement Warrant, generating gross proceeds of approximately $282,000. Approximately $314.1 million ($10.00 per Unit) of the net proceeds of the Public Offering (including the Overallotment Units) and certain of the proceeds of the Private Placement was placed in a 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)(1), (d)(2), (d)(3) and (d)(4) of Rule 2a7 under 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 our initial business combination and (ii) the distribution of the Trust Account as described below. If we are unable to complete an initial business combination within 24 months from the closing of the Public Offering, or July 30, 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 pershare 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 thenoutstanding public [/INST] Negative. </s>

CASTLE 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 results of operations together with our financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risk and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section titled “Risk Factors.” Overview We are a commercial-stage dermatological cancer company focused on providing physicians and their patients with personalized, clinically actionable genomic information to make more accurate treatment decisions. We believe that the traditional approach to developing a treatment plan for certain cancers using clinical and pathology factors alone is inadequate and can be improved by incorporating personalized genomic information. Our non-invasive products utilize proprietary algorithms to provide an assessment of a patient’s specific risk of metastasis or recurrence of their cancer, allowing physicians to identify patients who are likely to benefit from an escalation of care as well as those who may avoid unnecessary medical and surgical interventions. Our lead product, DecisionDx-Melanoma, is a GEP test that predicts the risk of metastasis or recurrence for patients diagnosed with invasive cutaneous melanoma, a deadly skin cancer. We estimate more than 130,000 patients are diagnosed with invasive cutaneous melanoma each year in the United States. We launched DecisionDx-Melanoma in May 2013. We also market DecisionDx-UM, which is a proprietary GEP test that predicts the risk of metastasis for patients with uveal melanoma, a rare eye cancer. We launched DecisionDx-UM in January 2010. Based on the substantial clinical evidence that we have developed, we have received Medicare coverage for both of our products, which represents approximately 50% of our addressable patient population. We also have two late-stage proprietary products in development that address SCC and suspicious pigmented lesions which are indications with high clinical need in dermatological cancer. These indications are areas of high clinical need in dermatological cancer and, together, represent an additional addressable market of approximately 500,000 patients in the United States. We have processed over 60,000 clinical samples since commercial launch and our annual revenue increased from $22.8 million in 2018 to $51.9 million in 2019. For the year ended December 31, 2019, year-over-year growth in new ordering clinicians for our DecisionDx-Melanoma test was 24.3%. Additionally, total ordering clinicians in 2019 for DecisionDx-Melanoma increased 32% to 3,927, year-over-year. The numbers of DecisionDx-Melanoma and DecisionDx-UM test reports delivered by us during the years ended December 31, 2019 and 2018 are presented in the table below: For additional information on the metrics we disclose, refer to “Information about certain metrics” below. Since our inception in 2008, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, discovering product candidates, conducting clinical study activities to generate evidence demonstrating the clinical validity, clinical utility, economic benefits, and patient outcomes of our products, and commercialization activities for those products. We currently market two proprietary GEP products and generate substantially all of our revenue from those activities. On July 29, 2019, we completed the IPO. In connection with the IPO, we issued and sold 4,600,000 shares of our common stock, including 600,000 shares associated with the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $16.00 per share. We received approximately $65.9 million in net proceeds, after deducting underwriting discounts and commissions and other offering expenses payable by us. Prior to the IPO, we financed our operations primarily through private placements of preferred stock, revenue generated from sales of our products, bank debt and convertible notes. The principal focus of our current commercial efforts is to distribute our molecular diagnostic testing products through our direct sales force in the U.S. The number of test reports we generate is a key indicator that we use to assess our business. A test report is generated when we receive a sample in our laboratory, the relevant information relating to that test is entered into our Laboratory Information Management System, the genomic profile of the sample is performed and a report providing the results of that profile is sent to the physician who ordered the test. We bill third-party payors and patients for the tests we perform. The majority of our revenue collections is paid by third-party insurers, including Medicare. We have received LCDs, which provide coverage for our tests that meet certain criteria for Medicare and Medicare Advantage beneficiaries, representing approximately 60 million covered lives. As it relates to DecisionDx-UM, we have contracts or have received positive medical policy decisions from additional payors representing approximately 83 million covered lives. A ‘‘covered life’’ means a subscriber, or a dependent of a subscriber, who is insured under an insurance policy for such an insurance carrier. On May 17, 2019, CMS determined that DecisionDx-UM meets the criteria for existing ADLT status. This means that beginning in 2021, the DecisionDx-UM Medicare rate will be set annually based upon the median private payor rate for the first half of the second preceding calendar year. Specifically, the median private payor rate from January 1 to June 30, 2019 will be used to set the Medicare rate for the calendar year 2021. We successfully submitted this data in January 2020. Note that our rate for 2020 will be set by Noridian, our local MAC. Also, on May 17, 2019, CMS determined that DecisionDx-Melanoma meets the criteria for ‘‘new ADLT’’ status. This means that from July 1, 2019 through March 31, 2020 the Medicare reimbursement rate will equal the initial list price of $7,193.00, subject to the possible recoupment provision described below. The rate for April 1, 2020 through December 31, 2021 will be calculated based upon the median private payor rate from July 1, 2019 to November 30, 2019. We successfully submitted this data in December 2019. Note that for DecisionDx-Melanoma tests reported for July 1, 2019 through March 31, 2020, CMS has the right to recoup the difference between the actual list and 130% of the weighted median if the original list price was greater than 130% of the weighted median or private payor rates. However, based on the data we collected and submitted to CMS during the data collection period ended November 30, 2019, the original list price amount was not greater than 130% of the weighted median of private payor rates. Therefore, we expect no recoupment to apply under this provision. Beginning in 2022, the rate will be set annually based upon the median private payor rate for the first half of the second preceding calendar year. For example, the rate for 2022 will be set using median private payor rate data from January 1, 2020 to June 30, 2020. Since our inception, we have incurred significant operating losses and negative cash flows. For the year ended December 31, 2018, our net loss was $6.4 million, our net cash used in operating activities was $12.3 million and we had an accumulated deficit of $57.5 million as of December 31, 2018. For the year ended December 31, 2019, our net income was $5.3 million (which includes the benefit of a $5.2 million non-cash debt extinguishment gain), our net cash provided by operating activities was $7.0 million and we had an accumulated deficit of $52.2 million as of December 31, 2019. We also have substantial indebtedness, the terms of which require us to meet a quarterly three-month trailing revenue covenant. Our ability to generate revenue sufficient to achieve and sustain profitability will depend heavily on the successful commercialization of our currently marketed products and the products we plan to launch in the future. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on the commercialization of our existing products, the development of our future product candidates, and the commercialization of our product candidates. Although we generated positive operating income during the year ended December 31, 2019, we expect to incur significant additional expenses and operating losses during the next two years as we invest in growing our commercial and research and development efforts. We believe that our existing cash and cash equivalents and anticipated cash generated from sales of our products will be sufficient to fund our operating expenses for the foreseeable future. However, 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. Our net income (losses) may fluctuate significantly from period to period, depending on the timing of our planned development activities, the growth of our sales and marketing activities and the timing of revenue recognition under ASC 606. We expect our expenses will increase substantially over time as we: • execute clinical studies to generate evidence supporting our current and future product candidates; • execute our commercialization strategy for our current and future products; • continue our ongoing and planned development of new products; • seek to discover and develop additional product candidates; • hire additional scientific and research and development staff; and • add additional operational, financial and management information systems and personnel. 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. Factors affecting our performance We believe there are several important factors that have impacted and that we expect will impact our operating performance and results of operations, including: • Report volume. We believe that the number of reports we deliver to physicians is an important indicator of growth of adoption among the healthcare provider community. Our revenue and costs are affected by the volume of testing and mix of customers. Our performance depends on our ability to retain and broaden adoption with existing prescribing physicians, as well as attract new physicians. • Reimbursement. We believe that expanding reimbursement is an important indicator of the value of our products. Payors require extensive evidence of clinical utility, clinical validity, patient outcomes and health economic benefits in order to provide reimbursement for diagnostic products. Our revenue depends on our ability to demonstrate the value of our products to these payors. • Gross margin. We believe that our gross margin is an important indicator of the operating performance of our business. Higher gross margins reflect the average selling price of our tests, as well as the operating efficiency of our laboratory operations. • New product development. A significant aspect of our business is our investment in research and development activities, including activities related to the development of new products. In addition to the development of new product candidates, we believe these studies are critical to gaining physician adoption of new products and driving favorable coverage decisions by payors for such products. Information about certain metrics The following provides additional information about certain metrics we have disclosed in this Management’s Discussion and Analysis of Financial Condition and Results of Operation. Test reports delivered for DecisionDx-Melanoma and DecisionDx-UM represents the number of completed test reports delivered by us during the reporting period indicated. The period in which a test report is delivered does not necessarily correspond with the period the related revenue, if any, is recognized, due to the timing and amount of adjustments for variable consideration under ASC 606. We use this metric to evaluate the growth in adoption of our tests and to measure against our internal performance objectives. We believe this metric is useful to investors in evaluating the volume of our business activity from period to period that may not be discernible from our reported revenues under ASC 606. New ordering clinicians for DecisionDx-Melanoma represents the number of clinicians who ordered the DecisionDx-Melanoma test for the first time during the reporting period specified. We believe this metric is useful in evaluating the effectiveness of our sales and marketing efforts in establishing new relationships with clinicians and increasing the adoption of our DecisionDx-Melanoma test. We also believe this metric provides useful information to investors in assessing our ability to expand the use of the DecisionDx-Melanoma test. Since this metric is based upon the reporting period in which an order is placed, it does not necessarily correspond to the reporting period in which a test report was delivered or in which any revenue was recognized. Total ordering clinicians for DecisionDx-Melanoma represents the total number of clinicians who ordered the DecisionDx-Melanoma test during the reporting period specified. The total ordering clinicians metric allows us to assess our sales and marketing efforts in both establishing new clinician relationships as well as maintaining existing ones. We believe that this metric provides useful information to investors in assessing our ability to both expand the use of the DecisionDx-Melanoma test with new clinicians and maintain existing clinician relationships. Since this metric is based upon the reporting period in which an order is placed, it does not necessarily correspond to the reporting period in which a test report was delivered or in which any revenue was recognized. Components of the Results of Operations Net Revenues We generate revenues from the sale of our products, primarily from the sale of DecisionDx-Melanoma and DecisionDx-UM. We bill third-party payors and patients for the tests we perform. Under ASC 606, we recognize revenue at the amount we expect to be entitled, subject to a constraint for variable consideration, in the period in which our tests are delivered to the treating physicians. We have determined that our contracts contain variable consideration under ASC 606 because the amounts paid by third-party payors may be paid at less than our standard rates or not paid at all, with such differences considered implicit price concessions. Variable consideration is recognized only to the extent it is probable that a significant reversal of revenue will not occur in future periods when the uncertainties are resolved. We consider variable consideration to be fully constrained (and therefore not recognized) for Medicare claims when the payment of such claims is subject to approval by an ALJ at an appeal hearing, due to the level of uncertainty and timing of the outcome. Variable consideration is evaluated each reporting period and adjustments are recorded as increases or decreases in revenues. Importantly, we expect to recognize any revenue adjudicated by the ALJ in the reporting period in which we are notified of the ALJ hearing outcome and it is determined that such decision will not be appealed. Due to ALJ hearings, potential future changes in insurance coverage policies, contractual rates, and other trends in the reimbursement of our tests, our revenues may fluctuate significantly from period to period. Our ability to increase our revenues will depend on our ability to further penetrate our target market, and, in particular, generate sales through our direct sales force, develop and commercialize additional tests, obtain reimbursement from additional third-party payors and increase our reimbursement rate for tests performed. In the near term, our financial performance will be highly dependent on reimbursement for DecisionDx-Melanoma. The use of DecisionDx-Melanoma is not yet broadly covered under positive coverage policies, although many third-party payors have begun to reimburse for this test. Cost of Sales The components of our cost of sales are material and service costs, personnel costs, which includes stock-based compensation expense, equipment and infrastructure expenses associated with testing samples, electronic medical records, order and delivery systems, shipping charges to transport samples, third-party test fees, and allocated overhead including rent, information technology costs, equipment depreciation and utilities. Costs associated with performing tests are recorded when the test is processed regardless of whether and when revenues are recognized with respect to that test. As a result, our cost of sales as a percentage of revenues may vary significantly from period to period because we do not recognize all revenues in the period in which the associated costs are incurred. We expect cost of sales in absolute dollars to increase as the number of tests we perform increases. Gross margin, calculated as net revenue minus cost of sales, is a key indicator we use to assess our business. For example, in 2016, we transitioned the performance of our genomic tests to our own dedicated clinical lab from a third-party contract lab. This transition increased the gross margin from our genomic tests while also increasing our level of control of the performance of our tests and laboratory quality metrics. Research and Development Research and development expenses include costs incurred to develop our genomic tests, collect clinical samples and conduct clinical studies to develop and support our products. These costs consist of personnel costs, including stock-based compensation expense, prototype materials, laboratory supplies, consulting costs, regulatory costs, electronic medical records set up costs, costs associated with setting up and conducting clinical studies and allocated overhead, including rent, information technology, equipment depreciation and utilities. We expense all research and development costs in the periods in which they are incurred. We expect our research and development expenses to increase in absolute dollars as we continue to invest in research and development activities related to developing enhanced and new products. Selling, General and Administrative Selling, general and administrative, or SG&A, expenses include executive, selling and marketing, legal, finance and accounting, human resources, billing and client services. These expenses consist of personnel costs, including stock-based compensation expense, direct marketing expenses, audit and legal expenses, consulting costs, training and medical education activities, payor outreach programs and allocated overhead, including rent, information technology, equipment depreciation, and utilities. In the near term, we expect increases in SG&A expenses related to compliance with the rules and regulations of the SEC and Nasdaq, investor relations activities, and additional insurance expenses. Other administrative and professional services expenses within SG&A are expected to increase with the scale of our business, but selling and marketing-related expenses are expected to increase significantly, consistent with our growth strategy. Interest Income Interest income consists primarily of interest earned on cash and cash equivalents in interest-bearing accounts. Interest Expense Interest expense is attributable to borrowings under our term debt, revolving line of credit and the convertible promissory notes issued in January and February of 2019, or the Q1 2019 Notes, and also includes the amortization of debt discount and issuance costs. Gain on Extinguishment of Debt The gain on extinguishment of debt is associated with the settlement of the Q1 2019 Notes in connection with the IPO. Other Expense, Net Other expense, net reflects changes in the fair value of (i) a convertible promissory note we issued to an investor in July 2019, or the July 2019 Note, (ii) our convertible preferred stock warrant liability and (iii) the embedded derivative associated with the Q1 2019 Notes. Income Tax Expense Our financial statements do not reflect any federal or state income tax benefits attributable to the net losses we have incurred, due to the uncertainty of realizing a benefit from those items. As of December 31, 2019, we had federal net operating loss carryforwards of $57.4 million, of which $43.5 million will begin to expire in 2028 if not utilized to offset taxable income, and $13.9 million may be carried forward indefinitely. Also, as of December 31, 2019, we had state net operating loss carryforwards of $42.2 million, which begin to expire in 2028 if not utilized to offset state taxable income. 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, except percentages): Net Revenues Net revenues increased by $29.1 million, or 127.6%, to $51.9 million due to a combination of increased test volume and higher per-unit revenues. Approximately 94% of the increase is attributable to DecisionDx-Melanoma test revenues with the remainder primarily attributable to DecisionDx-UM. For the year ended December 31, 2019, we experienced an increase in DecisionDx-Melanoma and DecisionDx-UM test volume of 26.9%, compared to the year ended December 31, 2018. Our 2019 per-unit revenues also benefited from the attainment of “new ADLT” status for our DecisionDx-Melanoma test, effective July 1, 2019, which resulted in a higher Medicare reimbursement rate for the test, as described above. Revenues for the year ended December 31, 2019 were also positively impacted by the full-year effect of our final LCD for DecisionDx-Melanoma. The LCD was issued by Palmetto, effective December 3, 2018, and provided for payment of covered claims submitted for reimbursement beginning in February 2018. For the years ended December 31, 2019 and 2018, we recorded net positive revenue adjustments of $2.5 million and $0.3 million, respectively, related to tests delivered in previous periods, associated with changes in estimated variable consideration. The additional positive revenue adjustments in the current year primarily relate to recognition of revenue for certain tests delivered in prior periods for which no revenue was recognizable originally, but was recognized upon cash collection of payments for the tests in the current-year period. Cost of Sales Cost of sales for the year ended December 31, 2019 increased by $2.0 million, or 38.0%, compared to the year ended December 30, 2018, primarily due to increased costs of supplies and services, attributable to the higher activity levels, as well as higher personnel costs due to additional headcount in our laboratory testing operations. Our gross margin percentage was 85.9% for the year ended December 31, 2019, compared to 76.8% for the same period in 2018, with the improvement principally a result of the increased operating leverage on the higher revenues. Due to the nature of our business, a significant portion of our cost of sales expenses represent fixed costs associated with our testing operations. Accordingly, our cost of sales expense will not necessarily increase or decrease commensurately with the change in net revenues from period to period. Research and Development Research and development expenses increased by $2.5 million, or 52.1%, for the year ended December 31, 2019, compared to the year ended December 31, 2018, primarily associated with increases in personnel costs. Selling, General and Administrative SG&A expense increased by $13.4 million, or 81.2%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. Approximately 52% of the increase is attributable to higher personnel costs, particularly due to increased headcount, which includes salaries, bonuses, benefits and stock-based compensation. In early 2019, we expanded our sales organization from 14 territories to 23 territories and implemented an additional expansion to 32 territories beginning in December 2019. The higher personnel costs also reflect expanded headcount in our administrative support functions. The remainder of the increase was primarily associated with higher professional fees (principally attributable to reimbursement and accounting), increased travel costs, increased spending for events and conferences, higher insurance expense and other general increases. Interest Income Interest income increased by $0.3 million for the year ended December 31, 2019, compared to the year ended December 31, 2018, as a result of higher interest-bearing balances of cash and cash equivalents. The higher cash and cash equivalents were primarily attributable to proceeds from the IPO and the issuance of convertible promissory notes during 2019. Interest Expense Interest expense increased by $2.3 million, or 101.0%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The effect of the issuance of the Q1 2019 Notes in January and February 2019 added $1.7 million in interest expense for the year ended December 31, 2019 and consisted of the accrual of the contractual 8% interest plus the amortization of issuance costs and debt discount. The remainder of the increase is due to a combination of higher average outstanding balances and higher interest rates on our variable-rate debt under our banking credit facility. Average outstanding bank debt balances were approximately $4.6 million higher during the year ended December 31, 2019 compared to the year ended December 31, 2018 and average interest rates increased by approximately 0.6% from the same period in 2018. Gain on Extinguishment of Debt We recorded a non-cash extinguishment gain related to the Q1 2019 Notes totaling $5.2 million during the year ended December 31, 2019, which was associated with the conversion of the Q1 2019 Notes into shares of common stock in connection with the IPO and was considered an extinguishment for accounting purposes. This gain resulted from certain accounting requirements associated with the extinguishment of debt with a beneficial conversion feature. See Note 7 to the financial statements for additional information. Other Expense, Net Other expense, net for the year ended December 31, 2019 consisted of losses associated with changes in fair value of the July 2019 Note, the liability for convertible preferred stock warrants and the embedded derivative associated with the Q1 2019 Notes of $2.1 million, $0.6 million and $0.2 million, respectively. The activity for the year ended December 31, 2018 consists entirely of changes in fair value of the liability for the convertible preferred stock warrants. These liabilities were adjusted to their current fair values each period, but effective with the IPO, the July 2019 Note and Q1 2019 Notes automatically converted into shares of common stock and we reclassified our liability for convertible preferred stock warrants to stockholders’ equity. Accordingly, no further changes in fair value for these items will be reflected in periods after the IPO date. Income Tax Expense We recorded minimal income tax expense in both the years ended December 31, 2019 and 2018, because the income tax expense (benefit) of net income (loss) in both periods was largely offset by changes in the valuation allowance on net deferred tax assets, as we have determined that it is more likely than not that these benefits will not be realized. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses and negative cash flows. For the year ended December 31, 2018, our net loss was $6.4 million, our net cash used in operating activities was $12.3 million and we had an accumulated deficit of $57.5 million as of December 31, 2018. For the year ended December 31, 2019, we reported net income of $5.3 million (which includes the benefit of a $5.2 million non-cash debt extinguishment gain), our net cash provided by operating activities was $7.0 million and we had an accumulated deficit of $52.2 million as of December 31, 2019. We also have substantial indebtedness, the terms of which require us to meet a three-month trailing revenue covenant, which is currently tested quarterly. As of December 31, 2019 and 2018, we are in compliance with this covenant. At the time of the issuance of our financial statements for the years ended December 31, 2018 and 2017, management’s projections, including consideration of certain revenue recognition policies, indicated potential non-compliance with the then- effective revenue covenant during the 12 months following the date of issuance of those financial statements. Subsequently, in June 2019, we entered into an amendment to our 2018 LSA, or the First Amendment, which, among other changes, modified the revenue covenant from a trailing six-month calculation to a trailing three-month calculation with revised revenue targets tested monthly. In February and March 2020, we entered into amendments of the 2018 LSA that, among other things, changed the covenant from being tested monthly to quarterly testing and established revenue targets for the year ending December 31, 2020. Management expects to be in compliance with the covenant for at least the next 12 months. Prior to the IPO, we had raised aggregate cash proceeds of $46.6 million from the sale of our convertible preferred stock, in various private placements beginning in 2008, which we have used to fund our operations. In addition, we have obtained financing through term debt, a revolving line of credit and convertible promissory notes, which are discussed further below. Initial Public Offering In connection with the closing of the IPO on July 29, 2019, we issued and sold 4,600,000 shares of our common stock, including 600,000 shares associated with the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $16.00 per share. We received approximately $65.9 million in net proceeds, after deducting underwriting discounts and commissions and other offering expenses payable by us. Funding Requirements Our primary uses of capital are, and we expect will continue to be, compensation and related expenses, clinical research and development services, laboratory and related supplies, legal and other regulatory expenses and general administrative costs. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on the commercialization of our existing products, the development of our future product candidates the potential commercialization of our product candidates, should their development be successful, and general administrative costs. We have two product candidates in the late stage development that we plan to launch commercially in the second half of 2020. The successful development of other product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the clinical development of all our product candidates. We are also unable to predict when, if ever, revenue will commence from sales of our product candidates. This is due to the numerous risks and uncertainties associated with developing genomic tests, including, among others, the uncertainty of: • successful commencement and completion of clinical study protocols; • successful identification and acquisition of tissue samples; • the development and validation of genomic classifiers; and • acceptance of new genomic tests by physicians, patients and third-party payors. A change in the outcome of any of these variables with respect to the development of any of our product candidates would significantly change the costs and timing associated with the development of that product candidate. We will also incur costs as a public company that we have not previously incurred or have previously incurred at lower rates, including increased costs and expenses for fees to members of our board of directors, increased personnel costs, increased director and officer insurance premiums, audit and legal fees, investor relations fees and expenses for compliance with public-company reporting requirements under the Exchange Act and rules implemented by the SEC and Nasdaq. As of December 31, 2019 and December 31, 2018, we had cash and cash equivalents of $98.8 million and $4.5 million, respectively. In the first quarter of 2019, we received net proceeds of $11.7 million from the sale of the Q1 2019 Notes. In July 2019, we received net proceeds of $9.2 million from the issuance of the July 2019 Note and $65.9 million in net proceeds from the IPO. We believe that our existing cash and cash equivalents and anticipated cash generated from sales of our products, will be sufficient to fund our operating expenses for the foreseeable future. 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. 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 those listed above. Until such time, if ever, as we can generate revenue sufficient to achieve and sustain profitability, we expect to finance our operations through our cash on hand and, to the extent necessary, a combination of equity and debt financings, which may not be available to us when needed, on terms that we deem to be favorable 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, the ownership interest of our stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we 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 product discovery and development activities or future commercialization efforts. Long-Term Debt Our long-term debt consists of term debt and a revolving line of credit and are presented in the table below (in thousands): Term Debt On November 30, 2018, we entered into the 2018 LSA with Oxford as collateral agent, and Oxford and SVB as equal syndicated lenders, or the Lenders. The 2018 LSA replaced the 2017 Loan and Security Agreement and provided for a $20.0 million term loan, or the 2018 Term Loan, and a credit line of up to $5.0 million (discussed in the ‘‘Revolving Line of Credit’’ section below), prior to amendment of the 2018 LSA on June 13, 2019, as discussed below. Our obligations under the 2018 LSA are secured by substantially all of our assets, excluding intellectual property and subject to certain other exceptions and limitations. We have the right to prepay the 2018 Term Loan in whole or in part at any time, subject to a prepayment fee of 2.50% if prepaid on or prior to November 30, 2019, 1.50% if prepaid after November 30, 2019 and on or prior to November 30, 2020, and 0.75% thereafter. Upon prepayment, we are also obligated to pay a non-refundable early termination fee of $496,785. Amounts prepaid or repaid under the 2018 Term Loan may not be reborrowed. Initially, the 2018 LSA contained a financial covenant that requires us to achieve a monthly trailing six-month revenue target each month throughout the term of the agreement, but the covenant amended on June 13, 2019 and changed to a monthly trailing three-month revenue target, as discussed further below. As of December 31, 2019 and December 31, 2018, we were in compliance with this covenant. On June 13, 2019, we entered into the First Amendment, which, among other things, (i) eliminated the $5.0 million revolving line and increased the 2018 Term Loan by $5.0 million and (ii) amended the financial covenant to require us to achieve a monthly trailing three-month revenue target each month throughout the term of the agreement. The revenue targets were amended primarily to align with a more current reflection of our revenue projections after taking into account the impact of ASC 606 on our revenue recognition following our early adoption of ASC 606. The First Amendment was accounted for as a modification of the 2018 LSA, and therefore no extinguishment gain or loss was recognized. For each month through December 31, 2019, the trailing three-month revenue requirements were calculated as a percentage of our previously approved applicable monthly revenue projections. In February 2020, we entered into an amendment of the 2018 LSA, or the Second Amendment, that, among other things, change the covenant from being tested monthly to quarterly testing. In March 2020, we entered into an amendment of the 2018 LSA, or the Third Amendment, with the Lenders to establish revenue targets for the year ending December 31, 2020. Such requirements, for the quarterly periods from January to December 2020, are equal to generally increasing dollar amounts, in millions, in the low double digits. For quarterly periods ending after December 31, 2020, the trailing three-month revenue requirements will be determined by the Lenders upon receipt and review of our quarterly financial projections for the year, subject to certain specified criteria regarding minimum requirements. Revenues, if any, that we recognize as a result of an ALJ appeal process from consolidated claims initiatives for DecisionDx-Melanoma do not count toward the minimum revenue requirements. We were in compliance with this covenant as of the most recently tested quarter. In addition, the 2018 LSA contains customary conditions of borrowing, events of default and covenants, including covenants that restrict our ability to dispose of assets, merge with or acquire other entities, incur indebtedness and make distributions to holders of our capital stock. Should an event of default occur, including the occurrence of a material adverse change, we could be liable for immediate repayment of all obligations under the 2018 LSA. The Second Amendment included a waiver, by the Lenders, of an event of default by us attributable to maintaining a balance in a certain third-party deposit account, beyond the maximum level permitted, without obtaining a control agreement for such deposit account in favor of the collateral agent, Oxford. In addition to the waiver, the Second Amendment also provided a modification to increase the maximum balance permitted for this deposit account. We are currently in compliance with this provision of the 2018 LSA. While we were able to obtain a waiver and amendment in this instance, there can be no assurance that the Lenders would agree to provide any future waivers or amendments if another event of default were to occur as result of noncompliance with this or any other covenant under the 2018 LSA. Should we seek to further amend the terms of the 2018 LSA, the consent of Oxford and SVB would be required, and there can be no assurance that any such amendment would be available on terms acceptable to us, if at all. The 2018 Term Loan bears interest at a floating rate equal to the greater of (1) 8.55% and (2) the 30-day U.S. LIBOR rate as reported in The Wall Street Journal on the last business day of the month that precedes the month in which the interest will accrue, plus 6.48%. The applicable interest rate on the 2018 Term Loan was 8.55% as of December 31, 2019 and 8.98% as of December 31, 2018, respectively. Interest on the 2018 Term Loan is payable monthly in arrears. We are permitted to make interest-only payments on the 2018 Term Loan through May 31, 2020. The principal is required to be repaid in 30 equal monthly installments beginning on June 1, 2020. All unpaid principal and accrued and unpaid interest are due on November 1, 2022, or the 2018 Term Loan Maturity Date. We are also obligated to make an additional final payment of 6.75% of the aggregate original principal amount, or $1,687,500 as of December 31, 2019, upon any prepayment or on the 2018 Term Loan Maturity Date. The final payment amount is being amortized as additional interest expense using the effective interest method of the term of the debt. The 2018 Term Loan was fully funded on November 30, 2018 and the 2018 Revolving Line (defined and discussed below) was fully drawn upon on November 30, 2018. Proceeds from the 2018 LSA were used to repay all outstanding obligations under the 2017 LSA and to provide working capital. As a condition of the loan, we issued Series F preferred stock warrants to the Lenders with an aggregate initial fair value of $158,000. In accordance with ASC 480-10, Distinguishing Liabilities from Equity, the warrants were liability-classified as the underlying to the warrant was a puttable security. The initial recognition of the warrant liability created a discount to the debt, which is being amortized over the debt term using the effective interest method. The 2018 LSA was accounted for as a modification of the previous lending arrangement with SVB and Oxford, and therefore no extinguishment gain or loss was recognized. Revolving Line of Credit Under the 2018 LSA, we had a $5.0 million revolving line of credit, or the 2018 Revolving Line, contingent on our satisfaction of borrowing base eligibility requirements. The 2018 Revolving Line bore interest at a floating per annum rate equal to the greater of (1) 6.25% and (2) 5.48% above the U.S. LIBOR rate. The applicable interest rate on the 2018 Revolving Line at December 31, 2018 was 7.98%. The 2018 Revolving Line was to be due in full no later than November 30, 2020, but was eliminated in connection with the First Amendment. Q1 2019 Convertible Promissory Notes In January and February 2019, we issued $11,770,000 principal amount of unsecured convertible promissory notes of which $4,756,000 was with related parties (executive officers, members of our board of directors or entities affiliated with them). The Q1 2019 Notes bear simple interest at a rate of 8% per annum. Originally, the Q1 2019 Notes had a maturity date of January 31, 2020, but on July 3, 2019 we entered into an amendment with the holders of the Q1 2019 Notes to extend the maturity date to June 30, 2020. Such amendment was treated as a modification of the existing debt and therefore no extinguishment gain or loss was recognized in connection with the amendment. Prior to the actual conversion of the Q1 2019 Notes on July 29, 2019 (discussed below), on or before the maturity date, the entire outstanding principal amount of and accrued interest on the Q1 2019 Notes, or the Conversion Amount, was automatically convertible into shares of our equity securities issued and sold in a single or series of related transactions, with the principal purpose of raising capital, in which we sell shares of such equity securities for aggregate gross proceeds of at least $10.0 million, or the Next Equity Financing. The number of shares of such equity securities issuable in the Next Equity Financing was equal to the quotient of the Conversion Amount as of the closing date of the Next Equity Financing divided by a per share price that is equal to 80% of the lowest per share purchase price of the equity securities sold in the Next Equity Financing. If the Q1 2019 Notes had not been repaid or converted prior to the maturity date, then, at the request of the holders of a majority of the then-outstanding principal amount of and accrued interest on the Q1 2019 Notes, then the Conversion Amount as of the maturity date would have converted into shares of our Series F redeemable convertible preferred stock, or any senior equity security issued by us after the first issuance of the Q1 2019 Notes, in each case at a conversion price equal to the price at which such security was last sold (which was $5.8208 for shares of our Series F redeemable convertible preferred stock). If we had undergone a change of control while the Q1 2019 Notes were outstanding, we would have been required to repurchase each note from each holder at a repurchase price equal to two times the principal amount of such note, plus any accrued and unpaid interest on such note as of the date of such repurchase. As discussed further in Note 7 to the financial statements appearing elsewhere in this Annual Report on Form 10-K, the Q1 2019 Notes contained a beneficial conversion feature and an embedded derivative, both of which created a significant debt discount that was being amortized over the life of the debt (that is, through June 30, 2020) using the effective interest method, which resulted in increases in non-cash interest expense in each succeeding reporting period until the Q1 2019 Notes were converted into shares of common stock on July 29, 2019. Extinguishment Gain The closing of the IPO on July 29, 2019 was considered to be the Next Equity Financing under the terms of the Q1 2019 Notes. Accordingly, on July 29, 2019, the Conversion Amount of the Q1 2019 Notes as of such date converted into 954,074 shares of common stock based on a price of $12.80 per share, or 80% of the IPO price of $16.00 per share. Based on applicable accounting guidance, the conversion of the Q1 2019 notes was considered an extinguishment for accounting purposes, which resulted in a gain of $5.2 million. The gain resulted from certain accounting requirements associated with the extinguishment of debt with a beneficial conversion feature. See Note 7 to the financial statements for additional information. July 2019 Convertible Promissory Note On July 12, 2019, we issued an unsecured convertible promissory note having a principal amount of $10,000,000 and our net proceeds, after deducting issuance costs, was $9.2 million. In connection with the issuance of the July 2019 Note, we also issued to the purchaser a warrant to purchase 209,243 shares of common stock at an exercise price of approximately $0.001 per share, which expires on July 12, 2026. The July 2019 Note bore simple interest at a rate of 8% per annum and had an original maturity date of June 30, 2020. As a result of the IPO, the outstanding principal amount plus accrued interest on the July 2019 Note converted into 707,032 shares of common stock on July 29, 2019, based on a price derived from a valuation calculated pursuant to the terms of the July 2019 Note. As discussed further in Note 7 to the financial statements, we accounted for the July 2019 Note at fair value and recognized a loss of $2.1 million during the year ended December 31, 2019, which represents the excess of the fair value of the shares issued upon conversion of the July 2019 Note over the net proceeds received. Operating Leases We have entered into various operating leases, which are primarily associated with our laboratory facilities and office space. Total future minimum payment obligations under our operating leases as of December 31, 2019 totaled approximately $6.4 million. The leases expire on various dates through 2027 and provide certain options to renew for additional periods. Refer to Note 9 to the financial statements for additional information on our leasing arrangements. Cash Flows As of December 31, 2019 and December 31, 2018, we had cash and cash equivalents of $98.8 million and $4.5 million, respectively. The following table summarizes our sources and uses of cash and cash equivalents for each of the periods presented (in thousands): Operating Activities Net cash provided by operating activities was $7.0 million for the year ended December 31, 2019 and was primarily attributable to net income of $5.3 million and net non-cash charges of $1.7 million (consisting of $2.1 million of fair value option adjustments, $1.9 million in amortization of debt discount and issuance costs, stock compensation expense of $1.2 million, preferred stock warrant fair value adjustments of $0.6 million, and $1.1 million of other items, partially offset by $5.2 million of a debt extinguishment gain). Net cash used in operating activities was $12.3 million for the year ended December 31, 2018 and was primarily attributable to the net loss of $6.4 million and increases in accounts receivable of $8.4 million, partially offset by increases in accrued compensation of $1.3 million and non-cash charges of $0.9 million. Investing Activities Net cash used in investing activities for the years ended December 31, 2019 and 2018 consisted entirely of purchases of property and equipment. Financing Activities Net cash provided by financing activities was $88.3 million for the year ended December 31, 2019 and consisted primarily of $65.9 million of proceeds from our IPO (net of underwriting discounts, commissions and issuance costs), $11.7 million of net proceeds from the issuance of the Q1 2019 Notes, $9.2 million of net proceeds from the issuance of the July 2019 Note, $1.8 million of net proceeds associated with an increase in the 2018 Term Loan in connection with an amendment to the 2018 LSA and $1.2 million of proceeds from the exercise of stock options, partially offset by principal repayments of $1.8 million on our line of credit. Net cash provided by financing activities was $15.8 million for the year ended December 31, 2018 and consisted primarily of $10.4 million attributable to proceeds received from the issuance of preferred stock and preferred stock warrants, $4.4 million from the issuance of term debt and preferred stock warrants in connection with the 2018 LSA and $1.0 million in proceeds from our line of credit. Contractual Obligations and Commitments Not required for smaller reporting companies. Off-Balance Sheet Arrangements We do not currently have, nor did we have any off-balance sheet arrangements, as defined in the rules and regulations of the SEC, during the periods presented. Critical Accounting Policies and Significant Judgments and Estimates Our financial statements are prepared in accordance with U.S. GAAP. The preparation of our financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, costs and expenses, 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 audited 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. Revenue Recognition We recognize revenue in accordance with ASC 606. In accordance with ASC 606, we follow a five-step process to recognize revenues: (1) identify the contract with the customer; (2) identify the performance obligations; (3) determine the transaction price; (4) allocate the transaction price to the performance obligation; and (5) recognize revenues when the performance obligations are satisfied. All of our revenues from contracts with customers are associated with the provision of diagnostic and prognostic cancer test reports. Our revenues are primarily derived from DecisionDx-Melanoma, for cutaneous melanoma, and we also have revenues attributable to DecisionDx-UM, for uveal melanoma. We have determined that we have a contract with the patient when the treating physician orders the test. Our contracts generally contain a single performance obligation, which is the delivery of the test report, and we satisfy our performance obligation at the point in time when we deliver the test report to the treating physician, at which point we can bill for the report. The amount of revenue recognized reflects the amount of consideration we expect to receive, or the transaction price, and considers the effects of variable consideration, which is discussed further below. Once we satisfy our performance obligations and bill for the test report, the timing of the collection of payments may vary based on the payment practices of the third-party payor and the existence of contractually established reimbursement rates. Most of the payments for our test reports are made by third-party payors, including Medicare and commercial health insurance carriers. Certain contracts contain a contractual commitment of a reimbursement rate that differs from our list prices. However, absent a contractually committed reimbursement rate with a commercial carrier or governmental program, our diagnostic tests may or may not be covered by these entities’ existing reimbursement policies. In addition, patients do not enter into direct agreements with us that commit them to pay any portion of the cost of the tests in the event that their insurance provider declines to reimburse us. We may pursue, on a case-by-case basis, reimbursement from such patients in the form of co-payments and co-insurance, in accordance with the contractual obligations that we have with the insurance carrier or health plan. These situations may result in a delay in the collection of payments. The Medicare claims that are covered by policy under an LCD are generally paid at the established rate by our Medicare contractor within 30 days from receipt. As the LCD currently only covers a portion of the DecisionDx-Melanoma test reports, we provide for patients covered by Medicare, we intend to attempt to expand this LCD coverage policy in the future. Medicare claims that were either submitted to Medicare prior to the LCD’s effective date or that are not otherwise covered by the terms of the LCD, but that may meet the definition of being reasonable and necessary pursuant to Section 1862(a)(1)(A) of the Social Security Act, are generally appealed by us. If our appeal is successful at the first level (termed “redetermination”), second level (termed “reconsideration”) or third level of appeal (de novo hearing with an ALJ), payment may be made for all or a portion of the claim. We have concluded that our contracts include variable consideration because the amounts paid by Medicare or commercial health insurance carriers may be paid at less than our standard rates or not paid at all, with such differences considered implicit price concessions. Variable consideration attributable to these price concessions is measured at the expected value using the “most likely amount” method under ASC 606. The amounts are determined by historical average collection rates by test type and payor category taking into consideration the range of possible outcomes, the predictive value of our past experiences, the time period of when uncertainties expect to be resolved and the amount of consideration that is susceptible to factors outside of our influence, such as the judgment and actions of third parties. Such variable consideration is included in the transaction price only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainties with respect to the amount are resolved. Variable consideration may be constrained and excluded from the transaction price in situations where there is no contractually agreed upon reimbursement coverage or in the absence of a predictable pattern and history of collectability with a payor. Variable consideration for Medicare claims is deemed to be fully constrained when the payment of such claims is subject to approval by an ALJ at an appeal hearing, due to factors outside our influence (i.e., judgment or actions of third parties) and the uncertainty of the amount to be received is not expected to be resolved for a long period of time. Variable consideration is evaluated each reporting period and adjustments are recorded as increases or decreases in revenues. Included in revenues for the years ended December 31, 2019 and 2018 were $2.5 million and $0.3 million, respectively, of revenue increases associated with changes in estimated variable consideration related to performance obligations satisfied in previous periods. Because our contracts with customers have an expected duration of one year or less, we have elected the practical expedient in ASC 606 to not disclose information about our remaining performance obligations. Any incremental costs to obtain contracts are recorded as SG&A expense as incurred due to the short duration of our contracts. Contract balances consisted solely of accounts receivable (both current and noncurrent) as of December 31, 2019 and 2018. DecisionDx-Melanoma Claims Consolidation In June 2017, we submitted to the Office of Medicare Hearings and Appeals, or OMHA, a formal request to participate in a program to consolidate and adjudicate large volumes of claim disputes at an accelerated rate. The program consolidates outstanding claim appeals pending at the ALJ level and uses a statistical-sampling approach where multiple ALJs will determine reimbursement results for a sample of claims which are then extrapolated to the universe of claims. Our consolidated appeal includes 2,698 DecisionDx-Melanoma claims dating from 2013 through spring 2017. The judges who will review the sample sets have been identified and the hearings were held in April 2019 with a supplemental hearing in May 2019. No formal ruling has been issued to date. In accordance with ASC 606, we have not recognized (fully constrained the variable consideration) any revenues attributable to these claims in our financial statements pending the outcome of this matter. We expect to recognize any revenue adjudicated by the ALJ in the reporting period in which we are notified of the ALJ hearing outcome and it is determined that such decision will not be appealed. Stock-Based Compensation Stock-based compensation expense for equity instruments issued to employees and non-employees, including the purchase rights issued under our 2019 Employee Stock Purchase Plan, or ESPP, is measured based on the grant-date fair value of the awards. The fair value of each employee stock option is estimated on the date of grant using the Black-Scholes option-pricing valuation model and on the offering date for the ESPP. We recognize compensation costs on a straight-line basis for all employee stock-based compensation awards over the requisite service period of the awards, which is generally the awards’ vesting period, which is typically four years for options and the two-year offering period for the ESPP. Forfeitures are accounted for as they occur. Following is a description of the significant assumptions used in the option pricing model: • Expected term. The expected term is the period of time that granted options are expected to be outstanding. For stock options, we have set the expected term using the simplified method based on the weighted average of both the period to vesting and the period to maturity for each option, as we have concluded that our stock option exercise history does not provide a reasonable basis upon which to estimate the expected term. For the ESPP, the expected term is the period of time from the offering date to the purchase date. • Expected volatility. Because of the limited period of time our stock has been traded in an active market, we calculate volatility by using the historical stock prices of a group of similar companies looking back over the estimated life of the option or the ESPP purchase right and averaging the volatilities of these companies. • Risk-free interest rate. We base the risk-free interest rate used in the Black-Scholes valuation model on the market yield in effect at the time of option grant and at the offering date for ESPP provided from the Federal Reserve Board’s Statistical Releases and historical publications from the Treasury constant maturities rates for the equivalent remaining terms. • Dividend yield. We have not paid, and do not have plans to pay, cash dividends. Therefore, we use an expected dividend yield of zero in the Black-Scholes option valuation model. 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, which intended all options granted to be exercisable at price per share not less than the per share fair value of our common stock underlying those options on the grant date. Subsequent to our IPO, the fair value of our common stock is the closing selling price per share of our common stock as reported on the Nasdaq Global Market on the date of grant or other relevant determination date. The following table sets forth the assumptions used to determine the fair value of stock options: The following table sets forth assumptions used to determine the fair value of the purchase rights issued under the ESPP: Recent Accounting Pronouncements Refer to Note 2, ‘‘Summary of Significant Accounting Policies,’’ in the accompanying notes to our financial statements included in this Annual Report on Form 10-K for a discussion of recent accounting pronouncements. JOBS Act Accounting Election We are an emerging growth company within the meaning of the JOBS Act. Section 107(b) of the JOBS Act provides that an emerging growth company can leverage the extended transition period, provided in Section 102(b) of the JOBS Act, for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. We have elected to use this extended transition period and, as a result, our financial statements may not be comparable to companies that comply with public company effective dates. We also intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of Sarbanes-Oxley. We will remain an emerging growth company until the earliest of (1) December 31, 2024, (2) the last day of the fiscal year (a) in which we have total annual gross revenue of at least $1.07 billion or (b) in which we are deemed to be a ‘‘large accelerated filer’’ as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock held by non-affiliates exceeded $700.0 million as of the prior June 30th, and (3) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period.

<s>[INST] Overview We are a commercialstage dermatological cancer company focused on providing physicians and their patients with personalized, clinically actionable genomic information to make more accurate treatment decisions. We believe that the traditional approach to developing a treatment plan for certain cancers using clinical and pathology factors alone is inadequate and can be improved by incorporating personalized genomic information. Our noninvasive products utilize proprietary algorithms to provide an assessment of a patient’s specific risk of metastasis or recurrence of their cancer, allowing physicians to identify patients who are likely to benefit from an escalation of care as well as those who may avoid unnecessary medical and surgical interventions. Our lead product, DecisionDxMelanoma, is a GEP test that predicts the risk of metastasis or recurrence for patients diagnosed with invasive cutaneous melanoma, a deadly skin cancer. We estimate more than 130,000 patients are diagnosed with invasive cutaneous melanoma each year in the United States. We launched DecisionDxMelanoma in May 2013. We also market DecisionDxUM, which is a proprietary GEP test that predicts the risk of metastasis for patients with uveal melanoma, a rare eye cancer. We launched DecisionDxUM in January 2010. Based on the substantial clinical evidence that we have developed, we have received Medicare coverage for both of our products, which represents approximately 50% of our addressable patient population. We also have two latestage proprietary products in development that address SCC and suspicious pigmented lesions which are indications with high clinical need in dermatological cancer. These indications are areas of high clinical need in dermatological cancer and, together, represent an additional addressable market of approximately 500,000 patients in the United States. We have processed over 60,000 clinical samples since commercial launch and our annual revenue increased from $22.8 million in 2018 to $51.9 million in 2019. For the year ended December 31, 2019, yearoveryear growth in new ordering clinicians for our DecisionDxMelanoma test was 24.3%. Additionally, total ordering clinicians in 2019 for DecisionDxMelanoma increased 32% to 3,927, yearoveryear. The numbers of DecisionDxMelanoma and DecisionDxUM test reports delivered by us during the years ended December 31, 2019 and 2018 are presented in the table below: For additional information on the metrics we disclose, refer to “Information about certain metrics” below. Since our inception in 2008, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, discovering product candidates, conducting clinical study activities to generate evidence demonstrating the clinical validity, clinical utility, economic benefits, and patient outcomes of our products, and commercialization activities for those products. We currently market two proprietary GEP products and generate substantially all of our revenue from those activities. On July 29, 2019, we completed the IPO. In connection with the IPO, we issued and sold 4,600,000 shares of our common stock, including 600,000 shares associated with the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $16.00 per share. We received approximately $65.9 million in net proceeds, after deducting underwriting discounts and commissions and other offering expenses payable by us. Prior to the IPO, we financed our operations primarily through private placements of preferred stock, revenue generated from sales of our products, bank debt and convertible notes. The principal focus of our current commercial efforts is to distribute our molecular diagnostic testing products through our direct sales force in the U.S. The number of test reports we generate is a key indicator that we use to assess our business. A test report is generated when we receive a sample in our laboratory, the relevant information relating to that test is entered into our Laboratory Information Management System, the genomic profile of the sample is performed and a report providing the results of that profile is sent to the physician who ordered the test. We bill thirdparty payors [/INST] Negative. </s>

PropTech Acquisition Corp

2020-03-20

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. References to “we,” “us,” “our” or the “Company” are to Proptech Acquisition Corporation, except where the context requires otherwise. References to our “management” or our “management team” are to our officers and directors, and references to the “sponsor” are to HC PropTech Partners I LLC. 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 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our initial business combination using cash from the proceeds of our initial public offering and the private placement of the private placement warrants, the proceeds of the sale of our shares in connection with our initial business combination (pursuant to forward purchase agreements or backstop agreements we may enter into), shares issued to the owners of the target, debt issued to bank or other lenders or the owners of the target, or a combination of the foregoing. 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 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 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 initial business combination plans. We cannot assure you that our plans to raise capital or to complete our initial business combination will be successful. On November 26, 2019, we completed our initial public offering of 17,250,000 units, including 2,250,000 units that were issued pursuant to the underwriters’ full exercise of their over-allotment option. The units were sold at a price of $10.00 per unit, generating gross proceeds to us of $172.5 million. We incurred offering costs of approximately $10.1 million, inclusive of approximately $6.0 million in deferred underwriting commissions. On November 26, 2019, simultaneously with the consummation of our initial public offering, we completed the private sale (the “private placement”) of 5,700,000 private placement warrants at a purchase price of $1.00 per warrant to our sponsor, generating gross proceeds to us of $5.7 million. Upon the closing of our initial public offering, an aggregate of $172.5 million of the net proceeds from our initial public offering and the private placement was deposited in a trust account established for the benefit of our public stockholders (the “trust account”). If we are unable to complete our initial business combination by May 26, 2021, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay our 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 our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to our warrants, which will expire worthless if we fail to complete our initial business combination by May 26, 2021. The representative of the underwriters has agreed to waive its rights to the deferred underwriting commission held in the trust account in the event we do not complete our initial business combination by May 26, 2021 and, in such event, such amounts will be included with the funds held in the trust account that will be available to fund the redemption of the public shares. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than $10.00. Our amended and restated certificate of incorporation provides that we will have only 18 months from the closing of our initial public offering (or until May 26, 2021) to complete our initial business combination. If we are unable to complete our initial business combination by May 26, 2021, we will: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay our 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 our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to our warrants, which will expire worthless if we fail to complete our initial business combination by May 26, 2021. Results of Operations We have neither engaged in any significant operations nor generated any operating revenue to date. Our only activities from inception related to our formation and our initial public offering, and since the closing of our initial public offering, the search for a prospective initial business combination. 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 an initial business combination. For the period from July 31, 2019 (inception) through December 31, 2019, we had net income of approximately $32,000, which consisted of approximately $239,000 in investment income, offset by approximately $78,000 in general and administrative expenses, approximately $13,000 in related-party administrative expenses, approximately $84,000 in franchise tax expense, and approximately $33,000 in income tax expense. Liquidity and Capital Resources As of December 31, 2019, we had approximately $1.4 million in our operating account, approximately $239,000 of investment income earned from investments held in the trust account that may be released to us to pay our taxes (less up to $100,000 of such net interest to pay dissolution expenses), and working capital of approximately $1.5 million (including approximately $116,000 of tax obligations). Through December 31, 2019, our liquidity needs have been satisfied through proceeds of $25,000 from our sponsor for issuance of the founder shares, $225,000 in loans from our sponsor, and the net proceeds from the private placement not held in the trust account. The balance of $225,000 in loans was paid in full at the closing of our initial public offering on November 26, 2019. Based on the foregoing, we believe that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of our initial business combination or one year from this filing. Over this time period, these funds will be used for payment of general and administrative expenses as well as expenses associated with identifying and evaluating prospective initial business combination candidates, performing due diligence on prospective target businesses and structuring, negotiating and consummating our initial business combination. Related Party Transactions Founder Shares In July 2019, our sponsor paid $25,000 in offering expenses on our behalf in exchange for the issuance of 3,881,250 founder shares. In October 2019, we effected a stock dividend for approximately .11 shares for each share of Class B common stock outstanding, resulting in our sponsor holding an aggregate of 4,312,500 founder shares (up to 562,500 shares of which were subject to forfeiture to the extent the underwriters did not exercise their over-allotment option in full). On November 26, 2019, the underwriters exercised their over-allotment in full; thus, these founder shares were no longer subject to forfeiture. The founder shares will automatically convert into shares of Class A common stock at the time of our initial business combination on a one-for-one basis, subject to adjustments, and are subject to certain transfer restrictions, as described in more detail below. Our initial stockholders have agreed not to transfer, assign or sell any of their founder shares until the earlier to occur of (A) one year after the completion of our initial business combination or (B) subsequent to our initial business combination, (x) 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 our initial business combination, or (y) the date on which we complete a liquidation, merger, capital stock exchange, reorganization 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. Any permitted transferees will be subject to the same restrictions and other agreements of our initial stockholders with respect to any founder shares. Private Placement Warrants Simultaneously with the consummation of our initial public offering, we completed the private placement of warrants to our sponsor, generating gross proceeds of $5.7 million. Each Private Placement Warrant is exercisable for one share of our 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 our initial business combination is not completed by May 26, 2021, 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 the sponsor or its permitted transferees. Our sponsor agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of our initial business combination. Promissory Note - Related Party On July 31, 2019, our sponsor agreed to loan us an aggregate of up to $300,000 to cover expenses related to the our initial public offering pursuant to a promissory note (the “Note”). The Note was non-interest bearing and was due upon the completion of our initial public offering. We borrowed $225,000 under the Note. The Note balance was paid in full at closing of our initial public offering on November 26, 2019. Administrative Support Agreement We agreed to pay $10,000 a month for office space, utilities, and secretarial and administrative support to our sponsor. Services commenced on the date the securities were first listed on the Nasdaq and will terminate upon the earlier of our initial business combination or our liquidation. We incurred approximately $13,000 for expenses in connection with such services for the period from July 31, 2019 (inception) through December 31, 2019, which is reflected in the accompanying statement of operations. Critical Accounting Policies and Estimates Investments Held in Trust Account Our portfolio of investments held in trust account are comprised mainly of 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, 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 investment income from investments held in 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 the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification 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 of redeemable shares of Class A common stock shall be affected by charges against additional paid-in capital. Accordingly, as of December 31, 2019, 16,316,085 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. We are 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; Commitments and Contractual Obligations We did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K, 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. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act and 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 those of companies that comply with new or revised accounting pronouncements as of public company effective dates. In addition, Section 107 of the JOBS Act also 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 intend to take advantage of the benefits of this extended transition period. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year (a) following November 26, 2024, (b) in which we have total annual gross revenue of at least $1.07 billion, or (c) in which we are deemed to be a large accelerated filer, which means the market value of our Class A common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period.

<s>[INST] Overview We are a blank check company incorporated as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our initial business combination using cash from the proceeds of our initial public offering and the private placement of the private placement warrants, the proceeds of the sale of our shares in connection with our initial business combination (pursuant to forward purchase agreements or backstop agreements we may enter into), shares issued to the owners of the target, debt issued to bank or other lenders or the owners of the target, or a combination of the foregoing. 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 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 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 initial business combination plans. We cannot assure you that our plans to raise capital or to complete our initial business combination will be successful. On November 26, 2019, we completed our initial public offering of 17,250,000 units, including 2,250,000 units that were issued pursuant to the underwriters’ full exercise of their overallotment option. The units were sold at a price of $10.00 per unit, generating gross proceeds to us of $172.5 million. We incurred offering costs of approximately $10.1 million, inclusive of approximately $6.0 million in deferred underwriting commissions. On November 26, 2019, simultaneously with the consummation of our initial public offering, we completed the private sale (the “private placement”) of 5,700,000 private placement warrants at a purchase [/INST] Positive. </s>

Oyster Point Pharma, Inc.

2020-02-27

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations 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. Please also see the section of this Annual Report on Form 10-K titled “Special Note Regarding Forward-Looking Statements.” Overview We are a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of first-in-class pharmaceutical therapies to treat ocular surface diseases. Our lead product candidate OC-01 (varenicline), a highly selective nicotinic acetylcholine receptor (nAChR) agonist, is being developed as a nasal spray to treat the signs and symptoms of dry eye disease (DED). OC-01’s novel mechanism of action is designed to re-establish tear film homeostasis by activating the trigeminal parasympathetic pathway and stimulating the glands and cells responsible for natural tear film production. In our Phase 2b clinical trial (ONSET-1) in 182 subjects, OC-01 demonstrated statistically significant improvements (as compared to placebo) in both signs and symptoms of DED. Based on OC-01’s clinical trial results and its rapid onset of action, we believe OC-01, if approved, has the potential to become the new standard of care and redefine how DED is treated for millions of patients. We initiated a Phase 3 clinical trial (ONSET-2) in July 2019 and expect to report top-line results by the end of the second quarter 2020. Based on the results from this second registrational trial, we plan to submit a New Drug Application (NDA) to the U.S. Food and Drug Administration (FDA) in the second half of 2020. We believe that targeting the parasympathetic nervous system through the use of locally administered cholinergic agonists has the potential to treat a wide range of diseases and disorders. We have identified several indications, including several outside of ophthalmology, where we believe this approach could provide a meaningful benefit to patients. Since our formation in June 2015, we have devoted substantially all of our resources to developing our product candidates. We have incurred significant operating losses to date. Our net losses were $45.7 million and $16.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $84.2 million. We expect that our operating expenses will increase significantly as we advance our product candidates through preclinical and clinical development, seek regulatory approval, and prepare for and, if approved, proceed to commercialization; acquire, discover, validate and develop additional product candidates; obtain, maintain, protect and enforce our intellectual property portfolio; and hire additional personnel. In addition, we have incurred and will continue to incur additional costs associated with operating as a public company. We do not have any products approved for sale and have not generated any revenue since inception. Our ability to generate product revenue will depend on the successful development, regulatory approval and eventual commercialization of one or more of our product candidates. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through private or public equity or debt financings, collaborative or other arrangements with corporate sources, or through other sources of financing. 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 product candidates. We plan to continue to use third-party service providers, including clinical research organizations (CROs) and contract manufacturing organization (CMOs), to carry out our preclinical and clinical development and to manufacture and supply the materials to be used during the development and commercialization of our product candidates. We do not currently have a sales force. If OC-01 is approved for the treatment of the signs and symptoms of DED, we intend to deploy a specialty sales force at launch of approximately 150 to 200 field representatives. Prior to our initial public offering (IPO), we funded our operations primarily from the sale and issuance of redeemable convertible preferred stock and convertible promissory notes. In February and April 2019, we raised net proceeds of $92.9 million from the sale of Series B redeemable convertible preferred stock. In October 2019, we entered into a non-exclusive patent license agreement with Pfizer, pursuant to which we made an upfront payment of $5.0 million. If we successfully commercialize OC-01, we may be required to pay a single milestone payment in the very low double-digit millions and tiered royalties on net sales of OC-01 at percentages ranging from the mid-single digits to the mid-teens. On November 4, 2019, we completed our IPO selling 5,750,000 shares of our common stock at $16.00 per share. Proceeds from our IPO, net of underwriting discounts and commissions and other offering expenses, were $82.1 million. In connection with the completion of our IPO on November 4, 2019, all then outstanding shares of redeemable convertible preferred stock converted into 14,193,281 shares of common stock. As of December 31, 2019, we had cash and cash equivalents of $139.1 million. We believe that those cash and cash equivalents will be sufficient to fund our projected operations for at least 12 months from the issuance date of our financial statements as of and for the year ended December 31, 2019. Components of Operating Results Revenue We have not generated any revenue from product sales and do not expect to do so in the near future. Operating Expenses Research and Development Expenses Substantially all of our research and development expenses consist of expenses incurred in connection with the development of our product candidates. These expenses include fees paid to third parties to conduct certain research and development activities on our behalf, consulting costs, costs for laboratory supplies, product acquisition and license costs, certain payroll and personnel-related expenses, including salaries and bonuses, employee benefit costs and stock-based compensation expenses for employees dedicated to our research and product development and allocated overhead expenses, including rent, equipment, depreciation, information technology costs and utilities. We expense both internal and external research and development expenses as they are incurred. We do not allocate our costs by product candidate, as a significant amount of research and development expenses include internal costs, such as payroll and other personnel expenses, laboratory supplies and allocated overhead expenses, and external costs, such as fees paid to third parties to conduct research and development activities on our behalf, are not tracked by product candidate. In particular, with respect to internal costs, several of our departments support multiple product candidate research and development programs, and therefore the costs cannot be allocated to a particular product candidate or development program. The following table shows our research and development expenses by type of activity (in thousands): We are focusing substantially all of our resources on the development of our product candidates, particularly OC-01. We expect our research and development expenses to increase substantially for at least the next few years, as we seek to initiate additional clinical trials for our product candidates, complete our clinical programs, pursue regulatory approval of our product candidates and prepare for the possible commercialization of these product candidates. Predicting the timing or cost to complete our clinical programs 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, we could be required to expend significant additional financial resources and time on the completion of clinical development. Furthermore, we are unable to predict when or if our product candidates will receive regulatory approval with any certainty. General and Administrative Expenses General and administrative expenses consist principally of payroll and personnel expenses, including salaries and bonuses, benefits and stock-based compensation expenses, professional fees for legal, consulting, accounting and tax services, allocated overhead expenses, including rent, 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, expanded infrastructure and higher consulting, legal and accounting services costs associated with complying with the applicable stock exchange and Securities and Exchange Commission (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 income earned on our cash and cash equivalents. 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, except percentages): Research and Development Expenses Research and development expenses increased by $19.9 million, or 144%, 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 our advancement of OC-01 and reflected an increase in fees due to CROs and CMOs of $12.5 million, an increase of $5.0 million related to the license acquisition payment made to Pfizer and an increase in payroll and personnel-related expenses, including salaries and bonuses, benefits and stock-based compensation expense, of $2.4 million. We expect that our research and development expenses will continue to increase as we continue to add personnel to support our research and development activities and incur further expenses for CROs and CMOs in order to continue the advancement of our product candidates. General and Administrative Expenses General and administrative expenses increased by $10.7 million, or 359%, 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 the expansion of our organization and reflected an increase in payroll and personnel-related expenses, including salaries, benefits and stock-based compensation expense, of $4.4 million, an increase in professional services and other expenses incurred in relation to our IPO readiness of $3.5 million, an increase in marketing expenses, of $1.5 million, an increase in facilities expenses, consisting primarily of rent and depreciation, of $0.3 million; and an increase in other general and administrative expenses of $1.0 million. Interest Income Interest income increased by $1.4 million, or 582%, from the year ended December 31, 2018 to the year ended December 31, 2019, primarily due to an increase in cash and cash equivalents as a result of the IPO in November 2019 and the sale of Series B redeemable convertible preferred stock in February and April 2019. Liquidity and Capital Resources Sources of Liquidity Since our formation in 2015 through December 31, 2019, we have funded our operations with an aggregate of $213.4 million in gross cash proceeds from the sale of redeemable convertible preferred stock and convertible promissory notes and the gross cash proceeds from our IPO. In February and April 2019, we received net cash proceeds of $84.9 million and $8.0 million, respectively, from the sale of Series B redeemable convertible preferred stock. On November 4, 2019, we received $82.1 million of net proceeds upon completion of our IPO. As of December 31, 2019, we had cash and cash equivalents of $139.1 million. Future Funding Requirements We have incurred net losses since our inception. For the years ended December 31, 2019 and 2018, we had net losses of $45.7 million and $16.5 million, respectively. As of December 31, 2019, we had an accumulated deficit of $84.2 million. We believe that our existing cash and cash equivalents in the amount of $139.1 million will be sufficient to fund our projected operations for at least 12 months from the issuance date of our financial statements as of and for the year ended December 31, 2019. To date, we have not generated any revenue. We do not expect to generate any meaningful revenue unless and until we obtain regulatory approval of and commercialize any of our product candidates or enter into collaborative agreements with third parties, and we do not know when, or if, either will occur. We expect to continue to incur significant losses for the foreseeable future, and we expect the losses to increase as we continue the development of, and seek regulatory approvals for, our product candidates and begin to commercialize any approved products. We are subject to all of the risks typically related to the development of new product candidates, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. 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 private or public equity or debt financings, collaborative or other arrangements with corporate sources, or through other sources of financing. 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 and costs of our drug discovery efforts, preclinical development activities, laboratory testing and clinical trials for our product candidates; •the number and scope of clinical programs we decide to pursue; •the cost, timing and outcome of preparing for and undergoing regulatory review of our product candidates; •the scope and costs of development and commercial manufacturing activities; •the cost and timing associated with commercializing our product candidates, if they receive marketing approval; •the extent to which we acquire or in-license other product candidates and technologies; •the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; •our ability to establish and maintain collaborations on favorable terms, if at all; •our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates and, ultimately, the sale of our products, following FDA approval; •our implementation of operational, financial and management systems; and •the costs associated with being 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. Furthermore, our operating plans may change in the future, and we will continue to require additional capital to meet operational needs and capital requirements associated with such operating plans. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing into which we enter may impose upon us additional covenants that restrict our operations, including limitations on our ability to incur liens or additional debt, pay dividends, repurchase our common stock, make certain investments or 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. Adequate 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. 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 or 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 develop and commercialize ourselves. If we are required to enter into collaborations and other arrangements to supplement our funds, we may have to give up certain rights that limit our ability to develop and commercialize our product candidates or may have other terms that are not favorable to us or our stockholders, which could materially affect our business and financial condition. See the section of this Annual Report on 10-K titled “Risk Factors” for additional risks associated with our substantial capital requirements. Summary Statement of Cash Flows The following table sets forth the primary sources and uses of cash, cash equivalents, and restricted cash for each of the periods presented below: Cash Flows from Operating Activities Net cash used in operating activities was $40.8 million for year ended December 31, 2019. Cash used in operating activities was primarily due to the use of funds in our operations to develop our product candidates resulting in a net loss of $45.7 million, adjusted by non-cash stock-based compensation expense of $3.3 million and by a decrease in changes in assets and liabilities of $1.6 million. Decrease in changes in assets and liabilities included an increase in prepaid expenses and other current assets of $2.6 million due to change in prepayments made to CROs and CMOs, offset by an increase in accrued liabilities of $4.2 million due to an increase in accrued research and development expenses and professional fees. Net cash used in operating activities was $17.1 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 our product candidates resulting in a net loss of $16.5 million, increased by a decrease in accrued liabilities of $1.2 million primarily due to a decrease in accrued research and development and accrued compensation expenses, and partially offset decrease in prepaid expenses and other current assets of $0.5 million. Cash Flows used in Investing Activities Net cash used in investing activities was $0.2 million for the year ended December 31, 2019, which related to the purchase of property and equipment. Net cash used in investing activities was zero for the year ended December 31, 2018. Cash Flows from Financing Activities Net cash provided by financing activities was $175.0 million for the year ended December 31, 2019, due to net proceeds from the sale of Series B redeemable convertible preferred stock of $92.9 million and net proceeds from the IPO of $82.1 million. We did not undertake any financing activities in the year ended December 31, 2018. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: ___________________ (1) We lease our office facilities in Princeton, New Jersey under two non-cancellable operating leases with an expiration dates of March 15, 2020 and July 31, 2022. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. In January 2020 we amended one lease of our office facilities in Princeton, New Jersey to include additional office space, with an expiration date of July 31, 2022. Total future minimum lease payments under this amendment are $0.4 million. We enter into contracts in the normal course of business with third-party contract organizations for preclinical and clinical studies and testing, manufacture and supply of our preclinical materials and other services and products used 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. In October 2016, we entered into an asset purchase agreement pursuant to which we acquired the compound OC-02. Under this agreement we are obligated to make milestone payments of up to an aggregate of $37.0 million upon achievement of certain development and regulatory milestone events. In March 2018, we made a payment of $1.5 million upon completion of the first of these milestones. We accrued such amount as of December 31, 2017 as we concluded that it was probable that such payment would be made. Under the asset purchase agreement, we are also obligated to make royalty payments at a mid-single digit percentage rates on net worldwide sales of the covered products. In addition, we are required to pay 15% of any (i) licensing revenue we receive that is related to OC-02 and (ii) revenue received from the sale of OC-02, up to a maximum aggregate amount of $10.0 million. These commitments are not included in the table above due to uncertainty of timing of any such payments. In October 2019, we entered into a non-exclusive patent license agreement (the License Agreement) with Pfizer, which granted us non-exclusive rights under Pfizer’s patent rights covering varenicline tartrate to develop, manufacture, and commercialize our OC-01 varenicline product candidate. Under the terms of the License Agreement, we made an upfront payment to Pfizer of $5.0 million. If we successfully commercialize OC-01, we may be required to pay a single milestone payment in the very low double-digit millions and tiered royalties on net sales of OC-01 at percentages ranging from the mid-single digits to the mid-teens. The royalty obligation to Pfizer will commence upon first commercial sale of OC-01 and will expire upon the later of (a) the expiration of all regulatory or data exclusivity granted to Pfizer in connection with varenicline in the United States; and (b) the expiration or abandonment of the last valid claims of the licensed patents. These commitments are not included in the table above due to uncertainty of timing of any such payments. 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 "Organization and Summary of Significant Accounting Policies" to our audited financial statements included elsewhere in this Annual Report on Form 10-K. Accrued Research and Development We have entered into various agreements with CMOs and CROs. 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. 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 CMOs and CROs 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. To date, our estimated accruals have not differed materially from the actual costs. 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. 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. In determining fair value of the stock options granted, we use the Black-Scholes model, which requires the input of subjective assumptions. These assumptions include: estimating the length of time employees will retain their vested stock options before exercising them (expected term), the estimated volatility of our common stock price over the expected term (expected volatility), risk-free interest rate and expected dividends. Changes in the following assumptions can materially affect the estimate of fair value and ultimately how much stock-based compensation expense is recognized; and the resulting change in fair value, if any, is recognized in our statement of operations and comprehensive loss during the period the related services are rendered. There are several assumptions that are required in the Black Scholes model. •Expected Term - The expected term is calculated using the simplified method which is used when 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 - We use an average historical stock price volatility of a peer group of comparable publicly traded companies in biotechnology and pharmaceutical related industries to be representative of its expected future stock price volatility, as we do not have any trading history for our common stock. For purposes of identifying these peer companies, we consider the industry, stage of development, size and financial leverage of potential comparable companies. For each grant, we measure historical volatility over a period equivalent to the expected term. •Expected Dividend Rate - We have not paid and do not anticipate paying any dividends in the near future. Accordingly, we estimate the dividend yield to be zero. •Risk-Free Interest Rate - The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of the stock award. Common Stock Valuations prior to our IPO 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 input from management. 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. Prior to the 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 valuations from an independent third-party valuation firm. Prior to the IPO 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, or the Practice Aid. The assumptions used to determine the estimated fair value of our common stock prior to the IPO were based on numerous objective and subjective factors, combined with management judgment, including: •external market conditions affecting the pharmaceutical and biotechnology industry and trends within the industry; •our stage of development and business strategy; •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; •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: •Option Pricing Method. Under the option pricing method, or OPM, shares are valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these •Probability-Weighted Expected Return Method. The probability-weighted expected return method, or PWERM, is a scenario-based analysis that estimates value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. Based on our early stage of development and other relevant factors, we determined that OPM method as well as a hybrid approach of the OPM and the PWERM methods were the most appropriate methods for allocating our enterprise value to determine the estimated fair value of our common stock. In valuing the equity prior to the IPO, 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 prior to our IPO reflected a non-marketability discount partially based on the anticipated likelihood and timing of a future liquidity event. Common Stock Valuations following our IPO Subsequent to the IPO, the fair value of our common stock is based on the closing quoted market price of our common stock as reported by the NASDAQ Global Select Market on the date of grant. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities arise due to differences between when assets or liabilities are recognized for tax purposes and when they are recognized for financial reporting purposes. Net operating losses and credit carryforwards are also deferred tax assets. Deferred tax assets and liabilities 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 that the position meets the more-likely-than-not threshold 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 the factors underlying the more-likely-than-not threshold assertion have changed and the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense or benefit. To date, there have been no interest or penalties charged in relation to the unrecognized tax benefits. Net operating loss carryforwards and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service and may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant stockholders over a three-year period in excess of 50 percentage points as defined under Sections 382 and 383 in the Internal Revenue Code, which could limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities. The amount of the annual limitation is determined based on our value immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. We have determined that no significant limitation would be placed on the utilization of our net operating loss and tax credit carryforwards due to prior ownership changes. Subsequent ownership changes may affect the limitation in future years. As of December 31, 2019, and 2018, we had unrecognized tax benefits, all of which would affect income tax expense if recognized, before consideration of our valuation allowance. We do not expect that our uncertain tax positions will materially change in the next 12 months. Off-Balance Sheet Arrangements Since our inception, we have not engaged in any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. 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, including in connection with any trade secret, copyright, patent or other intellectual property infringement claim by any third party with respect to our 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. We have also agreed to indemnify our directors and officers for certain events or occurrences while the director or officer is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the director’s or officer’s service. The maximum potential amount of future payments we could be required to make under these indemnification agreements is not specified in the agreements; however, we have director and officer insurance coverage that reduces our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal. JOBS Act Accounting Election The Jumpstart Our Business Startups Act of 2012 (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. However, we have chosen to irrevocably “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. We intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act. We will remain an emerging growth company until the earliest to occur of: (1) the last day of our first fiscal year in which we have total annual revenues of more than $1.07 billion; (2) the date we qualify as a “large accelerated filer,” with at least $700.0 million of equity securities held by non-affiliates; (3) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period; and (4) the last day of the fiscal year ending after the fifth anniversary of our initial public offering. Recent Accounting Pronouncements See the section titled “Organization and Summary of Significant Accounting Policies” in Note 1 to our financial statements included elsewhere in this Annual Report in the Form 10-K for additional information.

<s>[INST] Overview We are a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of firstinclass pharmaceutical therapies to treat ocular surface diseases. Our lead product candidate OC01 (varenicline), a highly selective nicotinic acetylcholine receptor (nAChR) agonist, is being developed as a nasal spray to treat the signs and symptoms of dry eye disease (DED). OC01’s novel mechanism of action is designed to reestablish tear film homeostasis by activating the trigeminal parasympathetic pathway and stimulating the glands and cells responsible for natural tear film production. In our Phase 2b clinical trial (ONSET1) in 182 subjects, OC01 demonstrated statistically significant improvements (as compared to placebo) in both signs and symptoms of DED. Based on OC01’s clinical trial results and its rapid onset of action, we believe OC01, if approved, has the potential to become the new standard of care and redefine how DED is treated for millions of patients. We initiated a Phase 3 clinical trial (ONSET2) in July 2019 and expect to report topline results by the end of the second quarter 2020. Based on the results from this second registrational trial, we plan to submit a New Drug Application (NDA) to the U.S. Food and Drug Administration (FDA) in the second half of 2020. We believe that targeting the parasympathetic nervous system through the use of locally administered cholinergic agonists has the potential to treat a wide range of diseases and disorders. We have identified several indications, including several outside of ophthalmology, where we believe this approach could provide a meaningful benefit to patients. Since our formation in June 2015, we have devoted substantially all of our resources to developing our product candidates. We have incurred significant operating losses to date. Our net losses were $45.7 million and $16.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $84.2 million. We expect that our operating expenses will increase significantly as we advance our product candidates through preclinical and clinical development, seek regulatory approval, and prepare for and, if approved, proceed to commercialization; acquire, discover, validate and develop additional product candidates; obtain, maintain, protect and enforce our intellectual property portfolio; and hire additional personnel. In addition, we have incurred and will continue to incur additional costs associated with operating as a public company. We do not have any products approved for sale and have not generated any revenue since inception. Our ability to generate product revenue will depend on the successful development, regulatory approval and eventual commercialization of one or more of our product candidates. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through private or public equity or debt financings, collaborative or other arrangements with corporate sources, or through other sources of financing. 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 product candidates. We plan to continue to use thirdparty service providers, including clinical research organizations (CROs) and contract manufacturing organization (CMOs), to carry out our preclinical and clinical development and to manufacture and supply the materials to be used during the development and commercialization of our product candidates. We do not currently have a sales force. If OC01 is approved for the treatment of the signs and symptoms of DED, we intend to deploy a specialty sales force at launch of approximately 150 to 200 field representatives. Prior to our initial public offering (IPO), we funded our operations primarily from the sale and issuance of redeemable convertible preferred stock and convertible promissory notes. In February and April 2019, we raised net proceeds of $92.9 million from the sale of Series B redeemable convertible preferred stock. [/INST] Negative. </s>

Pivotal Investment Corp II

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 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, 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 Placement Warrants, our capital stock, debt or a combination of cash, stock and debt. We are not limited to a particular industry or sector for purposes of consummating a business combination. However, we are currently focusing our search on companies in North America in industries ripe for disruption from continuously evolving digital technology and the resulting shift in distribution patterns and consumer purchase behavior. Our entire activity since inception relates to our formation, to prepare for our Initial Public Offering, which was consummated on July 16, 2019, and identifying a company for a business combination. Results of Operations Our only activities from March 20, 2019 (inception) through December 31, 2019 were organizational activities and those necessary to consummate the Initial Public Offering. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on cash and marketable securities 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 March 20, 2019 (inception) through December 31, 2019, we had net income of $1,206,018, which consists of interest income on marketable securities held in the Trust Account of $1,911,770 and an unrealized gain on marketable securities held in our Trust Account of $8,127, offset by operating costs of $393,291 and a provision for income taxes of $320,588. Liquidity and Capital Resources On July 16, 2019, we consummated our Initial Public Offering of 23,000,000 units, including 3,000,000 units subject to the underwriters’ over-allotment option. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $230,000,000. Simultaneously with the consummation of the Initial Public Offering, we consummated the private placement of 4,233,333 Private Placement Warrants at a price of $1.50 per Private Placement Warrant, generating total proceeds of $6,350,000. The Private Placement Warrants were purchased by our sponsor. Following the Initial Public Offering, a total of $230,000,000 was placed in the trust account. Transaction costs amounted to $13,185,704, consisting of $4,600,000 of underwriting fees, $8,050,000 of deferred underwriting fees and $535,704 of other costs. For the period from March 20, 2019 (inception) through December 31, 2019, cash used in operating activities was $624,353. Net income of $1,206,018 was affected by interest earned on marketable securities held in the Trust Account of $1,911,770, an unrealized gain on marketable securities held in our Trust Account of $8,127 and a deferred tax provision of $1,707. Changes in operating assets and liabilities used $87,819 of cash for operating activities. As of December 31, 2019, we had marketable securities held in the Trust Account of $231,919,897 (including approximately $1,920,000 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. 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. 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. As of December 31, 2019, we had cash held outside of the Trust Account of $624,943. 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, our stockholders, officers, 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 $1,500,000 of notes may be convertible into Private Warrants, at a price of $1.50 per 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 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 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 with a managing member of the Sponsor entered into a forward purchase contract with the Company to purchase, in a private placement to occur concurrently with the consummation of the Company’s initial Business Combination, up to $150,000,000 of the Company’s securities. The type and amount of securities to be purchased by the managing member of the Sponsor will be determined by the Company and the managing member of the Sponsor at the time the Company enters into the definitive agreement for the proposed Business Combination. This agreement would be independent of the percentage of stockholders electing to convert their public shares and may provide the Company with an increased minimum funding level for the initial Business Combination. The agreement is also conditioned on the Company’s board of directors, including an affiliate of the managing member of the Sponsor, having unanimously approved the proposed initial Business Combination. Accordingly, the managing member of the Sponsor may not agree to purchase any securities, in which case the Company may need to arrange alternate financing to complete the Business Combination. The underwriters are entitled to a deferred fee of $0.35 per Unit, or $8,050,000. The deferred fee will be forfeited by the underwriters solely in the event that the Company fails to complete a Business Combination, subject to the terms of the underwriting agreement. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies: Common stock subject to possible redemption We account for our common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of our balance sheet. 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. Related Party Transactions On March 29, 2019, the Sponsor purchased 5,750,000 founder shares of the Company’s Class B common stock for an aggregate price of $25,000. The founder shares will automatically convert into Class A common stock upon the consummation of a business combination on a one-for-one basis, subject to adjustments. As of December 31, 2019, the Sponsor transferred certain founder shares to our officers and directors. On April 9, 2019, an affiliate of the Sponsor loaned us an aggregate of $125,000 to cover expenses related to the IPO pursuant to a promissory note (the “Promissory Note”). The Promissory Note was non-interest bearing and payable on the earlier of February 28, 2020, the date on which the IPO was completed or the date on which we determined not to proceed with the IPO. The Promissory Note was repaid upon the consummation of the IPO on July 16, 2019. In addition, in order to finance transaction costs in connection with a business combination, the Sponsor or an affiliate of the Sponsor, or our officers and directors or any of their affiliates 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 does not close, we may use a portion of proceeds held outside the trust account to repay the Working Capital Loans but no proceeds held in the trust account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such Working Capital Loans may be convertible into warrants of the post business combination entity at a price of $1.50 per warrant. The warrants would be identical to the Private Warrants. On July 11, 2019, we entered into a forward purchase contract with a managing member of the Sponsor in which our Sponsor agreed to purchase, in a private placement to occur concurrently with the consummation of our initial business combination, up to $150,000,000 of our securities. The type and amount of securities to be purchased by the managing member of the Sponsor will be determined by the us and the managing member of the Sponsor at the time we enter into the definitive agreement for the proposed business combination. This agreement would be independent of the percentage of stockholders electing to convert their public shares and may provide us with an increased minimum funding level for the initial business combination. The agreement is also conditioned on our board of directors, including an affiliate of the managing member of the Sponsor, having unanimously approved the proposed initial business combination. Accordingly, the managing member of the Sponsor may not agree to purchase any securities, in which case we may need to arrange alternate financing to complete the business combination. Income Taxes The Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of December 31, 2019. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $250,000. At December 31, 2019, the Company has not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts. Fair Value of Financial Instruments The fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the accompanying balance sheet, primarily due to their short-term nature.

<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, 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 Placement Warrants, our capital stock, debt or a combination of cash, stock and debt. We are not limited to a particular industry or sector for purposes of consummating a business combination. However, we are currently focusing our search on companies in North America in industries ripe for disruption from continuously evolving digital technology and the resulting shift in distribution patterns and consumer purchase behavior. Our entire activity since inception relates to our formation, to prepare for our Initial Public Offering, which was consummated on July 16, 2019, and identifying a company for a business combination. Results of Operations Our only activities from March 20, 2019 (inception) through December 31, 2019 were organizational activities and those necessary to consummate the Initial Public Offering. 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 cash and 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 March 20, 2019 (inception) through December 31, 2019, we had net income of $1,206,018, which consists of interest income on marketable securities held in the Trust Account of $1,911,770 and an unrealized gain on marketable securities held in our Trust Account of $8,127, offset by operating costs of $393,291 and a provision for income taxes of $320,588. Liquidity and Capital Resources On July 16, 2019, we consummated our Initial Public Offering of 23,000,000 units, including 3,000,000 units subject to the underwriters’ overallotment option. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $230,000,000. Simultaneously with the consummation of the Initial Public Offering, we consummated the private placement of 4,233,333 Private Placement Warrants at a price of $1.50 per Private Placement Warrant, generating total proceeds of $6,350,000. The Private Placement Warrants were purchased by our sponsor. Following the Initial Public Offering, a total of $230,000,000 was placed in the trust account. Transaction costs amounted to $13,185,704, consisting of $4 [/INST] Negative. </s>

Hennessy Capital Acquisition Corp IV

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on August 6, 2018 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our initial business combination using cash from the proceeds of our initial public offering that was completed in March 2019 and the sale of warrants in a private placement (the “Private Placement”) that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in an initial business combination: ● may significantly dilute the equity interest of our stockholders; ● 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 incur other indebtedness to finance our initial business combination, 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 or other indebtedness contains covenants restricting our ability to obtain such financing while the debt security or other indebtedness 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, or limit 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, execution of our strategy and other purposes and ● other disadvantages compared to our competitors who have less debt. At December 31, 2019, we had approximately $1,124,000 in cash outside of the trust account. We expect to incur significant costs in the pursuit of an initial business combination and we cannot assure you that our plans to complete an initial business combination will be successful. Results of Operations For the period from August 6, 2018 (date of inception) to December 31, 2019 our activities consisted of our formation and preparation for our initial public offering and, subsequent to our initial public offering, identifying and completing a suitable initial business combination. As such, we had no operations or significant operating expenses until March 2019. Our normal operating costs since March 5, 2019 include costs associated with our search for an initial business combination (see below), costs associated with our governance and public reporting (see below), state franchise taxes of approximately $17,000 per month (see below), a charge of $15,000 per month from our sponsor for administrative services and approximately $29,000 per month ($11,600 of which is deferred as to payment until closing of our initial business combination) for compensation to our Chief Financial Officer as well as the costs of our public reporting and other costs, subsequent to our initial public offering. Travel costs associated with investigating potential initial business combination candidates were approximately $225,000 for the year ended December 31, 2019. As we identify initial business combination candidates, our costs will increase significantly as we negotiate a definitive agreement and related agreements and we incur additional professional, due diligence and consulting fees and travel costs. Costs associated with professional, due diligence and consulting fees related were approximately $2.08 million for the fiscal year ended December 31, 2019. Costs associated with our governance and public reporting have increased since our initial public offering and were approximately $307,000 for the fiscal year ended December 31, 2019. In addition, since our operating costs are not expected to be deductible for federal income tax purposes, we are subject to federal income taxes on the income from the trust account less taxes. Such federal income taxes were approximately $1.1 million for the fiscal year ended December 31, 2019 for the interest income earned on our U.S. treasury bill investments. However, we are permitted to withdraw, and have withdrawn, interest earned from the trust account for the payment of taxes. The initial public offering and the Private Placement closed on March 5, 2019 as more fully described in “Liquidity and Capital Resources” below. At that time, the proceeds in the trust account were initially invested in a money market fund that invested solely in direct U.S. government obligations meeting the applicable conditions of Rule 2a-7 of the Investment Company Act of 1940. In March 2019, the money market fund was largely liquidated and the trust assets were invested in U.S. government treasury bills which matured in September 2019 and yielded approximately 2.45% per year. In September 2019, the proceeds were invested in U.S. government treasury bills which matured in December 2019 and yielded approximately 1.8% per year. Interest earned on the trust account was approximately $5.523 million for the fiscal year ended December 31, 2019. At December 31, 2019, the U.S. government treasury bills held in the trust account yield approximately 1.5% and mature in June 2020. In March 2020, the Company liquidated these U.S. government treasury bills and invested the proceeds in a money market fund that invests solely in U.S. government treasury obligations (as discussed above). During the period from August 6, 2018 (date of inception) to December 31, 2018, operating expenses were nominal and we accumulated approximately $232,000 of deferred offering costs associated with our initial public offering. Liquidity and Capital Resources On March 5, 2019, we consummated our initial public offering of an aggregate of 30,015,000 units at a price of $10.00 per unit generating gross proceeds of approximately $300,150,000 before underwriting discounts and expenses. Simultaneously with the consummation of our initial public offering, we consummated the Private Placement of 13,581,500 private placement warrants, each exercisable to purchase one share of our Class A common stock at $11.50 per share, to our sponsor and certain funds and accounts managed by subsidiaries of BlackRock, Inc. (collectively, the “Anchor Investor”), at a price of $1.00 per private placement warrants, generating gross proceeds, before expenses, of approximately $13,581,500. The net proceeds from our initial public offering and Private Placement was approximately $305,056,000, net of the non-deferred portion of the underwriting commissions of $7,830,000 and offering costs and other expenses of approximately $856,000. $303,151,500 of the proceeds of our initial public offering and the Private Placement have been deposited in the trust account and are not available to us for operations (except amounts to pay taxes). At December 31, 2019, we had approximately $1,124,000 of cash available outside of the trust account to fund our activities until we consummate an initial business combination. Until the consummation of our initial public offering, our only sources of liquidity were an initial purchase of shares of our common stock for $28,000 by our sponsor and the Anchor Investor, and a total of $300,000 loaned by our sponsor against the issuance of an unsecured promissory note (the “Note”). The Note was non-interest bearing and was paid in full on March 5, 2019 in connection with the closing of our initial public offering. Although we had negative working capital of approximately $1,107,000 at December 31, 2019, our largest creditors, representing approximately $2,075,000 of liabilities, are professionals, consultants and advisors who continue to be owed money by us but are expected to continue assisting us with completing a Business Combination. As such, we believe, but cannot provide any assurance, that our approximately $1,024,000 of cash outside the trust account at December 31, 2019 represents sufficient liquidity to fund our operations until September 5, 2020, the date by which we must complete an initial business combination. We have only until September 5, 2020 to complete an initial business combination. If we do not complete an initial business combination by September 5, 2020, we will (i) cease all operations except for the purposes of winding up; (ii) as promptly as reasonably possible, but not more than ten business days thereafter, redeem the public shares of Class A common stock for a pro rata portion of the trust account, including interest, but less taxes payable (and less up to $100,000 of such net interest to pay dissolution expenses) and (iii) as promptly as reasonably possible following such redemption, dissolve and liquidate the balance of our net assets to our creditors and remaining stockholders, as part of our plan of dissolution and liquidation. The initial stockholders have waived their redemption rights with respect to their founder shares; however, if the initial stockholders or any of our officers, directors or their affiliates acquire shares of Class A common stock after our initial public offering, they will be entitled to a pro rata share of the trust account upon our redemption or liquidation in the event we do not complete an initial business combination within the required time period. In connection with generally accepted accounting principles, management has determined that this 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 September 5, 2020. In the event of such liquidation, it is possible that the per share value of the residual assets remaining available for distribution (including trust account assets) will be less than the price per unit in our initial public offering. 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 agreements for non-financial assets. Contractual obligations At December 31, 2019, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. In connection with our initial public offering, we entered into an Administrative Support Agreement with Hennessy Capital LLC, an affiliate of our sponsor, pursuant to which we pay Hennessy Capital LLC $15,000 per month for office space, utilities and secretarial and administrative support. In addition, commencing on March 1, 2019 (the date our securities were first listed on the Nasdaq Capital Market), we have agreed to compensate our Chief Financial Officer $29,000 per month prior to the consummation of the initial business combination, of which 60% is payable in cash currently and 40% in cash upon the successful completion of the initial business combination. Approximately $116,000 has been included in accrued liabilities for the deferred compensation of the Chief Financial Officer at December 31, 2019. Further, we have agreed to pay our President and Chief Operating Officer a success fee of $500,000 in cash upon the closing of an initial business combination. Upon completion of the initial business combination or the liquidation, we will cease paying or accruing these monthly fees. In connection with identifying an initial business combination candidate and negotiating an initial business combination, we have entered into and expects to enter into additional engagement letters or agreements with various consultants, advisors, professionals and others in connection with an initial business combination. The services under these engagement letters and agreements are material in amount and in some instances include contingent or success fees. Contingent or success fees (but not deferred underwriting compensation) would be charged to operations in the quarter that an initial business combination is consummated. In most instances (except with respect to our independent registered public accounting firm), these engagement letters and agreements are expected to specifically provide that such counterparties waive their rights to seek repayment from the funds in the trust account. 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. We have identified the following as our critical accounting policies: 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. Net Income (loss) Per Share Net income (loss) per common share is computed by dividing net income (loss) applicable to common stockholders by the weighted average number of shares of common stock outstanding for the period. We have not considered the effect of the warrants sold in our initial public offering and Private Placement (see Note 4 to the accompanying financial statements) to purchase an aggregate of 36,092,750 Class A ordinary shares in the calculation of diluted income (loss) per share, since their inclusion would be anti-dilutive under the treasury stock method. As a result, diluted income (loss) per common share is the same as basic loss per common share for the period. Because there is no longer uncertainty of forfeiture of 937,500 shares of Class B common stock in connection with our initial public offering, weighted average shares outstanding used to compute net loss per share for period from August 6, 2018 (date of inception) to December 31, 2019 has been retroactively restated to eliminate the reduction for shares subject to forfeiture. Also see Note 4 to the accompanying financial statements regarding restatement of outstanding founder shares for a stock dividend in February 2019. Our statements of operations include a presentation of income (loss) per share for common stock subject to redemption in a manner similar to the two-class method of income (loss) per share. Net income (loss) per share, basic and diluted for Class A common stock is calculated by dividing the interest income earned on the funds in the trust account, net of income tax expense and franchise tax expense, by the weighted average number of shares of Class A common stock outstanding since their original issuance. Net income (loss) per common share, basic and diluted, for Class B common stock is calculated by dividing the net income (loss), less income attributable to Class A common stock, by the weighted average number of shares of Class B common stock outstanding for the period. Net income (loss) available to each class of common stockholders is as follows for the fiscal year ended December 31, 2019 and for the period from August 6, 2018 to December 31, 2018: Financial Instruments The fair value of our assets and liabilities, which qualify as financial instruments under FASB ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the accompanying financial statements. Public Offering Costs We comply with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (SAB) Topic 5A- “Expenses of Offering”. The costs of our initial public offering are approximately $18,865,000 consisting of underwriters’ discounts of approximately $18,009,000 (including approximately $10,179,000 of which payment is deferred) and approximately $856,000 of professional, printing, filing, regulatory and other costs associated with our initial public offering were charged to additional paid in capital upon completion of the our initial public offering in March 2019. Income Taxes We follow the asset and liability method of accounting for income taxes under FASB ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the balance sheet carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. Our currently taxable income consists of interest income on the trust account net of taxes. Our general and administrative costs are generally considered start-up costs and are not currently deductible. During the year ended December 31, 2019 and the period from August 6, 2018 (date of inception) to December 31, 2018, we recorded income tax expense of approximately $1,110,000 and $0, respectively, primarily related to interest income earned on the trust account net of taxes. Our effective tax rates for the year ended December 31, 2019 and the period from August 6, 2018 (date of inception) to December 31, 2018 were approximately 49% and 0%, respectively, which differs from the expected income tax rate due to the start-up costs (discussed above and including costs for our initial business combination) which are not currently deductible. At December 31, 2019 and 2018, we had a deferred tax asset of approximately $640,000 and $-0-, respectively, primarily related to start-up costs. Management has determined that a full valuation allowance of the deferred tax asset is appropriate at this time. FASB ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. There were no unrecognized tax benefits as of December 31, 2019 or 2018. We recognize accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at December 31, 2019 or 2018. We are currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. We are subject to income tax examinations by major taxing authorities since inception. Redeemable Common Stock All of the 30,015,000 public shares sold as part of a unit in our initial public offering contain a redemption feature which allows for the redemption of public shares under the Company’s Liquidation or Tender Offer/Stockholder Approval provisions. In accordance with Financial Accounting Standards Board (“FASB”) ASC 480, redemption provisions not solely within the control of us require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although we did not specify a maximum redemption threshold, our charter provides that in no event will we redeem our public shares in an amount that would cause our net tangible assets (stockholders’ equity) to be less than $5,000,001 upon the closing of a Business Combination. We recognize changes in redemption value immediately as they occur and adjust the carrying value of the securities at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by adjustments to additional paid-in capital. Accordingly, at December 31, 2019, 28,817,019 of the 30,015,000 public shares were classified outside of permanent equity. 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 Non-controlling 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. We adopted this guidance during the fiscal year ended December 31, 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 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 non-controlling interests. The amendments in Part II of this update are not expected to have an impact on us. 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 incorporated on August 6, 2018 as a Delaware corporation and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our initial business combination using cash from the proceeds of our initial public offering that was completed in March 2019 and the sale of warrants in a private placement (the “Private Placement”) that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in an initial business combination: may significantly dilute the equity interest of our stockholders; 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 incur other indebtedness to finance our initial business combination, 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 or other indebtedness contains covenants restricting our ability to obtain such financing while the debt security or other indebtedness 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, or limit 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, execution of our strategy and other purposes and other disadvantages compared to our competitors who have less debt. At December 31, 2019, we had approximately $1,124,000 in cash outside of the trust account. We expect to incur significant costs in the pursuit of [/INST] Positive. </s>

HOOKIPA Pharma 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 in conjunction with our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in, or implied by, the forward-looking statements contained in the following discussion and analysis. Overview We are a clinical-stage biopharmaceutical company developing a new class of immunotherapeutics targeting infectious diseases and cancers based on our proprietary arenavirus platform that is designed to reprogram the body’s immune system. We are using our “off-the-shelf” technologies, VaxWave and TheraT, to elicit directly within patients a powerful and durable response of antigen-specific killer T cells and antibodies, thereby activating essential immune defenses against infectious diseases and cancers. We believe that our technologies can meaningfully leverage the human immune system for prophylactic and therapeutic purposes by eliciting killer T cell response levels previously not achieved by other published immunotherapy approaches. Our lead infectious disease product candidate, HB-101, is in a randomized, double-blinded Phase 2 clinical trial in patients awaiting kidney transplantation from CMV-positive donors. Our lead oncology product candidates, HB-201 and HB-202, are in development for the treatment of Human Papillomavirus-positive cancers. In December 2019, we initiated the Phase 1/2 clinical trial for HB-201 and expect preliminary results in late 2020 or early 2021. We plan to file an investigational new drug application, or IND, with the U.S. Food and Drug Administration, or FDA, for HB-202 in first half 2020. We have also entered into a strategic partnership with Gilead Sciences, Inc., or Gilead, to develop infectious disease product candidates intended to support functional cures for chronic Hepatitis B virus, or HBV, and human immunodeficiency virus, or HIV, infections. Based on preclinical data generated to date, Gilead has committed to preparations to advance the HBV and HIV candidates toward development. We have funded our operations to date primarily from private placements of our redeemable convertible preferred stock, with aggregate gross proceeds of approximately $142.5 million, grant funding and loans from an Austrian government agency, and $16.0 million in upfront and milestone payments from Gilead in connection with a research collaboration and license agreement. On April 23, 2019, we completed an initial public offering of our common stock, or IPO, in which we issued 6.0 million shares of our common stock, at $14.00 per share, for gross proceeds of $84.0 million, or net proceeds of $74.6 million. We do not expect to generate revenue from any product candidates that we develop until we obtain regulatory approval for one or more of such product candidates, if at all, and commercialize our products or enter into additional collaboration agreements with third parties. 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. All of our product candidates, including our most advanced product candidate, HB-101, will require substantial additional development time and resources before we would be able to apply for and receive regulatory approvals and begin generating revenue from product sales. Before launching our first products, if approved, we plan to establish our own manufacturing facility to minimize or eliminate our reliance on contract manufacturing organizations, or CMOs, which will require substantial capital expenditures and cause additional operating expenses. We currently have no marketing and sales organization and have no experience in marketing products; accordingly, we will incur significant expenses to develop a marketing organization and sales force in advance of generating any commercial product sales. As a result, we will need substantial additional capital to support our operating activities. In addition, we expect to incur additional legal, accounting and other expenses in operating our business, including the additional costs associated with operating as a public company. We currently anticipate that we will seek to fund our operations through equity or debt financings or other sources, such as government grants and additional collaboration agreements with third parties. Adequate funding may not be available to us on acceptable terms, or at all. If sufficient funds on acceptable terms are not available when needed, we will be required to significantly reduce our operating expenses and delay, reduce the scope of, or eliminate one or more of our development programs. Further, we expect to incur additional costs associated with operating as a public company. We have incurred net losses each year since our inception in 2011, including net losses of $43.0 million for the year ended December 31, 2019 and $16.2 million for the year ended December 31, 2018. As of December 31, 2019, we had an accumulated deficit of $103.0 million and we do not expect positive cash flows from operations in the foreseeable future. We expect to continue to incur net operating losses for at least the next several years as we advance our product candidates through clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization, continue our research and development efforts and invest to establish a commercial manufacturing facility. Components of Our Results of Operations Revenue from collaboration and licensing To date, we have not generated any revenue from product sales and do not expect to do so in the near future, if at all. All of our revenue to date has been derived from a research collaboration and license agreement with Gilead. On June 4, 2018, we entered into a Research Collaboration and License Agreement, or the Collaboration Agreement, with Gilead to evaluate potential vaccine products using or incorporating our TheraT technology and VaxWave technology for the treatment, cure, diagnosis or prevention of HBV and HIV. Under the Collaboration Agreement, we granted Gilead an exclusive, royalty-bearing license to our technology platform for researching, developing, manufacturing and commercializing products for HIV or HBV. We received a non-refundable $10.0 million upfront payment upon entering the Collaboration Agreement and through to December 31, 2019 we received $6.0 million in milestone payments for the delivery of research grade vectors. Gilead is obligated to reimburse us for our costs, including all benefits, travel, overhead, and any other expenses, relating to performing research and development activities under the Collaboration Agreement. We are also eligible to receive up to $140.0 million in developmental milestone payments for each of the HBV and HIV programs and up to $50.0 million in commercialization milestone payments for each of the HBV and HIV programs. Additionally, Gilead is obligated to pay royalties of a high single-digit to low-teens percentage on the worldwide net sales of each HBV product, and royalties of a mid-single-digit to low-teens percentage of worldwide net sales of each HIV product. We determined that our performance obligations under the terms of the Collaboration Agreement included one combined performance obligation for each of the HBV and HIV research programs, comprised of the transfer of intellectual property rights and providing research and development services. Accordingly, we recognize these amounts as revenue over the performance period of the respective services on a percent of completion basis using total estimated research and development labor hours for each of the performance obligations. Since entering into the Collaboration Agreement and through to December 31, 2019, we have received from Gilead the non-refundable upfront payment of $10.0 million and $6.0 million in milestone payments for the delivery of research grade vectors. In addition, we have recognized $6.3 million of cost reimbursements for research and development services performed under the Collaboration Agreement. In January 2020, we announced the achievement of a further milestone under the HBV program, entitling us to a milestone payment of $4.0 million. Operating Expenses Our operating expenses since inception have only consisted of research and development costs and general administrative costs. Research and Development Expenses Since our inception, we have focused significant resources on our research and development activities, including establishing our arenavirus platform, conducting preclinical studies, developing a manufacturing process, conducting a Phase 1 clinical trial and the currently ongoing Phase 2 clinical trial for HB-101 as well as initiating a Phase 1/2 trial for HB-201 and preparing an IND for HB-202. Research and development activities account for a significant portion of our operating expenses. Research and development costs are expensed as incurred. These costs include: · salaries, benefits and other related costs, including stock-based compensation, for personnel engaged in research and development functions; · expenses incurred in connection with the preclinical development of our programs and clinical trials of our product candidates, including under agreements with third parties, such as consultants, contractors, academic institutions and contract research organizations, or CROs; · the cost of manufacturing drug products for use in clinical trials, including under agreements with third parties, such as CMOs, consultants and contractors; · laboratory costs; · leased facility costs, equipment depreciation and other expenses, which include direct and allocated expenses; and · intellectual property costs incurred in connection with filing and prosecuting patent applications as well as third-party license fees. The majority of our research and development costs are external costs, which we track on a program-by-program basis. We do not track our internal research and development expenses on a program-by-program basis as they primarily relate to shared costs deployed across multiple projects under development. We expect our research and development expenses to increase substantially in the future as we advance our existing and future product candidates into and through clinical studies and pursue regulatory approval. The process of conducting the necessary clinical studies to obtain regulatory approval is costly and time-consuming. Clinical studies generally become larger and more costly to conduct as they advance into later stages and, in the future, we will be required to make estimates for expense accruals related to clinical study expenses. At this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the development of any product candidates that we develop from our programs. We are also unable to predict when, if ever, material net cash inflows will commence from sales of product candidates we develop, if at all. This is due to the numerous risks and uncertainties associated with developing product candidates, including the uncertainty of: · successful completion of preclinical studies and clinical trials; · sufficiency of our financial and other resources to complete the necessary preclinical studies and clinical trials; · acceptance of INDs for our planned clinical trials or future clinical trials; · successful enrollment and completion of clinical trials; · successful data from our clinical program that support an acceptable risk-benefit profile of our product candidates in the intended populations; · receipt and maintenance of regulatory and marketing approvals from applicable regulatory authorities; · scale-up of our manufacturing processes and formulation of our product candidates for later stages of development and commercialization; · establishing our own manufacturing capabilities or agreements with third-party manufacturers for clinical supply for our clinical trials and commercial manufacturing, if our product candidate is approved; · entry into collaborations to further the development of our product candidates; · obtaining and maintaining patent and trade secret protection or regulatory exclusivity for our product candidates; · successfully launching commercial sales of our product candidates, if and when approved; · acceptance of the product candidate’s benefits and uses, if and when approved, by patients, the medical community and third-party payors; · the prevalence and severity of adverse events experienced with our product candidates; · maintaining a continued acceptable safety profile of the product candidates following approval; · effectively competing with other therapies; · obtaining and maintaining healthcare coverage and adequate reimbursement from third-party payors; and · qualifying for, maintaining, enforcing and defending intellectual property rights and claims. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or another regulatory authority were to require us to conduct clinical trials beyond those that we anticipate will be required for the completion of clinical development of a product candidate, or if we experience significant delays in our clinical trials due to patient enrollment or other reasons, we would be required to expend significant additional financial resources and time on the completion of clinical development. General and Administrative Expenses Our general and administrative expenses consist primarily of personnel costs in our executive, finance and investor relations, business development and administrative functions. Other general and administrative expenses include consulting fees and professional service fees for auditing, tax and legal services, lease expenses related to our offices, premiums for directors and officers liability insurance, depreciation and other costs. 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 current and future product candidates, increase our headcount and investor relations activities and maintain compliance with requirements of The Nasdaq Global Select Market and the Securities and Exchange Commission. Grant Income Since inception, we have received grants from an Austrian government agency, either under funding agreements or under research incentive programs. In addition, we have received loans under funding agreements that bear interest at below market interest rate. We account for the grants received as other income and for the imputed benefits arising from the difference between a market rate of interest and the rate of interest as additional grant income, and record interest expense for the loans at a market rate of interest. Interest Expense Interest expense results primarily from loans under funding agreements with the Austrian Research Promotion Agency, recorded at a market rate of interest. The difference between interest payments payable pursuant to the loans, which rates are at below market interest rates, and the market interest rate, is accounted for as grant income. Income Taxes Income tax expense results from foreign minimum income tax and profit on a legal entity basis. The losses that we have incurred since inception result primary from the losses of our Austrian subsidiary. As of December 31, 2019, we had foreign net operating loss carryforwards of $112.3 million with no expiry date, resulting in a deferred tax asset of $29.2 million. We have considered that we will likely not realize the benefits of the deferred tax asset, and accordingly, have established a full valuation allowance as of December 31, 2019. 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 from collaboration and licensing Revenue was $11.9 million for the year ended December 31, 2019, compared to $7.6 million for the year ended December 31, 2018. The increase of $4.3 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 was due to higher recognition of revenue related to the upfront payment and higher cost reimbursements received under the Collaboration Agreement with Gilead. For the year ended December 31, 2019, this revenue included $4.3 million from reimbursement of research and development expenses and $4.4 million from partial recognition of revenue related to the upfront payment of $10.0 million that we received in June 2018. In addition to the recognition of the upfront payment we recognized $3.2 million in milestone payments. For the year ended December 31, 2018, revenue from reimbursement of research and development expenses was $2.0 million, revenue from partial recognition of the upfront payment was $2.8 million, and revenue for the achievement of the first pre-clinical milestone was $2.8 million. Research and Development Expenses For the year ended December 31, 2019, our research and development expenses were $46.3 million, compared to $22.0 million, for the year ended December 31, 2018. The primary drivers of the increase of $24.3 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 were an increase in direct research and development expenses by $19.9 million and an increase in internal research and development expenses of $4.4 million. Direct research and development expenses increased primarily due to the costs for conducting a Phase 2 clinical trial for our HB-101 program, the preparation costs of clinical trials for our HB-201 and HB-202 programs, expansion of earlier stage programs and other direct research and development costs, primarily in connection with securing manufacturing capacity for production of clinical trial material. In addition, costs related to our collaboration with Gilead contributed to the increase in direct expenses. Internal expenses increased mainly due to an increase in personnel-related research and development expenses increased by $3.1 million, primarily a result of our increased research and development headcount and an increase in stock compensation expenses. In addition, an increase in facility related costs of $0.4 million and in other internal costs of $0.9 million contributed to the overall increase in internal research and development expenses. The following table summarizes our research and development expenses by product candidate or program (in thousands): (1) Expenses incurred by us in connection with Gilead partnered programs are reimbursed to us by Gilead and accounted for as revenue. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2019 were $16.7 million, compared to $6.8 million for the year ended December 31, 2018. The increase of $9.9 million was primarily due to an increase in personnel related expenses of $5.4 million, an increase in professional and consulting fees of $2.5 million and an increase in other general and administrative expenses of $2.0 million. Personnel-related expenses increased mainly due to an increase in stock compensation expenses, an increase in salaries and the growth in headcount in our general and administrative functions. The increase in professional and consulting fees resulted from an increase in accounting, audit and legal fees as well as costs associated with ongoing business activities and costs to operate as a public company. Grant Income In the year ended December 31, 2019 we recorded grant income of $6.7 million, compared to $5.6 million in the year ended December 31, 2018 from grants, research incentives and imputed benefits from below market interest rates on loans from governmental agencies. The increase of $1.1 million was primarily due to higher income from Austrian research and development incentives, which was partially offset by the expiry of a grant from the Austrian Research Promotion Agency, or FFG. Interest Income and Expense Interest income was $1.6 million for the year ended December 31, 2019, compared to no interest income for the year ended December 31, 2018. The interest income represents interest from cash and cash equivalents held in US dollars resulting from the proceeds from the issuance of Series D Preferred Stock, our IPO, and payments received under our collaboration with Gilead. During the year ended December 31, 2019 our cash, cash equivalents and restricted cash were mainly held in dollars at US investment grade financial institutions or in money market funds. In addition smaller amounts were held in US dollars and euros at our Austrian subsidiary which produced no interest income due the low or zero interest rate policy in the European Monetary Union. Interest expenses for loans from government agencies were $0.9 million for the year ended December 31, 2019, compared to $0.8 million for the year ended December 31, 2018. Interest expense was recorded at the market rate of interest, which exceeded the contractual interest. Liquidity and Capital Resources Since our inception in 2011, we have funded our operations primarily through private placements of our convertible preferred stock, from grants, research incentives and borrowings under various agreements with public funding agencies, from an upfront payment, milestone payments and reimbursement of research and development expenses pursuant to the Collaboration Agreement with Gilead, and most recently through the proceeds of our IPO. We have raised gross proceeds of approximately $142.5 million from the issuance of our convertible preferred stock and $10.0 million from a non-refundable upfront payment pursuant to the Collaboration Agreement with Gilead. On April 23, 2019, we completed our IPO by issuing 6.0 million shares of our common stock, at $14.00 per share, for gross proceeds of $84.0 million, or net proceeds of $74.6 million. As of December 31, 2019, the principal amount outstanding under loans from government agencies was $7.3 million and we had cash, cash equivalents and restricted cash of $113.5 million. We entered into various funding agreements with the FFG. The loans by FFG, or the FFG Loans, were made on a project-by-project basis and bear interest at rates ranging from 0.75% to 1.0% per annum. In the event that the underlying program research results in a scientific or technical failure, the principal then outstanding under any loan may be forgiven by FFG and converted to non-repayable grant funding on a project-by-project basis. The FFG Loans contain no financial covenants and are not secured by any of our assets. Because the FFG Loans bear interest at below market rates we account for the imputed benefit arising from the difference between an estimated market rate of interest and the contractual interest rate as grant funding from FFG, which is included in grant income. On the date that FFG Loan proceeds are received, we recognize the portion of the loan proceeds allocated to grant funding as a discount to the carrying value of the loan and as unearned income. As of December 31, 2019, the unamortized debt discount related to FFG Loans was $2.6 million. We do not expect positive cash flows from operations in the foreseeable future, if at all. Historically, we have incurred operating losses as a result of ongoing efforts to develop our arenavirus technology platform and our product candidates, including conducting ongoing research and development, preclinical studies, clinical trials, providing general and administrative support for these operations and developing our intellectual property portfolio. We expect to continue to incur net operating losses for at least the next several years as we progress clinical development, seek regulatory approval, prepare for and, if approved, proceed to commercialization of our most advanced product candidates HB-101, HB-201 and HB-202, continue our research and development efforts relating to our other and future product candidates, and invest in our manufacturing capabilities and our own manufacturing facility. Future Funding Requirements We have no products approved for commercial sale. To date, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, undertaking preclinical studies and clinical trials of our product candidates. As a result, we are not profitable and have incurred losses in each period since our inception in 2011. As of December 31, 2019, we had an accumulated deficit of $103.0 million. We expect to continue to incur significant losses for the foreseeable future. We anticipate that our expenses will increase substantially as we: · pursue the clinical and preclinical development of our current and future product candidates; · leverage our technologies to advance product candidates into preclinical and clinical development; · seek regulatory approvals for product candidates that successfully complete clinical trials, if any; · attract, hire and retain additional clinical, quality control and scientific personnel; · establish our manufacturing capabilities through third parties or by ourselves and scale-up manufacturing to provide adequate supply for clinical trials and commercialization; · 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; · expand and protect our intellectual property portfolio; · establish a sales, marketing, medical affairs and distribution infrastructure to commercialize any products for which we may obtain marketing approval and intend to commercialize on our own or jointly; · acquire or in-license other product candidates and technologies; and · incur additional legal, accounting and other expenses in operating our business, including the costs associated with operating as a public company. Even if we succeed in commercializing one or more of our product candidates, we will continue to incur substantial research and development and other expenditures to develop and market additional product candidates. We may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. The size of our future net losses will depend, in part, on the rate of future growth of our expenses and our ability to generate revenue. Our prior losses and expected future losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital. We will require substantial additional financing and a failure to obtain this necessary capital could force us to delay, limit, reduce or terminate our product development programs, commercialization efforts or other operations. Since our inception, we have invested a significant portion of our efforts and financial resources in research and development activities for our VaxWave and TheraT technologies and our product candidates derived from these technologies. Preclinical studies and clinical trials and additional research and development activities will require substantial funds to complete. We believe that we will continue to expend substantial resources for the foreseeable future in connection with the development of our current product candidates and programs as well as any future product candidates we may choose to pursue, as well as the gradual gaining of control over our required manufacturing capabilities and other corporate uses. These expenditures will include costs associated with conducting preclinical studies and clinical trials, obtaining regulatory approvals, and manufacturing and supply, as well as marketing and selling any products approved for sale. In addition, other unanticipated costs may arise. Because the outcome of any preclinical study or clinical trial is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development and commercialization of our current or future product candidates. Our future capital requirements depend on many factors, including: · the scope, progress, results and costs of researching and developing our current and future product candidates and programs, and of conducting preclinical studies and clinical trials; · the number and development requirements of other product candidates that we may pursue, and other indications for our current product candidates that we may pursue; · the stability, scale and yields of our future manufacturing process as we scale-up production and formulation of our product candidates for later stages of development and commercialization; · the timing of, and the costs involved in, obtaining regulatory and marketing approvals and developing our ability to establish sales and marketing capabilities, if any, for our current and future product candidates we develop if clinical trials are successful; · the success of our collaboration with Gilead; · our ability to establish and maintain collaborations, strategic licensing or other arrangements and the financial terms of such agreements; · the cost of commercialization activities for our current and future product candidates that we may develop, whether alone or with a collaborator; · 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, or royalties on, our future products, if any; and · the emergence of competing oncology and infectious disease therapies and other adverse market developments. A change in the outcome of any of these or other variables with respect to the development of any of our current and future product candidates could significantly change the costs and timing associated with the development of that product candidate. Furthermore, our operating plans may change in the future, and we will need additional funds to meet operational needs and capital requirements associated with such operating plans. We do not have any committed external source of funds or other support for our development efforts. Until we can generate sufficient product and royalty revenue to finance our cash requirements, which we may never do, we expect to finance our future cash needs through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances, licensing arrangements and other marketing or distribution arrangements as well as grant funding. Based on our research and development plans, we expect that our existing cash and cash equivalents, will enable us to fund our operating expenses and capital expenditure requirements for at least the next 12 months. These estimates are based on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. If we raise additional capital through marketing and distribution arrangements or other collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish certain valuable rights to our product candidates, technologies, future revenue streams or research programs or grant licenses on terms that may not be favorable to us. If we raise additional capital through public or private equity offerings, the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. Further, to the extent that we raise additional capital through the sale of common stock or securities convertible or exchangeable into common stock, the ownership interest of our shareholders will be diluted. If we raise additional capital through debt financing, we would be subject to fixed payment obligations and 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 on favorable terms when needed, we may have to delay, reduce the scope of or terminate one or more of our research and development programs or clinical trials. Cash Flows The following table sets forth a summary of the primary sources and uses of cash (in thousands): Cash Used in Operating Activities During the year ended December 31, 2019, cash used in operating activities was $41.7 million, which consisted of a net loss of $43.0 million, adjusted by non-cash charges of $8.7 million and changes in our operating assets and liabilities of $7.4 million. The non-cash charges consisted primarily of stock-based compensation of $5.6 million and depreciation and amortization expense of $3.1 million. The change in our operating assets and liabilities was primarily due to an increase in prepaid expenses and other current assets of $6.0 million, a decrease in deferred revenues of $4.4 million, a decrease of accounts receivable of $3.6 million, and a decrease in operating lease liabilities of $2.4 million, partially offset by an increase in accounts payable of $4.2 million and an increase in accrued expenses and other current liabilities of $4.0 million. Changes in accounts payable, prepaid expenses and other current assets and liabilities in the year ended December 31, 2019 were generally due to growth in our business, the advancement of our research programs and the timing of invoicing and payments. Changes in operating lease liabilities in the year ended December 31, 2019 were mainly due to a prepayment related to embedded leases and regular lease payments. During the year ended December 31, 2018, cash used in operating activities was $15.0 million, which consisted of a net loss of $16.2 million, adjusted by non-cash charges of $1.5 million and cash used by changes in our operating assets and liabilities of $0.3 million. The change in our operating assets and liabilities included $13.5 million in cash as a result of increases in accounts receivables, prepaid expenses and other current assets. These charges were largely offset by an increase in accounts payable and other current liabilities of $4.6 million and an increase in deferred revenues of $8.6 million mainly driven by the unrecognized portion of the $10.0 million upfront payment received pursuant to the Collaboration Agreement. During the year ended December 31, 2017, cash used in operating activities was $11.9 million, which consisted of a net loss of $12.7 million, adjusted by non-cash charges of $1.1 million and cash used due to changes in our operating assets and liabilities of $0.3 million. The non-cash charges consisted primarily of depreciation and amortization expense of $0.4 million and stock-based compensation of $0.8 million. The change in our operating assets and liabilities was primarily due to a decrease of $1.2 million in accounts payable, partially offset by an increase of accrued expenses and other liabilities of $1.0 million. Cash Used in Investing Activities During the years ended December 31, 2019, 2018 and 2017, cash used in investing activities was $2.0 million, $2.2 million, and $1.3 million, respectively, which resulted from capital expenditures in connection with leasehold improvements to expand our laboratory space and for purchase of property and equipment. Cash Provided by Financing Activities During the year ended December 31, 2019, cash provided by financing activities was $109.8 million, which consisted of net proceeds of $37.3 million from the issuance of shares of our Series D convertible preferred stock in February 2019 and net proceeds of $74.7 million from our IPO in April 2019, partially offset by an upfront payment for embedded finance lease assets. During the year ended December 31, 2018, cash provided by financing activities was $6.9 million, which primarily consisted of $6.4 million in net proceeds from the issuance of shares of our Series C convertible preferred stock in December 2017, and of proceeds from borrowings of $0.4 million, received under the FFG Loans. During the year ended December 31, 2017, cash provided by financing activities was $58.9 million, which primarily consisted of net proceeds from the issuances of shares of our Series C convertible preferred stock of $58.1 million and $0.7 million in loan proceeds from FFG. 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. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): The contractual obligations table does not include any potential contingent payments upon the achievement by us of specified clinical, regulatory and commercial events, as applicable, or patent prosecution or royalty payments we may be required to make under license agreements we have entered into because the timing and likelihood of these contingent payments are not known. We enter into contracts in the normal course of business with CROs for clinical trials, preclinical research studies and testing, manufacturing and other services and products for operating purposes. These contracts generally provide for termination upon notice, and therefore we believe that our non-cancellable obligations under these agreements are not material. Our IPO provided a change in ownership structure of the Company and, as a consequence, we agreed a change in the due dates of a part of the debt obligations with the Austrian government agency to whom we owe our debt obligations. Intellectual Property Licenses In October 2011, we entered into a license agreement with University of Zurich for an exclusive, worldwide, royalty-bearing license for a propagation-deficient arenavirus vector. Pursuant to the license agreement, we are obligated to pay the University of Zurich low single-digit royalties on aggregate net sales of products licensed under the agreement, and to pay percentages ranging from the mid-single digits to 20% of the sublicense fees that we may receive from sublicensing, depending on the amount of fees received from sublicensees. In January 2017, we entered into a license agreement with University of Basel for an exclusive, worldwide, royalty-bearing license for a tri-segmented Pichinde virus vector. We are required to use reasonable efforts to make commercially available licensed products. Pursuant to the license agreement, we are obligated to pay nominal milestone payments for each licensed product upon the achievement of certain development and regulatory milestones and to pay royalties of low single digits of net sales of licensed products. We are also obligated to pay a low- to high-single digit percentage of the sublicense fees that we may receive from sublicensing. In February 2017, we entered into a license agreement with the University of Geneva for an exclusive, worldwide, royalty-bearing license for a tri-segmented arenavirus vector. Pursuant to the license agreement, we are obligated to pay the University of Geneva an annual fee which is fully deductible from any milestone, royalty or sublicense payments. We are also obligated to pay milestone nominal payments for each licensed product upon the achievement of certain development and regulatory milestones and to pay low single-digit royalties on aggregate net sales of products licensed under the agreement, and to pay percentages ranging from the low-single digits to 10% of the sublicense fees that we may receive from sublicensing. In the year ended December 31, 2019, we recorded $1.9 million in licensing fees from intellectual property licenses as research and development expenses. At December 31, 2019, no payable from sublicensing fees were included in accrued expenses and other current liabilities. In the year ended December 31, 2018, we recorded $0.1 million in licensing fees from intellectual property licenses as research and development expenses. At December 31, 2018, $0.5 million payable from sublicensing fees were included in accrued expenses and other current liabilities. For additional information on these license agreements, please see “Business-Intellectual Property-License Agreements.” 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 we have prepared in accordance with the rules and regulations of the SEC, and generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets 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. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and the methodologies and assumptions we apply under them have not materially changed since our Prospectus, except for our adoption of the new leasing standards which is discussed below. Recognition of revenue from contracts with customers We have entered into the Collaboration Agreement with Gilead for the development and commercialization of certain of its product candidates. Our performance obligations under the terms of this agreement include one combined performance obligation for each research program comprised of the transfer of intellectual property rights (licenses) and providing research and development services. Payments by Gilead to us under this agreement included a non-refundable up-front payment, payments for research and development activities, and may include payments based upon the achievement of defined pre-clinical development and commercial milestones and royalties on product sales if certain future conditions are met. We evaluate our collaboration and licensing arrangements pursuant to Accounting Standards Codification 606, or ASC 606. To determine the recognition of revenue from arrangements that fall within the scope of ASC 606, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when, or as, the Company satisfies a performance obligation. We present revenues from collaboration and licensing arrangements separately from other sources of revenue. Amounts received by us as non-refundable upfront payment under the collaboration and licensing agreement prior to satisfying the above revenue recognition criteria are recorded as deferred revenue in our consolidated balance sheets. Such amounts are recognized as revenue over the performance period of the respective services on a percent of completion basis for each of the obligations. Reimbursement of costs for or services under the collaboration and licensing agreement are presented as revenue and not deducted from expenses. Amounts of consideration allocated to the performance of research or manufacturing services are recognized over the period in which services are performed. Contingent milestone payments related to specified preclinical and clinical development milestones are not initially recognized within the transaction price as they are fully constrained under the guidance in ASC 606. The collaboration and licensing arrangement also includes certain sales-based milestone and royalty payments upon successful commercialization of a licensed product which we anticipate recognizing if and when sales from a licensed product are generated. Leasing Effective January 1, 2019, we adopted ASU No. 2016-02, Leases (Topic 842) as amended from time to time (the new leasing standards) using the modified retrospective transition approach with no restatement of prior periods or cumulative adjustment to retained earnings. Upon adoption, we elected the package of transition practical expedients, which allowed us to carry forward prior conclusions related to whether any expired or existing contracts are or contain leases, the lease classification for any expired or existing leases and initial direct costs for existing leases. We also elected the practical expedient to not reassess certain land easements and made an accounting policy election to not recognize leases with an initial term of 12 months or less within the consolidated balance sheets and to recognize those lease payments on a straight-line basis in the consolidated statements of operations over the lease term. Upon adoption of the new leasing standards an operating lease asset of $3.3 million and a corresponding operating lease liability of $3.3 million were recorded in our consolidated balance sheets. The adoption of the new leasing standards did not have a material impact on our consolidated statements of operations. The determination whether an arrangement was qualified as a lease was made at contract inception. Operating lease assets and liabilities are recognized at the commencement date of the lease based upon the present value of lease payments over the lease term. When determining the lease term, we include options to extend or terminate the lease when it is reasonably certain that the option will be exercised. We use the implicit rate when readily determinable and our incremental borrowing rate when the implicit rate is not readily determinable based upon the information available at the commencement date in determining the present value of the lease payments. The incremental borrowing rate is determined using a secured borrowing rate for the same currency and term as the associated lease. The lease payments used to determine operating lease assets may include lease incentives, stated rent increases and escalation clauses linked to rates of inflation when determinable and are recognized as operating lease assets on the consolidated balance sheets. Certain of our arrangements contain lease and non-lease components. We applied an accounting policy choice to separate or not to separate lease payments for the identified assets from any non-lease payments included in the contract by asset class. Operating leases are reflected in operating lease assets, in accrued expenses and other current liabilities and in non-current operating lease liabilities in our consolidated balance sheets. Lease expense for minimum lease payments is recognized on a straight-line basis over the lease term. 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 in this Annual Report on Form 10-K. Research and Development Costs Research and development costs are expensed as incurred. Research and development expenses consist of costs incurred in performing research and development activities, including salaries and bonuses, stock-based compensation, employee benefits, facilities costs, laboratory supplies, depreciation, manufacturing expenses and external costs of vendors engaged to conduct preclinical development activities and clinical trials as well as the cost of licensing technology. Advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. All patent-related costs incurred in connection with filing and prosecuting patent applications are classified as research and development expenses and expensed as incurred due to the uncertainty about the recovery of the expenditure. Upfront payments, milestone payments and annual payments made for the licensing of technology are generally expensed as research and development in the period in which they are incurred. Incremental sublicense fees triggered by contracts with customers are capitalized and expensed as research and development expenses over the period in which the relating revenue is recognized. Stock-Based Compensation We measure all stock options and other stock-based awards granted to employees and directors based on the fair value on the date of the grant and recognize compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We classify stock-based compensation expense in our consolidated statements of operations and comprehensive loss in the same manner in which the award recipient's payroll costs are classified. Generally, we issue stock options, with service-only vesting conditions and record expense using the graded-vesting method. We estimate the fair value of each stock option award 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. We do not estimate and apply a forfeiture rate as we have elected to account for forfeitures as they occur. Recognition of other income under government grant agreements and research incentives We recognize income from grants, research incentives and the imputed benefit arising from the difference between an estimated market rate of interest and the contractual interest rate on loans received from Austrian government agencies. Income from grants and incentives is recognized in the period during which the related qualifying expenses are incurred, provided that the conditions under which the grants or incentives were provided have been met. For grants under funding agreements and for proceeds under research incentive programs, we recognize grant and incentive income in an amount equal to the qualifying expenses incurred in each period multiplied by the applicable reimbursement percentage. Grant income that we have received in advance of incurring qualifying expenses is recorded in the consolidated balance sheets as deferred income. Grant and incentive income recognized upon incurring qualifying expenses in advance of receipt of grant funding or proceeds from research and development incentives is recorded in the consolidated balance sheets as prepaid expenses and other current assets. We have received loans under funding agreements that bear interest below market rates. We account for the imputed benefit arising from the difference between an estimated market interest rate and the actual interest rate charged on such loans as additional grant income, and record interest expense for the loans at a market interest. On the date that loan proceeds are received, we recognize the portion of the loan proceeds allocated to grant funding as a discount to the carrying value of the loan and as unearned income, which is subsequently recognized as additional grant income over the term of the funding agreement. Emerging Growth Company Status and Smaller Reporting Company As an “emerging growth company,” the Jumpstart Our Business Startups Act of 2012 allows us to delay adoption of new or revised accounting standards applicable to public companies until such standards are made applicable to private companies. However, we have irrevocably elected not to avail ourselves of this extended transition period for complying with new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. 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 our 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. For so long as we remain a smaller reporting company, we are permitted and intend to rely on exemptions from certain disclosure and other requirements that are applicable to other public companies that are not smaller reporting companies. Discussion of the year ended December 31, 2018 compared with the year ended December 31, 2017 is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our registration statement on Form S-1, as amended, as filed with the Securities Exchange Commission.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company developing a new class of immunotherapeutics targeting infectious diseases and cancers based on our proprietary arenavirus platform that is designed to reprogram the body’s immune system. We are using our “offtheshelf” technologies, VaxWave and TheraT, to elicit directly within patients a powerful and durable response of antigenspecific killer T cells and antibodies, thereby activating essential immune defenses against infectious diseases and cancers. We believe that our technologies can meaningfully leverage the human immune system for prophylactic and therapeutic purposes by eliciting killer T cell response levels previously not achieved by other published immunotherapy approaches. Our lead infectious disease product candidate, HB101, is in a randomized, doubleblinded Phase 2 clinical trial in patients awaiting kidney transplantation from CMVpositive donors. Our lead oncology product candidates, HB201 and HB202, are in development for the treatment of Human Papillomaviruspositive cancers. In December 2019, we initiated the Phase 1/2 clinical trial for HB201 and expect preliminary results in late 2020 or early 2021. We plan to file an investigational new drug application, or IND, with the U.S. Food and Drug Administration, or FDA, for HB202 in first half 2020. We have also entered into a strategic partnership with Gilead Sciences, Inc., or Gilead, to develop infectious disease product candidates intended to support functional cures for chronic Hepatitis B virus, or HBV, and human immunodeficiency virus, or HIV, infections. Based on preclinical data generated to date, Gilead has committed to preparations to advance the HBV and HIV candidates toward development. We have funded our operations to date primarily from private placements of our redeemable convertible preferred stock, with aggregate gross proceeds of approximately $142.5 million, grant funding and loans from an Austrian government agency, and $16.0 million in upfront and milestone payments from Gilead in connection with a research collaboration and license agreement. On April 23, 2019, we completed an initial public offering of our common stock, or IPO, in which we issued 6.0 million shares of our common stock, at $14.00 per share, for gross proceeds of $84.0 million, or net proceeds of $74.6 million. We do not expect to generate revenue from any product candidates that we develop until we obtain regulatory approval for one or more of such product candidates, if at all, and commercialize our products or enter into additional collaboration agreements with third parties. 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. All of our product candidates, including our most advanced product candidate, HB101, will require substantial additional development time and resources before we would be able to apply for and receive regulatory approvals and begin generating revenue from product sales. Before launching our first products, if approved, we plan to establish our own manufacturing facility to minimize or eliminate our reliance on contract manufacturing organizations, or CMOs, which will require substantial capital expenditures and cause additional operating expenses. We currently have no marketing and sales organization and have no experience in marketing products; accordingly, we will incur significant expenses to develop a marketing organization and sales force in advance of generating any commercial product sales. As a result, we will need substantial additional capital to support our operating activities. In addition, we expect to incur additional legal, accounting and other expenses in operating our business, including the additional costs associated with operating as a public company. We currently anticipate that we will seek to fund our operations through equity or debt financings or other sources, such as government grants and additional collaboration agreements with third parties. Adequate funding may not be available to us on acceptable terms, or at all. If sufficient funds on acceptable terms are not available when needed, we will be required to significantly reduce our operating expenses and delay, reduce the scope of, or eliminate one or more of our development [/INST] Positive. </s>

Cyclerion Therapeutics, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report on Form 10-K. Forward-Looking Information The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated and combined financial statements and the notes to those financial statements appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Special Note Regarding Forward-Looking Statements” and “Risk Factors” in Item 1A of this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements. Overview We are a clinical-stage biopharmaceutical company harnessing the power of soluble guanylate cyclase, or sGC, pharmacology to discover, develop and commercialize breakthrough treatments for serious and orphan diseases. Our focus is enabling the full therapeutic potential of next-generation sGC stimulators. Our strategy rests on a solid scientific foundation that is enabled by our people and capabilities, external collaborations and a responsive capital allocation approach. We operate in one reportable business segment-human therapeutics. Separation from Ironwood Pharmaceuticals On April 1, 2019, Ironwood Pharmaceuticals Inc., or Ironwood, completed the separation of its sGC business, and certain other assets and liabilities, into us as a separate, independent publicly traded company by way of a pro-rata distribution of our common stock through a dividend distribution of one share of our common stock, with no par value per share, for every 10 shares of Ironwood common stock held by Ironwood stockholders as of the close of business on March 19, 2019, the record date for the distribution, which we refer to herein as the Separation. As a result of the Separation, we became an independent public company and commenced trading under the symbol “CYCN” on the Nasdaq Global Select Market on April 2, 2019. In connection with the Separation, on March 30, 2019, we entered into certain agreements with Ironwood to provide a framework for our relationship with Ironwood following the Separation, including, among others, a Separation Agreement, a Tax Matters Agreement, and an Employee Matters Agreement. In addition, in connection with the Separation, on April 1, 2019, we entered into a Development Agreement, an Ironwood Transition Services Agreement, a Cyclerion Transition Services Agreement and an Intellectual Property License Agreement with Ironwood. On April 2, 2019, we issued 11,817,165 shares of our common stock, or the Private Placement Shares, to accredited investors for gross proceeds of $175 million (net proceeds of approximately $165 million) pursuant to the Amended and Restated Common Stock Purchase Agreement. We received the funds associated with the sale of the Private Placement Shares on April 2, 2019. Our historical consolidated and combined financial statements for the periods prior to the Separation have been derived from Ironwood’s combined financial statements and accounting records and are presented in conformity with United States Generally Accepted Accounting Principles, or U.S. GAAP. Our consolidated and combined financial statements reflect our financial position, results of operations and cash flows of the business that were transferred to us in the Separation. The historical financial statements may not be indicative of our future performance and do not necessarily reflect what our results of operations, financial condition and cash flows would have been had we operated as a separate, publicly traded company for the periods presented prior to the Separation. The consolidated and combined financial statements prior to the Separation included herein do not reflect any changes that occurred in our financing or operations as a result of the Separation from Ironwood. Financial Overview Research and Development Expense. Research and development expenses are incurred in connection with the discovery and development of our product candidates. These expenses consist primarily of the following costs: compensation, benefits and other employee-related expenses, research and development related facilities, third-party contracts relating to nonclinical study and clinical trial activities. All research and development expenses are charged to operations as incurred. The core of our research and development strategy is to harness the power of sGC pharmacology to develop therapies for serious and orphan diseases. Our portfolio of programs includes: Olinciguat is a once-daily, orally administered vascular sGC stimulator that is well suited for the potential treatment of sickle cell disease, or SCD. We are conducting a dose-ranging Phase 2 study, STRONG-SCD, that is expected to enroll up to 88 patients from both US and ex-US sites. This study is designed to explore a broad range of tolerated doses and optimize our understanding of the therapeutic potential of olinciguat in SCD. We expect topline data from this study in mid-2020. In June 2018, the U.S. Food and Drug Administration, or the FDA, granted Orphan Drug Designation to olinciguat for the treatment of patients with SCD. Orphan Drug Designation provides marketing exclusivity for seven years from the date of the product’s approval for marketing and contributes to a significant reduction in development costs. Praliciguat is an orally administered, once-daily systemic sGC stimulator that was evaluated in two recently completed Phase 2 proof-of-concept studies: a dose-ranging study in 156 adult patients with diabetic nephropathy, and a study in 196 adult patients with heart failure with preserved ejection fraction (HFpEF), CAPACITY-HFpEF. On October 30, 2019, we released topline results from these studies. In CAPACITY-HFpEF, the study did not meet statistical significance on its primary endpoint of improved exercise capacity from baseline as compared to placebo, measured by cardiopulmonary exercise testing. There was clear evidence of drug exposure and pharmacological activity as judged by expected reductions in blood pressure. Praliciguat was generally well tolerated. We are discontinuing development of praliciguat in HFpEF. The study of praliciguat in participants with diabetic nephropathy also did not meet statistical significance on its primary endpoint of reduction in albuminuria from baseline as compared to placebo, measured by urine albumin creatinine ratio. However, there was a trends toward improvement across the total intention-to-treat study population. Praliciguat was generally well tolerated. As previously announced, we intend to out-license praliciguat for late-stage global development and commercialization. IW-6463 is an orally administered central nervous system-penetrant sGC stimulator that, because it readily crosses the blood-brain barrier, affords an unprecedented opportunity to expand the utility of sGC pharmacology to serious neurodegenerative diseases. . On January 13, 2020 we released positive top line results from our first-in-human study of IW-6463. IW-6463 was generally well tolerated in healthy human adults. The study demonstrated IW-6463 penetration across the blood-brain-barrier at levels expected to be pharmacologically active as well as a mild reduction in blood pressure providing evidence of peripheral pharmacological activity. The Company intends to continue development activities for IW-6463. In December 2019 we initiated an ongoing translational pharmacology study in elderly subjects. Topline data from this study is expected in mid-2020. Discovery Research. Our discovery efforts are primarily focused on identifying, designing and developing sGC stimulators for serious and orphan diseases. sGC stimulation is a powerful mechanism that can broadly regulate blood flow, inflammation, fibrosis and metabolism. In diseases that are localized to specific organs or tissues, we believe that our organ-targeting strategy will maximize the efficacy of sGC pharmacology in these organs while reducing the potential for dose-limiting hemodynamic effects sometimes observed with sGC stimulation. Our initial focus is on the liver and the lung due to the clear role of nitric oxide signaling in diseases with high unmet need that affect these organs. Additional discovery efforts are ongoing and aimed at further expanding the potential of sGC stimulation in disorders of the CNS. The following table summarizes our research and development expenses related to our product pipeline, as well as employee and facility related costs allocated to research and development expense, for the years ended December 31, 2019 and 2018. These product pipeline expenses relate primarily to external costs associated with nonclinical studies and clinical trial costs, which are presented by development candidates. Securing regulatory approvals for new drugs is a lengthy and costly process. Any failure by us to obtain, or any delay in obtaining, regulatory approvals would materially adversely affect our product development efforts and our business overall. Given the inherent uncertainties of pharmaceutical product development, we cannot estimate with any degree of certainty how our programs will evolve, and therefore the amount of time or money that would be required to obtain regulatory approval to market them. As a result of these uncertainties surrounding the timing and outcome of any approvals, we are currently unable to estimate precisely when, if ever, our discovery and development candidates will be approved. We invest carefully in our pipeline, and the commitment of funding for each subsequent stage of our development programs is dependent upon the receipt of clear, supportive data. The successful development of our product candidates is highly uncertain and subject to a number of risks including, but not limited to: · The duration of clinical trials may vary substantially according to the type and complexity of the product candidate and may take longer than expected. · The FDA and comparable agencies in foreign countries impose substantial and varying requirements on the introduction of therapeutic pharmaceutical products, which typically require lengthy and detailed laboratory and clinical testing procedures, sampling activities and other costly and time-consuming procedures. · Data obtained from nonclinical and clinical activities at any step in the testing process may be adverse and lead to discontinuation or redirection of development activity. Data obtained from these activities also are susceptible to varying interpretations, which could delay, limit or prevent regulatory approval. · The duration and cost of discovery, nonclinical studies and clinical trials may vary significantly over the life of a product candidate and are difficult to predict. · The costs, timing and outcome of regulatory review of a product candidate may not be favorable, and, even if approved, a product may face post-approval development and regulatory requirements. · The emergence of competing technologies and products and other adverse market developments may negatively impact us. As a result of the factors listed above, including the factors discussed under the “Risk Factors” in Item 1A of this Annual Report on Form 10-K, we are unable to determine the duration and costs to complete current or future nonclinical and clinical stages of our product candidates or when, or to what extent, we will generate revenues from the commercialization and sale of our product candidates. Development timelines, probability of success and development costs vary widely. We anticipate that we will make determinations as to which additional programs to pursue and how much funding to direct to each program on an ongoing basis in response to the data from the studies of each product candidate, the competitive landscape and ongoing assessments of such product candidate’s commercial potential. General and Administrative Expense. General and administrative expense consists primarily of compensation, benefits and other employee-related expenses for personnel in our administrative, finance, legal, information technology, business development, communications and human resource functions. Other costs include the legal costs of pursuing patent protection of our intellectual property, general and administrative related facility costs, insurance costs and professional fees for accounting and legal services. Certain costs associated with our Separation from Ironwood are included in these expenses. We record all general and administrative expenses as incurred. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations is based upon our consolidated and combined financial statements prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make certain estimates and assumptions that may affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated and combined financial statements, and the amounts of expenses during the reported periods. Significant estimates and assumptions in our consolidated and combined financial statements include those related to allocation of expenses, assets and liabilities from Ironwood’s historical financial statements for the periods prior to the Separation, impairment of long-lived assets; income taxes, including the valuation allowance for deferred tax assets; research and development expenses; contingencies and share-based compensation. We base our estimates on our historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ materially from our estimates under different assumptions or conditions. Changes in estimates are reflected in reported results in the period in which they become known. We believe that our application of accounting policies requires significant judgments and estimates on the part of management and is the most critical to aid in fully understanding and evaluating our reported financial results. Our significant accounting policies are more fully described in Note 2, Summary of Significant Accounting Policies, of the consolidated and combined financial statements elsewhere in this Annual Report on Form 10-K. All research and development expenses are expensed as incurred. We defer and capitalize nonrefundable advance payments we make for research and development activities until the related goods are received or the related services are performed. See Note 2, Summary of Significant Accounting Policies, of the consolidated and combined financial statements appearing elsewhere in this Annual Report on Form 10-K. Results of Operations For the period prior to the Separation, our consolidated and combined financial statements include an allocation of expenses related to certain Ironwood corporate functions, including senior management, legal, human resources, finance, information technology and quality assurance. These expenses were allocated to Cyclerion based on direct usage or benefit where identifiable, with the remainder allocated pro-rata based on project related costs, headcount or other measures. We considered the allocation methodologies used to be a reasonable and appropriate reflection of the historical Ironwood expenses attributable to us. The expenses reflected in the consolidated and combined financial statements may not be indicative of expenses that will be incurred by us in the future. After the Separation, we began performing these corporate functions using internal resources or purchased services, certain of which are being provided by Ironwood under the transition services agreement. The following discussion summarizes the key factors we believed are necessary for an understanding of our consolidated financial statements. Revenue from related party. The increase in revenue from related party for the year ended December 31, 2019 compared to the year ended December 31, 2018 is the result of services performed under the Development Agreement for Ironwood, which was entered into in connection with the Separation. Research and Development Expense. The increase in research and development expense of approximately $7.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily related to an increase of approximately $3.0 million in employee-related expenses as compared to the pre-Separation allocation costs from Ironwood, including approximately $2.5 million related to one-time costs associated with a workforce reduction, an increase of approximately $1.7 million in facilities and operating costs allocated to research and development, and a net increase of approximately $2.7 million in external research costs. The net increase in external research costs was primarily due to an increase of approximately $6.5 million associated with olinciguat due to increased enrollment and site activity for the STRONG-SCD Phase 2 study as well as supporting ancillary studies, toxicology and manufacturing, and an increase of approximately $1.7 million associated with IW-6463 studies, partially offset by a decrease of approximately $4.5 million associated with praliciguat due to the timing of study activities which ceased enrollment and closed out by the end of 2019 and a decrease of approximately $1.0 million in discovery research. General and Administrative Expense. The increase in general and administrative expenses of approximately $6.9 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily was driven by increases of approximately $5.8 million in stock-based compensation as compared to the pre-Separation allocation from Ironwood, approximately $2.8 million in other employee-related costs, and approximately $1.0 million in facilities and other operating costs. These increases were partially offset by a net decrease of approximately $2.9 million in consulting fees and other professional services expenses. Interest and other income. Interest and investment income increased by approximately $2.0 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 due to $1.9 million of interest generated on excess operating funds from investments in U.S. government money market funds and overnight repurchase agreements and the recognition of approximately $0.1 million of net sublease income. There was no investment and sublease income for the year ended December 31, 2018 because there was no cash allocated to Cyclerion and no lease directly attributed to Cyclerion prior to the Separation. Liquidity and Capital Resources Prior to the Separation, the primary source of liquidity for our business was cash flow allocated to Cyclerion from Ironwood. Transfers of cash to and from Ironwood have been reflected in net parent investment in the historical combined balance sheets, statements of cash flows and statements of changes in stockholders’ equity (deficit). Ironwood’s cash has not been assigned to us for any of the periods prior to the Separation presented in the consolidated and combined financial statements because those cash balances are not directly attributable to us. Post Separation, transfers of cash to and from Ironwood related to the Transition Service Agreements, Development Agreement and provisions of the Separation Agreement, have been reflected in the consolidated and combined statement of cash flows. After giving effect to the completion of the Separation on April 1, 2019, we raised approximately $165 million net of direct financing expenses with the closing of the private placement on April 2, 2019. Subsequent to the Separation, we no longer participate in Ironwood’s centralized cash management or receive direct funding from Ironwood. On December 31, 2019, we had approximately $94.9 million of unrestricted cash and cash equivalents. Our cash equivalents include amounts held in U.S. government money market funds. We invest cash in excess of immediate requirements in accordance with our investment policy, which requires all investments held by us to be at least “AAA” rated or equivalent, with a remaining final maturity when purchased of less than twelve months, so as to primarily achieve liquidity and capital preservation. Our ability to fund our operations and capital needs will depend on our ongoing ability to generate cash from operations and access to capital markets and other sources of capital, as further described below. We anticipate that our principal uses of cash in the future will be primarily to fund our operations, working capital needs, capital expenditures and other general corporate purposes. Going Concern Based on our development plans and clinical stage patient testing and our timing expectations related to the progress of our discovery research programs, we expect that our existing cash and cash equivalents as of December 31, 2019, will be sufficient to fund our planned operating expenses and capital expenditure requirements through at least the first quarter of 2021. We have based this estimate on assumptions that may prove to be wrong, particularly as the process of testing drug candidates in clinical trials is costly and the timing of progress in these trials is uncertain. Cash Flows The following is a summary of cash flows for the years ended December 31, 2019 and 2018: Cash Flows from Operating Activities Net cash used in operating activities totaled approximately $102.2 million for the year ended December 31, 2019. The primary uses of cash were our net loss of $123.0 million, changes in assets of approximately $0.1 million and changes in liabilities of approximately $2.2 million. The changes in assets resulted primarily from increases in related party accounts receivable of approximately $1.5 million, prepaid expenses of approximately $1.1 million, and other assets of approximately $0.6 million, partially offset by a decrease in the operating lease right of use asset of approximately $3.1 million. The changes in liabilities resulted primarily from decreases in accrued research and development costs of approximately $3.1 million, accrued expenses of approximately $1.6 million and accounts payable of approximately $0.3 million, partially offset by increases in operating lease liabilities of approximately $2.7 million and related party accounts payable of approximately $0.1 million. These uses of cash were partially offset by non-cash items including share-based compensation of approximately $19.6 million, depreciation and amortization expense of approximately $2.7 million, and loss on disposal of property and equipment of approximately $0.8 million. Net cash used in operating activities totaled approximately $97.5 million for the year ended December 31, 2018. The primary uses of cash were our net loss of $115.3 million and changes in other current assets of less than $0.1 million. These uses of cash were partially offset by non-cash items of approximately $14.0 million, including approximately $12.5 million in share-based compensation expense and approximately $1.5 million in depreciation and amortization expense of property and equipment, changes in assets of $0.4 million resulting primarily from decreases in prepaid expenses and other assets of approximately $0.4 million and $0.1 million, respectively, and changes in liabilities of approximately $3.3 million resulting primarily from increases in accounts payable, accrued research and development costs, and accrued expenses and other current liabilities of approximately $1.0 million, $0.3 million and $2.0 million, respectively. Cash Flows from Investing Activities Cash used in investing activities for the year ended December 31, 2019 totaled approximately $6.7 million, resulting from purchases of property and equipment, primarily leasehold improvements, of approximately $6.9 million, partially offset by proceeds from the sale of property and equipment of approximately $0.2 million. Cash used in investing activities for the year ended December 31, 2018 totaled approximately $3.4 million, resulting from the purchase of property and equipment, primarily laboratory equipment. Cash Flows from Financing Activities Cash provided by financing activities for the year ended December 31, 2019 was approximately $211.6 million, primarily as a result of approximately $164.6 million in net proceeds from the private placement, approximately $46.5 million of cash transferred to us from Ironwood prior to Separation when Ironwood managed our cash and financing arrangements, and approximately $0.5 million from proceeds from the exercises of stock options and the employee stock purchase plan. Cash provided by financing activities for the year ended December 31, 2018 was approximately $100.9 million, resulting from the cash transferred to us from Ironwood based on changes in our cash used for operations. Funding Requirements We expect our expenses to increase as we advance the preclinical activities and clinical trials of our product candidates. In addition, as a result of the Separation, we expect to continue incur additional costs associated with operating as a public company. Our expenses will also increase as we: · continue advancing our product candidates into preclinical and clinical development; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · may potentially hire additional clinical, quality control and scientific personnel; · enhance our operational, financial and management systems and · maintain, expand and protect our intellectual property portfolio. We believe that our existing cash, cash equivalents and restricted cash as of December 31, 2019 will enable us to fund our operating expenses and capital expenditure requirements through at least the first quarter of 2021. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. Because of the many 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 or decrease significantly as a result of, many factors, including the: · scope, progress, results and costs of researching and developing our product candidates, and conducting preclinical studies and clinical trials; · costs, timing and outcome of regulatory review of our product candidates; · costs of future activities, including medical affairs, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; · cost and timing of necessary actions to support our strategic objectives; · costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; and · timing, receipt and amount of sales of, or milestone payments related to or royalties on, our current or future product candidates, if any. A change in any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing of the development of that product candidate. Further, our operating plans may change in the future, and we may need additional funds to meet operational needs and capital requirements associated with such operating plans. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances or licensing arrangements with third parties. As discussed under the “Risk Factors” in Item 1A of this Annual Report on Form 10-K, to preserve the tax-free treatment of the Separation, we may be barred, in certain circumstances, for a two year period following the Separation, from engaging in certain capital raising transactions. 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 shareholder. Debt financing and preferred equity financing, if available, may involve agreements that include restrictive covenants that limit our ability to take specified actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, debt financing would result in increased fixed payment obligations. If we raise funds through collaborations, strategic 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 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 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 Commitments and Obligations Tax-related Obligations We exclude assets, liabilities or obligations pertaining to uncertain tax positions from our summary of contractual commitments and obligations as we cannot make a reliable estimate of the period of cash settlement with the respective taxing authorities. As of December 31, 2019, we had no uncertain tax positions. Other Funding Commitments As of December 31, 2019, we had, and continue to have, several ongoing studies in various clinical trial stages. Our most significant clinical trial spending is with clinical research organizations, or CROs. The contracts with CROs generally are cancellable, with notice, at our option and do not have any significant cancellation penalties. Transition from Ironwood and Costs to Operate as an Independent Company Our consolidated and combined financial statements for the period prior to the Separation reflect our operating results and financial position as it was operated by Ironwood, rather than as an independent company. As a result of the Separation, we have incurred additional ongoing operating expenses to operate as an independent, publicly traded, company. These costs include the cost of various corporate headquarters functions, incremental information technology-related costs and incremental costs to operate stand-alone accounting, legal, human resources and other administrative functions. We also incur non-recurring expenses and non-recurring capital expenditures. As an independent company, our information technology operating costs may be higher than the costs allocated in the historical combined financial statements. In addition, we will incur non-recurring expenses and capital expenditures to establish independent information technology systems. We have entered into a Transition Services Agreement with Ironwood that will provide us with certain services and resources related to corporate functions for an initial term of up to two years from the date of the Separation (as applicable). This Transition Services Agreement will help us to operate our business independently prior to establishing stand-alone infrastructure. During the transition from Ironwood, we will incur non-recurring expenses to expand our infrastructure. It is not practicable to estimate the costs that would have been incurred in each of the periods presented in the historical financial statements for the functions described above. Actual costs that would have been incurred if we operated as a stand-alone company for the periods prior to the Separation would have depended on various factors, including organizational design, outsourcing and other strategic decisions related to corporate functions, information technology and back office infrastructure. Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K) or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in those types of relationships. We enter into guarantees in the ordinary course of business related to the guarantee of our own performance. New Accounting Pronouncements For a discussion of new accounting pronouncements see Note 2, Summary of Significant Accounting Policies, of the consolidated and combined financial statements appearing elsewhere in this Annual Report on Form 10-K.

<s>[INST] ForwardLooking Information The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated and combined financial statements and the notes to those financial statements appearing elsewhere in this Annual Report on Form 10K. This discussion contains forwardlooking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Special Note Regarding ForwardLooking Statements” and “Risk Factors” in Item 1A of this Annual Report on Form 10K, our actual results may differ materially from those anticipated in these forwardlooking statements. Overview We are a clinicalstage biopharmaceutical company harnessing the power of soluble guanylate cyclase, or sGC, pharmacology to discover, develop and commercialize breakthrough treatments for serious and orphan diseases. Our focus is enabling the full therapeutic potential of nextgeneration sGC stimulators. Our strategy rests on a solid scientific foundation that is enabled by our people and capabilities, external collaborations and a responsive capital allocation approach. We operate in one reportable business segmenthuman therapeutics. Separation from Ironwood Pharmaceuticals On April 1, 2019, Ironwood Pharmaceuticals Inc., or Ironwood, completed the separation of its sGC business, and certain other assets and liabilities, into us as a separate, independent publicly traded company by way of a prorata distribution of our common stock through a dividend distribution of one share of our common stock, with no par value per share, for every 10 shares of Ironwood common stock held by Ironwood stockholders as of the close of business on March 19, 2019, the record date for the distribution, which we refer to herein as the Separation. As a result of the Separation, we became an independent public company and commenced trading under the symbol “CYCN” on the Nasdaq Global Select Market on April 2, 2019. In connection with the Separation, on March 30, 2019, we entered into certain agreements with Ironwood to provide a framework for our relationship with Ironwood following the Separation, including, among others, a Separation Agreement, a Tax Matters Agreement, and an Employee Matters Agreement. In addition, in connection with the Separation, on April 1, 2019, we entered into a Development Agreement, an Ironwood Transition Services Agreement, a Cyclerion Transition Services Agreement and an Intellectual Property License Agreement with Ironwood. On April 2, 2019, we issued 11,817,165 shares of our common stock, or the Private Placement Shares, to accredited investors for gross proceeds of $175 million (net proceeds of approximately $165 million) pursuant to the Amended and Restated Common Stock Purchase Agreement. We received the funds associated with the sale of the Private Placement Shares on April 2, 2019. Our historical consolidated and combined financial statements for the periods prior to the Separation have been derived from Ironwood’s combined financial statements and accounting records and are presented in conformity with United States Generally Accepted Accounting Principles, or U.S. GAAP. Our consolidated and combined financial statements reflect our financial position, results of operations and cash flows of the business that were transferred to us in the Separation. The historical financial statements may not be indicative of our future performance and do not necessarily reflect what our results of operations, financial condition and cash flows would have been had we operated as a separate, publicly traded company for the periods presented prior to the Separation. The consolidated and combined financial statements prior to the Separation included herein do not reflect any changes that occurred in our financing or operations as a result of the Separation from Ironwood. Financial Overview Research and Development Expense. Research and development expenses are incurred in connection with the discovery and development of our product candidates. These expenses consist primarily of the following costs: compensation, benefits and other employeerelated expenses, research and development related facilities, thirdparty contracts relating to nonclinical study and clinical trial activities. All research and development expenses are charged to operations as [/INST] Negative. </s>

DOCUSIGN INC

2019-03-26

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 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, 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. Our fiscal year ends January 31. Executive Overview of Fiscal 2019 Results Overview DocuSign accelerates the process of doing business for companies and simplifies life for their customers and employees. We accomplish this by transforming the foundational element of business: the agreement. As the core part of our broader software suite for automating the agreement process, we offer the world’s #1 e-signature solution. Our software suite has achieved widespread adoption by businesses of all sizes by enabling them to digitally prepare, execute and act on agreements. We offer access to our eSignature platform on a subscription basis and price such subscriptions based on the functionality required by our customers and the quantity of Envelopes provisioned. Similar to how physical agreements were mailed for signature in paper envelopes historically, an Envelope is a digital container used to send one or more documents for signature or approval to one or more recipients. Our customers have the flexibility to put a large number of documents in an Envelope. For a number of use cases, multiple Envelopes are used over the course of the process. For example, in the purchase or sale of a home, multiple Envelopes are used over the course of the home-buying process. To drive customer reach and adoption, we also offer for free certain limited-time or feature-constrained versions of our platform. We generate substantially all our revenue from sales of subscriptions, which accounted for 95%, 93% and 91% of our revenue in the years ended January 31, 2019, 2018 and 2017. Our subscription fees include the use of our software suite and access to customer support. Subscriptions generally range from one to three years, and substantially all our multi-year customers pay in annual installments, one year in advance. We also generate revenue from professional and other non-subscription services, which consists primarily of fees associated with providing new customers deployment and integration services. Other revenue includes amounts derived from sales of on-premises solutions. Professional services and other revenue accounted for 5%, 7% and 9% of our revenue in the years ended January 31, 2019, 2018 and 2017. We anticipate continuing to invest in customer success through our professional services offerings as we believe it plays an important role in accelerating our customers’ deployment of our software suite, which helps to drive customer retention and expansion of the use of the DocuSign Agreement Cloud. We offer subscriptions to our software suite to enterprise businesses, commercial businesses and very small businesses, or VSBs, which include professionals, sole proprietorships and individuals. We sell to customers through multiple channels. Our go-to-market strategy relies on our direct sales force and partnerships to sell to enterprises and commercial businesses and our web-based self-service channel to sell to VSBs, which is the most cost-effective way to reach our smallest customers. We offer more than 300 off-the-shelf, prebuilt integrations with the applications that many of our customers already use-including those offered by Google, Microsoft, NetSuite, Oracle, Salesforce, SAP, SAP SuccessFactors and Workday-so that they can create, sign, send and manage agreements from directly within these applications. We have a diverse customer base spanning various industries and countries with no significant customer concentration. No single customer accounted for more than 3% of total revenue in each of the years ended January 31, 2019, 2018 and 2017. We focused initially on selling our e-signature solutions to commercial businesses and VSBs. We later expanded our focus to target enterprise customers by adding our first enterprise sales professionals in the year ended January 31, 2011. In the year ended January 31, 2013, we began to gain meaningful traction selling into new enterprise accounts with aggregate annual contract value, ACV, exceeding $5 million. To demonstrate this growth over time, the number of our customers with greater than $300,000 in ACV has increased from approximately 30 as of January 31, 2013 to 310 customers as of January 31, 2019. Each of our customer types have different purchasing patterns. VSBs tend to become customers quickly with very little to no direct interaction and generate smaller average contract values, while commercial and enterprise customers typically involve longer sales cycles, larger contract values and greater expansion opportunities for us. Financial Results for the Year Ended January 31, 2019 Cash, cash equivalents and investments were $933.2 million as of January 31, 2019. Convertible Senior Notes On September 18, 2018, we offered and issued $575.0 million aggregate principal amount of 0.5% Convertible Senior Notes due 2023, or the Notes, unless earlier converted or repurchased in accordance with their terms. We received net proceeds from the issuance of the Notes of approximately $560.8 million after deducting the initial purchasers’ discounts and transaction costs. Interest on the Notes is payable semiannually in arrears on March 15 and September 15 of each year, beginning on March 15, 2019. To mitigate potential dilution resulting from the issuance of the Notes, we entered into privately-negotiated capped call transactions, or Capped Calls, at the cost of $67.6 million. Follow-On Offering On September 18, 2018, we completed our follow-on offering, in which certain stockholders sold 8.1 million shares of common stock. The price per share to the public was $55.00. We did not receive any proceeds from the sale of shares by the selling stockholders. We incurred issuance costs of $1.3 million associated with the sale of such shares. Acquisition of SpringCM On September 4, 2018, we completed the acquisition of SpringCM, a leading cloud-based document generation and contract lifecycle management software company based in Chicago, Illinois. With the addition of SpringCM's capabilities in document generation, redlining, advanced document management and end-to-end agreement workflow, the deal further accelerates the broadening of our solution beyond e-signature to the rest of the agreement process-from preparing to signing, acting-on and managing agreements. Under the terms of the agreement, we acquired SpringCM for $218.8 million in cash. Initial Public Offering On May 1, 2018, we completed our IPO, in which we issued and sold 19.3 million shares of common stock at the price to the public of $29.00 for net proceeds to us of approximately $523.9 million, after underwriting discounts and commissions and offering expenses. Upon the completion of our IPO, all 100.2 million shares of our convertible preferred stock automatically converted into an aggregate of 100.4 million shares of our common stock; all our outstanding warrants to purchase shares of convertible preferred stock converted into 22,468 warrants to purchase shares of common stock, with the related warrant liability of $0.8 million reclassified into additional paid-in capital; and our amended and restated certificate of incorporation was filed and went in effect authorizing a total of 500.0 million shares of common stock and 10.0 million shares of preferred stock. Key Factors Affecting Our Performance We believe that our future performance will depend on many factors, including the following: Growing Our Customer Base We are highly focused on continuing to acquire new customers to support our long-term growth. We have invested, and expect to continue to invest, heavily in our sales and marketing efforts to drive customer acquisition. As of January 31, 2019, we had over 475,000 customers, including over 55,000 enterprise and commercial customers, as compared to over 370,000 customers and over 40,000 enterprise and commercial customers as of January 31, 2018. We define a customer as a separate and distinct buying entity, such as a company, an educational or government institution, or a distinct business unit of a large company that has an active contract to access our software suite. We define enterprise customers as companies generally included in the Global 2000. We generally define commercial customers to include both mid-market companies, which includes companies outside the Global 2000 that have greater than 250 employees, and small-to-medium-sized businesses, or SMBs, which are companies with between 10 and 249 employees, in each case excluding any enterprise customers. VSBs include companies with fewer than 10 employees. We refer to total customers as all enterprises, commercial businesses and VSBs. We believe that our ability to increase the number of customers on our software suite, particularly the number of enterprise and commercial customers, is an indicator of our market penetration, the growth of our business and our potential future business opportunities. Increasing awareness of our software suite, further developing our sales and marketing expertise and continuing to build features tuned to different industry needs have expanded the diversity of our customer base to include organizations of all sizes across nearly every industry. Retaining and Expanding Contracts with Existing Enterprise and Commercial Customers Many of our customers have increased spend with us as they have expanded their use of our offerings in both existing and new use cases across their front or back office operations. Our enterprise and commercial customers may start with just one-use case and gradually implement additional use cases across their organization once they see the benefits of our software suite. Several of our largest enterprise customers have deployed our software suite for hundreds of use cases across their organizations. We believe there is significant expansion opportunity with our customers following their initial adoption of our software suite. Increasing International Revenue Our international revenue represented 17% of our total revenue in each of the years ended January 31, 2019, 2018 and 2017. We started our international selling efforts in English-speaking common law countries, such as Canada, the United Kingdom and Australia, as we were able to leverage our core technologies in these jurisdictions since they have a similar approach to e-signature as the U.S. We have since made significant investments to be able to offer our solutions in select civil law countries. For example, in Europe, we have Standards-Based Signature technology tailored for eIDAS. In addition, to follow longstanding tradition in Japan, we enable signers to upload and apply their personal eHanko stamp to represent their signatures on an agreement. We plan to increase our international revenue by leveraging and continuing to expand the investments we have already made in our technology, direct sales force and strategic partnerships, as well as helping existing U.S.-based customers manage agreements across their international businesses. Additionally, we expect our strategic partnerships in key international markets, including our current relationships with SAP in Europe, to further grow. Investing for Growth We believe that our market opportunity is large, and we plan to invest to continue to support further growth. This includes expanding our sales headcount and increasing our marketing initiatives. We also plan to continue to invest in expanding the functionality of our software suite and underlying infrastructure and technology to meet the needs of our customers across industries. Components of Results of Operations Revenue We derive revenue primarily from subscriptions and, to a lesser extent, professional services. Subscription Revenue. Subscription revenue consists of fees for the use of our software suite and our technical infrastructure and access to customer support, which includes phone or email support. We typically invoice customers in advance on an annual basis. We recognized subscription revenue ratably over the term of the contract subscription period beginning on the date access to our software suite is provided, as long as all other revenue recognition criteria have been met. Professional Services and Other Revenue. Professional services revenue includes fees associated with new customers requesting deployment and integration services. We price professional services on a time and materials basis and on a fixed fee basis. We generally have standalone value for our professional services and recognize revenue based on standalone selling price as services are performed or upon completion of services for fixed fee contracts. Other revenue includes amounts derived from sales of on-premises solutions. Overhead Allocation We allocate shared costs, such as facilities (including rent, utilities and depreciation on equipment shared by all departments), information technology, information security costs and recruiting to all departments based on headcount. As such, allocated shared costs are reflected in each cost of revenue and operating expense category. Cost of Revenue Cost of Subscription Revenue. Cost of subscription revenue primarily consists of expenses related to hosting our software suite and providing support. These expenses consist of employee-related costs, including salaries, bonuses, benefits, stock-based compensation and other related costs, as well as personnel costs for employees associated with our technical infrastructure and customer support. These expenses also consist of software and maintenance costs, third-party hosting fees, outside services associated with the delivery of our subscription services, amortization expense associated with capitalized internal-use software and acquired intangible assets, credit card processing fees and allocated overhead. We expect our cost of revenue to continue to increase in absolute dollar amounts as we invest in our business. Cost of Professional Services and Other Revenue. Cost of professional services and other revenue consists primarily of personnel costs for our professional services delivery team, travel related costs and allocated overhead. Gross Profit and Gross Margin Gross profit is total revenue less total cost of revenue. Gross margin is gross profit expressed as a percentage of total revenue. We expect that gross profit and gross margin will continue to be affected by various factors including our pricing, timing and amount of investment to maintain or expand our hosting capability, the growth of our software suite support and professional services team, stock-based compensation expenses, amortization of costs associated with capitalized internal use software and acquired intangible assets and allocated overhead. Operating Expenses Our operating expenses consist of selling and marketing, research and development and general and administrative expenses. Selling and Marketing Expense. Selling and marketing expense consists primarily of personnel costs, including sales commissions. These expenses also include expenditures related to advertising, marketing, promotional events and brand awareness activities, as well as allocated overhead. We expect selling and marketing expense to continue to increase in absolute dollars as we enhance our product offerings and implement marketing strategies. Research and Development Expense. Research and development expense consists primarily of personnel costs. These expenses also include non-personnel costs, such as subcontracting, consulting and professional fees for third-party development resources and depreciation costs, as well as allocated overhead. Our research and development efforts focus on maintaining and enhancing existing functionality and adding new functionality. We expect research and development expense to increase in absolute dollars as we invest in the enhancement of our software suite. General and Administrative Expense. General and administrative expense consists primarily of employee-related costs for those employees associated with administrative services such as legal, human resources, information technology related to internal systems, accounting and finance. These expenses also include certain third-party consulting services, certain facilities costs and allocated overhead. We expect general and administrative expense to increase in absolute dollars to support the overall growth of our operations. Interest Expense After issuance of our Notes in September 2018, interest expense consists primarily of contractual interest expense, amortization of discount and amortization of debt issuance costs on our Notes. Prior to the issuance of the Notes, interest expense consisted primarily of commitment fees and amortization of costs related to our loan facility. Interest income and other income, net Interest income and other income, net, consists primarily of interest earned on our cash, cash equivalents and investments, as well as foreign currency transaction gains and losses. Provision for (Benefit from) Income Taxes Our provision for (benefit from) income taxes consists primarily of income taxes in certain foreign jurisdictions where we conduct business and state minimum taxes in the U.S., as well as certain tax benefits arising from acquisitions. We have a valuation allowance against our U.S. deferred tax assets, including U.S. net operating loss carryforwards. We expect to maintain this valuation allowance until it becomes more likely than not that the benefit of our U.S. deferred tax assets will be realized by way of expected future taxable income in the U.S. Discussion of 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: The following discussion and analysis are for the year ended January 31, 2019, compared to the same period in 2018 and the year ended January 31, 2018, compared to the same period in 2017, unless otherwise stated. Revenue Subscription Revenue Subscription revenue increased $179.1 million, or 37%, in the year ended January 31, 2019, and $136.0 million, or 39%, in the year ended January 31, 2018. Subscription revenue was 95%, 93% and 91% of total revenue in the years ended January 31, 2019, 2018 and 2017. The increases in both periods were primarily attributable to increases in subscription sales to new and existing customers. The increase in the year ended January 31, 2019 also reflects the addition of SpringCM. We continue to invest in a variety of customer programs and initiatives, which, along with expanded customer use cases, have helped increase our subscription revenue over time. We expect subscription revenue to continue to increase as we offer new functionality, attract new customers and integrate SpringCM's capabilities into our offerings. Professional Services and Other Revenue Professional services and other revenue increased by $3.4 million, or 10%, in the year ended January 31, 2019, and by $1.0 million, or 3%, in the year ended January 31, 2018 primarily due to increased engagement of professional services to support our growing customer base. Cost of Revenue and Gross Margin Cost of Subscription Revenue Cost of subscription revenue increased $33.9 million, or 40% in the year ended January 31, 2019, primarily due to: ▪ An increase of $15.3 million in stock-based compensation expense primarily driven by the expense related to RSUs with a performance condition satisfied on the effectiveness of our IPO Registration Statement, for which no expense was recorded in the same prior year period, and the expense on RSUs granted with a service-based condition only; ▪ An increase of $9.7 million in data center and other related operating costs to support our software suite and the impact of the acquisition of SpringCM; ▪ An increase of $5.3 million in personnel costs primarily driven by increases in headcount, the addition of SpringCM employees and the employer portion of payroll taxes related to RSU settlements with no such expense in the prior year; and ▪ An increase of $2.5 million in allocated overhead primarily driven by higher allocated facility and IT expenses. Cost of subscription revenue increased $10.5 million, or 14% in the year ended January 31, 2018, primarily due to: ▪ An increase of $7.6 million in data center and other related operating costs to support our software suite; and ▪ An increase of $2.0 million in personnel costs related to the hiring of employees to support customer service. Cost of Professional Services and Other Revenue Cost of professional service and other revenue increased $40.2 million, or 117%, in the year ended January 31, 2019, primarily due to: ▪ An increase of $24.9 million in stock-based compensation primarily driven by the expense related to RSUs with a performance condition satisfied on the effectiveness of our IPO Registration Statement, for which no expense was recorded in the same prior year period, and the expense on RSUs granted with a service-based condition only; ▪ An increase of $11.7 million in personnel costs primarily related to increased headcount in our professional services organization and the addition of SpringCM employees, as well as the employer portion of payroll taxes related to RSU settlements with no such expense in the prior year; ▪ An increase of $1.5 million in allocated overhead primarily driven by higher facility expenses; and ▪ An increase of $0.8 million in travel costs due to increased headcount. Cost of professional service and other revenue increased $5.3 million, or 18%, in the year ended January 31, 2018, primarily due to $5.0 million increase in personnel costs driven by increased headcount in our professional services organization. Sales and Marketing Sales and marketing expenses increased $261.7 million, or 94%, in the year ended January 31, 2019, primarily due to: ▪ An increase of $162.7 million in stock-based compensation expense primarily driven by the expense related to RSUs with a performance condition satisfied on the effectiveness of our IPO Registration Statement, for which no expense was recorded in the same prior year period, and the expense on RSUs granted with a service-based condition only; ▪ An increase of $58.3 million in personnel costs driven by increased headcount, the addition of SpringCM employees, the employer portion of payroll taxes related to RSU settlements with no such expense in the prior year, and higher commissions in line with higher sales; ▪ An increase of $14.5 million in marketing and advertising expense, primarily due to higher spend for online advertising campaigns; ▪ An increase of $10.4 million in allocated overhead due to increase in headcount and higher allocated IT and facility costs; ▪ An increase of $4.9 million in travel costs to support the increase in the personnel; ▪ An increase of $4.3 million in other expenses primarily due to higher spend on employee-related costs; ▪ An increase of $4.3 million in depreciation and amortization due to the amortization of the intangible assets acquired in the SpringCM acquisition on September 4, 2018; and ▪ An increase of $1.8 million in software and equipment due to increase sales tool licenses. Sales and marketing expenses increased $37.1 million, or 15%, in the year ended January 31, 2018, primarily due to: ▪ An increase of $29.1 million in personnel costs driven by increased headcount and higher commissions in line with higher sales; ▪ An increase of $2.3 million in travel costs to support the increase in the personnel; ▪ An increase of $3.3 million increase in allocated overhead due to increased headcount and facility costs; and ▪ An increase of $1.5 million in consulting fees for market and other research activities. Research and Development Research and development expenses increased $93.5 million, or 101%, in the year ended January 31, 2019, primarily due to: ▪ An increase of $69.2 million in stock-based compensation expense, primarily driven by the expense related to RSUs with a performance condition satisfied on the effectiveness of our IPO Registration Statement, for which no expense was recorded in the same prior year period, and the expense on RSUs granted with a service-based condition only; ▪ An increase of $14.0 million in personnel costs due to higher headcount, the addition of SpringCM employees and the employer portion of payroll taxes related to RSU settlements with no such expense in the prior year; ▪ An increase of $4.6 million in allocated overhead due to increased allocated IT and facility costs; ▪ An increase of $1.7 million in other expenses primarily due to higher employee costs; ▪ An increase of $1.6 million in professional fees due to higher consulting spend; and ▪ An increase of $0.9 million in travel costs to support the increase in the personnel. Research and development expenses increased $2.8 million, or 3%, in the year ended January 31, 2018. The increase of $8.9 million in personnel costs to support development efforts was partially offset by a $5.3 million decrease in stock-based compensation. In the year ended January 31, 2017, we incurred additional modification expense for certain employees whose employment ceased with no such expense in the year ended January 31, 2018. The remainder of the decrease in stock-based compensation expense is driven by the impact of options that were canceled or fully vested in the year ended January 31, 2017 with no options granted to research and development employees in the year ended January 31, 2018. General and Administrative General and administrative expenses increased $127.8 million, or 157%, in the year ended January 31, 2019, primarily due to: ▪ An increase of $109.1 million in stock-based compensation expense, primarily driven by the expense related to RSUs with a performance condition satisfied on the effectiveness of our IPO Registration Statement, for which no expense was recorded in the same prior year period, and the expense on RSUs granted with a service-based condition only; ▪ An increase of $10.0 million in professional fees, primarily driven by costs related to our IPO, secondary offering and preparation for operating as a public company, as well as higher audit and consulting costs; and ▪ An increase of $9.7 million in personnel costs primarily due to increased headcount and the employer portion of payroll taxes related to RSU settlements with no such expense in the prior year. General and administrative expenses increased $17.2 million, or 27%, in the year ended January 31, 2018, primarily due to: ▪ An increase of $5.1 million increase in personnel cost and of $2.6 million in allocated overhead in line with the increase in headcount; ▪ An increase of $5.0 million in business taxes in connection with growth of the business, assessments completed in certain jurisdictions and a foreign transfer tax; and ▪ An increase of $2.2 million in stock-based compensation expense driven by a significant grant made at the end of fiscal 2017. Interest expense Interest expense increased by $10.2 million in the year ended January 31, 2019, due to interest expense and amortization of discount and transaction costs on our Notes issued in September 2018. Interest expense remained relatively consistent in the year ended January 31, 2018. Interest Income and Other Income, Net In the year ended January 31, 2019, interest income and other income, net, increased by $5.8 million primarily due to an $11.5 million increase in interest income on higher cash and cash equivalent balances during the period and on investments in marketable securities that commenced in the last quarter of fiscal 2019. This was partially offset by foreign currency losses of $3.4 million compared to foreign currency gains of $2.2 million in the prior year, a change of $5.6 million, driven by the impact of the strengthening of the U.S. dollar on transactions denominated in foreign currency. In the year ended January 31, 2018, interest income and other income, net, increased by $1.8 million, primarily due to foreign currency transaction gains driven by remeasurement of certain monetary transactions. Provision for (Benefit from) Income Taxes We had a tax benefit of $1.8 million in the year ended January 31, 2019, compared to a provision for income taxes of $3.1 million in the year ended January 31, 2018. The change was primarily driven by a tax benefit of $7.1 million upon the release of a portion of our deferred tax valuation allowance in connection with the SpringCM acquisition. This tax benefit was partially offset by an increase in foreign tax expense, resulting from higher year-over-year earnings in certain foreign jurisdictions as we continue to scale our foreign operations to support our ongoing international growth. Tax expense in the year ended January 31, 2018, increased by $2.8 million. This increase was due to an increase in foreign tax expense, resulting from transfers of intellectual property and higher year-over-year earnings in certain foreign jurisdictions as we continue to scale our international operations to support our ongoing international growth. Quarterly Results of Operations The following table sets forth our unaudited quarterly consolidated results of operations for each of the quarters indicated. 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 reflects all normal recurring adjustments necessary for the fair statement of results of operations for these periods. This information should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. The results of historical periods are not necessarily indicative of the results in any future period and the results of a particular quarter or other interim period are not necessarily indicative of the results for a full year. Quarterly Consolidated Statements of Operations (1) Three months ended April 30, 2018, includes $262.8 million of stock-based compensation expense related to RSUs, for which the performance-based condition was satisfied on April 26, 2018, the effective date of our IPO Registration Statement. Percentage of Revenue Data Liquidity and Capital Resources Our principal sources of liquidity were cash and cash equivalents, investments and cash generated from operations. As of January 31, 2019, we had $769.0 million in cash and cash equivalents and short-term investments. We also had $164.2 million in long-term investments that provide additional capital resources. In May 2018, we received net proceeds of $523.9 million upon the completion of our IPO. In September 2018, we received net proceeds from the issuance of the Notes of approximately $560.8 million after deducting the initial purchasers’ discounts and transaction costs. 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. While we generated positive cash flows from operations of $76.1 million in the year ended January 31, 2019, we have generated losses from operations in the past as reflected in our accumulated deficit of $928.8 million as of January 31, 2019. We expect to continue to incur operating losses for the foreseeable future due to the investments we intend to make, and, as a result, we may require additional capital resources to execute strategic initiatives to grow our business. We typically invoice our customers annually in advance. Therefore, a substantial source of our cash is from such invoices, which are included on our consolidated balance sheets as accounts receivable until collection and contract liabilities. Our accounts receivable increased by $42.6 million, excluding accounts receivable acquired from SpringCM, compared to an increase of $28.1 million in the year ended January 31, 2018, which resulted in a $14.5 million decrease in cash provided by operating activities. Accordingly, collections from our customers have a material impact on our cash flows from operating activities. Contract liabilities consists of the unearned portion of billed fees for our subscriptions, which is subsequently recognized as revenue in accordance with our revenue recognition policy. As of January 31, 2019, we had contract liabilities of $388.8 million, including contract liabilities acquired from SpringCM, compared to $277.9 million as of January 31, 2018. The increase in contract liabilities resulted in net cash provided by operating activities of $100.9 million. Therefore, our growth in billings to existing and new customers has a material net beneficial impact on our cash flows from operating activities, after consideration of the impact on our accounts receivable. Our future capital requirements will depend on many factors including our growth rate, customer retention and expansion, the timing and extent of spending to support our efforts to develop our software suite, the expansion of sales and marketing activities and the continuing market acceptance of our software suite. We may in the future enter into arrangements to acquire or invest in complementary businesses, technologies and intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. On September 4, 2018, we acquired SpringCM for $218.8 million in cash. The acquisition was funded with cash on hand. In the fourth quarter of fiscal 2019, we settled 12.6 million RSUs for which the service-based condition was satisfied on or prior to December 14, 2018 and 0.8 million PSUs for which the performance condition was satisfied in January 2019. In connection with these settlements, we withheld 5.3 million shares and remitted tax liabilities of $215.3 million on behalf of the RSUs holders to the relevant tax authorities in cash. We also used $14.4 million to pay the employer portion of payroll taxes on all RSUs and PSUs settled during the fourth quarter with no such expenditure in the prior period. Credit Facility In May 2015, we signed a Senior Secured Credit Agreement with Silicon Valley Bank, or the Credit Agreement, and a syndicate of other banks. The Credit Agreement extended a revolving loan facility of up to $80.0 million with a letter of credit sub-facility up to $15.0 million (as a sublimit of the revolving loan facility) and a swingline sub-facility up to $5.0 million (as a sublimit of the revolving loan facility). Our obligations under the Credit Agreement were secured by substantially all our assets. The facility required us to comply with certain financial and non-financial covenants. The facility was subject to customary fees for loan facilities of this type, including ongoing commitment fees at a rate between 0.3% and 0.3375% per annum on the daily undrawn balance. The facility expired in May 2018. Cash Flows The following table summarizes our cash flows for the periods indicated: Cash Flows from Operating Activities 2019 Compared to 2018. Cash provided by operating activities increased by $21.1 million in the year ended January 31, 2019. This change was primarily due to an increase of $407.4 million in non-cash expenses, partially offset by a $374.2 million increase in net loss. The increase in non-cash expenses was driven by a $381.2 million increase in stock-based compensation expense primarily driven by the expense related to RSUs with a performance condition satisfied on the effectiveness of our IPO Registration Statement, for which no expense was recorded in the same prior year period, and the expense on RSUs granted with a service-based condition only. Net cash provided by operating assets and liabilities decreased by $12.1 million. Additions to deferred contract acquisition and fulfillment increased by $27.9 million and cash used from changes in accounts receivable increased by $14.5 million in line with higher sales. Cash used from changes in accounts payable also increased by $10.2 million driven by the timing of payments. These were partially offset by increases in cash provided from changes in accrued compensation of $16.9 million due to higher sales, addition of SpringCM, business growth and timing of payroll. Changes in contract liabilities and contract assets provided $13.1 million and $11.1 million in line with higher billings. 2018 Compared to 2017. We had positive cash flows from operating activities of $55.0 million in the year ended January 31, 2018 as compared to negative cash flows of $4.8 million in the year ended January 31, 2017, an increase of $59.8 million. This change was primarily driven by a $63.1 million decrease in net loss, partially offset by a $6.1 million decrease in cash from changes in operating assets and liabilities. There were several significant positive and negative movements from changes in operating assets and liabilities over the period. Net cash from the change in deferred rent decreased by $15.1 million. We did not have any significant new leases in the year ended January 31, 2018, while the year ended January 31, 2017 reflects the buildup in the deferred rent balance related to several new Seattle leases we entered into at the end of fiscal 2016. Net cash from the change in deferred contract acquisition costs decreased by $14.6 million in line with growth in sales. Net cash from changes in contract liabilities and accounts receivable increased by $16.7 million as our business continued to grow. Net cash from changes in other liabilities increased by $7.4 million primarily due to delayed consideration related to our acquisition of Algorithmic Research Ltd. and foreign income tax provision. Cash Flows from Investing Activities 2019 Compared to 2018. Cash used in investing activities increased by $645.6 million in the year ended January 31, 2019. We used $415.1 million to purchase investments and $218.8 million to acquire SpringCM during the year ended January 31, 2019. The remainder of the increase in cash used in investing activities related to $11.5 million increase in spend on purchases of property and equipment, in particular due to additional investments for our data centers and servers to support growth and leasehold improvements for our new office spaces. 2018 Compared to 2017. Cash used in investing activities decreased by $22.1 million in the year ended January 31, 2018 as compared to the prior year. Our cash outflows were primarily driven by purchases of property and equipment, which decreased by $24.4 million as compared to the prior year. During the year ended January 31, 2017, we made significant investments in leasehold improvements and furniture for our new Seattle leases with no similar spend during the year ended January 31, 2018. Cash Flows from Financing Activities 2019 Compared to 2018. Cash provided by financing activities increased by $827.4 million in the year ended January 31, 2019 as compared to the same prior year period. We received proceeds, net of transaction costs, of $560.8 million from the Notes issuance and proceeds, net of underwriting discounts and commissions and $529.3 million from the issuance of common stock in our IPO during the year ended January 31, 2019. We used $215.3 million to remit tax withholding obligations on RSUs settled during the fourth quarter of fiscal 2019 and $67.6 million to purchase capped calls in connection with the Notes issuance and $4.0 million for deferred offering costs related to our IPO. Proceeds from exercise of stock options increased by $23.8 million during the period compared to the prior year period. 2018 Compared to 2017. Cash provided by financing activities increased by $17.7 million in the year ended January 31, 2018 as compared to the prior year. Proceeds from exercises of stock options contributed an additional $18.3 million compared to the prior year as more of our employees exercised their stock options. Contractual Obligations and Commitments The following table represents our future non-cancelable contractual obligations as of January 31, 2019, aggregated by type: Our principal contractual obligations and commitments consist of obligations under the Notes (including principal and coupon interest), operating leases, as well as noncancelable contractual commitments that primarily relate to cloud infrastructure support and sales and marketing activities. Refer to Note 10 and Note 11 of the accompanying notes to our consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for more information on the Notes and for all other commitments. As of January 31, 2019, we had unused letters of credit outstanding associated with our various operating leases totaling $9.8 million. 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. Critical Accounting Policies and Estimates We prepare our financial statements in accordance with GAAP. Preparing 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. The critical accounting estimates, assumptions and judgments that we believe to have the most significant impact on our consolidated financial statements are revenue recognition, deferred contract acquisition costs, stock-based compensation, business combinations and valuation of goodwill and other acquired intangible assets and income taxes. Revenue Recognition We recognize revenue from contracts with customers using the five-step method described in Note 2 in our consolidated financial statements. 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 combine contracts entered into at or near the same time with the same customer if we determine that the contracts are negotiated as a package with a single commercial objective; the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or the services promised in the contracts are a single performance obligation. Our performance obligations consist of (i) subscription services, (ii) professional and other services, (iii) on-premises solutions and (iv) maintenance and support for our on-premises solutions. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on their relative standalone selling price. We determine standalone selling price, or SSP, for all our performance obligations using observable inputs, such as standalone sales and historical contract pricing. SSP is consistent with our overall pricing objectives, taking into consideration the type of subscription services and professional and other services. SSP also reflects the amount we would charge for that performance obligation if it were sold separately in a standalone sale and the price we would sell to similar customers in similar circumstances. In general, we satisfy the majority of our performance obligations over time as we transfer the promised services to our customers. For some of our services, such as delivery of on-premises solutions, we satisfy our performance obligations at a point in time. We review the contract terms and conditions to evaluate the timing and amount of revenue recognition; the related contract balances; and our remaining performance obligations. These evaluations require judgment that could affect the timing and amount of revenue recognized. Deferred Contract Acquisition Costs To determine the period of benefit of our deferred contract acquisition costs, we evaluate the type of costs incurred, the nature of the related benefit, and the specific facts and circumstances of our arrangements. We determine the period of benefit for commissions paid for the acquisition of the initial subscription contract by taking into consideration our initial estimated customer life and the technological life of our software suite and related significant features. We determine the period of benefit for commissions on renewal subscription contracts by considering the average contractual term for renewal contracts. We evaluate these assumptions on a quarterly basis and periodically review whether events or changes in circumstances have occurred that could impact the period of benefit. Stock-based Compensation Compensation cost for stock-based awards issued to employees, including stock options and RSUs, is measured at fair value on the date of grant and recognized over the service period. The fair value of stock options is estimated on the date of grant using a Black-Scholes model. The fair value of RSUs is estimated on the date of grant based on the fair value of our underlying common stock. Prior to our IPO, the fair value of our common stock for financial reporting purposes was determined considering objective and subjective factors and required judgment to determine the fair value of common stock for financial reporting purposes as of the date of each equity grant or modification. Substantially all RSUs that we issued through January 31, 2018, vest upon the satisfaction of both service-based and performance-based vesting conditions. The service-based condition is typically satisfied over a four-year service period. The performance-based condition related to these awards was satisfied on the effectiveness of our IPO Registration Statement, which occurred on April 26, 2018. Upon the effectiveness of our IPO Registration Statement, we recognized $262.8 million in stock-based compensation expense related to RSUs, for which the service-based condition was satisfied as of such date. The majority of RSUs granted after January 31, 2018 vest on the satisfaction of service-based condition only. From time-to-time, we grant RSUs that also include performance-based or market-based conditions. For RSUs granted with a performance condition, we recognize expense on a graded-vesting basis over the vesting period, after assessing the probability of achieving requisite performance criteria. For RSUs granted with a market condition, we use a lattice model simulation analysis which captures the impact of the vesting conditions to value the performance stock units and recognize the expense on a straight-line basis. We account for equity instruments issued to non-employees at fair value of the consideration received or fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date on which it is probable that performance will occur. We calculate the fair value of options and purchase rights granted under the Employee Stock Purchase Plan, or ESPP, based on the Black-Scholes option-pricing model. The Black-Scholes model requires the use of various assumptions including expected term and expected stock price volatility. We estimate the expected term for stock options using the simplified method due to the lack of historical exercise activity. The simplified method calculates the expected term as the midpoint between the vesting date and the contractual expiration date of the award. Almost all of our options have a contractual term of ten years. The expected term for the ESPP purchase rights is estimated using the offering period, which is typically six months. We estimate volatility for options and ESPP purchase rights using volatilities of a group of public companies in a similar industry, stage of life cycle, and size. The interest rate is derived from government bonds with a similar term to the option or ESPP purchase right granted. We have not declared, nor do we expect to declare dividends. Therefore, there is no dividend impact on the valuation of options or ESPP purchase rights. We use the straight-line method for employee expense attribution for stock options and ESPP purchase rights. Compensation expense is recognized net of forfeitures that are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates. Business Combinations and Valuation of Goodwill and Other Acquired Intangible Assets We estimate the fair value of assets acquired and liabilities assumed in a business combination. At the acquisition date, we measure goodwill as the excess of consideration transferred over the net of the acquisition date fair values of the tangible and intangible assets acquired and the liabilities assumed. Business combination accounting requires us to make assumptions and apply judgment. Key assumptions include, but are not limited to: • future cash flows from our revenue streams; • the acquired company's existing customer relationships; • royalty rates; and • discount rates. These estimates and assumptions are subjective. Our ability to realize the future cash flows used in our fair value calculations may be affected by changes in our financial condition, our financial performance or business strategies. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. During the measurement period of up to one year from the acquisition date, based on new information obtained that relates to facts and circumstances that existed as of the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. We record adjustments identified, if any, subsequent to the end of the measurement period in our consolidated statements of operations. Goodwill, Intangible Assets and Other Long-Lived Assets-Impairment Assessments Our test for goodwill impairment starts with a qualitative assessment to determine whether it is necessary to perform the 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 purposes of impairment testing, we have determined that we have one operating segment and one reporting unit. No impairment has been noted to date. We periodically review the carrying amounts of intangible assets and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. We measure the recoverability of these assets by comparing the carrying amount of such assets (or asset group) to the future undiscounted cash flow we expect the assets (or asset group) to generate. 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. Each period we evaluate the estimated remaining useful lives of intangible assets and other long-lived assets to assess whether a revision to the remaining periods of amortization is required. Assumptions and estimates about remaining useful lives of our intangible and other long-lived assets are subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends and internal factors such as changes in our business strategy. Although we believe the historical assumptions and estimates we have made are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. We have not recognized any intangible asset impairment charges to date. Income Taxes We are subject to income taxes in the U.S. (federal and state) and numerous foreign jurisdictions. Tax laws, regulations, administrative practices, principles, and interpretations in various jurisdictions may be subject to significant change, with or without notice, due to economic, political, and other conditions, and significant judgment is required in evaluating and estimating our provision and accruals for these taxes. Our effective tax rates could be affected by numerous factors, such as changes in our business operations, acquisitions, investments, entry into new businesses and geographies, intercompany transactions, the relative amount of our foreign earnings, including earnings being lower than anticipated in jurisdictions where we have lower statutory rates and higher than anticipated in jurisdictions where we have higher statutory rates, losses incurred in jurisdictions for which we are not able to realize related tax benefits, the applicability of special tax regimes, changes in foreign currency exchange rates, changes in our stock price, changes in our deferred tax assets and liabilities and their valuation, changes in the laws, regulations, administrative practices, principles, and interpretations related to tax, including changes to the global tax framework, competition, and other laws and accounting rules in various jurisdictions. In addition, a number of countries are actively pursuing changes to their tax laws applicable to corporate multinationals, such as the Tax Act. Finally, foreign governments may enact tax laws in response to the Tax Act that could result in further changes to global taxation and materially affect our financial position and results of operations. We recognize tax benefits from uncertain tax positions only if we believe that 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. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items, as a result, we may record unrecognized tax benefits in the future. At that time, we would make adjustments to these potential future reserves 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 would be different to the amounts we may potentially record in the future, 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 financial condition and operating results. The provision for income taxes would include the effects of any future accruals that we believe are appropriate to record, as well as the related net interest and penalties. We record a provision for income taxes for the anticipated tax consequences of the reported results of operations using the asset and liability method. Under this method, we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rate 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. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. The Tax Act significantly changed how the U.S. taxes corporations. The Tax Act requires complex computations to be performed that were not previously required by U.S. tax law, significant judgments to be made in interpretation of the provisions of the Tax Act, significant estimates in calculations, and the preparation and analysis of information not previously relevant or regularly produced. The U.S. Treasury Department, the IRS, and other standard-setting bodies will continue to interpret or issue guidance on how provisions of the Tax Act will be applied or otherwise administered. As future guidance is issued, we may make adjustments to amounts that we have previously recorded that may materially impact our provision for income taxes in the period in which the adjustments are made. Loss contingencies We evaluate contingent liabilities including threatened or pending litigation in accordance with the authoritative guidance on contingencies. We assess the likelihood of any adverse judgments or outcomes from potential claims or legal proceedings, as well as potential ranges of probable losses, when the outcomes of the claims or proceedings are probable and reasonably estimable. A determination of the amount of accrued liabilities required, if any, for these contingencies is made after the analysis of each separate matter. Because of uncertainties related to these matters, we base our estimates on the information available at the time of our assessment. As additional information becomes available, we reassess the potential liability related to our pending claims and litigation and may revise our estimates. Any revisions in the estimates of potential liabilities could have a material impact on our operating results and financial position. Recent Accounting Pronouncements See Note 1 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. Emerging Growth Company Status In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” may take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Therefore, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this 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. Non-GAAP Financial Measures and Other Key Metrics To supplement our consolidated financial statements, which are prepared and presented in accordance with GAAP, we use certain non-GAAP financial measures, as described below, to understand and evaluate our core operating performance. These non-GAAP financial measures, which may be different than similarly-titled measures used by other companies, are presented to enhance investors’ overall understanding of our financial performance and should not be considered a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. We believe that these non-GAAP financial measures provide useful information about our financial performance, enhance the overall understanding of our past performance and future prospects, and allow for greater transparency with respect to important metrics used by our management for financial and operational decision-making. We are presenting these non-GAAP measures to assist investors in seeing our financial performance using a management view, and because we believe that these measures provide an additional tool for investors to use in comparing our core financial performance over multiple periods with other companies in our industry. Non-GAAP gross profit, non-GAAP subscription gross profit, non-GAAP professional services and other gross profit, non-GAAP gross margin, non-GAAP income (loss) from operations, non-GAAP operating margin and non-GAAP net income (loss): We define these non-GAAP financial measures as the respective GAAP measures, excluding expenses related to stock-based compensation, employer payroll tax on employee stock transactions, amortization of acquisition-related intangibles, amortization of debt discount and issuance costs from our convertible senior notes issued in September 2018, acquisition-related expenses, partial releases of valuation allowance due to acquisition, and, as applicable, other special items. The amount of employer payroll tax-related items on employee stock transactions is dependent on our stock price and other factors that are beyond our control and do not correlate to the operation of the business. Costs associated with acquisitions include legal, accounting, other professional fees and other non-recurring costs. We believe it is useful to exclude these expenses in order to better understand the long-term performance of our core business and to facilitate comparison of our results to those of peer companies and over multiple periods. Free cash flows: We define free cash flow as net cash provided by (used in) operating activities less purchases of property and equipment. We believe free cash flow is an important liquidity measure of the cash (if any) that is available, after purchases of property and equipment, for operational expenses, investment in our business and to make acquisitions. Free cash flow is useful to investors as a liquidity measure because it measures our ability to generate or use cash in excess of our capital investments in property and equipment. Once our business needs and obligations are met, cash can be used to maintain a strong balance sheet and invest in future growth. Billings: We define billings as total revenue plus the change in our contract liabilities and refund liability less contract assets and unbilled accounts receivable in a given period. Billings reflects sales to new customers plus subscription renewals and additional sales to existing customers. Only amounts invoiced to a customer in a given period are included in billings. We believe billings is a key metric to measure our periodic performance. Given that most of our customers pay in annual installments one year in advance, but we typically recognize a majority of the related revenue ratably over time, we use billings to measure and monitor our ability to provide our business with the working capital generated by upfront payments from our customers. Reconciliation of gross profit and gross margin: Reconciliation of income (loss) from operations and operating margin: Reconciliation of net income (loss): (1) Represents a tax benefit related to the release of a portion of our deferred tax asset valuation allowance resulting from the SpringCM Acquisition. Computation of free cash flow: Computation of billings:

<s>[INST] Executive Overview of Fiscal 2019 Results Overview DocuSign accelerates the process of doing business for companies and simplifies life for their customers and employees. We accomplish this by transforming the foundational element of business: the agreement. As the core part of our broader software suite for automating the agreement process, we offer the world’s #1 esignature solution. Our software suite has achieved widespread adoption by businesses of all sizes by enabling them to digitally prepare, execute and act on agreements. We offer access to our eSignature platform on a subscription basis and price such subscriptions based on the functionality required by our customers and the quantity of Envelopes provisioned. Similar to how physical agreements were mailed for signature in paper envelopes historically, an Envelope is a digital container used to send one or more documents for signature or approval to one or more recipients. Our customers have the flexibility to put a large number of documents in an Envelope. For a number of use cases, multiple Envelopes are used over the course of the process. For example, in the purchase or sale of a home, multiple Envelopes are used over the course of the homebuying process. To drive customer reach and adoption, we also offer for free certain limitedtime or featureconstrained versions of our platform. We generate substantially all our revenue from sales of subscriptions, which accounted for 95%, 93% and 91% of our revenue in the years ended January 31, 2019, 2018 and 2017. Our subscription fees include the use of our software suite and access to customer support. Subscriptions generally range from one to three years, and substantially all our multiyear customers pay in annual installments, one year in advance. We also generate revenue from professional and other nonsubscription services, which consists primarily of fees associated with providing new customers deployment and integration services. Other revenue includes amounts derived from sales of onpremises solutions. Professional services and other revenue accounted for 5%, 7% and 9% of our revenue in the years ended January 31, 2019, 2018 and 2017. We anticipate continuing to invest in customer success through our professional services offerings as we believe it plays an important role in accelerating our customers’ deployment of our software suite, which helps to drive customer retention and expansion of the use of the DocuSign Agreement Cloud. We offer subscriptions to our software suite to enterprise businesses, commercial businesses and very small businesses, or VSBs, which include professionals, sole proprietorships and individuals. We sell to customers through multiple channels. Our gotomarket strategy relies on our direct sales force and partnerships to sell to enterprises and commercial businesses and our webbased selfservice channel to sell to VSBs, which is the most costeffective way to reach our smallest customers. We offer more than 300 offtheshelf, prebuilt integrations with the applications that many of our customers already useincluding those offered by Google, Microsoft, NetSuite, Oracle, Salesforce, SAP, SAP SuccessFactors and Workdayso that they can create, sign, send and manage agreements from directly within these applications. We have a diverse customer base spanning various industries and countries with no significant customer concentration. No single customer accounted for more than 3% of total revenue in each of the years ended January 31, 2019, 2018 and 2017. We focused initially on selling our esignature solutions to commercial businesses and VSBs. We later expanded our focus to target enterprise customers by adding our first enterprise sales professionals in the year ended January 31, 2011. In the year ended January 31, 2013, we began to gain meaningful traction selling into new enterprise accounts with aggregate annual contract value, ACV, exceeding $5 million. To demonstrate this growth over time, the number of our customers with greater than $300,000 in ACV has increased from approximately 30 as of January 31, 2013 to 310 customers as of January 31, 2019. Each of our customer types have different purchasing patterns. VSBs tend to become customers quickly with very little to no direct interaction and generate smaller average contract values, while commercial and enterprise customers typically involve longer sales cycles, larger contract [/INST] Negative. </s>

Corteva, Inc.

2020-02-14

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENTS ABOUT FORWARD-LOOKING STATEMENTS This report contains certain estimates and forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, which are intended to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and may be identified by their use of words like “plans,” “expects,” “will,” “anticipates,” “believes,” “intends,” “projects,” “estimates” or other words of similar meaning. All statements that address expectations or projections about the future, including statements about Corteva’s strategy for growth, product development, regulatory approval, market position, anticipated benefits of recent acquisitions, timing of anticipated benefits from restructuring actions, outcome of contingencies, such as litigation and environmental matters, expenditures, and financial results, as well as expected benefits from, the separation of Corteva from DuPont, are forward-looking statements. Forward-looking statements and other estimates are based on certain assumptions and expectations of future events which may not be accurate or realized. Forward-looking statements and other estimates also involve risks and uncertainties, many of which are beyond Corteva’s control. While the list of factors presented below is considered representative, no such list should be considered to be a complete statement of all potential risks and uncertainties. Unlisted factors may present significant additional obstacles to the realization of forward-looking statements. Consequences of material differences in results as compared with those anticipated in the forward-looking statements could include, among other things, business disruption, operational problems, financial loss, legal liability to third parties and similar risks, any of which could have a material adverse effect on Corteva’s business, results of operations and financial condition. Some of the important factors that could cause Corteva’s actual results to differ materially from those projected in any such forward-looking statements include: (i) failure to successfully develop and commercialize Corteva’s pipeline; (ii) effect of competition and consolidation in Corteva’s industry; (iii) failure to obtain or maintain the necessary regulatory approvals for some Corteva’s products; (iv) failure to enforce Corteva’s intellectual property rights or defend against intellectual property claims asserted by others; (v) effect of competition from manufacturers of generic products; (vi) impact of Corteva’s dependence on third parties with respect to certain of its raw materials or licenses and commercialization; (vii) costs of complying with evolving regulatory requirements and the effect of actual or alleged violations of environmental laws or permit requirements; (viii) effect of the degree of public understanding and acceptance or perceived public acceptance of Corteva’s biotechnology and other agricultural products; (ix) effect of changes in agricultural and related policies of governments and international organizations; (x) effect of industrial espionage and other disruptions to Corteva’s supply chain, information technology or network systems; (xi) competitor’s establishment of an intermediary platform for distribution of Corteva's products; (xii) effect of volatility in Corteva’s input costs; (xiii) failure to raise capital through the capital markets or short-term borrowings on terms acceptable to Corteva; (xiv) failure of Corteva’s customers to pay their debts to Corteva, including customer financing programs; (xv) failure to realize the anticipated benefits of the internal reorganizations taken by DowDuPont in connection with the spin-off of Corteva, including failure to benefit from significant cost synergies; (xvi) risks related to the indemnification obligations of legacy EID liabilities in connection with the separation of Corteva; (xvii) increases in pension and other post-employment benefit plan funding obligations; (xviii) effect of compliance with laws and requirements and adverse judgments on litigation; (xix) risks related to Corteva’s global operations; (xx) effect of climate change and unpredictable seasonal and weather factors; (xxi) effect of counterfeit products; (xxii) failure to effectively manage acquisitions, divestitures, alliances and other portfolio actions; (xxiii) risks related to non-cash charges from impairment of goodwill or intangible assets; and (xxiv) other risks related to the Separation from DowDuPont. Additionally, there may be other risks and uncertainties that Corteva is unable to currently identify or that Corteva does not currently expect to have a material impact on its business. Where, in any forward-looking statement or other estimate, an expectation or belief as to future results or events is expressed, such expectation or belief is based on the current plans and expectations of Corteva’s management and expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the expectation or belief will result or be achieved or accomplished. Corteva disclaims and does not undertake any obligation to update or revise any forward-looking statement, except as required by applicable law. A detailed discussion of some of the significant risks and uncertainties which may cause results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part I, Item 1A of this Form 10-K). Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Overview Refer to pages 3 - 4 for a discussion of the DowDuPont Merger of Equals, the Internal Reorganizations, and the Business Separations. Basis of Presentation Dow AgroSciences ("DAS") Common Control Combination The transfer or conveyance of DAS to Corteva was treated as a transfer of entities under common control. As such, the company recorded the assets, liabilities, and equity of DAS on its balance sheet at their historical basis. Transfers of businesses between entities under common control requires the financial statements to be presented as if the transaction had occurred at the point at which common control first existed (the Merger Effectiveness Time). As a result, the accompanying Consolidated Financial Statements and Notes thereto include the results of DAS as of the Merger Effectiveness Time. See Note 4 - Common Control Business Combination, to the Consolidated Financial Statements for additional information. Divestiture of EID ECP The transfer of EID ECP meets the criteria for discontinued operations and as such, results of operations are presented as discontinued operations and have been excluded from continuing operations for all periods presented. The comprehensive (loss) income, stockholder's equity and cash flows related to EID ECP have not been segregated and are included in the Consolidated Statements of Comprehensive (Loss) Income, Consolidated Statements of Equity and Consolidated Statements of Cash Flows, respectively, for all periods presented. Amounts related to EID ECP are consistently included or excluded from the Notes to the Consolidated Financial Statements based on the respective financial statement line item. See Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for additional information. Divestiture of EID Specialty Products Entities The transfer of the EID Specialty Products Entities meets the criteria for discontinued operations and as such, results of operations are presented as discontinued operations and have been excluded from continuing operations for all periods presented. The comprehensive (loss) income, stockholder's equity and cash flows related to the EID Specialty Products Entities have not been segregated and are included in the Consolidated Statements of Comprehensive (Loss) Income, Consolidated Statements of Equity and Consolidated Statements of Cash Flows, respectively, for all periods presented. Amounts related to the EID Special Products Entities are consistently included or excluded from the Notes to the Consolidated Financial Statements based on the respective financial statement line item. See Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for additional information. Predecessor / Successor Reporting For purposes of DowDuPont's financial statement presentation, Historical Dow was determined to be the accounting acquirer in the Merger and Historical DuPont's assets and liabilities are reflected at fair value as of the close of the Merger in the financial statements of DowDuPont. In connection with the Merger and the related accounting determination, Historical DuPont elected to apply push-down accounting and reflect in its financial statements, the fair value of its assets and liabilities. For purposes of Corteva’s financial statement presentation, periods following the close of the Merger are labeled “Successor” and reflect DowDuPont’s basis in the fair values of the assets and liabilities of Corteva/EID. All periods prior to the closing of the Merger reflect the historical accounting basis in EID 's assets and liabilities and are labeled “Predecessor.” The Consolidated Financial Statements and Footnotes include a black line division between the columns titled "Predecessor" and "Successor" to signify that the amounts shown for the periods prior to and following the Merger are not comparable. In addition, the company elected to make certain changes in presentation to harmonize its accounting and reporting with that of DowDuPont in the Successor periods. See Note 2 - Summary of Significant Accounting Policies, to the Consolidated Financial Statements for further discussion of these changes. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Items Affecting Comparability of Financial Results In addition to the Analysis of Operations discussion based on the GAAP as reported results, the following includes a supplemental Analysis of Operations discussion reflecting unaudited pro forma financial information, prepared in accordance with Article 11 of Regulation S-X. This unaudited pro forma financial information, for the years ended December 31, 2019 and 2018 assumes the Merger, the debt retirement transactions related to paying off or retiring portions of EID’s existing debt liabilities (as discussed in Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements), and the separation and distribution to DowDuPont stockholders of all the outstanding shares of Corteva common stock as if they had been consummated on January 1, 2016. The unaudited pro forma financial information for the year ended December 31, 2017 gives effect to the above noted transactions in addition to the common control business combination with DAS, as if it had been consummated on January 1, 2016. For additional information, see the Supplemental Unaudited Pro Forma Combined Financial Information in this section. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Overview The following is a summary of results from continuing operations for the year ended December 31, 2019: • The company reported net sales of $13,846 million, down 3 percent versus the year ended December 31, 2018, reflecting a 3 percent decline in currency. • Cost of goods sold ("COGS") totaled $8,575 million, down from $9,948 million for the year ended December 31, 2018, primarily driven by lower volumes as a result of weather-related planting delays in North America as well as lower amortization of inventory step-up. All inventory step-up has been amortized. • Restructuring and asset related charges - net were $222 million, a decrease from $694 million for the year ended December 31, 2018. • Integration and separation costs were $744 million, down from $992 million for the year ended December 31, 2018, reflecting post-Merger integration and Business Separation activities. • Loss from continuing operations after income taxes was $(270) million, as compared to a loss of $(6,775) million for the year ended December 31, 2018. • The company realized cost synergies of approximately $350 million for the year ended December 31, 2019, on track to deliver $1.2 billion through 2021. • Pro forma operating EBITDA was $1,987 million, down from $2,072 million for the year ended December 31, 2018. Refer to page 58 for further discussion of the company's Non-GAAP financial measures. In addition to the financial highlights above, the following events occurred during or subsequent to the year ended December 31, 2019: • The company launched a new pure play agriculture company with the new Corteva brand, new values, and a new purpose. • The company returned approximately $220 million to shareholders since the Separation through its previously announced share repurchase program and common stock dividends. • During the fourth quarter of 2019, the company decided to accelerate the ramp-up of its Enlist E3™ soybeans, as well as its Enlist One® and Enlist Duo® herbicides, in the U.S. and Canada. Refer to Prepaid Royalties within the Critical Accounting Estimates section on page 70 for additional information. • The company agreed to sell Chlorpyrifos assets in India; Bensulfuron-Methyl assets in Asia Pacific (excluding China); Quinoxyfen business assets; and a selection of U.S. herbicide brands during the fourth quarter. These actions are aligned with the company’s commitment to driving an active portfolio management approach focused on margin expansion and shareholder value creation. Priorities Corteva is committed to making an impact for its customers, while focusing on five priorities for shareholder value creation: (1) instilling a strong culture, (2) driving disciplined capital allocation, (3) developing innovative solutions, (4) attaining best-in-class cost structure and (5) delivering above market growth. The company believes the following key pillars will enable it to create significant value for its customers while delivering strong financial returns to its shareholders: • Developing and launching new offerings that address market needs by continuing to leverage its robust pipeline to introduce new proprietary seed traits and crop protection formulations that anticipate and meet evolving customer needs. • Utilizing its multi-channel and multi-brand capabilities to drive profitable growth by strategically aligning its brands and capabilities across different sales channels and creating a comprehensive multi-channel, multi-brand strategy. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued • Continuing to develop and maintain close connections with customers by working closely with farmers throughout the entire growing season to ensure all their seed and crop protection needs are anticipated and satisfied. • Focusing on operational excellence by integrating its operations and continuing to drive operating efficiencies, enabling a streamlined, efficient and focused organization while working to achieve a best-in-class cost structure and creating a strong culture based on productivity. • Furthering its commitment to sustainable and responsible agriculture by focusing on integrating sustainability criteria early in the product discovery and development phases as well as promoting the development of responsible solutions focused on reducing the environmental impact of agriculture over time. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Analysis of Operations Debt Redemptions/Repayments On March 22, 2019, EID issued notices of redemption in full of all of its outstanding notes (the “Make Whole Notes”) listed in the table below: The Make Whole Notes were redeemed on April 22, 2019 at the make-whole redemption prices set forth in the respective Make Whole Notes. On and after the date of redemption, the Make Whole Notes were no longer deemed outstanding, interest on the Make Whole Notes ceased to accrue and all rights of the holders of the Make Whole Notes were terminated. In March 2016, EID entered into a credit agreement that provides for a three-year, senior unsecured term loan facility in the aggregate principal amount of $4.5 billion (as amended, from time to time, the "Term Loan Facility") under which EID could make up to seven term loan borrowings and amounts repaid or prepaid were not available for subsequent borrowings. On May 2, 2019, EID terminated its Term Loan Facility and repaid the aggregate outstanding principal amount of $3 billion plus accrued and unpaid interest through and including May 1, 2019. In connection with the repayment of the Make Whole Notes and the Term Loan Facility, Corteva paid a total of $4.6 billion in the second quarter 2019, which included breakage fees and accrued and unpaid interest on the Make Whole Notes and Term Loan Facility. The repayment of the Make Whole Notes and Term Loan Facility was funded with cash from operations and a contribution from DowDuPont. On May 7, 2019, DowDuPont publicly announced the record date in connection with the Corteva Distribution. In connection with such announcement, EID was required to redeem $1.25 billion aggregate principal amount of 2.200% Notes due 2020 and $750 million aggregate principal amount of Floating Rate Notes due 2020 (collectively, the Special Mandatory Redemption, or “SMR Notes”) setting forth the date of redemption of the SMR Notes. On May 17, 2019 EID redeemed and paid a total of $2.0 billion, which included accrued and unpaid interest on the SMR Notes. EID funded the payment with a contribution from DowDuPont. Following the redemption, the SMR Notes are no longer outstanding and no longer bear interest, and all rights of the holders of the SMR Notes have terminated. EID recorded a loss on the early extinguishment of debt of $13 million related to the difference between the redemption price and the par value of the Make Whole Notes, the Term Loan Facility, and the SMR Notes, partially offset by the write-off of unamortized step-up related to the fair value step-up of EID’s debt. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Impact From Previously Enacted Tariffs In 2018, certain countries where the company’s products are manufactured, distributed or sold previously enacted tariffs on certain products. The tariffs contributed to an expected shift to soybeans from corn in Latin America and pressured North American farmer margins. These expectations were reflected in the revised long-term cash flow projections for the company's agriculture reporting unit in 2018, as discussed in Note 15 - Goodwill and Other Intangible Assets, to the Consolidated Financial Statements. In January, 2020 the United States and China signed "phase one" of a trade agreement ("China Trade Agreement") and the United States ("U.S.") and Mexico ratified the United States-Mexico-Canada Agreement ("USMCA"). The China Trade Agreement commits China to purchase at least $40 billion worth of U.S. farm goods annually and for China to reduce non-tariff barriers to agriculture products such as poultry and feed additives, as well as approval of biotechnology products. Additionally, the China Trade Agreement includes stronger intellectual property protections and the elimination of any pressure for foreign companies to transfer technology to Chinese firms as a condition of market access. While the USMCA will replace the North America Free Trade Agreement, it is not a one-for-one replacement. It is designed to modernize trade rules in North America, ensure open markets, protect innovations for a majority of U.S. goods, and enhance sanitary/phytosanitary standards. The company expects the impacts of these agreements to overall be positive for demand for U.S. agriculture products. Tax Reform On December 22, 2017, the Tax Cuts and Jobs Act (“The Act”) was enacted. The Act reduces the U.S. federal corporate income tax rate from 35 percent to 21 percent, requires companies to pay a one-time transition tax (“transition tax”) on earnings of foreign subsidiaries that were previously tax deferred, creates new provisions related to foreign sourced earnings, eliminates the domestic manufacturing deduction and moves to a territorial system. As of December 31, 2018, the company had completed its accounting for the tax effects of The Act. As a result of The Act, the company remeasured its U.S. federal deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21 percent. The company recorded a cumulative benefit of $2,847 million ($2,813 million benefit in the period September 1 through December 31, 2017 and $34 million benefit during 2018) to provision for (benefit from) income taxes on continuing operations in the company's Consolidated Statement of Operations with respect to the remeasurement of the company's deferred tax balances. Additionally, the company recorded a cumulative charge of $928 million ($746 million charge in the period September 1 through December 31, 2017 and $182 million charge during 2018) to provision for (benefit from) income taxes on continuing operations with respect to the one-time transition tax. For tax years beginning after December 31, 2017, The Act introduced new provisions for U.S. taxation of certain global intangible low-taxed income (“GILTI”). The Company has made the policy election to record any liability associated with GILTI in the period in which it is incurred. Additional details related to The Act can be found in Note 10 - Income Taxes, to the Consolidated Financial Statements. DowDuPont Agriculture Division Restructuring Program During the fourth quarter of 2018 and in connection with the ongoing integration activities, DowDuPont approved restructuring actions to simplify and optimize certain organizational structures in preparation for the Business Separations. The company recorded a pre-tax charge of $84 million, recognized in restructuring and asset related charges - net in the company's Consolidated Statement of Operations comprised of $78 million of severance and related benefit costs and $6 million related to asset related charges. For the year ended December 31, 2019, the company recorded a net pre-tax benefit of $14 million, recognized in restructuring and asset related charges - net in the company's Consolidated Statement of Operations comprised of $17 million of severance and related benefit credits and $3 million related to asset related charges. The company's actions related to this program are complete. DowDuPont Cost Synergy Program In September and November 2017, DowDuPont and EID approved post-merger restructuring actions under the DowDuPont Cost Synergy Program (the “Synergy Program”), adopted at the time by the DowDuPont Board of Directors. The Synergy Program was designed to integrate and optimize the organization following the Merger and in preparation for the Business Separations. The company recorded pre-tax restructuring charges of $845 million inception-to-date under the Synergy Program, consisting of severance and related benefit costs of $319 million, contract termination costs of $193 million, and asset-related charges of $333 million. Actions associated with the Synergy Program, including employee separations, are substantially complete. Future cash payments related to this program are anticipated to be approximately $69 million, related to the payment of severance and related benefits and contract termination costs. The company anticipates including cumulative savings associated with these actions within its cost synergy commitment of $1.2 billion through 2021. Additional details related to this plan can be found in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, on page 44 of this report and Note 7 - Restructuring and Asset Related Charges - Net, to the Consolidated Financial Statements. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued FMC Transactions On March 31, 2017, EID and FMC Corporation ("FMC") entered into a definitive agreement (the "FMC Transaction Agreement"). Under the FMC Transaction Agreement, and effective upon the closing of the transaction on November 1, 2017, FMC acquired the crop protection business and R&D assets that EID was required to divest in order to obtain European Commission approval of the Merger Transaction, (the "Divested Ag Business") and EID agreed to acquire certain assets relating to FMC’s Health and Nutrition segment, excluding its Omega-3 products (the "H&N Business") (collectively, the "FMC Transactions"). The sale of the Divested Ag Business meets the criteria for discontinued operations and as such, earnings are included within (loss) income from discontinued operations after income taxes in the Consolidated Statements of Operations for all periods presented. On November 1, 2017, EID completed the FMC Transactions through the disposition of the Divested Ag Business and the acquisition of the H&N Business. The fair value, as determined by the company, of the H&N Business was $1,970 million. The FMC Transactions included a cash consideration payment to EID of approximately $1,200 million, which reflects the difference in value between the Divested Ag Business and the H&N Business, as well as favorable contracts with FMC of $495 million. The carrying value of the Divested Ag Business approximated the fair value of the consideration received, thus no resulting gain or loss was recognized on the sale. The H&N Business was transferred to DowDuPont as part of the EID Specialty Products Entities. Refer to Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for further information. Separation of Performance Chemicals On July 1, 2015, EID completed the separation of its Performance Chemicals segment through the spin-off of all of the issued and outstanding stock of The Chemours Company ("Chemours"). In connection with the separation, EID and Chemours entered into a Separation Agreement and a Tax Matters Agreement as well as certain ancillary agreements. In accordance with generally accepted accounting principles in the U.S. ("GAAP"), the results of operations of its former Performance Chemicals segment are presented as discontinued operations and, as such, are included within (loss) income from discontinued operations after income taxes in the Consolidated Statements of Operations for all periods presented. Additional details regarding the separation and other related agreements can be found in Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements. Settlement of PFOA MDL As previously reported, approximately 3,550 lawsuits were consolidated in multi-district litigation (“MDL”); these lawsuits alleged personal injury from exposure to perfluorooctanoic acid and its salts, including the ammonium salt ("PFOA"), in drinking water as a result of the historical manufacture or use of PFOA. The plant operating units involved in the allegations are owned and operated by Chemours. The MDL was settled in early 2017 for $670.7 million in cash, with Chemours and EID (without indemnification from Chemours) each paying half. See Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements for additional information Net Sales Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 2019 versus 2018 Net sales were $13,846 million for the year ended December 31, 2019, compared to $14,287 million for the year ended December 31, 2018. The decrease was primarily driven by a 3 percent decline in currency. Unfavorable currency impacts were primarily driven by the Brazilian Real and the Euro. Volume was flat as strong demand for new product and gains in corn in EMEA were offset by significant weather-related planting delays in North America, resulting in lost spring applications of crop protection products and a reduction in planted area for soybeans. Pricing gains from new product launches and favorable mix in Latin America were offset by competitive pricing pressure, increases in replant, and increased grower incentive program discounts in North America. 2018 versus 2017 Net sales were $14,287 million for the year ended December 31, 2018 compared to $3,790 million for the period September 1 through December 31, 2017 and $6,894 million for the period January 1 through August 31, 2017. The increase was primarily driven by the inclusion of DAS for the full year in 2018 versus only four months in 2017 ($3,432 million increase). Pro forma net sales were $14,287 million for the year ended December 31, 2018 compared to pro forma net sales of $14,241 million for the year ended December 31, 2017. The increase was primarily driven by a 2 percent increase in local price, partially offset by a 2 percent decline in currency. The increase in local price was driven by a favorable mix in North America as well as increases in crop protection pricing in Latin America to offset currency pressure. Volume was flat as gains in crop protection due to new product launches, including VESSARYATM in Latin America, ENLISTTM products in North America and Latin America, and PYRAXALTTM in Asia Pacific, were offset by lower planted area in North America and Latin America and lower demand for nitrogen stabilizers in North America. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued COGS 2019 versus 2018 COGS was $8,575 million for the year ended December 31, 2019 compared to $9,948 million for the year ended December 31, 2018. The decrease was primarily driven by lower amortization of remaining inventory step up compared to the prior year ($272 million in 2019 compared to $1,554 million in 2018). The remaining COGS decrease was primarily driven by lower volumes as a result of weather-related planting delays in North America, cost synergies and a currency benefit, partially offset by higher input costs for both seed and crop protection. COGS as a percentage of net sales was 62 percent and 70 percent for the year ended December 31, 2019 and 2018, respectively. The amortization of inventory step-up was 2 percent and 11 percent of net sales for the year ended December 31, 2019 and 2018, respectively. On a pro forma basis, COGS was $8,386 million for the year ended December 31, 2019 and $8,449 million for the year ended December 31, 2018. The decrease was primarily driven by lower volumes as a result of weather-related planting delays in North America, cost synergies and a currency benefit, partially offset by higher input costs for both seed and crop protection. Pro forma COGS as a percentage of pro forma net sales was 61 percent and 59 percent for the year ended December 31, 2019 and 2018, respectively. The increase was due to higher input costs for both seed and crop protection, partially offset by cost synergies. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 2018 versus 2017 COGS was $9,948 million for the year ended December 31, 2018 compared to $2,915 million for the period September 1 through December 31, 2017 and $3,409 million for the period January 1 through August 31, 2017. The increase was primarily driven by the inclusion of DAS for the full year in 2018 versus only four months in 2017 ($2,383 million increase), the amortization of the inventory step-up of $1,554 million for the year ended December 31, 2018 (compared to $425 million period September 1 through December 31, 2017), increased expenses due to the elimination of the other operating charges financial statement line item subsequent to the Merger, and higher depreciation related to the fair value step up of property, plant and equipment. COGS as a percentage of net sales was 70 percent, 77 percent, and 49 percent for the year ended December 31, 2018, the period September 1 through December 31, 2017, and the period January 1 through August 31, 2017, respectively. The amortization of the inventory step-up was 11 percent of net sales for the year ended December 31, 2018 and the period September 1 through December 31, 2017, respectively. The elimination of the other operating charges financial statement line item would have increased COGS as a percentage of net sales by 3 percent for the period January 1 through August 31, 2017. The remaining COGS change as a percentage of net sales between the Predecessor and Successor periods of 2017 and 2018 was primarily due to higher raw material costs, partially offset by synergies. Pro forma COGS for the year ended December 31, 2018 was $8,449 million compared to $8,338 million for the year ended December 31, 2017. The increase was primarily driven by higher raw material costs and royalty expense, partially offset by synergies and a currency benefit. Pro forma COGS as a percentage of pro forma net sales was 59 percent for both the year ended December 31, 2018 and the year ended December 31, 2017. Other Operating Charges 2018 versus 2017 Other operating charges were $195 million for the period January 1 through August 31, 2017. In the Successor periods, other operating charges are included primarily in COGS, as well as selling, general and administrative expenses and amortization of intangibles. See Note 2 - Summary of Significant Accounting Policies, to the Consolidated Financial Statements for further discussion of the changes in presentation. Research and Development Expense ("R&D") 2019 versus 2018 R&D expense was $1,147 million (8 percent of net sales) for the year ended December 31, 2019 and $1,355 million (9 percent of net sales) for the year ended December 31, 2018. The decrease was primarily driven by cost synergies and additional actions taken to curtail spending. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Pro forma R&D expense was $1,147 million (8 percent of pro forma net sales) for the year ended December 31, 2019 and $1,352 million (9 percent of pro forma net sales) for the year ended December 31, 2018. The decrease was primarily driven by the factors described above. 2018 versus 2017 R&D expense was $1,355 million (9 percent of net sales) for the year ended December 31, 2018, $484 million (13 percent of net sales) for the period September 1 through December 31, 2017, and $591 million (9 percent of net sales) for the period January 1 through August 31, 2017. The increase was primarily driven by the inclusion of DAS for the full year in 2018 versus only four months in 2017 ($281 million increase). Pro forma R&D expense for the year ended December 31, 2018 was $1,352 million (9 percent of pro forma net sales) compared to $1,439 million (10 percent of pro forma net sales) for the year ended December 31, 2017. The decrease was primarily driven by cost synergies, partially offset by investments to support new product launches. Selling, General and Administrative Expenses ("SG&A") 2019 versus 2018 SG&A was $3,065 million for the year ended December 31, 2019 and $3,041 million for the year ended December 31, 2018. The increase was primarily driven by an increase in performance-based compensation, an increase in sales commissions resulting from commission rate increases and route to market changes in select markets, and settlement of a legal matter, partially offset by cost synergies. SG&A as a percentage of net sales was 22 percent and 21 percent for the year ended December 31, 2019 and December 31, 2018, respectively. Pro forma SG&A expense for the year ended December 31, 2019 was $3,068 million (22 percent of pro forma net sales) compared to $3,042 million (21 percent of pro forma net sales) for the year ended December 31, 2018. The increase was primarily driven by the factors described above. 2018 versus 2017 SG&A was $3,041 million for the year ended December 31, 2018, $920 million for the period September 1 through December 31, 2017, and $1,969 million for the period January 1 through August 31, 2017. The increase was primarily driven by the inclusion of DAS for the full year in 2018 versus only four months in 2017 ($472 million increase), partially offset by the inclusion of integration and separation costs and amortization of intangibles within SG&A in the Predecessor period. SG&A as a percentage of net sales was 21 percent, 24 percent, and 29 percent for the year ended December 31, 2018, the period September 1 through December 31, 2017, and the period January 1 through August 31, 2017, respectively. Integration and separation costs were 5 percent of net sales for the period January 1 through August 31, 2017. Pro forma SG&A expense for the year ended December 31, 2018 was $3,042 million compared to $3,109 million for the year ended December 31, 2017. The decrease was primarily driven by synergies and lower variable compensation, partially offset by increased commissions due to a change in the route to market. Pro forma SG&A as a percentage of pro forma net sales was 21 percent and 22 percent for the year ended December 31, 2018 and 2017, respectively. The decrease was primarily due to the reasons discussed above. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Amortization of Intangibles 2019 versus 2018 Intangible asset amortization was $475 million for the year ended December 31, 2019 and $391 million for the year ended December 31, 2018. The increase was primarily driven by amortization of germplasm assets, which changed from an indefinite lived intangible asset to definite lived with a useful life of 25 years in fourth quarter of 2019. Beginning in 2020, the company expects annual amortization expense to increase by approximately $250 million. The remaining increase in amortization expense is primarily due to the reclassification of amounts from indefinite-lived in-process research and development ("IPR&D") to developed technology as a result of the company's launch of its Qrome® corn hybrids following the receipt of regulatory approval from China. See Note 15 - Goodwill and Other Intangible Assets, to the Consolidated Financial Statements, for additional information for above items. 2018 versus 2017 Intangible asset amortization was $391 million for the year ended December 31, 2018 and $97 million for the period September 1 through December 31, 2017. In the Predecessor period, amortization of intangibles was included within SG&A, other operating charges, R&D, and COGS. Pro forma intangible asset amortization for the year ended December 31, 2018 was $391 million compared to $270 million for the year ended December 31, 2017. The increase was primarily driven by the inclusion of a full year of amortization expense in 2018 related to the favorable supply contracts entered into with FMC, upon closing of the FMC Transactions in November of 2017 (see page 38 for further information) and a full year of amortization expense for the intangible assets acquired related to Granular, Inc. in August of 2017. Restructuring and Asset Related Charges - Net Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 2019 versus 2018 Restructuring and asset related charges - net were $222 million for the year ended December 31, 2019 and $694 million for the year ended December 31, 2018. The activity for the year ended December 31, 2019 was comprised of $144 million of asset related charges (discussed in the "Asset Impairment" section, below) and a $92 million net charge related to the Synergy Program, offset by a net benefit of $14 million related to the DowDuPont Agriculture Division Restructuring Program. The $92 million net charge associated with the Synergy Program was comprised of $69 million of contract termination charges and $30 million of asset related charges, partially offset by a $7 million benefit on the reduction of severance and related benefit costs. The $14 million net benefit associated with the DowDuPont Agriculture Division Restructuring Program included a $17 million benefit on the reduction of severance and related benefit costs, partially offset by $3 million of asset related charges. 2018 versus 2017 Restructuring and asset related charges - net were $694 million for the year ended December 31, 2018, $270 million for the period September 1 through December 31, 2017, and $12 million for the period January 1 through August 31, 2017. The activity for the year ended December 31, 2018 was comprised of a $484 million charge related to the Synergy Program, a $126 million of asset related charges (discussed in the "Asset Impairment" section, below), and a $84 million charge related to the DowDuPont Agriculture Division Restructuring Program. The $270 million charge for the period September 1 through December 31, 2017 was primarily related to $135 million of severance and related benefit costs, $94 million of asset related charges and $40 million of contract termination charges as part of the Synergy Program. The $12 million charge for the period January 1 through August 31, 2017 was primarily comprised of severance and related benefit costs associated with previous restructuring programs. Pro forma restructuring and asset related charges - net for the year ended December 31, 2018 were $694 million compared to $271 million for the year ended December 31, 2017. The charge for the year ended December 31, 2017 was primarily related to the Synergy Program. Asset Impairment For the year ended December 31, 2019, the company recognized a $144 million pre-tax ($110 million after-tax) non-cash impairment charge in restructuring and asset related charges - net in the company's Consolidated Statements of Operations related to certain IPR&D assets within the seed segment. See Note 7 - Restructuring and Asset Related Charges - Net, and Note 23 - Fair Value Measurements, to the Consolidated Financial Statements for additional information. For the year ended December 31, 2018, the company recognized an $85 million pre-tax ($66 million after-tax) non-cash impairment charge in restructuring and asset related charges - net in the company's Consolidated Statements of Operations related to certain IPR&D assets within the seed segment. See Note 7 - Restructuring and Asset Related Charges - Net, and Note 23 - Fair Value Measurements, to the Consolidated Financial Statements for additional information. For the year ended December 31, 2018, management determined the fair values of investments in nonconsolidated affiliates in China were below the carrying values and had no expectation the fair values would recover. As a result, management concluded the impairment was other than temporary and recorded a non-cash impairment charge of $41 million in restructuring and asset related charges - net in the company's Consolidated Statements of Operations, none of which is tax-deductible, for the year ended December 31, 2018. See Note 7 - Restructuring and Asset Related Charges - Net, and Note 23 - Fair Value Measurements, to the Consolidated Financial Statements for additional information. Integration and Separation Costs 1. Beginning in the second quarter of 2019, this includes both integration and separation costs. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 2019 versus 2018 Integration and separation costs were $744 million for the year ended December 31, 2019 and $992 million for the year ended December 31, 2018. These costs primarily have consisted of financial advisory, information technology, legal, accounting, consulting, and other professional advisory fees associated with the preparation and execution of activities related to the Business Separations and the integration of EID’s Pioneer and Crop Protection businesses with DAS. Pro forma integration and separation costs were $632 million and $571 million for the year ended December 31, 2019 and 2018, respectively. The increase was primarily driven by an increase in financial advisory, information technology, legal, accounting, consulting, and other professional advisory fees associated with the preparation and execution of activities related to the Business Separations and the integration of EID’s Pioneer and Crop Protection businesses with DAS. 2018 versus 2017 Integration and separation costs were $992 million for the year ended December 31, 2018 and $255 million for the period September 1 through December 31, 2017. In the Predecessor period, integration and separation costs were included within SG&A. See Note 2 - Summary of Significant Accounting Policies, to the Consolidated Financial Statements for further discussion of the changes in presentation. Pro forma integration costs for the year ended December 31, 2018 were $571 million compared to $217 million for the year ended December 31, 2017. The increase was primarily driven by an increase in financial advisory, information technology, legal, accounting, consulting, and other professional advisory fees associated with the preparation and execution of activities related to the integration of EID’s Pioneer and Crop Protection businesses with DAS. Goodwill Impairment Charge The company recorded a non-cash goodwill impairment charge of $4,503 million in the year ended December 31, 2018 related to a goodwill impairment test for its agriculture reporting unit. See Note 15 - Goodwill and Other Intangible Assets, to the Consolidated Financial Statements for additional information regarding the company’s goodwill impairment charge. Other Income (Expense) - Net Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 2019 versus 2018 Other income (expense) - net was income of $215 million for the year ended December 31, 2019 and income of $249 million for the year ended December 31, 2018. The decrease was primarily due to a reduction in non-operating pension and other post employment credits and interest income, partially offset by a change in miscellaneous income and lower net exchange losses. Additionally, other income (expense) - net for the year ended December 31, 2019 included gains on divestitures in the crop protection segment of approximately $70 million partially offset by a loss on a divestiture in the seed segment of $(24) million. See Note 9 - Supplementary Information, to the Consolidated Financial Statements for additional information. 2018 versus 2017 Other income (expense) - net was income of $249 million for the year ended December 31, 2018, income of $805 million for the period September 1 through December 31, 2017 and an expense of $(501) million for the period January 1 through August 31, 2017. Other income (expense) - net for the period September 1 through December 31, 2017was primarily driven by a gain on the sale of the DAS Divested Ag Business of $671 million (See Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for additional information) and non-operating pension and other post employment benefit credits, partially offset by net exchange losses. Other income (expense) - net for the period January 1 through August 31, 2017 is primarily driven by net exchange losses and non-operating pension and other post employment benefit costs, partially offset by royalty and interest income. In the Successor periods, royalty income is included in net sales. Pro forma other income (expense) - net for the year ended December 31, 2018 was income of $249 million compared to expense of $(899) million for the year ended December 31, 2017. The expense for the year ended December 31, 2017 was primarily comprised of a $(469) million loss associated with an arbitration proceeding (included within the DAS combined financial statements for the period January 1 through August 31, 2017), net exchange losses of $(373) million, and a non-operating pension and other post employment benefit cost of $(189) million, partially offset by interest income of $109 million. See Note 9 - Supplementary Information, to the Consolidated Financial Statements for additional information. Loss on Early Extinguishment of Debt The company recorded a loss from early extinguishment of debt of $13 million and $81 million for the years ended December 31, 2019 and 2018, respectively. The loss for 2019 related to the difference between the redemption price and the par value of the Make Whole Notes, the Term Loan Facility, and the SMR Notes, partially offset by the write-off of unamortized step-up related to the fair value step-up of EID’s debt. The loss for 2018 was primarily related to the difference between the redemption price and the aggregate amount of the Tender Notes purchased in the Tender Offer, mostly offset by the write-off of unamortized step-up related to the fair value step-up of EID’s debt. Additional information regarding the company’s Tender Offer can be found on page 62 of this report and Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Interest Expense 2019 versus 2018 Interest expense was $136 million for the year ended December 31, 2019 and $337 million for the year ended December 31, 2018. The change was primarily driven by lower average long-term debt balances during 2019 due to debt redemption/repayment transactions. Pro forma interest expense for the year ended December 31, 2019 was $91 million compared to $76 million for the year ended December 31, 2018. The increase was primarily driven by interest expense incurred subsequent to March 31, 2019 related to the Make Whole Notes, the Term Loan Facility and SMR Notes which were repaid and/or redeemed in the second quarter of 2019. 2018 versus 2017 Interest expense was $337 million for the year ended December 31, 2018, $115 million for the period September 1 through December 31, 2017, and $254 million for the period January 1 through August 31, 2017. The change was primarily driven by amortization of the step-up of debt as a result of push-down accounting, partially offset by higher borrowing rates. Pro forma interest expense for the year ended December 31, 2018 was $76 million compared to $87 million for the year ended December 31, 2017. The decrease was primarily driven by lower debt balances. Provision for Income Taxes on Continuing Operations Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued For the year ended December 31, 2019, the company’s effective tax rate of 14.6 percent on pre-tax loss from continuing operations of $(316) million was unfavorably impacted by a tax charge of $146 million related to the U.S. state blended tax rate changes associated with the Business Separations and a tax charge of $35 million related to application of The Act’s foreign tax provisions. Other net unfavorable effective tax rate impacts included those related to the Argentine peso devaluation, integration and separation costs, non-tax-deductible amortization of the fair value step-up in inventories as a result of the Merger, the tax impact of certain net exchange losses recognized on the re-measurement of the net monetary asset positions which were not deductible in their local jurisdictions, as well as geographic mix of earnings. Those unfavorable impacts were partially offset by a tax benefit of $102 million related to an internal legal entity restructuring associated with the Business Separations, tax benefits of $38 million associated with the enactment of the Federal Act on Tax Reform and AHV Financing (“Swiss Tax Reform”), a $34 million tax benefit associated with the release of a valuation allowance recorded against the net deferred tax asset position of a legal entity in Switzerland, as well as $19 million of tax benefits associated with changes in accruals for certain prior year tax positions and reductions in the company’s unrecognized tax benefits due to the closure of various tax statutes of limitations. For the year ended December 31, 2019, the company’s effective tax rate was 3.7 percent on pro forma pre-tax income from continuing operations of $27 million. The pro forma pre-tax income from continuing operations excludes pre-tax charges of $205 million, $45 million and $93 million primarily related to the removal of amortization of the fair value-step-up of inventories as a result of the Merger, removal of interest expense related to paying off or retiring portions of EID’s existing debt liabilities (as discussed in Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements), and removal of expenses directly attributable to the Separation, respectively. The pro forma provision for income taxes on continuing operations excludes net tax benefits of $36 million, $10 million and $1 million related to the above items, respectively. For the year ended December 31, 2018, the company’s effective tax rate of 0.5 percent on pre-tax loss from continuing operations of $(6,806) million was unfavorably impacted by the non-tax-deductible impairment charge for the agriculture reporting unit and corresponding $75 million tax charge associated with a valuation allowance recorded against the net deferred tax asset position of a legal entity in Brazil, costs associated with the Merger with Dow (including a $50 million net tax charge on repatriation activities to facilitate the Business Separations), a $164 million net tax charge related to completing its accounting for the tax effects of the Act (see Note 10 - Income Taxes, of the Consolidated Financial Statements for additional detail), and the jurisdictional impacts related to the non-tax-deductible amortization of the fair value step-up in inventories as a result of the Merger. For the year ended December 31, 2018, the company’s effective tax rate was (8.7) percent on pro forma pre-tax loss from continuing operations of $(4,542) million. The pro forma pre-tax loss excludes pre-tax charges of $1,554 million, $342 million, and $368 million, primarily related to the removal of amortization of the fair value-step-up of inventories as a result of the Merger, removal of interest expense and the related loss on early extinguishment of debt related to paying off or retiring portions of EID’s existing debt liabilities (as discussed in Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements), and removal of expenses directly attributable to the Separation, respectively. The pro forma provision for income taxes on continuing operations excludes net tax benefits of $295 million, $78 million and $53 million related to the above items, respectively. For the period September 1 through December 31, 2017, the company’s effective tax rate of 481.8 percent on pre-tax loss from continuing operations of $(461) million was favorably impacted by a provisional net benefit of $(2,067) million that the company recognized due to the enactment of The Act, a net benefit of $261 million related to an internal legal entity restructuring associated with the Business Separations, as well as the geographic mix of earnings. Those impacts were partially offset by the non-tax deductible amortization of the fair value step-up in inventories as a result of the Merger, certain net exchange losses recognized on the remeasurement of the net monetary asset positions which were not tax deductible in their local jurisdictions, as well as the tax impact of costs associated with the Merger with Historical Dow and restructuring and asset related charges. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued For the period January 1 through August 31, 2017, the company’s effective tax rate of 1,067.6 percent on pre-tax loss from continuing operations of $(37) million was favorably impacted by the geographic mix of earnings, certain net exchange gains recognized on the remeasurement of the net monetary asset positions which were not taxable in their local jurisdictions, net favorable tax consequences of the adoption of Financial Accounting Standards Board ("FASB") Accounting Standards Update ("ASU") No. 2016-09, Compensation - Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting, tax benefits related to a reduction in the company’s unrecognized tax benefits due to the closure of various tax statutes of limitations, as well as tax benefits on costs associated with the Merger with Historical Dow and restructuring and asset related charges. The company's effective tax rate was 748.1 percent on pre-tax pro forma loss from continuing operations of $(389) million for the year ended December 31, 2017. The pro forma pre-tax loss excludes pre-tax charges of $482 million, $204 million, and $195 million, primarily related to the removal expenses directly attributable to the Merger, removal of interest expense related to paying off or retiring portions of EID’s existing debt liabilities (as discussed in Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements), and removal of expenses directly attributable to the Separation, respectively. The pro forma benefit from income taxes on continuing operations excludes net tax (benefits) charges of $(175) million, $(74) million and $(71) million related to the above items, respectively. Additionally, the pro forma benefit from income taxes on continuing operations reflects a $378 million reduction to the benefit as if Historical DuPont and DAS were consolidated affiliates for the Predecessor period. In addition, the pro forma pre-tax loss includes a pre-tax loss of $(772) million for DAS for the period January 1 through August 31, 2017, and a tax benefit of $236 million related to the loss. (Loss) Income from Discontinued Operations After Tax 2019 versus 2018 (Loss) income from discontinued operations after tax was $(671) million for the year ended December 31, 2019 and $1,748 million for the year ended December 31, 2018. The change was primarily driven by a non-cash goodwill impairment charge of $1,102 million and adjustments of certain unrecognized tax benefits for positions taken on items from prior years from previously divested businesses. 2018 versus 2017 (Loss) income from discontinued operations after tax was $1,748 million for the year ended December 31, 2018, $(568) million for the period September 1 through December 31, 2017, and $1,403 million for the period January 1 through August 31, 2017. The amounts are primarily driven by the divestitures of EID ECP, the EID Specialty Products Entities, the Divested Ag Business, and Performance Chemicals. Refer to Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for additional information. EID Analysis of Operations As discussed in Note 1 - Basis of Presentation, to the EID Consolidated Financial Statements, EID is a subsidiary of Corteva, Inc. and continues to be a reporting company, subject to the requirements of the Exchange Act. The below relates to EID only and is presented to provide an Analysis of Operations, only for the differences between EID and Corteva, Inc. Interest Expense 2019 versus 2018 EID’s interest expense was $242 million for the year ended December 31, 2019 and $337 million for the year ended December 31, 2018, driven by the items noted on page 47, under the header “Interest Expense - 2019 versus 2018”, partially offset by interest expense incurred on the related party loan between EID and Corteva, Inc. See Note 2 - Related Party Transactions, to the EID Consolidated Financial Statements for further information. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Provision for Income Taxes For the year ended December 31, 2019, EID had an effective tax rate of 16.8 percent on pre-tax loss from continuing operations of $(422) million, driven by the items noted on page 48, under the header “Provision for Income Taxes - 2019” and a tax benefit related to the interest expense incurred on the related party loan between EID and Corteva, Inc. See Note 3 - Income Taxes, to the EID Consolidated Financial Statements for further information. Corporate Outlook Global demand for agriculture products continues to be strong, but growth is slow. Slower growth in China and other key emerging markets is impacting the outlook for demand for commodity grains and oilseeds. Additionally, the recent U.S. - China Phase 1 trade agreement and the United States-Mexico-Canada Agreement are expected to have a positive impact on demand for U.S. agriculture products. It is expected that corn and soybean area and production will be higher in 2020 and the United States Department of Agriculture (“USDA”) estimates that farm prices will increase modestly. The company expects a 4 - 5 percent increase in net sales, driven by a return to more normalized conditions in North America and continued penetration of new product sales. Additionally, the company expects year over year currency impacts to be minimal. The company expects Operating EBITDA to increase approximately 12 percent and Operating Earnings Per Share to increase approximately 5 percent, driven by the above increase in sales, synergies and productivity actions. Refer to further discussion of Non-GAAP metrics on pages 58 - 60. Corteva is not able to reconcile its forward-looking non-GAAP financial measures to its most comparable U.S. GAAP financial measures, as it is unable to predict with reasonable certainty items outside of the company’s control, such as Significant Items, without unreasonable effort (refer to page 59 for Significant Items recorded in the years ended December 31, 2019, 2018 and 2017). However, the company expects non-operating benefits - net, to be slightly higher, as a result of an increase in long-term employee benefit credits, and expects an increase in amortization expense in 2020. Refer to Note 15 - Goodwill and Other Intangible Assets, to the Consolidated Financial Statements and to the company's discussion on Long-term Employee Benefits on page 72. Additionally, beginning January 1, 2020, the company expects to recognize non-cash accelerated prepaid royalty amortization expense as a restructuring and asset related charge. For further discussion of accelerated prepaid royalty amortization refer to the Company's Critical Accounting Estimates for Prepaid Royalties on page 70. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Supplemental Unaudited Pro Forma Financial Information The supplemental unaudited pro forma statements of operations (the "unaudited pro forma statements of operations") for Corteva for the years ended December 31, 2019 and 2018 give effect to the Merger, the debt retirement transactions related to paying off or retiring portions of EID’s existing debt liabilities (as discussed in Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements), and the separation and distribution to DowDuPont stockholders of all the outstanding shares of Corteva common stock as if they had been consummated on January 1, 2016. The unaudited pro forma statement of operations for the year ended December 31, 2017 gives effect to the above noted transactions in addition to the common control business combination with DAS, as if it had been consummated on January 1, 2016, which the Company believes provides meaningful information to investors as a useful comparison of year over year results. For the periods presented below, Corteva’s results for all periods prior to the Business Realignment and Internal Reorganization consist of the combined results of operations for Historical EID and DAS, and Corteva’s results for all periods after the Business Realignment and Internal Reorganization represent the consolidated balances of the company. The unaudited pro forma statements of operations below were prepared in accordance with Article 11 of Regulation S-X, and events that are not expected to have a continuing impact on the combined results (e.g., amortization of inventory step-up costs) are excluded. One-time transaction-related costs incurred prior to, or concurrent with, the closing of the Merger, the debt redemptions/repayments, and the Corteva Distribution are not included in the unaudited pro forma combined statements of operations through March 31, 2019. The unaudited pro forma combined statements of operations do not reflect restructuring or integration activities or other costs following the separation and distribution transactions that may be incurred to achieve cost or growth synergies of Corteva. As no assurance can be made that these costs will be incurred or the growth synergies will be achieved, no adjustment has been made. The unaudited pro forma statements of operations have been presented for informational purposes only and are not necessarily indicative of what Corteva’s results of operations actually would have been had the above transactions been completed on January 1, 2016. In addition, the unaudited pro forma statements of operations do not purport to project the future operating results of the company. The unaudited pro forma statements of operations were based on and should be read in conjunction with the audited Consolidated Financial Statements and Notes contained within this Annual Report on Form 10-K. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 1. Represents the removal of amortization of EID’s agriculture business’ inventory step-up recognized in connection with the Merger, as the incremental amortization is directly attributable to the Merger and will not have a continuing impact. 2. Represents removal of interest expense related to the debt redemptions/repayments. 3. Adjustments directly attributable to the separations and distributions of Corteva, Inc. include the following: removal of Telone® Soil Fumigant business (“Telone®”) results (as Telone® did not transfer to Corteva as part of the common control combination of DAS); impact from the distribution agreement entered into between Corteva and Dow that allows for Corteva to become the exclusive distributor of Telone® products for Dow; elimination of one-time transaction costs directly attributable to the Corteva Distribution; the impact of certain manufacturing, leasing and supply agreements entered into in connection with the Corteva Distribution; and the related tax impacts of these items. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 1. Represents the removal of amortization of EID’s agriculture business’ inventory step-up recognized in connection with the Merger, as the incremental amortization is directly attributable to the Merger and will not have a continuing impact. 2. Represents removal of interest expense and loss on early extinguishment of debt related to the debt redemptions/repayments. 3. Adjustments directly attributable to the separations and distributions of Corteva, Inc. includes the following: removal of Telone®; impact from the distribution agreement entered into between Corteva and Dow that allows for Corteva to become the exclusive distributor of Telone® products for Dow; elimination of one-time transaction costs directly attributable to the Corteva Distribution; the impact of certain manufacturing, leasing and supply agreements entered into in connection with the Corteva Distribution; and the related tax impacts of these items. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued 1. Represents DAS results for the period January 1 through August 31, 2017; the removal of the results of the DAS Brazil corn seed business which was sold to CITIC Agri Fund in the fourth quarter of 2017 as a condition of regulatory approval of the Merger between Historical Dow and Historical DuPont; and certain reclassification adjustments to align the financial statement presentation of DAS to that of Corteva. 2. Adjustments directly attributable to the Merger include the following: elimination of intercompany transactions between DAS and EID; reclassification of the Predecessor period financial statement presentation to align with Successor presentation; additional depreciation expense related to the fair value step-up of EID's agriculture business' property, plant and equipment; additional amortization expense related to the fair value step-up of EID's agriculture business' intangible assets; elimination of one time transaction costs directly attributable to the Merger; reduction in interest expense related to the amortization of the fair value adjustment to EID's long-term debt; the removal of amortization of EID’s agriculture business’ inventory step-up recognized in connection with the Merger; the reclassification of interest associated with uncertain tax positions; and the related tax impacts of these items. 3. Represents removal of interest expense related to the debt redemptions/repayments. 4. Adjustments directly attributable to the separations and distributions of Corteva, Inc. includes the following: removal of Telone®; impact from the distribution agreement entered into between Corteva and Dow that allows for Corteva to become the exclusive distributor of Telone® products for Dow; elimination of one-time transaction costs directly attributable to the Corteva Distribution; the impact of certain manufacturing, leasing and supply agreements entered into in connection with the Corteva Distribution; and the related tax impacts of these items. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Recent Accounting Pronouncements See Note 3 - Recent Accounting Guidance, to the Consolidated Financial Statements for a description of recent accounting pronouncements. Segment Reviews The company operates in two reportable segments: seed and crop protection. The company’s seed segment is a global leader in developing and supplying advanced germplasm and traits that produce optimum yield for farms around the world. The segment offers trait technologies that improve resistance to weather, disease, insects and weeds, and trait technologies that enhance food and nutritional characteristics, and also provides digital solutions that assist farmer decision-making with a view to optimize product selection and, ultimately, maximize yield and profitability. The segment competes in a wide variety of agricultural markets. The crop protection segment serves the global agricultural input industry with products that protect against weeds, insects and other pests, and disease, and that improve overall crop health both above and below ground via nitrogen management and seed-applied technologies. The segment is a leader in global herbicides, insecticides, below-ground nitrogen stabilizers and pasture and range management herbicides. Summarized below are comments on individual segment net sales and segment operating EBITDA for the years ended December 31, 2019, December 31, 2018 and December 31, 2017. For all periods presented, segment operating EBITDA is calculated on a pro forma basis, as this is the manner in which the chief operating decision maker ("CODM") assesses performance and allocates resources. Additionally, segment sales for the year ended December 31, 2017 are calculated on a pro forma basis. Pro forma adjustments used in the calculation of pro forma segment operating EBITDA were determined in accordance with Article 11 of Regulation S-X. For the years ended December 31, 2019 and 2018, these adjustments give effect to the Merger, the debt retirement transactions related to paying off or retiring portions of EID’s existing debt liabilities (as discussed in Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements), and the separation and distribution to DowDuPont stockholders of all the outstanding shares of Corteva common stock as if they had been consummated on January 1, 2016. For the year ended December 31, 2017, in addition to the above, the adjustments give effect to the common control business combination with DAS, as if it had been consummated on January 1, 2016 (refer to supplemental unaudited pro forma financial statements on page 51). The company defines segment operating EBITDA as earnings (i.e., income from continuing operations before income taxes) before interest, depreciation, amortization, corporate expenses, non-operating costs-net and foreign exchange gains (losses), excluding the impact of significant items (including goodwill impairment charges). Non-operating costs-net consists of non-operating pension and OPEB costs, tax indemnification adjustments, environmental remediation and legal costs associated with legacy EID businesses and sites. Tax indemnification adjustments relate to changes in indemnification balances, as a result of the application of the terms of the Tax Matters Agreement, between Corteva and Dow and/or DuPont that are recorded by the company as pre-tax income or expense. See Note 25 - Segment Information, to the Consolidated Financial Statements for details related to significant pre-tax benefits (charges) excluded from segment operating EBITDA. All references to prices are based on local price unless otherwise specified. A reconciliation of pro forma segment operating EBITDA to income from continuing operations before income taxes for the years ended December 31, 2019 and 2018 is included in Note 25 - Segment Information, to the Consolidated Financial Statements. As previously noted, the Predecessor period reflects the results of operations and assets and liabilities of Historical DuPont and excludes the DAS business. As a result, the company's segment results for the Predecessor and Successor periods of 2017 do not reflect the manner in which the company's CODM assesses performance and allocates resources, therefore the company determined that presenting segment results for each standalone period in 2017 would not be meaningful to the reader. Therefore, segment metrics are not presented for the Successor and Predecessor periods of 2017, and instead are presented for the full year of 2017 on a pro forma basis. Refer to page 60 for reconciliation of pro forma income from continuing operations after income taxes to pro forma segment operating EBITDA, for the year ended December 31, 2017. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Seed Seed net sales were $7,590 million in 2019, down from $7,842 million in 2018. The decrease was primarily due to a 2 percent decline in currency and a 1 percent decline in volume. Local price was flat. Unfavorable currency impacts were primarily due to the Brazilian Real, Eastern European currencies, and the Euro. Volume gains in corn in EMEA were more than offset by significant weather-related planting delays in North America, leading to a reduction in planted area for soybeans, and multi-channel and multi-brand rationalization impacts in North America. Competitive pricing pressure in soybeans in the U.S. and increased soybean and corn replant in North America were offset by favorable mix and continued penetration of PowerCore Ultra® in Latin America. Seed pro forma operating EBITDA was $1,040 million in 2019, down 9 percent from $1,139 million in 2018. Competitive pricing pressure, the unfavorable impact of currency, increased commissions and input costs, and volume declines more than offset cost synergies and ongoing productivity. Seed net sales were $7,842 million in 2018, $1,520 million for the period September 1 through December 31, 2017 and $5,865 million for the period January 1 through August 31, 2017. Pro forma net sales for the year ended December 31, 2017 were $8,056 million. The decrease in pro forma net sales was primarily due to a 3 percent decline in volume and a 1 percent decline in currency, partially offset by a 1 percent increase in local price. Volume declines represented lower planted area in North America and Latin America. Increases in local price and product mix were driven by continued penetration of new corn hybrids and A-Series soybeans. Seed pro forma operating EBITDA was $1,139 million in 2018, down 3 percent from $1,170 million in 2017. Cost synergies were more than offset by lower volume, higher raw material costs and royalty expense, and investments to support new product launches and digital platforms. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Crop Protection Crop protection net sales were $6,256 million in 2019, down from $6,445 million in 2018. The decrease was primarily due to a 3 percent decline in currency and a 1 percent decline in portfolio, partially offset by a 1 percent increase in volume. Local price was flat. Unfavorable currency impacts were primarily due to Brazilian Real and the Euro. Volume gains driven by new product launches - including EnlistTM and ArylexTM herbicides and IsoclastTM insecticide - were partially offset by the unfavorable weather in North America, which resulted in lost spring applications. Pricing gains from new products launches were offset by increased grower incentive program discounts in North America. The portfolio impact was driven by divestitures in North America and Asia Pacific. Crop Protection pro forma operating EBITDA was $1,066 million in 2019, down 1 percent from $1,074 million in 2018. Volume declines in North America, the unfavorable impact of currency, and higher input costs more than offset cost synergies, sales from new products, and ongoing productivity. Crop protection net sales were $6,445 million in 2018, $2,270 million for the period September 1 through December 31, 2017 and $1,029 million for the period January 1 through August 31, 2017. Pro forma net sales for the year ended December 31, 2017 were $6,185 million. The increase in pro forma net sales was primarily due to a 3 percent increase in volume and a 3 percent increase in local price, partially offset by a 2 percent decline in currency. Volume gains were driven by new product launches such as VessaryaTM fungicides, EnlistTM products, and IsoclastTM, Pyraxalt™ and Spinosyn™ insecticides and were partly offset by lower demand for nitrogen stabilizers in North America and currency pressures in Latin America. Increases in local prices were driven by continuing efforts to capture value in established brands across the crop protection portfolio globally. Crop Protection pro forma operating EBITDA was $1,074 million in 2018, up 15 percent from $936 million in 2017. Cost synergies and sales gains from new product launches were partially offset by growth investments, including for new product launches, higher raw material costs and the unfavorable impact of currency. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Non-GAAP Financial Measures The company presents certain financial measures that do not conform to U.S. GAAP and are considered non-GAAP measures. These measures include pro forma operating EBITDA and pro forma operating earnings per share. Management believes that these non-GAAP measures best reflect the ongoing performance of the company during the periods presented and provide more relevant and meaningful information to investors as they provide insight with respect to ongoing operating results of the company and a more useful comparison of year over year results. These non-GAAP measures supplement the company's U.S. GAAP disclosures and should not be viewed as an alternative to U.S. GAAP measures of performance. Furthermore, such non-GAAP measures may not be consistent with similar measures provided or used by other companies. Reconciliations for these non-GAAP measures to U.S. GAAP are provided below. For all periods presented, these non-GAAP measures are being reconciled to a pro forma GAAP financial measure prepared and presented in accordance with Article 11 of Regulation S-X, which are reconciled to the GAAP reported figures. See Article 11 Pro Forma Combined Statements of Operations on page 51. Pro Forma Operating EBITDA is defined as earnings (i.e., income from continuing operations before income taxes) before interest, depreciation, amortization, non-operating benefits, net and foreign exchange gains (losses), excluding the impact of significant items (including goodwill impairment charges). Non-operating benefits, net consists of non-operating pension and OPEB credits, tax indemnification adjustments, environmental remediation and legal costs associated with legacy businesses and sites of Historical DuPont. Tax indemnification adjustments relate to changes in indemnification balances, as a result of the application of the terms of the Tax Matters Agreement, between Corteva and Dow and/or DuPont that are recorded by the company as pre-tax income or expense. Pro forma operating earnings per share is defined as "Earnings per common share from continuing operations - diluted" excluding the after-tax impact of significant items (including goodwill impairment charges), the after-tax impact of non-operating benefits, net, and the after-tax impact of amortization expense associated with intangible assets existing as of the Separation from DowDuPont. Although amortization of the Company's intangible assets is excluded from these non-GAAP measures, management believes it is important for investors to understand that such intangible assets contribute to revenue generation. Amortization of intangible assets that relate to past acquisitions will recur in future periods until such intangible assets have been fully amortized. Any future acquisitions may result in amortization of additional intangible assets. Reconciliation of Pro Forma Income from Continuing Operations after Income Taxes to Pro Forma Operating EBITDA Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued As discussed in Note 25 - Segment Information, the Predecessor period reflects the results of operations and assets and liabilities of Historical DuPont and excludes the DAS business. As a result, the company's segment results for the Predecessor and Successor periods of 2017 do not reflect the manner in which the company's chief operating decision maker assesses performance and allocates resources, therefore the company determined that presenting segment results for each standalone period in 2017 would not be meaningful to the reader. Below is a reconciliation of pro forma income from continuing operations after income taxes to pro forma segment operating EBITDA for the year ended December 31, 2017. Significant Items 1. The tax benefit impact of significant items for the year ended December 31, 2019 includes a net tax charge of $35 million related to application of the U.S. Tax Reform’s foreign tax provisions, a net tax charge of $146 million related to U.S. state blended tax rate changes associated with the Business Separations, and a net tax benefit of $(102) million related to an internal legal entity restructuring associated with the Business Separations. Unless specifically addressed above, the income tax effect on significant items was calculated based upon the enacted tax laws and statutory income tax rates applicable in the tax jurisdiction(s) of the underlying non-GAAP adjustment. 2. The tax only significant item (benefits) charges are primarily related to effects of U.S. and Swiss Tax Reform, the Internal Reorganizations and Business Separations, and the release of a tax valuation allowance recorded against the net deferred tax asset position of a Swiss legal entity. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Reconciliation of Pro Forma Income (Loss) from Continuing Operations Attributable to Corteva and Pro Forma Earnings (Loss) Per Share of Common Stock from Continuing Operations - Diluted to Pro Forma Operating Earnings and Pro Forma Operating Earnings Per Share Liquidity & Capital Resources The company continually reviews its sources of liquidity and debt portfolio and occasionally may make adjustments to one or both to ensure adequate liquidity. The company's cash, cash equivalents and marketable securities at December 31, 2019 and December 31, 2018 were $1.8 billion, and $2.3 billion respectively. Total debt at December 31, 2019 and December 31, 2018 was $122 million and $7,938 million, respectively. The decrease in cash and debt balances was primarily due to debt redemption/repayment transactions. See further information under Note 17 - Short-term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements. The company's credit ratings impact its access to the debt capital markets and cost of capital. The company remains committed to a strong financial position and strong investment-grade rating. The company's long-term and short-term credit ratings assigned to EID are as follows: 1. In addition, Standard & Poor’s has assigned to Corteva, Inc. a long-term issuer rating of A- with Stable outlook. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued The company believes its ability to generate cash from operations and access to capital markets and commercial paper markets will be adequate to meet anticipated cash requirements to fund its operations, including seasonal working capital, capital spending, dividend payments, share repurchases and pension contributions. Corteva's strong financial position, liquidity and credit ratings will provide access as needed to capital markets and commercial paper markets to fund seasonal working capital needs. The company's liquidity needs can be met through a variety of sources, including cash provided by operating activities, commercial paper, syndicated credit lines, bilateral credit lines, long-term debt markets, bank financing and committed receivable repurchase facilities. The company has access to approximately $6.4 billion in committed and uncommitted unused credit lines at December 31, 2019. These unused credit lines provide support to meet the company’s short-term liquidity needs and for general corporate purposes which may include funding of pension contributions, severance payments, working capital, capital expenditures, and funding Corteva's expenses. In November 2018, EID entered into a $3.0 billion five-year revolving credit facility and a $3.0 billion three-year revolving credit facility (the “2018 Revolving Credit Facilities”). The 2018 Revolving Credit Facilities became effective May 2019 in connection with the termination of the EID $4.5 billion Term Loan Facility and the $3.0 billion Revolving Credit Facility dated May 2014. Corteva, Inc. became a party to the 2018 Revolving Credit Facilities upon the Corteva Distribution. The 2018 Revolving Credit Facilities contain customary representations and warranties, affirmative and negative covenants and events of default that are typical for companies with similar credit ratings. The 2018 Revolving Credit Facilities also contain a financial covenant requiring that the ratio of total indebtedness to total capitalization for Corteva and its consolidated subsidiaries not exceed 0.60. At December 31, 2019, the company was in compliance with these covenants. The company's indenture covenants include customary limitations on liens, sale and leaseback transactions, and mergers and consolidations affecting manufacturing plants, mineral producing properties or research facilities located in the U.S. and the consolidated subsidiaries owning such plants, properties and facilities subject to certain limitations. The outstanding long-term debt also contains customary default provisions. The company has meaningful seasonal working capital needs based in part on providing financing to its customers. Working capital is funded through multiple methods including commercial paper, a receivable repurchase facility, factoring and cash from operations. In February 2019, in line with seasonal working capital requirements, the company entered into a committed receivable repurchase agreement of up to $1.3 billion (the "2019 Repurchase Facility") which expired in December 2019. Under the 2019 Repurchase Facility, the company sold a portfolio of available and eligible outstanding customer notes receivables to participating institutions and simultaneously agreed to repurchase at a future date. In February 2020, the company entered into a new committed receivable repurchase facility of up to $1.3 billion (the "2020 Repurchase Facility") which expires in December 2020. See further discussion of the 2020 Repurchase Facility in Note 27 - Subsequent Events, to the Consolidated Financial Statements. The company has factoring agreements with third-party financial institutions primarily in Latin America to sell its trade receivables under both recourse and non-recourse agreements in exchange for cash proceeds in an effort to reduce its receivables risk. For arrangements that include an element of recourse, the company provides a guarantee of the trade receivables in the event of customer default. Refer to Note 12 - Accounts and Notes Receivable - Net, to the Consolidated Financial Statements for more information. The company also organizes agreements with third-party financial institutions who directly provide financing for select customers of its seed and crop protection products in each region. Terms of the third-party loans are less than a year and programs are renewed on an annual basis. In some cases, the company guarantees a portion of the extension of such credit to such customers. Refer to Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements for more information on the company’s guarantees. Capacity Expansion The company's Board of Directors authorized an investment of approximately $145 million to increase Spinosyns fermentation capacity by 30% to address global market growth in insecticides that handle chewing insects in specialty and row crops. The additional capacity will be staged to come online over the next few years. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Debt Redemptions/Repayments In the fourth quarter of 2018, the company offered to purchase for cash approximately $6.2 billion of outstanding debt securities from each registered holder of the applicable series of debt securities (the “Tender Offers”). The company retired $4.4 billion aggregate principal amount of such debt securities in connection with the Tender Offers, which expired on December 11, 2018. The retirement of these debt securities was funded with cash contributions from DowDuPont. On March 22, 2019, EID issued notices of redemption in full of all of its outstanding notes (the “Make Whole Notes”) listed in the table below: The Make Whole Notes were redeemed on April 22, 2019 at the make-whole redemption prices set forth in the respective Make Whole Notes. On and after the date of redemption, the Make Whole Notes were no longer deemed outstanding, interest on the Make Whole Notes ceased to accrue and all rights of the holders of the Make Whole Notes were terminated. For further information on the Make Whole Notes, see Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements and Recent Developments. In March 2016, the company entered into a credit agreement that provides for a three-year, senior unsecured term loan facility in the aggregate principal amount of $4.5 billion (as amended, from time to time, the "Term Loan Facility") under which EID could make up to seven term loan borrowings and amounts repaid or prepaid were not available for subsequent borrowings. On May 2, 2019, EID terminated its Term Loan Facility and repaid the aggregate outstanding principal amount of $3 billion plus accrued and unpaid interest through and including May 1, 2019. For further information on the termination of the Term Loan Facility, see Note 17 - Short-Term Borrowings, Long-Term Debt and Available Credit Facilities, to the Consolidated Financial Statements and Recent Developments. In connection with the repayment of the Make Whole Notes and the Term Loan Facility, EID paid a total of $4.6 billion in the second quarter 2019, which included breakage fees and accrued and unpaid interest on the Make Whole Notes and Term Loan Facility. The repayment of the Make Whole Notes and Term Loan Facility was funded with cash from operations and a contribution from DowDuPont. On May 7, 2019, DowDuPont publicly announced the record date in connection with the Corteva Distribution. In connection with such announcement, EID was required to redeem $1.25 billion aggregate principal amount of 2.200% Notes due 2020 and $750 million aggregate principal amount of Floating Rate Notes due 2020 (collectively, the Special Mandatory Redemption or “SMR Notes”) setting forth the date of redemption of the SMR Notes. The date of redemption was May 17, 2019 and the company paid a total of $2.0 billion, which included accrued and unpaid interest on the SMR Notes. The company funded the payment with a contribution from DowDuPont. Following the redemption, the SMR Notes are no longer outstanding and no longer bear interest and all rights of the holders of the SMR Notes have terminated. The company's cash, cash equivalents and marketable securities at December 31, 2019 and December 31, 2018 are $1.8 billion and $2.3 billion, respectively, of which $1.5 billion at December 31, 2019 and $1.7 billion at December 31, 2018, was held by subsidiaries in foreign countries, including United States territories. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued The Act required companies to pay a one-time transition tax on the untaxed earnings of foreign subsidiaries (see Note 10 - Income Taxes, to the Consolidated Financial Statements for further details of The Act). Upon actual repatriation, such earnings could be subject to withholding taxes, foreign and / or U.S. state income taxes, and taxes resulting from the impact of foreign currency movements. The Act also introduced a 100 percent dividends received deduction regarding earnings of foreign subsidiaries. The cash held by foreign subsidiaries is generally used to finance the subsidiaries' operational activities and future foreign investments. At December 31, 2019, management believed that sufficient liquidity is available in the U.S. Cash provided by operating activities for the year ended December 31, 2019 was $1,070 million compared to $483 million for the year ended December 31, 2018. The increase in cash provided by operating activities was primarily driven by lower pension contributions in 2019, as a result of the company’s 2018 discretionary pension contribution, and a decrease in integration and separation costs, partially offset by the net impact of lower net income and working capital changes as a result of the Internal Reorganizations and Business Realignments in 2019. Cash provided by operating activities was $3,674 million for the period September 1 through December 31, 2017, primarily driven by Corteva's seasonal cash flows and a tax refund related to voluntary pension contributions made in the Predecessor period, partially offset by transaction costs and the PFOA multi-district litigation settlement, which was primarily paid in September. Cash used for operating activities was $(3,949) million for the period January 1 through August 31, 2017, primarily driven by pension contributions of $3,024 million, Corteva's seasonal cash flows, transaction costs and tax payments, partially offset by earnings. Cash used for investing activities was $(904) million for the year ended December 31, 2019 compared to $(505) million for the year ended December 31, 2018, primarily due to a decrease in net proceeds from sales and maturities of investments, partially offset by a reduction in capital expenditures as a result of the Internal Reorganizations and Business Realignments in 2019 and an increase in proceeds from sales of property, businesses and consolidated companies. Cash provided by investing activities was $3,678 million for the period September 1 through December 31, 2017, primarily driven by approximately $1,200 million of cash received for the FMC Transactions, approximately $1,100 million of cash received for the DAS Divested Ag Business (see Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for additional information) and net proceeds from investments, partially offset by capital expenditures. Cash used for investing activities was $(2,382) million for the period January 1 through August 31, 2017, primarily driven by net purchases of investments, capital expenditures, payments for the acquisition of Granular and net payments from foreign currency contracts, partially offset by proceeds from the sale of property and businesses. Capital expenditures totaled $1,163 million for the year ended December 31, 2019, $1,501 million for the year ended December 31, 2018, $499 million for the period September 1 through December 31, 2017, and $687 million for the period January 1 through August 31, 2017. The company expects 2020 capital expenditures to be between $500 million and $600 million. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Cash used for financing activities was $(2,929) million for the year ended December 31, 2019 compared to $(2,624) million for the year ended December 31, 2018. The change was due to repayments of commercial paper and long-term debt and transfers of cash to DowDuPont in connection with the Internal Reorganization and Business Realignments in 2019, partially offset by a net increase in contributions from Dow and DowDuPont, primarily for repayment of long-term debt, and a decrease in distributions to Dow and DowDuPont which were used to fund a portion of DowDuPont’s dividend payments, and in 2018 to fund a portion of DowDuPont’s share repurchases. Cash used for financing activities was $(3,607) million for the period September 1 through December 31, 2017, primarily driven by repayments of commercial paper, distributions to Dow and DowDuPont and dividends paid to Historical DuPont shareholders, partially offset by borrowings under the Term Loan. Dividend payments to shareholders of Historical DuPont common stock included a third quarter 2017 dividend declared for common stockholders of record July 31, 2017 and paid in September 2017. Cash provided by financing activities was $5,632 million for the period January 1 through August 31, 2017, primarily driven by a debt offering in May of 2017 as well as borrowings from commercial paper, the Repurchase Facility, and the Term Loan Facility, partially offset by dividends paid to stockholders. In June 2019, the company's Board of Directors authorized a common stock dividend of $0.13 per share, payable on September 13, 2019, to shareholders of record on July 31, 2019. In October 2019, the company's Board of Directors authorized a common stock dividend of $0.13 per share, payable on December 18, 2019, to shareholders of record on November 29, 2019. On June 26, 2019, the company announced that the Board of Directors authorized a $1 billion share repurchase program to purchase Corteva, Inc.'s common stock, par value $0.01 per share, without an expiration date. The program is expected to be completed in three years. During 2019, the company purchased and retired 824,000 shares for a total cost of $25 million. See Note 19 - Stockholders' Equity, to the Consolidated Financial Statements for additional information related to the share buyback plan. EID Liquidity Discussion As discussed in Note 1 - Basis of Presentation, to the EID Consolidated Financial Statements, EID is a subsidiary of Corteva, Inc. and continues to be a reporting company, subject to the requirements of the Exchange Act. The below relates to EID only and is presented to provide a Liquidity discussion, only for the differences between EID and Corteva, Inc. Cash provided by operating activities EID’s cash provided by operating activities for the year ended December 31, 2019 was $996 million compared to $483 million for the year ended December 31, 2018. The increase was primarily driven by the items noted on page 63, under the header “Cash provided by (used for) operating activities,” partially offset by interest incurred on the related party loan between EID and Corteva, Inc. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Cash used for financing activities EID’s cash used for financing activities was $(2,855) million for the year ended December 31, 2019 compared to $(2,624) million for the year ended December 31, 2018. The change was due to repayments of commercial paper and long-term debt, transfers of cash to DowDuPont in connection with the Internal Reorganization and Business Realignments in 2019, and a net decrease in contributions from Dow and DuPont, primarily for repayment of long-term debt, partially offset by proceeds received from the related party loan between EID and Corteva, Inc., and a decrease in distributions to Dow and DowDuPont which were used to fund a portion of DowDuPont’s dividend payments, and in 2018 to fund a portion of DowDuPont’s share repurchases. See Note 2 - Related Party Transactions, to the EID Consolidated Financial Statements for further information on the related party loan between EID and Corteva, Inc. Critical Accounting Estimates The company's significant accounting policies are more fully described in Note 2 - Summary of Significant Accounting Policies, to the Consolidated Financial Statements. Management believes that the application of these policies on a consistent basis enables the company to provide the users of the financial statements with useful and reliable information about the company's operating results and financial condition. The preparation of the Consolidated Financial Statements in conformity with generally accepted accounting principles ("GAAP") in the United States of America requires management to make estimates and assumptions that affect the reported amounts, including, but not limited to, receivable and inventory valuations, impairment of tangible and intangible assets, long-term employee benefit obligations, income taxes, environmental matters and litigation. Management's estimates are based on historical experience, facts and circumstances available at the time and various other assumptions that are believed to be reasonable. The company reviews these matters and reflects changes in estimates as appropriate. Management believes that the following represent some of the more critical judgment areas in the application of the company's accounting policies which could have a material effect on the company's financial position, liquidity or results of operations. Pension Plans and Other Post Employment Benefits Accounting for employee benefit plans involves numerous assumptions and estimates. Discount rate and expected return on plan assets are two critical assumptions in measuring the cost and benefit obligation of the company's pension and OPEB plans. Management reviews these two key assumptions when plans are re-measured. These and other assumptions are updated periodically to reflect the actual experience and expectations on a plan specific basis as appropriate. As permitted by GAAP, actual results that differ from the assumptions are accumulated on a plan by plan basis and to the extent that such differences exceed 10 percent of the greater of the plan's benefit obligation or the applicable plan assets, the excess is amortized over the average remaining service period of active employees or the average remaining life expectancy of the inactive participants if all or almost all of a plan’s participants are inactive. Substantially all of the company's benefit obligation for pensions and OPEB are attributable to the benefit plans in the U.S. In the U.S., the single equivalent discount rate is developed by matching the expected cash flow of the benefit plans to a yield curve constructed from a portfolio of high quality fixed-income instruments provided by the plans' actuaries as of the measurement date. The company measures the service and interest cost components utilizing a full yield curve approach by applying the specific spot rates along the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. For non-U.S. benefit plans, historically the company utilized prevailing long-term high quality corporate bond indices to determine the discount rate, applicable to each country, at the measurement date. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Within the U.S., the company establishes strategic asset allocation percentage targets and appropriate benchmarks for significant asset classes with the aim of achieving a prudent balance between return and risk. Strategic asset allocations in other countries are selected in accordance with the laws and practices of those countries. Where appropriate, asset-liability studies are also taken into consideration. The long-term expected return on plan assets in the U.S. is based upon historical real returns (net of inflation) for the asset classes covered by the investment policy, expected performance, and projections of inflation and interest rates over the long-term period during which benefits are payable to plan participants. Consistent with prior years, the long-term expected return on plan assets in the U.S. reflects the asset allocation of the plan and the effect of the company's active management of the plan's assets. In connection with pension contributions of $2,900 million to its principal U.S. pension plan for the period of January 1, 2017 through August 31, 2017, an investment policy study was completed for the principal U.S. pension plan. The study resulted in new target asset allocations for the U.S. pension plan with resulting changes to the expected return on plan assets. The long-term rate of return on assets decreased from 8.00 percent for the Predecessor period to 6.25 percent for the Successor period in 2017. In determining annual expense for the principal U.S. pension plan, the company uses a market-related value of assets rather than its fair value. Accordingly, there may be a lag in recognition of changes in market valuation. As a result, changes in the fair value of assets are not immediately reflected in the company's calculation of net periodic pension cost. Generally, the market-related value of assets is calculated by averaging market returns over 36 months, however, as a result of the Merger, for the Successor periods, the market-related value of assets was calculated by averaging market returns from September 1, 2017 through the respective year ends. The following table shows the market-related value and fair value of plan assets for the principal U.S. pension plan: For plans other than the principal U.S. pension plan, pension expense is determined using the fair value of assets. The following table highlights the potential impact on the company's pre-tax earnings due to changes in certain key assumptions with respect to the company's pension and OPEB plans, based on assets and liabilities at December 31, 2019: Additional information with respect to pension and OPEB expenses, liabilities and assumptions is discussed under "Long-term Employee Benefits" beginning on page 72 and in Note 20 - Pension Plans and Other Post Employment Benefits, to the Consolidated Financial Statements. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Environmental Matters Accruals for environmental matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. At December 31, 2019, the company had accrued obligations of $336 million for probable environmental remediation and restoration costs, including $51 million for the remediation of Superfund sites. As remediation activities vary substantially in duration and cost from site to site, it is difficult to develop precise estimates of future site remediation costs. The company's estimates are based on a number of factors, including the complexity of the geology, the nature and extent of contamination, the type of remedy, the outcome of discussions with regulatory agencies and other Potentially Responsible Parties ("PRPs") at multi-party sites and the number of and financial viability of other PRPs. Therefore, considerable uncertainty exists with respect to environmental remediation and costs, and, under adverse changes in circumstances, it is reasonably possible that the ultimate cost with respect to these particular matters could range up to $620 million above 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 or cash flows. For further discussion, see Environmental Matters in Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 3 - Recent Accounting Guidance, and Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements. Legal Contingencies The company's results of operations could be affected by significant litigation adverse to the company, including product liability claims, patent infringement and antitrust claims, and claims for third party property damage or personal injury stemming from alleged environmental torts. The company records accruals for legal matters when the information available indicates that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Management makes adjustments to these accruals to reflect the impact and status of negotiations, settlements, rulings, advice of counsel and other information and events that may pertain to a particular matter. Predicting the outcome of claims and lawsuits and estimating related costs and exposure involves substantial uncertainties that could cause actual costs to vary materially from estimates. In making determinations of likely outcomes of litigation matters, management considers many factors. These factors include, but are not limited to, the nature of specific claims including unasserted claims, the company's experience with similar types of claims, the jurisdiction in which the matter is filed, input from outside legal counsel, the likelihood of resolving the matter through alternative dispute resolution mechanisms, and the matter's current status. Considerable judgment is required in determining whether to establish a litigation accrual when an adverse judgment is rendered against the company in a court proceeding. In such situations, the company will not recognize a loss if, based upon a thorough review of all relevant facts and information, management believes that it is probable that the pending judgment will be successfully overturned on appeal. A detailed discussion of significant litigation matters is contained in Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements. Indemnification Assets The company has entered into various agreements where the company is indemnified for certain liabilities by DuPont, Dow, and Chemours. The term of this indemnification is generally indefinite and includes defense costs and expenses, as well as monetary and non-monetary settlements and judgments. In connection with the recognition of liabilities related to these matters, the company records an indemnification asset when recovery is deemed probable. In assessing the probability of recovery, the company considers the contractual rights under the separation agreements and any potential credit risk. Future events, such as potential disputes related to recovery as well as the solvency of DuPont, Dow, and / or Chemours, could cause the indemnification assets to have a lower value than anticipated and recorded. The company evaluates the recovery of the indemnification assets recorded when events or changes in circumstances indicate the carrying values may not be fully recoverable. See Note 5 - Divestitures and Other Transactions, to the Consolidated Financial Statements for additional information related to indemnifications. Income Taxes The breadth of the company's operations and the global complexity of tax regulations require assessments of uncertainties and judgments in estimating taxes the company will ultimately pay. The final taxes paid are dependent upon many factors, including negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation and resolution of disputes arising from federal, state and international tax audits in the normal course of business. The resolution of these uncertainties may result in adjustments to the company's tax assets and tax liabilities. It is reasonably possible that changes to the company’s global unrecognized tax benefits could be significant; however, due to the uncertainty regarding the timing of completion of audits and possible outcomes, a current estimate of the range of increases or decreases that may occur within the next twelve months cannot be made. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Deferred income taxes result from differences between the financial and tax basis of the company's assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and magnitude of appropriate valuation allowances against deferred tax assets. The realization of these assets is dependent on generating future taxable income, as well as successful implementation of various tax planning strategies. For example, changes in facts and circumstances that alter the probability that the company will realize deferred tax assets could result in recording a valuation allowance, thereby reducing the deferred tax asset and generating a deferred tax expense in the relevant period. In some situations, these changes could be material. See Note 10 - Income Taxes, to the Consolidated Financial Statements for additional information. At December 31, 2019, the company had a net deferred tax liability balance of $633 million, inclusive of a valuation allowance of $457 million. Realization of deferred tax assets is expected to occur over an extended period of time. As a result, changes in tax laws, assumptions with respect to future taxable income, and tax planning strategies could result in adjustments to deferred tax assets. See Note 10 - Income Taxes, to the Consolidated Financial Statements for additional details related to the deferred tax liability balance. Valuation of Assets and Impairment Considerations The assets and liabilities of acquired businesses are measured at their estimated fair values at the dates of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired, including identified intangibles, is recorded as goodwill. The determination and allocation of fair value to the assets acquired and liabilities assumed is based on various assumptions and valuation methodologies requiring considerable management judgment, including estimates based on historical information, current market data and future expectations. The principal assumptions utilized in the company's valuation methodologies include revenue growth rates, operating margin estimates, royalty rates, and discount rates. Although the estimates are deemed reasonable by management based on information available at the dates of acquisition, those estimates are inherently uncertain. Assessment of the potential impairment of goodwill, other intangible assets, property, plant and equipment, investments in nonconsolidated affiliates, and other assets is an integral part of the company's normal ongoing review of operations. Testing for potential impairment of these assets is significantly dependent on numerous assumptions and reflects management's best estimates at a particular point in time. The dynamic economic environment in which the company's segments operate, and key economic and business assumptions with respect to projected selling prices, market growth and inflation rates, can significantly affect the outcome of impairment tests. Estimates based on these assumptions may differ significantly from actual results. Changes in factors and assumptions used in assessing potential impairments can have a significant impact on the existence and magnitude of impairments, as well as the time in which such impairments are recognized. In addition, the company continually reviews its portfolio of assets to ensure they are achieving their greatest potential and are aligned with the company's growth strategy. Strategic decisions involving a particular group of assets may trigger an assessment of the recoverability of the related assets. Such an assessment could result in impairment losses. The company performs its annual goodwill impairment assessment during the fourth quarter at the reporting unit level which is defined as the operating segment or one level below the operating segment. One level below the operating segment, or component, is a business in which discrete financial information is available and regularly reviewed by segment management. The company aggregates certain components into reporting units based on economic similarities. As a result of the Internal Reorganizations and Realignments, the company changed its reportable segments to seed and crop protection to reflect the manner in which the company's chief operating decision maker assesses performance and allocates resources. The change in reportable segments resulted in changes to the company's reporting units for goodwill impairment testing to align with the level at which discrete financial information is available for review by management. The company’s reporting units include seed, crop protection and digital. In connection with the change in reportable segments and reporting units, goodwill was reassigned from the former agriculture reporting unit to the seed, crop protection and digital reporting units using a relative fair value allocation approach. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued For purposes of the annual goodwill impairment test, 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 commodity 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 carrying value of a reporting unit exceeds its estimated fair value, additional quantitative testing is required. If additional quantitative testing is required, the reporting unit’s fair value is compared with its carrying amount, and an impairment charge, if any, is recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value. The company determined fair values for each of the reporting units using the income approach or market approach. Under the income approach, fair value is determined based on the present value of estimated future cash flows, discounted at an appropriate risk-adjusted rate. The company uses its internal forecasts to estimate future cash flows and includes an estimate of long-term future growth rates based on its most recent views of the long-term outlook for each reporting unit. Actual results may differ from those assumed in the company’s forecasts. The company derives its discount rates using a capital asset pricing model and analyzing published rates for industries relevant to its reporting units to estimate the cost of equity financing. The company uses discount rates that are commensurate with the risks and uncertainty inherent in the respective reporting units and in its internally developed forecasts. Discount rates used in the company’s reporting unit valuations ranged from 9.5% to 10.5%. Under the market approach, the company uses metrics of publicly traded companies or historically completed transactions for comparable companies. Estimating the fair value of reporting units requires the use of estimates and significant judgments that are based on a number of factors including actual operating results. It is reasonably possible that the judgments and estimates described above could change in future periods. The company’s assets and liabilities were measured at fair value as of the date of the Merger, and as a result, any declines in projected cash flows or increases in discount rates could have a material, negative impact on the fair value of the company's reporting units and assets and therefore result in an impairment. As discussed above, in connection with the change in reportable segments and reporting units, the company performed a goodwill impairment analysis for the former agriculture reporting unit immediately prior to the realignment and the newly created reporting units immediately after the realignment. The impairment analysis was performed using a discounted cash flow model (a form of the income approach), utilizing Level 3 unobservable inputs or a market approach. The company’s significant estimates in this analysis include, but are not limited to, future cash flow projections, the weighted average cost of capital, the terminal growth rate, and the tax rate. The company’s estimates of future cash flows are based on current regulatory and economic climates, recent operating results, and planned business strategy. The company believes the current assumptions and estimates utilized are both reasonable and appropriate. Based on the goodwill impairment analysis performed both immediately prior to and immediately subsequent to the realignment, the company concluded the fair value of the former agriculture reporting unit and the newly created reporting units exceeded their carrying value, and no goodwill impairment charge was necessary. In the third quarter of 2019, and in connection with strategic product and portfolio reviews, the company determined that the fair value of certain intangible assets classified as developed technology, other intangible assets and IPR&D within the seed segment that primarily relate to heritage DAS intangibles previously acquired from Cooperativa Central de Pesquisa Agrícola's ("Coodetec") was less than the carrying value due to the company’s focus on advancing more competitive products and eliminating redundancy and complexity across the breeding programs. As a result, the company recorded a pre-tax, non-cash intangible asset impairment charge of $54 million ($41 million after-tax). The key assumptions used in determining the fair value of these intangibles involve management judgment and estimates relating to future operating performance and economic conditions that may differ from actual cash flows. Refer to Note 7 - Restructuring and Asset Related Charges - Net, Note 15 - Goodwill and Other Intangible Assets, and Note 23 - Fair Value Measurements, to the Consolidated Financial Statements for more information. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued In the fourth quarter of 2019, quantitative testing was performed on all of the company’s reporting units. Based on the results of the quantitative testing, the estimated fair value of each of the reporting units exceeded their carrying values. For the seed reporting unit, the excess fair value over carrying value is approximately 12%, and therefore carries a higher risk of impairment charges in future periods. The dynamic economic environments in which the company's diversified product lines operate, and key economic and product line assumptions with respect to projected selling prices, product mix, market growth and inflation rates, can significantly affect the outcome of impairment tests. Estimates based on these assumptions may differ significantly from actual results. Changes in factors, circumstances and assumptions used in assessing potential impairments can have a significant impact on the existence and magnitude of impairments, as well as the time in which such impairments are recognized. In the fourth quarter of 2019, the company also performed an impairment test on indefinite-lived intangibles and determined that the fair value of certain IPR&D assets had declined as a result of the company’s decision to accelerate the ramp up of the Enlist E3TM trait platform in the company’s soybean portfolio mix across all brands over the next five years with minimal use of the Roundup Ready 2 Yield® and Roundup Ready 2 Xtend® traits thereafter for the remaining term of the non-exclusive license with the Monsanto Company. This resulted in the company concluding that the recoverability of certain IPR&D projects associated with Roundup Ready 2 Xtend® were impaired, resulting in a pre-tax, non-cash impairment charge of $90 million ($69 million after-tax). Refer to Note 7 - Restructuring and Asset Related Charges - Net, Note 15 - Goodwill and Other Intangible Assets, and Note 23 - Fair Value Measurements, to the Consolidated Financial Statements for more information. The company’s goodwill and indefinite-lived intangibles for the seed reporting unit at December 31, 2019 is shown below (in millions): Prepaid Royalties The company’s seed segment currently has certain third-party biotechnology trait license agreements, which require up-front and variable payments subject to the licensor meeting certain conditions. These payments are reflected as other current assets and other assets and are amortized to cost of goods sold as seeds containing the respective trait technology are utilized over the term of the license. The rate of royalty amortization expense recognized is based on the company’s strategic plans which include various assumptions and estimates including product portfolio, market dynamics, farmer preferences, growth rates and projected planted acres. Changes in factors and assumptions included in the strategic plans, including potential changes to the product portfolio in favor of internally developed biotechnology, could impact the rate of recognition of the relevant prepaid royalty. At December 31, 2019, the balance of prepaid royalties reflected in other current assets and other assets was $440 million and $794 million, respectively. The majority of the balance of prepaid royalties relates to the company’s wholly owned subsidiary, Pioneer Hi-Bred International, Inc.’s (“Pioneer”) non-exclusive license in the United States and Canada for the Monsanto Company's Genuity® Roundup Ready 2 Yield® glyphosate tolerance trait and Roundup Ready 2 Xtend® glyphosate and dicamba tolerance trait for soybeans (“Roundup Ready 2 License Agreement”). The prepaid royalty asset relates to a series of up-front, fixed and variable royalty payments to utilize the traits in Pioneer’s soybean product mix. The company’s historical expectation has been that the technology licensed under the Roundup Ready 2 License Agreement would be used as the primary herbicide tolerance trait platform in the Pioneer® brand soybean through the term of the agreement. DAS and MS Technologies, L.L.C. jointly developed and own the Enlist E3TM herbicide tolerance trait for soybeans which provides tolerance to 2, 4-D choline in Enlist Duo® and Enlist One® herbicides, as well as glyphosate and glufosinate herbicides. In connection with the validation of breeding plans and large-scale product development timelines, during the fourth quarter of 2019, the company is accelerating the ramp up of the Enlist E3TM trait platform in the company’s soybean portfolio mix across all brands, including Pioneer® brands, over the next five years. During the ramp-up period, the company is expected to significantly reduce the volume of products with the Roundup Ready 2 Yield® and Roundup Ready 2 Xtend® herbicide tolerance traits beginning in 2021, with expected minimal use of the trait platform thereafter for the remainder of the Roundup Ready 2 License Agreement (the “Transition Plan”). The rate of royalty expense is therefore expected to significantly increase through higher amortization of the prepaid royalty as fewer seeds containing the respective trait are expected to be utilized. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued In connection with the departure from these traits in the company's product portfolio, beginning January 1, 2020 the company will present and disclose the accelerated prepaid royalty amortization expense as a component of restructuring and asset related charges - net in the Consolidated Statement of Operations. The accelerated prepaid royalty amortization expense will represent the difference between the rate of amortization based on the revised number of units expected to contain the Roundup Ready 2 Yield® and Roundup Ready 2 Xtend® trait technology and the per unit cash rate per the Roundup Ready 2 License Agreement. The non-cash accelerated prepaid royalty amortization expense estimated for 2020 is approximately $160 million, aggregating to approximately $500 million over the next five years. Further changes in factors and assumptions associated with usage of the trait platform licensed under the Roundup Ready 2 License Agreement, including the Transition Plan, could further impact the rate of recognition of the prepaid royalty and statement of operations presentation of the accelerated prepaid royalty amortization expense. Off-Balance Sheet Arrangements Certain Guarantee Contracts Information with respect to the company's guarantees is included in Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements. Historically, the company has not had to make significant payments to satisfy guarantee obligations; however, the company believes it has the financial resources to satisfy these guarantees. Contractual Obligations Information related to the company's significant contractual obligations is summarized in the following table: 1. Included in the Consolidated Financial Statements. 2. Represents enforceable and legally binding agreements in excess of $1 million to purchase goods or services that specify fixed or minimum quantities; fixed, minimum or variable price provisions; and the approximate timing of the agreement. 3. The company's contractual obligations do not reflect an offset for recoveries associated with indemnifications by Chemours, Dow, and DuPont in accordance with the Chemours Separation Agreement and the Separation Agreement (related to the Corteva Distribution), respectively. Refer to Note 5 - Divestitures and Other Transactions, and Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements for additional detail related to the indemnifications. 4. Represents undiscounted remaining payments under Pioneer license agreements ($643 million on a discounted basis). 5. Primarily represents employee-related benefits other than pensions and other post employment benefits and asset retirement obligations. 6. Due to uncertainty regarding the completion of tax audits and possible outcomes, the timing of certain payments of obligations related to unrecognized tax benefits cannot be made and have been excluded from the table above. See Note 10 - Income Taxes, to the Consolidated Financial Statements for additional detail. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued The company expects to meet its contractual obligations through its normal sources of liquidity and believes it has the financial resources to satisfy the contractual obligations that arise in the ordinary course of business. Long-term Employee Benefits The company has various obligations to its employees and retirees. The company maintains retirement-related programs in many countries that have a long-term impact on the company's earnings and cash flows. These plans are typically defined benefit pension plans, as well as medical, dental and life insurance benefits for pensioners and survivors and disability benefits for employees (other post employment benefits or OPEB plans). Substantially all of the company's worldwide benefit obligation for pensions and essentially all of the company's worldwide OPEB obligations are attributable to the U.S. benefit plans. Pension coverage for employees of the company's non-U.S. consolidated subsidiaries is provided, to the extent deemed appropriate, through separate plans. The company regularly explores alternative solutions to meet its global pension obligations in the most cost effective manner possible as demographics, life expectancy and country-specific pension funding rules change. Where permitted by applicable law, the company reserves the right to change, modify or discontinue its plans that provide pension, medical, dental, life insurance and disability benefits. Benefits under defined benefit pension plans are based primarily on years of service and employees' pay near retirement. In November 2016, the company announced changes to the U.S. pension and OPEB plans. The company froze the pay and service amounts used to calculate pension benefits for active employees who participate in the U.S. pension plans on November 30, 2018. Therefore, as of November 30, 2018, active employees participating in the U.S. pension plans will not accrue additional benefits for future service and eligible compensation received. In addition to the changes to the U.S. pension plans, OPEB eligible employees who will be under the age of 50 as of November 30, 2018 will not receive post-retirement medical, dental and life insurance benefits. The majority of employees hired in the U.S. on or after January 1, 2007 are not eligible to participate in the pension and post-retirement medical, dental and life insurance plans, but receive benefits in the defined contribution plans. Pension benefits are paid primarily from trust funds established to comply with applicable laws and regulations. The actuarial assumptions and procedures utilized are reviewed periodically by the plans' actuaries to provide reasonable assurance that there will be adequate funds for the payment of benefits. The company did not make contributions to the principal U.S. pension plan for the year ended December 31, 2019. Funding for each pension plan other than the principal U.S. pension plan is governed by the rules of the sovereign country in which it operates. Thus, there is not necessarily a direct correlation between pension funding and pension expense. In general, however, improvements in plans' funded status tends to moderate subsequent funding needs. The company contributed $39 million, $103 million, $34 million and $67 million to its funded pension plans other than the principal U.S. pension plan for the year ended December 31, 2019, the year ended December 31, 2018, the period September 1 through December 31, 2017, and the period January 1 through August 31, 2017, respectively. U.S. pension benefits that exceed federal limitations are covered by separate unfunded plans and these benefits are paid to pensioners and survivors from operating cash flows. The company's remaining pension plans with no plan assets are paid from operating cash flows. The company made benefit payments of $82 million, $111 million, $35 million and $57 million to its unfunded plans for the year ended December 31, 2019, the year ended December 31, 2018, the period September 1 through December 31, 2017, and the period January 1 through August 31, 2017, respectively. The company's OPEB plans are unfunded and the cost of the approved claims is paid from operating cash flows. Pre-tax cash requirements to cover actual net claims costs and related administrative expenses were $202 million, $216 million, $59 million and $166 million for the year ended December 31, 2019, the year ended December 31, 2018, the period September 1 through December 31, 2017, and the period January 1 through August 31, 2017, respectively. Changes in cash requirements reflect the net impact of higher per capita health care costs, demographic changes, plan amendments and changes in participant premiums, co-pays and deductibles. In 2020, the company expects to contribute approximately $60 million to its pension plans other than the principal U.S. pension plan, and about $240 million for its OPEB plans. The company is evaluating potential discretionary contributions in 2020 to the principal U.S. pension plan, that could reduce a portion of the underfunded benefit obligation. Any discretionary contributions depend on various factors including market conditions and tax deductible limits. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued The company's income can be significantly affected by pension and defined contribution benefits as well as OPEB costs. The following table summarizes the extent to which the company's loss from continuing operations before income taxes for the year ended December 31, 2019, the year ended December 31, 2018, the period September 1 through December 31, 2017, and the period January 1 through August 31, 2017 was affected by pre-tax charges related to long-term employee benefits: The above (credit) charges for pension and OPEB are determined as of the beginning of each period. Long-term employee credits were $(48) million for the year ended December 31, 2019 and $(69) million for the year ended December 31, 2018. The change is due to decrease in expected return on plan assets. Activities for the period ended December 31, 2018 and for the period September 1 through December 31, 2017 benefited from the absence of the amortization of net losses from accumulated other comprehensive loss. See "Pension Plans and Other Post Employment Benefits" under the Critical Accounting Estimates section beginning on page 65 of this report for additional information on determining annual expense. For 2020, long-term employee benefits credit from continuing operations is expected to increase by about $180 million. The increase is mainly due to lower interest cost. Environmental Matters The company operates global manufacturing, product handling and distribution facilities that are subject to a broad array of environmental laws and regulations. Such rules are subject to change by the implementing governmental agency, and the company monitors these changes closely. Company policy requires that all operations fully meet or exceed legal and regulatory requirements. In addition, the company implements voluntary programs to reduce air emissions, minimize the generation of hazardous waste, decrease the volume of water use and discharges, increase the efficiency of energy use and reduce the generation of persistent, bioaccumulative and toxic materials. Management has noted a global upward trend in the amount and complexity of proposed chemicals regulation. The costs to comply with complex environmental laws and regulations, as well as internal voluntary programs and goals, are significant and will continue to be significant for the foreseeable future. Pre-tax environmental expenses charged to income from continuing operations before income taxes are summarized below: About 85 percent of total pre-tax environmental operating costs charged to income from continuing operations for the year ended December 31, 2019 resulted from operations in the U.S. Based on existing facts and circumstances, management does not believe that year-over-year changes, if any, in environmental operating costs charged to current operations will have a material impact on the company's financial position, liquidity or results of operations. Annual expenditures in the near term are not expected to vary significantly from the range of such expenditures experienced in the past few years. Longer term, expenditures are subject to considerable uncertainty and may fluctuate significantly. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued Environmental Operating Costs As a result of its operations, the company incurs costs for pollution abatement activities including waste collection and disposal, installation and maintenance of air pollution controls and wastewater treatment, emissions testing and monitoring, and obtaining permits. The company also incurs costs related to environmental related research and development activities including environmental field and treatment studies as well as toxicity and degradation testing to evaluate the environmental impact of products and raw materials. Remediation Accrual Changes in the remediation accrual balance are summarized below: 1. Excludes indemnified remediation obligations. 2. Represents the net change in indemnified remediation obligations based on activity as well as the removal from EID's accrued remediation liabilities of obligations that have been fully transferred to Chemours and DuPont. Pursuant to the Chemours Separation Agreement and the Corteva Separation Agreement, as discussed in Note 5 - Divestitures and Other Transactions, and Note 18 - Commitments and Contingent Liabilities, to the Consolidated Financial Statements, EID is indemnified by Chemours and DuPont for certain environmental matters. Considerable uncertainty exists with respect to environmental remediation costs, and, under adverse changes in circumstances, the potential liability may range up to $620 million above the amount accrued as of December 31, 2019. However, based on existing facts and circumstances, management does not believe that any loss, in excess of amounts accrued, related to remediation activities at any individual site will have a material impact on the financial position, liquidity or results of operations of the company. The above noted $336 million accrued obligations includes the following: 1. Represents liabilities that are subject the $200 million thresholds and sharing arrangements as discussed on page, under Corteva Separation Agreement. 2. The company has recorded an indemnification asset related to these accruals, including $30 million related to the Superfund sites. 3. Accrual balance represents management’s best estimate of the costs of remediation and restoration, although it is reasonably possible that the potential exposure, as indicated, could range above the amounts accrued, as there are inherent uncertainties in these estimates. Part II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, continued As of December 31, 2019, the company has been notified of potential liability under the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund") or similar state laws at about 500 sites around the U.S., including approximately 140 sites for which the company does not believe it has liability based on current information. Active remediation is under way at 70 of the 500 sites. In addition, the company has resolved its liability at approximately 210 sites, either by completing remedial actions with other PRPs or by participating in "de minimis buyouts" with other PRPs whose waste, like the company's, represented only a small fraction of the total waste present at a site. The company received notice of potential liability at 2 new sites during 2018 compared with 3 notices in 2017. There were no new notices in 2019. Environmental Capital Expenditures Capital expenditures for environmental projects, either required by law or necessary to meet the company’s internal environmental goals, were approximately $13 million for the year ended December 31, 2019. The company currently estimates expenditures for environmental-related capital projects to be approximately $8 million in 2020. Climate Change The company believes that climate change is an important global environmental concern that presents risks and opportunities. The Board of Directors maintains oversight of these risks and opportunities. Management regularly assesses and manages climate-related issues. The company completed a non-financial materiality assessment and identified short-, medium- and long-term climate-related risks and opportunities. The results of this assessment are integrated into the company’s businesses, strategy and financial planning. Continuing political and social attention to climate change and its impacts has resulted in regulatory and market-based approaches to limit greenhouse gas emissions. The company believes there is a way forward for sustainable climate change mitigation that both enables farmers to meet the demands of a growing population and secures the economic future for the vast majority of the world’s population who depend on agriculture for their livelihoods. Extreme and volatile weather due to climate change may have an adverse impact on customers’ ability to use its products, potentially reducing sales volumes, revenues and margins. The company continuously evaluates opportunities for existing and new product and service offerings to meet the anticipated demands of climate-smart agriculture and mitigate the impact of extreme and volatile weather. Corteva is working to shrink its role in the emission of greenhouse gasses. The company is seeking ways to reduce its impact and providing tools and incentives for customers to do the same. Corteva champions climate positive agriculture, utilizing carbon storage and other means to remove more carbon from the atmosphere than it emits without sacrificing farmer productivity or ongoing profitability. The company is developing metrics and targets that will be used to assess and manage material and relevant climate-related risks and opportunities. The company is committed to engaging with multiple stakeholders and partners around the globe who have innovative and actionable ideas to help safeguard the health and well-being of the planet and its people. The company integrates processes for identifying, assessing and managing climate-related risk into its overall risk management. By doing more to address climate change today, the company is fortifying its ability to grow food, grow progress and build a sustainable industry that will help humanity thrive for generations to come. Part II

<s>[INST] This report contains certain estimates and forwardlooking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, which are intended to be covered by the safe harbor provisions for forwardlooking statements contained in the Private Securities Litigation Reform Act of 1995, and may be identified by their use of words like “plans,” “expects,” “will,” “anticipates,” “believes,” “intends,” “projects,” “estimates” or other words of similar meaning. All statements that address expectations or projections about the future, including statements about Corteva’s strategy for growth, product development, regulatory approval, market position, anticipated benefits of recent acquisitions, timing of anticipated benefits from restructuring actions, outcome of contingencies, such as litigation and environmental matters, expenditures, and financial results, as well as expected benefits from, the separation of Corteva from DuPont, are forwardlooking statements. Forwardlooking statements and other estimates are based on certain assumptions and expectations of future events which may not be accurate or realized. Forwardlooking statements and other estimates also involve risks and uncertainties, many of which are beyond Corteva’s control. While the list of factors presented below is considered representative, no such list should be considered to be a complete statement of all potential risks and uncertainties. Unlisted factors may present significant additional obstacles to the realization of forwardlooking statements. Consequences of material differences in results as compared with those anticipated in the forwardlooking statements could include, among other things, business disruption, operational problems, financial loss, legal liability to third parties and similar risks, any of which could have a material adverse effect on Corteva’s business, results of operations and financial condition. Some of the important factors that could cause Corteva’s actual results to differ materially from those projected in any such forwardlooking statements include: (i) failure to successfully develop and commercialize Corteva’s pipeline; (ii) effect of competition and consolidation in Corteva’s industry; (iii) failure to obtain or maintain the necessary regulatory approvals for some Corteva’s products; (iv) failure to enforce Corteva’s intellectual property rights or defend against intellectual property claims asserted by others; (v) effect of competition from manufacturers of generic products; (vi) impact of Corteva’s dependence on third parties with respect to certain of its raw materials or licenses and commercialization; (vii) costs of complying with evolving regulatory requirements and the effect of actual or alleged violations of environmental laws or permit requirements; (viii) effect of the degree of public understanding and acceptance or perceived public acceptance of Corteva’s biotechnology and other agricultural products; (ix) effect of changes in agricultural and related policies of governments and international organizations; (x) effect of industrial espionage and other disruptions to Corteva’s supply chain, information technology or network systems; (xi) competitor’s establishment of an intermediary platform for distribution of Corteva's products; (xii) effect of volatility in Corteva’s input costs; (xiii) failure to raise capital through the capital markets or shortterm borrowings on terms acceptable to Corteva; (xiv) failure of Corteva’s customers to pay their debts to Corteva, including customer financing programs; (xv) failure to realize the anticipated benefits of the internal reorganizations taken by DowDuPont in connection with the spinoff of Corteva, including failure to benefit from significant cost synergies; (xvi) risks related to the indemnification obligations of legacy EID liabilities in connection with the separation of Corteva; (xvii) increases in pension and other postemployment benefit plan funding obligations; (xviii) effect of compliance with laws and requirements and adverse judgments on litigation; (xix) risks related to Corteva’s global operations; (xx) effect of climate change and unpredictable seasonal and weather factors; (xxi) effect of counterfeit products; (xxii) failure to effectively manage acquisitions, divestitures, alliances and other portfolio actions; (xxiii) risks related to noncash charges from impairment of goodwill [/INST] Positive. </s>

Urovant Sciences Ltd.

2019-06-14

2019-03-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition, results of operations, and cash flows should be read in conjunction with the audited consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, include forward-looking statements that involve risks and uncertainties. You should review the “Risk Factors” set forth in this Annual Report on Form 10-K 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. Overview We are a clinical-stage biopharmaceutical company focused on developing and commercializing innovative therapies for urologic conditions. Our lead product candidate, vibegron, is an oral, once-daily, small molecule that was observed to be highly selective for the human beta-3 adrenergic receptor in in vitro assays. Vibegron is currently being developed for three potential indications: overactive bladder, or OAB, the treatment of OAB in men with benign prostatic hyperplasia, or BPH, and the treatment of abdominal pain due to irritable bowel syndrome, or IBS. Our second product candidate, URO-902, is a novel gene therapy that we are developing for patients with OAB who have failed oral pharmacological therapy. In March 2019, we reported positive top-line results from our international pivotal Phase 3 EMPOWUR trial evaluating vibegron for the treatment of OAB. In this pivotal Phase 3 clinical trial with over 1,500 patients, vibegron 75 mg met both co-primary efficacy endpoints and all seven key secondary endpoints. Onset of action for the co-primary endpoints was observed as early as week two, the first time point measured, and statistically significant efficacy was maintained at all timepoints measured through the end of the study. We plan to submit a new drug application, or NDA, to the U.S. Food and Drug Administration, or FDA, by the first quarter of 2020. OAB is a highly prevalent condition, with more than 30 million Americans over the age of 40 suffering from bothersome symptoms. In large, randomized, placebo-controlled, international Phase 2b and Japanese Phase 3 clinical trials in a total of over 2,600 OAB patients, vibegron 50 mg and 100 mg met all primary and secondary efficacy endpoints compared to placebo at week 8 and week 12, respectively. Our Phase 3 clinical trial had a design in line with these clinical trials. We believe vibegron, if approved by the FDA, may offer a differentiated profile compared to current OAB therapies, including the potential for broader efficacy claims if the FDA approves the inclusion of urgency data, rapid onset of action data, and a single convenient once-daily dose in the label. Vibegron has been well tolerated in all clinical trials to date, has not been associated with clinically relevant drug-drug interactions, such as the inhibition of CYP2D6, and has not demonstrated a QTc signal at any of the human doses tested. In March 2019, we initiated the Phase 3 COURAGE randomized, double blind, placebo-controlled trial for OAB in men with BPH who are also taking BPH medications but continue experiencing OAB symptoms in approximately 1,000 patients. The study is being conducted in two phases, with the first phase focusing on safety and the second phase assessing efficacy and safety, and is testing 75 mg of vibegron versus placebo, the same dose studied in our Phase 3 EMPOWUR trial. The primary efficacy analysis for the co-primary efficacy endpoints will be measured at 12 weeks and include change from baseline in the average number of micturitions per 24 hours and change from baseline in the average number of urgency episodes per 24 hours. Secondary endpoints include change from baseline in the average number of nocturia episodes per night, which is awakening at night to use the bathroom to urinate. The duration for the double-blind study is 24 weeks. In addition, a 28-week open-label extension study will evaluate the long-term safety and efficacy of vibegron in men with OAB symptoms and on another therapy for BPH. In December 2018, we enrolled our first patient in a 200 patient Phase 2a randomized, double blind, placebo-controlled trial with vibegron 75 mg for abdominal pain due to IBS. We expect to receive top-line data from the Phase 2a clinical trial in 2020. The primary endpoint will be a 30% reduction in abdominal pain intensity, while secondary endpoints will include Global Improvement Scale ratings, stool symptoms and safety. Our second product candidate, URO-902, is a novel gene therapy that we are developing for patients with OAB who have failed oral pharmacological therapy. There are no currently available FDA-approved gene therapy treatments for OAB. We plan to initiate a placebo-controlled, randomized, multicenter proof-of-concept Phase 2a clinical trial in the fourth quarter of 2019 to evaluate the safety and efficacy of URO-902 in approximately 50 to 80 patients. We were incorporated in January 2016, and our operations to date have been limited to organizing and staffing our company, identifying and in-licensing our product candidates, including acquiring the rights to vibegron and URO-902, preparing for and advancing the clinical development of our product candidates and preparing for the potential commercialization of vibegron. We have not generated any revenue and 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 vibegron, URO-902 and any future product candidates. Our operations were previously supported by our affiliates, Roivant Sciences, Inc. (“RSI”) and Roivant Sciences GmbH (“RSG”), each a wholly owned subsidiary of our parent company, Roivant Sciences Ltd. (“RSL”). RSI provided us with certain administrative, financial and research and development services, and RSG provided us with services in relation to the identification of potential product candidates, assistance with clinical trials and other development, administrative and financial activities, in each case, pursuant to the Services Agreements. Under the terms of the services agreements with RSI and RSG, we are obligated to pay or reimburse RSI and RSG for the costs they, or third parties acting on their behalf, incur in providing services to us. In addition, we are obligated to pay to RSI and RSG a pre-determined markup on costs incurred by them in connection with any general and administrative and support services as well as research and development services. Our reliance on RSI and RSG has decreased significantly as we have completed the hiring of personnel to manage our operations and the development and potential commercialization of vibegron and any future product candidates. We do not expect our reliance on RSI and RSG to be significant in the future. In October 2018, we completed our initial public offering, or IPO, in which we sold 10,297,813 common shares, including the partial exercise of the underwriters’ over-allotment option to purchase additional shares, at a public offering price of $14.00 per common share. The net proceeds to us were approximately $132.9 million, after deducting $10.1 million in underwriting discounts and commissions and $1.2 million in offering expenses. In February 2019, we and our subsidiaries, Urovant Holdings Limited (“UHL”), Urovant Sciences GmbH (“USG”) and Urovant Sciences, Inc. (“USI”), entered into a secured debt financing agreement with Hercules Capital, Inc., or Hercules, as agent and lender, or the Loan Agreement, in the amount of $100.0 million. A first tranche of $15.0 million was funded upon execution of the Loan Agreement, and the remaining $85.0 million is available in three additional optional tranches through June 30, 2021, subject to certain terms and conditions, including the achievement of certain milestones. As of March 31, 2019, we had an accumulated deficit of $175.5 million. We recorded net losses of $111.3 million and $37.1 million for the years ended March 31, 2019 and 2018. Financial Operations Overview Revenue We currently do not have any products approved for sale and have not generated any revenue since inception. If we are able to successfully develop, receive regulatory approval for and commercialize vibegron, URO-902 or any future product candidate alone or in collaboration with third parties, we may generate revenue from vibegron, URO-902 or any such future product candidate. Research and Development Expenses Our research and development expenses to date have been primarily attributed to the license of the rights to vibegron and the continued development of vibegron for OAB. We expect to increase the number of our research and development programs while maintaining our current research and development spend as we complete the open-label extension study of our ongoing Phase 3 EMPOWUR trial for the treatment of OAB, advance our Phase 3 clinical trial of vibegron for the treatment of OAB in men with BPH, advance our Phase 2a clinical trial of vibegron for the treatment of abdominal pain due to IBS, and initiate and advance our planned Phase 2a clinical trial for URO-902 for the treatment of OAB in patients who have not responded to oral pharmacological therapies. Research and development expenses will include program-specific costs, as well as unallocated costs. Program-specific costs include: • direct third-party costs such as expenses incurred under agreements with clinical research organizations, or CROs, and contract manufacturing organizations, or CMOs, the cost of consultants who assist with the development of vibegron on a program-specific basis, investigator grants, sponsored research, manufacturing costs in connection with producing materials for use in conducting nonclinical studies and clinical trials, and other third-party expenses directly attributable to the development of our product candidates. Unallocated costs primarily include: • employee-related expenses, such as salaries, share-based compensation, benefits and travel expense for our research and development personnel; • costs allocated to us for activities performed by RSI and RSG under the Services Agreements and share-based compensation expense allocated to us from RSL; and • other expenses, which include the costs of consultants who assist with research and development activities not specific to a program. Research and development expenses also include in-process research and development expense related to our acquisition of the rights to our product candidates from Merck and ICI. Research and development activities will continue to be central to our business model. Product candidates in later stages of clinical development, such as vibegron, generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to be significant over the next several years as we advance the clinical development of vibegron and prepare to seek regulatory approval. It is difficult to determine with certainty the duration and completion costs of any clinical trial we may conduct. The duration, costs and timing of clinical trials of our current and future product candidates will depend on a variety of factors that include, but are not limited to: the number of trials required for approval; the per patient trial costs; the number of patients that participate in the trials; the number of sites included in the trials; the countries in which the trial is conducted; the length of time required to enroll eligible patients; the number of doses that patients receive; the drop-out or discontinuation rates of patients; the potential additional safety monitoring or other studies requested by regulatory agencies; the duration of patient follow-up; the timing and receipt of regulatory approvals; the costs of clinical trial material; and the efficacy and safety profile of the product candidate. In addition, the probability of success for vibegron, URO-902 and any other product candidates will depend on numerous factors, including competition, manufacturing capability and commercial viability. As a result, we are unable to determine the duration and completion costs of our programs or when and to what extent we will generate revenue from commercialization and sale of any of our product candidates. Our research and development activities may be subject to change from time to time as we evaluate our priorities and available resources. General and Administrative Expenses General and administrative expenses consist primarily of employee-related expenses, such as salaries, share-based compensation, benefits and travel expenses for general and administrative personnel, professional fees for legal, consulting, accounting, auditing and tax services, commercial readiness costs, rent and facilities expense, information technology costs, general overhead and services received under the Services Agreements with RSI and RSG. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities, potential commercialization efforts and increased costs of continuing to operate as a public company. These increases will likely include increased costs related to the hiring of additional personnel, professional fees and additional rent and other facilities related costs, among other expenses. Additionally, we anticipate increased costs associated with being a public company, including expenses related to services associated with maintaining compliance with the requirements of The Nasdaq Global Select Market, or Nasdaq, and the SEC, insurance and investor relations costs. We expect to incur increased costs associated with establishing sales, marketing, and commercialization functions in advance of potential future regulatory approvals and commercialization of our product candidates. If any of our current or future product candidates obtains U.S. regulatory approval, we expect that we would incur significantly increased expenses associated with building a sales and marketing team and funding commercial activities. Results of Operations The following table sets forth our results of operations for the years ended March 31, 2019 and 2018 (in thousands): Research and Development Expenses For the years ended March 31, 2019 and 2018, our research and development expenses consisted of the following (in thousands): Research and development expenses increased by $59.8 million, to $92.2 million, for the year ended March 31, 2019 compared to $32.4 million for the year ended March 31, 2018. The increase in research and development expenses primarily includes the following changes: • $49.6 million increase in CRO costs primarily to advance the Phase 3 EMPOWUR study; • $3.9 million increase in chemistry, manufacturing and controls costs; • $4.4 million increase in other program-specific third-party research and development costs; • $5.3 million increase due to personnel-related costs; • $1.2 million increase in share-based compensation expense for stock options and restricted stock units granted to employees; • $0.5 million increase in other unallocated third-party research and development costs; • $0.3 million increase for in-process research and development paid under the ICI license agreement; • $2.4 million decrease in share-based compensation expense allocated to us by RSL; and • $3.0 million decrease in costs billed to us under the Service Agreements. General and Administrative Expenses General and administrative expenses increased by $14.0 million, to $18.6 million, for the year ended March 31, 2019 compared to $4.6 million for the year ended March 31, 2018. The increase in general and administrative expenses primarily includes the following changes: • $5.5 million increase in personnel-related costs; • $2.0 million increase in legal and other professional and consulting fees; • $1.9 million increase in market research and other commercial readiness costs; • $2.5 million increase in general overhead and corporate expenses; • $1.8 million increase in share-based compensation expense for stock options granted to employees, board members and consultants; and • $0.3 million increase in share-based compensation expense allocated to us by RSL and costs billed under the Services Agreements. Interest Expense, Net Interest expense, net consists of interest expense related to the Hercules Loan Agreement as well as the associated non-cash amortization of debt discount and issuance costs, partially offset by interest income earned on cash equivalents. Interest expense, net, was $0.3 million for the year ended March 31, 2019. Liquidity and Capital Resources Sources of Liquidity In October 2018, we completed our IPO, in which we sold 10,297,813 common shares, including 297,813 common shares pursuant to the partial exercise of the underwriters’ over-allotment option to purchase additional shares, at a public offering price of $14.00 per common share. The net proceeds to us were approximately $132.9 million, after deducting $10.1 million in underwriting discounts and commissions and $1.2 million in offering expenses. In February 2019, we entered into a Loan Agreement with Hercules, as agent and lender in the amount of $100.0 million. A first tranche of $15.0 million was funded in February 2019, and the remaining $85.0 million is available in three additional optional tranches through June 30, 2021, subject to certain terms and conditions, including the achievement of certain milestones. As a result of the positive Phase 3 EMPOWUR data achieved in March 2019, one of the additional optional defined tranches of $30.0 million is currently accessible by us through September 30, 2019. As of March 31, 2019, we had an accumulated deficit of $175.5 million and a cash and cash equivalents balance of $85.4 million, as compared to $64.2 million and $7.2 million, respectively, as of March 31, 2018. Prior to our IPO and the Loan Agreement with Hercules, all operations to date had been financed through capital contributions or short-term advances from RSL or its affiliates. Capital Requirements For the years ended March 31, 2019 and 2018, we had a net loss of $111.3 million and $37.1 million, respectively, and we have never generated any revenue. We expect to continue to incur significant operating losses at least for the next several years. We do not expect to generate product revenue until we successfully complete development and obtain regulatory approval for any of our current or future product candidates, which may never occur. Our net losses and negative cash flows may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our planned clinical trials, our expenditures on other research and development activities and our pre-commercialization efforts. We anticipate that our capital requirements will increase substantially as we: • advance our Phase 3 trial of vibegron for the treatment of OAB in men with BPH; • advance our Phase 2a trial of vibegron for the treatment of abdominal pain due to IBS; • initiate and advance our planned Phase 2a clinical trial for URO-902 for the treatment of OAB in patients who have not responded to oral pharmacological therapies; • finish the EMPOWUR clinical trial and file the NDA for vibegron in adults with OAB; • expand our chemistry, manufacturing, and control and other manufacturing related activities; • seek to identify, acquire, develop and commercialize additional product candidates; • integrate acquired technologies into a comprehensive regulatory and product development strategy; • maintain, expand and protect our intellectual property portfolio; • hire scientific, clinical, quality control and administrative personnel; • add operational, financial and management information systems and personnel, including personnel to support our drug development efforts; • seek regulatory approvals for any product candidates that successfully complete clinical trials; • ultimately establish a sales, marketing and distribution infrastructure and scale up external manufacturing capabilities to commercialize any drug candidates for which we may obtain regulatory approval; • service debt obligations and payment of interest associated with the Hercules Loan Agreement; and • continue to operate as a public company. Our primary use of cash is to fund the development of vibegron for the treatment of OAB, advance our Phase 3 clinical trial for vibegron for the treatment of OAB in men with BPH, advance our Phase 2a clinical trial for vibegron in patients with abdominal pain due to IBS, and initiate and advance our planned Phase 2a clinical trial for URO-902 for the treatment of OAB in patients who have not responded to oral pharmacological therapies. We expect our operating expenses to continue to increase in the future as we expand our operations to continue to develop our product candidates and prepare for the potential future regulatory approvals and commercialization of vibegron. Based on anticipated spend and timing of expenditure assumptions, we currently believe that our existing cash and cash equivalents, together with the $30.0 million tranche under the Hercules Loan Agreement, which is available through September 30, 2019, will be sufficient to fund our committed operating expenses and capital expenditure requirements for at least the next 12 months from the filing date of this Annual Report on Form 10-K. The availability of the $30.0 million tranche was subject to achievement of a clinical milestone, which was achieved with the positive top-line results from the Phase 3 EMPOWUR trial, among other conditions that were also met. This estimate is based on our current assumptions, including assumptions relating to our ability to manage our spend, that may prove to be wrong, and we could use our available capital resources sooner than we currently expect. We will need additional funding to complete the clinical development of, and seek regulatory approval for, vibegron for the treatment of OAB in men with BPH and abdominal pain due to IBS, URO-902, and commercially launch vibegron or URO-902, if approved. Adequate additional funding may not be available to us on acceptable terms, or at all. Until such time, if ever, as we can generate substantial product revenue from sales of vibegron, URO-902 or any future product candidate, we expect to finance our cash needs through a combination of the remaining financing commitment available to us from the Hercules Loan Agreement, equity offerings, debt financings and potential collaboration, license or development agreements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your rights as a common shareholder. Our agreement with Hercules Capital, Inc. involves, and any agreements for future debt or preferred equity financings, if available, may involve covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, if we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may be required to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise 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 vibegron or URO-902, grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves or potentially discontinue operations. Cash Flows The following table sets forth a summary of our cash flows for the years ended March 31, 2019 and 2018 (in thousands): Operating Activities For the year ended March 31, 2019, $109.0 million of cash was used in operating activities. This was primarily attributable to a net loss of $111.3 million, an increase of $7.5 million in prepaid expenses and other current assets and a decrease of $1.5 million in amounts due to RSL. These amounts were partially offset by an increase of $6.7 million in accounts payable and accrued expenses, $3.4 million in share-based compensation expense from stock options and restricted stock units granted to employees, board members and consultants, and $0.6 million in share-based compensation expense allocated to us by RSL based upon the relative percentage of time utilized by employees of RSL, RSG and RSI on our matters. For the year ended March 31, 2018, $34.1 million of cash was used in operating activities. This was primarily attributable to a net loss of $37.1 million and an increase of $5.2 million in prepaid expenses and other current assets. These amounts were partially offset by an increase of $4.4 million in accounts payable and accrued expenses, $0.4 million in share-based compensation expense from stock options granted to employees and consultants, $2.8 million in share-based compensation expense allocated to us by RSL based upon the relative percentage of time utilized by employees of RSL, RSG and RSI on our matters, and an increase of $0.6 million in amounts due to RSL based on the allocation of personnel expenses associated with the formation of our company, development of our product pipeline and corporate matters. Investing Activities For the year ended March 31, 2019, $0.6 million of cash was used in investing activities, all for the purchase of furniture and equipment. For the year ended March 31, 2018, $0.5 million of cash was used in investing activities, all for the purchase of furniture and equipment. Financing Activities For the year ended March 31, 2019, cash provided by financing activities of $188.6 million was primarily attributable to the net proceeds of $132.9 million from our IPO, capital contributions from RSL of $41.6 million and net proceeds of $14.1 million from the debt financing with Hercules Capital, Inc. For the year ended March 31, 2018, cash provided by financing activities of $37.0 million was attributable to capital contributions from RSL. Contractual Obligations and Commitments We enter into agreements in the normal course of business with vendors for services and products for operating purposes such as CROs for clinical trials, which are cancelable at any time by us, subject to payment of our remaining obligations under binding purchase orders and, in certain cases, nominal early termination fees, generally upon 30 days’ prior written notice. These payments are not included in the table of contractual obligations below. The following table provides information with respect to our contractual obligations as of March 31, 2019 and the effect such obligations are expected to have on our liquidity and cash flows in future years (in thousands): Long-Term Debt Obligation Long-term debt obligation reflects our obligation to pay interest on the outstanding principal amount as of March 31, 2019 of $15.0 million under the Hercules Loan Agreement and to make periodic principal repayments, along with an end of term charge of 4.25% of the principal amount at maturity under the Hercules Loan Agreement. Our long-term debt obligation under the Hercules Loan Agreement bears interest at a prime-based variable rate with a floor of 10.15% per annum and maximum of 12.15% per annum. The related interest on the aggregate principal amounts outstanding to Hercules included in the above table was estimated using the interest rate in effect at March 31, 2019. See Note 5, “Long-term debt,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion of the Hercules Loan Agreement. Operating Lease Obligations Operating lease obligations include future rent payments under two office leases in Irvine, California. The first lease was for 8,038 square feet of office space pursuant to a lease agreement that was set to expire in February 2020 but was terminated early in June 2019. The second lease is for 21,489 square feet of office space pursuant to a lease agreement which commenced in June 2019 and expires in May 2026, with the option to extend the lease term for an additional five years. The minimum lease payments included in the table above do not include any related common area maintenance charges or real estate taxes. In addition, the operating lease obligations included in the table above do not include potential rent payments during the optional lease renewal term. In June 2019, we entered into a sublease agreement with our affiliate, RSI, for 2,784 square feet of office space located in Durham, North Carolina that expires in July 2025. The lease has scheduled rent increases each year. The total future minimum lease payments under this sublease agreement are not included in the table above but are approximately $0.6 million. License and Collaboration Agreements We received an exclusive license to develop, manufacture and commercialize vibegron worldwide, excluding Japan and certain other Asian territories, pursuant to our license agreement with Merck Sharp & Dohme Corp., or Merck, which we entered into in February 2017. Pursuant to this agreement, we made an upfront payment of $25.0 million to Merck during the year ended March 31, 2017. Additionally, we agreed to pay Merck up to an aggregate of $44.0 million upon the achievement of certain regulatory milestone events and up to an aggregate of $80.0 million upon the achievement of certain sales milestone events. Further, we agreed to pay Merck tiered royalties in the sub-teen double-digits on net sales of licensed products made by us, our affiliates or our sublicensees, subject to standard offsets and reductions as set forth in the agreement. We cannot, at this time, estimate the timing or likelihood of achieving these milestones or generating future product sales which result in royalty payments to be made under this agreement. Therefore, such payments are not included in the table above. See Note 3, “License agreements,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion of our license agreement with Merck. In June 2017, we entered into an intellectual property purchase agreement with RSG, a wholly owned subsidiary of our parent company, RSL, as amended on May 22, 2018, pursuant to which we assigned all of our rights, titles, claims and interests in and to all intellectual property rights under our license agreement with Merck, solely as it relates to any of our rights or obligations in China, to RSG. In connection with this assignment, we also entered into a separate collaboration agreement with RSG in June 2018, setting forth the parties’ respective rights and obligations to each other in connection with the development of vibegron in their respective territories. See Note 6, “Related party transactions,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information. Vibegron is also being developed by Kyorin Pharmaceutical Co., Ltd., or Kyorin, for the treatment of OAB in Japan and certain other Asian territories. We entered into a collaboration agreement with Kyorin in August 2017. Pursuant to this agreement, our maximum obligation to Kyorin is $11.5 million, of which $1.0 million was paid during the year ended March 31, 2018. The remaining obligations under this agreement will be due upon the achievement of certain regulatory milestones by Kyorin in Japan and us in the United States, subject to certain conditions. In September 2018, Kyorin received marketing approval from Japan’s Ministry of Health, Labour and Welfare for vibegron for the treatment of adults with OAB. We cannot, at this time, estimate the timing or likelihood of achieving the milestones under this agreement. Therefore, such payments are not included in the table above. See Note 10, “Commitments and contingencies,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding our collaboration agreement with Kyorin. We received an exclusive license to develop, manufacture and commercialize URO-902 worldwide, pursuant to our license agreement with Ion Channel Innovations, LLC, or ICI, which we entered into in August 2018. Pursuant to this agreement, we made an upfront payment of $0.25 million to ICI during the year ended March 31, 2019. Additionally, we agreed to pay ICI up to an aggregate of $35.0 million upon the achievement of certain development and regulatory milestone events and up to an aggregate of $60.0 million upon the achievement of certain sales milestone events. Further, we agreed to pay ICI tiered royalties in the mid-to-high single digits on net sales of licensed products made by us, our affiliates or our sublicensees, subject to certain reductions. We cannot, at this time, estimate the timing or likelihood of achieving these milestones or generating future product sales which result in royalty payments to be made under this agreement. Therefore, such payments are not included in the table above. See Note 3, “License agreements,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion of our license agreement with ICI. Supply Agreement As of March 31, 2019, under our enzyme supply agreement, we could be required to make minimum purchase commitments of up to $3.75 million and a milestone payment of $0.5 million. We are unable to estimate the timing or likelihood of the payments under this agreement as the financial commitment is subject to the first regulatory approval of vibegron in any of the United States, Europe or Canada. See Note 10, “Commitments and contingencies,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding our enzyme supply agreement. Off-Balance Sheet Arrangements During the periods presented, we did not have nor do we currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Jumpstart Our Business Startups Act We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under this act, an emerging growth company can delay the adoption of new or revised accounting standards issued subsequent to the enactment of the JOBS Act 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. However, we intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002, as amended. We will remain an emerging growth company until the earlier of (1) the date (a) March 31, 2024, (b) in which we have total annual gross revenue of at least $1.07 billion or (c) in which we are deemed to be a large accelerated filer, which means the market value of our common shares that are held by non-affiliates exceeds $700 million as of the prior September 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. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the dates of the consolidated balance sheets and the reported amounts of expenses during the reporting periods. In accordance with U.S. GAAP, we evaluate our estimates and judgments on an ongoing basis. Significant estimates include assumptions used in the determination of some of our costs incurred under our Services Agreements, which costs are charged to research and development and general and administrative expense, as well as assumptions used to estimate the fair value of common share and option awards. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We define our critical accounting policies as those under U.S. GAAP that require us to make subjective estimates and judgments about matters that are uncertain and are likely to have a material impact on our financial condition and results of operations, as well as the specific manner in which we apply those principles. While our accounting policies are more fully described in Note 2 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following are the critical accounting policies used in the preparation of our consolidated financial statements that require significant estimates and judgments. Share-Based Compensation We recognize share-based compensation expense related to stock options granted to employees based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting share-based compensation expense, for stock options that only have service vesting requirements or performance-based vesting requirements without market conditions using the Black-Scholes option-pricing model. The grant date fair value of the share-based awards with service vesting requirements is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. Determining the appropriate amount to expense for performance-based awards based on the achievement of stated goals requires judgment. The estimate of expense is revised periodically based on the probability of achieving the required performance targets and adjustments are made as appropriate. The cumulative impact of any revisions is reflected in the period of change. If any applicable financial performance goals are not met, no compensation cost is recognized and any previously recognized compensation cost is reversed. For performance-based awards with market conditions, we determine the fair value of awards as of the grant date using a Monte Carlo simulation model. We recognize share-based compensation expense related to stock options granted to non-employees issued in exchange for services based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting share-based compensation expense, using the Black-Scholes option-pricing model; however, the fair value of the stock options granted to non-employees is remeasured each reporting period until the service is complete, and the resulting increase or decrease in value, if any, is recognized as expense or a reduction in previously recognized expense, respectively, during the period the related services are rendered. The Black-Scholes option-pricing model requires the use of highly subjective assumptions, which determine the fair value of share-based awards. These assumptions include: Expected term. Our expected term represents the period that the share-based awards are expected to be outstanding. Since we have limited option exercise history, we have generally elected to estimate the expected life of an award based upon the SEC approved “simplified method” (based on the mid-point between the vesting date and the end of the contractual term) noted under the provisions of Staff Accounting Bulletin, or SAB, No. 107 with the continued use of this method extended under the provisions of SAB No. 110. For share-based awards granted to non-employees, the expected term represents the contractual term of the award. Expected volatility. Because we do not have an extended trading history for our common shares, the expected volatility was estimated using weighted-average measures of implied volatility and the historical volatility of our peer group of companies for a period equal to the expected life of the stock options. Our peer group of publicly traded biopharmaceutical companies was chosen based on our similar size, stage in the life cycle or area of specialty. Risk-free interest rate. The risk-free interest rate is based on the rates paid on securities issued by the United States Treasury with a term approximating the expected life of the stock options. Expected dividend. We have never paid, and do not anticipate paying, cash dividends on our common shares. Therefore, the expected dividend yield was assumed to be zero. In addition to the Black-Scholes option-pricing model assumptions, we adopted ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, or ASU No. 2016-09, on April 1, 2017 and as a result, have made an entity-wide accounting policy election to account for pre-vesting award forfeitures when they occur. As part of the valuation of share-based compensation under the Black-Scholes option-pricing model, it is necessary for us to estimate the fair value of our common shares. Prior to our initial public offering, we were required to periodically estimate the fair value of our common shares when issuing options and in computing our estimated share-based compensation expense. Given the absence of a public trading market prior to the completion our initial public offering, and in accordance with the American Institute of Certified Public Accountants’ Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, we exercised reasonable judgment and considered numerous objective and subjective factors to determine our best estimate of the fair value of our common shares. The estimation of the fair value of the common shares considered factors including the following: the estimated present value of our future cash flows; our business, financial condition and results of operations; our forecasted operating performance; the illiquid nature of our common shares; industry information such as market size and growth; market capitalization of comparable companies and the estimated value of transactions such companies have engaged in; and macroeconomic conditions. In connection with our initial public offering, we reassessed the fair value of our options. Subsequent to our initial public offering, the estimated fair value of share-based payment awards has been determined as indicated in the preceding paragraphs. Research and Development Expense Research and development costs are expensed as incurred. Clinical trial costs are accrued over the service periods specified in the contracts and adjusted as necessary based upon an ongoing review of the level of effort and costs actually incurred. The estimate of the work completed is developed through discussions with internal personnel and external service providers as to the progress of stage of completion of the services and the agreed-upon fee to be paid for such services. As actual costs become known, the accrued estimates are adjusted. Such estimates are not expected to be materially different from amounts actually incurred, however our understanding of the status and timing of services performed, the number of subjects enrolled, and the rate of subject enrollment may vary from estimates and could result in reporting amounts that are higher or lower than incurred in any particular period. The estimate of accrued research and development expense is dependent, in part, upon the receipt of timely and accurate reporting from clinical research organizations and other third-party service providers. Payments for a product license prior to regulatory approval of the product and payments for milestones achieved prior to regulatory approval of the product are expensed in the period incurred as research and development. Milestone payments made in connection with regulatory approvals are capitalized and amortized to cost of product sales over the remaining useful life of the asset. Research and development costs are charged to expense when incurred and primarily consist of the intellectual property and research and development materials acquired and expenses from third parties who conduct research and development activities on our behalf. We have evaluated the in-license agreements of vibegron from Merck and URO-902 from ICI based on the applicable guidance in ASC No. 805, Business Combinations, and have determined that the in-process research and development, or IPR&D, assets licensed did not meet the definition of a business and thus the transactions were not considered a business combination. We then evaluated, pursuant to ASC 730, Research and Development, whether the IPR&D assets had an alternative future use and concluded they did not. As a result, we recorded the upfront license payment of $25.0 million under the Merck agreement and $0.25 million upfront license payment under the ICI agreement as research and development expense upon entry into the license agreements. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. When uncertain tax positions exist, we recognize the tax benefit of tax positions to the extent that the benefit will more likely than not be realized. The determination as to whether the tax benefit will more likely than not be realized is based upon the technical merits of the tax position as well as consideration of the available facts and circumstances. As of March 31, 2019 and 2018, we did not have any significant uncertain tax positions. Recent Accounting Pronouncements For information regarding recently issued accounting pronouncements and the expected impact on our audited consolidated financial statements, see Note 2, “Summary of significant accounting policies,” to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company focused on developing and commercializing innovative therapies for urologic conditions. Our lead product candidate, vibegron, is an oral, oncedaily, small molecule that was observed to be highly selective for the human beta3 adrenergic receptor in in vitro assays. Vibegron is currently being developed for three potential indications: overactive bladder, or OAB, the treatment of OAB in men with benign prostatic hyperplasia, or BPH, and the treatment of abdominal pain due to irritable bowel syndrome, or IBS. Our second product candidate, URO902, is a novel gene therapy that we are developing for patients with OAB who have failed oral pharmacological therapy. In March 2019, we reported positive topline results from our international pivotal Phase 3 EMPOWUR trial evaluating vibegron for the treatment of OAB. In this pivotal Phase 3 clinical trial with over 1,500 patients, vibegron 75 mg met both coprimary efficacy endpoints and all seven key secondary endpoints. Onset of action for the coprimary endpoints was observed as early as week two, the first time point measured, and statistically significant efficacy was maintained at all timepoints measured through the end of the study. We plan to submit a new drug application, or NDA, to the U.S. Food and Drug Administration, or FDA, by the first quarter of 2020. OAB is a highly prevalent condition, with more than 30 million Americans over the age of 40 suffering from bothersome symptoms. In large, randomized, placebocontrolled, international Phase 2b and Japanese Phase 3 clinical trials in a total of over 2,600 OAB patients, vibegron 50 mg and 100 mg met all primary and secondary efficacy endpoints compared to placebo at week 8 and week 12, respectively. Our Phase 3 clinical trial had a design in line with these clinical trials. We believe vibegron, if approved by the FDA, may offer a differentiated profile compared to current OAB therapies, including the potential for broader efficacy claims if the FDA approves the inclusion of urgency data, rapid onset of action data, and a single convenient oncedaily dose in the label. Vibegron has been well tolerated in all clinical trials to date, has not been associated with clinically relevant drugdrug interactions, such as the inhibition of CYP2D6, and has not demonstrated a QTc signal at any of the human doses tested. In March 2019, we initiated the Phase 3 COURAGE randomized, double blind, placebocontrolled trial for OAB in men with BPH who are also taking BPH medications but continue experiencing OAB symptoms in approximately 1,000 patients. The study is being conducted in two phases, with the first phase focusing on safety and the second phase assessing efficacy and safety, and is testing 75 mg of vibegron versus placebo, the same dose studied in our Phase 3 EMPOWUR trial. The primary efficacy analysis for the coprimary efficacy endpoints will be measured at 12 weeks and include change from baseline in the average number of micturitions per 24 hours and change from baseline in the average number of urgency episodes per 24 hours. Secondary endpoints include change from baseline in the average number of nocturia episodes per night, which is awakening at night to use the bathroom to urinate. The duration for the doubleblind study is 24 weeks. In addition, a 28week openlabel extension study will evaluate the longterm safety and efficacy of vibegron in men with OAB symptoms and on another therapy for BPH. In December 2018, we enrolled our first patient in a 200 patient Phase 2a randomized, double blind, placebocontrolled trial with vibegron 75 mg for abdominal pain due to IBS. We expect to receive topline data from the Phase 2a clinical trial in 2020. The primary endpoint will be a 30% reduction [/INST] Positive. </s>

Cabaletta Bio, 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 together with the section entitled “Selected Financial Information” and our financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K, or 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 section entitled “Risk Factors,” 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. You should carefully read the section entitled “Risk Factors” 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.” 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 clinical-stage biotechnology company focused on the discovery and development of engineered T cell therapies for B cell-mediated autoimmune diseases. Our proprietary technology utilizes CAAR T cells that are designed to selectively bind and eliminate B cells that produce disease-causing autoantibodies, or pathogenic B cells, while sparing normal B cells. Our lead CAAR T cell product candidate was designed based on or CAR T cell technology that has been successfully developed and is marketed for the treatment of B cell cancers. We believe our technology, in combination with our proprietary Cabaletta Approach for selective B cell Ablation platform, called our CABA platform, has applicability across over two dozen B cell-mediated autoimmune diseases that we have identified, reviewed and prioritized. In order to accelerate product development for our lead program and to access a proven cell therapy manufacturing platform, we have entered into a collaboration with the Trustees of the University of Pennsylvania, or Penn. We hold multiple agreements with Penn to develop CAAR T cell therapies for the treatment of these diseases. Our goal is to leverage our team’s expertise in autoimmunity and engineered T cell therapy and our collaboration with Penn to rapidly discover and develop our portfolio of CAAR T product candidates. Our initial focus is on pemphigus vulgaris, or PV, which is an autoimmune blistering skin disease. We submitted an IND to the FDA in August 2019. Our IND was cleared in September 2019, and we plan to initiate our DesCAARTesTM Trial in 2020. In January 2020, the FDA granted DSG3-CAART orphan drug designation for the treatment of PV. We are also advancing additional product candidates currently in discovery-stage or preclinical development for the treatment of muscle-specific kinase myasthenia gravis, or MuSK MG, mucocutaneous PV, or mcPV, and Hemophilia A with FVIII alloantibodies. We were incorporated in April 2017. In August 2018, we entered into multiple agreements with Penn to develop the CAAR T technology to treat B cell-mediated autoimmune diseases. Our operations to date have been financed primarily by net proceeds of $86.4 million from the sale of convertible notes and convertible preferred stock and net proceeds of $71.0 million from the sale of common stock in our initial public offering, or IPO, in October 2019. As of December 31, 2019, we had $136.2 million in cash and cash equivalents. Amended and Restated License Agreement with the Trustees of the University of Pennsylvania and the Children’s Hospital of Philadelphia In August 2018, we entered into a license agreement with Penn, which was amended and restated in July 2019 to include the Children’s Hospital of Philadelphia, or CHOP, collectively, the Institutions, and collectively with such amendment, the License Agreement, pursuant to which we obtained (a) a non-exclusive, non-sublicensable, worldwide research license to make, have made and use products in two subfields of use, (b) effective as of October 2018, an exclusive, worldwide, royalty-bearing license, with the right to sublicense, under certain of the Institutions’ intellectual property to make, use, sell, offer for sale and import products in the same two subfields of use, and (c) effective as of October 2018, a non-exclusive, worldwide, royalty-bearing license, with limited rights to sublicense, under certain of Penn’s know-how to make, have made, use, sell, offer for sale, import and have imported products in the same two subfields of use. Our rights are subject to the rights of the U.S. government and certain rights retained by the Institutions. Unless earlier terminated, the License Agreement will expire with respect to a product upon the later of (a) the expiration of the last to expire patent or patent application covering such product or (b) 10 years after the first commercial sale of such product. We may terminate the License Agreement in its entirety or on a subfield-by-subfield basis at any time for convenience upon a certain number of days’ prior written notice. Penn may terminate the License Agreement in its entirety or on a subfield-by-subfield basis for our uncured material breach, including for our failure to meet certain diligence obligations and milestone events. We, however, may extend the achievement date of any milestone event for an additional period of time by making a payment in a certain amount, subject to certain limitations in the number of times each event may be extended. Sponsored Research Agreements We have two sponsored research agreements with Penn for the laboratories of Drs. Payne and Milone, who are also our scientific co-founders and members of our scientific advisory board. Under these agreements, we are committed to funding a defined research plan for three years through April 2021. The total estimated three-year cost of the two agreements is $8.5 million, which satisfies the $2.0 million annual obligation under the License Agreement. Master Translational Research Services Agreement In October 2018, we entered into a services agreement with Penn, or the Services Agreement, pursuant to which Penn agreed to perform certain services related to the research and development of the technology licensed to us under the License Agreement, as well as certain clinical, regulatory and manufacturing services. The research and development activities are detailed in Penn organization-specific addenda that are separately executed. The Services Agreement will expire on the later of (i) October 19, 2021 or (ii) completion of the services for which we have engaged Penn under the Services Agreement. Components of Operating Results Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from the sales of products for several years, if at all. If our development efforts for our current or future product candidates are successful and result in marketing approval, we may generate revenue in the future from product sales. 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. We may also in the future enter into license or collaboration agreements for our product candidates or intellectual property, and we may generate revenue in the future from payments as a result of such license or collaboration agreements. Operating Expenses Research and Development Our research and development expenses include: • personnel costs, which include salaries, benefits and stock-based compensation expense; • expenses incurred under agreements with consultants, third-party contract organizations that conduct research and development activities on our behalf; • costs related to sponsored research service agreements; • costs related to production of preclinical and clinical materials, including fees paid to contract manufacturers; • licensing fees for intellectual property and know-how; • laboratory and vendor expenses related to the execution of preclinical studies and planned clinical trials; and • laboratory supplies and equipment used for internal research and development activities. We have not reported program costs since inception because historically we have not tracked or recorded our research and development expenses on a pre-clinical program-by-program basis. We use our personnel and infrastructure resources across the breadth of our research and development activities, which are directed toward identifying and developing product candidates. We expense all research and development costs in the periods in which they are incurred. Costs for certain research and development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by Penn, our vendors and third-party service providers. 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 and we 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. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. Because of the numerous risks and uncertainties associated with product development, we cannot determine with certainty the duration and completion costs of the 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, including: • successful completion of preclinical studies and IND-enabling studies; • development of chemistry, manufacturing and controls, or CMC, processes and procedures for purposes of IND applications; • successful patient enrollment in, and the initiation and completion of, clinical trials; • the impact of any business interruptions to our operations or to those of our clinical sites, manufacturers, suppliers, or other vendors resulting from the coronavirus disease (COVID-19) outbreak or similar public health crisis; • receipt of regulatory approvals from applicable regulatory authorities; • establishing commercial manufacturing capabilities or arrangements with third-party manufacturers; • obtaining and maintaining patent and trade secret protection and non-patent exclusivity; • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; • acceptance of our product candidates, if and when approved, by patients, the medical community and third-party payors; • effectively competing with other therapies and treatment options; • a continued acceptable safety and efficacy profile following approval; • enforcing and defending intellectual property and proprietary rights and claims; and • achieving desirable medicinal properties for the intended indications. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our preclinical studies and clinical trials. We may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. A change in the outcome of any of these factors could mean a significant change in the costs and timing associated with the development of our current and future preclinical and clinical product candidates. 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, or if we experience significant delays in execution of or enrollment in any of our preclinical studies or clinical trials, we could be required to expend significant additional financial resources and time on the completion of preclinical and clinical development. We expect our research and development expenses to increase for the foreseeable future as we continue the development of product candidates. General and Administrative Expenses Our general and administrative expenses consist primarily of personnel costs, costs related to maintenance and filing of intellectual property, depreciation expense and other expenses for outside professional services, including legal, human resources, audit and accounting services. Personnel costs consist of salaries, benefits and stock-based compensation expense. We expect our general and administrative expenses to increase over the next several years to support our continued research and development activities, manufacturing activities, increased costs of operating as a public company and the potential commercialization of our product candidates. We anticipate our general and administrative costs will increase and with respect to the hiring of additional personnel, developing commercial infrastructure, fees to outside consultants, lawyers and accountants, and increased costs associated with being a public company such as expenses related to services associated with maintaining compliance with Nasdaq listing rules and SEC requirements, insurance and investor relations costs. Other Income and (Expense) Our other income and (expense) includes (i) interest income earned on money-market fund cash equivalents; and (ii) fair value adjustments on convertible notes for which we have elected the fair value option of accounting. Results of Operations for the years ended December 31, 2019 and 2018 The following sets forth our results of operations: Research and Development Expenses Research and development expenses were $11.7 million for the year ended December 31, 2019 as compared to $4.5 million for the year ended December 31, 2018. The table below summarizes our research and development expenses: Specific changes in our research and development expenses period-on-period include a: • $3.5 million increase in personnel costs due to the hiring of additional research and development staff during 2019, including $0.8 million of stock-based compensation expense; • $2.0 million increase for manufacturing of preclinical and clinical supplies in anticipation of the planned DesCAARTesTM Trial; • $1.7 million increase in development services from the commencement of preclinical research; • $0.4 million increase in clinical trial work from the initial start-up costs of the planned DesCAARTesTM Trial; and • $0.9 million decrease for intellectual property license expense principally resulting from the one-time license fee in September 2018. General and Administrative Expenses General and administrative expenses were $7.0 million for the year ended December 31, 2019 as compared to $1.7 million for the year ended December 31, 2018. The increase of $5.3 million in our general and administrative expenses period-on-period includes: • $2.8 million additional personnel costs due to the hiring of additional general and administrative employees in 2019, including an increase of $0.8 million of stock-based compensation expense; • $1.1 million of additional services, including legal, audit and accounting, public relations, recruiting and other consulting fees; and • $1.4 million increase in other general and administrative expenses including rent, insurance and other costs associated with being a public company. Other Income and (Expense) Interest income has increased $1.5 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 due to our higher balance of cash and cash equivalents as a result of proceeds received from our issuances of our convertible notes in May 2018, convertible preferred stock in October 2018 and January 2019 and common stock in October 2019. Other expense of $6.2 million for the year ended December 31, 2018 is comprised of fair value adjustments to our convertible notes. Liquidity and Capital Resources Since our inception in April 2017 through December 31, 2019, our operations have been financed by proceeds of $86.4 million from the sale of convertible notes and our convertible preferred stock and proceeds of $71.0 million from the sale of common stock in our initial public offering. As of December 31, 2019, we had $136.2 million in cash and cash equivalents. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. We have incurred losses since our inception and, as of December 31, 2019, we had an accumulated deficit of $33.0 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding prepaid expenses and other current assets, accounts payable and accrued expenses. Any product candidates we may develop may never achieve commercialization and we anticipate that we will continue to incur losses for the foreseeable future. We expect that our research and development expenses, general and administrative expenses, and capital expenditures will continue to increase. As a result, 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 or other capital sources, including potentially collaborations, licenses and other similar arrangements. Our primary uses of capital are, and we expect will continue to be, compensation and related expenses, third-party clinical research, manufacturing and development services, costs relating to the build-out of our headquarters, laboratories and manufacturing facility, license payments or milestone obligations that may arise, laboratory and related supplies, clinical costs, manufacturing costs, legal and other regulatory expenses and general overhead costs. Based upon our current operating plan, we believe that our existing cash and cash equivalents as of December 31, 2019 will enable us to fund our operating expenses and capital expenditure requirements through at least the third quarter of 2022. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. We will continue to require additional financing to advance our current product candidates through clinical development, to develop, acquire or in-license other potential product candidates and to fund operations for the foreseeable future. We will continue to seek funds through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. 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. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. If we are unable to raise capital, we will need to delay, reduce or terminate planned activities to reduce costs. 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, developing and manufacturing our lead product candidates or any future product candidates, and conducting preclinical studies and clinical trials; • the timing of, and the costs involved in, obtaining regulatory approvals or clearances for our lead product candidates or any future product candidates; • the impact of any business interruptions to our operations or to those of our clinical sites, manufacturers, suppliers, or other vendors resulting from the coronavirus disease (COVID-19) outbreak or similar public health crisis; • the number and characteristics of any additional product candidates we develop or acquire; • the timing of any cash milestone payments if we successfully achieve certain predetermined milestones; • the cost of manufacturing our lead product candidate or any future product candidates and any products we successfully commercialize, including costs associated with building-out our manufacturing capabilities; • 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 expenses needed to attract and retain skilled personnel; • the costs associated with being a public company; and • the timing, receipt and amount of sales of any future approved or cleared products, if any. 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. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities The use of cash in all periods resulted primarily from our net losses adjusted for non-cash charges and changes in components of working capital. During the year ended December 31, 2019, cash used in operating activities of $16.0 million was attributable to our net loss of $16.9 million, increased by the net change of $1.5 million in our net operating assets and liabilities and offset by non-cash charges of $2.4 million for stock-based compensation charges and depreciation. During the year ended December 31, 2018, cash used in operating activities of $4.7 million was attributable to our net loss of $12.2 million, increased by the net change of $0.5 million in our net operating assets and liabilities and offset by non-cash charges of $8.0 million for changes in fair value of our convertible notes, common stock issued for the Penn license and stock-based compensation charges. Investing Activities During the year ended December 31, 2019, we used $0.7 million of cash and cash equivalents in investing activities consisting of purchases of property and equipment. We had no investing activities during the year ended December 31, 2018. Financing Activities During the year ended December 31, 2019, cash provided by financing activities of $119.9 million was attributable to $48.7 million of net proceeds upon the issuance of Series B convertible preferred stock in January 2019 and $71.2 million of net proceeds from the issuance of common stock in our initial public offering in October 2019. During the year ended December 31, 2018, cash provided by financing activities of $37.7 million was comprised of $12.5 million of proceeds upon the issuance of convertible notes in May 2018, $12.6 million of proceeds on the milestone closing of the convertible notes and issuance of our Series A-1 convertible preferred stock in October 2018, and $12.6 million net proceeds upon the issuance of our Series A convertible preferred stock in October 2018. Contractual Obligations and Commitments In February 2019, we entered into an operating lease agreement for new office space in Philadelphia, Pennsylvania. The lease term commenced in May 2019 and will expire in July 2022. The initial annual base rent is $0.3 million, and such amount will increase by 2% annually on each anniversary of the commencement date. Our commitments include: • The License Agreement. Under the License Agreement, we are required to make milestone payments upon successful completion of certain development, regulatory and sales milestones on a product-by-product and geographical basis. The payment obligations under the License Agreement are contingent upon future events such as our achievement of specified development, 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 the License Agreement. As of December 31, 2019, we are unable to estimate the timing or likelihood of achieving the milestones or making future product sales. We are also obligated to pay $2.0 million annually for three years beginning August 2018 for funding to the laboratories of Drs. Payne and Milone. Under the License Agreement, we must use commercially reasonable efforts to develop and commercialize a product in each subfield. During the term of the License Agreement until the first commercial sale of the first product, we are obligated to pay Penn a non-refundable, non-creditable annual license maintenance fee of $10,000. We are required to pay certain milestone payments upon the achievement of specified clinical and commercial milestones. Milestone payments are reduced by a certain percentage for the second product that achieves a milestone, by an additional percentage for the third product that achieves a milestone, and so on, for each subsequent product that achieves a milestone. In the event that we are able to successfully develop and launch multiple products under the License Agreement, total milestone payments could approach $20.0 million. Penn is also eligible to receive tiered royalties at percentage rates in the low single-digits, subject to an annual minimum royalty, on annual worldwide net sales of any products that are commercialized by us or our sublicensees that contain or incorporate, or are covered by, the intellectual property licensed by us. To the extent we sublicense our license rights under the License Agreement, Penn would be eligible to receive tiered sublicense income at percentage rates in the mid-single to low double-digits. We have also entered into a subscription and technology transfer agreement with Penn, pursuant to which we owed Penn an upfront subscription fee, which was paid in 2019, and a nominal non-refundable royalty on net sales of products, a portion of which will be credited toward milestone payments and royalties under this License Agreement. Technology transfer activities would be at our cost and subject to agreement as to the technology to be transferred. • Master Translational Research Services Agreement with Penn. Under the Services Agreement, we have contracted for additional research and development services from various laboratories within Penn. The Services Agreement will expire on the later of (i) October 19, 2021 or (ii) completion of the services for which we have engaged Penn under the Services Agreement. We may incur up to $900 through the remaining term of the Addendum in 2020 related to the manufacture of vector under the Center for Advanced Retinal and Ocular Therapeutics, or CAROT, addendum. • Sponsored Research Agreements. We have two sponsored research agreements, or SRAs, with Penn for the laboratories of our scientific co-founders Drs. Payne and Milone. Under the SRAs, we have committed to funding a defined research plan for three years through April 2021. We have estimated the three-year cost of the two SRAs to be $8.5 million, which satisfies the $2.0 million annual obligation under the License Agreement. • Manufacturing agreements. Under agreement with a manufacturer, we are progressing a staged plan for vector development and may incur up to $1,300 in committed spend. • Other Purchase Commitments. In the normal course of business, we enter into various purchase commitments with third-party contract manufacturers for the manufacture and processing of our product candidates and related raw materials, contracts with contract research organizations for clinical trials and agreements with vendors for other services and products for operating purposes. These agreements generally provide for termination or cancellation other than for costs already incurred. Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently have, any off-balance sheet arrangements as defined under SEC rules. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with 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 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 more detail in Note 2 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. Research and Development Costs We estimate costs of research and development activities conducted by service providers, which include activities under the License Agreement, the conduct of sponsored research, preclinical studies 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 the accrued and other current liabilities or prepaid expenses on the balance sheets and within research and development expense on the statements of operations. We estimate these costs based on factors such as estimates of the work completed and budget provided and in accordance with agreements established with our collaboration partners and third-party service providers. We make significant judgments and estimates in determining the accrued liabilities and prepaid expense balances in each reporting period. As actual costs become known, we adjust our accrued liabilities or prepaid expenses. We have not experienced any material differences between accrued costs and actual costs incurred since our inception. Stock-based Compensation We recognize compensation costs related to stock-based awards, including stock options and non-vested stock, based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation, using the Black-Scholes option-pricing model, or Black-Scholes. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. Black-Scholes requires the use of subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Fair Value of Common Stock-Historically, for all periods prior to our initial public offering in October 2019, the fair value of the shares of common stock underlying our stock-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, 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, or the Practice Aid. • 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 expected term to be the midpoint between the vesting date and the contractual life of the stock-based awards. • Expected Volatility- As a privately held company historically, the Company has limited trading history for its common stock and, as such, 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 were chosen based on their similar size, stage in the life cycle or area of specialty. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. • Risk-Free Interest Rate-The risk-free interest rate is based on the U.S. Treasury 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 use an expected dividend yield of zero. We will continue to use judgment in evaluating the assumptions utilized for our stock-based compensation expense calculations on a prospective basis. In addition to the assumptions used in Black-Scholes, the amount of stock-based compensation expense we recognize in our financial statements includes stock option forfeitures as they occurred. Determination of the Fair Value of Convertible Notes We have elected the fair value option for the accounting for our convertible notes issued in 2018. Fair value adjustments to the convertible notes are included in our other income and (expenses). The fair value of the initial closing of our convertible notes in May 2018 was determined to be equal to the proceeds of $12.5 million on issuance. The fair value of the convertible notes on conversion and of the milestone-based closing in October 2018 was determined to be equal to the value of our Series A-1 convertible preferred stock and Series A-2 convertible preferred stock into which the convertible notes were converted, which was determined to be $3.39 per share of Series A-1 convertible preferred stock and Series A-2 convertible preferred stock, using an OPM framework and utilized the back-solve method for inferring and allocating the equity value predicated on the concurrent sale of Series A convertible preferred stock. This method was selected as we concluded that the sale of the Series A convertible preferred stock was an arm’s-length transaction. Application of the OPM back-solve method involves making assumptions for the expected time to liquidity, volatility and risk-free rate and then solving for the value of equity such that value for the most recent financing equals the amount paid. The OPM allocation of total equity value was determined with reference to a recent financing transaction and we assumed a 71% volatility rate, a 1.3-year estimated term and a probability weighted average discount for lack of marketability of 35%. All outstanding convertible notes converted to convertible preferred stock in October 2018. There were no convertible notes outstanding as of December 31, 2019 and 2018. 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. 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 use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Subject to certain conditions, as an emerging growth company, we may rely on certain other exemptions and reduced reporting requirements, 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. Recently Issued Accounting Pronouncements In February 2016, the Financial Accounting Standards Board, or the FASB, issued ASU 2016-02, Leases (Topic 842), with guidance regarding the accounting for and disclosure of leases. The update requires lessees to recognize the liabilities related all leases, including operating leases, with a term greater than 12 months on the balance sheet. This update also requires lessees and lessors to disclose key information about their leasing transactions. This guidance was effective for public companies for annual and interim periods beginning after December 15, 2018. For all other entities this standard is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021. Early adoption is permitted. We will adopt Topic 842 for our annual period ending December 31, 2021, and we have yet to evaluate the effect that ASU 2016-02 will have on our financial statements or financial statement disclosures.

<s>[INST] Overview We are a clinicalstage biotechnology company focused on the discovery and development of engineered T cell therapies for B cellmediated autoimmune diseases. Our proprietary technology utilizes CAAR T cells that are designed to selectively bind and eliminate B cells that produce diseasecausing autoantibodies, or pathogenic B cells, while sparing normal B cells. Our lead CAAR T cell product candidate was designed based on or CAR T cell technology that has been successfully developed and is marketed for the treatment of B cell cancers. We believe our technology, in combination with our proprietary Cabaletta Approach for selective B cell Ablation platform, called our CABA platform, has applicability across over two dozen B cellmediated autoimmune diseases that we have identified, reviewed and prioritized. In order to accelerate product development for our lead program and to access a proven cell therapy manufacturing platform, we have entered into a collaboration with the Trustees of the University of Pennsylvania, or Penn. We hold multiple agreements with Penn to develop CAAR T cell therapies for the treatment of these diseases. Our goal is to leverage our team’s expertise in autoimmunity and engineered T cell therapy and our collaboration with Penn to rapidly discover and develop our portfolio of CAAR T product candidates. Our initial focus is on pemphigus vulgaris, or PV, which is an autoimmune blistering skin disease. We submitted an IND to the FDA in August 2019. Our IND was cleared in September 2019, and we plan to initiate our DesCAARTesTM Trial in 2020. In January 2020, the FDA granted DSG3CAART orphan drug designation for the treatment of PV. We are also advancing additional product candidates currently in discoverystage or preclinical development for the treatment of musclespecific kinase myasthenia gravis, or MuSK MG, mucocutaneous PV, or mcPV, and Hemophilia A with FVIII alloantibodies. We were incorporated in April 2017. In August 2018, we entered into multiple agreements with Penn to develop the CAAR T technology to treat B cellmediated autoimmune diseases. Our operations to date have been financed primarily by net proceeds of $86.4 million from the sale of convertible notes and convertible preferred stock and net proceeds of $71.0 million from the sale of common stock in our initial public offering, or IPO, in October 2019. As of December 31, 2019, we had $136.2 million in cash and cash equivalents. Amended and Restated License Agreement with the Trustees of the University of Pennsylvania and the Children’s Hospital of Philadelphia In August 2018, we entered into a license agreement with Penn, which was amended and restated in July 2019 to include the Children’s Hospital of Philadelphia, or CHOP, collectively, the Institutions, and collectively with such amendment, the License Agreement, pursuant to which we obtained (a) a nonexclusive, nonsublicensable, worldwide research license to make, have made and use products in two subfields of use, (b) effective as of October 2018, an exclusive, worldwide, royaltybearing license, with the right to sublicense, under certain of the Institutions’ intellectual property to make, use, sell, offer for sale and import products in the same two subfields of use, and (c) effective as of October 2018, a nonexclusive, worldwide, royaltybearing license, with limited rights to sublicense, under certain of Penn’s knowhow to make, have made, use, sell, offer for sale, import and have imported products in the same two subfields of use. Our rights are subject to the rights of the U.S. government and certain rights retained by the Institutions. Unless earlier terminated, the License Agreement will expire with respect to a product upon the later of (a) the expiration of the last to expire patent or patent application covering such product or (b) 10 years after the first commercial sale of such product. We may terminate the License Agreement in its entirety or on a subfieldbysubfield basis at any time for convenience upon [/INST] Negative. </s>

IDEAYA Biosciences, 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 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 an oncology-focused precision medicine company committed to the discovery and development of targeted therapeutics for patient populations selected using molecular diagnostics. Our approach integrates small molecule drug discovery with extensive capabilities in identifying and validating translational biomarkers to develop targeted therapies for select patient populations most likely to benefit. We are applying these capabilities across multiple classes of precision medicine, including direct targeting of oncogenic pathways and synthetic lethality - which represents an emerging class of precision medicine targets. IDE196 Clinical Development Our most advanced product candidate is IDE196, a protein kinase C, or PKC, inhibitor for genetically-defined cancers having GNAQ or GNA11 gene mutations, which we in-licensed from Novartis. We initiated a Phase 1/2 clinical trial IDE196-001 in June 2019 to evaluate IDE196 in solid tumors harboring GNAQ or GNA11 hotspot mutations in a basket trial design, including in metastatic uveal melanoma, or MUM, and other solid tumor indications such as cutaneous melanoma or colorectal cancer. We have completed enrollment of patients in the Phase 1 dose escalation portion of the Phase 1/2 clinical trial at sites in the U.S. and Australia, including patients in MUM and patients having other solid tumors with GNAQ or GNA11 hotspot mutations using a powder-in-capsule, or PIC, formulation. We are continuing to enroll MUM patients in a Phase 1 tablet formulation sub-study evaluating pharmacokinetics and food effect. We have initiated the Phase 2 expansion portion of the clinical trial for patients having tumors with GNAQ or GNA11 hotspot mutations for indications other than metastatic uveal melanoma, such as in cutaneous melanoma or colorectal cancer. The thirty-eight MUM patients in the Phase 1 dose escalation arm of the clinical trial were dosed at 300 mg BID or 400 mg BID. The 400 mg BID dosing regimen consisted of a 200mg BID run-in for the first seven days of dosing, followed by 400 mg BID dosing thereafter for the duration of treatment. IDE196 has been generally well tolerated at each dose level, with 1 reported Grade 3 fatigue attributed to IDE196 on the 400 mg BID regimen and otherwise no reported drug-related adverse events, or AEs at or above Grade 3 in any patients. We generally observed higher average steady state exposure of free IDE196 and higher trough concentration of IDE196 at the higher 400 mg BID dose relative to the 300 mg BID dose, based on pharmacokinetic, or PK, analysis. We anticipate providing an update with interim clinical data from our Phase 1/2 clinical trial in MUM in the second half of 2020. In January 2020, we initiated a Phase 1 sub-study within the Phase 1/2 clinical trial to evaluate an immediate release tablet formulation of IDE196 in MUM patients, comparing the pharmacokinetic profile of the tablet formulation to the powder-in-capsule form of IDE196 used in the dose escalation portion of the Phase 1/2 clinical trial. In this sub-study, the data to date shows that the pharmacokinetic profile of the tablet form of IDE196, including Cmax and AUCtotal, is comparable to the pharmacokinetic profile of the PIC form of IDE196. This Phase 1 sub-study is continuing to enroll additional MUM patients to evaluate steady state pharmacokinetic properties of the tablet and explore food effect properties of IDE196 using the tablet formulation. Once testing of the tablet formulation of IDE196 is completed, the tablet, dosed at 400 mg BID, will be used at the recommended Phase 2 dose, or RP2D, for the expansion portion of the clinical trial into which we are continuing to enroll patients having tumors with GNAQ or GNA11 hotspot mutations for indications other than metastatic uveal melanoma. We will evaluate whether to also expand into the Phase 2 portion of the clinical trial in MUM patients as data from our Phase 1 dose escalation portion of the clinical trial continues to mature in the second half of 2020. Our ongoing clinical translational research includes molecular characterization of patient tissue samples, including tumor samples, with a goal of evaluating whether certain molecular characteristics correlate with patient outcomes. Analytical screening in support of our tissue-type agnostic strategy is ongoing, including comprehensive genomic profiling and advanced genomic analyses of patient tumor samples from the ongoing Phase 1/2 clinical trial. We have established and continue to pursue our Genomics Profiling Initiative, or GPI. GPI is our initiative leveraging various Next Generation Sequencing (NGS) platforms in partnership with other companies to identify patients having tumors with specific mutations, such as tumors with activating GNAQ/11 hotspot mutations in solid tumors outside of uveal melanoma, or non-MUM tumors. These patient diagnostic screening efforts have identified patients having non-MUM tumors with activating GNAQ/11 hotspot mutations, and we are evaluating these patients for potential enrollment into the ongoing non-MUM Phase 2 portion of our Phase 1/2 basket trial. We recently entered into a clinical trial collaboration and supply agreement with Pfizer Inc., pursuant to which Pfizer will supply us with their MEK inhibitor, binimetinib, to evaluate the combination in patients with tumors harboring activating GNAQ or GNA11 hotspot mutations. We are planning to evaluate the safety and efficacy of IDE196 in combination with binimetinib in patients with metastatic uveal melanoma in the ongoing Phase 1/2 clinical trial, which we are targeting to initiate in mid-2020. Following our evaluation of tolerability and preliminary efficacy from the IDE196 / binimetinib combination clinical trial in MUM, we may also evaluate IDE196 / binimetinib combination therapy in patients having solid tumors with activating GNAQ/11 hotspot mutations outside of uveal melanoma. We may also evaluate IDE196 in combination with one or more additional anti-cancer agent(s) in metastatic uveal melanoma patients and in patients having solid tumors with activating GNAQ/11 hotspot mutations outside of uveal melanoma. IDE196 was initially developed by Novartis, and we obtained an exclusive, worldwide license to IDE196 from Novartis in September 2018. Pursuant to our license agreement with Novartis, except for Novartis’ ongoing Phase 1 clinical trial, we control all future clinical development, and all commercial rights to IDE196, and may rely on and incorporate data previously submitted to the FDA by Novartis into our own regulatory submissions. Novartis has completed enrollment in a Phase 1 clinical trial it is conducting to evaluate IDE196 in metastatic uveal melanoma. Phase 1 monotherapy data from Novartis was presented at the American Association for Cancer Research, or AACR, in April 2019. A confirmed Complete Response at the 200 mg BID dose level was observed at month 31 in one of four patients previously reported with confirmed partial response out of 30 total (28 evaluable) BID patients in the monotherapy arm of the Novartis clinical trial. As of March 20, 2020, this patient with a confirmed Complete Response in the monotherapy arm of this clinical trial remains on treatment with IDE196. In an end of Phase 1 meeting with the FDA in the fourth quarter of 2019, the FDA indicated that our proposed single-arm Phase 2 portion of the IDE196-001 Phase 1/2 clinical trial may be adequate to support a new drug application, or NDA, seeking Accelerated Approval for IDE196 monotherapy in MUM. The FDA indicated that such a single-arm, potentially registration-enabling part of the Phase 1/2 clinical trial could target enrollment of 60 evaluable MUM patients with the primary endpoint of overall response rate, or ORR, as determined by blinded independent central review, or BICR, supported by BICR-determined duration of response, or DOR, as a secondary endpoint. We initiated 13-week good laboratory practice-, or GLP-, compliant toxicology studies in two species in November 2019, and have completed the in-life portion of these studies in support of an FDA requirement that results of these studies be submitted prior to enrollment of more than approximately 50 patients in the potentially registrational arm that will support a marketing application. We will evaluate clinical tolerability and efficacy data from each of the ongoing IDE196 monotherapy Phase 1 dose escalation portion of the clinical trial in MUM patients and the planned IDE196 / binimetinib combination therapy Phase 1/2 portion of the clinical trial in MUM patients, prior to initiation of a potentially registrational clinical trial in MUM. We will provide updated guidance on timing for a potential NDA submission for IDE196 in MUM after making such decision on a potential registrational pathway in MUM. Preclinical Evaluation of IDE196 in other Potential Patient Populations or Indications We have advanced our preclinical evaluation of IDE196 for potential use in other oncology patient populations. We have suspended plans for evaluation of IDE196 as a potential therapeutic for patients with solid tumors having PKC fusions, based on preclinical validation studies which to date do not support clinical development for such patients. Likewise, our preclinical assessment to date of the potential use of IDE196 for treatment of patients with epidermal growth factor receptor-, or EGFR-, mutant non-small cell lung cancer, or NSCLC, tumors which are TKI-resistant does not currently support clinical development activities for treating such patients with IDE196 alone, or in combination with an EGFR. We have also suspended plans for evaluation of IDE196 in patients with solid tumors outside of metastatic uveal melanoma, where the tumors have GNAQ or GNA11 “non-hotspot” mutations in loci different from the loci of activating mutations in uveal melanoma. Current preclinical data and results do not currently support clinical development for patients with such non-hotspot mutations. Accordingly, our ongoing Phase 1/2 basket trial will continue to focus on patients having tumors with activating GNAQ or GNA11 hotspot mutations. We are continuing our preclinical evaluation of IDE196 in Sturge-Weber Syndrome, or SWS, a rare neurocutaneous disorder characterized by capillary malformations and associated with mutations in GNAQ. Our preclinical evaluation will include potential feasibility for pediatric use. Synthetic Lethality Programs We believe synthetic lethality, as an emerging class of precision medicine, represents one of the most exciting, potentially impactful new areas of development in oncology, and we are investing a significant portion of our resources to be a leader in this emerging field. Our synthetic lethality pipeline includes four potential first-in-class programs. Our lead synthetic lethality program targets MAT2A for patients having solid tumors with MTAP deletions - a patient population estimated to represent approximately 15% of solid tumors. We anticipate submitting an IND to the FDA for this program in the fourth quarter of 2020. We have a synthetic lethality program targeting Pol-theta for solid tumors with homologous recombination deficiency, or HRD, including BRCA mutations, for which we expect to designate a development candidate in the second half of 2020. We are pursuing a synthetic lethality program targeting Werner helicase, or WRN, in tumors with high microsatellite instability, or MSI, and have observed a dose-dependent cellular viability effect and a dose-dependent cellular pharmacodynamic, or PD, response in multiple endogenous MSI high cell lines. We also have a program targeting PARG for patients having tumors with BRCA2 mutations, impaired base excision repair, or BER and potentially other genetic and/or molecular signatures such as replication stress signatures. We are advancing each program in our synthetic lethality portfolio. We are applying our fully integrated research and translational capabilities to each of our synthetic lethality research programs. We have solved the crystal structures for each of our four programs, generally enabling structure-based drug design, and we are conducting preclinical in vivo efficacy studies in three of our synthetic lethality programs. Our lead synthetic lethality research program targets MAT2A for solid tumors with MTAP deletions. We have selected a lead compound MAT2A inhibitor as a potential drug candidate. We are also continuing our preclinical evaluation of other compounds in our lead series, and have satisfactorily completed preliminary toxicological evaluation of several compounds in our lead series. Preclinically, we have shown a dose-dependent cellular viability effect and pharmacodynamic engagement of MAT2A with our small molecule inhibitors. We have solved the crystal structure of MAT2A, enabling ongoing structure-based drug design. We have demonstrated single agent in vivo efficacy of our small MAT2A inhibitors in MTAP-null models. We have shown tumor growth inhibition with our selected lead compound and other compounds in our lead series in an HCT116 MTAP -/- engineered model. We have also shown anti-tumor activity, including tumor growth inhibition or tumor regression, with our selected lead compound and other compounds in our lead series in multiple MTAP -/- endogenous models. We have scaled our lead compound for evaluation in non-GLP toxicology studies in two species to support selection of early development candidate in the second quarter of 2020. Subject to selection of a development candidate and satisfactory completion of GLP toxicology studies with such development candidate, we anticipate submitting an IND to the FDA for the selected development candidate inhibitor of MAT2A in the fourth quarter of 2020. Agios Pharmaceuticals presented initial data from its Phase 1 clinical trial evaluating a small molecule MAT2A inhibitor designated as AG270 in patients having tumors with MTAP deletion at the AACR/NCI/EORTC conference in October 2019. We believe that our MAT2A inhibitor compounds are differentiated from an Agios compound, AGI-25696, which we believe to be representative of a series of Agios compounds including AG270, with distinct properties across multiple parameters, including in vivo activity, physiochemical properties, and off-target toxicity profile, including in particular, no evidence of acute liver injury or increased bilirubin in preclinical studies across multiple compounds in our lead series. We believe synthetic lethality, as an emerging class of precision medicine targets, represents one of the most exciting, potentially impactful new areas of development in oncology, and we are investing a significant portion of our resources to become a leader in this emerging field. In addition to our MAT2A program, we continue to progress other synthetic lethality programs in our pipeline, including Pol-theta for patients having tumors with BRCA or other homologous recombination deficiency, or HRD, mutations Werner, or WRN, for patients having tumors with high microsatellite instability, or MSI, and PARG for patients having tumors with BRCA2 mutations, impaired base excision repair, or BER, and potentially other genetic and/or molecular signatures, including replication stress signature. We entered into a Second Amendment, or the Lease Amendment, to the Company’s lease, or the South San Francisco Lease, with ARE-SAN FRANCISCO NO. 17, LLC, or the Lessor, relating to space leased by the Company at its corporate headquarters located at 7000 Shoreline Court, Suite 350, South San Francisco, California 94080. The Lease Amendment expands the square footage leased by the Company pursuant to the South San Francisco Lease by an additional approximately 5,500 square feet, or the Expansion Premises, subject to the Company’s right to terminate the lease of approximately 4,500 square feet of the Expansion Premises prior to February 1, 2020 concurrent with the payment of an early termination fee, on the terms and subject to the conditions set forth therein. Concurrent with the execution of the Lease Amendment, and in consideration of the Company’s relocation of certain of its target identification and validation operations from San Diego to its facilities in South San Francisco, the Company entered into a termination agreement with ARE-SD-Region No. 35, LLC, an affiliate of the Lessor, with respect to the Company’s existing lease at 3033 Science Park Road, San Diego, California 92121, pursuant to which the such lease was terminated on September 30, 2019. We amended the Evaluation, Option and License Agreement between IDEAYA and Cancer Research Technologies, or CRT, also known as Cancer Research UK, or Cancer Research UK, and the University of Manchester, or University of Manchester, in March 2020 to expand our research collaboration with Cancer Research UK / U Manchester. The expanded collaborative research will include evaluation of an IDEAYA proprietary small molecule PARG inhibitor in multiple in vitro and in vivo cancer xenograft models. This research will also evaluate replication stress signature as a potential patient selection biomarker. In the March 2020 amendment to the Evaluation, Option and License Agreement with Cancer Research UK and University of Manchester, the parties reduced the license fee due at exercise of our option, extended the research period for one year from the date of the March 2020 amendment, and also extended the option period, during which IDEAYA has rights to exercise an option to certain license rights, for up to four years, including an initial one year period from the date of this March 2020 amendment, an additional eighteen month extension contingent upon our certification of ongoing research activities, and up to three additional six month extensions contingent upon both our certification of ongoing research activities and payment of certain extension fees, which together with the reduced license fee would equal the original license fee. We plan to continue to use third-party service providers, including clinical research organizations, or CROs, and clinical manufacturing organizations, or 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 IPO in May 2019, we had funded our operations primarily with an aggregate of $140.1 million in gross cash proceeds from the sale and issuance of redeemable convertible preferred stock and convertible promissory notes. In May 2019, we sold and issued 5,750,000 shares of common stock, including 750,000 shares as a result of the full exercise of the over-allotment option by the underwriters, at $10.00 per share for gross proceeds of $57.5 million. The aggregated net proceeds from our IPO, inclusive of the full over-allotment option exercise, were approximately $50.2 million after deducting underwriting discounts and commissions and other offering costs. Upon the closing of our IPO, all redeemable convertible preferred shares then outstanding automatically converted into 13,139,794 shares of common stock. Since our inception in June 2015, we have devoted substantially all of our resources to discovering and developing our product candidates. We have incurred significant operating losses to date and expect that our operating expenses will increase significantly as we advance our product candidates through preclinical and clinical development, seek regulatory approval, and prepare for, and, if approved, proceed to commercialization; acquire, discover, validate and develop additional product candidates; obtain, maintain, protect and enforce our intellectual property portfolio; and hire additional personnel. In addition, we expect to incur additional costs associated with operating as a public company. Our net losses were $42.0 million and $34.3 million for the years ended December 31, 2019 and December 31, 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $92.5 million. Our ability to generate product revenue will depend on the successful development, regulatory approval and eventual commercialization of one or more of our product candidates. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through the sale of equity, debt financings, or other capital sources, including 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 our product candidates. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $100.5 million. We believe that our cash, cash equivalents and marketable securities will be sufficient to fund our planned operations for at least 12 months from the date of the issuance of these financial statements. Components of Operating Results Operating Expenses Research and Development Expenses Substantially all of our research and development expenses consist of expenses incurred in connection with discovery and development of our product candidates. These expenses include certain payroll and personnel-related expenses, including salaries, employee benefit costs and stock-based compensation expenses for our research and product development employees, fees paid to third parties to conduct certain research and development activities on our behalf including fees paid to CMOs and CROs in support of manufacturing and clinical activity for IDE 196, consulting costs, costs for laboratory supplies, costs for product 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 CMOs and CROs. 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. 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 CMOs and CROs 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. Costs of certain activities, such as preclinical studies, are generally recognized based on an evaluation of the progress to completion of specific tasks. Nonrefundable payments made prior to the receipt of goods or services that will be used or rendered for future research and development activities are deferred and capitalized 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 do not allocate our costs by product candidate, as a significant amount of research and development expenses include internal costs, such as payroll and other personnel expenses, laboratory supplies and allocated overhead; and external costs, such as fees paid to third parties to conduct research and development activities on our behalf, none of which are tracked by product candidate. In particular, with respect to internal costs, several of our departments support multiple product candidate research and development programs, and therefore the costs cannot be allocated to a particular product candidate or development program. We are focusing substantially all of our resources on the development of our product candidates. We expect our research and development expenses to increase substantially during the next few years, as we seek to initiate clinical trials for our product candidates, complete our clinical program, pursue regulatory approval of our product candidates and prepare for a possible commercial launch. 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, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development. Furthermore, we are unable to predict when or if our product candidates will receive regulatory approval with any certainty. General and Administrative Expenses General and administrative expenses consist primarily of payroll and personnel-related expenses, including salaries, employee benefit costs and stock-based compensation expense, professional fees for legal, patent, consulting, accounting and tax services, allocated overhead, including rent, 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 expense, patent costs for our product candidates, expanded infrastructure and higher consulting, legal and accounting services associated with maintaining compliance with our NASDAQ stock exchange listing and requirements of the Securities and Exchange Commission, or the SEC, investor relations costs and director and officer insurance premiums associated with being a public company. Interest Income Interest income consists primarily of interest income earned on our cash, cash equivalents and marketable securities. Other Income (Expense), Net Other income (expense), net primarily consists of changes in the fair value of our redeemable convertible preferred stock liability and realized gains and losses on the sale of available-for-sale securities. Results of Operations A discussion regarding our financial condition and results of operations for fiscal year 2019 compared to fiscal year 2018 is presented below. A discussion regarding our financial condition and results of operations for fiscal year 2018 compared to fiscal year 2018 can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our final prospectus filed pursuant to Rule 424(b)(4) under the Securities Act with the SEC on May 24, 2019, which is available free of charge on the SEC’s website at http://www.sec.gov and at our investor relations website, https://ir.ideayabio.com/. Comparison of the Years Ended December 31, 2019 and December 31, 2018 The following table summarizes our results of operations for the periods indicated (in thousands): Research and Development Expenses Research and development expenses increased by $2.6 million, or 8%, 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 in fees paid to CROs and CMOs of $4.2 million related primarily to our Phase 1/2 clinical trial to evaluate IDE196 in solid tumors and the advancement of our lead product candidates through preclinical studies; an increase in payroll and personnel-related expenses, including salaries, benefits and stock-based compensation expense, of $3.3 million related to increased average headcount to support our growth; an increase in clinical and research consulting costs of $1.0 million; and an increase in allocated overhead, including rent, equipment, depreciation, information technology costs and utilities of $0.5 million. These increases were partially offset by a decrease in license fees of $6.3 million related to our license agreement with Novartis, which was comprised of a one-time cash payment of $2.5 million and issuance of 263,615 shares of Series B redeemable convertible preferred stock with a fair value of $3.8 million to an affiliate of Novartis in the year ended December 31, 2018. General and Administrative Expenses General and administrative expenses increased by $5.3 million, or 113%, 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 in payroll and personnel-related expenses, including salaries, benefits and stock-based compensation expense, of $1.8 million related to increased average headcount to support our growth; an increase in professional fees for legal, consulting, accounting, tax and other services as a public company of $1.6 million; an increase in directors’ and officers’ liability insurance premiums of $1.2 million as a public company; an increase in facility related costs related to the amendment to our lease agreement in South San Francisco for additional space, which commenced on June 1, 2018, of $0.3 million; and an increase in fees for software licenses and subscriptions of $0.4 million related to upgrades to our IT infrastructure. Interest Income Interest income increased by $0.3 million, or 15%, from the year ended December 31, 2018 to the year ended December 31, 2019, primarily due to an increase in interest income on our cash, cash equivalents and marketable securities balances, which increased during the year ended December 31, 2019 compared to the year ended December 31, 2018 as a result of the net proceeds from our IPO in May 2019. Other Income (Expense), Net Other income (expense), net decreased by $0.1 million, or 90%, from the year ended December 31, 2018 to the year ended December 31, 2019, primarily due to the change in the fair value of the redeemable convertible preferred stock liability, which was settled during the first quarter of 2018. Liquidity and Capital Resources; Plan of Operations Sources of Liquidity Prior to the completion of our IPO in May 2019, we had funded our operations primarily with an aggregate of $140.1 million in gross cash proceeds from the sale and issuance of redeemable convertible preferred stock and convertible promissory notes. In May 2019, we sold and issued 5,750,000 shares of common stock, including 750,000 shares as a result of the full exercise of the over-allotment option by the underwriters, at $10.00 per share for gross proceeds of $57.5 million. The aggregate net proceeds from our IPO, inclusive of the full over-allotment option exercise, were approximately $50.2 million after deducting underwriting discounts and commissions and other offering costs. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $100.5 million. Future Funding Requirements We have incurred net losses since our inception. For the years ended December 31, 2019 and December 31, 2018, we had net losses of $42.0 million and $34.3 million, respectively, and we expect to incur substantial additional losses in future periods. As of December 31, 2019, we had an accumulated deficit of $92.5 million. 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 date of the issuance of these financial statements. To date, we have not generated any revenue. We do not expect to generate any meaningful revenue unless and until we obtain regulatory approval of and commercialize any of our product candidates or enter into collaborative agreements with third parties, and we do not know when, or if, either will occur. We expect to continue to incur significant losses for the foreseeable future, and we expect the losses to increase as we continue the development of, and seek regulatory approvals for, our product candidates and begin to commercialize any approved products. We are subject to all of the risks typically related to the development of new product candidates, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business. Moreover, we expect to incur additional costs associated with operating as a public company. We 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 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 our business strategies. 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 and costs of our drug discovery, preclinical development activities, laboratory testing and clinical trials for our product candidates; • the number and scope of clinical programs we decide to pursue; • the scope and costs of manufacturing development and commercial manufacturing activities; • the extent to which we acquire or in-license other product candidates and technologies; • the cost, timing and outcome of regulatory review of our product candidates; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • our ability to establish and maintain collaborations on favorable terms, if at all; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates; • the costs associated with being a public company; and • the cost and timing associated with commercializing our product candidates, if they receive marketing approval. A change in the outcome of any of these or other variables with respect to the development of any of our product candidates could significantly change the costs and timing associated with the development of that product candidate. Furthermore, our operating plans may change in the future, and we will continue to require additional capital to meet operational needs and capital requirements associated with such operating plans. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing into which we enter may impose upon us additional covenants that restrict our operations, including limitations on our ability to incur liens or additional debt, pay dividends, repurchase our common stock, make certain investments or 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 product candidates 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 the section of this Annual Report titled “Part I, Item 1A. - 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, cash equivalents, and restricted cash for each of the periods presented below (in thousands): Cash Flows from Operating Activities Net cash used in operating activities was $39.3 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 our product candidates resulting in a net loss of $42.0 million, adjusted for the net amortization of premiums and discounts on marketable securities of $0.5 million and an increase in prepaid expenses and other assets of $2.0 million mainly due to advance payments for director’s and officers’ liability insurance premiums and fees for CROs, partially offset by depreciation and amortization expense of $1.2 million and stock-based compensation expense of $2.2 million, and an increase in accrued and other liabilities of $2.0 million mainly due to fees to CMOs and CROs in support of manufacturing and clinical activity for IDE196 and personnel-related expenses. Net cash used in operating activities was $27.6 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 our product candidates resulting in a net loss of $34.3 million, adjusted for the net amortization of premiums and discounts on marketable securities of $0.8 million and increase in prepaid expenses and other assets of $0.2 million, partially offset by the issuance of Series B redeemable convertible preferred stock pursuant to the Novartis license agreement of $3.8 million, depreciation and amortization expense of $0.9 million, stock-based compensation expense of $1.0 million, an increase in accrued and other liabilities of $1.7 million primarily due to an increase in accrued research and development and accrued compensation expenses and an increase in accounts payable of $0.3 million mainly due to the timing of payments to our service providers. Cash Flows from Investing Activities Net cash provided by investing activities was $2.3 million for the year ended December 31, 2019, which consisted primarily of $73.5 million provided by maturities of marketable securities and $18.1 million from sales of marketable securities, partially offset by $88.0 million used to purchase marketable securities and $1.4 million used to purchase property and equipment. Net cash used in investing activities was $63.2 million for the year ended December 31, 2018, which consisted primarily of $133.3 million used to purchase marketable securities and $1.7 million used to purchase property and equipment, partially offset by $65.8 million provided by maturities of marketable securities and $6.0 million provided by sales of marketable securities. Cash Flows from Financing Activities Net cash provided by financing activities was $50.6 million for the year ended December 31, 2019, which consisted primarily of $50.3 million of net proceeds from our IPO. Net cash provided by financing activities was $105.4 million for the year ended December 31, 2018, which consisted primarily of $105.4 million of net proceeds from the issuance of Series A and Series B redeemable convertible preferred stock. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): Payments Due by Period Less than 1 year 1 to 3 years 3 to 5 years More than 5 years Total Operating lease obligations(1) $ 1,564 $ 3,250 $ 3,131 $ - $ 7,945 (1) We lease our laboratory and office facilities in South San Francisco, California under non-cancelable operating leases with expiration dates in July 2024. In May 2018, we amended our South San Francisco facility lease agreement to expand the size of the original premises by adding approximately 7,340 rentable square feet of additional space. The lease payments above do not include any related common area maintenance charges or real estate taxes. In September 2019, we further amended our South San Francisco facility lease agreement to expand the size of the premises by adding 5,588 rentable square feet of additional space, which we have not taken possession of as of December 31, 2019. The lease payments above do not include the lease payments for the 5,588 square feet of additional space, as the related right-of-use asset and lease liability have not been recognized in the balance sheet as of December 31, 2019. We enter into contracts in the normal course of business with third-party contract organizations for preclinical and clinical studies and testing, manufacture and supply of our preclinical and clinical materials 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. In September 2018, we entered into a license agreement with Novartis International Pharmaceuticals Ltd., or Novartis, to develop and commercialize Novartis’ LXS196 (also known as IDE196), a PKC inhibitor for the treatment of cancers having GNAQ and GNA11 mutations. In consideration of license and rights granted under the license agreement, we made a one-time cash payment of $2.5 million to Novartis and issued 263,615 shares of Series B redeemable convertible preferred stock to an affiliate of Novartis. Under the license agreement, we agreed to make contingent development and sales milestone payments of up to $29.0 million and mid to high single digit royalty payments of the net sales of licensed products. Such milestones and royalties are dependent on future activity or product sales and are not provided for in the table above as the timing and amounts, if any, are not estimable. 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 2 to the financial statements appearing elsewhere in this prospectus. Accrued Research and Development We have entered into various agreements with CMOs and CROs. 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. 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 CMOs and CROs 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 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. Prior to January 1, 2019, we accounted for stock options issued to non-employees based on the fair value of the stock options, using the Black-Scholes option pricing model, at the measurement date and is subject to periodic adjustments as the stock options vest and at the end of each reporting period and the resulting change in value, if any, is recognized in our statements of operations and comprehensive loss during the period the related services are rendered. Upon adoption of ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Non-employee Share-Based Payment Accounting, starting January 1, 2019, we account for stock options issued non-employees based on the fair value of the stock options in the same manner as stock options granted to employees, as described in the preceding paragraphs. 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 of stock options 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 - 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 sufficient 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. • 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 as reported on The NASDAQ Global Select Market. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities arise due to differences between when assets or liabilities are recognized for tax purposes and when they are recognized for financial reporting purposes. Net operating losses and credit carryforwards are also deferred tax assets. Deferred tax assets and liabilities 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 that the position meets the more-likely-than-not threshold and is measured at the largest amount of benefit that is likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (1) the factors underlying the more-likely-than-not threshold assertion have changed and (2) the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of interest expense and other expense, respectively. To date, there have been no interest or penalties charged in relation to the unrecognized tax benefits. Net operating loss carryforwards, or NOLs, and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service, or IRS, and may become subject to an annual limitation in the event of ownership changes as defined under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended (generally, cumulative changes in the ownership interest of significant stockholders over a three-year period in excess of 50 percentage points), which could limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities. The amount of the annual limitation is determined based on our value immediately prior to such an ownership change. Subsequent ownership changes may further affect the limitation in future years. We do not expect any previous ownership changes (as defined under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended) to result in a limitation that will materially reduce the total amount of net operating loss carryforwards and credits that can be utilized. As of December 31, 2019 and December 31, 2018, we had unrecognized tax benefits, all of which would affect income tax expense if recognized, before consideration of our valuation allowance. We do not expect that our uncertain tax positions will materially change in the next 12 months. On December 22, 2017, the U.S. government enacted comprehensive tax legislation through the Tax Cuts and Jobs Act, or Tax Act. The Tax Act significantly revises the future ongoing U.S. corporate income tax by, among other things, lowering the U.S. corporate income tax rates and implementing a modified territorial tax system. The corporate tax rate was reduced from 34% to 21% for tax years beginning after December 31, 2017. Changes in tax law are accounted for in the period of enactment. As such, our financial statements as of December 31, 2017 reflect the impact of this Tax Act, which primarily consisted of remeasuring our deferred tax assets, deferred tax liabilities and valuation allowance using the newly enacted U.S. corporate tax rate. This rate change resulted in a $2.3 million reduction in our net deferred tax assets from the prior year with a corresponding offset to the valuation allowance. Under the Tax Act, net operating losses arising after December 31, 2017 do not expire and cannot be carried back. However, the Tax Act limits the amount of net operating losses that can be used annually to 80% of taxable income for net operating losses arising in periods beginning after December 31, 2017. Existing net operating losses arising in years ending on or before December 31, 2017 are not affected by these provisions. 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. Indemnification Agreements We enter into standard indemnification arrangements in the ordinary course of business with vendors and other parties. Pursuant to these arrangements, we indemnify, hold harmless and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party. 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. 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. However, we have chosen to irrevocably “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Recent Accounting Pronouncements See the section titled “Summary of Significant Accounting Policies-Recent Accounting Pronouncements” in Note 2 to our financial statements included elsewhere in this prospectus for additional information.

<s>[INST] Overview We are an oncologyfocused precision medicine company committed to the discovery and development of targeted therapeutics for patient populations selected using molecular diagnostics. Our approach integrates small molecule drug discovery with extensive capabilities in identifying and validating translational biomarkers to develop targeted therapies for select patient populations most likely to benefit. We are applying these capabilities across multiple classes of precision medicine, including direct targeting of oncogenic pathways and synthetic lethality which represents an emerging class of precision medicine targets. IDE196 Clinical Development Our most advanced product candidate is IDE196, a protein kinase C, or PKC, inhibitor for geneticallydefined cancers having GNAQ or GNA11 gene mutations, which we inlicensed from Novartis. We initiated a Phase 1/2 clinical trial IDE196001 in June 2019 to evaluate IDE196 in solid tumors harboring GNAQ or GNA11 hotspot mutations in a basket trial design, including in metastatic uveal melanoma, or MUM, and other solid tumor indications such as cutaneous melanoma or colorectal cancer. We have completed enrollment of patients in the Phase 1 dose escalation portion of the Phase 1/2 clinical trial at sites in the U.S. and Australia, including patients in MUM and patients having other solid tumors with GNAQ or GNA11 hotspot mutations using a powderincapsule, or PIC, formulation. We are continuing to enroll MUM patients in a Phase 1 tablet formulation substudy evaluating pharmacokinetics and food effect. We have initiated the Phase 2 expansion portion of the clinical trial for patients having tumors with GNAQ or GNA11 hotspot mutations for indications other than metastatic uveal melanoma, such as in cutaneous melanoma or colorectal cancer. The thirtyeight MUM patients in the Phase 1 dose escalation arm of the clinical trial were dosed at 300 mg BID or 400 mg BID. The 400 mg BID dosing regimen consisted of a 200mg BID runin for the first seven days of dosing, followed by 400 mg BID dosing thereafter for the duration of treatment. IDE196 has been generally well tolerated at each dose level, with 1 reported Grade 3 fatigue attributed to IDE196 on the 400 mg BID regimen and otherwise no reported drugrelated adverse events, or AEs at or above Grade 3 in any patients. We generally observed higher average steady state exposure of free IDE196 and higher trough concentration of IDE196 at the higher 400 mg BID dose relative to the 300 mg BID dose, based on pharmacokinetic, or PK, analysis. We anticipate providing an update with interim clinical data from our Phase 1/2 clinical trial in MUM in the second half of 2020. In January 2020, we initiated a Phase 1 substudy within the Phase 1/2 clinical trial to evaluate an immediate release tablet formulation of IDE196 in MUM patients, comparing the pharmacokinetic profile of the tablet formulation to the powderincapsule form of IDE196 used in the dose escalation portion of the Phase 1/2 clinical trial. In this substudy, the data to date shows that the pharmacokinetic profile of the tablet form of IDE196, including Cmax and AUCtotal, is comparable to the pharmacokinetic profile of the PIC form of IDE196. This Phase 1 substudy is continuing to enroll additional MUM patients to evaluate steady state pharmacokinetic properties of the tablet and explore food effect properties of IDE196 using the tablet formulation. Once testing of the tablet formulation of IDE196 is completed, the tablet, dosed at 400 mg BID, will be used at the recommended Phase 2 dose, or RP2D, for the expansion portion of the clinical trial into [/INST] Positive. </s>

Orchard Therapeutics plc

2020-02-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Some of the information contained in this discussion and analysis and 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 section titled “Risk Factors” in Part I-Item 1A 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. We have historically conducted our business through Orchard Therapeutics (Europe) Limited (formerly Orchard Therapeutics Limited) and subsidiaries. Following the completion of our initial public offering in November 2018, our consolidated financial statements present the consolidated results and operations of Orchard Therapeutics plc and subsidiaries. Business Overview Orchard Therapeutics is a global gene therapy leader dedicated to transforming the lives of people affected by rare diseases through the development of innovative, potentially curative gene therapies. Our ex vivo autologous gene therapy approach harnesses the power of genetically-modified blood stem cells and seeks to correct the underlying cause of disease in a single administration. The company has one of the deepest gene therapy product candidate pipelines in the industry and is advancing seven clinical-stage programs across multiple therapeutic areas, including inherited neurometabolic disorders, primary immune deficiencies and blood disorders, where the disease burden on children, families and caregivers is immense and current treatment options are limited or do not exist. Since our inception in 2015, we have devoted substantially all of our resources to conducting research and development of our product candidates, in-licensing and acquiring rights to 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, including ADSs and convertible preferred shares. Through December 31, 2019, we had received net proceeds of $335.1 million from sales of ADSs in our initial public offering and follow-on public offering, $283.4 million from sales of our convertible preferred shares, , and $24.5 million from our senior term facilities agreement (the “Credit Facility”) with MidCap Financial (Ireland) Limited (“MidCap Financial”). We have incurred significant operating losses since our inception in 2015. With the exception of our commercial product Strimvelis®, which was acquired in April 2018, we will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. Our net losses were $163.4 million and $230.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, and 2018, we had an accumulated deficit of $453.7 million and $290.2 million, respectively. As of December 31, 2019, we had cash, cash equivalents, and marketable securities of $325.0 million, excluding restricted cash. Our 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. 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, government contracts 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. Components of our results of operations Revenue Since inception through December 31, 2019, we have generated $4.6 million in net revenue from product sales for sales of Strimvelis. We do not expect to generate any significant revenue from the sale of products, with the exception of Strimvelis, in the near future. Our product candidate, OTL-200, for the treatment of MLD is currently under review with the European Medicines Agency and we expect a regulatory decision on approval in 2020. If that product candidate is approved and we are able to identify patients and secure reimbursement for our treatment, we will begin to generate revenue from the sale of such product candidate. If our development efforts for our other product candidates that we may develop in the future are successful and result in regulatory 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. During the year ended December 31, 2019, we recognized $2.5 million in net product sales. Strimvelis is currently distributed exclusively at the San Raffaele Hospital in Milan, Italy. We expect that product sales of Strimvelis will fluctuate quarter over quarter, in particular as we continue to promote the product and increase market access. Net product sales for the year ended December 31, 2019 may not be representative of our sales for any future period. Cost of product sales Cost of sales consists of costs to manufacture, including raw materials, distribute and administer Strimvelis and royalty payments due to third-parties that are tied to sales. 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: • expenses incurred under agreements with third parties, including CROs that conduct research, preclinical activities and clinical trials on our behalf as well as contract manufacturing organizations that manufacture lentiviral vectors and cell-based drug products for use in our preclinical and clinical trials; • expenses to acquire technologies to be used in research and development; • salaries, benefits and other related costs, including share-based compensation expense, for personnel engaged in research and development functions; • costs of outside consultants, including their fees, share-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; • facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs; • upfront, milestone and management fees for maintaining licenses under our third-party licensing agreements; and • grant awards or other government incentives unrelated to income taxes that we earn that are recorded as an offset to the related research and development costs incurred We expense research and development cost 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 financial statements as a prepaid expense or accrued research and development expenses. United Kingdom research and development tax credits are recorded as an offset to research and development expense. Amortization of the Strimvelis loss provision is also recorded as an offset to research and development expense (See Note 2 of our consolidated financial statements). In 2018 we issued ordinary shares to various academic and health care institutions as part of the consideration for entering into several license agreements to in-license intellectual property rights and know-how relevant to our programs. This consideration was accounted for as research and development expense based on the fair value of the shares issued as of the time the agreements were executed or amended. 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 and contract manufacturing organizations in connection with our preclinical and clinical development activities. 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 direct research and development expenses for that program. License fees and other costs incurred prior to designating a product candidate for development are included in other program expense. 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. 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 or the manufacturing requirements to conduct those clinical trials. We expect that our research and development expenses will continue to increase for the foreseeable future as a result of our expanded portfolio of product candidates and as we: (i) expedite the clinical development and seek to obtain marketing approval for our lead product candidates, including OTL-101 for ADA-SCID, OTL-200 for MLD and OTL-103 for WAS; (ii) initiate additional clinical trials for our product candidates, including OTL-102 for X-CGD, OTL-300 for TDT, OTL-201 for MPS-IIIA, and OTL-203 for MPS-I; (iii) seek to improve the efficiency and scalability of our manufacturing processes and supply chain; and (iv) build our in-house process development, analytical and manufacturing capabilities and continue to discover and develop additional product candidates. We also expect to incur additional expenses related to milestone, royalty payments and maintenance fees payable to third parties with whom we have entered into license agreements to acquire the rights related to our product candidates. The successful development of our product candidates and commercialization of Strimvelis and our product candidates, if approved, is highly uncertain. This is due to the numerous risks and uncertainties associated with product development and commercialization, including the following: • completing research and preclinical development of our product candidates and identifying new gene therapy product candidates; • conducting and fully enrolling clinical trials in the development of our product candidates; • seeking and obtaining regulatory and marketing approvals for product candidates for which we complete registrational clinical trials that achieve their primary endpoints; • launching and commercializing product candidates for which we obtain regulatory and marketing approval by expanding our existing sales force, marketing and distribution infrastructure or, alternatively, collaborating with a commercialization partner; • maintaining marketing authorization and related regulatory compliance for Strimvelis in the European Union; • qualifying for, and maintaining, adequate coverage and reimbursement by government and private payors for Strimvelis and any product candidate for which we obtain marketing approval; • establishing and maintaining supply and manufacturing processes and relationships with third parties that can provide adequate, in both amount and quality, products and services to support clinical development of our product candidates and the market demand for Strimvelis and any of our product candidates for which we obtain marketing approval; • obtaining market acceptance of Strimvelis and our product candidates, if approved, as viable treatment options with acceptable safety profiles; • addressing any competing technological and market developments; • implementing additional internal systems and infrastructure, as needed, including robust quality systems and compliance systems; • negotiating favorable terms in any collaboration, licensing or other arrangements into which we may enter and performing our obligations under such arrangements; • maintaining, protecting and expanding our portfolio of intellectual property rights, including patents, trade secrets and know-how; and • attracting, hiring and retaining qualified personnel. 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, EMA 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 and we may never succeed in obtaining regulatory approval for any of our product candidates. Selling, general and administrative expenses Selling, general and administrative expenses consist primarily of salaries and other related costs, including share-based compensation, for personnel in our executive, finance, commercial, corporate and business development, and administrative functions. Selling, 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 selling, general and administrative expenses will increase in the future as we increase our selling, general and administrative headcount to support our continued research and development and potential commercialization of our expanded portfolio of product candidates. In addition, we are expanding our organization into multiple countries in Europe to support the potential commercialization of OTL-200 for MLD, which is currently under regulatory review by the EMA. We also expect to incur increased expenses associated with compliance with our obligations as 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 Interest income Interest income consists of income earned on our cash and cash equivalents and marketable securities. Interest expense Interest expense consists of interest associated with our Credit Facility with MidCap Financial, which we entered into in May 2019. The Credit Facility bears a variable interest rate at a rate of 6.0% above LIBOR, plus a final payment equal to 4.5% of the principal borrowed under the Credit Facility. In fiscal year 2020, we will have a full year of interest expense, as compared to 7 months in 2019. Other income (expense) Other income (expense), net consists primarily of realized and unrealized foreign currency transaction gains and losses. Results of operations Information pertaining to fiscal year 2017 was included in the Company’s Annual Report on Form 20-F for the year ended December 31, 2018 on page 122 under Item 5, “Operating and Financial Review and Prospects,” which was filed with the U.S. Securities and Exchange Commission on March 22, 2019 Comparison of the years ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Research and development expenses The table below summarizes our research and development expenses by therapeutic area: The overall decline in research and development expenses of $88.0 million is due to the absence of a $133.6 million in-process research and development charge associated with the GSK transaction in 2018. This charge in 2018 was primarily allocated to programs within the neurometabolic disorders and the primary immune deficiencies therapeutic areas. The charge was partially offset by increases in spending on programs and unallocated costs, as described below. Direct research and development expenses for neurometabolic programs declined by $48.2 million. The decline is primarily driven by a $69.3 million in-process research and development charge for OTL-200 related to the GSK transaction that occurred in 2018. Excluding the effects of this charge, direct expenses associated with OTL-200 increased by $3.0 million compared to 2018. In addition, we incurred an increase in spending of $17.2 million on our OTL-203 for MPS-I, which primarily relates to the upfront and clinical milestone expenses incurred upon entering into our license arrangement with Telethon-OSR in May 2019. Direct expenses for OTL-201 increased by $0.3 million compared to 2018, which was primarily attributable to increases in manufacturing and process development-related costs. Direct research and development expenses for primary immune deficiency-related programs declined by $72.5 million. The decline is primarily driven by a $64.3 million in-process research and development charge for OTL-103 related to the GSK transaction that occurred in 2018. Excluding the effects of this charge, direct expenses associated with OTL-103 increased by $1.1 million compared to 2018. Direct expenses associated with OTL-101 declined by $5.3 million, due to a $7.0 million decrease in manufacturing and process development costs with third-party contract manufacturers compared to 2018. Direct expenses for Strimvelis also declined by $2.9 million due to a decline in research and development-related manufacturing costs, and costs associated with transitioning of Strimvelis from GSK that were incurred in 2018, but did not recur in 2019. Direct research and development expenses for blood disorder-related programs increased by $1.5 million in 2019 due to increased expenses for OTL-300 compared to 2018. The increase in costs related to OTL-300 was primarily due to increased clinical trial costs. The increase in costs associated with other research and preclinical programs relates to costs associated with having additional early-stage programs in our pipeline in 2019 compared to 2018. Unallocated research and development costs and offsets to research and development expenses increased by $30.3 million generally due to an increase in personnel related costs of $12.2 million and share-based compensation of $4.7 million. Further, other research and development costs such as lab supplies and consumables, external manufacturing and process development, and other unallocated costs not yet attributable to a specific developmental program increased by $13.7 million in 2019 compared to 2018. Occupancy costs increased by $4.5 million, generally associated with a full year of lease expense associated with our Fremont manufacturing facility. The increases noted above were offset by an increase in the U.K. research and development tax credit that is recorded as an offset to research and development expense of $7.3 million. Amortization of the Strimvelis loss provision, which is also accounted for as an offset to research and development expense, declined by $2.5 million in 2019, attributable to lower costs incurred for our Strimvelis program compared to 2018. Selling, general and administrative expenses The table below summarizes our selling, general and administrative expenses by functional area: Selling, general and administrative expenses were $57.2 million in 2019, compared to $31.4 million in 2018. The increase of $25.9 million was primarily due to increased personnel-related costs of $9.3 million from an increased headcount in our selling, general and administrative functions. Share-based compensation expense increased by $8.0 million in 2019 compared to 2018 due to the higher number of employees receiving grants. Consulting, professional, and insurance-related costs increased by $3.4 million, primarily due to a $2.0 million increase in directors and officers insurance as a result of being a public company for a full year in 2019. Expenses associated with marketing and commercialization of Strimvelis, and costs associated with preparing for the potential future commercialization of our product candidates, if approved, increased by $6.1 million. Other income (expense), net Other income, net for 2019 and 2018 was $7.2 million and $5.5 million, respectively. During 2019, we had realized and unrealized gains on foreign currency transactions of $1.4 million, compared to $4.4 million for 2018. Additionally, we had interest income of $7.3 million in 2019, compared to $1.1 million in 2018. The increase in interest income of $6.2 million relates to interest from our cash equivalents and marketable securities after investing the proceeds received from our initial public offering and follow-on offering. The increase in interest expense of $1.5 million in 2019 is attributable to our Credit Facility, which we entered into in May 2019 and was therefore not in place in 2018. Liquidity and capital resources. From our inception through December 31, 2019, we have generated $4.6 million from product sales and incurred significant operating losses and negative cash flows from our operations. We currently have only one commercial product, Strimvelis, which we acquired from GSK in April 2018 and our product candidates are in various phases of preclinical and clinical development. OTL-200 is currently under regulatory review by the European Medicines Agency and we expect a decision in 2020. We do not expect to generate significant revenue from sales of any products in 2020 and until we have obtained additional regulatory approvals, secured broader reimbursement and gained product acceptance. To date, we have financed our operations primarily with proceeds from the sale of ADSs in our initial public offering and follow-on offering, proceeds from the sale of convertible preferred shares, reimbursements from our research agreement with UCLA and, following transfer of the ADA-SCID research program sponsorship from UCLA to us in July 2018, a grant from CIRM, and our Credit Facility. Through December 31, 2019, we have received net proceeds of $335.2 million from the sale of ADSs in our initial public offering and follow-on offering, net proceeds of $283.4 million from sales of convertible preferred shares, $24.5 million in net proceeds from our Credit Facility, and reimbursement of $7.9 million from our agreement with CIRM, which was formerly a subcontract agreement with UCLA. As of December 31, 2019, we had cash, cash equivalents, and marketable securities of $325.0 million, excluding restricted cash. We currently have no ongoing material financing commitments, such as lines of credit or guarantees, that are expected to affect our liquidity over the next five years, other than our manufacturing, lease, and debt obligations described below. Cash flows Information pertaining to fiscal year 2017 was included in the Company’s Annual Report on Form 20-F for the year ended December 31, 2018 on page 122 under Item 5, “Operating and Financial Review and Prospects,” which was filed with the U.S. Securities and Exchange Commission on March 22, 2019. The following table summarizes our cash flows for each of the periods presented: Operating activities During 2019, operating activities used $166.1 million of cash, primarily resulting from our net loss of $163.4 million. Cash usage from changes in our operating assets and liabilities was $17.7 million, which was primarily driven by an increase in our research and development tax credit receivable of $17.6 million. Non-cash adjustments to operating activities of $15.0 million was generally due to $19.4 million in non-cash share-based compensation expense, offset by $3.9 million in amortization of the Strimvelis loss provision as an offset to research and development expense. Further, there were unrealized foreign currency transaction gains on investments held by our U.K. subsidiary of $1.9 million. Included within operating activities was a cash payment of $17.2 million for our upfront and milestone payments associated with entering into our MPS-I license agreement with Telethon-OSR. During 2018, operating activities used $97.5 million of cash, primarily resulting from our net loss of $230.5 million, off-set by net cash provided by changes in our operating assets and liabilities of $36.5 million and net non-cash charges and credits of $96.5 million, which included $93.4 million for the issuance of our preferred shares as non-cash license fees under the GSK Agreement, $6.8 million in non-cash share-based compensation, $1.4 million in non-cash milestone expense, and $1.2 million in depreciation expense. These amounts were offset by a $6.3 million reduction in the Strimvelis loss provision. Net cash provided by changes in our operating assets and liabilities for 2018 is primarily due to the impact of a $10.1 million increase in our research and development tax credit receivable and a $6.8 million increase in other receivables, prepaid expenses and other assets, offset by a $31.7 million increase in accrued expenses and other current liabilities, a $6.9 million increase in other long-term liabilities, and a $14.8 million increase in accounts payable. Included within operating activities was a cash payment of $14.2 million for the GSK upfront license fee. The change in net cash used in operating activities from 2018 to 2019 is the result of our increased net loss, excluding the non-cash in-process research and development charge of $93.4 million from the GSK agreement which was settled with preferred shares, and generally due to growth in our business and the advancement of our development programs, as described in “-Results of operations.” Investing activities During 2019, 2018, and 2017, we used $309.4 million, $4.0 million and, $1.6 million, respectively, of cash in investing activities. The increase in cash used for investing activities in 2019 compared to prior years is attributable to the investing of the proceeds received from our initial public offering, follow-on offering, and term loan for the purchase of $414.0 million of highly-rated, short duration marketable securities, offset by the sale and maturity of such securities of $109.0 million. We expect the cash used in investing activities for capital expenditures to increase substantially in the future to fund the construction and equipment to build-out our manufacturing facility in Fremont, California. Financing activities During 2019, we had proceeds from our follow-on offering of $129.7 million, net of underwriting discounts and issuance costs paid, and proceeds from the issuance of our term loan of $24.5 million, net of debt issuance costs. Additionally, we had proceeds of $3.3 million from the exercise of share options and issuance of ordinary shares as part of our 2018 Employee Stock Purchase Plan, or ESPP. During 2018, net cash provided by financing activities was $354.9 million, consisting of $2.3 million of net proceeds from subsequent closing of our Series B convertible preferred shares in January 2018, $147.1 million of net proceeds from the sale of our Series C convertible preferred shares in August 2018, and $205.5 million of net proceeds from the sale of our ADSs in our initial public offering in November 2018. Funding requirements We expect our expenses and capital expenditures to increase substantially in connection with our ongoing activities, particularly as we advance the preclinical activities and clinical trials of our product candidates and as we: • seek marketing approvals for our product candidates that successfully complete clinical trials, if any; • continue to grow a sales, marketing and distribution infrastructure for our commercialization of Strimvelis in the European Union, and any product candidates for which we may submit for and obtain marketing approval anywhere in the world; • continue our development of our product candidates, including continuing our ongoing advanced registrational trials and supporting studies, and any other clinical trials that may be required to obtain marketing approval for our product candidates; • conduct IND and CTA-enabling studies for our preclinical programs; • initiate additional clinical trials and preclinical studies for our other product candidates; • seek to identify and develop, acquire or in-license additional product candidates; • develop the necessary processes, controls and manufacturing data to obtain marketing approval for our product candidates and to support manufacturing of product to commercial scale; • develop and implement plans to establish and operate our own in-house manufacturing operations and facility; • hire and retain additional personnel, such as non-clinical, clinical, pharmacovigilance, quality assurance, regulatory affairs, manufacturing, distribution, legal, compliance, medical affairs, finance, general and administrative, commercial and scientific personnel; • develop, maintain, expand and protect our intellectual property portfolio; and • comply with our obligations as a public company. Because of the numerous risks and uncertainties associated with biopharmaceutical 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. We believe our existing cash, will enable us to fund our operating expenses and capital expenditure requirements into the second half of 2021. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. 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 U.S. 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 greater detail in Note 2 to our consolidated financial statements 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. United Kingdom research and development tax credit As a company that carries out research and development activities, we are able to submit tax credit claims from two U.K. research and development tax relief programs, the Small and Medium-sized Enterprises research and development tax credit (“SME”) program and the Research and Development Expenditure Credit (“RDEC”) program depending on eligibility. Qualifying expenditures largely comprise employment costs for research staff, consumables and certain internal overhead costs incurred as part of research projects for which we do not receive income. Each reporting period, we evaluate which tax relief programs we are expected to be eligible for and record a reduction to research and development expense for the portion of the expense that we expect to qualify under the programs, that we plan to submit a claim for, and we have reasonable assurance that the amount will ultimately be realized. Based on criteria established by HM Revenue and Customs (“HMRC”), we expect a proportion of expenditures being carried in relation to our pipeline research, clinical trials management and manufacturing development activities to be eligible for the research and development tax relief programs for the years ended December 31, 2019, 2018 and 2017. The RDEC and SME credits are not dependent on us generating future taxable income or on our ongoing tax status or tax position. We have assessed our research and development activities and expenditures to determine whether the nature of the activities and expenditures will qualify for credit under the tax relief programs and whether the claims will ultimately be realized based on the allowable reimbursable expense criteria established by the U.K. government which are subject to interpretation. At each period end, we estimate the reimbursement available to us based on available information at the time. We recognize credits from the research and development incentives when the relevant expenditure has been incurred and there is reasonable assurance that the reimbursement will be received. Such credits are accounted for as reductions in research and development expense. We make estimates of the research and development tax credit receivable as of each balance sheet date, based upon facts and circumstances known to us at the time. Although we do not expect our estimates to be materially different from amounts actually recognized, our estimates could differ from actual results. To date, there have not been any material adjustments to our prior estimates of the research and development tax credit receivable. 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 prepaid and 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 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, research institutions and other vendors 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. Valuation of share-based compensation We measure share-based awards granted to employees, non-employees and directors 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. Forfeitures are accounted for as they occur. Generally, we issue share-based awards in the form of stock options with only service-based vesting conditions and record the expense for these awards using the straight-line method. We have also issued share-based awards with performance-based vesting conditions for which the expense is recognized when achievement of such performance conditions becomes probable. The fair value of each share option is estimated on the date of grant using the Black-Scholes option pricing model. Until the completion of our initial public offering in November 2018, we had been a private company and lacked company-specific historical and implied volatility information for our shares. 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 share options has been determined utilizing the “simplified method” for awards that qualify as “plain-vanilla” options. Prior to the adoption of ASU 2018-07, the expected term of share options granted to non-employees was the contractual term. After adoption of ASU 2018-07, the expected term of share options granted to non-employees is determined in the same manner as share options granted to employees. 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 ordinary shares and do not expect to pay any cash dividends in the foreseeable 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 SEC. Tabular disclosure of contractual obligations. The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1) Amounts reflect commitments for costs associated with our external contract manufacturing organizations, which we engaged to manufacture clinical trial materials. Our manufacturing commitment included non-cancelable minimum payments to be made as of December 31, 2019. (2) Amounts reflect minimum payments due for our office and laboratory space leases. Further information about our leases is described in Note 7 of our consolidated financial statements. (3) Amounts in the table reflect contractually required principal, interest, and final payments payable under the Credit Facility. For the purposes of this table, the interest due under the Credit Facility was calculated using an assumed interest rate of 7.7% per annum, which was the interest rate in effect as of December 31, 2019. The table also assumes repayment of the term loan beginning 24 months following the date of the Credit Facility. We enter into contracts in the normal course of business with contract manufacturing organizations and other third parties for clinical trials and preclinical research studies and testing. Manufacturing 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. Excluding our agreement with GSK, we may incur potential contingent payments totaling up to $68.0 million upon our achievement of clinical, regulatory and commercial milestones, 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 certain intellectual property. Pursuant to our agreement with Oxford BioMedica, we may incur the obligation to issue additional ordinary shares upon the achievement of a certain development milestone. Due to the uncertainty of the achievement and timing of the events requiring payment under these agreements, the amounts to be paid by us are not fixed or determinable at this time and are excluded from the table above. In January 2018, we leased office space in London, United Kingdom, with a term through January 2023. The annual rent commitment is approximately $0.8 million. In November 2017, we leased office and laboratory space in Menlo Park, California with a term through December 2020. The annual rent commitment is approximately $0.8 million. In March 2018, we leased office space in Boston, Massachusetts, with a term through September 2022. The annual rent commitment is approximately $0.3 million. In December 2018, we leased office and manufacturing space in Fremont, California, with a term through May 2030. The annual rent commitment is approximately $2.8 million. In December 2018, we leased additional office space in London, United Kingdom, with a term through January 2023. The annual rent commitment is approximately $0.1 million. Finally, in January 2020, we commenced a lease in Boston, Massachusetts for office space with a term through September 2026. The annual rent commitment is approximately $0.8 million. Under the GSK Agreement, we are also obligated to pay non-refundable royalties and milestone payments in relation to the gene therapy programs acquired by GSK and OTL-101. We will pay a mid-single-digit percentage royalty on the combined annual net sales of ADA-SCID products, which includes Strimvelis and our product candidate, OTL-101. We will also pay tiered royalty rates at percentages from the mid-teens to the low twenties for the MLD and WAS products, upon marketing approval, calculated as percentages of aggregate cumulative net sales of the MLD and WAS products, respectively. We will pay a tiered royalty at percentages from the high single-digit to the low teens for the TDT product, upon marketing approval, calculated as percentages of aggregate annual net sales of the TDT product. These royalties owed to GSK are in addition to any royalties owed to other third parties under various license agreements for the GSK programs. We may pay up to an aggregate of £90.0 million in milestone payments upon achievement of certain sales milestones. Our royalty obligations with respect to MLD and WAS may be deferred for a certain period in the interest of prioritizing available capital to develop each product. Our royalty obligations are subject to reduction on a product-by-product basis in the event of market control by biosimilars, and will expire in April 2048. As consideration for the licenses and options in the Telethon-OSR agreements acquired and assumed in the GSK Agreement, we are required to make payments to Telethon-OSR upon achievement of certain product development milestones. We are also required to pay Telethon-OSR a fee in connection with the exercise of our option for each collaboration program. We are obligated to pay up to an aggregate of €31.0 million in connection with product development milestones with respect to those programs for which we have exercised an option under this agreement (that is, our WAS, MLD and TDBT programs). Additionally, we are required to pay to Telethon-OSR a tiered mid-single to low-double digit royalty percentage on annual sales of licensed products covered by patent rights on a country-by-country basis, as well as a low double-digit percentage of sublicense income received from any certain third party sublicensees of the collaboration programs. In May 2019, we entered into a license agreement with Telethon-OSR, under which Telethon-OSR granted to the Company an exclusive worldwide license for the research, development, manufacture and commercialization of Telethon-OSR’s ex vivo autologous hematopoietic stem cell lentiviral based gene therapy for the treatment of MPS-I, including the Hurler variant. Under the terms of the agreement, Telethon-OSR is entitled to receive €15 million combined upfront and milestone payment from us. We are also required to make milestone payments if certain development, regulatory and commercial milestones are achieved. Additionally, we will be required to pay Telethon-OSR a tiered mid-single to low-double digit royalty percentage on annual net sales of licensed products. In May 2019, we entered into a Credit Facility with MidCap Financial, as agent, and additional lenders from time to time (together with MidCap Financial, the “Lenders”), to borrow up to $75.0 million in term loans. To date, we have borrowed $25.0 million under an initial term loan. The remaining $50.0 million under the Credit Facility may be drawn down in the form of a second and third term loan, the second term loan being a $25.0 million term loan available no earlier than September 30, 2019 and no later than December 31, 2020 upon submission of certain regulatory filings and evidence of our having $100 million in cash and cash equivalent investments; and the third term loan being a $25.0 million term loan available no earlier than July 1, 2020 and no later than September 30, 2021 upon certain regulatory approvals and evidence of the Company having $125 million in cash and cash equivalent investments. Each term loan under the Credit Facility bears interest at an annual rate equal to 6% plus LIBOR. We are required to make interest-only payments on the term loan for all payment dates prior to 24 months following the date of the Credit Facility, unless the third tranche is drawn, in which case the Company is required to make interest-only payments for all payment dates prior to 36 months following the date of the Credit Facility. The term loans under the Credit Facility will begin amortizing on either the 24-month or the 36-month anniversary of the Credit Facility (as applicable), with equal monthly payments of principal plus interest to be made by us to the Lenders in consecutive monthly installments until the loan matures. In addition, a final payment of 4.5% is due on maturity. We are currently eligible to draw down the second term loan totaling $25.0 million following the recent regulatory filing with the European Medicines Agency for OTL-200 for MLD. It is expected that LIBOR will be phased out by the end of 2021. The Alternative Reference Rates Committee of the Federal Reserve Board has identified the Secured Overnight Financing Rate (SOFR) as the preferred alternative to LIBOR. As our Credit Facility utilizes LIBOR as a factor in determining the applicable interest rate, the expected discontinuation and transition may require us to renegotiate certain terms of the agreement to replace LIBOR with a new reference rate, which could increase the cost of servicing our debt and have an adverse effect on our results of operations and cash flows.

<s>[INST] We have historically conducted our business through Orchard Therapeutics (Europe) Limited (formerly Orchard Therapeutics Limited) and subsidiaries. Following the completion of our initial public offering in November 2018, our consolidated financial statements present the consolidated results and operations of Orchard Therapeutics plc and subsidiaries. Business Overview Orchard Therapeutics is a global gene therapy leader dedicated to transforming the lives of people affected by rare diseases through the development of innovative, potentially curative gene therapies. Our ex vivo autologous gene therapy approach harnesses the power of geneticallymodified blood stem cells and seeks to correct the underlying cause of disease in a single administration. The company has one of the deepest gene therapy product candidate pipelines in the industry and is advancing seven clinicalstage programs across multiple therapeutic areas, including inherited neurometabolic disorders, primary immune deficiencies and blood disorders, where the disease burden on children, families and caregivers is immense and current treatment options are limited or do not exist. Since our inception in 2015, we have devoted substantially all of our resources to conducting research and development of our product candidates, inlicensing and acquiring rights to 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, including ADSs and convertible preferred shares. Through December 31, 2019, we had received net proceeds of $335.1 million from sales of ADSs in our initial public offering and followon public offering, $283.4 million from sales of our convertible preferred shares, , and $24.5 million from our senior term facilities agreement (the “Credit Facility”) with MidCap Financial (Ireland) Limited (“MidCap Financial”). We have incurred significant operating losses since our inception in 2015. With the exception of our commercial product Strimvelis®, which was acquired in April 2018, we will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. Our net losses were $163.4 million and $230.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, and 2018, we had an accumulated deficit of $453.7 million and $290.2 million, respectively. As of December 31, 2019, we had cash, cash equivalents, and marketable securities of $325.0 million, excluding restricted cash. Our 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. 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, government contracts 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. Components of our results of operations Revenue Since inception through December 31, 2019, we have generated $4.6 million in net revenue from product sales for sales of Strimvelis. We do not expect to generate any significant revenue from the sale of products, with the exception of Strimvelis, in the near future. Our product candidate, OTL200, for the treatment of MLD is currently under review with the European Medicines Agency and we expect a regulatory decision on approval in 2020. If that product candidate is approved and we are able to identify patients and secure reimbursement for our treatment, we will begin to generate revenue from the sale of such product candidate. If our development efforts for our other product candidates that we may develop in the future are successful and result in regulatory approval, or collaboration or license agreements with third parties, we [/INST] Positive. </s>

89bio, 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 consolidated financial statements and 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 includes forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those described in or implied by these 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 elsewhere in this Annual Report on Form 10-K. Overview We are a clinical-stage biopharmaceutical company focused on the development and commercialization of innovative therapies for the treatment of liver and cardio-metabolic diseases. Our lead product candidate, BIO89-100, a specifically engineered glycoPEGylated analog of FGF21, is currently being developed for the treatment of NASH. NASH is a severe form of NAFLD, characterized by inflammation and fibrosis in the liver that can progress to cirrhosis, liver failure, HCC and death. There are currently no approved products for the treatment of NASH. FGF21 is a clinically-validated mechanism that has been shown in humans to reduce steatosis and address cardio-metabolic dysregulation. We believe BIO89-100 may be a differentiated FGF21 therapy based on its robust and durable biological effects and a favorable tolerability profile, as well as its potential for a longer dosing interval. Combining these characteristics with the ability to address the key liver pathologies in NASH, as well as the underlying metabolic dysregulation in NASH patients, BIO89-100 has the potential to become a mainstay of NASH therapy. We successfully completed a Phase 1a, first-in-human, SAD clinical trial with 58 healthy volunteers. The magnitude and significance of BIO89-100’s biological effects after a single dose on lipid parameters were robust and durable. In July 2019, we initiated our POC Phase 1b/2a clinical trial in patients with NASH or patients with NAFLD and a high risk of NASH and we expect to report topline data in the second half of 2020. We also intend to develop BIO89-100 for the treatment of SHTG, a condition identified by severely elevated levels of triglycerides (greater than or equal to 500 mg/dL), which is associated with an increased risk of NASH, cardiovascular events and acute pancreatitis. We expect to initiate our Phase 2 trial in SHTG patients in the first half of 2020 in order to evaluate the ability of BIO89-100 to reduce fasting plasma triglyceride levels compared to baseline levels and to report topline data in the first half of 2021. Based on FDA guidance for the development of SHTG treatments, as well as the regulatory path followed by other companies that have successfully developed SHTG therapies, we believe that a combination of smaller clinical trials and shorter development timelines could mean that SHTG potentially represents a quicker path to market for BIO89-100. We believe BIO89-100 has the potential to address multiple drivers underlying metabolic dysregulation, which would make it an ideal candidate for selected liver and cardio-metabolic diseases. We commenced operations in 2018 and have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring our initial product candidate, BIO89-100, and licensing certain related technology, conducting research and development activities, including preclinical studies and early clinical trials, and providing general and administrative support for these operations. We have funded our operations since our inception to December 31, 2019 through the issuance and sale of capital stock. As of December 31, 2019, our cash and cash equivalents totaled $93.3 million. Based on our current operating plan, we believe that our cash and cash equivalents will be sufficient to meet our anticipated cash requirements into the second half of 2021. On November 8, 2019, our Registration Statements on Form S-1 (File No. 333-234174 and 333-234617) relating to our IPO, were declared effective by the SEC. Pursuant to the Registration Statements, we issued and sold an aggregate of 6,100,390 shares of common stock (inclusive of 795,703 shares pursuant to the underwriters’ option to purchase additional shares) at a price of $16.00 per share for aggregate cash proceeds of $87.7 million, net of underwriting discounts and commissions and estimated offering costs. Both the sale and issuance of 5,304,687 shares in the IPO and the sale and issuance of an additional 795,703 shares pursuant to the underwriters’ option to purchase additional shares closed on November 13, 2019. Upon the closing of the IPO, all outstanding shares of convertible preferred stock automatically converted into 7,077,366 shares of common stock. Subsequent to the closing of the IPO, there were no shares of preferred stock outstanding. We have incurred net losses since our inception. Our net losses were $57.4 million and $16.2 million for 2019 and the period from January 18 (inception) to December 31, 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $73.6 million. We expect to continue to incur significant expenses and increasing operating losses as we advance BIO89-100 and any future product candidates through clinical trials, seek regulatory approval for BIO89-100 and any future product candidates, expand our clinical, regulatory, quality, manufacturing and commercialization capabilities, protect our intellectual property, prepare for and, if approved, proceed to commercialization of BIO89-100 and any future product candidates, expand our general and administrative support functions, including hiring additional personnel, and incur additional costs associated with operating as a public company. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and our expenditures on other research and development activities. We have never generated revenue and do not expect to generate revenue from product sales unless and until we successfully complete development and obtain regulatory approval for BIO89-100, which we expect will not be for at least several years, if ever. Accordingly, until such time as we can generate significant revenue from sales of BIO89-100, if ever, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings or other capital sources, including potential collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements when needed would have a negative impact on our financial condition and could force us to delay, 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. Reorganization We were incorporated in January 2018 in Israel under the name 89Bio Ltd. 89bio, Inc. was incorporated in June 2019 for the purpose of an internal reorganization transaction. In September 2019, all of the equity holders of 89Bio Ltd. exchanged 100% of the equity of 89Bio Ltd. for 100% of the equity of 89bio, Inc (the “Reorganization”). Following this reorganization, 89Bio Ltd. became a wholly owned subsidiary of 89bio, Inc. The Reorganization was retrospectively adjusted to inception given the transaction was between entities under common control. Agreements with Teva In April 2018, we entered into the FGF21 Agreement with Teva, under which we acquired certain patents, intellectual property and other assets relating to Teva’s glycoPEGylated FGF21 program, including BIO89-100. Under the FGF21 Agreement, Teva also granted us a perpetual, non-exclusive (but exclusive as to BIO89-100), non-transferable, worldwide license to patents and know-how related to glycoPEGylation technology for use in the research, development, manufacture and commercialization of BIO89-100 and products containing BIO89-100. We also entered into an Asset Transfer and License Agreement with Teva under which we acquired from Teva certain patents, intellectual property and other assets relating to Teva’s development program of small molecule inhibitors of FASN (the “FASN Agreement” and collectively with the FGF21 Agreement, the “Teva Agreements”). Pursuant to the Teva Agreements, we paid Teva a nonrefundable upfront payment of $6.0 million in 2018. In addition, we are required to make certain payments to Teva under each of the Teva Agreements of up to $2.5 million for the achievement of certain development milestones, and additional payments of up to $65.0 million upon achievement of certain commercial milestones, for a total under both Teva Agreements of up to $135.0 million. We are also obligated to pay Teva tiered royalties at percentages in the low-to-mid single-digits on worldwide net sales of products containing BIO89-100 or FASN. The assets acquired from Teva did not meet the definition of a business and therefore, this acquisition was treated as an asset acquisition for accounting purposes. In addition, we recorded the total consideration transferred to Teva in connection with this acquisition as research and development expense because the acquired technology represented in-process research and development and had no alternative future use. Components of Results of Operations Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our lead product candidate, BIO89-100. Our research and development expenses consist primarily of external costs related to preclinical and clinical development, including costs related to acquiring patents and intellectual property, expenses incurred under license agreements and agreements with contract research organizations and consultants, costs related to acquiring and manufacturing clinical trial materials, including under agreements with contract manufacturing organizations and other vendors, costs related to the preparation of regulatory submissions and expenses related to laboratory supplies and services, as well as personnel costs. Personnel costs consist of salaries, employee benefits and share-based compensation for individuals involved in research and development efforts. We expense all research and development expenses in the periods in which they are incurred. We accrue for costs incurred as the services are being provided by monitoring the status of specific activities and the invoices received from our external service providers. We adjust our accrual as actual costs become known. Payments associated with licensing agreements to acquire 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. Where contingent milestone payments are due to third parties under research and development arrangements or license agreements, the milestone payment obligations are expensed when the milestone results are probable and estimable, which is generally upon achievement of milestones. We expect our research and development expenses to increase substantially for the foreseeable future as we continue the development of BIO89-100 and continue to invest in research and development activities. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time consuming, and the successful development of BIO89-100 and any future product candidates is highly uncertain. To the extent that BIO89-100 continues to advance into larger and later stage clinical trials, our expenses will increase substantially and may become more variable. The actual probability of success for BIO89-100 or any future product candidate 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, we are unable to determine the timing of initiation, duration and completion costs of our research and development efforts or when and to what extent we will generate revenue from the commercialization and sale of BIO89-100 or any future product candidate. Our future clinical development costs may vary significantly based on factors such as: • the cost and timing of manufacturing BIO89-100 and any future product candidates; • 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 evaluated in the trials; • the drop-out or discontinuation rates of patients; • potential additional safety monitoring requested by regulatory agencies; • the duration of patient participation in the trials and follow-up; • the phase of development of BIO89-100 and any future product candidates; and • the efficacy and safety profile of BIO89-100 and any future product candidates. General and Administrative Expenses Our general and administrative expenses consist primarily of personnel costs, expenses for outside professional services, including legal, human resource, audit and accounting services, consulting costs and allocated facilities costs. Personnel and related costs consist of salaries, benefits and share-based compensation for personnel in executive, finance and other administrative functions. Facilities costs consist of rent and maintenance of facilities. We expect our general and administrative expenses to increase for the foreseeable future as we increase the size of our administrative function to support the growth of our business and support our continued research and development activities. We also anticipate increased expenses as a result of operating as a public company, including increased expenses related to audit, legal, regulatory and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs. Other Expenses (Income), Net Other expenses (income), net primarily consists of the revaluation of our convertible preferred stock liability. Results of Operations Year Ended December 31, 2019 and the Period from January 18, 2018 (inception) to December 31, 2018 The following table summarizes our results of operations for the periods presented (in thousands): Research and Development Expenses The following table summarizes the period-over-period changes in research and development expenses for the periods indicated (in thousands): Research and development expenses increased by $7.7 million, or 56%, to $21.4 million for the year ended December 31, 2019 from $13.7 million during the period from January 18, 2018 (inception) to December 31, 2018. The increase was primarily due to an increase of $3.9 million in contract manufacturing costs, an increase of $3.6 million in clinical development costs as we continue to advance our current clinical programs with our lead product candidate, BIO89-100 and an increase of $2.9 million in pre-clinical costs. In addition, personnel-related costs, including share-based compensation, increased by $2.7 million and other expenses increased by $0.6 million due to increased headcount and other costs as we ramped up our operations. These increases were partially offset by a $6.0 million decrease due to an up-front license payment to Teva during the period from January 18, 2018 (inception) to December 31, 2018 and there were no such license payment expenses related to Teva during the year ended December 31, 2019. General and Administrative Expenses General and administrative expenses increased by $3.8 million, or 257%, to $5.3 million for the year ended December 31, 2019 from $1.5 million during the period from January 18, 2018 (inception) to December 31, 2018. The increase was primarily due to an increase of $1.9 million in professional and accounting consulting service fees incurred in connection with our preparation to become a public company, an increase of $1.6 million in personnel-related costs, including share-based compensation, driven by an increase in headcount and an increase of $0.3 million in insurance related costs. Other Expenses (Income), Net Other expenses (income), net increased by $29.6 million to $30.6 million for the year ended December 31, 2019 from $1.0 million during the period from January 18, 2018 (inception) to December 31, 2018. The increase in other expenses was primarily due to the revaluation of our convertible preferred stock liability. Liquidity and Capital Resources To date, we have incurred significant net losses and negative cash flows from operations. As of December 31, 2019, we had available cash and cash equivalents of $93.3 million and an accumulated deficit of $73.6 million. Prior to our IPO, we funded our operations from the issuance and sale of capital stock. In connection with our IPO, we issued and sold an aggregate of 6,100,390 shares of common stock (inclusive of 795,703 shares of common stock from the exercise of the option to purchase additional shares granted to the underwriters) at a price of $16.00 per share. We received proceeds of $87.7 million, net of underwriting discounts and commissions and estimated offering costs. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures related to our lead product candidate, BIO89-100. We plan to increase our research and development expenses substantially for the foreseeable future as we continue the clinical development of our current and future product candidates. At this time, due to the inherently unpredictable nature of clinical development, we cannot reasonably estimate the costs we will incur and the timelines that will be required to complete development, obtain marketing approval, and commercialize our current product candidate or any future product candidates. For the same reasons, we are also unable to predict when, if ever, we will generate revenue from product sales or our current or any future license agreements which we may enter into or whether, or when, if ever, we may achieve profitability. Clinical and preclinical development timelines, the probability of success, and development costs can differ materially from expectations. In addition, we cannot forecast the timing and amounts of milestone, royalty and other revenue from licensing activities, which future product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. Based on our research and development plans, we expect that our existing cash and cash equivalents will be sufficient to fund our operations into the second half of 2021. However, our operating plans and other demands on our cash resources may change as a result of many factors, and we may seek additional funds sooner than planned. There can be no assurance that we will be successful in acquiring additional funding at levels sufficient to fund our operations or on terms favorable to us. Our future funding requirements will depend on many factors, including the following: • the progress, timing, scope, results and costs of our clinical trials of BIO89-100 and preclinical studies or clinical trials of other potential product candidates we may choose to pursue in the future, including the ability to enroll patients in a timely manner for our clinical trials; • the costs and timing of obtaining clinical and commercial supplies and validating the commercial manufacturing process for BIO89-100 and any other product candidates we may identify and develop; • the cost, timing and outcomes of regulatory approvals; • the timing and amount of any milestone, royalty or other payments we are required to make pursuant to current or any future collaboration or license agreements; • costs of acquiring or in-licensing other product candidates and technologies; • the terms and timing of establishing and maintaining collaborations, licenses and other similar arrangements; • the costs associated with attracting, hiring and retaining additional qualified personnel as our business grows; • our efforts to enhance operational systems and hire additional personnel to satisfy our obligations as a public company, including enhanced internal controls over financial reporting; and • the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. We expect to continue to generate substantial operating losses for the foreseeable future as we expand our research and development activities. We will continue to fund our operations primarily through utilization of our current financial resources and through additional raises of capital to advance our current product candidate through clinical development, to develop, acquire or in-license other potential product candidates and to fund operations for the foreseeable future. However, there is no assurance that such funding will be available to us or that it will be obtained on terms favorable to us or will provide us with sufficient funds to meet our objectives. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. To the extent that we raise additional capital through partnerships or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams or research programs or to grant licenses on terms that may not be favorable to us. If we raise additional capital through public or private equity offerings, the ownership interest of our then-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 adequate financing when needed, we may have to delay, reduce the scope of or suspend one or more of our clinical trials or preclinical studies, research and development programs or commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. Cash Flows The following table summarizes our cash flows for the periods presented (in thousands): Net Cash Used in Operating Activities During the year ended December 31, 2019, net cash used in operating activities was $25.5 million, which consisted of a net loss of $57.4 million, partially offset by non-cash charges of $31.0 million and a net change of $0.9 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of the revaluation of our convertible preferred stock liability of $30.6 million and $0.4 million in share-based compensation. The change in our operating assets and liabilities was primarily due to a $2.9 million increase in accounts payable and accrued expenses as we grew our operations, partially offset by a $2.0 million increase in other current assets and other assets due to the timing of payments. During the period from January 18, 2018 (inception) to December 31, 2018, net cash used in operating activities was $12.5 million, which consisted of a net loss of $16.2 million, partially offset by non-cash charges of $1.1 million and a net change of $2.6 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of the revaluation of our convertible preferred stock liability of $1.0 million and $0.1 million in share-based compensation. The change in our net operating assets and liabilities was primarily due to a $2.7 million increase in accounts payable and accrued expenses as we grew our operations. Net Cash Used in Investing Activities During the year ended December 31, 2019 and the period from January 18, 2018 (inception) to December 31, 2018, net cash used in investing activities consisted of purchases of fixed assets. Net Cash Provided by Financing Activities During the year ended December 31, 2019 net cash provided by financing activities was $107.7 million, which consisted of net proceeds of $87.7 million received from our initial public offering and net proceeds of $20.0 million received from the issuance and sale of our convertible preferred stock. During the period from January 18 (inception) to December 31, 2018 net cash provided by financing activities was $23.8 million, which primarily consisted of net proceeds of $23.7 million from the issuance and sale of our convertible preferred stock. Contractual Obligations and Other Commitments We are a smaller reporting company, as defined by Rule 12b-2 under the Securities and Exchange Act of 1934 and in Item 10(f)(1) of Regulation S-K, and are not required to provide the information under this item. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements, as defined in the rules and regulations of the SEC, and do not have any holdings in variable interest entities. 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 (“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 as of 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. While our significant accounting policies are described in the notes to our consolidated 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 We record accrued expenses for estimated preclinical and clinical trial and research expenses related to the services performed but not yet invoiced pursuant to contracts with research institutions, contract research organizations and clinical manufacturing organizations that conduct and manage preclinical studies, and clinical trials, and research services on our behalf. Payments for these services are based on the terms of individual agreements and payment timing may differ significantly from the period in which the services were performed. Our estimates are based on factors such as the work completed, including the level of patient enrollment. 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. Our estimates of accrued expenses are based on the facts and circumstances known at the time. If we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates. As actual costs become known, we adjust our accrued expenses. To date, we have not experienced significant changes in our estimates of preclinical studies and clinical trial accruals. Convertible Preferred Stock Liability The freestanding instruments related to the commitments by the Series A convertible preferred shareholders to purchase and by us to sell our Series A convertible preferred shares in subsequent closings, contingent upon the achievement of certain developmental milestones and approval by the board of directors, at a fixed price per share, were considered a liability (or an asset) measured at fair value as the shares underlying the rights contain liquidation preferences upon certain “deemed liquidation events” that were not solely within the Company’s control and which were considered in-substance contingent redemption features. The instruments were subject to revaluation at each balance sheet date until settlement or extinguishment, with revaluations recognized as a component of either other expenses (income), net in the consolidated statements of operations and comprehensive loss, or additional paid-in capital in the consolidated balance sheets. Share-Based Compensation We recognize compensation expense related to share-based awards granted to employees, directors, and non-employee service providers, including stock options, based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting share-based compensation, using the Black-Scholes option-pricing model. The grant date fair value of the share-based awards, which have graded vesting, is recognized using the straight-line method over the requisite service period of each award, which is generally the vesting period of the respective awards. We recognize forfeitures as they occur. We use the Black-Scholes option-pricing model to estimate the fair value of stock option awards that requires the use of subjective assumptions to determine the fair value of share-based awards. These assumptions include: • Expected volatility-Since we have limited trading history for our common stock due to our short trading history, the expected volatility was estimated based on the average volatility for comparable publicly traded biotechnology companies during the equivalent period of the calculated expected term of the options granted. 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 bonds in effect at the time of grant for periods corresponding with the expected term of the option. • Expected term-The expected term of options granted to employees and directors is determined using the “simplified” method. Under this approach, the expected term is presumed to be the mid-point between the weighted-average vesting term and the contractual term of the option. The simplified method makes the assumption that the employee will exercise share options evenly over the period when the share options are vested and ending on the date when the share options would expire. The expected option term for options granted to non-employees is based on the contractual term. • Expected dividend-We have never paid dividends on our shares of common stock and have no plans to pay dividends on our shares of common stock. Therefore, we used an expected dividend of zero. We will continue to use judgment in evaluating the expected volatility and expected term utilized for our share-based compensation calculations on a prospective basis. 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. Prior to our IPO, given the absence of a public trading market for our shares of 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 shares of common stock, including timely valuations of our shares of common stock prepared by an unrelated third-party valuation firm, important developments in our operations, sales of convertible preferred shares, 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 shares of common stock, among other factors. Following our IPO, the closing price per share of our common stock as reported on The Nasdaq Global Market on the date of grant is used to determine the determine the fair value of each share of common stock. Options granted shall be exercisable at a price per share not less than the estimated per share fair value of shares of common stock underlying those options on the date of grant. Recent Accounting Pronouncements See Note 2 to our consolidated financial statements appearing under Part II, Item 8 for more information about recent accounting pronouncements, the timing of their adoption, and our assessment, to the extent we have made one yet, of their potential impact on our financial condition of results of operations. 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 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 consolidated financial statements and our interim consolidated financial statements may not be comparable to companies that comply with new or revised accounting pronouncements.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company focused on the development and commercialization of innovative therapies for the treatment of liver and cardiometabolic diseases. Our lead product candidate, BIO89100, a specifically engineered glycoPEGylated analog of FGF21, is currently being developed for the treatment of NASH. NASH is a severe form of NAFLD, characterized by inflammation and fibrosis in the liver that can progress to cirrhosis, liver failure, HCC and death. There are currently no approved products for the treatment of NASH. FGF21 is a clinicallyvalidated mechanism that has been shown in humans to reduce steatosis and address cardiometabolic dysregulation. We believe BIO89100 may be a differentiated FGF21 therapy based on its robust and durable biological effects and a favorable tolerability profile, as well as its potential for a longer dosing interval. Combining these characteristics with the ability to address the key liver pathologies in NASH, as well as the underlying metabolic dysregulation in NASH patients, BIO89100 has the potential to become a mainstay of NASH therapy. We successfully completed a Phase 1a, firstinhuman, SAD clinical trial with 58 healthy volunteers. The magnitude and significance of BIO89100’s biological effects after a single dose on lipid parameters were robust and durable. In July 2019, we initiated our POC Phase 1b/2a clinical trial in patients with NASH or patients with NAFLD and a high risk of NASH and we expect to report topline data in the second half of 2020. We also intend to develop BIO89100 for the treatment of SHTG, a condition identified by severely elevated levels of triglycerides (greater than or equal to 500 mg/dL), which is associated with an increased risk of NASH, cardiovascular events and acute pancreatitis. We expect to initiate our Phase 2 trial in SHTG patients in the first half of 2020 in order to evaluate the ability of BIO89100 to reduce fasting plasma triglyceride levels compared to baseline levels and to report topline data in the first half of 2021. Based on FDA guidance for the development of SHTG treatments, as well as the regulatory path followed by other companies that have successfully developed SHTG therapies, we believe that a combination of smaller clinical trials and shorter development timelines could mean that SHTG potentially represents a quicker path to market for BIO89100. We believe BIO89100 has the potential to address multiple drivers underlying metabolic dysregulation, which would make it an ideal candidate for selected liver and cardiometabolic diseases. We commenced operations in 2018 and have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring our initial product candidate, BIO89100, and licensing certain related technology, conducting research and development activities, including preclinical studies and early clinical trials, and providing general and administrative support for these operations. We have funded our operations since our inception to December 31, 2019 through the issuance and sale of capital stock. As of December 31, 2019, our cash and cash equivalents totaled $93.3 million. Based on our current operating plan, we believe that our cash and cash equivalents will be sufficient to meet our anticipated cash requirements into the second half of 2021. On November 8, 2019, our Registration Statements on Form S1 (File No. 333234174 and 333234617) relating to our IPO, were declared effective by the SEC. Pursuant to the Registration Statements, we issued and sold an aggregate of 6,100,390 shares of common stock (inclusive of 795,703 shares pursuant to the underwriters’ option to purchase additional shares) at a price of $16.00 per share for aggregate c [/INST] Positive. </s>

Pennant Group, Inc.

2020-03-04

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated and combined financial statements and accompanying notes, which appear elsewhere in this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report. See Item 1A., Risk Factors and Cautionary Note Regarding Forward-Looking Statements. Overview We are a leading provider of high-quality healthcare services to patients of all ages, including the growing senior population, in the United States. We strive to be the provider of choice in the communities we serve through our innovative operating model. We operate in multiple lines of businesses including home health, hospice and senior living services across Arizona, California, Colorado, Idaho, Iowa, Nevada, Oklahoma, Oregon, Texas, Utah, Washington, Wisconsin and Wyoming. As of December 31, 2019, our home health and hospice business provided home health, hospice and home care services from 63 agencies operating across 13 states, and our senior living business operated 52 senior living communities throughout six states. The following table summarizes our affiliated home health and hospice agencies and senior living communities as of: The Spin-Off Transactions On October 1, 2019, Ensign completed the Spin-Off, which was effected through a tax free distribution to Ensign’s stockholders of substantially all of the outstanding shares of Pennant common stock. Each Ensign stockholder received a distribution of one share of Pennant common stock for every two shares of Ensign's common stock, plus cash in lieu of fractional shares. As a result of the Spin-Off on October 1, 2019, Pennant began trading as an independent publicly traded company on the NASDAQ under the symbol “PNTG.” We expect to benefit from a continuing relationship with Ensign, which continues to be a holding company comprised of various healthcare service providers across the post-acute care continuum. In connection with the Spin-Off, we entered a transition services agreement with Ensign (the “Transition Services Agreement”) with a two-year term, subject to extension upon the mutual agreement of the parties. Pursuant to the Transition Services Agreement, Ensign and Pennant agree to provide certain transition services to each other, including finance, information technology, human resources, employee benefits and other services to ensure an orderly transition following the distribution. Effective October 1, 2019, we amended our master lease agreements with Ensign and certain other landlords. These amendments modify the rental payments, the initial lease term or both. In accordance with Topic 842, the amended lease agreements are considered modified and subjected to lease modification guidance. The right-of-use asset and lease liabilities related to these agreements were remeasured based on the change in the lease conditions such as rent payment and lease terms. The incremental borrowing rate was also be adjusted to mirror the revised lease terms which become effective at the date of the modification, which is the date of the Spin-Off. The Ensign Leases and new third-party master lease agreements have initial terms ranging between 14 and 16 years, with extension options and annual rent escalators based on changes in the consumer price index. See “Certain Relationships and Related Party Transactions-Agreements with Ensign Related to the Spin-Off,” contained within the Information Statement as well as the Form 8-K filed with the SEC on October 3, 2019 for further discussion of the agreements entered into in connection with the Spin-Off. On October 1, 2019, Pennant entered into a credit agreement (the “Credit Agreement”), which provides for a revolving credit facility with a borrowing capacity of $75.0 million (the “Revolving Credit Facility”). The interest rates applicable to loans under the Revolving Credit Facility are, at the Company’s election, either Adjusted LIBOR (as defined in the Credit Agreement) plus a margin ranging from 2.5% to 3.5% per annum or Base Rate (as defined in the Credit Agreement) plus a margin ranging from 1.5% to 2.5% per annum, in each case based on the ratio of Consolidated Total Net Debt to Consolidated EBITDA (each, as defined in the Credit Agreement). In addition, Pennant pays a commitment fee of 0.6% per annum on the undrawn portion of the commitments under the Revolving Credit Facility. The balance of our Revolving Credit Facility was $20.0 million, as of December 31, 2019. For further discussion including the classification of debt issuance costs of $1.5 million, see Note 11, Debt. Recent Activities Acquisitions. During 2019, we expanded our operations through the acquisition of two senior living operations, two home health agencies, five hospice agencies, and two home care agencies. We did not assume any liabilities in connection with these acquisitions. The addition of these operations added a total of 143 senior living units to be operated by our independent operating subsidiaries. We entered into a separate operations transfer agreement with the prior operator as part of each transaction. The aggregate purchase price for these acquisitions was $18.8 million. For further discussion of our acquisitions, see Note 7, Acquisitions, in the Notes to the consolidated and combined financial statements. Trends When we acquire turnaround or start-up operations, we expect that our combined metrics may be impacted. We expect these metrics to vary from period to period based upon the maturity of the operations within our portfolio. We have generally experienced lower occupancy rates at our senior living communities and lower census at our home health and hospice agencies for recently acquired operations; as a result, we generally anticipate lower consolidated and segment margins during years of acquisition growth. Regulation On October 31, 2019, CMS issued the final rule updating the Medicare HH PPS rates and wage index for calendar year 2020 and implementing PDGM. The final rule established a 1.5% increase in the home health base payment. PDGM introduces case mix calculation methodology refinements, changes to LUPA thresholds, the elimination of therapy thresholds, a change to the unit of payment from a 60-day episode to a 30-day payment period, and a reduction in fiscal year 2020 and full elimination in fiscal year 2021 of RAPs. Under PDGM, effective January 1, 2020, the initial certification of patient eligibility, plan of care, and comprehensive assessment will remain valid for 60-day episodes of care, but payments for home health services will be made based upon 30-day payment periods. CMS implemented PDGM in a budget neutral manner, and that neutrality assumed that providers will make certain coding and behavioral changes. Therefore, the rule’s ultimate impact will vary by provider based on factors including patient mix, admission source, and providers’ ability to adapt to the new reimbursement model. With the support of our professional resource team, our local clinical and operational leaders have been preparing for this reimbursement change. While we could experience revenue headwinds related to the included behavioral assumptions and payment disruptions, we anticipate that we will offset any negative impact from PDGM through a mix of behavioral changes and a continued focus on cost control while producing optimal clinical outcomes. In addition, we anticipate that reimbursement changes resulting from the implementation of PDGM could result in increased home health acquisition and consolidation opportunities for us. Segments We have two reportable segments: (1) home health and hospice services, which includes our home health, home care and hospice businesses; and (2) senior living services, which includes the operation of assisted living, independent living and memory care communities. Our Chief Executive Officer and President, who is our CODM, reviews financial information at the operating segment level. We also report an “all other” category that includes general and administrative expense from our Service Center. Key Performance Indicators We manage the fiscal aspects of our business by monitoring key performance indicators that affect our financial performance. These indicators and their definitions include the following: Home Health and Hospice Services •Total home health admissions. The total admissions of home health patients, including new acquisitions, new admissions and readmissions. •Total Medicare home health admissions. Total admissions of home health patients, who are receiving care under Medicare reimbursement programs, including new acquisitions, new admissions and readmissions. •Average Medicare revenue per completed 60-day home health episode. The average amount of revenue for each completed 60-day home health episode generated from patients who are receiving care under Medicare reimbursement programs. •Average hospice daily census. The average number of patients who are receiving hospice care during any measurement period divided by the number of days during such measurement period. •Total hospice admissions. Total admissions of hospice patients, including new acquisitions, new admissions and recertifications. •Hospice Medicare revenue per day. The average daily Medicare revenue recorded during any measurement period for services provided to hospice patients. The following table summarizes our overall home health and hospice statistics for the periods indicated: Senior Living Services •Occupancy. The ratio of actual number of days our units are occupied during any measurement period to the number of units available for occupancy during such measurement period. •Average monthly revenue per occupied unit. The revenue for senior living services during any measurement period divided by actual occupied senior living units for such measurement period divided by the number of months for such measurement period. The following table summarizes our senior living statistics for the periods indicated: Revenue Sources Home Health and Hospice Services Home Health. We derive the majority of our home health business revenue from Medicare and managed care. The Medicare payment is adjusted for differences between estimated and actual payment amounts, an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Medicare HH PPS provides home health agencies with payments for each 60-day episode of care for each beneficiary. If a beneficiary is still eligible for care after the end of the first episode, a second episode can begin. There are no limits to the number of episodes a beneficiary who remains eligible for the home health benefit can receive. While payment for each episode is adjusted to reflect the beneficiary’s health condition and needs, a special outlier provision exists to ensure appropriate payment for those beneficiaries that have the most expensive care needs. The payment under the Medicare program is also adjusted for certain variables including, but not limited to: (a) a low utilization payment adjustment if the number of visits was fewer than five; (b) a partial payment if the patient transferred to another provider or the Company received a patient from another provider before completing the episode; (c) a payment adjustment based upon the level of therapy services required; (d) the number of episodes of care provided to a patient, regardless of whether the same home health provider provided care for the entire series of episodes; (e) changes in the base episode payments established by the Medicare program; (f) adjustments to the base episode payments for case mix and geographic wages; and (g) recoveries of overpayments. On October 31, 2019, CMS issued the final rule updating the Medicare HH PPS rates and wage index for calendar year 2020 and implementing PDGM. The final rule established a 1.5% increase in the home health base payment. PDGM introduces case-mix calculation methodology refinements, changes to LUPA thresholds, the elimination of therapy thresholds, a change to the unit of payment from a 60-day episode to a 30-day episode, and a reduction in fiscal year 2020 and full elimination in fiscal year 2021 of RAPs Hospice. We derive the majority of our hospice business revenue from our hospice business from Medicare reimbursement. The estimated payment rates are calculated as daily rates for each of the levels of care we deliver. Rates are set based on specific levels of care, are adjusted by a wage index to reflect healthcare labor costs across the country and are established annually through federal legislation. The following are the four levels of care provided under the hospice benefit: •Routine Home Care. Care that is not classified under any of the other levels of care, such as the work of nurses, social workers or home health aides. •General Inpatient Care. Pain control or acute or chronic symptom management that cannot be managed in a setting other than an inpatient Medicare-certified facility, such as a hospital, skilled nursing facility or hospice inpatient facility. •Continuous Home Care. Care for patients experiencing a medical crisis that requires nursing services to achieve palliation and symptom control, if the agency provides a minimum of eight hours of care within a 24-hour period. •Inpatient Respite Care. Short-term, inpatient care to give temporary relief to the caregiver who regularly provides care to the patient. CMS has established a two-tiered payment system for RHC. Hospices are reimbursed at a higher rate for RHC services provided from days of service 1 through 60 and a lower rate for all subsequent days of service. CMS also provided for a Service Intensity Add-On, which increases payments for certain RHC services provided by registered nurses and social workers to hospice patients during the final seven days of life. Medicare reimbursement is adjusted for an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. Additionally, as Medicare hospice revenue is subject to an inpatient cap limit and an overall payment cap, we monitor our provider numbers and estimate amounts due back to Medicare to the extent that the cap has been exceeded. Senior Living Services . As of December 31, 2019, we provided assisted living, independent living and memory care services at 52 communities. Within our senior living operations, we generate revenue primarily from private pay sources, with a portion earned from Medicaid or other state-specific programs. Primary Components of Expense Cost of Services (excluding rent, general and administrative expense and depreciation and amortization). Our cost of services represents the costs of operating our independent operating subsidiaries, which primarily consists of payroll and related benefits, supplies, purchased services, and ancillary expenses such as the cost of pharmacy and therapy services provided to patients. Cost of services also includes the cost of general and professional liability insurance and other general cost of services specifically attributable to our operations. Rent-Cost of Services. Rent-cost of services consists solely of base minimum rent amounts payable under lease agreements to our landlords. Our subsidiaries lease and operate but do not own the underlying real estate at our operations, and these amounts do not include taxes, insurance, impounds, capital reserves or other charges payable under the applicable lease agreements. General and Administrative Expense. General and administrative expense consists primarily of payroll and related benefits and travel expenses for our Service Center personnel, including training and other operational support. General and administrative expense also includes professional fees (including accounting and legal fees), costs relating to our information systems, stock-based compensation and rent for our Service Center offices. Depreciation and Amortization. Property and equipment are recorded at their original historical cost. Depreciation is computed using the straight-line method over the estimated useful lives of the depreciable assets (ranging from three to 15 years). Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the remaining lease term. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based on our consolidated and combined financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements and related disclosures requires us to make judgments, 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. On an ongoing basis we review our judgments and estimates, including but not limited to those related to revenue, cost allocations, leases, intangible assets, goodwill, and income taxes. We base our estimates and judgments upon our historical experience, knowledge of current conditions and our belief of what could occur in the future considering available information, including assumptions that we believe to be reasonable under the circumstances. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty, and actual results could differ materially from the amounts reported. While we believe that our estimates, assumptions, and judgments are reasonable, they are based on information available when the estimate was made. Refer to Note 2, Basis of Presentation and Summary of Significant Accounting Policies, within the Consolidated and Combined Financial Statements for further information on our critical accounting estimates and policies, which are as follows: •Revenue recognition - The estimate of variable considerations to arrive at the transaction price, including methods and assumptions used to determine settlements with Medicare and Medicaid payors or retroactive adjustments due to audits and reviews; •Cost allocation - The Consolidated and Combined Financial Statements include allocations of costs for certain shared services provided to the Company by Ensign subsidiaries prior to the spin-off on October 1, 2019. These costs were allocated to the Company on a basis of revenue, location, employee count, or other measures; •Leases - We use our estimated incremental borrowing rate based on the information available at lease commencement date in determining the present value of future lease payments; •Acquisition accounting - The assumptions used to allocate the purchase price paid for assets acquired and liabilities assumed in connection with our acquisitions; and •Income taxes - The estimation of valuation allowance or the need for and magnitude of liabilities for uncertain tax position. Recent Accounting Pronouncements Information concerning recently issued accounting pronouncements which are not yet effective is included in Note 2, Basis of Presentation and Summary of Significant Accounting Policies in the Audited Financial Statements. As indicated in Note 2, we are still evaluating the impact of the recently issued accounting pronouncements on our financial statements. Results of Operations The following table sets forth details of our revenue, expenses and earnings as a percentage of total revenue for the periods indicated: Year Ended December 31, 2019 Compared to the Year Ended December 31, 2018 Revenue (a) Home care and other revenue is included with home health revenue in other disclosures in this report. Our consolidated and combined revenue increased $52.5 million, or 18.3%. Revenue from acquired operations increased our consolidated and combined revenue by $18.6 million or 6.5% during the year ended December 31, 2019. Home Health and Hospice Services Home health and hospice revenue increased $37.6 million, or 22.2%. Medicare and managed care revenue increased $30.5 million, or 21.7%. Revenue growth was due to movement on numerous levels including all key metrics listed above, and primarily driven by increases in total home health admissions of 24.2% and average daily census of 26.4%, which growth was partially driven by an increase of $17.0 million or 10.1% from the addition of nine home health, hospice and home care operations between December 31, 2018 and December 31, 2019. Senior Living Services Senior living revenue increased $14.9 million, or 12.7%, for the year ended December 31, 2019 when compared to the same period in the prior year. An increase of $1.6 million or 1.4% in revenue from the addition of two senior living communities occurred during the year ended December 31, 2019. We also experienced an increase in occupancy of 0.7%. Cost of Services The following table sets forth total cost of services by each of our reportable segments for the periods indicated: Consolidated and Combined cost of services increased $46.5 million or 21.9%. Cost of services as a percentage of revenue increased by 2.2% to 76.5% compared to 74.3% for the year ended December 31, 2018. Home Health and Hospice Services Cost of services related to our home health and hospice services segment increased $31.7 million, or 22.3%, primarily due to increased volume of services. Cost of services as a percentage of revenue for the year ended December 31, 2019 remained flat when compared to the year ended December 31, 2018. Senior Living Services Cost of services related to our senior living services segment increased $14.8 million, or 21.1%, and by 4.5% as a percent of revenue as a result of the increase in costs associated with newly acquired communities and additional field-based resources to support our growing infrastructure. Our acquisition focus is to opportunistically acquire underperforming operations. Historically, we generally experience higher cost of services at newly acquired operations; therefore, we anticipate fluctuation in cost of services as a percentage of revenue during years of acquisition growth. Rent-Cost of Services. While actual rent increased from $31.2 million in the year ended December 31, 2018 to $35.0 million in the year ended December 31, 2019, primarily as a result of acquisitions and through certain lease modifications which occurred in connection with the Spin-Off. Rent as a percentage of total revenue decreased by 0.6% from 10.9% to 10.3% in the year ended December 31, 2019, as the growth in revenue outpaced the increase in rent expense. General and Administrative Expense. Our general and administrative expense increased from 6.6% to 10.4% as a percentage of revenue, or from $18.8 million to $35.1 million, primarily due to transaction related costs of $13.2 million or 3.9% of revenue. After the Spin-Off additional general and administrative costs of $3.0 million were incurred as part of the Transition Services Agreement of which $0.5 million is for costs associated with running concurrent systems and process which may occur throughout the term of the agreement. Depreciation and Amortization. Depreciation and amortization expense remained relatively flat as a percentage of total revenue. Provision for Income Taxes. As of the completion of the Spin-Off, approximately $10.3 million of transaction costs became nondeductible, having a one-time impact of increasing our effective tax rate significantly. Income tax expense recorded for the year ended December 31, 2019 reflects tax benefits of approximately $1.9 million from share-based payment awards that were partially offset by non-deductible items. See Note 14, Income Taxes, to the Consolidated and Combined Financial Statements included elsewhere in this report filed on Form 10-K for further discussion. Comparison of Prior Year Information For a comparison of our results of operations of the fiscal year ended December 31, 2018 as compared to the year ended December 31, 2017 refer to Item 2. Financial Information of our Form 10 filed with the SEC on September 3, 2019. Liquidity and Capital Resources Prior to the Spin-Off, we participated in a cash management arrangement with Ensign with the net activity of cash reflected in the Net Parent Investment. Following the Spin-Off, we no longer participate in this cash management arrangement with Ensign. Our principal sources of liquidity following the Spin-Off will be our cash on hand, our ability to generate cash through operations, and a newly established Credit Agreement described in further detail below. Revolving Credit Facility The Revolving Credit Facility is not subject to interim amortization and the Company will not be required to repay any loans under the Revolving Credit Facility prior to maturity in 2024. The Company is permitted to prepay all or any portion of the loans under the Revolving Credit Facility prior to maturity without premium or penalty, subject to reimbursement of any LIBOR breakage costs of the lenders. In connection with the Spin-Off, we incurred indebtedness of $30.0 million, which we subsequently reduced to $20.0 million as of December 31, 2019. The $30.0 million reflects proceeds from issuance of indebtedness under the Revolving Credit Facility, including approximately $1.5 million in financing cost. The proceeds from the issuance of indebtedness were used to pay a distribution to Ensign of $11.6 million as well as Spin-Off related transaction costs and for general working capital purposes. We believe that our existing cash, cash equivalents, cash generated through operations and our access to financing facilities, together with funding through third-party sources such as commercial banks, will be sufficient to fund our operating activities, anticipated capital expenditures and growth needs. The following table presents selected data from our combined statement of cash flows for the periods presented: Year Ended December 31, 2019 Compared to the Year Ended December 31, 2018 Our net cash provided by operating activities for the year ended December 31, 2019 decreased by $13.7 million. The decrease was primarily due to a decrease in net income as a result of Spin-Off related transaction costs. Our net cash used in investing activities for the year ended December 31, 2019 increased by $17.0 million. This use of cash is primarily attributable to our spending on business and asset acquisitions which increased by $13.5 million, and an increase in capital expenditure spending of $3.1 million in support of establishing post Spin-Off stand-alone systems. Our net cash provided by (used in) financing activities increase by approximately $31.1 million for the year ended December 31, 2019 when compared to December 31, 2018 due primarily to activity within or Credit Agreement and a cash distribution to Ensign in connection with the Spin-off. Contractual Obligations, Commitments and Contingencies (a) Lease amounts include minimum rental payments under our non-cancelable operating leases. The amounts presented are consistent with contractual terms and are not expected to differ significantly from actual results under our existing leases. In connection with the Spin-Off, we amended our master lease agreements with Ensign and certain other landlords. (b) Assumes all long-term debt is outstanding until scheduled maturity. (c) Interest payments on long-term debt are projected for future periods using the interest rates in effect as of December 31, 2019. Interest payments may differ in the future based on changes in market interest rates and borrowings.

<s>[INST] Overview We are a leading provider of highquality healthcare services to patients of all ages, including the growing senior population, in the United States. We strive to be the provider of choice in the communities we serve through our innovative operating model. We operate in multiple lines of businesses including home health, hospice and senior living services across Arizona, California, Colorado, Idaho, Iowa, Nevada, Oklahoma, Oregon, Texas, Utah, Washington, Wisconsin and Wyoming. As of December 31, 2019, our home health and hospice business provided home health, hospice and home care services from 63 agencies operating across 13 states, and our senior living business operated 52 senior living communities throughout six states. The following table summarizes our affiliated home health and hospice agencies and senior living communities as of: The SpinOff Transactions On October 1, 2019, Ensign completed the SpinOff, which was effected through a tax free distribution to Ensign’s stockholders of substantially all of the outstanding shares of Pennant common stock. Each Ensign stockholder received a distribution of one share of Pennant common stock for every two shares of Ensign's common stock, plus cash in lieu of fractional shares. As a result of the SpinOff on October 1, 2019, Pennant began trading as an independent publicly traded company on the NASDAQ under the symbol “PNTG.” We expect to benefit from a continuing relationship with Ensign, which continues to be a holding company comprised of various healthcare service providers across the postacute care continuum. In connection with the SpinOff, we entered a transition services agreement with Ensign (the “Transition Services Agreement”) with a twoyear term, subject to extension upon the mutual agreement of the parties. Pursuant to the Transition Services Agreement, Ensign and Pennant agree to provide certain transition services to each other, including finance, information technology, human resources, employee benefits and other services to ensure an orderly transition following the distribution. Effective October 1, 2019, we amended our master lease agreements with Ensign and certain other landlords. These amendments modify the rental payments, the initial lease term or both. In accordance with Topic 842, the amended lease agreements are considered modified and subjected to lease modification guidance. The rightofuse asset and lease liabilities related to these agreements were remeasured based on the change in the lease conditions such as rent payment and lease terms. The incremental borrowing rate was also be adjusted to mirror the revised lease terms which become effective at the date of the modification, which is the date of the SpinOff. The Ensign Leases and new thirdparty master lease agreements have initial terms ranging between 14 and 16 years, with extension options and annual rent escalators based on changes in the consumer price index. See “Certain Relationships and Related Party TransactionsAgreements with Ensign Related to the SpinOff,” contained within the Information Statement as well as the Form 8K filed with the SEC on October 3, 2019 for further discussion of the agreements entered into in connection with the SpinOff. On October 1, 2019, Pennant entered into a credit agreement (the “Credit Agreement”), which provides for a revolving credit facility with a borrowing capacity of $75.0 million (the “Revolving Credit Facility”). The interest rates applicable to loans under the Revolving Credit Facility are, at the Company’s election, either Adjusted LIBOR (as defined in the Credit Agreement) plus a margin ranging from 2.5% to 3.5% per annum or Base Rate (as defined in the Credit Agreement) plus a margin ranging from 1.5% to 2.5% per annum, in each case based on the ratio of Consolidated Total Net Debt to Consolidated EBITDA (each, as defined in the Credit Agreement). In addition, Pennant pays a commitment fee of 0.6% per annum on the undrawn portion of the commitments under the Revolving Credit Facility. The balance of our Revolving Credit Facility was $20.0 million, as of December 31, 2 [/INST] Negative. </s>

10x Genomics, Inc.

2020-02-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion of our financial condition and results of operations in conjunction with our audited consolidated financial statements and the related notes and other financial information included elsewhere in this Annual Report and our audited consolidated financial statements and notes thereto. As discussed in the section titled “Special Note Regarding Forward Looking Statements,” the following discussion and analysis, in addition to historical financial information, contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in the section titled “Risk Factors” under Part I, Item 1A above. We operate on a fiscal year that ends on December 31. Overview We are a life sciences technology company focused on building innovative products and solutions to interrogate, understand and master biological systems at resolution and scale that matches the complexity of biology. Our expanding suite of offerings leverages our cross-functional expertise across chemistry, biology, hardware and software to provide a comprehensive, dynamic and high-resolution view of complex biological systems. We have launched multiple products that enable researchers to understand and interrogate biological analytes in their full biological context. Our commercial product portfolio leverages our Chromium instruments, which we refer to as “instruments,” and our proprietary microfluidic chips, slides, reagents and other consumables for both our Visium and Chromium solutions, which we refer to as “consumables.” We bundle our software with these products to guide customers through the workflow, from sample preparation through analysis and visualization. Since launching our first product in mid-2015, and as of December 31, 2019, we have sold 1,666 instruments to customers around the world, including 97 of the top 100 global research institutions as ranked by Nature in 2018 based on publications and 19 of the top 20 global biopharmaceutical companies by 2018 revenue. Our products cover a wide variety of applications and allow researchers to analyze biological systems at fundamental resolutions and on massive scales, such as at the single cell level for millions of cells. Our Chromium instruments and Chromium consumables are designed to work together exclusively. After buying a Chromium instrument, customers purchase consumables from us for use in their experiments. Accordingly, as the installed base of our instruments grows, we expect recurring revenue from consumable sales to become an increasingly important driver of our operating results. As such, our revenue growth is expected to outpace growth in our instrument placements as our business develops. In addition to instrument and consumable sales, we derive revenue from post-warranty service contracts for our Chromium instruments. For the years ended December 31, 2019 and 2018, sales of our Chromium instruments accounted for 14% and 25% of our revenue, respectively, sales of our consumables accounted for 84% and 74% of our revenue, respectively, and sales of services accounted for 2% and 1% of our revenue, respectively. We currently serve thousands of researchers in more than 40 countries. Our customers include a range of academic, government, biopharmaceutical, biotechnology and other leading institutions around the globe. In both the years ended December 31, 2019 and 2018, approximately 70% of our direct sales revenue came from sales to academic institutions. As of December 31, 2019, we employed a commercial team of over 200 employees, including more than 75 commissioned sales representatives, many with Ph.D. degrees and many with significant industry experience. We follow a direct sales model in North America and certain regions of Europe, representing the majority of our revenue. We sell our products through third-party distributors in Asia, certain regions of Europe, Oceania, South America, the Middle East and Africa. We currently sell our products for research use only. For the years ended December 31, 2019 and 2018, sales within North America accounted for approximately 57% and 58% of our revenue, respectively. Revenue increased 68% to $245.9 million in the year ended December 31, 2019 as compared to $146.3 million in the year ended December 31, 2018, primarily due to the adoption of our instruments by customers and the associated consumables on those instruments. We focus a substantial portion of our resources on developing new products and solutions. Our research and development efforts are centered around improving the performance of our existing assays and software, developing new Chromium solutions such as multi-omics solutions, developing our Visium platform, improving and developing new capabilities for our Chromium platform, developing combined software and workflows across multiple solutions and investigating new technologies. We incurred research and development expenses of $83.1 million and $47.5 million for the years ended December 31, 2019 and 2018, respectively. We intend to make significant investments in this area for the foreseeable future. In addition, in 2018, we made acquisitions for an aggregate purchase price of $62.4 million. There were no similar acquisitions in the year ended December 31, 2019. Our instrument manufacturing is contracted out to a third-party contract manufacturer and we manufacture the majority of our consumable products in-house, with a small amount of our components outsourced to key suppliers. We have designed our operating model to be capital efficient and to scale efficiently as our product volumes grow. Historically, we have financed our operations primarily from the sale of our instruments and consumable products, the issuance and sale of our convertible preferred stock and common stock and the issuances of debt. On September 16, 2019, we completed an initial public offering (“IPO”), in which we sold 11,500,000 shares of Class A common stock (which included 1,500,000 shares that were offered and sold pursuant to the full exercise of the IPO underwriters’ option to purchase additional shares) at a price to the public of $39.00 per share. We received aggregate net proceeds of $410.8 million after deducting, offering costs, underwriting discounts and commissions of $37.7 million. Since our inception in 2012, we have incurred net losses in each year. Our net losses were $31.3 million and $112.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $262.4 million and cash and cash equivalents totaling $424.2 million. We expect to continue to incur significant expenses for the foreseeable future and to incur operating losses in the near term. We expect our expenses will increase substantially in connection with our ongoing activities, as we: • attract, hire and retain qualified personnel; • scale our technology platforms and introduce new products and services; • protect and defend our intellectual property; • acquire businesses or technologies; and • invest in processes, tools and infrastructure to support the growth of our business. Acquisitions In October 2019, we completed the acquisition of a worldwide royalty-free, nonexclusive license to certain intellectual property as part of the 2019 Becton Dickinson Settlement and Patent Cross License Agreement. Under the terms of this agreement, we are required to make aggregate payments of $25 million in annual amounts of $6.25 million over four years beginning in January 2020. In November 2018, we completed the acquisition of Spatial Transcriptomics, a privately held company based in Stockholm, Sweden, for an all cash purchase price of $38.6 million. With the acquisition of Spatial Transcriptomics, we obtained intellectual property relating to the spatial interrogation of biological analytes, which we believe will open up the possibilities for discoveries in oncology, neuroscience and immunology, as well as in the broader area of biology. Pursuant to the Spatial Transcriptomics acquisition agreement, we are obligated to make contingent payments to the sellers through December 31, 2022. Aside from this obligation, all of our obligations under the Spatial Transcriptomics acquisition agreement have been fully performed. In November 2018, we completed the acquisition of a worldwide exclusive license to foundational intellectual property relating to spatial analysis technologies from Prognosys Biosciences, Inc. (“Prognosys”), for a combination of cash and common stock for a purchase price of $3.3 million. All of our obligations under the Prognosys license agreement have been fully performed. In March 2018, we completed the acquisition of Epinomics, a privately held company based in California, for an all cash purchase price of $22.2 million. Epinomics’s patent portfolio includes foundational intellectual property and a worldwide exclusive license relating to ATAC-seq, which supplements our existing patent portfolio and enables us to provide ATAC-seq solutions for single cell and other epigenetic applications. All of our obligations under the Epinomics acquisition agreement have been fully performed. Key business metrics We regularly review a number of operating and financial metrics, including the instrument installed base and consumable pull-through, to evaluate our business, measure our performance, identify trends affecting our business, formulate financial projections and make strategic decisions. We believe that these metrics are representative of our current business; however, we anticipate these may change or may be substituted for additional or different metrics as our business grows and as we introduce new products. Instrument installed base Our products are sold to academic, government, biopharmaceutical, biotechnology and other leading institutions around the globe. Our Chromium Controller instrument is user installable and does not require in-person training. Our recently introduced Chromium Connect instrument requires installation and we offer in-person training for its use. We believe the instrument installed base is one of the indicators of our ability to drive customer adoption of our products. We define the instrument installed base as the cumulative number of Chromium instruments sold since inception. Our quarterly instrument unit volumes can fluctuate due to a number of factors, including the procurement and budgeting cycles of many of our customers, especially government and academic institutions where unused funds may be forfeited or future budgets reduced if purchases are not made by their fiscal year end. Similarly, our biopharmaceutical customers typically have calendar year fiscal years which may result in a disproportionate amount of their purchasing activity occurring during our fourth quarter. We also believe the timing of unit sales has been impacted and will continue to be impacted by the timing of product introductions and transitions which can either accelerate or delay demand of existing and new products depending on the needs of individual researchers to conclude existing studies or to use new and improved product capabilities. Further, the growth of our market in certain geographic regions and our continued efforts to service these regions impact unit volumes quarter to quarter. Finally, our recently introduced Chromium Connect instrument could create variability in our installed base since Chromium Connect instruments require installation and in-person training prior to being added to our instrument installed base. We therefore believe that an annual representation of our instrument installed base is most appropriate for assessing trends in our business. Chromium consumable pull-through per instrument Our consumables portfolio includes proprietary microfluidic chips, slides, reagents and other consumables for both our Visium and Chromium solutions. Our Chromium instruments and Chromium consumables are designed to work together exclusively. This Chromium closed-system model generates recurring revenue from each instrument we sell. Our growth in the instrument installed base has been the largest contributor to our growth in consumable sales. In addition, we believe that annual consumable pull-through per instrument is an indicator of our ability to generate future consumable revenue and the rate of customer adoption of our new applications. We define consumable pull-through per instrument as the total consumables revenue in the given quarter divided by the average instrument installed base during that quarter. We calculate the average instrument installed base for a given quarter using the instrument installed base as of the last day of the prior quarter and the instrument installed base as of the last day of the given quarter. We calculate the annual consumable pull-through per instrument figure by summing the quarterly pull-through for the quarters in a given year. The figures in the table above represent the annual consumable pull-through per instrument for the years ended December 31, 2019 and 2018. We do not believe the consumable pull-through per instrument in an individual quarter is an effective indicator of the current state of our business trends. Our quarterly consumable pull-through can fluctuate due to a number of factors. In addition to timing of product transitions such as the Next GEM consumable transition, other factors such as the budget and funding cycles of our customers can cause our quarterly consumables pull-through fluctuate quarter to quarter. For example, a significant portion of our current customers are reliant on government funding and research grants. These funds and grants typically expire at year end, resulting in a higher consumable pull-through per instrument in the fourth quarter relative to the first three quarters of the year. Finally, as we continue to expand into new markets globally as well as into new industries, our average pull-through could be adversely impacted in a particular period. We therefore believe that an annual, rather than quarterly, representation of our consumable pull-through is most appropriate for assessing trends in our business. Our current customer base includes customers who purchase consumables for use on a shared or centralized instrument. We refer to customers who purchase consumables but do not own an instrument as “halo users.” For the year ended December 31, 2019, halo users represented close to half of our revenue from sales of consumables. Halo users, as well as the future introduction of consumables that may not use instruments, such as our recently introduced Visium solution, or Chromium instruments that are expected to use a greater amount of consumables, such as our Chromium Connect instrument, could reduce the utility of this metric and make it difficult to compare consumable pull-through per instrument metrics over time. Key factors affecting our performance We believe that our financial performance has been and in the foreseeable future will continue to be primarily driven by the following factors. 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. Our ability to successfully address the factors below is subject to various risks and uncertainties, including those described under the heading “Risk Factors.” Instrument sales Our financial performance has largely been driven by, and in the future will continue to be impacted by, the rate of sales of our Chromium instruments. Management focuses on instrument sales as an indicator of current business success and a leading indicator of likely future sales of consumables. We expect our instrument sales to continue to grow as we increase penetration in our existing markets and expand into, or offer new features and solutions that appeal to new markets. We plan to grow our instrument sales in the coming years through multiple strategies including expanding our sales efforts globally and continuing to enhance the underlying technology and applications for life sciences research. As part of this strategy and in an effort to increase the rate of sales of our instruments, we increased our sales force by 54% from December 31, 2018 through December 31, 2019, with more than 75 commissionable sales representatives as of December 31, 2019. We regularly solicit feedback from our customers and focus our research and development efforts on enhancing the Chromium Controller instrument and enabling its ability to use additional applications that address their needs, which we believe in turn helps to drive additional sales of our instruments and consumables. We have developed and recently introduced our Chromium Connect instrument, which is an automated version of our current Chromium Controller instrument. We believe the automated features of the Chromium Connect will increase our addressable market by increasing utilization by biopharmaceutical customers. Our sales process varies considerably depending upon the type of customer to whom we are selling. Our sales process with small laboratories and individual researchers is often short, and in some cases, we receive purchase orders from these customers in under a month. Our sales process with other institutions can be longer with most customers submitting purchase orders within six months. Given the variability of our sales cycle, we have in the past experienced, and likely will in the future experience, fluctuations in our instrument sales on a period-to-period basis. Recurring consumable revenue We regularly assess trends relating to recurring consumable revenue based on our product offerings, our customer base and our understanding of how our customers use our products. As our instrument installed base expands, consumables revenue on an absolute basis is expected to increase and over time should be an increasingly important contributor to our revenue. We expect our annual consumable pull-through per instrument to be relatively stable as the instrument installed base increases. Our expansion into new markets with less experienced users could adversely impact average pull-through, but we expect the sales of our recently introduced Visium Spatial Gene Expression solution as well as the release of new products and applications for our Chromium instruments and Visium platform to increase consumable pull-through per instrument and offset these declines. We have reported our Visium product revenue as part of consumable revenue and included it in the average pull-through per instrument calculation. Even though Visium is not processed through a Chromium instrument, we will sell the product primarily to Chromium instrument users and view it as pull-through from a business perspective. Revenue mix and gross margin Our revenue is derived from sales of our instruments, consumables and services. There have been fluctuations in the mix between instruments and consumables and amongst our consumables. Our consumable revenue as a percentage of total revenue has continued to grow. Each of our consumables solutions is designed to allow researchers to study a different aspect of biology, such as DNA, RNA, protein or epigenetics, at a resolution and scale that may be impractical or impossible using existing tools. As each of our solutions has been introduced, they have been initially purchased by a small number of early adopters. As these early adopters successfully perform experiments and publish scientific articles using our solutions, the utility of these solutions is more broadly understood and the solutions are then subsequently adopted by the larger research community. The revenue contribution from these and other consumable products has varied and is expected to vary on a quarterly basis due to several factors, including the publication of scientific papers demonstrating the value of the consumables, the availability of grants to fund research, budgetary timing and our introduction of new product features and new consumables offerings. For each of the years ended December 31, 2019 and 2018, our Single Cell Gene Expression consumables, which were introduced in 2016, accounted for the majority of our consumables revenue. For the year ended December 31, 2018, the remaining consumables revenue was substantially comprised of sales of our Single Cell Immune Profiling consumables, which we introduced in 2017. For the year ended December 31, 2019, the remaining consumables revenue was substantially comprised of sales of our Single Cell Immune Profiling consumables and our Single Cell ATAC consumables. The mix in variance between these periods was attributable to the introduction of our Single Cell ATAC consumables in the fourth quarter of 2018 which was met with significant initial demand. Revenue from each of our Single Cell Gene Expression, Single Cell Immune Profiling and Single Cell ATAC consumables increased in absolute dollars period over period. Revenue contribution from our Single Cell Gene Expression consumables decreased as a percentage of overall consumables revenue while revenue contribution from our Single Cell Immune Profiling and to a greater extent our Single Cell ATAC consumables increased as a percentage of overall consumables revenue for the year ended December 31, 2019. In the fourth quarter of 2019, we introduced our new Visium product, which exhibited high initial demand. Over time, as our instrument installed base grows and sales of our Visium products increase, we expect consumables revenue to constitute a larger percentage of revenue. In addition, our margins are higher for those instruments and consumables that we sell directly to customers as compared to those that we sell through distributors. While we expect the mix of direct sales as compared to sales through distributors to remain relatively constant in the near term, we are currently evaluating increasing our direct sales capabilities in certain geographies. From the fourth quarter of 2016 to the first quarter of 2019, we offered two versions of the Chromium Controller, one at a $125,000 list price with firmware that enabled the use of all our Chromium consumables and another at a $75,000 list price with firmware that enabled the use of only our Single Cell Chromium consumables. Beginning in the first quarter of 2019, we standardized our instrument offering on the fully enabled Chromium Controller with a list price of $75,000. In addition to this list price reduction, we offered various discount incentives to drive increased product adoption resulting in our Chromium Controller average selling price decreasing in the year ended 2019 from those realized in 2017 and 2018. The list prices of our consumables vary by solution. Future instrument and consumable selling prices and gross margins may fluctuate due to a variety of factors, including the introduction by others of competing products and solutions or the attempted integration by third parties of capabilities similar to ours into their existing products, such as sequencers. We aim to mitigate downward pressure on our average selling prices by increasing the value proposition offered by our instruments and consumables, primarily by, for example, expanding the applications for our instruments and increasing the quantity and quality of data that can be obtained using our consumables. In the near term, we expect the reduced accrued royalties related to the Bio-Rad litigation as described below under “Part I, Item 3 - Legal Proceedings,” product mix changes between established products and lower margin new products, and investment in the expansion of manufacturing, warehousing and product distribution facilities to have the greatest impact on our margins. In addition to the impact of competing products entering the market, the future margin profiles of our instruments and consumables will depend upon the outcome of such litigation, any royalties we are required to pay and the royalty rates and products to which such royalties apply. Continued investment in growth Our significant revenue growth has been driven by rapid innovation towards novel solutions that command price premiums and quick adoption of our solutions by our customer base. In 2019, we introduced four new products or updates to existing products. We intend to continue to make focused investments to increase revenue and scale operations to support the growth of our business and therefore expect expenses in this area to increase. We have invested, and will continue to invest, significantly in our manufacturing capabilities and commercial infrastructure. The transition to our new Pleasanton global headquarters and research and development center, which we completed in 2019, will help us achieve these goals in the near term by providing additional manufacturing, research and development and general office space. We plan to further invest in research and development as we hire employees with the necessary scientific and technical backgrounds to enhance our existing products and help us bring new products to market, and we expect to incur additional research and development expenses and higher stock-based compensation expenses as a result. We also plan to invest in sales and marketing activities, and we expect to incur additional general and administrative expenses and to have higher stock-based compensation expenses as we support our growth and status as a publicly traded company. As cost of revenue, operating expenses and capital expenditures fluctuate over time, we may experience short-term, negative impacts to our results of operations and cash flows, but we are undertaking such investments in the belief that they will contribute to long-term growth. Acquisitions of key technologies We have made, and intend to continue to make, investments that meet management’s criteria to expand or add key technologies that we believe will facilitate the commercialization of new products in the future. Such investments could take the form of an asset acquisition, the acquisition of a business or the exclusive or non-exclusive license of patented technology. Any such acquisitions we make may affect our future financial results. For example, our 2018 acquisitions of Spatial Transcriptomics and Epinomics were largely comprised of purchases of intellectual property which were expensed as in-process research and development in the quarter during which such acquisitions occurred. While we have not previously entered into material joint-development, partnership or joint- venture agreements, we may in the future decide to do so and any such arrangements may limit our rights and the commercial opportunities of any jointly developed technology. Components of Results of Operations Revenue We generate virtually all of our revenue through the sale of our instruments and consumables to customers. We also generate a small portion of our revenue from instrument service agreements which relate to extended warranties. Our revenue is subject to fluctuation based on the foreign currency in which our products are sold, principally for sales denominated in the euro. Revenue from consumables is largely driven by the size of our instrument installed base and the volume of consumables sold per instrument. Beginning in the fourth quarter of 2019, revenue from consumables also includes sales of our Visium products, which do not require the use of an instrument. Our instruments and consumables are generally sold without the right of return. Revenue is recognized as instruments and consumables are shipped. Revenue is recognized net of any sales incentive, distributor rebates and commissions and any taxes collected from customers. Some of our recently announced products, such as our Chromium Connect instrument, may result in our recognizing revenue with respect to such products upon installation rather than upon shipment. Instrument service agreements are typically entered into for a one-year term, with the coverage period beginning after the expiration of the standard one-year warranty period. Revenue from the sale of instrument service agreements are recognized ratably over the coverage period. Since its introduction in May 2019, the revenue attributable to our Next GEM microfluidics chips and associated consumables has continued to increase. We expect the transition to Next GEM to have a minimal impact on our revenue since we intend to sell those products at prices similar to the GEM products they are replacing. Cost of revenue, gross profit and gross margin Cost of revenue. Cost of revenue primarily consists of manufacturing costs incurred in the production process including personnel and related costs, costs of component materials, manufacturing overhead, packaging and delivery costs and allocated costs including facilities and information technology. We plan to hire additional employees as well as expand our manufacturing, warehousing and product distribution facilities, including increasing manufacturing automation to support our growth. In addition, cost of revenue includes royalty costs for licensed technologies included in our products, warranty costs, provisions for slow-moving and obsolete inventory and personnel and related costs and component costs incurred in connection with our obligations under our instrument service agreements. Beginning with the three months ended December 31, 2018, we began recording royalty accruals relating to sales of our GEM microfluidic chips and associated consumables, which are the subject of the Bio-Rad litigation discussed in Item I, Part 3 above, as cost of revenue. Gross profit/gross margin. Gross profit is calculated as revenue less cost of revenue. Gross margin is gross profit expressed as a percentage of revenue. Our gross profit and gross margins in future periods are expected to fluctuate from quarter to quarter and will depend on a variety of factors, including: market conditions that may impact our pricing; sales mix changes among consumables, instruments and services; product mix changes between established products and new products; excess and obsolete inventories; royalties; our cost structure for manufacturing operations relative to volume; and product warranty obligations. We currently anticipate that we will experience an increase in absolute dollars of both revenue and cost of revenue as we grow our business. Additionally, we expect gross margins to be positively impacted through the end of 2020 by reduced accrued royalties related to the Bio-Rad litigation. We expect this positive impact to be reduced, at least partially, by expenses related to our planned increases in manufacturing and distribution capacity in our Pleasanton, California headquarters as well as in certain locations outside the United States. As noted above, since Next GEM’s introduction in May 2019, we experienced improved gross profit for the year ended December 31, 2019, as we sold more Next GEM microfluidic chips and associated consumables because these products are not subject to the royalty payments to Bio-Rad. However, consumables subject to the 15% royalty accrual related to the Bio-Rad litigation still comprised a large percentage of our consumable sales for year ended December 31, 2019. We expect our gross margins for 2020 will be positively impacted by the continued transition of our customers to our Next GEM microfluidic chips and associated consumables since these microfluidic chips and associated consumables are not subject to the 15% royalty accrual (See “Part I, Item 3 - Legal Proceedings”) and have similar selling prices to the GEM products that they are replacing. Further developments in our litigation with Bio-Rad could have a material impact on our gross margins, both in the near term and beyond. Beginning on August 28, 2019, our cost of revenue no longer includes a 15% royalty accrual related to the Bio-Rad litigation on our instruments, since all Chromium instruments that have been sold since that date operate exclusively with our Next GEM solutions. As a result, we expect that this will continue to positively impact gross margins for those instrument sales in the near term. Because the Next GEM product selling prices and product manufacturing costs are similar to the GEM products they are replacing, we do not anticipate that Next GEM selling prices and product manufacturing costs will have a significant effect on our gross margins. Operating expenses Research and development. Research and development expense primarily consists of personnel and related costs, independent contractor costs, laboratory supplies, equipment maintenance prototype and materials expenses, amortization of developed technology and intangibles and allocated costs including facilities and information technology. We plan to continue to invest significantly in our research and development efforts, including hiring additional employees, to enhance existing products and develop new products. We also expect allocated facilities and information technology costs to increase in future periods as a result of higher costs associated with the transition to our global headquarters and research and development center in Pleasanton, California. As a result of these and other initiatives, we expect research and development expense will increase in absolute dollars in future periods and vary from period to period as a percentage of revenue. In-process research and development. In-process research and development consists of costs incurred to acquire intellectual property for research and development. We expect these costs to be recognized only in periods during which we complete an acquisition of assets comprised in whole or part of intellectual property for research and development. While we periodically evaluate acquisitions of this nature from time to time, we have no definitive agreements currently in place to acquire additional intellectual property for research and development. Selling, general and administrative. Selling, general and administrative expense primarily consists of costs related to the selling and marketing of our products, including sales incentives and advertising expenses and costs associated with our finance, accounting, legal (excluding accrued contingent liabilities), human resources and administrative personnel. Related costs associated with these functions, such as attorney and accounting fees, recruiting services, administrative services, insurance, public relations and communication activities, marketing programs and trade show appearances, travel, customer service costs and allocated costs including facilities and information technology, are also included in selling, general and administrative expenses. We expect to incur additional selling, general and administrative expenses due to continued investment in our sales, marketing and customer service efforts to support the anticipated growth of our business. We also expect increased infrastructure costs, as well as increased costs for accounting, human resources, legal including litigation-related fees and contingency payments, insurance, investor relations and other costs associated with being a public company. We expect to continue our hiring, in the United States as well as internationally, in all these areas in line with the continued growth of our business. We also expect allocated facilities costs to increase in future periods as a result of higher costs associated with the transition to our global headquarters and research and development center in Pleasanton, California. We also expect allocated information technology costs to increase following the expected implementation of a new enterprise resource planning system in 2020. As a result of these and other initiatives, we expect selling, general and administrative expenses to vary from period to period as a percentage of revenue and increase in absolute dollars in future periods. We expect our stock-based compensation expense allocated to cost of revenue, research and development expenses and selling, general and administrative expenses to increase in absolute dollars. Accrued contingent liabilities Accrued contingent liabilities is comprised of changes in our litigation reserve, primarily relating to our litigation with Bio-Rad discussed above under “Part I, Item 3 - Legal Proceedings.” The litigation reserve currently consists of accruals we make for our estimated losses in these pending legal proceedings. We record a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Changes in the reserve are made as we change our estimates or make payments in damages or settlement. In the year ended December 31, 2018, we recorded a $30.6 million charge to reflect our best estimate of loss in resolving our ongoing disputes. In the year ended December 31, 2019, we recorded an additional $1.5 million charge related to additional pre- and post- judgment interest. Beginning in the fourth quarter of 2018, we began recording an accrual for estimated royalties as cost of revenue. For the years ended December 31, 2019 and 2018, we accrued royalties of $29.2 million and $7.4 million, respectively. As of December 31, 2019 and 2018, the total amount accrued was $68.7 million and $38.0 million, respectively, comprising of the original charge, the estimated royalties and the interest charges. Should we ultimately obtain a more favorable outcome in this litigation any reversal of the accrual related to the litigation would be reflected as a change to this item in the period in which it occurs. Any reversal for amounts recorded as estimated royalty accruals would be credited to our cost of revenue in such period. Interest income Interest income consists of interest earned on our cash and cash equivalents which are invested in bank deposit and in money market funds. Interest expense Interest expense consists primarily of interest on our outstanding debt. Other income (expense), net Other income (expense), net primarily consists of realized and unrealized gains and losses related to foreign exchange rate remeasurements recorded from consolidating our foreign subsidiaries each period-end. Provision for income taxes Our provision for income taxes consists primarily of foreign taxes and state taxes in the United States. As we expand the scale and scope of our international business activities, any changes in the United States and foreign taxation of such activities may increase our overall provision for income taxes in the future. As of December 31, 2019, we had federal net operating loss carryforwards (“NOLs”) of approximately $110.7 million and federal tax credit carryforwards of approximately $12.3 million. Our federal NOLs generated after January 1, 2018, which total $6.5 million, are carried forward indefinitely, while all of our other federal NOLs and tax credit carryforwards expire beginning in 2032. As of December 31, 2019, we had state NOLs of approximately $87 million, which expire beginning in 2032. In addition, we had state tax credit carryforwards of approximately $11 million, which do not expire. Our ability to utilize such carryforwards for income tax savings is subject to certain conditions and may be subject to certain limitations in the future due to ownership changes. As such, there can be no assurance that we will be able to utilize such carryforwards. We have experienced a history of losses and a lack of future taxable income would adversely affect our ability to utilize these NOLs and research and development credit carryforwards. We currently maintain a full valuation allowance against these tax assets. Under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended (the “Code”), if a corporation undergoes an “ownership change,” the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change attributes, such as research tax credits, to offset its post-change income may be limited. In general, an “ownership change” will occur if there is a cumulative change in our ownership by “5% shareholders” that exceeds 50 percentage points over a rolling three-year period. Similar rules may apply under state tax laws. We completed a study through the date of our IPO to determine whether an ownership change had occurred under Section 382 or 383 of the Code, and we determined at that time that an ownership change occurred in 2013. As a result, our net operating losses generated through November 1, 2013 may be subject to limitation under Section 382 of the Code. The amount of pre-change loss carryforwards which may be subject to this limitation is $4.8 million. Our ability to use net operating loss carryforwards, research and development credit carryforwards and other tax attributes to reduce future taxable income and liabilities may be further limited as a result of future changes in stock ownership. As a result, if we earn net taxable income, our ability to use our pre-change net operating loss carryforwards or other pre-change tax attributes to offset United States federal and state taxable income may still be subject to limitations, which could potentially result in increased future tax liability to us. Results of Operations (1) Includes stock-based compensation expense as follows: The following table sets forth our consolidated results of operations data as a percentage of revenue for the periods presented. (1) Includes stock-based compensation expense as follows: Comparison of the Year Ended December 31, 2019 and 2018 Revenue Revenue increased $99.6 million, or 68%, for the year ended December 31, 2019 as compared to year ended December 31, 2018. The increase was driven primarily by an increase in consumables revenue partially offset by lower instrument revenue. Consumables revenue increased $99.3 million, or 92%, to $206.9 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The growth in consumables revenue was substantially driven by the growth in the instrument installed base. We experienced continued increases in revenue from our Single Cell Gene Expression, Single Cell Immune Profiling and Single Cell ATAC consumables. In addition, in the fourth quarter of 2019 we began selling our Visium Spatial Gene Expression solution which experienced high initial demand. Instrument revenue decreased $1.6 million, or 4%, to $34.9 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Lower average selling prices were partially offset by higher volumes. The Chromium Controller average selling price decreased by 21% for the year ended December 31, 2019. Lower average selling prices for the year ended 2019 as compared to 2018 were the result of our 2019 first quarter list price reduction for our fully enabled Chromium Controller which brought down the list price for these instruments to $75,000 from $125,000. In addition, we offered various pricing discounts to drive product adoption. The number of instruments sold during the year ended December 31, 2019 was 645 units, an increase of 22% as compared to the prior year, resulting in an ending installed base of 1,666 instruments. Cost of revenue, gross profit and gross margin Cost of revenue increased $32.4 million, or 113%, in the year ended December 31, 2019 as compared to the year ended December 31, 2018. In addition to higher cost of sales in line with revenue growth, the increase was also due to additional accrued royalties of $21.7 million related to the judgment in the Bio-Rad litigation and higher inventory reserves. Gross profit increased $67.2 million, or 57%, and gross margin percentage decreased by 5 points for the year ended December 31, 2019 as compared to the year ended December 31, 2018. These changes were primarily due to increased revenue partially offset by higher accrued royalties related to the judgment in the Bio-Rad litigation in the year ended December 31, 2019. Operating expenses N/M: result not meaningful. Research and development expense increased $35.6 million, or 75%, for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The increase was primarily driven by an increase in personnel expenses of $19.3 million and laboratory materials, supplies and expensed equipment of $10.9 million, which were attributable to an increase in headcount and expenses supporting our continued research and development efforts to enhance our existing products and develop new products. In addition, we incurred additional allocated costs of $5.0 million for facilities to support the expansion of our operations. In-process research and development expense for the year ended December 31, 2018 relates to intellectual property we purchased in connection with our acquisitions of Spatial Transcriptomics and Epinomics and our acquisition of an exclusive license to certain intellectual property from Prognosys. There were no similar purchases in the year ended December 31, 2019. Selling, general and administrative expenses increased $42.9 million, or 49%, for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The increase in expenses was primarily driven by an increase in personnel expenses of $27.8 million, increased allocated costs of $7.3 million for facilities, and an increase of $3.6 million of marketing expenses to support our future sales growth and the overall expansion of our operations. In addition, expenses for the year ended December 31, 2019 included $3.6 million of increased professional services and insurance costs associated with our status as a publicly traded company compared to the year ended December 31, 2018. Accrued contingent liabilities decreased by $29.1 million, or 95%, for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The change is due to the decrease in expenses relating to the litigation with Bio-Rad, for which we established an accrual of $30.6 million in November 2018. Other income (expense), net Interest income increased by $1.8 million to $2.8 million for the year ended December 31, 2019 from $1.0 million for the year ended December 31, 2018. The increase was primarily due to interest income earned from the investment of the net proceeds from the IPO completed in September 2019. Interest expense increased by $0.7 million to $3.1 million for the year ended December 31, 2019 from the year ended December 31, 2018. The slight increase was driven primarily by higher interest rates on our then-outstanding term loan borrowings and the interest paid on the revolving credit facility. Other income (expense) is comprised of realized and unrealized losses from foreign currency rate measurement fluctuations for the years ended December 31, 2019 and December 31, 2018. Comparison of the Year Ended December 31, 2018 and 2017 Revenue Revenue increased $75.2 million, or 106%, for the year ended December 31, 2018 as compared to the prior year. The increase was driven primarily by an increase in consumables revenue. Consumables revenue increased $61.3 million, or 133%, to $107.5 million for the year ended December 31, 2018 as compared to the prior year. $54.9 million of the increase in consumables revenue was due to growth in the instrument installed base and $6.4 million of the increase was due to increased pull-through per instrument driven by new product introductions and updates to existing products. Instrument revenue increased $12.1 million, or 49%, for the year ended December 31, 2018 as compared to the prior year due to higher volumes of instruments sold, partially offset by lower average selling prices. The number of instruments sold during the year ended December 31, 2018 was 530 units, an increase of 74% as compared to the prior year, resulting in an ending installed base of 1,021 instruments. The Chromium Controller average selling price decreased by 14% from the prior year, contributing to the $6.0 million decrease in instruments revenue. The incremental discounts offered to drive product adoption and increase our instrument installed base resulted in $4.4 million of this decrease in instrument revenue and the shift towards the version of the Chromium Controller with firmware that enabled the use of only our Single Cell Chromium Consumables, which was offered at a lower price than the fully enabled version, resulted in $1.6 million of this decrease in instrument revenue. Cost of revenue, gross profit and gross margin Cost of revenue increased $18.1 million, or 171%, for the year ended December 31, 2018 as compared to the prior year. In addition to higher cost of sales in line with revenue growth, the increase was primarily due to additional royalties of $7.4 million related to the Bio-Rad litigation which we began accruing in the fourth quarter of 2018, higher inventory reserves of $1.2 million as we transitioned to newer versions of our products and higher warranty-related expenses of $1.2 million. Gross profit increased $57.1 million, or 94%, for the year ended December 31, 2018 as compared to the prior year, primarily due to increased revenue partially offset by additional accrued royalties. Gross margin percentage decreased by 5 points for the year ended December 31, 2018 as compared to the prior year, driven primarily by accrued royalties in the fourth quarter of 2018. Operating expenses Research and development expense increased $15.4 million, or 48%, for the year ended December 31, 2018 as compared to the prior year. The increase was primarily driven by an increase in personnel expenses of $7.8 million and laboratory materials and supplies expenses of $4.4 million, which were attributable to an increase in headcount and expenses supporting our continued research and development efforts to enhance our existing products and develop new products. In-process research and development expense relates to intellectual property we purchased in 2018 in connection with our acquisitions of Spatial Transcriptomics and Epinomics and our acquisition of an exclusive license to certain intellectual property from Prognosys, in each case to be used as part of our research and development efforts to enhance our existing products and develop new products. There were no similar purchases in 2017. See the section above titled “-Acquisitions.” Selling, general and administrative expenses increased $41.2 million, or 88%, for the year ended December 31, 2018 as compared to the prior year. The increase in expenses was primarily driven by an increase in personnel expenses of $15.0 million to support our sales growth and the overall expansion of our operations and increased outside legal fees of $16.5 million. Accrued contingent liabilities consisted of $30.6 million of expenses relating to the litigation with Bio-Rad, for which we established an accrual in November 2018. There was no similar accrual in 2017. Other income (expense), net N/M: result not meaningful. Interest income increased $0.7 million for the year ended December 31, 2018 as compared to the prior year. The increase was driven primarily by higher cash and cash-equivalent balances in interest bearing accounts along with increased yields on such balances. Interest expense increased $1.6 million for the year ended December 31, 2018 as compared to the prior year. The increase was driven primarily by higher outstanding term loan borrowings in 2018 following the refinancing of our previous loan and security agreement in February 2018 and increased interest rates. The change in other income (expense), net during the year ended December 31, 2018 was driven by realized and unrealized losses from foreign currency rate measurement fluctuations. Foreign currency losses increased compared to the prior year as a result of the overall strengthening of the U.S. dollar when compared to the foreign currencies in which we operate. Liquidity and Capital Resources As of December 31, 2019, we had approximately $424.2 million in unrestricted cash and cash equivalents which were primarily held in U.S. bank deposit accounts and money market funds, $33.4 million in accounts receivable and an accumulated deficit of $262.4 million. Approximately $5.0 million of cash, which serves as collateral for an outstanding letter of credit, $45.2 million of cash on deposit with a financial institution in connection with the issuance of a bond related to the Bio-Rad litigation, and $2.1 million of cash, which is held in escrow related to royalties on certain sales in connection with the Bio-Rad litigation, were classified as noncurrent restricted cash as of December 31, 2019. While we generated positive cash flows from operations of $34.6 million for the year ended December 31, 2019, we have generated negative cash flows from operations since inception through the year ended December 31, 2019 and we have generated losses from operations since inception as reflected in our accumulated deficit of $262.4 million. We expect to continue to incur operating losses for the foreseeable future due to the investments we intend to make and as a result we may require additional capital resources to execute strategic initiatives to grow our business. In August 2019, the U.S. District Court for the District of Delaware entered final judgment in the amount of approximately $35 million and subsequently ordered that we may post a bond in the amount of $52 million in lieu of payment of the final judgment. On September 13, 2019, we posted a $52 million bond in lieu of payment of the final judgment pending our ongoing appeal. In connection with the bond, we deposited $45 million as collateral in a segregated cash account, where it will be held until the conclusion of the appeal. On October 10, 2019, the Court denied our motion to decrease the bond amount and stayed any execution or enforcement of the judgment until the completion of appeal, and for thirty days thereafter. Pursuant to the judgment, we place into escrow each quarter an amount equal to 15% of net sales of our GEM microfluidic chips and associated consumables subsequent to the effective date of the injunction, which was August 28, 2019. The amounts have and will be held until conclusion of the appeal and are classified as noncurrent restricted cash. As of December 31, 2019, the amount placed into escrow was $2.1 million. In October 2019, we entered into an agreement to make an aggregate payment of $25.0 million in annual amounts of $6.25 million over four years beginning in January 2020 in connection with the 2019 Becton Dickinson Settlement and Patent Cross License Agreement. See Note 7 to the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report. We currently anticipate making aggregate capital expenditures of between approximately $55 million and $70 million during the next 18 months, which includes the construction costs of our global expansion and for equipment to be used for manufacturing and research and development. Our future capital requirements will depend on many factors including our revenue growth rate, research and development efforts, the timing and extent of additional capital expenditures to invest in existing and new facilities, the expansion of sales and marketing and international activities, the timing of capital expenditures relating to our planned implementation of a new enterprise resource planning system and the introduction of new products. We have and may in the future enter into arrangements to acquire or invest in businesses, services and technologies, including intellectual property rights, and any such acquisitions or investments could significantly increase our capital needs. We believe that our existing cash and cash equivalents, and cash generated from sales of our products 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. Sources of liquidity Since our inception, we have financed our operations and capital expenditures primarily through sales of convertible preferred stock and common stock, revenue from sales and issuances of debt. In September 2019, we completed our IPO for proceeds of $410.8 million, net of offering costs, underwriter discounts and commissions of $37.7 million. Silicon Valley Bank Loan and Security Agreement We are party to a Second Amended and Restated Loan and Security Agreement, dated February 9, 2018, with Silicon Valley Bank (as amended, restated or supplemented from time to time, the “Loan and Security Agreement”), under which (i) $30.0 million of term loan borrowings were outstanding and (ii) no borrowings were outstanding under the $25.0 million revolving line of credit, in each case as of December 31, 2019. The term loan borrowings were prepaid in full on February 20, 2020. We were in compliance with all covenants under the Loan and Security Agreement as of December 31, 2019, remained in compliance with such covenants at the time the term loan borrowings were prepaid in full on February 20, 2020 and currently remain in compliance with such covenants. Borrowings under the term loan were to mature on December 1, 2022 and accrued interest at a floating rate equal to the greater of The Wall Street Journal prime rate plus 2.0% or 6.25% per annum. Monthly payments of interest were due on the term loan through December 31, 2019, after which equal monthly installments of principal and interest were to be due. The revolving line of credit matures on December 1, 2022 and the amount available under the revolving line of credit is based on 80% of eligible receivables and is subject to a borrowing base calculation. Borrowings under the revolving line of credit accrue interest which is payable monthly at a floating rate equal to the greater of The Wall Street Journal prime rate plus 0.25% or 4.5% per annum. Cash flow summary The following table summarizes our cash flows for the periods indicated: Operating activities The net cash provided by operating activities of $34.6 million in the year ended December 31, 2019 was due primarily to a net loss of $31.3 million with adjustments for stock-based compensation expense of $13.3 million and depreciation and amortization of $7.1 million and an increase from the net change in operating assets and liabilities of $44.8 million. The inflow from operating assets and liabilities was primarily due to an increase in accrued contingent liabilities of $30.7 million, an increase in noncurrent deferred rent of $12.7 million, an increase in accrued expenses and other current liabilities of $5.8 million, an increase in accrued compensation and other related benefits of $5.3 million, and an increase in accounts payable of $4.9 million, partially offset by an increase in inventory of $6.7 million, an increase in accounts receivable of $5.3 million, an increase in prepaid expenses and other current assets of $3.5 million. The net cash used in operating activities of $76.4 million in the year ended December 31, 2018 was due primarily to a net loss of $112.5 million with adjustments for depreciation and amortization of $3.9 million and stock-based compensation expense of $2.7 million and an increase from the net change in operating assets and liabilities of $28.0 million. The inflow from operating assets and liabilities was primarily due to the establishment of an accrual for contingent liabilities of $38.0 million, an increase in noncurrent deferred rent of $3.3 million, an increase in accounts payable of $2.6 million, an increase in accrued compensation and other related benefits of $2.6 million, an increase in accrued expenses and other current liabilities of $1.7 million and an increase in deferred revenue of $1.7 million, partially offset by an increase in accounts receivable of $14.7 million, an increase in inventory of $3.7 million and an increase in prepaid expenses and other current assets of $2.4 million. The net cash used in operating activities of $10.7 million in the year ended December 31, 2017 was due primarily to a net loss of $18.8 million with adjustments for depreciation and amortization of $4.3 million and stock-based compensation expense of $1.7 million. The inflow from operating assets and liabilities was primarily due to an increase in accrued compensation and other related benefits of $3.5 million, an increase in accounts payable of $3.0 million, an increase in accrued expenses and other current liabilities of $1.8 million, and an increase in deferred revenue of $1.3 million, partially offset by an increase in accounts receivable of $5.1 million, an increase in inventory of $2.0 million and an increase in prepaid expenses and other current assets of $0.7 million. Investing activities The net cash used in investing activities of $42.8 million in the year ended December 31, 2019 was due to purchases of property and equipment of $42.7 million. The net cash used in investing activities of $6.7 million in the year ended December 31, 2018 was due to purchases of property and equipment of $6.3 million and the purchase of intangible assets of $0.4 million. The net cash used in investing activities of $3.8 million in the year ended December 31, 2017 was due to purchases of property and equipment of $3.8 million. Financing activities The net cash provided by financing activities of $414.6 million in the year ended December 31, 2019 was primarily from proceeds of $410.8 million from issuance of Class A common stock in our IPO, net of issuance costs and proceeds of $3.8 from the issuance of common stock from the exercise of stock options. The net cash provided by financing activities of $105.4 million in the year ended December 31, 2018 was primarily from proceeds from the issuance of convertible preferred stock, net of issuance costs, of $84.8 million, net proceeds from additional borrowings of $19.5 million, and proceeds of $1.8 million from the issuance of common stock from the exercise of stock options, partially offset by payments on debt obligations of $0.7 million. The net cash provided by financing activities of $20.6 million in the year ended December 31, 2017 was primarily from proceeds from the issuance of convertible preferred stock, net of issuance costs, of $20.0 million and proceeds of $1.1 million from the issuance of common stock from the exercise of stock options, partially offset by payments of capital lease obligation of $0.4 million. Concentrations of credit risk As of December 31, 2019 and 2018, no single customer represented 10% or more of our accounts receivable balance. There was no single customer, including distributors, that individually exceeded 10% of our revenue during the years ended December 31, 2019, 2018 and 2017. Contractual Obligations and Commitments The following table summarizes our commitments to settle contractual obligations as of December 31, 2019: (1) As of December 31, 2019, the outstanding principal balance of our term loan under our Loan and Security Agreement was $30.0 million. Monthly payments of interest were due under the term loan through December 31, 2019, with equal monthly installments of principal and interest due for thirty-six months thereafter. An end of term payment of $1.8 million due to the lender upon maturity, prepayment or acceleration of the term loan is reflected as additional interest expense over the term of the loan. On February 20, 2020 we prepaid the outstanding principal balance in full. See Note 5 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report for more information regarding the terms of the Loan and Security Agreement. (2) We have entered into various non-cancelable leases for certain offices with contractual lease periods expiring between 2019 and 2029. As of December 31, 2019, we had an unused letter of credit in the amount of $5.0 million outstanding associated with the lease of our new Pleasanton headquarters and research and development center. (3) We are required to make an aggregate payment of $25.0 million in four annual installments related to the purchase of certain licenses. The present value of these payments of $22.4 million is recognized as a liability in our audited consolidated financial statements as of December 31, 2019. (4) Other obligations include purchase obligations, prepaid services and royalties. Purchase obligations relate to our contract manufacturer which manufacturers our instruments and makes advance purchases of components based on our sales forecasts and the placement of purchase orders by us. To the extent components are purchased by the contract manufacturer on our behalf and cannot be used by the contract manufacturer’s other customers, we are obligated to purchase such components. In addition, certain supplier agreements require us to make minimum annual purchases under the agreements. To date, we have met the minimum purchase commitments. Prepaid services include subscription software services for which we have entered into non-cancelable arrangements. Royalties include minimum commitments for license arrangements. 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. Critical Accounting Policies and Estimates Our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report 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 Consolidated Financial Statements included in Part II, Item 8 of this Annual Report. Revenue recognition We generate revenue from sales of our products and services. Our products consist of instruments and consumables, including proprietary microfluidic chips, slides, reagents and other consumables for both our Visium and Chromium solutions. We also generate a small portion of our revenue from instrument service agreements which relate to extended warranties. Effective January 1, 2019, we adopted Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers, using the modified retrospective transition method. The cumulative effect of initially adopting ASC Topic 606 was immaterial. The revenue recognition accounting policy described below relates to revenue transactions from January 1, 2019 and onward, which are accounted for in accordance with ASC Topic 606-Revenue from Contracts with Customers. We recognize revenue when control of the products and services is transferred to our customers in an amount that reflects the consideration we expect to receive from our customers in exchange for those products and services. This process involves identifying the contract with a customer, determining the performance obligations in the contract, determining the contract price, allocating the contract price to the distinct performance obligations in the contract, and recognizing revenue when the performance obligations have been satisfied. A performance obligation is considered distinct from other obligations in a contract when it provides a benefit to the customer either on its own or together with other resources that are readily available to the customer and is separately identified in the contract. We consider a performance obligation satisfied once we have transferred control of a good or service to the customer, meaning the customer has the ability to use and obtain the benefit of the good or service. Revenue from product sales is recognized when control of the product is transferred, which is generally upon shipment to the customer. In instances where right of payment or transfer of title is contingent upon the customer’s acceptance of the product, revenue is deferred until all acceptance criteria have been met. Instrument service agreements, which relate to extended warranties, are typically entered into for one-year terms, following the expiration of the standard one-year warranty period. Revenue for extended warranties is recognized ratably over the term of the extended warranty period as a stand ready performance obligation. Revenue is recorded net of discounts, distributor commissions and sales taxes collected on behalf of governmental authorities. Customers are invoiced generally upon shipment, or upon order for services, and payment is typically due within 45 days. Cash received from customers in advance of product shipment or providing services is recorded as a contract liability. Our contracts with our customer generally do not include rights of return or a significant financing component. We regularly enter into contracts that include various combinations of products and services which are generally distinct and accounted for as separate performance obligations. The transaction price is allocated to each performance obligation in proportion to its standalone selling price. We determine standalone selling price using average selling prices with consideration of current market conditions. If the product or service has no history of sales or if the sales volume is not sufficient, we rely upon prices set by management, adjusted for applicable discounts. The revenue recognition accounting policy described below relates to revenue transactions prior to January 1, 2019, which are accounted for in accordance with ASC Topic 605-Revenue Recognition. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price to the customer is fixed or determinable and collectability is reasonably assured. We assess collectability based on factors such as the customer’s creditworthiness and past collection history, if applicable. If collection is not reasonably assured, revenue recognition is deferred until receipt of payment. We also assess whether a price is fixed or determinable by, among other things, reviewing contractual terms and conditions related to payment. Delivery occurs when there is a transfer of title and risk of loss passes to the customer. Certain of our sales arrangements involve the delivery of multiple products and services within contractually binding arrangements. Multiple-deliverable sales transactions typically consist of the sale and delivery of one or more instruments and consumables together and may include an instrument service agreement. For sales arrangements that include multiple deliverables, we use the stated contractual price for the instrument service agreements, if and when sold, and allocate the remaining contract consideration at the inception of the contract to the other units of accounting based upon their relative selling price. We may use our best estimate of selling price for individual deliverables when vendor specific objective evidence or third-party evidence is unavailable. A delivered item is considered to be a separate unit of accounting when it has value to the customer on a stand-alone basis. Our products, other than instrument service agreements, are typically delivered together or within a short time frame, generally within one to three months of the contract date. Instrument service agreements are typically entered into for a one-year term, following the expiration of the standard one-year warranty period. Our products are generally sold without the right of return. Amounts received before revenue recognition criteria are met are classified in the balance sheets as deferred revenue. Inventory Inventory is recorded at the lower of cost, determined on a first-in, first-out basis, or net realizable value. We use judgment to analyze and determine if the composition of its inventory is obsolete, slow-moving or unsalable and frequently review such determinations. We write down specifically identified unusable, obsolete, slow-moving or known unsalable inventory in the period that it is first recognized by using a number of factors including product expiration dates, open and unfulfilled orders and sales forecasts. Any write-down of its inventory to net realizable value establishes a new cost basis and will be maintained even if certain circumstances suggest that the inventory is recoverable in subsequent periods. Costs associated with the write-down of inventory are recorded to cost of revenue on our consolidated statements of operations. We make assumptions about future demand, market conditions and the release of new products that may supersede old ones. However, if actual market conditions are less favorable than anticipated, additional inventory write-downs could be required. Stock-based compensation We estimate the fair value of share-based payment awards granted to employees and directors on the grant date using the Black-Scholes option-pricing model. The fair value of share-based payment awards is recognized as compensation expense on a straight-line basis over the requisite service period in which the awards are expected to vest, which is generally four years, and forfeitures are recognized as they occur. Share-based payment awards that include both a service condition and a performance condition are considered expected to vest when the performance condition is probable of being met. The Black-Scholes model considers several variables and assumptions in estimating the fair value of stock-based awards. These variables include the per share fair value of the underlying common stock, exercise price, expected term, risk-free interest rate, expected annual dividend yield and expected stock price volatility over the expected term. For all stock options granted, we calculated the expected term using the simplified method for “plain vanilla” stock option awards. We had no publicly available stock price information prior to our IPO and limited available stock price information subsequent to our IPO; therefore, we have used the historical volatility of the stock price of similar publicly traded peer companies. 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. Equity instruments granted to nonemployees are valued using the Black-Scholes option pricing model. Nonemployee stock-based compensation is recognized over the related performance period, which is generally the vesting term of the awards. Common stock valuation Prior to our IPO, there was no public market for our common stock. As such, the estimated fair value of our common stock and underlying stock options has been determined at each grant date by our board of directors, with input from management, based on the information known to us on the grant date and upon a review of any recent events and their potential impact on the estimated per share fair value of our common stock. As part of these fair value determinations, our board of directors obtained and considered valuation reports prepared by a third-party valuation firm in accordance with the guidance outlined in the American Institute of Certified Public Accountants Technical Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. For valuations after the completion of our initial public offering, the fair value of each share of underlying common stock is based on the closing price of our Class A common stock as reported on the date of grant. Accrued contingent liabilities We have been and are currently involved in various legal proceedings which arise in the ordinary course of business. The outcomes of these legal proceedings are not within our complete control or may not be known for prolonged periods of time. Management is required to assess the probability of loss and amount of such loss, if any, in preparing our consolidated financial statements. We evaluate the likelihood of a potential loss from legal proceedings to which we are a party. We record a liability for such claims when a loss is deemed probable and the amount can be reasonably estimated. Significant judgment may be required in the determination of both probability and whether an exposure is reasonably estimable. Our judgments are subjective based on the status of the legal proceedings, the merits of our defenses and consultation with in-house and outside legal counsel. As additional information becomes available, we reassess the potential liability related to pending claims and may revise our estimates. Due to the inherent uncertainties of the legal processes in the multiple jurisdictions in which we operate, our judgments may be materially different than the actual outcomes, which could have material adverse effects on our business, financial conditions and results of operations. Acquisitions of intellectual property We evaluate acquisitions of assets and other similar transactions to assess whether or not the transaction should be accounted for as a business combination or asset acquisition by first applying a screen to determine if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. If the screen is met, the transaction is accounted for as an asset acquisition. If the screen is not met, further determination is required as to whether or not we have acquired inputs and processes that have the ability to create outputs, which would meet the requirements of a business. We account for an asset acquisition under Accounting Standards Codification, Business Combinations Topic 805, Subtopic 50, which requires the acquiring entity in an asset acquisition to recognize net assets based on the cost to the acquiring entity on a relative fair value basis, which includes transaction costs in addition to consideration given. Goodwill is not recognized in an asset acquisition and any excess consideration transferred over the fair value of the net assets acquired is allocated to the non-monetary identifiable assets based on relative fair values. In-process research and development expenses are expensed as incurred provided there is no alternative future use. Contingent consideration payments in asset acquisitions are recognized when the contingency is resolved and the consideration is paid or becomes payable (unless the contingent consideration meets the definition of a derivative, in which case the amount becomes part of the basis in the asset acquired). Upon recognition of the contingent consideration payment, the amount is included in the cost of the acquired asset or group of assets. 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 (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. Recent Accounting Pronouncements See Note 2, “Summary of Significant Accounting Policies” in our Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report for a discussion of recent accounting pronouncements. 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 this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.

<s>[INST] As discussed in the section titled “Special Note Regarding Forward Looking Statements,” the following discussion and analysis, in addition to historical financial information, contains forwardlooking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forwardlooking statements as a result of various factors, including those set forth in the section titled “Risk Factors” under Part I, Item 1A above. We operate on a fiscal year that ends on December 31. Overview We are a life sciences technology company focused on building innovative products and solutions to interrogate, understand and master biological systems at resolution and scale that matches the complexity of biology. Our expanding suite of offerings leverages our crossfunctional expertise across chemistry, biology, hardware and software to provide a comprehensive, dynamic and highresolution view of complex biological systems. We have launched multiple products that enable researchers to understand and interrogate biological analytes in their full biological context. Our commercial product portfolio leverages our Chromium instruments, which we refer to as “instruments,” and our proprietary microfluidic chips, slides, reagents and other consumables for both our Visium and Chromium solutions, which we refer to as “consumables.” We bundle our software with these products to guide customers through the workflow, from sample preparation through analysis and visualization. Since launching our first product in mid2015, and as of December 31, 2019, we have sold 1,666 instruments to customers around the world, including 97 of the top 100 global research institutions as ranked by Nature in 2018 based on publications and 19 of the top 20 global biopharmaceutical companies by 2018 revenue. Our products cover a wide variety of applications and allow researchers to analyze biological systems at fundamental resolutions and on massive scales, such as at the single cell level for millions of cells. Our Chromium instruments and Chromium consumables are designed to work together exclusively. After buying a Chromium instrument, customers purchase consumables from us for use in their experiments. Accordingly, as the installed base of our instruments grows, we expect recurring revenue from consumable sales to become an increasingly important driver of our operating results. As such, our revenue growth is expected to outpace growth in our instrument placements as our business develops. In addition to instrument and consumable sales, we derive revenue from postwarranty service contracts for our Chromium instruments. For the years ended December 31, 2019 and 2018, sales of our Chromium instruments accounted for 14% and 25% of our revenue, respectively, sales of our consumables accounted for 84% and 74% of our revenue, respectively, and sales of services accounted for 2% and 1% of our revenue, respectively. We currently serve thousands of researchers in more than 40 countries. Our customers include a range of academic, government, biopharmaceutical, biotechnology and other leading institutions around the globe. In both the years ended December 31, 2019 and 2018, approximately 70% of our direct sales revenue came from sales to academic institutions. As of December 31, 2019, we employed a commercial team of over 200 employees, including more than 75 commissioned sales representatives, many with Ph.D. degrees and many with significant industry experience. We follow a direct sales model in North America and certain regions of Europe, representing the majority of our revenue. We sell our products through thirdparty distributors in Asia, certain regions of Europe, Oceania, South America, the Middle East and Africa. We currently sell our products for research use only. For the years ended December 31, 2019 and 2018, sales within North America accounted for approximately 57% and 58% of our revenue, respectively. Revenue increased 68% to $245.9 million in the year ended December 31, 2019 as compared to $146.3 million in the year ended December 31, 2018, primarily due to the adoption of our instruments by customers and the associated consumables on those instruments. We focus a substantial portion of our resources on developing new products and solutions. Our research and development efforts are centered around [/INST] Positive. </s>

Annovis Bio, Inc.

2020-03-25

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 appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. You should read “Cautionary Note Regarding Forward-Looking Statements” and Item 1A. Risk Factors of 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 in or implied by the forward-looking statements contained in the following discussion and analysis. Overview Company Overview We are a clinical stage, drug platform company addressing neurodegeneration such as Alzheimer’s disease (AD), Parkinson’s disease (PD) and Alzheimer’s disease in Down Syndrome (AD-DS). Our lead compound, ANVS401, is a small molecule administered orally that attacks neurodegeneration by entering the brain and inhibiting the translation of neurotoxic proteins-amyloid precursor protein APP/Aβ (APP), tau/phospho-tau (tau) and α-Synuclein (αSYN)-thereby improving axonal transport. Human studies in four MCI patients have shown that ANVS401 lowered the levels of neurotoxic proteins and inflammatory factors. In preclinical studies, lower neurotoxic protein levels led to improved axonal transport, reduced inflammation, lower nerve cell death and improved function. AD is a substantial market affecting over 30 million people worldwide and is expected to grow to over 100 million by 2050. While the market for neurodegeneration is over $100 billion, to date there are no disease modifying drugs (DMD) for any neurodegenerative condition. Enormous efforts have gone into developing better drugs to treat neurodegeneration and the outcomes have been sobering. The results of clinical trials in AD, the two AD orphan indications AD-DS and early onset familial AD or in PD have not supported the development of successful disease modifying therapies. ANVS401 is a small lipophilic molecule that is orally available and readily enters the brain, as demonstrated by preclinical pharmacokinetics analyses showing brain concentrations approximately six to eight times higher than plasma concentrations. ANVS401 has a mechanism of action that we believe to be unique, in that it inhibited the over-translation of and, therefore, reduced the levels of several neurotoxic proteins both in vitro and in vivo including APP, tau and αSYN. By targeting multiple neurotoxic proteins, ANVS401 resembles a combination therapy approach, with the added convenience of being a single drug with a single drug target. Therefore, we have worked to understand how ANVS401 is able to inhibit the translation of more than one neurotoxic protein. We are presently conducting a Phase 2a study in AD patients in collaboration with the ADCS and plan to initiate a second Phase 2a proof-of-concept study of ANVS401 in the first quarter of 2020 with 50 PD patients. We have designed the two Phase 2a studies with Parexel by applying our understanding of the underlying disease states in neurodegeneration and by measuring not just target, but also pathway validation in the spinal fluid of these patients. If we are able to show both target and pathway validation in two patient populations, we believe that our opportunity for successful Phase 3 studies is better than if we merely demonstrated target validation in one patient population. We have never been profitable and have incurred net losses since inception. Our net losses were $990,980 and $713,871 for the years ended December 31, 2019 and 2018, respectively, and our accumulated deficit at December 31, 2019 was $8,777,028. We expect to incur losses for the foreseeable future, and we expect these losses to increase as we continue our development of, and seek regulatory approvals for, 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. Financial Operations Overview The following discussion sets forth certain components of our statements of operations as well as factors that impact those items. Research and Development Expenses Our research and development expenses consist of expenses incurred in development and clinical studies relating to our product candidates, including: • expenses associated with clinical development; • personnel-related expenses, such as salaries, benefits, travel and other related expenses, including stock-based compensation; • payments to third-party contract research organizations, or CROs, contractor laboratories and independent contractors; and • depreciation, maintenance and other facility-related expenses. We expense all research and development costs as incurred. Clinical development expenses for our product candidates are a significant component of our current research and development expenses. Product candidates in later stage clinical development generally have higher research and development expenses than those in earlier stages of development, primarily due to increased size and duration of the clinical trials. We track and record information regarding external research and development expenses for each study or trial that we conduct. From time to time, we use third-party CROs, contractor laboratories and independent contractors in clinical studies. We recognize the expenses associated with third parties performing these services for us in our clinical studies based on the percentage of each study completed at the end of each reporting period. Our research and development expenses in 2019 primarily related to two long-term animal toxicology studies which began in November 2019-a six-month study in rats and a nine-month study in dogs. We expect that our research and development expenses in 2020 and for the next several years will be higher than in 2019 as a result of the continuation of our long-term toxicology studies, increased expenditures for our Phase 2a study in AD and our expected initiation of our Phase 2a study in PD in April 2020. These expenditures are subject to numerous uncertainties regarding timing and cost to completion. Completion of our clinical development and clinical trials may take several years or more and the length of time generally varies according to the type, complexity, novelty and intended use of our product candidates. The cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including, among others: • the number of sites included in the clinical trials; • the length of time required to enroll suitable patients; • the size of patient populations participating in the clinical trials; • the duration of patient follow-ups; • the development stage of the product candidates; and • the efficacy and safety profile of the product candidates. Due to the early stage of our research and development, we are unable to determine the duration or completion costs of our development of ANVS401. As a result of the difficulties of forecasting research and development costs of ANVS401 as well as the other uncertainties discussed above, we are unable to determine when and to what extent we will generate revenues from the commercialization and sale of approved product candidates. General and Administrative Expenses General and administrative expenses consist primarily of salaries, benefits and other related costs, including stock-based compensation, for personnel serving in our executive, finance, accounting, legal and human resource functions. Our general and administrative expenses also include facility and related costs not included in research and development expenses, professional fees for legal services, including patent-related expenses, consulting, tax and accounting services, insurance and general corporate expenses. We expect that our general and administrative expenses will increase with the continued development and potential commercialization of our product candidates. We expect that our general and administrative expenses in 2020 and for the next several years will be higher than in 2019 as we increase our employee count. Following our IPO in January 2020, we also anticipate increased expenses relating to our operation as a public company, including increased costs for the hiring of additional personnel, and for payment to outside consultants, including lawyers and accountants, to comply with additional regulations, corporate governance, internal control and similar requirements applicable to public companies, as well as increased costs for insurance. Interest Income (Expense), net Interest income (expense) consists primarily of interest earned on our cash and cash equivalents and interest expense on our convertible promissory notes, including amortization of deferred financing fees and debt discount. Grant Income Grants received are recognized as grant income in the statements of operations as and when they are earned for the specific research and development projects for which these grants are designated. In September 2019, we received a Notice of Award for a $1.7 million grant from the National Institute on Aging of the NIH to cover the costs of long-term toxicology studies on ANVS401 in rats and dogs. We expect grant income to increase in 2020 as a result of the continuation of our long-term toxicology studies. Income Taxes As of December 31, 2019, the Company had U.S. federal net operating loss carryforwards of $4,256,228, which may be available to offset future income tax liabilities. Federal net operating loss carryforwards generated in 2017 and prior of $2,764,240 will expire beginning 2032. The remaining $1,491,988 of federal net operating loss carryforwards generated in 2018 and later, do not expire but are limited 80% of taxable income in future years. Net operating loss and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service (the “IRS”) and may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant shareholders over a three-year period in excess of 50% as defined under Sections 382 and 383 in the Internal Revenue Code. This could substantially limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities. The amount of the annual limitation is determined based on our value immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. Critical Accounting Policies and Use of Estimates We have based our management’s discussion and analysis of financial condition and results of operations on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments, including those related to clinical development expenses and stock-based compensation. We base our estimates on historical experience and on various other factors that we believe to be appropriate under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are more fully discussed in Note 2 to our audited financial statements appearing at the end of 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. Research and Development Expenses We rely on third parties to conduct our preclinical studies and to provide services, including data management, statistical analysis and electronic compilation. Once our clinical trials begin, at the end of each reporting period, we will compare the payments made to each service provider to the estimated progress towards completion of the related project. Factors that we will consider in preparing these estimates include the number of patients enrolled in studies, milestones achieved and other criteria related to the efforts of our vendors. These estimates will be subject to change as additional information becomes available. Depending on the timing of payments to vendors and estimated services provided, we will record net prepaid or accrued expenses related to these costs. Fair Value of Common Stock and Stock-Based Compensation We account for grants of stock options to employees and non-employees based on their grant date fair value and recognize compensation expense over the vesting periods. We estimate the fair value of stock options as of the date of grant using 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, the expected volatility of our common stock, the risk-free interest rate and the expected dividend rate. Prior to our IPO, in the absence of a public trading market for our common stock, on each grant date, we developed an estimate of the fair value of our common stock underlying the option grants. We determined the fair value of our common stock using methodologies, approaches and assumptions consistent with the AICPA Practice Guide, Valuation of Privately Held Company Equity Securities Issued as Compensation, and based in part on input from an independent third-party valuation firm. Following the closing of our IPO on January 31, 2020, we will no longer have to estimate the fair value of the common stock, rather we will determine the value based on quoted market prices. Grant Income Grants received are recognized as grant income in the statements of operations as and when they are earned for the specific research and development projects for which these grants are designated. Grants payments received in excess of grant income earned are recognized as deferred grant on the balance sheet and grant income earned in excess of grant payments received is recognized as grant receivable on the balance sheets. Results of Operations Operating expenses and other income (expense) were comprised of the following: Years Ended December 31, 2019 and 2018 Research and Development Expenses Research and development expenses increased by $664.6 thousand for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily the result of contract research costs associated with our long-term toxicology studies in rats and dogs which began in November of 2019. General and Administrative Expenses General and administrative expenses increased by $227.1 thousand for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily the result of a $403.5 thousand increase in professional fees for accounting, audit, legal, technology and investor relations services, partially offset by a $83.3 thousand decrease in intellectual property legal costs and a $74.2 thousand decrease in stock-based compensation expense. Change in Fair Value of Derivative Liability The derivative liability represents an embedded derivative in our convertible promissory notes which were issued in March 2019. At each balance sheet date, we estimated the fair value of the derivative liability and recognized any change in our statements of operations. There was no derivative liability during the year ended December 31, 2018. Interest Income (Expense), Net Net interest expense increased $41.6 thousand for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily the result of interest recognized on our convertible promissory notes issued in March 2019. Grant Income Grant income increased $735.1 thousand for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was the result of income recognized related to a grant from the NIH to reimburse the costs of our long-term toxicology studies in rats and dogs, which studies began in November 2019. Liquidity and Capital Resources Since our inception in 2008, we have devoted most of our cash resources to research and development and general and administrative activities. We have financed our operations primarily with the proceeds from the sale of common stock, convertible preferred stock and convertible promissory notes. To date, we have not generated any revenues from the sale of products, and we do not anticipate generating any revenues from the sales of products for the foreseeable future. We have incurred losses and generated negative cash flows from operations since inception. As of December 31, 2019, our principal source of liquidity was our cash, which totaled $56,250. Equity Financings For the years ended December 31, 2019 and 2018, we received net proceeds of $0 and $246,449, respectively, from the sale of common stock and redeemable convertible preferred stock. We closed our IPO on January 31, 2020, raising gross proceeds of $13.8 million and net proceeds of $12.1 million, after deducting underwriting discounts and commissions and offering expenses. Debt Financings At December 31, 2019, we had outstanding $530,000 principal amount of convertible promissory notes, which were issued in March 2019. We had no debt outstanding during the year ended December 31, 2018. Upon the closing of our IPO on January 31, 2020, the outstanding convertible promissory notes plus accrued interest converted into 118,470 shares of our common stock at a 20% discount to the public offering price. Future Capital Requirements We expect that the net proceeds from our IPO will be sufficient to fund our operations and capital requirements for at least the next 18 months. We believe that these available funds will be sufficient to complete our Phase 2a clinical trial for ANVS401 and commence the planning of our Phase 3 study in AD-DS for this product candidate. However, it is difficult to predict our spending for our product candidates prior to obtaining FDA approval. Moreover, changing circumstances may cause us to expend cash significantly faster than we currently anticipate, and we may need to spend more cash than currently expected because of circumstances beyond our control. To the extent that our capital resources are insufficient to meet our future operating and capital requirements, we will need to finance our cash needs through public or private equity offerings, debt financings, collaboration and licensing arrangements or other financing alternatives. We have no committed external sources of funds. Additional equity or debt financing or collaboration and licensing arrangements may not be available on acceptable terms, if at all. Cash Flows The following table summarizes our cash flows from operating, investing and financing activities. Years ended December 31, 2019 and 2018 Operating Activities For the year ended December 31, 2019, cash used in operations was $476.5 thousand compared to $558.6 thousand for the year ended December 31, 2018. The decrease in cash used in operations was primarily the result of the increase in accounts payable and accrued expense balances from 2018. We expect cash used in operating activities to increase in 2020 as compared to 2019 due to an expected increase in our operating losses associated with ongoing development of our product candidates and additional costs associated with being a public company. Financing Activities Cash provided by financing activities was $443.1 thousand during the year ended December 31, 2019, attributable to $530.0 thousand proceeds from the sale of convertible promissory notes partially offset by the payment of $78.6 thousand deferred offering costs associated with our IPO and $8.3 thousand of fees on the issuance of the convertible promissory notes. Cash provided by financing activities was $246.4 thousand during the year ended December 31, 2018, attributable to $243.6 thousand from the sale of 270,722 shares of our Series A-1 Preferred Stock and $2.8 thousand from the sale of 14,286 shares of our common stock. We completed our IPO on January 31, 2020, raising gross proceeds of $13.8 million and net proceeds of $12.1 million, after deducting underwriting discounts and commissions and offering expenses. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, except for short-term operating leases, or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities. Recent Accounting Pronouncements In February 2016, the Financial Accounting Standards Board (“FASB”) issued its final standard on lease accounting, ASU No. 2016-02, Leases (Topic 842), which superseded Topic 840, Leases, which was further modified in ASU No. 2018-10, Codification Improvements to Topic 842, Leases, ASU No. 2018-11, Leases (Topic 842) Targeted Improvements and ASU No. 2019-01 Leases (Topic 842) Codification Improvements to clarify the implementation guidance. The new pronouncement requires the recognition on the balance sheet of right-of-use assets and lease liabilities for all long-term leases, including operating leases, on the balance sheet. The pronouncement requires that lease arrangements longer than 12 months result in an entity classifying leases as a finance or operating leases. However, unlike current U.S. GAAP, which requires only capital leases to be recognized on the balance sheet, ASU 2016-02 will require both types of leases to be recognized on the balance sheet. ASU 2016-02 also requires disclosures about the amount, timing, and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements. The pronouncement is effective for all public business entities for interim and annual periods beginning after December 15, 2018 and for non-public business entities with annual periods beginning after December 15, 2019 with early adoption permitted. In July 2018, the FASB issued ASU No. 2018-11, which provides targeted improvements to the new lease standard, including an option to apply the transition provisions at its adoption date instead of at the earliest comparative period presented in its financial statements. We adopted the new leasing standards using a modified retrospective transition approach to be applied to leases existing as of or entered into after January 1, 2019. The adoption of this guidance did not have a material impact on our financial statements. In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments, which provides specific guidance related to eight cash flow classification issues. The pronouncement is effective for interim and annual periods beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. We elected to early adopt the new pronouncement in the first quarter of 2019. Such early adoption of ASU 2016-15 in the first quarter of 2019 did not have an impact on our financial statements. In November 2016, the FASB issued ASU 2016-18, Restricted Cash, which requires changes in restricted cash and restricted cash equivalents to be explained on the statement of cash flows by including restricted cash and restricted cash equivalents in the beginning-of-period and end-of-period total cash and cash equivalents shown on the statement of cash flows. The pronouncement is effective for interim and annual periods beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. We elected to early adopt ASU 2016-18. The early adoption of ASU 2016-18 in the first quarter of 2019 did not have an impact on our financial statements. In March 2018, the FASB issued ASU 2018-5-Income Taxes (Topic 740): Amendments to SEC Paragraphs pursuant to SEC Staff Accounting Bulletin No. 118. This ASU provided guidance related to Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 118 (“SAB 118”), which addresses the accounting implications of the Tax Act. SAB 118 allows a company to record provisional amounts during a measurement period not to extend beyond one year of the enactment date and was effective upon issuance. We have analyzed the Tax Act, and in certain areas, has made reasonable estimates of the effects on its financial statements and tax disclosures. In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820)-Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement. The new guidance improves and clarifies the fair value measurement disclosure requirement of ASC 820. The new disclosure requirements include the changes in unrealized gains or losses included in other comprehensive income for recurring Level 3 fair value measurement held at the end of reporting period and the explicit requirement to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. The other provisions of ASU 2018-13 also include eliminated and modified disclosure requirements. The guidance is effective for fiscal years beginning after December 15, 2019 with early adoption permitted, including in an interim period for which financial statements have not been issued or made available for issuance. We have evaluated the impact of adoption of this ASU and determined that it will not have a significant impact on our financial statements. In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The amendments in ASU 2019-12 simplify the accounting for income taxes by removing certain exceptions to the general principles in Topic 740 and clarifying and amending existing guidance. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020, with early adoption permitted. We are currently evaluating ASU 2019-12 but do not believe the adoption of this standard will have a significant impact on our financial statements. Significant Contractual Obligations and Commitments We lease our office facilities under a month-to-month operating lease. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by applicable SEC regulations. JOBS Act Section 107 of the JOBS Act also 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 new or revised accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, 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 Company Overview We are a clinical stage, drug platform company addressing neurodegeneration such as Alzheimer’s disease (AD), Parkinson’s disease (PD) and Alzheimer’s disease in Down Syndrome (ADDS). Our lead compound, ANVS401, is a small molecule administered orally that attacks neurodegeneration by entering the brain and inhibiting the translation of neurotoxic proteinsamyloid precursor protein APP/Aβ (APP), tau/phosphotau (tau) and αSynuclein (αSYN)thereby improving axonal transport. Human studies in four MCI patients have shown that ANVS401 lowered the levels of neurotoxic proteins and inflammatory factors. In preclinical studies, lower neurotoxic protein levels led to improved axonal transport, reduced inflammation, lower nerve cell death and improved function. AD is a substantial market affecting over 30 million people worldwide and is expected to grow to over 100 million by 2050. While the market for neurodegeneration is over $100 billion, to date there are no disease modifying drugs (DMD) for any neurodegenerative condition. Enormous efforts have gone into developing better drugs to treat neurodegeneration and the outcomes have been sobering. The results of clinical trials in AD, the two AD orphan indications ADDS and early onset familial AD or in PD have not supported the development of successful disease modifying therapies. ANVS401 is a small lipophilic molecule that is orally available and readily enters the brain, as demonstrated by preclinical pharmacokinetics analyses showing brain concentrations approximately six to eight times higher than plasma concentrations. ANVS401 has a mechanism of action that we believe to be unique, in that it inhibited the overtranslation of and, therefore, reduced the levels of several neurotoxic proteins both in vitro and in vivo including APP, tau and αSYN. By targeting multiple neurotoxic proteins, ANVS401 resembles a combination therapy approach, with the added convenience of being a single drug with a single drug target. Therefore, we have worked to understand how ANVS401 is able to inhibit the translation of more than one neurotoxic protein. We are presently conducting a Phase 2a study in AD patients in collaboration with the ADCS and plan to initiate a second Phase 2a proofofconcept study of ANVS401 in the first quarter of 2020 with 50 PD patients. We have designed the two Phase 2a studies with Parexel by applying our understanding of the underlying disease states in neurodegeneration and by measuring not just target, but also pathway validation in the spinal fluid of these patients. If we are able to show both target and pathway validation in two patient populations, we believe that our opportunity for successful Phase 3 studies is better than if we merely demonstrated target validation in one patient population. We have never been profitable and have incurred net losses since inception. Our net losses were $990,980 and $713,871 for the years ended December 31, 2019 and 2018, respectively, and our accumulated deficit at December 31, 2019 was $8,777,028. We expect to incur losses for the foreseeable future, and we expect these losses to increase as we continue our development of, and seek regulatory approvals for, 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. Financial Operations Overview The following discussion sets forth certain components of our statements of operations as well as factors that impact those items. Research and Development Expenses Our research and development expenses consist of expenses incurred in development and clinical studies relating to our product candidates, including: expenses associated with clinical development; personnelrelated expenses, such as salaries, benefits, travel and other related expenses, including stockbased compensation; payments to thirdparty contract research organizations, or CROs, contract [/INST] Negative. </s>

Viela Bio, Inc.

2020-03-25

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 appearing elsewhere in this Annual Report on Form 10-K and our final prospectus for our initial public offering filed pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, or the Securities Act, on October 4, 2019, or the Prospectus. 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 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 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. Investors and others should note that we routinely use the Investor Relations section of our website to announce material information to investors and the marketplace. While not all of the information that we post on the Investor Relations section of our website is of a material nature, some information could be deemed to be material. Accordingly, we encourage investors, the media, and others interested in us to review the information that it shares on the Investor Relations section of our website, www.vielabio.com. Overview We are a clinical-stage biotechnology company pioneering treatments for autoimmune disease. Our approach seeks to redefine the treatment of autoimmune diseases by focusing on critical biological pathways shared across multiple indications. We believe this approach, which targets the underlying molecular pathogenesis of the disease allows us to develop more precise therapies, identify patients more likely to respond to treatment and pursue multiple diseases for each of our product candidates. Our lead product candidate, inebilizumab, is a humanized mAb designed to target CD19, a molecule expressed on the surface of a broad range of immune system B cells. In January 2019, we reported positive pivotal clinical trial data for inebilizumab in patients with NMOSD. NMOSD is a rare, devastating condition that attacks the optic nerve, spinal cord and brain stem, and often leads to irreversible blindness and paralysis. We received Breakthrough Therapy Designation for the treatment of this disease from the FDA in April 2019 and in August 2019, the FDA accepted for review our BLA for inebilizumab. The FDA set a PDUFA date of June 11, 2020. In addition, we have a broad pipeline of two additional clinical-stage and two pre-clinical product candidates focused on a number of other autoimmune diseases with high unmet medical needs, including myasthenia gravis, IgG4-related disease, Sjögren’s syndrome and lupus, as well as other conditions such as kidney transplant rejection. A Phase 2b trial in Sjögren’s syndrome, which is designed as Phase 3-enabling, is ongoing and in 2019, we initiated a separate Phase 2 trial in kidney transplant rejection. We incorporated on December 11, 2017 under the laws of the State of Delaware. From December 11, 2017 to December 31, 2017 we had no substantive operations. In February 2018, we acquired six molecules from MedImmune, of which five constitute our current product candidates, for a purchase price of approximately $142.3 million financed by AstraZeneca’s purchase of our Series A preferred stock. Following the asset purchase, we entered into several agreements with AstraZeneca and MedImmune, including a license agreement, a master supply and development services agreement, sublicense agreements, a transition services agreement, a clinical supply agreement and a commercial supply agreement. To date, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, identifying and developing product candidates, enhancing our intellectual property portfolio, undertaking research, conducting pre-clinical studies and clinical trials, conducting pre-commercial and commercial launch activities, and securing manufacturing for our development programs. 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 primarily with proceeds from private placement of convertible preferred stock and the IPO. In October 2019, we completed the IPO and issued and sold an aggregate 9,085,000 shares of common stock, which included 1,185,000 shares of our common stock issued pursuant to the underwriters’ option to purchase additional shares, at a public offering price of $19.00 per share, for net proceeds of $156.9 million after deducting underwriting discounts and commissions and other offering costs. We have incurred significant operating losses since our inception, which are mainly attributed to research and development costs and employee payroll expense included in general and administrative expenses. Our net loss was $86.4 million and $190.3 million for the years ended December 31, 2019 and 2018 respectively. Our operating losses may fluctuate significantly from quarter-to-quarter and year-to-year as a result of several factors, including the timing of our pre-clinical studies and clinical trials and our expenditures related to other research and development activities. We expect to continue to incur operating losses for the foreseeable future. We anticipate these losses will increase substantially as we advance our product candidates through pre-clinical and clinical development, develop additional product candidates and seek regulatory approvals for our product candidates. We do not expect to generate any revenues from product sales unless and until we successfully complete development and obtain regulatory approval for one or more product candidates. In addition, if we obtain marketing approval for any product candidate, we expect to incur pre-commercialization expenses and significant commercialization expenses related to marketing, sales, manufacturing and distribution. We may also incur expenses in connection with the in-licensing of additional product candidates. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations, compliance 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 sales of our product candidates, if ever, we expect to finance our cash needs through public or private equity offerings, debt financings, collaborations and licensing arrangements or other capital sources. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements as and when needed would have a negative impact on our financial condition and could force us to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market our product candidates that we would otherwise prefer to develop and market ourselves. In December 2019 an outbreak of a novel strain of coronavirus was identified in Wuhan, China. This virus continues to spread globally, has been declared a pandemic by the World Health Organization and has spread to over 100 countries, including the United States. The impact of this pandemic has been and will likely continue to be extensive in many aspects of society, which has resulted in and will likely continue to result in significant disruptions to businesses and capital markets around the world. The extent to which the coronavirus impacts us will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of the coronavirus and the actions to contain the coronavirus or treat its impact, among others. At present, we are not experiencing significant impact or delays from COVID-19 on our business, operations and, if approved, commercialization plans. However, in order to prioritize patient health and that of the investigators at clinical trial sites, we have paused enrollment of new patients for four weeks in certain of our clinical trials, including our Phase 2b trial of VIB4920 in Sjogren’s syndrome, our Phase 2 trial of VIB4920 in kidney transplant rejection, and our Phase 2 trial of inebilizumab in kidney transplant desensitization. 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, we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. In May 2019, we entered into a license and collaboration agreement with Hansoh Pharma, for co-development and commercialization of inebilizumab in China, Hong Kong, and Macau for NMOS as well as other potential inflammation/autoimmune and hematologic malignancy diseases. Under the terms of the agreement, we received up-front licensing fees of an aggregate of $20 million and may receive payments contingent on certain development, regulatory and commercial milestones, for up to an aggregate of $203 million, plus royalties on net sales ranging from low double-digits to high teens. Pursuant to the agreement, we granted Hansoh Pharma an exclusive, royalty-bearing, license to import, sell, have sold, offer for sale, and otherwise commercialize inebilizumab in China, Hong Kong, and Macau, as covered by our patent rights. We also granted Hansoh Pharma an exclusive license with us to co-develop inebilizumab in additional diseases in China, Hong Kong and Macau. Hansoh Pharma will be responsible for leading development and commercialization of inebilizumab in China, Hong Kong and Macau. We will be responsible for supplying inebilizumab to Hansoh Pharma pursuant to a supply agreement that we expect to enter into. In October 2019, we entered into the MTPC License Agreement with MTPC for co-development and commercialization of inebilizumab in the MTPC Territory for NMOSD as well as other indications that we and MTPC mutually agree to add to the MTPC License Agreement. Under the terms of the MTPC License Agreement, we are eligible to receive up-front licensing fees of an aggregate of $30.0 million which has been recorded as accounts receivable on the balance sheet as of December 31,2019, as well as development and commercialization milestones and payments based, in part, on sales revenue. In January 2020, we received the upfront payment of $30.0 million. Pursuant to the MTPC License Agreement, we granted MTPC an (i) exclusive license under our intellectual property to develop, commercialize, and conduct final manufacturing of inebilizumab in the MTPC Territory, and (ii) a non-exclusive license under any patent we control solely to the extent useful or necessary to enable MTPC to develop, commercialize and finally manufacture products in the MTPC Territory, but excluding rights to any active pharmaceutical ingredient or compound other than inebilizumab. MTPC will be responsible for leading development, commercialization, and final manufacturing of inebilizumab in the MTPC Territory. We will be responsible for supplying inebilizumab to MTPC pursuant to a supply agreement that we expect to enter into. On a country-by-country and product-by-product basis, the licenses will become perpetual, non-exclusive and fully paid-up upon the later of (a) the expiration of the last valid claim of a Company patent covering the product; (b) the expiration of any regulatory exclusivity with respect to the product; or (c) 10 years after the first commercial sale of the product in such country. Components of our Results of Operations Revenue We have not generated any revenue from the sale of products since our inception and do not expect to generate substantial revenue from the sale of products in the near future, if at all. We have generated revenue from commercial license and collaboration agreements related to the treatment of NMOSD with inebilizumab. In addition, if our development efforts for our product portfolio, including inebilizumab, 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 product sales or payments from such collaboration or license agreements, or a combination of product sales and payments from such agreements. Research and Development Expenses To date, our research and development expenses, net of the acquisition of IPR&D that is disclosed separately, have related primarily to development of inebilizumab, VIB4920 and VIB7734, pre-clinical studies and other pre-clinical activities related to our portfolio. Research and development expenses are recognized as incurred, and payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. Research and development expenses include: • salaries, payroll taxes, employee benefits, and stock-based compensation charges for those individuals involved in research and development efforts; • external research and development expenses incurred under agreements with contract research organizations and consultants to conduct our pre-clinical, toxicology and other pre-clinical studies, as well as clinical trials of our product candidates; • laboratory supplies; • costs related to manufacturing product candidates, including fees paid to third-party manufacturers and raw material suppliers; • license fees and research funding; and • facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent, maintenance of facilities, insurance, equipment and other supplies. Clinical trial costs are a significant component of research and development expenses and include costs associated with third-party contractors. A majority of these payments are pass-through payments that are made to MedImmune and AstraZeneca pursuant to the existing contracts in place associated with the IPR&D assets acquired (see Note 8, "Asset acquisition" for additional information). Through our agreements with MedImmune and AstraZeneca, we outsource a substantial portion of our clinical trial activities, utilizing external entities such as CROs, independent clinical investigators and other third-party service providers to assist us with the execution of our clinical trials. 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 relating to our product candidates. We plan to substantially increase our research and development expenses for the foreseeable future, as we continue the development of our product candidates and seek to discover and develop new product candidates. Due to the inherently unpredictable nature of pre-clinical and clinical development, we cannot determine with certainty the timing of the initiation, duration or costs of future clinical trials and pre-clinical studies of product candidates. Clinical and pre-clinical development timelines, the probability of success and the amount of associated development costs can differ materially from expectations. We anticipate that we will make determinations as to which product candidates and development programs to pursue and how much funding to direct to each product candidate or program on an ongoing basis in response to the results of ongoing and future pre-clinical studies and clinical trials, regulatory developments and our ongoing assessments as to each product candidate’s commercial potential. In addition, we cannot forecast which product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. Our future clinical development costs may vary significantly based on factors such as: • per patient trial costs; • the number of patients needed to determine a recommended dose; • the number of trials required for regulatory 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 who participate in the trials; • the number of doses that patients receive; • the drop-out or discontinuation rates of patients; • potential additional safety monitoring requested by regulatory agencies; • the duration of patient participation in the trials and follow-up; • the phase of development of the product candidate; • the efficacy and safety profile of the product candidate; and • developments related to the coronavirus outbreak and impact of it and COVID-19 on the costs and timing associated with the conduct of our clinical trials and other related activities. General and Administrative Expenses General and administrative expenses consist primarily of salaries and employee-related costs, including stock-based compensation for personnel in our executive, finance and other administrative functions. Other significant costs include facility and/or rent-related costs, legal fees relating to intellectual property and corporate matters, professional fees for accounting and consulting services and insurance costs. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities, pre-commercialization and, if any product candidates receive marketing approval, commercialization activities. We also anticipate increased expenses related to audit, legal, regulatory and tax-related services associated with maintaining compliance with stock exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs associated with operating as a public company. Acquisition of In-Process Research and Development Acquisition of IPR&D represents the expense recognized related to the Asset Purchase Agreement with AstraZeneca and MedImmune (the “APA”). The six molecules we acquired from MedImmune pursuant to the APA consist of multiple IPR&D projects related to biological therapies which are intended to treat an interrelated subset of autoimmune disorders, represented in part by common biological characteristics. See Note 8, "Asset acquisition" for further information. Interest Income Interest income consists of interest earned on our cash and cash equivalents and marketable securities. Results of Operations Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: License Revenue. License revenue was $50.0 million for the year ended December 31, 2019. The increase of $50.0 million was due to the revenue recognized in 2019 pursuant to the Co-Development and Commercial License Agreement with Hansoh Pharma and the MTPC License Agreement. There was no revenue generated during the year ended December 31, 2018. Research and Development Expenses. Research and development expenses were $104.6 million and $42.4 million for the years ended December 31, 2019 and 2018, respectively. The increase of $62.2 million was primarily driven by regulatory milestone payment of approximately $19.8 million in September 2019, in connection with acceptance for review by the FDA of the Company’s BLA for inebilizumab in patients with NMOSD in August 2019, and an increase of $8.6 million in personnel related costs due to an increase in headcount, and $33.8 million of direct program and external costs for payments to our research and development contractors driven primarily by manufacturing activities to support the BLA filing and pending approval process, and clinical trials for other potential indications for inebilizumab, as well as increased clinical material supplies for VIB4920. General and Administrative Expenses. General and administrative expenses were $35.1 million and $6.6 million for the years ended December 31, 2019 and 2018, respectively. The increase of $28.5 million was due primarily to increases of $12.6 million in professional services related to accounting services, corporate legal fees and patent legal fees, $10.9 million in personnel related expenses, including stock-based compensation, due to an increase in headcount, and $5.0 million of facility related and other administrative expenses. Acquisition of In-process Research and Development. Acquisition of IPR&D was $143.3 million for the year ended December 31, 2018, and consisted of IPR&D assets with no alternative future use acquired from the MedImmune and AstraZeneca. We did not acquire any IPR&D assets in 2019. Interest Income. Interest income was $3.3 million and $2.0 million for the years ended December 31, 2019 and 2018, respectively. The increase of $1.2 million was due primarily to higher cash and cash equivalents and marketable securities held during the year ended December 31, 2019. Liquidity and Capital Resources Cash Flows We have incurred 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 cash and cash equivalents of $200.9 million. The following table sets forth a summary of the net cash flow activity for the years ended December 31, 2019 and 2018: Operating Activities Net cash used in operating activities was $105.0 million and $29.5 million for the years ended December 31, 2019 and 2018, respectively. The net cash used in operating activities for the year ended December 31, 2019 was primarily due to our net loss of $86.4 million, partially offset by non-cash charges of $3.8 million related to depreciation, stock-based compensation expense and net amortization of premiums and discounts on marketable securities, and cash provided by changes in our operating assets and liabilities of $22.4 million. The net cash used in operating activities for the year ended December 31, 2018 was primarily due to our net loss of $190.3 million, partially offset by non-cash charges of $143.3 million primarily related to our acquisition of IPR&D assets from MedImmune and AstraZeneca and cash provided by changes in our operating assets and liabilities of $15.5 million. Investing Activities Net cash used in investing activities was $146.4 million and $143.8 million for the years ended December 31, 2019 and 2018, respectively. The net cash used in investing activities for the year ended December 31, 2019 was primarily due to purchases, sales and maturities of marketable securities, and purchase of property and equipment. The net cash used in investing activities for the year ended December 31, 2018 was primarily due to our acquisition of IPR&D from MedImmune and AstraZeneca and purchases of property and equipment. Financing Activities Net cash provided by financing activities was $325.4 million for the year ended December 31, 2019, primarily due to the net proceeds of $167.0 million from the issuance of Series A-3 and Series B convertible preferred stock and $156.9 million of net proceeds from the IPO. Net cash provided by financing activities was $300.3 million for the year ended December 31, 2018 and was due to proceeds from the issuance of Series A-1 and A-2 convertible preferred stock. Funding Requirements We believe that our existing cash, will be sufficient to meet our anticipated cash requirements through 2022. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could deplete our capital resources sooner than we expect. Our future capital requirements will depend on many factors, including: • the receipt of marketing approval, if any, and revenue received from any potential commercial sales of inebilizumab or other product candidates, and product pricing, as well as product coverage and the adequacy of reimbursement of third-party payors, relating to any such product; • the cost of commercialization activities for and manufacturing of inebilizumab and other product candidates if we receive marketing approval for any such product candidate, including marketing, sales and distribution costs; • the initiation, progress, timing, costs and results of drug discovery, pre-clinical studies and clinical trials of inebilizumab, VIB4920 and VIB7734 and any other future product candidates; • the number and characteristics of product candidates that we pursue; • the outcome, timing and costs of seeking regulatory approvals; • the cost of manufacturing VIB4920 and VIB7734 and future product candidates for clinical trials in preparation for marketing approval and in preparation for commercialization; • the costs of any third-party products used in our combination clinical trials that are not covered by such third party or other sources; • the costs associated with hiring additional personnel and consultants as our pre-clinical and clinical activities increase; • the emergence of competing therapies and other adverse market developments; • the ability to establish and maintain strategic licensing 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 extent to which we in-license or acquire other products and technologies; • the costs of operating as a public company; and • the extent to which our business is adversely impacted by the effects of the novel coronavirus outbreak or by other health epidemics or pandemics. Until such time, if ever, as we can generate substantial product revenues to support our capital requirements, we expect to finance our cash needs through a combination of public or private equity offerings, debt financings, collaborations and licensing arrangements or other capital sources. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, or other similar arrangements with third parties, we may need to relinquish valuable rights to our product candidates, future revenue streams, research programs or may have to grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. If we are unable to raise additional funds through equity or debt financings as and when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations at December 31, 2019: (1) We have excluded payments totaling $1.2 million over 60 months related to a lease for a piece of lab equipment as the commencement date of the lease is subject to delivery and acceptance, which is currently uncertain. We enter into contracts in the normal course of business with CROs, clinical supply manufacturers and vendors for pre-clinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. We have also entered into license and collaboration agreements with third parties, which are in the normal course of business. 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. We expect to pay approximately $20.0 million if the BLA for inebilizumab is approved by the FDA for NMOSD. However, we are currently unable to estimate the timing or likelihood of achieving other milestones or generating future product sales. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses and stock-based compensation. We base our estimates on historical experience, known trends and events, and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 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", we believe the following accounting policies and estimates to be most critical to the preparation of our financial statements. Accrued Research and Development As part of the process of preparing our financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments, if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract-to-contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Revenue Recognition for Contracts with Customers To date, we have generated no revenues from sales of products. Effective January 1, 2019, we adopted Accounting Standards Update, or ASU, No. 2014-09, Revenue (ASC 606): Revenue from Contracts with Customers, or ASC 606, 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 periods were prepared and reported in accordance with ASC Topic 605, Revenue Recognition, or ASC 605. The adoption of ASC 606 resulted in no cumulative adjustment as we had substantially no assets until executing the Asset Acquisition in February 2018 (as described in Note 8, "Asset acquisition") and did not enter into a revenue contract with a customer until May 2019 (as described in Note 14, "Collaboration agreements"). 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, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract and 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. 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, they 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 current portion of deferred revenue in the accompanying balance sheet. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date are classified as deferred revenue, net of current portion. 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 enter 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; clinical and development, regulatory, and sales milestone payments; and royalties on future product sales. We also analyze our collaboration arrangements to assess whether they are within the scope of ASC 808, 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 606. For those elements of the arrangement that are accounted for pursuant to ASC 606, we apply the five-step model described above. For a complete discussion of accounting for collaboration revenues, see Note 14, "Collaboration agreements". Stock-Based Compensation Expense Stock-based compensation expense represents the cost of the grant date fair value of equity awards recognized over the requisite service period of the awards (usually the vesting period) on a straight-line basis. We estimate the fair value of equity awards using the Black-Scholes option pricing model and recognize forfeitures as they occur. Estimating the fair value of equity awards as of the grant date using valuation models, such as the Black-Scholes option pricing model, is affected by assumptions regarding a number of variables, including the risk-free interest rate, the expected stock price volatility, the expected term of stock options, the expected dividend yield and the fair value of the underlying common stock on the date of grant. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These inputs are subjective and generally require significant analysis and judgment to develop. See Note 2, "Summary of significant accounting policies" for 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 granted for the years ended December 31, 2019 and 2018. Other Company Information Net Operating Loss and Research and Development Carryforwards and Other Income Tax Information At December 31, 2019, we had federal and state net operating loss carryforwards of $114.6 million. Federal and state net operating losses generated in 2019 and future years can be carried forward indefinitely. As of December 31, 2019, we also had federal research credit carryforwards of $13.2 million. The federal research and development tax credit carryforwards expire beginning in 2039 unless previously utilized, and the state research and development tax credit carryforwards expire beginning in 2025. We believe that it is more likely than not that we will not realize the benefits of the deferred tax assets. Accordingly, a full valuation allowance has been established against the net deferred tax assets as of December 31, 2019. Management reevaluates the positive and negative evidence at each reporting period. We have not completed a Section 382 study to assess whether an ownership change has occurred or whether there have been multiple ownership changes since our formation due to the complexity and cost associated with such a study and the fact that there may be additional such ownership changes in the future. Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of our net operating loss and research and development tax credit carryforwards may be limited in the event a cumulative change in ownership of more than 50% occurs within a three-year period. Emerging Growth Company Status We are an emerging growth company as defined in the JOBS Act. Under the JOBS Act, companies have extended transition periods available for complying with new or revised accounting standards. We have elected this exemption to delay adopting new or revised accounting standards until such time as those standards apply to private companies. Where allowable, we have early adopted certain standards as described in Note 2, "Summary of significant accounting policies". In addition, we intend to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, we are entitled to rely on certain exemptions as an emerging growth company, we are not 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(b), (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 Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation-related items. These exemptions will apply for a period of five years following the completion of this offering or until we no longer meet the requirements of being an emerging growth company, whichever is earlier. Recently Issued and Adopted Accounting Pronouncements A description of recently issued and adopted accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2, "Summary of significant accounting policies". Off-Balance Sheet Arrangements During the periods presented we did not have, nor do we currently have, any off-balance sheet arrangements as defined under SEC rules.

<s>[INST] Investors and others should note that we routinely use the Investor Relations section of our website to announce material information to investors and the marketplace. While not all of the information that we post on the Investor Relations section of our website is of a material nature, some information could be deemed to be material. Accordingly, we encourage investors, the media, and others interested in us to review the information that it shares on the Investor Relations section of our website, www.vielabio.com. Overview We are a clinicalstage biotechnology company pioneering treatments for autoimmune disease. Our approach seeks to redefine the treatment of autoimmune diseases by focusing on critical biological pathways shared across multiple indications. We believe this approach, which targets the underlying molecular pathogenesis of the disease allows us to develop more precise therapies, identify patients more likely to respond to treatment and pursue multiple diseases for each of our product candidates. Our lead product candidate, inebilizumab, is a humanized mAb designed to target CD19, a molecule expressed on the surface of a broad range of immune system B cells. In January 2019, we reported positive pivotal clinical trial data for inebilizumab in patients with NMOSD. NMOSD is a rare, devastating condition that attacks the optic nerve, spinal cord and brain stem, and often leads to irreversible blindness and paralysis. We received Breakthrough Therapy Designation for the treatment of this disease from the FDA in April 2019 and in August 2019, the FDA accepted for review our BLA for inebilizumab. The FDA set a PDUFA date of June 11, 2020. In addition, we have a broad pipeline of two additional clinicalstage and two preclinical product candidates focused on a number of other autoimmune diseases with high unmet medical needs, including myasthenia gravis, IgG4related disease, Sjögren’s syndrome and lupus, as well as other conditions such as kidney transplant rejection. A Phase 2b trial in Sjögren’s syndrome, which is designed as Phase 3enabling, is ongoing and in 2019, we initiated a separate Phase 2 trial in kidney transplant rejection. We incorporated on December 11, 2017 under the laws of the State of Delaware. From December 11, 2017 to December 31, 2017 we had no substantive operations. In February 2018, we acquired six molecules from MedImmune, of which five constitute our current product candidates, for a purchase price of approximately $142.3 million financed by AstraZeneca’s purchase of our Series A preferred stock. Following the asset purchase, we entered into several agreements with AstraZeneca and MedImmune, including a license agreement, a master supply and development services agreement, sublicense agreements, a transition services agreement, a clinical supply agreement and a commercial supply agreement. To date, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, identifying and developing product candidates, enhancing our intellectual property portfolio, undertaking research, conducting preclinical studies and clinical trials, conducting precommercial and commercial launch activities, and securing manufacturing for our development programs. 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 primarily with proceeds from private placement of convertible preferred stock and the IPO. In October 2019, we completed the IPO and issued and sold an aggregate 9,085,000 shares of common stock, which included 1,185,000 shares of our common stock issued pursuant to the underwriters’ option to purchase additional shares, at a public offering price of $19.00 per share, for net proceeds of $156.9 million after deducting underwriting discounts and commissions and other offering costs. We have incurred significant operating losses since our inception, which are mainly attributed to research and development costs and employee payroll expense included in general and administrative expenses. Our net loss was $86.4 million and $1 [/INST] Negative. </s>

Fulcrum Therapeutics, Inc.

2020-03-05

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are a clinical-stage biopharmaceutical company focused on improving the lives of patients with genetically defined rare diseases in areas of high unmet medical need. We have developed a proprietary product engine that we employ to systematically identify and validate cellular drug targets that can potentially modulate gene expression to treat the known root cause of genetically defined diseases. We are using our product engine to identify targets that can be drugged by small molecules regardless of the particular underlying mechanism of gene mis-expression. We have identified drug targets to treat the root causes of facioscapulohumeral muscular dystrophy, or FSHD, and certain hemoglobinopathies, namely sickle cell disease, or SCD, and ß-thalassemia. In August 2019, we initiated a Phase 2b clinical trial and a Phase 2 open label clinical trial of losmapimod, our product candidate for FSHD, to evaluate the efficacy and safety of losmapimod in addressing the underlying cause of FSHD. We plan to submit an investigational new drug application, or IND, for FTX-6058, our product candidate for certain hemoglobinopathies, in the second half of 2020. FTX-6058 is a novel upregulator of fetal hemoglobin. In pre-clinical research, treatment with FTX-6058 was shown to increase HbF levels to approximately 30% of total hemoglobin as measured by high performance liquid chromatography and mass spectrometry methods in human erythroid progenitor cells from multiple donors. FTX-6058 also elevated HbF in vivo in animal models at plasma concentrations reasonably expected to be achieved in humans. Since inception, our operations have focused on organizing and staffing our company, business planning, raising capital, establishing our intellectual property, building our discovery platform, including our proprietary compound library and product engine, identifying drug targets and potential product candidates, in-licensing assets, producing drug substance and drug product material for use in clinical trials and conducting pre-clinical studies and early clinical trials. To date, we have funded our operations primarily through the issuance of common stock in our initial public offering, or IPO, convertible preferred stock and convertible notes, and an upfront payment received under the collaboration and license agreement, or the Acceleron Collaboration Agreement, with Acceleron Pharma Inc., or Acceleron. On July 22, 2019, we completed an IPO of our common stock and issued and sold 4,500,000 shares of common stock at a public offering price of $16.00 per share, resulting in net proceeds of $63.9 million after deducting underwriting discounts and commissions and estimated offering expenses. Upon completion of the IPO, all 112,500,000 shares of outstanding convertible preferred stock automatically converted into 16,071,418 shares of common stock. In December 2019, we entered into the Acceleron Collaboration Agreement, to identify biological targets to modulate specific pathways associated with a targeted indication within the pulmonary disease space. Under the collaboration and license agreement with Acceleron, we granted Acceleron an exclusive worldwide license under certain intellectual property rights to make, have made, use, sell, have sold, import, export, distribute and have distributed, market, have marketed, promote, have promoted, or otherwise exploit molecules and products directed against or expressing certain biological targets identified by us for the treatment, prophylaxis, or diagnosis of a targeted indication within the pulmonary disease space. The primary goal of the collaboration is to identify and validate potential biological targets for further research, in order to support the development, manufacture and commercialization of product candidates by Acceleron for the targeted indication by leveraging our proprietary product engine. Under the terms of the Acceleron Collaboration Agreement, we received a $10.0 million upfront payment from Acceleron in December 2019. We are also eligible to receive up to $438.5 million in the aggregate in milestone payments with respect to certain research, developmental, clinical, regulatory and sales-related milestones. We are also be eligible to receive tiered royalty payments based on Acceleron’s (and any of its affiliates’ and sublicensees’) annual worldwide net sales of products directed to any identified targets. We have incurred significant operating losses since our inception and we expect to continue to incur significant operating losses for the foreseeable future. Our ability to generate product revenue sufficient to achieve profitability, if ever, will depend heavily on the successful development and eventual commercialization of one or more of our product candidates. Our net losses were $82.7 million and $32.6 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $150.8 million. We expect our expenses and operating losses will increase substantially over the next several years in connection with our ongoing activities, as we: • continue our clinical development of losmapimod, including our ongoing Phase 2b and Phase 2 open label clinical trials; • continue IND-enabling studies and prepare for a planned Phase 1 clinical trial of FTX-6058; • advance clinical-stage product candidates into later stage trials; • pursue the discovery of drug targets for other rare diseases and the subsequent development of any resulting product candidates; • seek regulatory approvals for any product candidates that successfully complete clinical trials; • scale up our manufacturing processes and capabilities, or arrange for a third party to do so on our behalf, to support our clinical trials of our product candidates and commercialization of any of our product candidates for which we obtain marketing approval; • establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain regulatory approval; • acquire or in-license products, product candidates, technologies and/or data referencing rights; • make any milestone payments to affiliates of GlaxoSmithKline plc, or GSK, under our right of reference and license agreement with GSK upon the achievement of specified clinical or regulatory milestones; • maintain, expand, enforce, defend and protect our intellectual property; • hire additional clinical, quality control 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 and our operations as a public company. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our product candidates, or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. Because of the numerous risks and uncertainties associated with drug development, we are unable to predict the timing or amount of increased expenses or the timing of 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 $96.7 million in cash and cash equivalents. We believe that our existing cash and cash equivalents will enable us to fund our operating expenses and capital expenditure requirements into the third quarter of 2021. We have based this estimate on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. See “-Liquidity and Capital Resources.” Components of Results of Operations Revenue We have not generated any revenue from product sales and do not expect to generate revenue from the sale of products for several years, if at all. If our development efforts for our current or future product candidates are successful and result in marketing approval, we may generate revenue in the future from product sales. 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. For the year ended December 31, 2019, we recognized no collaboration revenue under the Acceleron Collaboration Agreement. As of December 31, 2019, we have recorded $10.0 million of deferred revenue associated with the Acceleron Collaboration Agreement, which is classified as either current or net of current portion in our consolidated balance sheets based on the period over which the revenue is expected to be recognized. As of December 31, 2019, we had not received any milestone, royalty, or cost reimbursement payments under the Acceleron Collaboration Agreement. In the future, we will generate revenue from the Acceleron Collaboration Agreement associated with the $10.0 million upfront payment, which we have recorded as deferred revenue as of December 31, 2019, and reimbursement of costs incurred under the Acceleron Collaboration Agreement, and we may generate additional revenue from milestones and royalty payments under the Acceleron Collaboration Agreement. We expect that our revenue will fluctuate from quarter-to-quarter and year-to-year based upon our pattern of performance under the Acceleron Collaboration Agreement and as a result of the timing, amount, and achievement of milestones and reimbursement of costs incurred under the Acceleron Collaboration Agreement. We may also in the future enter into additional license or collaboration agreements for our product candidates or intellectual property, and we may generate revenue in the future from payments as a result of such license or collaboration agreements. Operating Expenses Research and Development Expenses Research and development expenses represent costs incurred by us for the discovery, development, and manufacture of our product candidates and include: • external research and development expenses incurred under agreements with contract research organizations, or CROs, contract manufacturing organizations, or CMOs, and consultants; • salaries, payroll taxes, employee benefits and stock-based compensation expenses for individuals involved in research and development efforts; • laboratory supplies; • in-process research and development, or IPR&D, expenses, which relate to IPR&D acquired as part of an asset acquisition for which there is no alternative future use; • costs related to the achievement of a specified clinical milestone payable to GSK; • costs related to compliance with regulatory requirements; and • facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent, maintenance of facilities, insurance and other operating costs. We expense research and development costs as incurred. We recognize expenses for certain development activities, such as clinical trials and manufacturing, based on an evaluation of the progress to completion of specific tasks using data such as patient enrollment or other 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 expenses incurred. Non-refundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid expenses. These 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. External costs represent a significant portion of our research and development expenses, which we track on a program-by-program basis following the nomination of a development candidate. Our internal research and development expenses consist primarily of personnel-related expenses, including stock-based compensation expense. We do not track our internal research and development expenses on a program-by-program basis as the resources are deployed across multiple projects. The following table summarizes our external research and development expenses by program following nomination as a development candidate for the years ended December 31, 2019 and 2018. Pre-development candidate expenses, unallocated expenses and internal research and development expenses are classified separately. Losmapimod external expenses include IPR&D expenses. We nominated FTX-6058 as a development candidate in the third quarter of 2019. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing, and estimated costs of the efforts that will be necessary to complete the remainder of the development of our product candidates. We are also unable to predict when, if ever, material net cash inflows will commence from our product candidates, if approved. This is due to the numerous risks and uncertainties associated with developing our product candidates, including the uncertainty related to: • the timing and progress of preclinical and clinical development activities; • the number and scope of preclinical and clinical programs we decide to pursue; • our ability to raise additional funds necessary to complete clinical development of and commercialize our product candidates; • our ability to maintain our current research and development programs and to establish new ones; • our ability to establish new licensing or collaboration arrangements; • the progress of the development efforts of parties with whom we may enter into collaboration arrangements; • the successful initiation and completion of clinical trials with safety, tolerability and efficacy profiles that are satisfactory to the U.S. Food and Drug Administration, or FDA, or any comparable foreign regulatory authority; • the receipt and related terms of regulatory approvals from applicable regulatory authorities; • the availability of raw materials and active pharmaceutical ingredient, or API, for use in production of our product candidates; • our ability to establish and operate a manufacturing facility, or secure manufacturing supply through relationships with third parties; • our ability to consistently manufacture our product candidates in quantities sufficient for use in clinical trials; • our ability to obtain and maintain intellectual property protection and regulatory exclusivity, both in the United States and internationally; • our ability to maintain, enforce, defend and protect our rights in our intellectual property portfolio; • the commercialization of our product candidates, if and when approved; • our ability to obtain and maintain third-party coverage and adequate reimbursement for our product candidates, if approved; • the acceptance of our product candidates, if approved, by patients, the medical community and third-party payors; • competition with other products; and • a continued acceptable safety profile of our products following receipt of any regulatory approvals. 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, and potentially other candidates. Research and development activities account for a significant portion of our operating expenses. We expect our research and development expenses to increase significantly in future periods as we continue to implement our business strategy, which includes advancing losmapimod and FTX-6058 through clinical development, expanding our research and development efforts, including hiring additional personnel to support our research and development efforts, and seeking regulatory approvals for our product candidates that successfully complete clinical trials. In addition, product candidates in later stages of clinical development generally incur higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. As a result, we expect our research and development expenses to increase as our product candidates advance into later stages of clinical development. However, we do not believe that it is possible at this time to accurately project total program-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. General and Administrative Expenses General and administrative expenses consist of personnel-related costs, including salaries, benefits and stock-based compensation expense, for our personnel in executive, finance and accounting, human resources, business operations and other administrative functions, legal fees related to patent, intellectual property and corporate matters, fees paid for accounting and tax services, consulting fees and facility-related costs not otherwise included in research and development expenses. We expect our general and administrative expenses will increase for the foreseeable future to support our expanded infrastructure and increased costs of expanding our operations and operating as a public company. These increases will likely include increased expenses related to accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with operating as a public company. Other Income, Net Other income, net consists primarily of interest income related to our investments in cash equivalents and proceeds from the sale of drug material to a third party during February 2018. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following summarizes our results of operations for the years ended December 31, 2019 and 2018, along with the changes in those items in dollars: Collaboration Revenue We recognized no collaboration revenue during the years ended December 31, 2019 and 2018. As of December 31, 2019, we have recorded $10.0 million of deferred revenue associated with the Acceleron Collaboration Agreement, which is classified as either current or net of current portion in our consolidated balance sheets based on the period over which the revenue is expected to be recognized. We will recognize revenue under the Acceleron Collaboration Agreement based on our pattern of performance of the identified performance obligation, which is the period over which we will perform research services under the Acceleron Collaboration Agreement. Research and Development Expenses Research and development expense increased by $45.9 million from $25.2 million for the year ended December 31, 2018 to $71.1 million for the year ended December 31, 2019. The increase in research and development expense was primarily attributable to the following: • $25.6 million in increased IPR&D expenses associated with the recognition of the fair value attributable to the right of reference and license agreement with GSK during the year ended December 31, 2019; • $9.1 million in increased costs for external clinical activities as we advanced losmapimod into Phase 1, Phase 2b, and Phase 2 open label clinical trials, and conducted preparatory studies in anticipation of initiating those Phase 2 clinical trials; • $4.0 million in increased personnel-related costs due to increased headcount, including $0.9 million of increased stock-based compensation expense; • $2.5 million in increased costs associated with the achievement of a milestone due under the right of reference and license agreement with GSK upon the initiation of a Phase 2 clinical trial of losmapimod; • $1.3 million in increased costs for IND-enabling studies for FTX-6058; • $1.0 million in increased laboratory supplies to support our expanding research efforts; and • $0.6 million in increased facility-related costs, including depreciation and other utility and maintenance costs. General and Administrative Expenses General and administrative expenses increased by $4.8 million from $8.3 million for the year ended December 31, 2018 to $13.1 million for the year ended December 31, 2019. The increase in general and administrative expenses was primarily attributable to the following: • $2.5 million in increased consulting and professional fees, including for insurance premiums, legal services, investor relations, market research, recruiting, and accounting; and • $2.3 million in increased personnel-related costs, primarily due to increased general and administrative headcount to support the growth of our research and development organization, including $1.2 million of increased stock-based compensation expense. Other Income, Net Other income, net increased by $0.6 million from $0.9 million for the year ended December 31, 2018 to $1.5 million for the year ended December 31, 2019. Other income, net during the year ended December 31, 2019 was primarily attributable to investment income of $1.5 million from cash equivalents. During the year ended December 31, 2018, other income, net related primarily to the sale of drug material to a third party for $0.4 million and investment income of $0.5 million from cash equivalents. Liquidity and Capital Resources Sources of Liquidity We have incurred significant operating losses since our inception and expect to continue to incur significant operating losses for the foreseeable future and may never become profitable. 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. Through December 31, 2019, we have primarily funded our operations with aggregate gross proceeds of $222.0 million from the issuance of common stock in our IPO, convertible preferred stock and convertible notes, and an upfront payment received under the Acceleron Collaboration Agreement. As of December 31, 2019, we had cash and cash equivalents of $96.7 million. On July 22, 2019, we completed an IPO of our common stock and issued and sold 4,500,000 shares of common stock at a public offering price of $16.00 per share, resulting in net proceeds of $63.9 million after deducting underwriting discounts and commissions and estimated offering expenses. Cash Flows The following table provides information regarding our cash flows for the years ended December 31, 2019 and 2018: Net Cash Used in Operating Activities Net cash used in operating activities was $39.5 million during the year ended December 31, 2019 compared to net cash used in operating activities of $22.6 million during the year ended December 31, 2018. The increase in net cash used in operating activities of $16.9 million was primarily due to an increase in net loss of $50.1 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018, partially offset by net changes in our operating assets and liabilities of $4.8 million, and a net increase in non-cash expenses of $28.4 million primarily due to an increase in IPR&D expenses of $25.6 million, an increase in stock-based compensation expense of $2.1 million, and an increase in depreciation expense of $0.7 million. Net Cash Used in Investing Activities Net cash used in investing activities was $0.9 million during the year ended December 31, 2019 compared to net cash used in investing activities of $9.0 million during the year ended December 31, 2018. Net cash used in investing activities for the years ended December 31, 2019 and 2018 primarily consisted of purchases of property and equipment. The decrease in net cash used in investing activities of $8.1 million was primarily due to a decrease in purchases of property and equipment associated with our new facility lease that commenced in December 2017. Net Cash Provided by Financing Activities Net cash provided by financing activities was $64.3 million during the year ended December 31, 2019 compared to net cash provided by financing activities of $105.0 million during the year ended December 31, 2018. The net cash provided by financing activities during the year ended December 31, 2019 was primarily the result of $64.2 million of net proceeds received from our IPO, after deducting underwriting discounts and commissions and estimated offering expenses. As of December 31, 2019, $0.3 million of offering expenses were unpaid. The net cash provided by financing activities during the year ended December 31, 2018 was primarily the result of $105.1 million of net proceeds received from private placements of our Series A preferred stock and Series B preferred stock. Funding Requirements We expect our expenses to increase substantially in connection with our ongoing research and development activities, particularly as we continue the research and development of, initiate clinical trials of, and seek marketing approval for, our product candidates. In addition, we expect to incur additional costs associated with operating as a public company. As a result, we expect to incur substantial operating losses and negative operating cash flows for the foreseeable future. Based on our current operating plan, we believe that our existing cash and cash equivalents as of December 31, 2019 will enable us to fund our operating expenses and capital expenditure requirements into the third quarter of 2021. However, we have based this estimate on assumptions that may prove to be wrong and we could exhaust our capital resources sooner than we expect. Our funding requirements and timing and amount of our operating expenditures will depend largely on: • the progress, costs and results of our ongoing Phase 2b and Phase 2 open label clinical trials of losmapimod; • the scope, progress, results and costs of discovery research, preclinical development, laboratory testing and clinical trials for our product candidates, including our planned Phase 1 clinical trial of FTX-6058; • the number of and development requirements for other product candidates that we pursue; • the costs, timing and outcome of regulatory review of our product candidates; • our ability to enter into contract manufacturing arrangements for supply of API and manufacture of our product candidates and the terms of such arrangements; • the success of our collaboration with Acceleron; • our ability to establish and maintain additional strategic collaborations, licensing or other arrangements and the financial terms of such arrangements; • the payment or receipt of milestones, royalties and other collaboration-based revenues, if any; • the costs and timing of future commercialization activities, including product manufacturing, sales, marketing and distribution, for any of our product candidates for which we may receive marketing approval; • the amount and timing of revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property and proprietary rights and defending any intellectual property-related claims; and • the extent to which we acquire or in-license other products, product candidates, technologies or data referencing rights. 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. We will need to continue to rely on additional financing to achieve our business objectives. In addition to the variables described above, if and when any of our product candidates successfully complete development, we will incur substantial additional costs associated with regulatory filings, marketing approval, post-marketing requirements, maintaining our intellectual property rights, and regulatory protection, in addition to other commercial costs. We cannot reasonably estimate these costs at this time. 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, collaboration arrangements, strategic alliances and marketing, distribution or licensing arrangements. We currently have no credit facility or committed sources of capital. To the extent that we raise additional capital through the future sale of equity securities, the ownership interests of our stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our existing common stockholders. If we raise additional funds through the issuance of debt securities, these securities could contain covenants that would restrict our operations. We may require additional capital beyond our currently anticipated amounts, and additional capital may not be available on reasonable terms, or at all. If we raise additional funds through collaboration arrangements, strategic alliances or marketing, distribution or licensing arrangements in the future, we may have to relinquish valuable rights to our technologies, future revenue streams or product candidates, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate 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 The following table summarizes our contractual obligations as of December 31, 2019 and the effects that these obligations are expected to have on our liquidity and cash flows in future periods: (1) Represents future minimum lease payments under our non-cancelable operating lease, which expires in June 2028. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. Under our right of reference and license agreement that we entered into in February 2019 with affiliates of GSK, we have payment obligations that are contingent upon the occurrence of future events such as our achievement of specified clinical, regulatory and sales milestones and are required to make royalty payments in connection with the sale of products developed under the agreement. Specifically, we may owe GSK up to $37.5 million in certain specified clinical and regulatory milestones, including a $2.5 million milestone payment we made to GSK during the year ended December 31, 2019 upon the initiation of a Phase 2 clinical trial, and up to $60.0 million in certain specified sales milestones and royalties on product sales, if any. We have not included any such contingent milestone or royalty payment obligations in the table above because the amount (in the case of potential royalty payments), timing and likelihood of such payments are not always known. For additional information regarding this license agreement, including our payment obligations thereunder, see “Business-Right of Reference and License Agreement with GlaxoSmithKline,” and Note 10 to our annual consolidated financial statements included elsewhere in this Annual Report on Form 10-K. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials, pre-clinical research studies, synthetic chemistry and testing and manufacturing services. These contracts are generally cancelable by us upon up to 30 days’ 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 and through the date of cancellation. These payments are not included in the preceding table as the amount and timing of these payments are not known. Off-Balance Sheet Arrangements We did not have, during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make judgments and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of expenses during the reported periods. Our estimates are based on our historical experience, known trends and events, 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 and amount of expense recognized that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We evaluate our estimates and assumptions on an ongoing basis. The effects of material revisions in estimates, if any, will be reflected in the consolidated financial statements prospectively from the date of change in estimates. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the most significant areas involving management’s judgments and estimates. See Note 2 to our annual consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a description of our other significant accounting policies. Revenue Recognition Under the Financial Accounting Standards Board Accounting Standards Codification, or ASC, 606, Revenue from Contracts with Customers, 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. In applying ASC 606, we perform the following five steps: 1) Identify the contract with the customer A contract with a customer exists when (i) we enter into an enforceable contract with a customer that defines each party’s rights regarding the goods or services to be transferred and identifies the related payment terms, (ii) the contract has commercial substance and (iii) we determine that collection of substantially all consideration for goods and services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration. 2) Identify the promises and performance obligations in the contract Performance obligations promised in a contract are identified based on the goods and services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the good or service either on its own or together with other available resources, and are distinct in the context of the contract, whereby the transfer of the good or service is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised goods and services, we must apply judgment to determine whether promised goods and services are capable of being distinct and distinct in 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 customer and the availability of the associated expertise in the 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 these criteria are not met, the promised goods and services are accounted for as a combined performance obligation. 3) Determine the transaction price The transaction price is determined based on the consideration to which we will be entitled in exchange for transferring goods and services to the customer. If the consideration promised in a contract includes a variable amount, we estimate the amount of consideration to which we 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 unconstrained amount of estimated variable consideration in the transaction price. The amount included in the transaction price is constrained to the amount for which 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, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment. Changes to the constraint of variable consideration can have a material effect on the amount of revenue recognized in the period. If an arrangement includes research and development 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, such as regulatory approvals, are generally not considered probable of being achieved until the underlying events occur or the associated approvals are received. For arrangements with licenses of intellectual property that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, we recognize royalty revenue and sales-based milestones at the later of (i) when the related sales occur, or (ii) when the performance obligation to which the royalty has been allocated has been satisfied. 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 assess our revenue generating arrangements in order to determine whether a significant financing component exists. 4) Allocate the transaction price to the performance obligations in the contract If the contract contains a single performance obligation, the entire transaction consideration is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction consideration to each performance obligation on a relative standalone selling price basis unless the transaction consideration is variable and meets the criteria to be allocated entirely to a single performance obligation or to a distinct service that forms part of a single performance obligation. 5) Recognize revenue when or as the Company satisfies a performance obligation We may satisfy performance obligations over time or at a point in time, depending on the nature of the performance obligation. Revenue is recognized over time if the customer simultaneously receives and consumes the benefits provided by the entity’s performance, the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced, or the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. If the entity does not satisfy a performance obligation over time, the related performance obligation is satisfied at a point in time by transferring the control of a promised good or service to a customer. For revenue that we recognize over time, we assess whether an input or an output method is the appropriate measure of progress associated with the satisfaction of the performance obligation. In determining the appropriate method for measuring progress, we consider the nature of the good or service that the we have promised to transfer to the customer. Output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract. Input methods recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation. Estimates inherent to our measurement of progress associated with the satisfaction of performance obligations include the total estimated costs to satisfy the associated performance obligation. See Note 9, “Acceleron Collaboration Agreement”, for further information on the application of ASC 606 to the Acceleron Collaboration Agreement. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Non-refundable advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Stock-Based Compensation We measure stock-based compensation expense related to all restricted stock awards and stock options based on the fair value of the award on the date of grant. We recognize compensation expense for these awards over the requisite service period, 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 have also granted certain stock-based awards with performance-based vesting conditions. We recognize compensation expense for awards with performance-based vesting conditions over the remaining service period using an accelerated attribution method when management determines that achievement of the performance condition is probable. At each reporting date, we evaluate if the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions. We determine the fair value of restricted stock awards based on the estimated fair value of our common stock on the date of grant, less any applicable purchase price. We estimate the fair value of stock options granted using the Black-Scholes option-pricing model. The determination of the grant date fair value of stock options using an option pricing model is affected principally by our estimated fair value of our common stock and requires management to make a number of other assumptions, including the expected term of the option, the estimated volatility of the underlying shares, the risk-free interest rate, and expected dividends. The assumptions used in the determination of the grant date fair value of stock options represent management’s best estimates at the time of measurement. Given the lack of public market for our common stock prior to the closing of our IPO and a lack of company-specific historical and implied volatility data, we based the estimate of expected volatility on the historical volatility of a representative group of publicly traded companies for which historical information is available. The historical volatility is calculated based on a period of time commensurate with the assumption used for the expected term. We use the simplified method to calculate the expected term for all stock options. We utilize this method as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. The risk-free interest rate is based on a U.S. 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 do not have current plans to pay any dividends on common stock. In future periods, we expect stock-based compensation expense to increase, due in part to our existing unrecognized stock-based compensation expense and as we grant additional stock-based awards to continue to attract and retain our employees. Determination of Fair Value of Common Stock and Series B Preferred Stock prior to our IPO Prior to our IPO, there was no public market for our common stock. As a result, the estimated fair value of our common stock and Series B preferred stock was determined by our board of directors and management, respectively, as of the date of each equity issuance considering our most recently available third-party valuations of common stock or Series B preferred stock, and our assessment of additional objective and subjective factors. We were required to estimate the fair value of our common stock underlying our stock-based awards when estimating the grant date fair value of those awards. Additionally, we were required to estimate the fair value of the Series B preferred stock issued pursuant to the right of reference and license agreement that we entered into with GSK in February 2019. The third-party valuations of our common stock and our Series B preferred stock 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. The assumptions underlying these valuations represented our best estimates, which involved inherent uncertainties and the application of judgment. Following the closing of our IPO, we have determined the fair value of our common stock based on the quoted market price of our common stock on the Nasdaq Global Market. 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. 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 financial statements appearing at the end of this Annual Report on Form 10-K. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012 permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have elected not to “opt out” of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time private companies adopt the new or revised standard and will do so until such time that we either (i) irrevocably elect to “opt out” of such extended transition period or (ii) no longer qualify as an emerging growth company.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company focused on improving the lives of patients with genetically defined rare diseases in areas of high unmet medical need. We have developed a proprietary product engine that we employ to systematically identify and validate cellular drug targets that can potentially modulate gene expression to treat the known root cause of genetically defined diseases. We are using our product engine to identify targets that can be drugged by small molecules regardless of the particular underlying mechanism of gene misexpression. We have identified drug targets to treat the root causes of facioscapulohumeral muscular dystrophy, or FSHD, and certain hemoglobinopathies, namely sickle cell disease, or SCD, and ßthalassemia. In August 2019, we initiated a Phase 2b clinical trial and a Phase 2 open label clinical trial of losmapimod, our product candidate for FSHD, to evaluate the efficacy and safety of losmapimod in addressing the underlying cause of FSHD. We plan to submit an investigational new drug application, or IND, for FTX6058, our product candidate for certain hemoglobinopathies, in the second half of 2020. FTX6058 is a novel upregulator of fetal hemoglobin. In preclinical research, treatment with FTX6058 was shown to increase HbF levels to approximately 30% of total hemoglobin as measured by high performance liquid chromatography and mass spectrometry methods in human erythroid progenitor cells from multiple donors. FTX6058 also elevated HbF in vivo in animal models at plasma concentrations reasonably expected to be achieved in humans. Since inception, our operations have focused on organizing and staffing our company, business planning, raising capital, establishing our intellectual property, building our discovery platform, including our proprietary compound library and product engine, identifying drug targets and potential product candidates, inlicensing assets, producing drug substance and drug product material for use in clinical trials and conducting preclinical studies and early clinical trials. To date, we have funded our operations primarily through the issuance of common stock in our initial public offering, or IPO, convertible preferred stock and convertible notes, and an upfront payment received under the collaboration and license agreement, or the Acceleron Collaboration Agreement, with Acceleron Pharma Inc., or Acceleron. On July 22, 2019, we completed an IPO of our common stock and issued and sold 4,500,000 shares of common stock at a public offering price of $16.00 per share, resulting in net proceeds of $63.9 million after deducting underwriting discounts and commissions and estimated offering expenses. Upon completion of the IPO, all 112,500,000 shares of outstanding convertible preferred stock automatically converted into 16,071,418 shares of common stock. In December 2019, we entered into the Acceleron Collaboration Agreement, to identify biological targets to modulate specific pathways associated with a targeted indication within the pulmonary disease space. Under the collaboration and license agreement with Acceleron, we granted Acceleron an exclusive worldwide license under certain intellectual property rights to make, have made, use, sell, have sold, import, export, distribute and have distributed, market, have marketed, promote, have promoted, or otherwise exploit molecules and products directed against or expressing certain biological targets identified by us for the treatment, prophylaxis, or diagnosis of a targeted indication within the pulmonary disease space. The primary goal of the collaboration is to identify and validate potential biological targets for further research, in order to support the development, manufacture and commercialization of product candidates by Acceleron for the targeted indication by leveraging our proprietary product engine. Under the terms of the Acceleron Collaboration Agreement, we received a $10.0 million upfront payment from Acceleron in December 2019. We are also eligible to receive up to $438.5 million in the aggregate in milestone payments with respect to certain research, developmental, clinical, regulatory and salesrelated milestones. We are also be eligible to receive tiered royalty payments [/INST] Positive. </s>

Clarivate Analytics PLC

2020-03-02

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 “Item 6. Selected Financial Data” and our Consolidated Financial Statements, including the notes thereto, included elsewhere in this annual report. Certain statements in this section are forward-looking statements that involve risks and uncertainties, such as statements regarding our plans, objectives, expectations and intentions. Our future results and financial condition may differ materially from those we currently anticipate as a result of the factors we describe under “Item 1A. Risk Factors.” Certain income statement amounts discussed herein are presented on an actual and on a constant currency basis. We calculate constant currency by converting the non-U.S. dollar income statement balances for the most current year to U.S. dollars by applying the average exchange rates of the preceding year. Certain amounts that appear in this section may not sum due to rounding. Overview We offer a collection of high quality, market leading information and analytic products and solutions through our Science and Intellectual Property (“IP”) Product Groups. Our Science Product Group consists of our Web of Science and Life Science Product Lines, and our IP Product Group consists of our Derwent, CompuMark and MarkMonitor Product Lines. Our highly curated Web of Science products are offered primarily to universities, helping them navigate scientific literature, facilitate research and evaluate and measure the quality of researchers, institutions and scientific journals across various academic disciplines. Our Life Sciences Product Line offerings serve the content and analytical needs of pharmaceutical and biotechnology companies across the drug development lifecycle, including content on discovery and pre-clinical research, competitive intelligence, regulatory information and clinical trials. Our Derwent Product Line offerings help patent and legal professionals in R&D intensive businesses evaluate the novelty and patentability of new ideas and products to help protect and research patents. Our CompuMark products and services allow businesses and legal professionals to access our comprehensive trademark database. Finally, our MarkMonitor offerings include enterprise web domain portfolio management products and services. Factors Affecting the Comparability of Our Results of Operations The following factors have affected the comparability of our results of operations between the periods presented in this annual report and may affect the comparability of our results of operations in future periods. Our Transition to Operations as a Standalone Business We began to transition to a standalone company in October 2016, when Onex and Baring acquired subsidiaries and assets comprising the intellectual property and science business of Thomson Reuters for approximately $3,600,000 and formed Clarivate. Transition Services Agreement At the time of our separation from Thomson Reuters in 2016, we entered into a transition services agreement with Thomson Reuters, pursuant to which Thomson Reuters provided us with certain transitional support services, including facilities management, human resources, accounting and finance, sourcing, certain data center services, and sales and marketing and other back office services. We have replaced all transition services agreement services by building up comparable internal functions during the course of 2017, 2018 and 2019, though we continued to rely to a limited extent on certain Thomson Reuters data center services until we complete our product migration to either Amazon Web Services, or our own systems in 2019. Pursuant to the transition services agreement, we paid Thomson Reuters a fee based on Thomson Reuters’ historical allocation for such services to our business when it was owned by Thomson Reuters. These transition services agreement fees amounted to $10,481, $55,764 and $89,942 in the years ended December 31, 2019, 2018 and 2017, respectively. Our standalone operating costs have differed substantially from the historical costs of services under the transition services agreement and may differ substantially in the future, which may impact the comparability of our results of operations between the periods presented in this annual report and with those for future periods. Purchase Accounting Impact of Our Separation from Thomson Reuters in 2016 In addition, purchase accounting adjustments related to our separation from Thomson Reuters in 2016 included a revaluation of deferred revenues to account for the difference in value between the customer advances retained by us upon the consummation of our separation from Thomson Reuters in 2016 and our outstanding performance obligations related to those advances. The difference in value is written down as an adjustment to revenues as the related performance obligations, which cannot be recognized as revenues under GAAP, are fulfilled. This resulted in negative adjustments to revenues of $438, $3,152, and $49,673 in the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, the relevant performance obligations have been substantially fulfilled and the valuation difference has been written down. As a result, our consolidated revenues and margins are not comparable between the periods presented in this annual report and may not be comparable with those for future periods. To facilitate comparability between periods we present Adjusted Revenues in this annual report to eliminate, among other things, the impact of the deferred revenues adjustment. See “- Certain Non-GAAP Measures - Adjusted Revenues, Adjusted Subscription Revenues and Adjusted Transactional Revenues.” Merger with Churchill Capital Corp. In January 2019, we entered into an agreement to merge with Churchill Capital Corp, which closed in May 2019. At closing, our available cash increased by approximately $682,087, of which $650,000 was applied to pay down our existing debt and the remainder was used to pay costs related to the merger and for general corporate purposes. Following the consummation of the merger, our ordinary shares and warrants began trading on the NYSE and NYSE American, respectively. Our filings with the SEC and listing on the NYSE have required us to develop the functions and resources necessary to operate as a public company, including employee-related costs and equity compensation, which have resulted in increased operating expenses, which we estimate to be approximately $6,458 per year. Acquisition of Decision Resources Group On January 17, 2020, we entered into an agreement to acquire DRG, a premier provider of high-value data, analytics and insights products and services to the healthcare industry, from Piramal Enterprises Limited, which is a part of global business conglomerate Piramal Group. The acquisition closed on February 28, 2020. The aggregate consideration paid in connection with the closing of the DRG acquisition was approximately $950,000, comprised of $900,000 in cash paid on the closing date and approximately $50,000 in Clarivate ordinary shares to be issued to Piramal Enterprises Limited following the one-year anniversary of closing. In February 2020, we completed an underwritten public offering of 27,600,000 of our ordinary shares, generating net proceeds of $540,736, which we used to fund a portion of the cash consideration for the DRG acquisition. In addition, we incurred an incremental $360,000 of term loans under our term loan facility and used the net proceeds from such borrowings, together with cash on hand, to fund the remainder of the cash consideration for the DRG acquisition and to pay related fees and expenses. MarkMonitor Brand Protection, Antipiracy and Antifraud Disposition In November 2019, we entered into an agreement with an unrelated third-party for the sale of certain assets and liabilities of our MarkMonitor Product Line within the IP Group. The divestment closed in January 2020 for a consideration of approximately $3,751. As a result of this divestiture, we recorded an impairment loss of $18,431 for the year ended December 31, 2019. As of December 31, 2019, we determined that these assets and liabilities met the criteria to be classified as held for sale. All assets and liabilities of the divested business are reclassified to Assets held for sale and Liabilities held for sale respectively on our December 31, 2019 Consolidated Balance Sheet. The divestiture did not represent a strategic shift, and is not expected to have a significant effect on our financial results or operations in future periods. We retained the MarkMonitor Domain Management business. Refinancing Transactions In October 2019, we closed a private offering of $700,000 in principal amount of secured notes due 2026 and entered into new credit facilities in an initial principal amount of $1,150,000. We used the net proceeds from the offering of notes, together with drawings under the credit facilities, to refinance all amounts outstanding under our prior credit facilities, to redeem our then-outstanding notes and pay fees and expenses related to the foregoing, and to fully fund our $200,000 payment obligation under the agreement terminating our obligations under the tax receivable agreement entered into in connection with our merger with Churchill Capital Corp. Termination of Tax Receivable Agreement In connection with our merger with Churchill Capital Corp, we entered into a tax receivable agreement with Onex and Baring and certain other pre-merger shareholders of the Company. The tax receivable agreement generally would have required us to pay the counterparties 85% of the amount of cash savings, if any, realized (or, in some cases, deemed to be realized) as a result of the utilization of certain tax assets. In August 2019, we entered into an agreement pursuant to which all of our future payment obligations under the tax receivable agreement would terminate in exchange for a payment of $200,000, which we made in November 2019. We believe that termination of the tax receivable agreement will significantly improve our free cash flow profile by eliminating near-term cash outflows of up to $30,000 annually that we were expecting to pay starting in early 2021. IPM Product Line Divestiture In October 2018, we sold certain subsidiaries and assets related to our intellectual property management (IPM) Product Line for a total purchase price of $100,130 gross of restricted cash and cash included in normalized working capital and related adjustments, of which $31,378 was used to repay a portion of the term loan. As a result, we recorded a net gain on sale of $36,072 for the year ended December 31, 2018. Our consolidated financial statements included elsewhere in this annual report include the results of operations related to our divested IPM Product Line through the date of divestiture, including revenues of $0, $20,450 and $31,854 for the years ended December 31, 2019, 2018, and 2017, respectively. The divestiture did not represent a strategic shift, and is not expected to have a significant effect on our financial results or operations in future periods, although as a result our consolidated revenues and profits for the periods presented in this annual report may not be comparable between periods or with those for future periods. To facilitate comparability between periods we present Adjusted Revenues in this annual report to eliminate, among other things, IPM Product Line revenues for 2019, 2018, and 2017. See “- Certain Non-GAAP Measures - Adjusted Revenues, Adjusted Subscription Revenues and Adjusted Transactional Revenues.” Darts-ip Acquisition On November 27, 2019, our IP Product Group completed the acquisition of Darts-ip, a leading provider of case law data for intellectual property professionals. We acquired 100% of the voting equity interest of the acquired business. All assets and liabilities are included in our consolidated financial statements. Effect of Currency Fluctuations As a result of our geographic reach and operations across regions, we are exposed to currency transaction and currency translation impacts. Currency transaction exposure results when we generate revenues in one currency and incur expenses in another. While we seek to limit our currency transaction exposure by matching revenues and expenses, we are not always able to do so. For example, our revenues were denominated approximately 81% in U.S. dollars, 9% in euros, 3% in British pounds and 7% in other currencies for the year ended December 31, 2019, 79% in U.S. dollars, 7% in euros, 7% in British pounds and 7% in other currencies for the year ended December 31, 2018 and 79% in U.S. dollars, 7% in euros, 7% in British pounds and 7% in other currencies for the year ended December 31, 2017, while our direct expenses before depreciation and amortization, tax and interest in 2019, 2018 and 2017, were denominated approximately 70%, 70%, and 73% in U.S. dollars, 9%, 9%, and 8% in euros, 13%, 11%, and 11% in British pounds and 8%, 10%, and 8% in various other currencies, respectively. The financial statements of our subsidiaries outside the U.S. and the UK are typically measured using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the balance sheet date exchange rates, while income and expense items are translated at the average monthly exchange rates. Resulting translation adjustments are recorded in Accumulated other comprehensive income (loss) on the Consolidated Balance Sheets. Subsidiary monetary assets and liabilities that are denominated in currencies other than the functional currency are remeasured using the month-end exchange rate in effect during each month, with any related gain or loss recorded in Other operating expense, net within the Consolidated Statements of Operations. We do not currently hedge our foreign currency transaction or translation exposure. As a result, significant currency fluctuations could impact the comparability of our results between periods, while such fluctuations coupled with material mismatches in revenues and expenses could also adversely impact our cash flows. See “

<s>[INST] Overview We offer a collection of high quality, market leading information and analytic products and solutions through our Science and Intellectual Property (“IP”) Product Groups. Our Science Product Group consists of our Web of Science and Life Science Product Lines, and our IP Product Group consists of our Derwent, CompuMark and MarkMonitor Product Lines. Our highly curated Web of Science products are offered primarily to universities, helping them navigate scientific literature, facilitate research and evaluate and measure the quality of researchers, institutions and scientific journals across various academic disciplines. Our Life Sciences Product Line offerings serve the content and analytical needs of pharmaceutical and biotechnology companies across the drug development lifecycle, including content on discovery and preclinical research, competitive intelligence, regulatory information and clinical trials. Our Derwent Product Line offerings help patent and legal professionals in R&D intensive businesses evaluate the novelty and patentability of new ideas and products to help protect and research patents. Our CompuMark products and services allow businesses and legal professionals to access our comprehensive trademark database. Finally, our MarkMonitor offerings include enterprise web domain portfolio management products and services. Factors Affecting the Comparability of Our Results of Operations The following factors have affected the comparability of our results of operations between the periods presented in this annual report and may affect the comparability of our results of operations in future periods. Our Transition to Operations as a Standalone Business We began to transition to a standalone company in October 2016, when Onex and Baring acquired subsidiaries and assets comprising the intellectual property and science business of Thomson Reuters for approximately $3,600,000 and formed Clarivate. Transition Services Agreement At the time of our separation from Thomson Reuters in 2016, we entered into a transition services agreement with Thomson Reuters, pursuant to which Thomson Reuters provided us with certain transitional support services, including facilities management, human resources, accounting and finance, sourcing, certain data center services, and sales and marketing and other back office services. We have replaced all transition services agreement services by building up comparable internal functions during the course of 2017, 2018 and 2019, though we continued to rely to a limited extent on certain Thomson Reuters data center services until we complete our product migration to either Amazon Web Services, or our own systems in 2019. Pursuant to the transition services agreement, we paid Thomson Reuters a fee based on Thomson Reuters’ historical allocation for such services to our business when it was owned by Thomson Reuters. These transition services agreement fees amounted to $10,481, $55,764 and $89,942 in the years ended December 31, 2019, 2018 and 2017, respectively. Our standalone operating costs have differed substantially from the historical costs of services under the transition services agreement and may differ substantially in the future, which may impact the comparability of our results of operations between the periods presented in this annual report and with those for future periods. Purchase Accounting Impact of Our Separation from Thomson Reuters in 2016 In addition, purchase accounting adjustments related to our separation from Thomson Reuters in 2016 included a revaluation of deferred revenues to account for the difference in value between the customer advances retained by us upon the consummation of our separation from Thomson Reuters in 2016 and our outstanding performance obligations related to those advances. The difference in value is written down as an adjustment to revenues as the related performance obligations, which cannot be recognized as revenues under GAAP, are fulfilled. This resulted in negative adjustments to revenues of $438, $3,152, and $49,673 in the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, the relevant performance obligations have been substantially fulfilled and the valuation difference has been written down. As a result, our consolidated revenues and margins are not comparable between the periods presented in this annual report and may not be comparable with those for future periods. To facilitate comparability between [/INST] Positive. </s>

Replay Acquisition Corp.

2020-03-25

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations We are a blank check company incorporated as a Cayman Islands exempted company on November 6, 2018 and formed for the purpose of effecting a merger, amalgamation, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular business, industry or geographical location for purposes of consummating a business combination, we have initially focused our search for a target in Argentina and/or Brazil focused on industries that we believe have favorable prospects and a high likelihood of generating strong risk-adjusted returns for our shareholders. These industries include, but are not limited to, the consumer, telecommunications and technology, energy, financial services and real estate sectors. The registration statement for our initial public offering was declared effective on April 3, 2019. On April 8, 2019, we consummated our initial public offering of 28,750,000 units at an offering price of $10.00 per unit, including the issuance of 3,750,000 units as a result of the underwriters’ full exercise of their over-allotment option, generating gross proceeds of $287,500,000. Each unit consists of one ordinary share, par value $0.0001 per share, and one-half of one warrant, each whole warrant entitling the holder thereof to purchase one ordinary share at a price of $11.50 per share, subject to adjustment. An aggregate of 2,500,000 units were purchased by certain affiliates of our sponsor in our initial public offering for gross proceeds of $25,000,000. Simultaneously with the consummation of our initial public offering and the full over-allotment option, we consummated a private placement of 7,750,000 private placement warrants to our sponsor at a price of $1.00 per private placement warrant, generating total proceeds of $7,750,000. Following our initial public offering and the private placement, and after deducting offering expenses, $287,500,000 (including $9,187,500 of deferred underwriting commissions) were placed in the trust account established for the benefit of our public shareholders. If we are unable to complete an initial business combination by April 8, 2021, we will (1) cease all operations except for the purpose of winding up, (2) as promptly as reasonably possible but not more than 10 business days thereafter, subject to lawfully available funds therefor, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest (less up to $100,000 of interest to pay dissolution expenses and which interest shall be net of taxes payable), divided by the number of then issued and outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (3) as promptly as reasonably possible following such redemption, subject to the approval of our remaining shareholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. On August 15, 2019, we received the Notice from the staff of NYSE Regulation indicating that we are not currently in compliance with Section 802.01B of the Manual, which requires us to maintain a minimum of 300 public shareholders on a continuous basis. Pursuant to the Notice, we are subject to the procedures set forth in Sections 801 and 802 of the Manual. We submitted a business plan that demonstrates how we expect to return to compliance with the minimum public shareholders requirement within 18 months of receipt of the Notice. We anticipate that we will satisfy this listing requirement within such time period once we consummate our initial business combination. On October 24, 2019, we were notified by the staff of NYSE Regulation that the NYSE’s Listings Operations Committee agreed to accept our business plan, and we are currently subject to quarterly monitoring for compliance with such plan. Our ordinary shares, warrants and units, which trade under the symbols “RPLA,” “RPLA WS” and “RPLA.U,” respectively, will continue to be listed and traded on the NYSE during the cure period, subject to our compliance with the NYSE’s other applicable continued listing standards, and will bear the indicator “.BC” on the consolidated tape to indicate noncompliance with the NYSE’s continued listing standards. Results of Operations Our entire activity since November 6, 2018 (inception) through December 31, 2019 was in preparation for our initial public offering, and since our initial public offering, our activity has been limited to the search for a prospective initial business combination. We will not generate any operating revenues until the closing and completion of our initial business combination. We generate non-operating income in the form of investment income on investments held in the trust account after our initial public offering. 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 approximately $4.2 million, which consisted of approximately $4.6 million in gain on marketable securities, dividends and interest held in the trust account, offset by approximately $327,000 in general and administrative expenses. For the period from November 6, 2018 (inception) through December 31, 2018, we had net loss of approximately $3,000, which consisted of approximately $3,000 in general and administrative expenses. Liquidity and Capital Resources As of December 31, 2019, we had approximately $1.6 million outside of the trust account, approximately $4.6 million of investment income available in the trust account to pay for tax obligations (less up to $100,000 of interest to pay dissolution expenses), and a working capital surplus of approximately $1.6 million. Through December 31, 2019, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares to our sponsor, $250,000 in loans from our sponsor under an unsecured promissory note and approximately $2,000 in advances from a related party. Subsequent to the consummation of our initial public offering, we received the net proceeds from the consummation of the private placement not held in the trust account of $2.0 million. We fully repaid the note and the advances to our sponsor and the related party in May 2019. Following our initial public offering and the private placement, $287.5 million was placed in the trust account, including approximately $9.2 million of deferred underwriting commissions. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (which interest shall be net of taxes payable and excluding deferred underwriting commissions) to complete our initial business combination. To the extent that our ordinary shares or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a business combination, and to pay taxes to the extent the interest earned on the trust account is not sufficient to pay our taxes. In 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. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1.5 million of such working capital loans may be convertible into warrants at a price of $1.00 per warrant. The warrants would be identical to the private placement warrants. To date, we had no borrowings under the working capital loans. Based on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of an initial business combination or one year from this filing. Related Party Transactions Founder Shares In December 2018, our sponsor purchased 7,187,500 founders shares for an aggregate price of $25,000. In March 2019, our sponsor transferred to our independent directors an aggregate of 90,000 founder shares at the same price originally paid for such shares. Our sponsor agreed to forfeit up to 937,500 founder shares to the extent that the over-allotment option was not exercised in full by the underwriters. The forfeiture was to be adjusted to the extent that the over-allotment option was not exercised in full by the underwriters so that the founder shares would represent 20.0% of our issued and outstanding shares after our initial public offering. On April 5, 2019, the underwriters fully exercised their over-allotment option which closed simultaneously with our initial public offering; thus, the 937,500 founder shares were no longer subject to forfeiture. Our sponsor and our officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their founder shares until the earlier to occur of: (A) one year after the completion of our initial business combination or (B) subsequent to our initial business combination, (x) if the last reported sale price of the ordinary shares equals or exceeds $12.00 per share (as adjusted for share splits, share dividends, rights issuances, subdivisions, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after our initial business combination, or (y) the date on which we complete a liquidation, merger, amalgamation, share exchange, reorganization or other similar transaction that results in all of our shareholders having the right to exchange their ordinary shares for cash, securities or other property. Private Placement Warrants Simultaneously with the closing of our initial public offering on April 8, 2019, we sold 7,750,000 private placement warrants to our sponsor at a price of $1.00 per private placement warrant, generating gross proceeds of $7.75 million. Each private placement warrant is exercisable for one ordinary share at a price of $11.50 per share. A portion of the net proceeds from the private placement was added to the proceeds from our initial public offering held in the trust account. If we do not complete our initial business combination by April 8, 2021, the private placement warrants will expire worthless. The private placement warrants are non-redeemable and exercisable on a cashless basis so long as they are held by our sponsor or its permitted transferees. Our sponsor and our officers and directors agreed, subject to limited exceptions, not to transfer, assign or sell any of their private placement warrants until 30 days after the completion of our initial business combination. Related Party Loans On December 1, 2018, our sponsor agreed to loan us an aggregate of up to $250,000 to cover expenses related to our initial public offering pursuant to an unsecured promissory note. This loan was non-interest bearing and payable on the earlier of June 30, 2019 or the completion of our initial public offering. We borrowed $250,000 under the note, and fully repaid on May 6, 2019. In addition to the promissory note, we borrowed approximately $2,000 from a related party for general and administrative expenses. We repaid this amount on May 7, 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 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 does not close, we may use a portion of proceeds held outside the trust account to repay the working capital loans but no proceeds held in the trust account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such working capital loans may be convertible into warrants at a price of $1.00 per warrant. The warrants would be identical to the private placement warrants. To date, we had no borrowings under the working capital loans. Reimbursement Our sponsor, 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, officers, directors or our or any of 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. Commitments and Contingencies Registration 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 ordinary shares underlying such securities, are entitled to registration rights pursuant to a registration rights agreement entered into on April 3, 2019. These holders will be entitled to certain demand and “piggyback” registration rights. However, the registration rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until the termination of the applicable lock-up period for the securities to be registered. We will bear the expenses incurred in connection with the filing of any such registration statements. Underwriting Agreement We granted the underwriters a 45-day option from April 3, 2019 to purchase up to 3,750,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On April 5, 2019, the underwriters fully exercised their over-allotment option which closed simultaneously with our initial public offering. Except on the 2,500,000 units sold to certain affiliates of our sponsor in our initial public offering, the underwriters were entitled to an underwriting discount of $0.20 per unit, or $5.25 million in the aggregate, paid upon the closing of our initial public offering. In addition, $0.35 per unit, or approximately $9.2 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. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following as our 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 the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption (if any) are classified as liability instruments 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 the occurrence of uncertain future events. Accordingly, at December 31, 2019, 27,942,373 ordinary shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ equity section of our balance sheet. At December 31, 2018, we did not have any ordinary shares subject to possible redemption outstanding. Net Income Per Ordinary Share We comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” Net income per share is computed by dividing net income by the weighted-average number of ordinary shares outstanding during the periods. We had not considered the effect of the warrants sold in our initial public offering (including the consummation of the full over-allotment option) and the private placement to purchase an aggregate of 22,125,000 ordinary shares in the calculation of diluted income per share, because their inclusion would be anti-dilutive under the treasury stock method. Our statement of operations includes a presentation of income per ordinary share subject to redemption in a manner similar to the two-class method of income per share. Net income per share, basic and diluted for public shares is calculated by dividing the investment income earned on the trust account of approximately $4.6 million, by the weighted average number of 28,750,000 public shares outstanding since the initial issuance. Net loss per share, basic and diluted for founder shares is calculated by dividing the net income (approximately $4.2 million, less income attributable to public shares in the amount of $4,6 million, resulting in a loss of approximately $327,000), by the weighted average number of 7,187,500 founder shares outstanding for the period. 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. Off-Balance Sheet Arrangements and Contractual Obligations 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 long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations or other long-term liabilities. 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, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] The registration statement for our initial public offering was declared effective on April 3, 2019. On April 8, 2019, we consummated our initial public offering of 28,750,000 units at an offering price of $10.00 per unit, including the issuance of 3,750,000 units as a result of the underwriters’ full exercise of their overallotment option, generating gross proceeds of $287,500,000. Each unit consists of one ordinary share, par value $0.0001 per share, and onehalf of one warrant, each whole warrant entitling the holder thereof to purchase one ordinary share at a price of $11.50 per share, subject to adjustment. An aggregate of 2,500,000 units were purchased by certain affiliates of our sponsor in our initial public offering for gross proceeds of $25,000,000. Simultaneously with the consummation of our initial public offering and the full overallotment option, we consummated a private placement of 7,750,000 private placement warrants to our sponsor at a price of $1.00 per private placement warrant, generating total proceeds of $7,750,000. Following our initial public offering and the private placement, and after deducting offering expenses, $287,500,000 (including $9,187,500 of deferred underwriting commissions) were placed in the trust account established for the benefit of our public shareholders. If we are unable to complete an initial business combination by April 8, 2021, we will (1) cease all operations except for the purpose of winding up, (2) as promptly as reasonably possible but not more than 10 business days thereafter, subject to lawfully available funds therefor, redeem the public shares, at a pershare price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest (less up to $100,000 of interest to pay dissolution expenses and which interest shall be net of taxes payable), divided by the number of then issued and outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (3) as promptly as reasonably possible following such redemption, subject to the approval of our remaining shareholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. On August 15, 2019, we received the Notice from the staff of NYSE Regulation indicating that we are not currently in compliance with Section 802.01B of the Manual, which requires us to maintain a minimum of 300 public shareholders on a continuous basis. Pursuant to the Notice, we are subject to the procedures set forth in Sections 801 and 802 of the Manual. We submitted a business plan that demonstrates how we expect to return to compliance with the minimum public shareholders requirement within 18 months of receipt of the Notice. We anticipate that we will satisfy this listing requirement within such time period once we consummate our initial business combination. On October 24, 2019, we were notified by the staff of NYSE Regulation that the NYSE’s Listings Operations Committee agreed to accept our business plan, and we are currently subject to quarterly monitoring for compliance with such plan. Our ordinary shares, warrants and units, which trade under the symbols “RPLA,” “RPLA WS” and “RPLA.U,” respectively, will continue to be listed and traded on the NYSE during the cure period, subject to our compliance with the NYSE’s other applicable continued listing standards, and will bear the indicator “.BC” on the consolidated tape to indicate noncompliance with the NYSE’s continued listing standards. Results of Operations Our entire activity since November 6, 2018 (inception) through December 31, 2019 was in preparation for our initial public offering [/INST] Negative. </s>

PINTEREST, INC.

2020-02-07

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 related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from these forward-looking statements as a result of many factors, including those discussed in “Risk Factors” and “Note About Forward-Looking Statements” included elsewhere in this Annual Report on Form 10-K. A discussion regarding our financial condition and results of operation 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 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 April 18, 2019. Overview of 2019 Results Our key financial and operating results as of and for the year ended December 31, 2019 are as follows: •Revenue was $1,142.8 million, an increase of 51% compared to 2018. •Monthly active users ("MAUs") were 335 million, an increase of 26% compared to December 31, 2018. •Share-based compensation expense was $1,377.8 million, an increase of $1,362.9 million compared to 2018. •Total costs and expenses were $2,531.6 million. •Loss from operations was $1,388.9 million. •Net loss was $1,361.4 million. •Adjusted EBITDA was $16.7 million. •Cash, cash equivalents and marketable securities were $1,713.3 million. •Headcount was 2,217. •We now serve ads in 28 countries, up from seven at December 31, 2018. Trends in User Metrics Monthly Active Users. We define a monthly active user as an authenticated Pinterest user who visits our website, opens our mobile application or interacts with Pinterest through one of our browser or site extensions, such as the Save button, at least once during the 30-day period ending on the date of measurement. We present MAUs based on the number of MAUs measured on the last day of the current period. We calculate average MAUs based on the average of the number of MAUs measured on the last day of the current period and the last day prior to the beginning of the current period. MAUs are the primary metric by which we measure the scale of our active user base. Quarterly Monthly Active Users (in millions) Note: United States and International may not sum to Global due to rounding. A portion of our MAUs visit Pinterest on a weekly basis. We define a weekly active user (“WAU”) as an authenticated Pinterest user who visits our website, opens our mobile application or interacts with Pinterest through one of our browser or site extensions, such as the Save button, at least once during the seven-day period ending on the date of measurement. We actively monitor the relationship of WAUs to MAUs, which has stayed relatively consistent over time. As of December 31, 2019, the proportion of WAUs to MAUs was 57%. We have experienced significant growth in our global MAUs over the last several years. In particular, our international MAUs have grown significantly as a result of our focus on localizing content in international markets. We expect our international user growth to continue to outpace U.S. user growth in the near term. Trends in Monetization Metrics Revenue. We calculate revenue by user geography based on our estimate of the geography in which ad impressions are delivered. The geography of our users affects our revenue and financial results because we currently only monetize certain countries and currencies and because we monetize different geographies at different average rates. Our revenue in the United States is higher primarily due to our decision to focus our earliest monetization efforts there and also due to the relative size and maturity of the U.S. digital advertising market. Quarterly Revenue (in millions) Note: Revenue by geography in the charts above is geographically apportioned based on our estimate of the geographic location of our users when they perform a revenue-generating activity. This allocation differs from our disclosure of revenue disaggregated by geography in the notes to our consolidated financial statements where revenue is geographically apportioned based on our customers’ billing addresses. United States and International may not sum to Global and quarterly amounts may not sum to annual due to rounding. Average Revenue per User (“ARPU”). We measure monetization of our platform through our average revenue per user metric. We define ARPU as our total revenue in a given geography during a period divided by average MAUs in that geography during the period. We calculate ARPU by geography based on our estimate of the geography in which revenue-generating activities occur. We present ARPU on a U.S. and international basis because we currently monetize users in different geographies at different average rates. U.S. ARPU is higher primarily due to our decision to focus our earliest monetization efforts there and also due to the relative size and maturity of the U.S. digital advertising market. Quarterly Average Revenue per User For the year ended December 31, 2019, global ARPU was $3.81, which represents an increase of 21% compared to the year ended December 31, 2018. For the year ended December 31, 2019, U.S. ARPU was $12.07 and international ARPU was $0.54, which represent increases of 34% and 115%, respectively, compared to the year ended December 31, 2018. Factors Affecting Our Performance Growth in MAUs. User growth trends, which are reflected in the number of MAUs, are a key factor that affects our revenue and financial results. As our user base and the quality of engagement of our users grow, we believe the potential to increase our revenue grows. We are focused on increasing the ways Pinners use and get value from our platform and on expanding our user base, with an emphasis on international markets. We may face challenges enhancing the quality of engagement and increasing the size of our user base, including competition from alternative products and services, saturation of existing markets, difficulties scaling in international markets, a lack of sufficiently relevant content available on Pinterest, actions by external parties (such as changes in search engine methodologies and policies and disruptions in single sign-on access) or changes in regulations (which require changes to our products in a manner that negatively impacts our user growth, retention and engagement). We expect revenue growth will be driven more by the quality of user engagement and higher monetization of users than by sheer growth of users. To the extent our user growth slows, our revenue growth will become increasingly dependent on our ability to increase the quality of user engagement. Growth in Monetization. Monetization trends, which are reflected in ARPU, are a key factor that affects our revenue and financial results. We are in the early stages of our monetization efforts. We are focused on increasingly serving more mid-market and unmanaged advertisers and expanding our sales efforts to reach advertisers in additional international markets, with an initial focus on Western Europe and other select markets to follow. We are working on building more self-serve tools to help our mid-market and unmanaged advertisers with ad creation, campaign scaling and measurement. There are many variables that impact ARPU, including the number of ad impressions shown on our platform and the price per ad, which depends on a number of factors including the engagement of our audience and the quality of that engagement, the number and diversity of advertisers, our ability and decision to serve contextually relevant advertisements, the amount of advertising spend, an advertiser’s objectives, ad performance and the effectiveness of our advertising products and our ability to measure that effectiveness for our advertisers, as well as the effect of geographic differences on each of these factors. Due to our decision to focus our earliest monetization efforts in the United States, we have less experience monetizing international markets and therefore may experience challenges scaling and monetizing these markets due to differences in Pinners' taste and interests and advertisers' expectations. The international advertising market is also smaller and less mature than the U.S. digital advertising market. We use MAUs and ARPU to assess the growth and health of the overall business and believe that these metrics best reflect our ability to attract, retain, engage and monetize our users, and thereby drive revenue. Investment in Technology. We make investments in technology that we believe will enhance Pinner and advertiser experiences. Key investment areas for our platform include machine learning, computer vision and our recommendation engine. We also invest heavily in our advertising products, including our self-serve platform and first- and third-party measurement tools. Our ability to grow our user base, attract new advertisers and increase our revenue will depend, in part, on our ability to continue innovating in visual search and discovery and our ability to successfully launch new products for Pinners and advertisers. We plan to continue making significant investments in research and development and may develop products for Pinners that cannot be monetized immediately, if ever. Investment in Talent. Our business relies on our ability to attract and retain talent. As of December 31, 2019, we had 2,217 full-time employees, an increase of 23% compared to December 31, 2018. Competition. We face significant competition in almost every aspect of our business. We primarily compete with consumer internet companies that are either tools (search, ecommerce) or media (newsfeeds, video, social networks). We also compete for advertising revenue across a variety of formats. Some of our competitors have greater financial resources and substantially larger user bases. These competitors’ economies of scale allow them to have access to larger volumes of data and platforms that are used on a more frequent basis than ours, which may enable them to better understand their user base and develop and deliver more targeted advertising. We must compete effectively for users and advertisers in order to grow our business and increase our revenue. We believe that our ability to compete for users depends on a number of factors, including the quality of our users’ experience on our service and on other platforms. We believe that our ability to compete effectively for advertisers depends on a number of factors, including our ability to offer attractive advertising products with robust targeting and measurement tools. Seasonality. We experience seasonality in user growth, engagement and monetization on our platform. Historically, we have had lower engagement in the second calendar quarter. Industry advertising spend tends to be strongest in the fourth quarter, and we observe a similar pattern in our historical advertising revenue. Significant user and monetization growth has partially offset these trends in historical periods, and thus we expect the impact of seasonality to be more pronounced in the future. Share-Based Compensation. We began granting restricted stock units ("RSUs") in March 2015. We measure RSUs based on the fair market value of our common stock on the grant date. RSUs granted under our 2009 Plan are subject to both a service condition, which is typically satisfied over four years, and a performance condition, which was deemed satisfied upon the pricing of our IPO. We did not record any share-based compensation expense for our RSUs prior to our IPO because the performance condition had not yet been satisfied. Upon pricing our IPO, we recorded cumulative share-based compensation expense using the accelerated attribution method for those RSUs granted under our 2009 Plan for which the service condition had been satisfied at that date. We will record the remaining unrecognized share-based compensation expense over the remainder of the requisite service period. RSUs granted under our 2019 Omnibus Incentive Plan (the "2019 Plan") are subject only to a service condition, which is typically satisfied over four years. We record share-based compensation expense for these RSUs on a straight-line basis over the requisite service period. As of December 31, 2019, we had $635.1 million of unrecognized share-based compensation expense, which we expect to recognize over a weighted-average period of 3.2 years. For more information about the factors impacting our performance, see “Risk Factors.” Components of Results of Operations Revenue. We generate revenue by delivering ads on our website and mobile application. Advertisers purchase ads directly with us or through their relationships with advertising agencies. We recognize revenue only after transferring control of promised goods or services to customers, which occurs when a user clicks on an ad contracted on a cost per click ("CPC") basis, views an ad contracted on a cost per thousand impressions ("CPM") basis or views a video ad contracted on a cost per view ("CPV") basis. Cost of Revenue. Cost of revenue consists primarily of expenses associated with the delivery of our service, including the cost of hosting our website and mobile application. Cost of revenue also includes personnel-related expense, including salaries, benefits and share-based compensation for employees on our operations teams, payments associated with partner arrangements, credit card and other transaction processing fees, and allocated facilities and other supporting overhead costs. Research and Development. Research and development consists primarily of personnel-related expense, including salaries, benefits and share-based compensation for our engineers and other employees engaged in the research and development of our products, and allocated facilities and other supporting overhead costs. Sales and Marketing. Sales and marketing consists primarily of personnel-related expense, including salaries, commissions, benefits and share-based compensation for our employees engaged in sales, sales support, marketing, business development and customer service functions, advertising and promotional expenditures, professional services and allocated facilities and other supporting overhead costs. Our marketing efforts also include user- and advertiser-focused marketing expenditures. General and Administrative. General and administrative consists primarily of personnel-related expense, including salaries, benefits and share-based compensation for our employees engaged in finance, legal, human resources and other administrative functions, professional services, including outside legal and accounting services, and allocated facilities and other supporting overhead costs. Other Income (Expense), Net. Other income (expense), net consists primarily of interest earned on our cash equivalents and marketable securities. Provision for Income Taxes. Provision for income taxes consists primarily of income taxes in foreign jurisdictions, U.S. federal and state income taxes adjusted for discrete items. Adjusted EBITDA. We define Adjusted EBITDA as net loss adjusted to exclude depreciation and amortization expense, share-based compensation expense, interest and other income (expense), net and provision for (benefit from) income taxes. See “Non-GAAP Financial Measure” for more information and for a reconciliation of net loss, the most directly comparable financial measure calculated and presented in accordance with GAAP, to Adjusted EBITDA. Results of Operations The following tables set forth our consolidated statements of operations data (in thousands): (1)Includes share-based compensation expense as follows (in thousands): (2)See “Selected Financial Data-Non-GAAP Financial Measure” for more information and for a reconciliation of net loss, the most directly comparable financial measure calculated and presented in accordance with GAAP, to Adjusted EBITDA. The following table sets forth our consolidated statements of operations data (as a percentage of revenue): Years Ended December 31, 2019 and 2018 Revenue Revenue for the year ended December 31, 2019 increased by $386.8 million compared to the year ended December 31, 2018. Revenue based on our estimate of the geographic location of our users increased by 43% in the United States to $1,025.5 million and by 187% internationally to $117.2 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. For the year ended December 31, 2019, U.S. revenue growth was driven by a 34% increase in U.S. ARPU supported by a 8% increase in U.S. MAUs, and international revenue growth was driven by a 115% increase in international ARPU supported by a 35% increase in international MAUs. ARPU growth in the U.S. and internationally was driven by higher monetization of both of those user bases largely due to an increase in advertising demand from new and existing advertisers on our platform, which resulted in an increase in the number of advertisements served. The increase in advertising demand resulted in an increase in the price of U.S. advertisements, while the price of international advertisements decreased due to our continued expansion into new countries. However, the impact of pricing changes was not significant in the U.S. or internationally. Cost of Revenue Cost of revenue for the year ended December 31, 2019 increased by $117.3 million compared to the year ended December 31, 2018. The increase was primarily due to higher absolute hosting costs due to user growth and a $31.7 million increase in share-based compensation expense recorded following our IPO. Research and Development Research and development for the year ended December 31, 2019 increased by $955.4 million compared to the year ended December 31, 2018. The increase was primarily due to a $854.0 million increase in share-based compensation expense following our IPO and a 23% increase in average headcount, which drove higher personnel and facilities-related expenses. Sales and Marketing Sales and marketing for the year ended December 31, 2019 increased by $351.7 million compared to the year ended December 31, 2018. The increase was primarily due to a $238.5 million increase in share-based compensation expense following our IPO and a 34% increase in average headcount, which drove higher personnel and facilities-related expenses, as well as higher marketing expenses. General and Administrative General and administrative for the year ended December 31, 2019 increased by $276.6 million compared to the year ended December 31, 2018. The increase was primarily due to a $238.7 million increase in share-based compensation expense following our IPO and a 24% increase in average headcount, which drove higher personnel and facilities-related expenses. Other Income (Expense), Net Other income (expense), net for the year ended December 31, 2019 increased by $15.9 million compared to the year ended December 31, 2018. The increase was primarily due to higher returns on our marketable securities as a result of higher interest rates and higher invested balances following our investment of the proceeds of our IPO. Provision for Income Taxes Provision for income taxes was primarily due to profits generated by our foreign subsidiaries. Net Loss and Adjusted EBITDA Net loss for the year ended December 31, 2019 was $1,361.4 million, as compared to $63.0 million for the year ended December 31, 2018. Adjusted EBITDA was $16.7 million for the year ended December 31, 2019, as compared to $(39.0) million for the year ended December 31, 2018, due to the factors described above. See “Selected Financial Data-Non-GAAP Financial Measure” for more information and for a reconciliation of net loss, the most directly comparable financial measure calculated and presented in accordance with GAAP, to Adjusted EBITDA. Quarterly Results of Operations Data The following tables set forth our unaudited quarterly consolidated results of operations for each of the eight quarters in the period ended December 31, 2019. Our unaudited quarterly results of operations have been prepared on the same basis as our audited consolidated financial statements, and we believe they reflect all normal recurring adjustments necessary for the fair statement of our results of operations for these periods. This information should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Our historical operating data may not be indicative of our future performance. (1)Upon pricing our IPO, the performance condition for RSUs granted under our 2009 Plan was deemed satisfied, and we recorded cumulative share-based compensation expense for those RSUs for which the service condition had been satisfied at that date. For the three months ended June 30, 2019, we recorded total share-based compensation expense of $1,134.6 million. (2)Includes share-based compensation expense as follows (in thousands): (3)Represents assumed noncumulative dividends on undistributed earnings that, if declared, would have been distributed to holders of our redeemable convertible preferred stock. (4)The following table presents a reconciliation of net income (loss), the most directly comparable financial measure calculated and presented in accordance with GAAP, to Adjusted EBITDA (in thousands): The following table sets forth the components of our unaudited quarterly consolidated statements of operations for each of the periods presented (as a percentage of revenue): Liquidity and Capital Resources We have historically financed our operations primarily through sales of our stock and payments received from our customers. Our primary uses of cash are personnel-related costs and the cost of hosting our website and mobile application. As of December 31, 2019, we had $1,713.3 million in cash, cash equivalents and marketable securities. Our cash equivalents and marketable securities are primarily invested in short-duration fixed income securities, including government and investment-grade corporate debt securities and money market funds. As of December 31, 2019, $21.7 million of our cash and cash equivalents was held by our foreign subsidiaries. In November 2018, we entered into a five-year $500.0 million revolving credit facility with an accordion option which, if exercised, would allow us to increase the aggregate commitments by the greater of $100.0 million and 10% of our consolidated total assets, provided we are able to secure additional lender commitments and satisfy certain other conditions. Interest on any borrowings under the revolving credit facility accrues at either LIBOR plus 1.50% or at an alternative base rate plus 0.50%, at our election, and we are required to pay an annual commitment fee that accrues at 0.15% per annum on the unused portion of the aggregate commitments under the revolving credit facility. The revolving credit facility also allows us to issue letters of credit, which reduce the amount we can borrow. We are required to pay a fee that accrues at 1.50% per annum on the average aggregate daily maximum amount available to be drawn under any outstanding 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 holders of our stock or the stock of our subsidiaries, make investments or engage in transactions with our affiliates. The revolving credit facility also contains two financial maintenance covenants: a consolidated total assets covenant and a minimum liquidity balance of $350.0 million, which includes any available borrowing capacity. The obligations under the revolving credit facility are secured by liens on substantially all of our domestic assets, including certain domestic intellectual property assets. We are in compliance with all covenants and there were no amounts outstanding under this facility as of December 31, 2019. On April 23, 2019, we closed our IPO in which we issued and sold 75,000,000 shares of Class A common stock at $19.00 per share. We received net proceeds of $1,368.0 million after deducting underwriting discounts and commissions and before deducting offering costs of $9.8 million. We utilized a portion of the net proceeds from this offering to pay approximately $302.7 million to satisfy the tax withholding and remittance obligations related to the settlement of RSUs. On April 29, 2019, we issued and sold an additional 11,250,000 shares of Class A common stock at $19.00 per share pursuant to the underwriters’ option to purchase additional shares. We received additional net proceeds of $205.2 million after deducting underwriting discounts and commissions. We believe our existing cash, cash equivalents and marketable securities and amounts available under our revolving credit facility 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. For the years ended December 31, 2019, 2018 and 2017, our net cash flows were as follows (in thousands): Operating Activities Cash flows from operating activities consist of our net loss adjusted for certain non-cash reconciling items, such as share-based compensation expense, depreciation and amortization, and changes in our operating assets and liabilities. Net cash provided by operating activities increased by $61.0 million for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to a decrease in our net loss after adjusting for non-cash reconciling items. Investing Activities Cash flows from investing activities consist of capital expenditures for improvements to new and existing office spaces. We also actively manage our operating cash and cash equivalent balances and invest excess cash in short-duration marketable securities, sales and maturities of which we use to fund our ongoing working capital requirements. Net cash used in investing activities increased by $700.6 million for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to increased purchases of marketable securities and less proceeds from maturities of marketable securities. Financing Activities Cash flows from financing activities consist of net proceeds from our IPO, tax withholdings on release of RSUs and proceeds from the exercise of stock options. Net cash provided by financing activities increased by $1,130.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to net proceeds from our IPO, offset by tax withholdings on release of RSUs. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements as of December 31, 2019. Contractual Obligations The following table summarizes our contractual obligations and commitments as of December 31, 2019 (in thousands): In May 2017, we amended the enterprise agreement governing our use of services from AWS with an addendum. Under the agreement, as amended by the addendum, we agreed that a substantial majority of our monthly usage of certain compute, storage, data transfer and other services must be provided under the addendum, and we are required to purchase at least $750.0 million of cloud services, which we primarily use for compute, storage and data transfer services, from AWS through July 2023. If we fail to meet the contractual commitment, we are required to pay the difference, except in limited circumstances, such as termination due to acquisition of us by another cloud services provider (which would result in an obligation to pay liquidated damages under the addendum), but we are not otherwise subject to annual purchase commitments during the remainder of the six-year term of the addendum. The addendum restricts our ability to terminate the agreement until the minimum spend commitment is satisfied, other than termination only under certain additional conditions (such as the other party’s material breach or acquisition of us by another cloud services provider). As of December 31, 2019, the remaining contractual commitment was $171.3 million, which we expect to meet during the term of the addendum primarily through our use of AWS cloud services. In March 2019, we entered into a lease for approximately 490,000 square feet of office space to be constructed near our current headquarters campus in San Francisco, California. The estimated commencement and expiration dates are in 2022 and 2033, respectively. We may terminate the lease prior to commencement if certain contingencies are not satisfied. We will be subject to total non-cancelable minimum lease payments of approximately $420.0 million, which is excluded from the table above, if these contingencies are met, and we will record a right-of-use asset and related lease liability of no more than that amount at lease commencement using our incremental borrowing rate at that date. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with GAAP. Preparing our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses as well as related disclosures. Because these estimates and judgments may change from period to period, actual results could differ materially, which may negatively affect our financial condition or results of operations. We base our estimates and judgments on historical experience and various other assumptions that we consider reasonable, and we evaluate these estimates and judgments on an ongoing basis. We refer to such estimates and judgments, discussed further below, as critical accounting policies and estimates. Refer to Note 1 to our consolidated financial statements for further information on our other significant accounting policies. Revenue Recognition We generate revenue by delivering ads on our website and mobile application. We recognize revenue only after transferring control of promised goods or services to customers, which occurs when a user clicks on an ad contracted on a CPC basis, views an ad contracted on a CPM basis or views a video ad contracted on a CPV basis. We typically bill customers on a CPC, CPM or CPV basis, and our payment terms vary by customer type and location. The term between billing and payment due dates is not significant. We occasionally offer customers free ad inventory and revenue is recognized only after satisfying our contractual performance obligations. When contracts with our customers contain multiple performance obligations, we allocate the overall transaction price, which is the amount of consideration to which we expect to be entitled in exchange for promised goods or services, to each of the distinct performance obligations based on their relative standalone selling prices. We generally determine standalone selling prices based on the effective price charged per contracted click, impression or view, and we do not disclose the value of unsatisfied performance obligations because the original expected duration of our contracts is generally less than one year. Share-Based Compensation We have granted RSUs since March 2015. We measure RSUs based on the fair market value of our common stock on the grant date. RSUs granted under our 2009 Plan are subject to both a service condition, which is typically satisfied over four years, and a performance condition, which was deemed satisfied upon the pricing of our IPO. We did not record any share-based compensation expense for our RSUs prior to our IPO because the performance condition had not yet been satisfied. Following the closing of our IPO, we recorded cumulative share-based compensation expense using the accelerated attribution method for those RSUs granted under our 2009 Plan for which the service condition had been satisfied at that date. We will record the remaining unrecognized share-based compensation expense over the remainder of the requisite service period. RSUs granted under our 2019 Plan are subject to a service condition only, which is typically satisfied over four years. We recognize share-based compensation expense on these RSUs on a straight-line basis over the requisite service period. Valuation of Common Stock and Redeemable Convertible Preferred Stock Warrants Until our IPO, we determined the fair value of our common stock and redeemable convertible preferred stock warrants using the most observable inputs available to us, including recent sales of our stock as well as income and market valuation approaches. The income approach estimates the value of our business based on the future cash flows we expect to generate discounted to their present value using an appropriate discount rate to reflect the risk of achieving the expected cash flows. The market approach estimates the value of our business by applying valuation multiples derived from the observed valuation multiples of comparable public companies to our expected financial results. We used the Probability Weighted Expected Return Method ("PWERM") to allocate the value of our business among our outstanding stock and share-based awards. We applied the PWERM by first defining the range of potential future liquidity outcomes for our business, such as an IPO, and then allocating its value to our outstanding stock and share-based awards based on the relative probability that each outcome will occur. We used the Option Pricing Method to allocate the value of our business to our outstanding stock and share-based awards under the non-IPO outcome we considered within the PWERM. Applying these valuation and allocation approaches involved the use of estimates, judgments, and assumptions that are highly complex and subjective, such as those regarding our expected future revenue, expenses, and cash flows, discount rates, valuation multiples, the selection of comparable public companies, and the probability of future events. Changes in any or all of these estimates and assumptions, or the relationships between these assumptions, impacted our valuation as of each valuation date and may have a material impact on the valuation of our common stock and redeemable convertible preferred stock warrants. Following our IPO, there is an active market for our Class A common stock and the warrants to purchase shares of our preferred stock were net exercised, so we no longer apply these valuation and allocation approaches. Leases and Operating Lease Incremental Borrowing Rate We lease office space under operating leases with expiration dates through 2033. We determine whether an arrangement constitutes a lease and record lease liabilities and right-of-use assets on our consolidated balance sheets at lease commencement. We measure lease liabilities based on the present value of the total lease payments not yet paid discounted based on the more readily determinable of the rate implicit in the lease or our incremental borrowing rate, which is the estimated rate we would be required to pay for a collateralized borrowing equal to the total lease payments over the term of the lease. We estimate our incremental borrowing rate based on an analysis of publicly traded debt securities of companies with credit and financial profiles similar to our own. We measure right-of-use assets based on the corresponding lease liability adjusted for (i) payments made to the lessor at or before the commencement date, (ii) initial direct costs we incur and (iii) tenant incentives under the lease. We begin recognizing rent expense when the lessor makes the underlying asset available to us, we do not assume renewals or early terminations unless we are reasonably certain to exercise these options at commencement, and we do not allocate consideration between lease and non-lease components. Recent Accounting Pronouncements Refer to Note 1 to our consolidated financial statements for recent accounting pronouncements.

<s>[INST] A discussion regarding our financial condition and results of operation 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 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 April 18, 2019. Overview of 2019 Results Our key financial and operating results as of and for the year ended December 31, 2019 are as follows: Revenue was $1,142.8 million, an increase of 51% compared to 2018. Monthly active users ("MAUs") were 335 million, an increase of 26% compared to December 31, 2018. Sharebased compensation expense was $1,377.8 million, an increase of $1,362.9 million compared to 2018. Total costs and expenses were $2,531.6 million. Loss from operations was $1,388.9 million. Net loss was $1,361.4 million. Adjusted EBITDA was $16.7 million. Cash, cash equivalents and marketable securities were $1,713.3 million. Headcount was 2,217. We now serve ads in 28 countries, up from seven at December 31, 2018. Trends in User Metrics Monthly Active Users. We define a monthly active user as an authenticated Pinterest user who visits our website, opens our mobile application or interacts with Pinterest through one of our browser or site extensions, such as the Save button, at least once during the 30day period ending on the date of measurement. We present MAUs based on the number of MAUs measured on the last day of the current period. We calculate average MAUs based on the average of the number of MAUs measured on the last day of the current period and the last day prior to the beginning of the current period. MAUs are the primary metric by which we measure the scale of our active user base. Quarterly Monthly Active Users (in millions) Note: United States and International may not sum to Global due to rounding. A portion of our MAUs visit Pinterest on a weekly basis. We define a weekly active user (“WAU”) as an authenticated Pinterest user who visits our website, opens our mobile application or interacts with Pinterest through one of our browser or site extensions, such as the Save button, at least once during the sevenday period ending on the date of measurement. We actively monitor the relationship of WAUs to MAUs, which has stayed relatively consistent over time. As of December 31, 2019, the proportion of WAUs to MAUs was 57%. We have experienced significant growth in our global MAUs over the last several years. In particular, our international MAUs have grown significantly as a result of our focus on localizing content in international markets. We expect our international user growth to continue to outpace U.S. user growth in the near term. Trends in Monetization Metrics Revenue. We calculate revenue by user geography based on our estimate of the geography in which ad impressions are delivered. The geography of our users affects our revenue and financial results because we currently only monetize certain countries and currencies and because we monetize different geographies at different average rates. Our revenue in the United States is higher primarily due to our decision to focus our earliest monetization efforts there and also due to the relative size and maturity of the U.S. digital advertising market. Quarterly Revenue (in millions) Note: Revenue by geography in the charts above is geographically apportioned based on our estimate of the geographic location of our users when they perform a revenuegenerating activity. This allocation differs from our disclosure of revenue disaggregated by geography in the notes to our consolidated financial statements where revenue is geographically apportioned based on our customers’ billing addresses. United [/INST] Positive. </s>

Progyny, 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 the related notes and other financial information 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 expressed or implied by such forward-looking statements. Important factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in Part I, Item 1A. “Risk Factors” 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 final prospectus filed with the SEC on October 25, 2019 pursuant to Rule 424(b)(4) (File No. 333-233965), or the Prospectus, under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Overview We envision a world where anyone who wants to have a child can do so. Our mission is to make dreams of parenthood come true through healthy, timely and supported fertility journeys. Through our differentiated approach to benefits plan design, patient education and support and active network management, our clients’ employees are able to pursue the most effective treatment from the best physicians and achieve optimal outcomes. Progyny is a leading benefits management company specializing in fertility and family building benefits solutions in the United States. Our clients include many of the nation’s most prominent employers across a broad array of industries. We launched our fertility benefits solution in 2016 with our first five employer clients, and we have grown our base of clients to over 130. We currently provide coverage to approximately 2.1 million employees and their partners (known in our industry as covered lives), who we refer to as our members. We have achieved this growth by demonstrating that our purpose-built, data-driven and disruptive platform consistently delivers superior clinical outcomes in a cost-efficient manner while driving exceptional client and member satisfaction. We have retained substantially all of our clients since inception, and our member satisfaction over that same time period is evidenced by our most recent industry-leading Net Promoter Score, or NPS, of +72 for our fertility benefits solution and +80 for our integrated pharmacy benefits solution, Progyny Rx. Fertility Benefits Solution. Our fertility benefits solution includes providing members with access to effective and cost-efficient fertility treatments through our Smart Cycle plan design. Smart Cycles are proprietary treatment bundles designed by us to include those medical services available to our members through our selective network of high-quality fertility specialists. Medical services under our Smart Cycles include everything needed for a comprehensive fertility treatment cycle, including all necessary diagnostic testing and access to the latest technology (e.g., in the case of IVF, preimplantation genetic testing). We currently offer 17 different Smart Cycle treatment bundles, which may be used in various combinations depending on the member’s need. Each Smart Cycle treatment bundle has a separate unit value (i.e., some have fractional values and some have whole values). Our clients contract to purchase a cumulative Smart Cycle unit value per eligible member. These can range from one to an unlimited unit value. Members, in consultation with their PCAs, can choose their preferred provider clinics within our network and utilize the specific Smart Cycle treatment bundles necessary for the treatment pathway they determine throughout their fertility journey. In addition, we provide care management services as part of our fertility benefits solution, which include active management of our selective network of high-quality fertility specialists, real-time member eligibility and treatment authorization, member-facing digital solutions, detailed quarterly reporting for our clients supported by our dedicated account management teams and end-to-end comprehensive concierge member support provided by our in-house staff of PCAs. Clients can also add adoption and surrogacy reimbursement programs as part of this solution. Progyny Rx. We went live with our integrated pharmacy benefits solution in 2018. Progyny Rx can only be purchased by clients that purchase our fertility benefits solution. Progyny Rx provides our members with access to the medications needed during their fertility treatment. As part of this solution, we provide care management services, which include our formulary plan design, simplified authorization, assistance with prescription fulfillment and timely delivery of the medications by our network of specialty pharmacies, as well as medication administration training, pharmacy support services and continuing PCA support. Our Clients. We currently serve over 130 self-insured employers in the United States across more than 25 industries. Our current clients, who are industry leaders across both high-growth and mature industries and who range in size from 1,000 to 250,000 employees, represent approximately 2.1 million covered lives. Revenue Model Our clients primarily contract with us to provide our fertility benefits solution and, where added on by our clients, our Progyny Rx solution. Our revenue has both a utilization-based component and a population-based component, as follows: · Utilization Component. Clients pay us for the fertility benefits and Progyny Rx solutions utilized by their employees. With respect to the fertility benefits solution, we bill clients for Smart Cycles in accordance with our bundled case rates, which vary by the type of fertility service rendered and clinic location. Case rates include all third-party fertility specialists, anesthesiology and laboratory services, as well as all of our care management services. With respect to Progyny Rx, we bill the client for the fertility medication dispensed to their employees in connection with the authorized fertility treatments. Medication fees also include our formulary management, drug utilization review and cost containment services and other care management services. · Population-Based Component. Clients who purchase our fertility benefits solution also typically pay us a per employee per month fee, or PEPM fee, which is population-based. This allows us to provide access to our PCAs for fertility and family building education and guidance and other digital tools to all of our members, regardless of whether they ultimately pursue fertility treatment. PEPM fees represented 1% of our total revenue for the years ended December 31, 2019 and 2018. Our revenue in a given year is determined by both the utilization of our fertility benefits and Progyny Rx solutions by our members and the number of members enrolled in our clients’ benefits plans. Each year, we contract directly with new clients for our fertility benefits solution and, where added by the client, our Progyny Rx solution. Given that the majority of our clients contract with us for a January 1st benefits plan start date, our sales cycle follows the conventional healthcare benefits cycle, which largely concludes by the end of October of the prior year to allow for benefits education and annual open enrollment to occur in November. For some clients that are considering a start date later in the year, the sales cycle can extend through the next year. Similarly, for existing clients, any changes in plan designs are typically elected by the end of October so that clients can inform their employees of the benefits during the open enrollment period ahead of a January 1st plan year start. Key Operational and Business Metrics In addition to the measures presented in our consolidated financial statements, we use the following key operational and business metrics to evaluate our business, measure our performance, develop financial forecasts, and make strategic decisions. Member and Client Base. Our addressable market is large self-insured employers. There are approximately 8,000 self-insured employers in the United States (excluding quasi-governmental entities, such as universities and school systems, and labor unions) who have a minimum of 1,000 employees, representing approximately 69 million potential covered lives in total. Our current member base of approximately 2.1 million represents only 3% of our total market opportunity. We intend to continue to drive new client acquisition by investing significantly in sales and marketing to engage, educate and drive awareness of the unmet need around fertility solutions among benefits executives. We also increase brand awareness and adoption with self-insured employers by leveraging our strong relationships with benefits consultants. In particular, we are focused on expanding the number of clients with more than 2,500 covered lives. As of December 31, 2019 and 2018 we serve 87 and 33 clients, respectively, representing 1,517,000 and 720,200 members, respectively. Importantly, as we have continued to grow, we have meaningfully diversified our client base across more than 25 different industries currently from just two industries when we launched our fertility benefits solution in 2016. We are expanding our client base within each industry and have an industry-specific strategy that enables us to most effectively target our addressable market. Because our clients within an industry compete with each other for employees, we believe our solutions are increasingly viewed as an important way for them to differentiate from, or remain competitive with, one another. Additionally, we believe that our expanding presence has resulted in a heightened awareness of the need to offer fertility benefits and has informed the market of the value we provide to our clients and our members, which we believe also helps facilitate growth. In addition, we are continuously utilizing our established client relationships to evaluate other potential fertility solutions that could benefit our members and simultaneously drive growth. Our ability to attract new clients will depend on a number of factors, including the effectiveness and pricing of our solutions, offerings of our competitors, the effectiveness of our marketing efforts to drive awareness and the demand for fertility benefits solutions overall. We define a client as an organization for which we have an active contract in the period indicated. We count each organization we contract with as a single client including divisions, segments or subsidiaries of larger organizations to the extent we contract separately with them. Benefits Utilization. A key driver of our revenue is the number of members we serve and the rate at which they utilize their fertility benefits. As our client base has grown, our membership has grown from approximately 110,000 members in 2016 when we launched our fertility benefits solution to 1.5 million members at December 31, 2019. The following table highlights the number of ART cycles performed for Progyny members and the member utilization rates for each of the periods presented. (1) Represents the number of ART cycles performed, including IVF with a fresh embryo transfer, IVF freeze all cycles/embryo banking, frozen embryo transfers and egg freezing. (2) Represents the member utilization rate for all services, including but not limited to, ART cycles, initial consultations, IUIs and genetic testing. The utilization rate for all members includes all unique members (female and male) who utilize the benefit during that period while the utilization rate for female only includes only unique females who utilize the benefit during that period. For the purposes of calculating utilization rates in any given period, the results reflect the number of unique members utilizing the benefit for that period. Individual periods cannot be combined as member treatments may span multiple periods. Components of Results of Operations Revenue Revenue includes fertility benefits solution revenue, pharmacy benefits solution revenue and PEPM fees. Fertility Benefits Solution Revenue Fertility benefits solution revenue primarily represents utilization of our fertility benefits solution. Our client contracts are typically for a three-year term and pricing for this solution is established for each Smart Cycle treatment bundle, based in part on when the client first became a client and the number of members covered under the solution. Fertility benefits solution revenue includes amounts we receive directly from members, including deductibles, co-insurance and co-payments associated with the treatments under the fertility benefits solution. Revenue is recognized based on the negotiated price with our clients and includes the portion to be paid directly by the member. Revenue is recognized when the Smart Cycle is completed for a member. Revenue is also accrued for authorized Smart Cycles rendered based on member appointments scheduled with a fertility specialist in our network but for which no claim has yet been reported, net of an allowance for appointment cancellations. Pharmacy Benefits Solution Revenue Pharmacy benefits solution revenue primarily represents utilization of Progyny Rx. For clients who contract for the fertility benefits solution, we offer an add-on, separate, fully integrated pharmacy benefits solution designed by us. Progyny Rx provides our members with access to our formulary plan design, simplified authorization, prescription fulfillment and timely delivery of the medications used during treatment through our network of specialty pharmacies, as well as provides our members with medication administration training and other pharmacy support services. Prescription drugs are dispensed by our contracted mail order specialty pharmacies. Revenue related to the dispensing of prescription drugs by the specialty pharmacies in our network includes the prescription fees negotiated with our clients, including the portion that we collect directly from members (deductibles, co-insurance and co-payments). The contractual fees agreed to with our clients are inclusive of the cost of the prescription drug from our specialty providers, less any applicable discounts, as well as the related clinical and care management services. Revenue from these arrangements are recognized when the drugs are dispensed. This solution was introduced in the marketplace in the third quarter of 2017 and went live with a select number of clients in January 1, 2018. Per employee per month (PEPM) fee Clients who purchase our fertility benefits solution also pay us a population based PEPM fee which provides access to our PCAs for fertility and family building education and guidance and other digital tools for all of our covered members, regardless of whether or not they ultimately pursue fertility treatment. We earn a PEPM fee for the majority of our clients. Revenue from the PEPM fee is billed and recognized monthly based upon the contractual fee and the number of employees at that specific client for that month. Cost of Services Our cost of services has three primary components: (1) fertility benefit services; (2) pharmacy benefit services; and (3) vendor rebates. Fertility Benefit Services Fertility benefit services costs include: (1) fees paid to provider clinics within our network, labs and anesthesiologists; (2) costs incurred (including salaries, bonuses, benefits, stock-based compensation, other related costs, and an allocation of our general overhead, depreciation and amortization) for those employees associated with our care management service functions: Provider Account Management, PCA and Provider Relations teams; and (3) and related information technology support costs. Our contracts with provider clinics are typically for a term of one to two years. Pharmacy Benefits Services Pharmacy benefits services costs include: (1) the fees for prescription drugs dispensed and clinical services provided during the reporting period by our specialty pharmacy partners; (2) costs incurred (including salaries, bonuses, benefits, stock-based compensation, other related costs, and an allocation of our general overhead, depreciation and amortization) for those employees associated with our care management service functions: PCA and Provider Relations teams; and (3) related information technology support costs. Contracts with the specialty pharmacies are typically for a term of one year. Vendor Rebates We receive a rebate on certain medications purchased by our specialty pharmacies. Our contractual arrangements with pharmaceutical manufacturers provide for us to receive a rebate from established list prices, which is paid subsequent to dispensing. These rebates are recorded as a reduction to cost of services when prescriptions are dispensed. Gross Profit and Gross Margin Gross profit is total revenue less total cost of services. Gross margin is gross profit expressed as a percentage of total revenue. We expect that gross profit and gross margin will continue to be affected by various factors including the geographic location where treatments are performed, as well as pricing with each of our clients, provider clinics, labs, specialty pharmacies and pharmaceutical companies, all of which are negotiated separately, have different contracting start and end dates and durations which are not coterminous with each other. Additionally, staffing levels necessary to deliver our care management services will continue to grow as we continue to add clients and their associated members. Operating Expenses Our operating expenses consist of sales and marketing and general and administrative expenses. Sales and Marketing Expense Sales and marketing expense consists primarily of employee related costs, including salaries, bonuses, commissions, benefits, stock-based compensation, other related costs, and an allocation of our general overhead, depreciation and amortization for those employees associated with sales and marketing. These expenses also include third-party consulting services, advertising, marketing, promotional events, and brand awareness activities. We expect sales and marketing expense to continue to increase in absolute dollars as we continue to invest and grow our business. General and Administrative Expense General and administrative expense consists primarily of employee related costs, including salaries, bonuses, benefits, stock-based compensation, other related costs, and an allocation of our general overhead, depreciation and amortization for those employees associated with general and administrative services such as executive, legal, human resources, information technology, accounting, and finance. These expenses also include third-party consulting services and facilities costs. We anticipate that we will incur additional costs (including a step up in public company related expenses) for employees and professional fees and insurance and related third-party consulting services on an ongoing basis as a public company. Other Expense, net Other expense includes interest expense and stock warrant valuation adjustment. Benefit (Provision) for Income Taxes We are subject to income taxes in the United States. As of December 31, 2019, and 2018, we recorded a full valuation allowance for our deferred tax assets based on our historical loss and the uncertainty regarding our ability to project future taxable income. In future periods, if we conclude we have future taxable income sufficient to recognize the deferred tax assets, we may reduce or eliminate the valuation allowance. Results of Operations The following tables set forth our results of operations for the periods presented and as a percentage of revenue for those periods: (1) Includes stock-based compensation expense as follows: Non-GAAP Financial Measure - Adjusted EBITDA Adjusted EBITDA is a supplemental financial measure that is not required by, or presented in accordance with U.S. GAAP. We believe that Adjusted EBITDA, when taken together with our U.S. GAAP financial results, provides meaningful supplemental information regarding our operating performance and facilitates internal comparisons of our historical operating performance on a more consistent basis by excluding certain items that may not be indicative of our business, results of operations or outlook. In particular, we believe that the use of Adjusted EBITDA is helpful to our investors as it is a measure used by management in assessing the health of our business, determining incentive compensation, evaluating our operating performance, and for internal planning and forecasting purposes. Adjusted EBITDA 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. Some of the limitations of Adjusted EBITDA include: (1) it does not properly reflect capital commitments to be paid in the future; (2) 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; (3) it does not consider the impact of stock-based compensation expense; (4) it does not reflect other non-operating expenses, including interest expense, net; (5) it does not consider the impact of any stock warrant valuation adjustment; (6) it does not reflect tax payments that may represent a reduction in cash available to us; (7) it does not include legal fees that may be payable in connection with a vendor arbitration; and (8) it does not include non-deferred costs associated with the IPO. In addition, 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. Because of these limitations, when evaluating our performance, you should consider Adjusted EBITDA alongside other financial performance measures, including our net income (loss) from continuing operations and other U.S. GAAP results. We calculate Adjusted EBITDA as net loss from continuing operations, adjusted to exclude depreciation and amortization, stock-based compensation expense, net interest expense, convertible preferred stock warrant valuation adjustment, provision (benefit) for income taxes, legal fees associated with a vendor arbitration and non-deferred IPO costs. The following table presents a reconciliation of Adjusted EBITDA to net loss from continuing operations for each of the periods indicated: Year ended December 31, Net (loss) income from continuing operations $ (8,569) $ (5,116) Add: Depreciation and amortization 2,135 1,883 Stock-based compensation expense 5,061 2,997 Interest expense, net Convertible preferred stock warrant valuation adjustment 18,176 2,944 Provision (benefit) for income taxes (1,777) Legal fees associated with a vendor arbitration 1,319 - Non-deferred IPO Costs - Adjusted EBITDA $ 18,342 $ 1,428 Comparison of Years Ended December 31, 2019 and 2018 Revenue Revenue increased by $124.3 million, or 118%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase is primarily due to a $89.8 million or 90% increase in revenue from our fertility benefits solution and a $34.4 million or 614% increase in revenue from our Progyny Rx solution. The increase in revenue from our fertility benefits solution was primarily due to the increase in the number of clients and covered lives. The increase in revenue from our Progyny Rx solution was also driven by the number of clients and covered lives that added the Progyny Rx benefit. The growth outpaces the fertility benefits revenue due to the fact that Progyny Rx was introduced in the marketplace in the third quarter of 2017 and went live with a select number of clients in January 1, 2018. Our revenue growth in 2019 benefited from having Progyny Rx available for the full selling season in 2018 to both new and existing clients. Cost of Services Cost of services increased by $98.2 million, or 114%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase is primarily due to a $93.0 million increase in medical treatment and pharmacy prescription costs associated with the fertility treatments delivered and a $5.2 million increase in personnel and overhead costs for our care management services teams and an increase in costs of adjudicating claims. Gross Profit and Gross Margin Gross profit increased by $26.1 million, or 134%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. Gross margin increased 140 basis points for the year ended December 31, 2019 compared to year ended December 31, 2018 primarily due to increased operating efficiencies. Operating Expenses Sales and Marketing Expense Sales and marketing expense increased by $4.6 million, or 63%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to a $3.6 million increase in personnel related costs (including a $0.4 million increase in stock based compensation) due to additional headcount and commissions for sales and marketing functions. General and Administrative Expense General and administrative expense increased by $8.3 million, or 53%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to a $3.6 million increase in personnel-related costs (including a $1.1 million increase in stock based compensation) due to additional headcount for general and administrative functions, $1.5 million increase in legal costs (including $1.3 million increase in legal costs associated with a vendor arbitration), $0.8 million increase in bad debt, and $2.4 million increase in other related general and administrative expenses including incremental costs related to being a public company. Other Expense, Net Other expense, net increased by $14.8 million, or 430%, for 2019 compared to 2018. This increase was primarily due to a charge related to the fair value adjustment of the preferred stock warrant of $15.2 million, offset by a $0.4 million in lower interest expense. The preferred stock warrants were converted to common stock warrants in connection with the IPO and will no longer be marked to market. Benefit (Provision) for Income Taxes For the year ended December 31, 2019 we recorded a provision for state taxes of $12,000. There is no provision or benefit for federal income taxes recorded for the year ended December 31, 2019. For the year ended December 31, 2018, we recorded a benefit for income taxes of $1.8 million as a result of the intraperiod tax allocation rules offsetting an equivalent provision for taxes associated with the sale of the discontinued operations of our early embryo viability assessment business. Liquidity and Capital Resources Since inception, we have financed our operations primarily through sales of our solutions and the net proceeds we have received from sales of equity securities as further detailed below. As of December 31, 2019, our principal sources of liquidity were $80.4 million of cash and cash equivalents and $15 million of cash available on the revolving line of credit with Silicon Valley Bank. Our cash and cash equivalents and working capital are affected by the timing of payments to third party providers and collections from clients and have increased as our revenue has increased. In particular, during the ramp up and onboarding of new clients who typically begin their benefits plan year as of January 1st, our accounts receivable has historically increased more than our accounts payable, accrued expenses and other current liabilities in the early part of each calendar year. Historically, these timing impacts have reversed throughout the remainder of the fiscal year. Accordingly, our working capital, and its impact on cash flow from operations, can fluctuate materially from period to period. On October 29, 2019, we completed our IPO in which we issued and sold 6,700,000 shares of common stock at a public offering price of $13.00 per share. We received net proceeds of $77.5 million from the IPO, after deducting underwriters’ discounts and commissions of $5.9 million and offering costs of $3.7 million. We believe that our existing cash and cash equivalents, cash flow from operations and the cash available on the revolving line of credit 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 sales of our solutions and client renewals, the timing and the amount of cash received from clients, the expansion of our sales and marketing activities and the continuing market adoption of our solutions. 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. In June 2018, we entered into an agreement with Silicon Valley Bank to replace our then outstanding term loan with a revolving line of credit of up to $15.0 million that will mature on June 8, 2021. The available revolving line of credit is based upon an advance rate of 80% of “eligible” accounts receivable and may be used to fund our working capital and other general corporate needs. Eligible accounts receivable includes accounts billed with aging 90 days or less and excludes accounts receivable due for member copayments, coinsurance, and deductibles. When we hold unrestricted cash balances greater than $5.0 million, interest accrues at a floating rate per annum equal to the greater of prime rate or 4.75%. If the unrestricted cash balance is less than $5.0 million, interest accrues at a floating rate per annum equal to the greater of prime rate plus 0.5% or 4.75%, with interest payable monthly. The following table summarizes our cash flows from continuing operations for the periods presented: Operating Activities Net cash used in operating activities was $1.5 million for the year ended December 31, 2019, primarily consisting of a $8.6 million net loss from continuing operations adjusted for certain non-cash items, which include $5.1 million of stock based compensation expense, a $18.2 million change in fair value of warrant liabilities, $2.1 million of depreciation and amortization, and $1.6 million from bad debt expense. Changes in operating assets and liabilities resulted in cash used in operating activities from increases in accounts receivable of $25.3 million and prepaid assets and other assets of $4.5 million, offset by cash provided by operating activities from increases in accounts payable of $3.5 million and accrued expenses and other current liabilities of $6.4 million. These changes are a result of the impact of revenue growth combined with the timing of payments to third party providers and collections from clients. Net cash provided by operating activities was $2.3 million for the year ended December 31, 2018, primarily consisting of $0.7 million of net income, adjusted for certain non-cash items, which include $3.0 million of stock-based compensation, $2.9 million change in fair value of warrant liabilities, $1.9 million of depreciation and amortization, and $0.8 million from bad debt expense and the loss from discontinued operations of $5.8 million. The non-cash adjustments were partially offset by a $1.8 million increase in deferred tax benefits resulting from the sale of a discontinued business. Changes in operating assets and liabilities resulted in cash used in operating activities from increases in accounts receivable of $12.8 million, offset by cash provided by operating activities from increases in accounts payable of $10.4 million and accrued expenses and other current liabilities of $2.8 million. These changes are as a result of the impact of revenue growth combined with the timing of payments to third party providers and collections from clients. Investing Activities Net cash used in investing activities from continuing operations was $3.0 million and $0.6 million for the years ended December 31, 2019 and 2018, respectively, consisting of purchases of computers, software, and leasehold improvements. Leasehold improvements of $2.0 million during 2019 were associated with the buildout of our new corporate office which was occupied in February 2020. Financing Activities Net cash provided by financing activities was $84.5 million for the year ended December 31, 2019, primarily consisting of $78.4 million in proceeds from the issuance of common stock in our IPO ($0.9 million of IPO costs were not paid yet as of December 31, 2019), $6.5 million from stock option exercises, and $0.1 million from warrant exercises, partially offset by $0.3 million in net payments on our revolving line of credit with Silicon Valley Bank, and repurchases of common stock of $0.2 million. Net cash used by financing activities was $8.7 million for the year ended December 31, 2018 primarily due to repayment of $5.4 million term loan and $3.7 million of treasury stock purchases of common and preferred stock from existing shareholders partially offset by $0.3 million in net borrowings on our revolving line of credit with Silicon Valley Bank. 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. The table does not include obligations under agreements that we can cancel without a significant penalty. In September 2019, we entered into a sublease agreement for our corporate offices in New York, New York. The sublease is for a 25,212 square foot office and will expire in May 2029. Pursuant to the sublease, we will pay the base rent of approximately $1.3 million per year through the end of the fifth lease year and approximately $1.4 million per year thereafter through the expiration date. 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. Critical Accounting Policies and Estimates Our consolidated financial statements and accompanying notes have been prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the amounts reported amounts of assets, liabilities, revenue and 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. For additional information about our critical accounting policies and estimates, see Note 1 - Business and Basis of Presentation and Note 2 - Summary of Significant Accounting Policies in the notes to the consolidated financial statements included in Part II, Item 8, of this Annual Report on Form 10-K. Revenue Recognition Our revenue is recognized when control of the promised goods or services is transferred to our clients in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. We apply the following five-step model to recognize revenue from contracts with our clients: · 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, a performance obligation is satisfied Our contracts typically have a stated term of three years and include contractual termination options after the first year, allowing the client to terminate the contract with 30 to 90 days’ notice. Fertility Benefits Revenue We primarily generate revenue through our fertility benefits solution, in which we provide our clients and their employees and partners, or our members, with fertility benefits. As part of the fertility benefits solution, we provide access to effective and cost-efficient fertility treatments, referred to as Smart Cycles, as well as other related services. Smart Cycles are our proprietary treatment bundles that include certain medical services available to members through our proprietary, credentialed network of provider clinics. In addition to access to our Smart Cycle treatment bundles and access to our network of provider clinics, the fertility benefits solution includes other comprehensive services, which we refer to as care management services, such as active management of the provider clinic network, real-time member eligibility and treatment authorization, member-facing digital tools throughout the Smart Cycle and detailed quarterly reporting all supported by client facing account management and end-to-end comprehensive member support provided by our in house staff of PCAs. The promises within our fertility benefits contract with a client represent a single performance obligation because we provide a significant service of integrating our Smart Cycles and access to the fertility treatment services provided by provider clinics with the other comprehensive services into the combined fertility benefits solution that the client contracted to receive. Our fertility benefits solution is a stand-ready obligation that is satisfied over the contract term. Our contracts include the following sources of consideration, which are all variable: a PEPM administration fee (in most, but not all contracts) and a fixed rate per Smart Cycle. The PEPM administration fee is allocated between the fertility benefits solution and the pharmacy benefits solution based on standalone selling price, estimated using an expected cost plus margin method. We allocate the variable consideration related to the fixed rate per Smart Cycle to the distinct period during which the related services were performed as those fees relate specifically to our efforts to provide our fertility benefits solution to our clients in the period and represent the consideration we are entitled to for the fertility benefits services provided. As a result, the fixed rate per Smart Cycle is included in the transaction price and recognized in the period in which the Smart Cycle is provided to the member. Our contracts also include potential service level agreement refunds related to outcome based service metrics. These service level refunds, which are determined based on results of a full plan year, if met, are based on a percentage of the PEPM fee paid by clients. We estimate the variable consideration related to the total PEPM administration fee, less estimated refunds related to service level agreements, and recognize the amounts allocated to the fertility benefits solution ratably over the contract term. Our estimate of service level agreement refunds, have not historically resulted in significant adjustments to the transaction price. Clients are invoiced on a monthly basis for the PEPM administration fee. We invoice our clients and members for their respective portions of the fixed rate per Smart Cycle bundle when all treatment services within a Smart Cycle are completed by the provider clinic. Once an invoice is issued, payment terms are typically between 30 to 60 days. We assess whether we are the principal or the agent for each arrangement with a client, since fertility treatment services are provided by a third party-the provider clinics. We are the principal in our arrangements with clients and therefore present revenue gross of the amounts paid to the provider clinics because we control the specified service (the fertility benefits solution) before it is transferred to the client. We integrate the fertility treatment services provided by the provider clinics into the overall fertility benefits solution that the client contracted to receive. In addition, we define the scope of the potential services to be performed by the provider clinics and monitor the performance of the provider clinics. Furthermore, we are primarily responsible for fulfilling the promise to the client and have discretion in setting the pricing, as we separately negotiate agreements with the provider clinics, which establish pricing for each treatment service. Pricing of services from provider clinics is independent from the fees charged to clients. Pharmacy Benefits Revenue For clients that have the fertility benefits solution, we offer, as an add-on, our pharmacy benefits solution, which is a separate, fully integrated pharmacy benefit. As part of the pharmacy benefits solution, we provide care management services, which include our formulary plan design, prescription fulfillment, simplified authorization and timely delivery of the medications used during treatment through our network of specialty pharmacies, and clinical services consisting of member assessments, UnPack It calls, telephone support, online education, medication administration training, pharmacy support services and continuing PCA support. The pharmacy-related promises represent a single performance obligation because we provide a significant service of integrating the formulary plan design, prescription fulfillment, clinical services and PCA support into the combined pharmacy benefits solution that the client contracted to receive. The pharmacy benefits solution is a stand-ready obligation that is satisfied over the contract term. Our contracts include the following sources of consideration, all of which are variable: a PEPM administration fee (in most, but not all contracts) and a fixed fee per fertility drug. As described above, the PEPM administration fee, less estimated refunds related to service level agreements, is allocated to the pharmacy benefits solution and recognized ratably over the contract term. We allocate the variable consideration related to the fixed fee per fertility drug to the distinct period during which the related services were performed, as those fees relate specifically to our efforts to provide our pharmacy benefits solution to clients in the period and represents the consideration we are entitled to for the pharmacy benefits services provided. As a result, the fixed fee per fertility drug is included in the transaction price and recognized in the period in which we are entitled to consideration from a client, which is when a prescription is filled and delivered to the members. As stated above, clients are invoiced on a monthly basis for the PEPM administration fee. We invoice the client and the member for their respective portions of the fixed fee per fertility drug, when the prescription services are completed by the specialty pharmacy. Once an invoice is issued, payment terms are typically between 30 to 60 days. We assess whether we are the principal or the agent for each arrangement with a client, as prescription fulfillment and clinical services are provided by a third party-the specialty pharmacies. We are the principal in our arrangements with clients, and therefore present revenue gross of the amounts paid to the specialty pharmacies. We control the specified service (the pharmacy benefits solution) before it is transferred to the client. We integrate the prescription fulfillment and clinical services provided by the pharmacies and PCAs into the overall pharmacy benefits solution that the client contracted to receive. In addition, we define the scope of the potential services to be performed by the specialty pharmacies and monitor the performance of the specialty pharmacies. Furthermore, we are primarily responsible for fulfilling the promise to the client and have discretion in setting the pricing, as we separately negotiate agreements with pharmacies, which establish pricing for each drug. Pricing of fertility drugs is independent from the fees charged to clients. Accrued Receivable and Accrued Claims Payable Accrued receivables for those fertility benefits claims are estimated based on historical experience for each period based on the fertility benefits services provided but for which a claim has not been received from the provider clinic. At the same time, cost of services and accrued claims payables (included within accrued expense and other current liabilities) are estimated based on the amount to be paid to the provider clinics and historical gross margin achieved. Estimates are adjusted to actual at the time of billing. Adjustments to original estimates have been not been material. Stock-Based Compensation We estimate the fair value of stock options granted to employees and directors using the Black-Scholes option-pricing model, which requires the input of subjective assumptions, including (1) the expected stock price volatility, (2) the expected term of the award, (3) the risk-free interest rate and (4) expected dividends. Effective January 1, 2018, we changed our accounting policy to account for forfeitures as they occur. Prior to January 1, 2018, forfeitures were estimated at the date of grant and revised, if necessary, in subsequent periods if actual forfeitures differed from those estimates. The fair value of the shares of common stock underlying the stock options has historically been determined by our Board of Directors as there was no public market for the common stock. The Board of Directors determines the fair value of our common stock by considering a number of objective and subjective factors, including: the valuation of comparable companies, sales of redeemable convertible preferred stock to unrelated third parties, our operating and financial performance, the lack of liquidity of common stock and general and industry specific economic outlook, amongst other factors. We selected companies with comparable characteristics to us, including enterprise value, risk profiles and position within the industry and with historical share price information sufficient to meet the expected term of the stock options. The following assumptions were used to calculate the fair value of stock options granted to employees: Common Stock Valuations The fair value of the common stock underlying our stock-based awards has historically been determined by our Board of Directors, with input from management and contemporaneous third-party valuations. We believe that our Board of Directors has the relevant experience and expertise to determine the fair value of our common stock. Prior to our IPO, the absence of a public trading market of our common stock, and in accordance with the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, our Board of Directors exercised reasonable judgment and considered numerous objective and subjective factors to determine the best estimate of the fair value of our common stock at each grant date. These factors include: · the prices of common or preferred stock sold to third-party investors by us and in secondary transactions; · 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 introduction of new services; · our stage of development; · likelihood of achieving a liquidity event, such as an IPO or a merger or acquisition of the 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 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 business operations as of each valuation date and is 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 using either the option pricing method, or OPM, or a hybrid method. The hybrid method is a hybrid of the probability weighted expected return method, or PWERM, and OPM. The option pricing method is based on a binomial lattice model, which allows for the identification of a range of possible future outcomes, each with an associated probability. The OPM 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. In determining the fair value of the enterprise using the PWERM, we developed assumptions for an IPO liquidity event and the various outcomes that it could yield. With the OPM model, we assumed a stay private scenario. Our valuations prior to March 2019 were based on the OPM. Beginning March 31, 2019, we valued our common stock based on a hybrid method of the PWERM and the OPM. Application of these approaches involves the use of estimates, judgment, 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 impact our valuations as of each valuation date and may have a material impact on the valuation of our common stock. Since our IPO, our Board of Directors determines the fair value of each share of underlying common stock based on the closing price of our common stock, on the date of grant, as reported by Nasdaq. Future expense amounts for any particular period could be affected by changes in our assumptions or market conditions. Recently Adopted Accounting Pronouncements For a full discussion of recently adopted accounting pronouncements, see Note 2 - Summary of Significant Accounting Policies, in the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. Emerging Growth Company Status 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 We envision a world where anyone who wants to have a child can do so. Our mission is to make dreams of parenthood come true through healthy, timely and supported fertility journeys. Through our differentiated approach to benefits plan design, patient education and support and active network management, our clients’ employees are able to pursue the most effective treatment from the best physicians and achieve optimal outcomes. Progyny is a leading benefits management company specializing in fertility and family building benefits solutions in the United States. Our clients include many of the nation’s most prominent employers across a broad array of industries. We launched our fertility benefits solution in 2016 with our first five employer clients, and we have grown our base of clients to over 130. We currently provide coverage to approximately 2.1 million employees and their partners (known in our industry as covered lives), who we refer to as our members. We have achieved this growth by demonstrating that our purposebuilt, datadriven and disruptive platform consistently delivers superior clinical outcomes in a costefficient manner while driving exceptional client and member satisfaction. We have retained substantially all of our clients since inception, and our member satisfaction over that same time period is evidenced by our most recent industryleading Net Promoter Score, or NPS, of +72 for our fertility benefits solution and +80 for our integrated pharmacy benefits solution, Progyny Rx. Fertility Benefits Solution. Our fertility benefits solution includes providing members with access to effective and costefficient fertility treatments through our Smart Cycle plan design. Smart Cycles are proprietary treatment bundles designed by us to include those medical services available to our members through our selective network of highquality fertility specialists. Medical services under our Smart Cycles include everything needed for a comprehensive fertility treatment cycle, including all necessary diagnostic testing and access to the latest technology (e.g., in the case of IVF, preimplantation genetic testing). We currently offer 17 different Smart Cycle treatment bundles, which may be used in various combinations depending on the member’s need. Each Smart Cycle treatment bundle has a separate unit value (i.e., some have fractional values and some have whole values). Our clients contract to purchase a cumulative Smart Cycle unit value per eligible member. These can range from one to an unlimited unit value. Members, in consultation with their PCAs, can choose their preferred provider clinics within our network and utilize the specific Smart Cycle treatment bundles necessary for the treatment pathway they determine throughout their fertility journey. In addition, we provide care management services as part of our fertility benefits solution, which include active management of our selective network of highquality fertility specialists, realtime member eligibility and treatment authorization, memberfacing digital solutions, detailed quarterly reporting for our clients supported by our dedicated account management teams and endtoend comprehensive concierge member support provided by our inhouse staff of PCAs. Clients can also add adoption and surrogacy reimbursement programs as part of this solution. Progyny Rx. We went live with our integrated pharmacy benefits solution in 2018. Progyny Rx can only be purchased by clients that purchase our fertility benefits solution. Progyny Rx provides our members with access to the medications needed during their fertility treatment. As part of this solution, we provide care management services, which include our formulary plan design, simplified authorization, assistance with prescription fulfillment and timely delivery of the medications by our network of specialty pharmacies, as well as medication administration training, pharmacy support services and continuing PCA support. Our Clients. We currently serve over 130 selfinsured employers in the United States across more than 25 industries. Our current clients, who are industry leaders across both highgrowth and mature industries and who range in size from 1,000 to 250,000 employees, represent approximately 2.1 million covered lives. Revenue Model Our clients primarily contract with us to provide our fertility benefits solution and, where added on by our clients, our Progyny Rx solution. Our revenue has both a utilizationbased component and a populationbased component, as follows: · Utilization Component. Clients pay us for the fertility benefits and Progyny Rx solutions utilized by their employees. With respect to the fertility benefits solution [/INST] Negative. </s>

Longevity Acquisition Corp

2019-05-29

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 9, 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. 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 the Initial Public Offering, described below, and identifying a target business 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 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 March 9, 2018 (inception) through February 28, 2019, we had a net loss of $14,269, which consists of operating costs of $439,639 and an unrealized loss on marketable securities held in our Trust Account of $4,760, offset by interest income on marketable securities held in the Trust Account of $430,130. Liquidity and Capital Resources On August 31, 2018, we consummated the Initial Public Offering of 4,000,000 Units at a price of $10.00 per Unit, generating gross proceeds of $40,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 270,000 Private Units to the sponsor and the underwriter at a price of $10.00 per unit, generating gross proceeds of $2,700,000. Following the Initial Public Offering and the sale of the Private Units, a total of $40,000,000 was placed in the Trust Account and we had $1,061,385 of cash held outside of the Trust Account, after payment of costs related to the Initial Public Offering, and available for working capital purposes. We incurred $2,631,167 in transaction costs, including $1,200,000 of underwriting fees, $1,000,000 of deferred underwriting fees and $431,167 of offering costs. For the period from March 9, 2018 (inception) through February 28, 2019, cash used in operating activities was $454,831, consisting primarily of net loss of $14,269 and interest earned on cash and marketable securities held in the Trust Account and not available for operations of $430,130, offset by an unrealized loss on marketable securities held in our Trust Account of $4,760. Changes in our operating assets and liabilities used cash of $15,192. At February 28, 2019, we had marketable securities held in the Trust Account of $40,425,370. We intend to use substantially all of the funds held in the Trust Account (excluding deferred underwriting commissions 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. At February 28, 2019, we had cash of $639,102 held outside the Trust Account. 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 consummate 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 Private Units, at a price of $10.00 per unit at the option of the lender. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimate of 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 consummate such financing simultaneously with the consummation 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 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 other than an agreement to pay an affiliate of a member of our sponsor a monthly fee of $10,000 for office space, utilities and administrative support provided to the Company. We began incurring these fees on August 28, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting 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, the 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 loss 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 9, 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 requirements, execution of our strategy and other purposes and other disadvantages compared [/INST] Positive. </s>

Prevail 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 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 of Form 10-K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are a gene therapy company leveraging breakthroughs in human genetics with the goal of developing and commercializing disease-modifying AAV-based gene therapies for patients with devastating neurodegenerative diseases. We are applying a precision medicine approach to neurodegeneration by studying our gene therapies in genetically defined patient populations. We believe this will increase the probability of creating disease-modifying therapies that improve patients’ lives. Our lead program is PR001 for the treatment of PD-GBA and nGD. We are focused on developing a broad pipeline of gene therapies for a range of neurodegenerative diseases, including PR006 for the treatment of FTD-GRN and PR004 for the treatment of synucleinopathies. We have initiated dosing in the PROPEL trial, our Phase 1/2 clinical trial of PR001 for the treatment of PD-GBA patients. We currently intend to report interim data on a subset of patients from this trial in the second half of 2020. In December 2019, we announced that our Investigational New Drug application, or IND, for PR001 for the treatment of nGD is now active. We currently intend to initiate two Phase 1/2 clinical trials of PR001 for the treatment of nGD patients in 2020, the first for patients with Type 2 Gaucher disease and the second for patients with Type 3 Gaucher disease. Our Phase 1/2 clinical trials in the PD-GBA and nGD patient populations will investigate the safety and tolerability of PR001, and will also measure key biomarkers and exploratory efficacy endpoints. The FDA has granted PR001 Orphan Drug designation for the treatment of Gaucher disease and Rare Pediatric Disease Designation for the treatment of nGD. In addition, the FDA has granted Fast Track designation for PR001 for the treatment of PD-GBA. In our comprehensive preclinical program in both mouse models and non-human primates, PR001 was observed to be well tolerated and demonstrated robust and widespread biodistribution. Additionally, in mouse models, we observed significant increases in enzyme activity, reductions in lipid accumulation and improvements in motor function. In March 2020, we announced that our IND for PR006 for the treatment of FTD-GRN is now active. Study startup activities are ongoing for the PROCLAIM trial, our Phase 1/2 clinical trial of PR006 for the treatment of FTD-GRN patients, and we anticipate that this trial will initiate in mid-2020. The FDA has granted Fast Track designation for PR006 for the treatment of FTD-GRN and Orphan Drug designation for PR006 for the treatment of FTD. In our comprehensive preclinical program in in vitro models, mouse models and non-human primates, PR006 was observed to be well tolerated and demonstrated robust and widespread biodistribution. Additionally, in mouse models, PR006 increased expression of progranulin protein in the brain and CSF, reduced indicators of lysosomal dysfunction in the brain, and suppressed expression of markers of inflammation in the brain. In 2019, we announced our strategic collaboration with Lonza, with whom we have been working since 2018, with an initial focus on process development and GMP, or good manufacturing practices, manufacturing of our two lead programs, PR001 and PR006. Under this collaboration, focused on the baculovirus/Sf9 production system for gene therapies, we and Lonza will work together closely on process development and scaling up production of PR001 and PR006, and Lonza will manufacture PR001 and PR006 for late-stage clinical and commercial supply at its gene therapy center of excellence in Houston, Texas. The collaboration also has the potential to extend to Prevail’s future pipeline of AAV-based gene therapy programs. In collaboration with Lonza, we have developed and scaled up a process that demonstrates promising yield and potency, and our GMP manufacturing preparations are underway. We have also initiated studies and assessments to evaluate comparability between the material produced in the baculovirus/Sf9 production system and the material produced in the HEK293 production system. Since our inception, we have focused primarily on organizing and staffing our company, raising capital, establishing and protecting our intellectual property portfolio, in-licensing the rights to AAV9 in particular fields, developing and progressing our gene therapy product candidates through preclinical studies, establishing our manufacturing supplier base and preparing for the initiation of our clinical trials. We do not have any product candidates approved for sale and have not generated any revenue from product sales as of December 31, 2019. On June 24, 2019, we completed our IPO whereby we sold an aggregate of 7,353,000 shares of our common stock at a price of $17.00 per share. The aggregate net proceeds received by us from the offering were approximately $113.0 million, after deducting underwriting discounts and commissions and offering expenses payable by us of $12.0 million. Prior to our IPO, we have funded our operations primarily through equity and convertible debt financings and have raised an aggregate of approximately $129.0 million of gross proceeds through these offerings. We have incurred significant operating losses to date. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $63.2 million and $19.1 million for the year ended December 31, 2019 and 2018, respectively. We expect our expenses and losses to increase as we continue to advance our product candidates from discovery and research, through preclinical development, into human clinical trials and seek regulatory approval of our product candidates. Furthermore, we expect to incur additional costs associated with operating as a public company, including significant legal, audit, accounting, director and officer liability insurance, investor relations and other expenses that we did not incur as a private company. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and our expenditures on other research and development activities. We do not have any products approved for sale. We do not expect to generate any revenue from product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Accordingly, until such time as we can generate substantial product revenues to support our cost structure, if ever, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. If we are unable to raise additional capital when needed, we could be forced to delay, limit, reduce or terminate our product candidate development or future commercialization efforts or grant rights to third parties to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. As of December 31, 2019 and 2018, we had cash and cash equivalents of $168.1 million and $63.0 million, respectively. License Agreements License Agreement with REGENXBIO Inc. for GBA1 In August 2017, we entered into a license agreement, or the REGENXBIO GBA1 License, with REGENXBIO. Under the REGENXBIO GBA1 License, REGENXBIO granted us an exclusive, worldwide license under certain patents and patent applications to make, have made, use, import, sell and offer for sale products for the treatment of disease, including but not limited to Parkinson’s disease and Gaucher disease, whether or not caused by mutations in the gene that produces the GBA1 enzyme in humans by in vivo gene therapy using AAV9 delivering the gene (or any portion thereof) encoding for GBA1. As consideration for the licensed rights under the REGENXBIO GBA1 License, we issued 2,430,000 shares of our common stock in a concurrent private placement to REGENXBIO. We are also obligated, pursuant to the REGENXBIO GBA1 License, to pay REGENXBIO: (1) an annual maintenance fee; (2) mid- to high-single digit royalty percentages on net sales of licensed products, subject to reduction in specified circumstances; and (3) mid-teen to low-twenties royalty percentages of any sublicense fees we receive from sublicensees for the licensed intellectual property rights. See Note 3 to our financial statements appearing elsewhere in this Annual Report on Form 10-K for additional information regarding this license. License Agreement with REGENXBIO Inc. for Option Genes In May 2018, we entered into a license agreement, or the REGENXBIO Option Genes License, with REGENXBIO pursuant to which REGENXBIO granted us three distinct exclusive options for specified genes, or the Option Genes, which were exercisable at our sole discretion through May 10, 2019. In April 2019, we exercised all three options, including for AAV9 delivering the genes encoding for progranulin and α-Synuclein. Each option represented the right to obtain an exclusive, worldwide license under certain patents and patent applications to make, have made, use, import, sell and offer for sale products for the treatment or prevention of disease, including but not limited to Parkinson’s disease, whether or not caused by mutations in any Option Gene that is the subject of the applicable license, in humans by in vivo gene therapy using AAV9 delivering the applicable licensed Option Gene and/or RNA interference or antisense modalities that target the applicable licensed Option Gene. Under the terms of the REGENXBIO Option Genes License, we paid REGENXBIO an initial fee of $0.6 million, and upon the exercise of the options, an additional up-front fee of $0.6 million per exercised option, or an aggregate of $1.8 million. In addition, with respect to each licensed Option Gene, we are required to pay REGENXBIO: (1) an annual maintenance fee; (2) mid- to high-single digit royalty percentages on net sales of the licensed product, subject to reduction in specified circumstances; and (3) mid-teen to low-twenties royalty percentages of any sublicense fees we receive from sublicensees for the licensed intellectual property rights. If a licensed product includes the GBA1 gene and otherwise would be subject to royalties under the REGENXBIO GBA1 License, then royalties for that licensed product will only be due under the REGENXBIO Option Genes License. See the section titled “Business-License Agreements-License Agreement with REGENXBIO Inc. for Option Genes” and Note 3 to our financial statements appearing elsewhere in this Annual Report on Form 10-K for additional information regarding this license. Financial Operations Overview Research and Development Expenses Since inception, research and development expenses are primarily comprised of costs incurred for the manufacture of clinical supply and process development initiatives, costs incurred in preparation for clinical trials and activities related to regulatory filings for our product candidates and preclinical and discovery work on our gene therapy product candidates. Research and development expenses are recognized as incurred. Payments made prior to the receipt of goods or services rendered are capitalized and recognized as expense as the goods are delivered or services are performed. We do not track our internal research and development expenses at the program level. Research and development expenses include or could include: • employee-related expenses, including salaries, bonuses, benefits, stock-based compensation, other related costs for those employees involved in research and development efforts; • external research and development expenses incurred under agreements with CROs, investigative sites and consultants and vendors engaged to conduct our preclinical studies or provide the research and development services; • costs related to manufacturing material for our preclinical studies, clinical trials, and manufacturing process development efforts, including fees paid to CDMOs; • laboratory supplies and research materials; • costs related to compliance with regulatory requirements; and • facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent, maintenance of facilities, insurance and equipment. We expect our research and development expenses to increase as we continue to advance our clinical stage product candidates and manufacturing process development and supply, as well as conduct discovery and research activities for our preclinical programs. We cannot determine with certainty the timing of the initiation, the duration or the cost to complete current or future preclinical studies and clinical trials of our product candidates due to the inherently unpredictable nature of preclinical and clinical development. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. We anticipate that we will make determinations as to which product candidates to pursue and the level of funding to direct to each product candidate on an ongoing basis in response to the results of ongoing and future preclinical and clinical studies, regulatory developments and our ongoing assessments as to each product candidate’s commercial potential. We will need to raise substantial additional capital in the future. Our clinical development costs are expected to increase significantly as we initiate clinical trials. Our future expenses may vary significantly from period to period based on factors such as: • per patient trial costs; • the number of patients enrolled in each trial; • the number of trials required for regulatory approval; • any follow-up commitment or confirmatory trials; • the number of sites included in the trials; • the countries in which the trials are conducted; • the length of time required to enroll eligible patients; • the drop-out or discontinuation rates of patients; • potential additional safety monitoring requested by regulatory agencies; • the duration of patient participation in the trials and follow-up; • the phase of development of the product candidate; and • the efficacy and safety profile of the product candidate. General and Administrative Expenses General and administrative expenses are comprised of employee-related expenses and third-party service provider costs, such as legal, audit, insurance, and finance and accounting consultants. Employee-related expenses include salaries, bonuses, benefits, stock-based compensation, and other related costs, for those employees in general and administrative functions. We expect our general and administrative expenses will increase in the future as we increase our general and administrative headcount to support our expanding research and development operations and activities and incur costs associated with operating as a public company, including maintaining public company compliant standards and requirements. Change in Fair Value of Derivative Liability To derive the fair value of the derivative liabilities embedded within a convertible note issued to one of our investors, we estimated the fair value of the convertible note with and without the derivative liabilities using a discounted cash flow approach. The difference between the “with” and “without” convertible note prices determined the fair value of the derivative liabilities at issuance and immediately prior to conversion. This convertible note converted into shares of our Series A Preferred Stock in March 2018. Interest Income (Expense), Net We have institutional money market accounts that pay interest on a monthly basis. In connection with the issuance of the convertible note, we incurred interest expense at 8% per annum. In addition, we recorded amortization of the debt issuance cost as interest expense during the year ended December 31, 2018, upon the conversion of the note. Results of Operations Comparison of the years ended December 31, 2019 and 2018 The following table summarizes our results of operations: Research and Development Expenses Research and development expenses increased by $34.7 million to $48.8 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The increase was primarily due to our lead programs, PR001 and PR006, as we incurred increased manufacturing and process development costs of $13.8 million, increased cost for clinical trial activities of $8.1 million, and increased costs of $4.7 million for preclinical studies, lab materials, and facility cost. The remaining increase is attributed to increased headcount resulting in a $6.3 million increase in personnel costs, including a $1.0 million increase for stock-based compensation, and a $1.8 million increase in license fees. General and Administrative Expenses General and administrative expenses increased by $12.3 million to $17.0 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The increase was primarily due to increased headcount resulting in a $4.0 million increase in personnel costs, including a $1.7 million increase in stock-based compensation expense, a $4.7 million increase in legal fees, and a $3.6 million increase in professional services fees and other expenses, which primarily consisted of accounting and consulting services, director’s and officer’s insurance, depreciation and facility cost. Change in Fair Value of Derivative Liability We recorded a loss in the amount of $0.8 million attributable to changes in fair value of the derivative liability during the year ended December 31, 2018. No such loss was incurred for the year ended December 31, 2019. Interest Income, Net During the years ended December 31, 2019 and 2018, we generated $2.6 million and $0.9 million, respectively, in interest income from our institutional money market accounts. During the year ended December 31, 2018, we also incurred interest expense of $0.5 million related to a convertible note issued to one of our investors, which converted into shares of our Series A Preferred Stock in March 2018. No such transaction occurred in 2019. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. Our net losses were $63.2 million and $19.1 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019 and 2018, we had an accumulated deficit of $84.1 million and $20.9 million, respectively. To date, we have focused primarily on organizing and staffing our company, raising capital, establishing and protecting our intellectual property portfolio, in-licensing AAV9, developing and progressing our gene therapy product candidates through preclinical studies, preparing and for the initiating of clinical trials, and establishing our manufacturing process to ensure the continued supply of product. Our primary use of cash is to fund operating expenses, which consist primarily of research and development, and general and administrative expenditures. We do not have any products approved for sale. We do not expect to generate any revenue from product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. Since our inception, we have funded our operations primarily through equity and convertible debt financings. In March 2019, we raised an aggregate of approximately $49.8 million of net proceeds from our Series B Preferred Stock financing. In June 2019, we completed our IPO whereby we sold an aggregate of 7,353,000 shares of our common stock for aggregate net proceeds of approximately $113.0 million, after deducting underwriting discounts and commissions and offering expenses payable by us of approximately $12.0 million. As of December 31, 2019, we had cash and cash equivalents of $168.1 million. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to capital preservation and liquidity. Cash Flows Historical Cash Flows The following table shows a summary of our cash flows for the periods presented: Operating Activities Cash used in operating activities for the year ended December 31, 2019 was $55.8 million as compared to $14.0 million for the year ended December 31, 2018. The increase in cash used was primarily the result of increased operating expenses for research and development activities, including costs incurred for activities performed by third party vendors and employee-related expenses. In addition, our net loss was $63.2 million, which included non-cash charges of $6.2 million, consisting primarily of $4.3 million of stock-based compensation expense, $0.3 million of depreciation and amortization expense, and a $1.6 million non-cash increase in the operating lease right-of-use-asset. The change in our net operating assets was primarily the result of a $5.8 million increase in prepaid expenses and other current assets, comprised of $3.5 million relating to our external manufacturing services, $0.9 million for director’s and officer’s insurance, and $1.4 million relating to other external research and development activities and an allowance on facility space. In addition, the change in net operating liabilities also included a $7.8 million increase in accounts payable and accrued expenses, primarily associated with research and development expenses, and a net decrease in operating lease liabilities of $0.7 million. Cash used in operating activities for the year ended December 31, 2018 was $14.0 million, consisting of a net loss of $19.1 million, which included non-cash charges of $3.5 million, primarily consisting of $0.8 million attributable to changes in fair value of the derivative liabilities associated with the convertible note, $0.5 million related to the amortization of the convertible note issuance costs, discount, and other non-cash interest, $1.6 million of stock-based compensation expense, $0.5 million related to the right-of-use-asset derived from our lease for office and lab space and $0.1 million of depreciation and amortization expense. The change in our net operating assets was primarily the result of a $0.5 million increase in prepaid expenses and other current assets and a $2.3 million increase in accounts payable and accrued expenses primarily associated with research and development expenses and a decrease in operating lease liabilities of $0.2 million. Investing Activities Cash used for investing activities was $2.1 million for the year ended December 31, 2019, primarily due to purchases of property and equipment in connection with the office and lab space build out. Cash used for investing activities was $0.6 million for the year ended December 31, 2018, primarily due to the increase in purchases of property and equipment. Financing Activities Cash provided by financing activities for the year ended December 31, 2019 was $162.9 million. The inflows were related to the net proceeds received from the Series B Preferred Stock financing in March 2019, which generated $49.8 million, the net proceeds received from the IPO in June 2019, which generated $113.0 million, and $0.1 million related to the exercise of options. Cash provided by financing activities during the year ended December 31, 2018 was $64.9 million. The inflow was related to net proceeds from the Series A Preferred Stock financing in March and April 2018, which generated $64.9 million. Funding Requirements We believe our existing cash and cash equivalents will be sufficient to meet our anticipated cash requirements for at least 12 months from the issuance date of these financial statements. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could expend our capital resources sooner than we expect. Additionally, the process of testing product candidates in clinical trials is costly, and the timing of progress and expenses in these trials is uncertain. Our future capital requirements will depend on many factors, including: • the scope and rate of progress of our preclinical and toxicology studies, and clinical trials for PR001 and PR006 and any future product candidates that may enter the clinic; • the scope and costs of manufacturing study materials and manufacturing process development, both internally and externally, and related clinical manufacturing activities; • the cost, timing and outcome of regulatory review of our product candidates; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • the terms and timing of establishing and maintaining collaborations, licenses and other similar arrangements; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our product candidates; • the costs associated with operating as being a public company; • the results and cost to defense of any litigation or other legal proceedings to which we or our officers or directors may be a party; • the timing of any milestone and royalty payments to current and future licensors, if any; • the extent to which we acquire, or in-license other best-in-class AAV-based viral vectors, product candidates or technologies; and • the cost associated with commercializing any product candidates, if and when they receive marketing approval. Until such time, if ever, as we can generate substantial product revenues to support our cost structure, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations and other similar arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, or other similar arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. In addition, our ability to raise necessary financing could be impacted by the COVID-19 pandemic and its effects on the market conditions. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves or potentially discontinue operations. Critical Accounting Policies and Significant Judgments and Estimates The preparation of our financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make estimates and judgments that affect the amounts reported in those financial statements and accompanying notes. 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 accounting policies described below involve a high degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of our operations. Research and Development Costs, Accrued Research and Development Costs and Related Prepaid Expenses Research and development costs are expensed as incurred. Research and development expenses consist principally of personnel costs, including salaries, stock-based compensation, and benefits for employees, third-party license fees and other operational costs related to our research and development activities, including allocated facility-related expenses and external costs of outside vendors, and other direct and indirect costs. Research and development advance payments are deferred and capitalized as prepaid expenses. The capitalized amounts are expensed as the related goods are delivered or services are performed. Clinical trial costs are accrued over the service periods specified in the contracts and adjusted as necessary based on an ongoing review of the level of effort and costs actually incurred. The estimate of the work completed is developed through discussions with internal personnel and external service providers as to the progress of stage of completion of the services and the agreed-upon fee to be paid for such services. As actual costs become known, the accrued estimates are adjusted. Such estimates are not expected to be materially different from amounts actually incurred, however our understanding of the status and timing of services performed, the number of subjects enrolled, and the rate of subject enrollment may vary from estimates and could result in reporting amounts that are higher or lower than incurred in any particular period. The estimate of accrued research and development expense is dependent, in part, upon the receipt of timely and accurate reporting from clinical research organizations and other third-party service providers. Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use, or ROU, assets, operating lease liabilities, and long-term operating lease liabilities in our balance sheets. 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 commencement date based on the present value of lease payments over the lease term. As our leases do not provide a readily determinable implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. The operating lease ROU asset also includes any lease prepayments, offset by lease incentives. Our facilities operating leases have lease and non-lease components for which we have elected to apply the practical expedient and account for each lease component and related non-lease component as one single component. Operating lease cost is recognized on a straight-line basis over the lease term. Stock-Based Compensation We measure all stock options and other stock-based awards granted to our employees, directors, consultants and other non-employee service providers based on the fair value on the date of the grant, and we recognize compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We recognize forfeitures at the time forfeitures occur. We classify stock-based compensation expense in our statement of operations in the same way the award recipient’s payroll costs are classified or in which the award recipients’ service payments are classified. We use the Black-Scholes option-pricing model to estimate the fair value of stock options on the date of grant. Using the Black-Scholes option-pricing model requires management to make significant assumptions and judgments, including with respect to the expected term of the option, risk-free interest rate, stock-price volatility and dividend yield. In addition, prior to the IPO, the fair value of the shares of common stock underlying our stock-based awards was determined by our board of directors with input from management and contemporaneous third-party valuations. Given the absence of a public trading market for our common stock prior to the IPO, our board of directors considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including but not limited to the prices of common or convertible 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, the history of our company, hiring of key personnel and the experience of our management, our stage of development, the market performance of comparable publicly traded companies and the U.S. and global capital market conditions. Subsequent to the IPO, fair value of each share of underlying common stock is based on the closing price of our common stock as reported by Nasdaq on the date of grant. The following table summarizes the assumptions for the Black-Scholes option-pricing valuation model used to estimate the fair value of stock options granted during the periods presented: 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 and assumptions. Future expense amounts for any particular period could be affected by changes in our assumptions or market 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 the expected future tax consequences of events that have been recognized in the financial statements or our tax returns. Under this method, deferred tax assets and liabilities are determined on the basis of the differences between the financial statements and tax basis of the assets and liabilities using 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 income in the period that includes the enactment date. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes. We recognize deferred tax assets to the extent that we believe that these assets are more likely than not to be realized. In making such a determination, management considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. Valuation allowances are provided, if based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. If management determines that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, management would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. We record uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) management determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, management recognizes the largest amount of tax benefit that is more than 50% likely to be realized upon ultimate settlement with the related tax authority. We provide reserves for potential payments of tax to various tax authorities related to uncertain tax positions. These reserves are based on a determination of whether and how much of a tax benefit taken by us in our tax filings or positions is more likely than not to be realized following resolution of any potential contingencies related to the tax benefit. Potential interest related to the underpayment of income taxes will be classified as a component of interest expense and any related penalties will be classified in operating expenses in the statement of operations. Emerging Growth Company Status In April 2012, the Jumpstart Our Business Startups Act, or the JOBS Act, was enacted. Section 107 of the JOBS Act provides that an emerging growth company may take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Therefore, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this 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. Recently Adopted Accounting Pronouncements Descriptions of recently issued accounting pronouncements that may potentially impact our financial position, result of operations or cash flows are disclosed in Note 2 to our 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 by applicable SEC rules and regulations.

<s>[INST] Overview We are a gene therapy company leveraging breakthroughs in human genetics with the goal of developing and commercializing diseasemodifying AAVbased gene therapies for patients with devastating neurodegenerative diseases. We are applying a precision medicine approach to neurodegeneration by studying our gene therapies in genetically defined patient populations. We believe this will increase the probability of creating diseasemodifying therapies that improve patients’ lives. Our lead program is PR001 for the treatment of PDGBA and nGD. We are focused on developing a broad pipeline of gene therapies for a range of neurodegenerative diseases, including PR006 for the treatment of FTDGRN and PR004 for the treatment of synucleinopathies. We have initiated dosing in the PROPEL trial, our Phase 1/2 clinical trial of PR001 for the treatment of PDGBA patients. We currently intend to report interim data on a subset of patients from this trial in the second half of 2020. In December 2019, we announced that our Investigational New Drug application, or IND, for PR001 for the treatment of nGD is now active. We currently intend to initiate two Phase 1/2 clinical trials of PR001 for the treatment of nGD patients in 2020, the first for patients with Type 2 Gaucher disease and the second for patients with Type 3 Gaucher disease. Our Phase 1/2 clinical trials in the PDGBA and nGD patient populations will investigate the safety and tolerability of PR001, and will also measure key biomarkers and exploratory efficacy endpoints. The FDA has granted PR001 Orphan Drug designation for the treatment of Gaucher disease and Rare Pediatric Disease Designation for the treatment of nGD. In addition, the FDA has granted Fast Track designation for PR001 for the treatment of PDGBA. In our comprehensive preclinical program in both mouse models and nonhuman primates, PR001 was observed to be well tolerated and demonstrated robust and widespread biodistribution. Additionally, in mouse models, we observed significant increases in enzyme activity, reductions in lipid accumulation and improvements in motor function. In March 2020, we announced that our IND for PR006 for the treatment of FTDGRN is now active. Study startup activities are ongoing for the PROCLAIM trial, our Phase 1/2 clinical trial of PR006 for the treatment of FTDGRN patients, and we anticipate that this trial will initiate in mid2020. The FDA has granted Fast Track designation for PR006 for the treatment of FTDGRN and Orphan Drug designation for PR006 for the treatment of FTD. In our comprehensive preclinical program in in vitro models, mouse models and nonhuman primates, PR006 was observed to be well tolerated and demonstrated robust and widespread biodistribution. Additionally, in mouse models, PR006 increased expression of progranulin protein in the brain and CSF, reduced indicators of lysosomal dysfunction in the brain, and suppressed expression of markers of inflammation in the brain. In 2019, we announced our strategic collaboration with Lonza, with whom we have been working since 2018, with an initial focus on process development and GMP, or good manufacturing practices, manufacturing of our two lead programs, PR001 and PR006. Under this collaboration, focused on the baculovirus/Sf9 production system for gene therapies, we and Lonza will work together closely on process development and scaling up production of PR001 and PR006, and Lonza will manufacture PR001 and PR006 for latestage clinical and commercial supply at its gene therapy center of excellence in Houston, Texas. The collaboration also has the potential to extend to Prevail’s future pipeline of AAVbased gene therapy programs. In collaboration with Lonza, we have developed and scaled up a process that demonstrates promising yield and potency, and our GMP manufacturing preparations are underway. We have also initiated studies and assessments to evaluate comparability between the material produced [/INST] Negative. </s>

Cerence Inc.

2019-12-19

2019-09-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis presented below should be read in conjunction with the Combined Financial Statements and the corresponding notes, and included elsewhere in this Form 10-K. The information presented in this section includes forward-looking statements, which are described in detail in the section titled “Cautionary Statement Concerning Forward-Looking Statements.” The matters discussed in these forward-looking statements are subject to risks, uncertainties, and other factors that could cause actual results to differ materially from those made, projected, or implied in the forward-looking statements. See the section titled “Risk Factors” for a discussion of the risks, uncertainties, and assumptions associated with these statements. Overview Cerence builds automotive cognitive assistance solutions to power natural and intuitive interactions between automobiles, drivers and passengers, and the broader digital world. We possess one of the world’s most popular software platforms for building automotive virtual assistants. Our customers include all major OEMs or their tier 1 suppliers worldwide. We deliver our solutions on a white-label basis, enabling our customers to deliver customized virtual assistants with unique, branded personalities and ultimately strengthening the bond between automobile brands and end users. Our vision is to enable a more enjoyable, safer journey for everyone. Our principal offering is our software platform, which our customers use to build virtual assistants that can communicate, find information and take action across an expanding variety of categories. Our software platform has a hybrid architecture combining edge software components with cloud-connected components. Edge software components are installed on a vehicle’s head unit and can operate without access to external networks and information. Cloud-connected components are comprised of certain speech and natural language understanding related technologies, AI-enabled personalization and context-based response frameworks, and content integration platform. We generate revenue primarily by selling software licenses and cloud-connected services. Our edge software components are typically sold under a traditional per unit perpetual software license model, in which a per unit fee is charged for each software instance installed on an automotive head unit. We typically license cloud-connected software components in the form of a service to the vehicle end user, which is paid for in advance. In addition, we generate professional services revenue from our work with our customers during the design, development and deployment phases of the vehicle model lifecycle and through maintenance and enhancement projects. We have existing relationships with all major OEMs or their tier 1 suppliers, and while our customer contracts vary, they generally represent multi-year engagements, giving us visibility into future revenue. Business Trends Under ASC 605, we experienced total revenue growth of 10.7% and 13.2%, during fiscal year 2019 and fiscal year 2018, respectively, primarily driven by our connected and professional services revenues due to increased market penetration of our connected and professional services solutions. License revenues increased slightly during fiscal 2019 due to a higher volume of licensing royalties from new and existing customers. Due to the historical strength of licensed edge technologies and our interpretation of industry trends, we believe license revenues will continue to experience growth into the future. Consistent with the increased revenue and customer demand, fiscal year 2019 was another key investment year for the Cerence business in which we focused on accelerating research and development, or R&D, and expanding our professional services team to improve the end user experience we are able to deliver. Under ASC 605, total cost of revenues increased by 19.2% during fiscal year 2019, primarily driven by the hiring of more professional services staff. Under ASC 605, total operating expenses grew by 23.1% during fiscal year 2019, primarily driven by innovation initiatives in order to increase our competitive position in the market. We hired a significant amount of new engineering and product innovation personnel, resulting in a 15.0% increase in R&D expenses. Our acquisition of Voicebox Technology Corporation, or Voicebox, on April 2, 2018, which provided additional customer relationships and technology, and the incurrence of professional service costs to establish the Cerence business as a standalone public company drove a $11.5 million increase in restructuring and other costs, net. We anticipate that our R&D expenses will continue to represent the majority of our operating expenses as we focus on developing new products and advancing our core technologies. Basis of Presentation The accompanying combined financial data was derived from the consolidated financial statements and accounting records of Nuance. The Combined Financial Statements were prepared for the year ended September 30, 2019 (which we refer to as fiscal year 2019), the year ended September 30, 2018 (which we refer to as fiscal year 2018), and the year ended September 30, 2017 (which we refer to as fiscal year 2017). Cerence was spun off from Nuance, a leading provider of speech and language solutions for businesses and consumers around the world. The preparation of these financial statements required considerable judgement and reflect significant assumptions and allocations that we believe are reasonable. These financial statements reflect the combined historical results of operations, financial position, and cash flows of the Cerence business in conformity with GAAP. However, the historical combined financial information may not be indicative of our future performance and does not necessarily reflect what our combined results of operations, financial position, and cash flows would have been had our business operated as a separate publicly traded company during the periods presented. Specifically, the Combined Financial Statements include certain assets and liabilities that have historically been held at the corporate level of Nuance, but are allocable to Cerence. Nuance provided certain services such as legal, accounting, information technology, human resources, treasury and other infrastructure support on our behalf. The cost of these services has been allocated to us based on various financial measures that we determined to most closely align with each service. While we have determined these allocations are a reasonable representation of benefits received and services utilized by the Cerence business, actual costs that would have been incurred if we had been a standalone company would depend on factors such as the organizational structure, infrastructure, information technology, and strategic decision making. Following the completion of the Spin-Off, we expect to incur expenditures relating to the start-up of our own standalone corporate functions and information technology systems, reorganizing and hiring employees, and other miscellaneous transaction related costs. Since we are publicly traded on Nasdaq following the Spin-Off, we are required to incur costs to establish public company functions such as internal audit, corporate treasury, and investor relations. Additionally, we will incur costs for Nasdaq listing fees, compensation of our newly formed Board, public company insurance, external audit, and external legal counsel. Refer to Note 2 to the accompanying Combined Financial Statements included elsewhere in this Form 10-K for additional information. Comparability of Results As of October 1, 2018, we adopted ASC 606 using the modified retrospective approach from the previous guidance, ASC 605. Our transition to ASC 606 represents a change in accounting policy that is reflected in our Combined Financial Statements for the fiscal year ended September 30, 2019. The adoption of ASC 606 limits the comparability of revenue and expenses, including cost of revenue and certain operating expenses, presented in the results of operations for the fiscal year ended September 30, 2019 when compared to prior reporting periods. Refer to Note 3 to our Condensed Combined Financial Statements included elsewhere in this Form 10-K for further details on our adoption of ASC 606 and a reconciliation of our operating results for the fiscal year September 30, 2019 under ASC 606 to the results under ASC 605. Key Metrics In evaluating our financial condition and operating performance, we focus on revenue, operating margins, and cash flow from operations. For the fiscal year 2019 as compared to fiscal year 2018: • Total revenue under ASC 606 increased by $26.3 million, or 9.5%, to $303.3 million from $277.0 million for fiscal year 2018 under ASC 605. Comparing both periods under ASC 605, total revenue increased by $29.5 million or 10.7%, from $277.0 million to $306.5 million. • Operating margin under ASC 606 decreased by 9.7 percentage points to 3.6% from 13.3% for fiscal year 2018 under ASC 605. Comparing both periods under ASC 605, operating margin decreased by 8.7 percentage points from 13.3% to 4.6%. • Cash provided by operating activities for fiscal year 2019 was $88.1 million, a decrease of $27.2 million, or 23.6%, from cash provided by operating activities of $115.3 million for fiscal year 2018. For fiscal year 2018 as compared to fiscal year 2017: • Total revenue increased by $32.3 million, or 13.2%, from $244.7 million to $277.0 million. • Operating margin decreased by 12.7 percentage points from 26.0% to 13.3%. • Cash provided by operating activities increased by $18.5 million, or 19.1%, from $96.8 million to $115.3 million. Operating Results The following table shows the total operating results of the Cerence business for the fiscal year September 30, 2019 under ASC 606 and ASC 605, fiscal year 2018, and fiscal year 2017 (dollars in thousands): Our revenue consists primarily of license revenue, connected services revenue and revenue from professional services. License revenue primarily consists of license royalties associated with our edge software components, with costs of license revenue primarily consisting of third-party royalty expenses for certain external technologies we leverage. Connected services revenue represents the subscription fee that provides access to our connected services components, including the customization and construction of our connected services solutions. Cost of connected service revenue primarily consists of labor costs of software delivery services, infrastructure, and communications fees that support our connected services solutions. Professional services revenue is primarily comprised of porting, integrating, and customizing our embedded solutions, with costs primarily consisting of compensation for services personnel, contractors and overhead. Our operating expenses include R&D, sales and marketing and general and administrative expenses. R&D expenses primarily consist of salaries, benefits, and overhead relating to research and engineering staff. Sales and marketing expenses includes salaries, benefits, and commissions related to our sales, product marketing, product management, and business unit management teams. General and administrative expenses primarily consist of personnel costs for administration, finance, human resources, general management, fees for external professional advisers including accountants and attorneys, and provisions for doubtful accounts. Amortization of acquired patents and core technology are included within cost of revenues whereas the amortization of other intangible assets, such as acquired customer relationships, trade names and trademarks, are included within operating expenses. Customer relationships are amortized over their estimated economic lives based on the pattern of economic benefits expected to be generated from the use of the asset. Other identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives. Restructuring costs are costs related to reorganizing various business units, including costs associated with employee severance, closing and opening facilities, terminating contracts, and separation costs related to establishing Cerence business as a standalone public company. Acquisition-related costs include transition and integration costs, professional service fees, and fair value adjustments related to business and asset acquisitions, including potential acquisitions. Other income (expense), net consists primarily of foreign exchange gains (losses). Fiscal Year 2019 Compared with Fiscal Year 2018 and Fiscal Year 2018 Compared with Fiscal Year 2017 Total Revenues The following table shows total revenues by product type, including the corresponding percentage change (dollars in thousands): Fiscal Year 2019 Compared with Fiscal Year 2018 Total revenues under ASC 606 for fiscal year 2019 is $3.2 million lower compared to revenue for the same period presented under ASC 605 primarily due to the loss of deferred revenue related to professional services upon the adoption of ASC 606. Under ASC 605, certain professional services contracts were accounted for using the completed contract method, whereas under ASC 606, these contracts were accounted for under the percentage of completion method. Under ASC 605, total revenues for fiscal year 2019 were $306.5 million, an increase of $29.5 million, or 10.7%, from $277.0 million from fiscal year 2018. This growth was primarily driven by increased demand for our connected and professional solutions. Our fixed backlog includes $353.3 million of future revenue related to remaining performance obligations and $55.6 million of contractual commitments which have not yet been invoiced, was $408.9 million as of September 30, 2019. Our variable backlog includes estimated future revenue from variable forecasted royalties related to our embedded and connected businesses, was $955.7 million as of September 30, 2019. Our estimation of forecasted royalties is based on our royalty rates for embedded and connected technologies from expected car shipments under our existing contracts over the term of the programs. Anticipated shipments are based on historical shipping experience and current customer projections that management believes are reasonable as of the date of this Form 10-K. Both our embedded and connected technologies are priced and sold on a per-vehicle or device basis, where we receive a single fee for either or both the embedded license and the connected service term. However, our fixed and variable backlog may not be indicative of our actual future revenue. The revenue we actually recognize is subject to several factors, including the number and timing of vehicles our customers ship, potential terminations or changes in scope of customer contracts and currency fluctuations. As of September 30, 2019, we estimate that our adjusted backlog includes $408.9 million of fixed backlog and $955.7 million of variable backlog, was approximately $1.36 billion, with approximately 50% of revenue expected to be recognized over the next three years. The growth of our backlog is primarily due to the continued strength of our embedded and connected businesses and the high design win rates that we have achieved over the last several years. License Revenue License revenue under ASC 606 for fiscal year 2019 is $0.4 million higher compared to the same period presented under ASC 605 primarily due to the re-allocation of contract consideration to multiple performance obligations based on standalone selling prices. Under ASC 605, license revenue for fiscal year 2019 was $171.9 million, an increase of $0.9 million, or 0.5%, from $171.1 million for fiscal year 2018. License revenue increased primarily due to a higher volume of licensing royalties from new and existing customers. As a percentage of total revenue, license revenue under ASC 605 decreased by 5.7 percentage points from 61.8% for fiscal year 2018 to 56.1% for fiscal year 2019. Connected Services Revenue Connected services revenue under ASC 606 for fiscal year 2019 is $0.9 million lower compared to the same period presented under ASC 605 primarily due to re-allocation of contract consideration to multiple performance obligations based on standalone selling prices. Under ASC 605, connected services revenue for fiscal year 2019 was $79.6 million, an increase of $19.4 million, or 32.2%, from $60.2 million for fiscal year 2018. This increase was primarily driven by greater demand for our connected services solutions as our customers increasingly deploy hybrid solutions. As a percentage of total revenue, connected services revenue under ASC 605 increased by 4.2 percentage points from 21.7% for fiscal year 2018 to 26.0% for fiscal year 2019. Professional Services Revenue Professional services revenue under ASC 606 for fiscal year 2019 is $2.7 million lower compared to the same period presented under ASC 605 primarily due to the loss of deferred revenue upon the adoption of ASC 606. Under ASC 605, certain professional services contracts were accounted for using the completed contract method, whereas under ASC 606, these contracts were accounted for under the percentage of completion method. Under ASC 605, professional service revenue for fiscal year 2019 was $54.9 million, an increase of $9.2 million, or 20.2%, from $45.7 million for fiscal year 2018. This increase was primarily driven by demand for the integration and customization services related to our edge software and the timing of services rendered. As a percentage of total revenue, professional services revenue under ASC 605 increased by 1.4 percentage points from 16.4% for fiscal year 2018 to 17.9% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 Our total revenues for fiscal year 2018 were $277.0 million, an increase of $32.3 million, or 13.2%, from $244.7 million from fiscal year 2017. This growth was primarily driven by license royalties. We also experienced notable growth in connected services revenues resulting from increased demand for our hybrid solutions. License Revenue License revenue for fiscal year 2018 was $171.1 million, an increase of $22.3 million, or 15.0%, from $148.8 million for fiscal year 2017. License revenues increased primarily due to a higher volume of licensing royalties from new and existing customers utilizing our technologies. This was a result of an increase in overall cars shipped and more customers licensing suites of our software and technologies rather than individual licenses. As a percentage of total revenue, license revenue increased by 1.0 percentage points from 60.8% for fiscal year 2017 to 61.8% for fiscal year 2018. Connected Services Revenue Connected services revenue for fiscal year 2018 was $60.2 million, an increase of 31.8%, or $14.5 million, from $45.7 million for fiscal year 2017. This increase is primarily driven by greater demand for our connected services solutions as our customers shift their preferences from shipping automobiles with fully customized embedded solutions to hybrid solutions. As a percentage of total revenue, connected services revenue increased by 3.0 percentage points from 18.7% for fiscal year 2017 to 21.7% for fiscal year 2018. Professional Services Revenue Professional services revenue for fiscal year 2018 was $45.7 million, a decrease of $4.5 million, or 9.0%, from $50.2 million for fiscal year 2017. Professional services revenue decreased primarily due to industry shift towards connected service solutions and a change in our pricing strategy. As a percentage of total revenue, professional services revenue decreased by 3.9 percentage points from 20.3% for fiscal year 2017 to 16.4% for fiscal year 2018. Total Cost of Revenues and Gross Profits The following table shows total cost of revenues by product type and the corresponding percentage change (dollars in thousands): The following table shows total gross profit by product type and the corresponding percentage change (dollars in thousands): Fiscal Year 2019 Compared with Fiscal Year 2018 Total cost of revenues under ASC 606 for fiscal year 2019 is $0.4 million higher compared to total cost of revenues for the same period presented under ASC 605. Under ASC 605, total cost of revenues for fiscal year 2019 were $98.9 million, an increase of $16.0 million, or 19.2%, from $83.0 million for fiscal year 2018. The increase in cost of revenues resulted primarily from the growth of our cloud-based connected services revenue, which required an increase in cloud-based infrastructure and employee costs, and our investments in professional services staff to meet customer program demands. We also experienced an increase in amortization of intangible assets that was included in costs of revenues primarily due to our acquisition of Voicebox on April 2, 2018, which increased the carrying value of our total intangible assets. Total gross profit under ASC 606 for fiscal year 2019 is $3.6 million lower compared to total gross profit for the same period presented under ASC 605. Under ASC 605, we experienced an increase in total gross profit of $13.6 million, or 7.0%, from $194.0 million to $207.6 million, which was primarily driven by increased demand for our connected services solutions. Cost of License Revenue The difference between cost of license revenue under ASC 605 and ASC 606 was immaterial. Under ASC 605, cost of license revenue for fiscal year 2019 was $2.1 million, an increase of $0.9 million, or 79.1%, from $1.2 million for fiscal year 2018. Cost of license revenues increased due to third-party royalty expenses associated with external technologies we leverage in our edge software components. As a percentage of total cost of revenue, cost of license revenue under ASC 605 increased by 0.7 percentage points from 1.4% for fiscal year 2018 to 2.1% for fiscal year 2019. License gross profit under ASC 606 for the fiscal year ended September 30, 2019 is $0.4 million higher compared to license gross profit for the same period presented under ASC 605. Under ASC 605, license gross profit increased by $0.1 million, or 0.0%, since costs associated with license royalties are minimal. Cost of Connected Services Revenue Cost of connected services revenue under ASC 606 for fiscal year 2019 is $0.3 million lower compared to cost of connected services revenue for the same period presented under ASC 605. Under ASC 605, cost of connected services revenue for fiscal year 2019 was $37.8 million, an increase of $4.9 million, or 15.0%, from $32.9 million for fiscal year 2018. Cost of connected services revenue increased primarily as a result of the growth of cloud-based connected services revenue from new and existing customers utilizing our software delivery services for hybrid solutions. As a percentage of total cost of revenue, cost of connected service revenue under ASC 605 decreased by 1.4 percentage points from 39.7% for fiscal year 2018 to 38.3%% for fiscal year 2019. Connected services gross profit under ASC 606 for fiscal year 2019 is $0.7 million lower compared to connected services gross profit for the same period presented under ASC 605. Under ASC 605, connected services gross profit increased $14.5 million, or 53.0%, from $27.3 million to $41.8 million which was primarily due to connected services revenue growth on relatively fixed cloud infrastructure and employee costs. Cost of Professional Services Revenue Cost of professional services revenue under ASC 606 for fiscal year 2019 is $0.7 million higher compared to cost of professional services revenue for the same period presented under ASC 605. Under ASC 605, cost of professional services revenue for fiscal year 2019 was $50.5 million, an increase of $9.4 million, or 22.8%, from $41.1 million for fiscal year 2018. Cost of professional services revenue increased primarily due to our investments in professional services staff to meet customer program demands. As a percentage of total cost of revenue, cost of professional services revenue under ASC 605 increased by 1.5 percentage points from 49.6% for fiscal year 2018 to 51.1% for fiscal year 2019. Professional services gross profit under ASC 606 for the fiscal year ended September 30, 2019 is $3.4 million lower compared to professional services gross profit for the same period presented under ASC 605. Under ASC 605, professional services gross profit decreased $0.1 million, or 3.1%, from $4.6 million to $4.4 million which was primarily due to industry trends and changes made to our professional services pricing strategy. Fiscal Year 2018 Compared with Fiscal Year 2017 Our total cost of revenues for fiscal year 2018 were $83.0 million, an increase of $14.5 million, or 21.1%, from $68.5 million for fiscal year 2017. The increase in cost of revenues was primarily the result of hiring more professional services staff and higher cloud infrastructure and employee costs for connected services in order to provide our customization and implementation services to our customers. We experienced an increase in our amortization of intangible assets that was included in costs of revenues primarily due to our acquisition of Voicebox, which increased the carrying value of our total intangible assets. We experienced an increase in gross profit of $17.8 million, or 10.1%, from $176.2 million to $194.0 million which was primarily driven by increased demand for our license and connected services solutions. Cost of License Revenue Cost of license revenue for fiscal year 2018 were $1.2 million, an increase of $0.4 million, or 49.5%, from $0.8 million for fiscal year 2017. Cost of license revenues increased due to third-party royalty expenses associated with external technologies we leverage in our edge software components. As a percentage of total cost of revenue, cost of license revenue increased by 0.3 percentage points from 1.1% for fiscal year 2017 to 1.4% for fiscal year 2018. License gross profit increased $21.9 million, or 14.8%, from $148.0 million to $169.9 million since costs associated with license royalties are minimal. Cost of Connected Services Revenue Cost of connected services revenue for fiscal year 2018 were $32.9 million, an increase of $7.6 million, or 30.2%, from $25.3 million for fiscal year 2017. Cost of connected services revenue increased primarily as a result of the growth of cloud-based connected services revenue from new and existing customers utilizing our software delivery services for hybrid solutions. As a percentage of total cost of revenue, cost of connected service revenue increased by 2.8 percentage points from 36.9% for fiscal year 2017 to 39.7% for fiscal year 2018. Connected services gross profit increased $6.9 million, or 33.8%, from $20.4 million to $27.3 million, which was primarily due to connected services revenue growth on relatively fixed cloud infrastructure and employee costs. Cost of Professional Services Revenue Cost of professional services revenue for fiscal year 2018 were $41.1 million, an increase of $5.5 million, or 15.6%, from $35.6 million for fiscal year 2017. Cost of professional services revenue increased primarily due to our investments in professional services staff to meet customer program demands which differentiate our service offerings. As a percentage of total cost of revenue, cost of professional services revenue decreased by 2.3 percentage points from 51.9% for fiscal year 2017 to 49.6% for fiscal year 2018. Professional services gross profit decreased $9.8 million, or 69.2%, from $14.1 million to $4.3 million, which was primarily the result of a change in our pricing strategy and increased hiring of professional services staff as we invest in expanding and differentiating our professional services offerings. Operating Expenses The tables below show each component of operating expense. Other income (expense), net and provision for income taxes are non-operating expenses and presented in a similar format (dollars in thousands). R&D Expenses Year Ended September 30, % Change % Change 2019 vs. 2018 2018 vs. 2017 Research and development $ 93,061 $ 80,957 $ 56,755 % % Fiscal Year 2019 Compared with Fiscal Year 2018 Historically, R&D expenses are our largest operating expense as we continue to build on our existing software platforms and develop new technologies. R&D expenses for fiscal year 2019 were $93.1 million, an increase of $12.1 million, or 15.0%, from $81.0 million for fiscal year 2018. R&D expense increased primarily as a result of hiring more engineers and other essential product innovation personnel. Investing in R&D personnel is essential to advancing our technologies and enhancing in-car experiences. As a percentage of total operating expenses, R&D expenses decreased by 3.4 percentage points from 51.5% for fiscal year 2018 to 48.1% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 Historically, R&D expenses are our largest operating expense as we continue to build on our existing software platforms and develop new technologies. R&D expenses for fiscal year 2018 were $81.0 million, an increase of $24.2 million, or 42.6%, from $56.8 million for fiscal year 2017. R&D expense increased primarily as a result of hiring more engineers and other essential product innovation personnel. Investing in R&D personnel is essential to advancing our technologies and enhancing in-car experiences. As a percentage of total operating expenses, R&D expenses increased by 1.1 percentage points from 50.4% for fiscal year 2017 to 51.5% for fiscal year 2018. Sales & Marketing Expenses Year Ended September 30, % Change % Change 2019 vs. 2018 2018 vs. 2017 (ASC 606) (ASC 605) (ASC 605) (ASC 605) (ASC 605) (ASC 605) Sales and marketing $ 36,261 $ 36,653 $ 30,553 $ 29,909 % % Fiscal Year 2019 Compared with Fiscal Year 2018 Sales and marketing expenses under ASC 606 for fiscal year 2019 are $0.4 million lower compared to sales and marketing expenses for the same period presented under ASC 605 due to the amortization of capitalized sales commission expenses over the period of benefit. Under ASC 605, sales commissions were expensed as incurred. Under ASC 605, sales and marketing expenses for fiscal year 2019 were $36.7 million, an increase of $6.1 million, or 20.0%, from $30.6 million for fiscal year 2018. Sales and marketing expenses increased primarily as a result of higher sales quota attainment and the expansion of our sales and marketing staff levels. As a percentage of total operating expenses, sales and marketing expenses under ASC 605 decreased by 0.5 percentage points from 19.4% for fiscal year 2018 to 18.9% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 Sales and marketing expenses for fiscal year 2018 were $30.6 million, an increase of $0.7 million, or 2.2%, from $29.9 million for fiscal year 2017. Sales and marketing expenses increased primarily as a result of higher compensation expenses associated with our existing sales and marketing staff, third party service fees, and other miscellaneous sales and marketing expenses. This increase was offset by reduced commission expenses resulting from recent changes in our commission plans and stock compensation expenses. As a percentage of total operating expenses, sales and marketing expenses decreased by 7.2 percentage points from 26.6% for fiscal year 2017 to 19.4% for fiscal year 2018. General & Administrative Expenses Year Ended September 30, % Change % Change 2019 vs. 2018 2018 vs. 2017 General and administrative $ 25,926 $ 19,873 $ 17,485 % % Fiscal Year 2019 Compared with Fiscal Year 2018 General and administrative expenses for the fiscal year ended September 30, 2019 were $25.9 million, an increase of $6.1 million, or 30.5%, from $19.9 million for the fiscal year ended September 30, 2018. The increase in general and administrative expenses was primarily attributable to professional and legal fees, administrative salaries expenses, and software fees. As a percentage of total operating expenses, general and administrative expenses increased by 0.8 percentage points from 12.6% for fiscal year 2018 to 13.4% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 General and administrative expenses for fiscal year 2018 were $19.9 million, an increase of $2.4 million, or 13.7%, from $17.5 million for fiscal year 2017. The increase in general and administrative expenses was primarily attributable to professional and legal fees, administrative salaries expenses, and software fees. As a percentage of total operating expenses, general and administrative expenses decreased by 2.9 percentage points from 15.5% for fiscal year 2017 to 12.6% for fiscal year 2018. Amortization of Intangible Assets Fiscal Year 2019 Compared with Fiscal Year 2018 Intangible asset amortization for fiscal year 2019 was $21.0 million, an increase of $4.4 million, or 26.6%, from $16.6 million for fiscal year 2018. The increase primarily relates to our acquisition of Voicebox which resulted in the addition of several customer relationships that increased amortization expense. As a percentage of total cost of revenues, intangible asset amortization within cost of revenues decreased by 0.8 percentage points from 9.4% for fiscal year 2018 to 8.6% for fiscal year 2019. As a percentage of total operating expenses, intangible asset amortization expenses within operating expenses increased by 0.8 percentage points from 5.6% for fiscal year 2018 to 6.5% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 Intangible asset amortization for fiscal year 2018 was $16.6 million, an increase of $3.9 million, or 31.2%, from $12.7 million for fiscal year 2017. The increase primarily relates to our acquisition of Voicebox which resulted in the addition of several customer relationships that increased amortization expense. This increase was partially offset by certain other customer relationships and tradenames becoming fully amortized during fiscal year 2018. As a percentage of total cost of revenues, intangible asset amortization within cost of revenues decreased by 0.7 percentage points from 10.1% for fiscal year 2017 to 9.4% for fiscal year 2018. As a percentage of total operating expenses, intangible asset amortization expenses within operating expenses increased by 0.5 percentage points from 5.1% for fiscal year 2017 to 5.6% for fiscal year 2018. Restructuring and Other Costs, Net Year Ended September 30, % Change % Change 2019 vs. 2018 2018 vs. 2017 Restructuring and other costs, net $ 24,404 $ 12,863 $ 1,865 % % Fiscal Year 2019 Compared with Fiscal Year 2018 Restructuring and other costs, net for fiscal year 2019 were $24.4 million, an increase of $11.5 million, from $12.9 million for fiscal year 2018. Restructuring and other costs, net increased primarily due to professional service fees incurred to establish the Cerence business as a standalone public company. As a percentage of total operating expense, restructuring and other costs, net increased by 4.4 percentage points from 8.2% for fiscal year 2018 to 12.6% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 Restructuring and other costs, net for fiscal year 2018 were $12.9 million, an increase of $11.0 million, from $1.9 million for fiscal year 2017. Restructuring and other costs, net increased primarily due to professional service fees incurred to establish the Cerence business as a standalone public company and the reorganization of Voicebox business units in order to achieve process optimization and cost reductions following the acquisition. As a percentage of total operating expense, restructuring and other costs, net increased by 6.5 percentage points from 1.7% for fiscal year 2017 to 8.2% for fiscal year 2018. Acquisition-related Costs Year Ended September 30, % Change % Change 2019 vs. 2018 2018 vs. 2017 Acquisition-related costs $ $ 4,082 $ (77 )% % Fiscal Year 2019 Compared with Fiscal Year 2018 Acquisition-related costs for fiscal year 2019 were $0.9 million, a decrease of $3.1 million, from $4.1 million for fiscal year 2018. Acquisition costs decreased as a direct result of integration, legal, and other professional fees incurred resulting from the acquisition of Voicebox on April 2, 2018. As a percentage of total operating expense, acquisition-related costs decreased by 2.1 percentage points from 2.6% for fiscal year 2018 to 0.5% for fiscal year 2019. Fiscal Year 2018 Compared with Fiscal Year 2017 Acquisition-related costs for fiscal year 2018 were $4.1 million, an increase of $3.4 million, from $0.7 million for fiscal year 2017. Acquisition costs increased as a direct result of integration, legal, and other professional fees incurred resulting from the acquisition of Voicebox on April 2, 2018. As a percentage of total operating expense, acquisition-related costs increased by 1.9 percentage points from 0.7% for fiscal year 2017 to 2.6% for fiscal year 2018. Other Income (Expense), Net Year Ended September 30, % Change % Change 2019 vs. 2018 2018 vs. 2017 (ASC 606) (ASC 605) (ASC 605) (ASC 605) (ASC 605) (ASC 605) Other income (expense), net $ $ $ (54 ) $ (483 ) (772 )% (89 )% Fiscal Year 2019 Compared with Fiscal Year 2018 Other income (expense), net for fiscal year 2019 was $0.4 million , an increase of $0.4 million, or 772.2%, from $(0.1) million for fiscal year 2018. The net increase in other income (expense), net over the prior fiscal year was primarily the result of foreign currency differences year over year. Fiscal Year 2018 Compared with Fiscal Year 2017 Other income (expense), net for fiscal year 2018 was less than $(0.1) million, a decrease of $0.4 million, or 88.8%, from $(0.5) million for fiscal year 2017. The net increase in other income (expense), net over the prior fiscal year was primarily the result of foreign currency gains (losses) year over year. (Benefit from) Provision for Income Taxes Fiscal Year 2019 Compared with Fiscal Year 2018 Our effective income tax rate for fiscal year 2019 was (796.5)%, compared to 84.0% for fiscal year 2018. Consequently, our benefit from income taxes for fiscal year 2019 was $89.1 million, a net change of $120.0 million, or 388.1%, from a provision for income taxes of $30.9 million for fiscal year 2018. The effective income tax rate for fiscal year 2019 differed from the U.S. statutory rate of 21.0% primarily due to a net tax benefit of $91.7 million related to intangible property transfers, partially offset by an uncertain tax position. The net tax benefit is also partially offset by global intangible low-taxed income, or GILTI, tax expense of $3.9 million. Fiscal Year 2018 Compared with Fiscal Year 2017 Our effective income tax rate for fiscal year 2018 was 84.0%, compared to 25.2% for fiscal year 2017. Consequently, provision for income taxes for fiscal year 2018 was $30.9 million, an increase of $15.0 million, or 94.1 %, from $15.9 million for fiscal year 2017. The effective income tax rate for fiscal year 2018 differed from the blended U.S. statutory rate of 24.5%, primarily due to the net tax provisions resulting from the Tax Cuts and Jobs Act, or TCJA, remeasurement of deferred tax assets and liabilities at the lower enacted rate which yielded approximately $23.1 million of benefit for the year ended September 30, 2018, our R&D credits, and the domestic production activities deduction. The effective income tax rate for fiscal year 2017 differed from the U.S. statutory rate of 35.0% due to our earnings in foreign jurisdictions that are subject to significantly lower rates, R&D credits, and the domestic production activities deduction. Liquidity and Capital Resources Historically, the Cerence business has generated positive cash flows from operations. As part of Nuance, the Cerence business utilized a centralized approach to cash management and financing its operations. Under this approach, the Cerence business did not maintain its own cash and cash equivalent balances. Nuance bills customers and collects cash associated with the Cerence business’s operations. Nuance approves and provides all cash required for operating or investing activities outside of the Cerence business’s normal course of business. This cash management arrangement is not reflective of the manner in which the Cerence business would have financed its operations if it had been a standalone business during the historical periods presented. Historically, the Cerence business was not allocated cash or cash equivalents from Nuance. Additionally, the Cerence business was not allocated any debt or interest expense since Nuance’s corporate borrowings were not specifically identifiable to the Cerence business for any of the historical periods presented. Our ability to fund future operating needs will depend on our ability to generate positive cash flows from operations and finance additional funding in the capital markets as needed. Upon the Distribution, Nuance allocated $110.0 million in cash and cash equivalents to the Cerence business, which was adequate to meet the short-term net working capital needs of our business at the close of the Distribution. More specifically, as of September 30, 2019 net working capital of our business, excluding current deferred revenue and deferred cost, was $42.2 million. This balance is representative of the short-term net cash inflows based on the working capital at that date and is also relatively consistent with the balance at September 30, 2018. Based on our history of generating positive cash flows and the $110.0 million of allocated cash and cash equivalents coupled with this working capital profile, we believe we will be able to meet our short-term operating cash needs. We believe we will meet all expected future cash requirements and obligations, through a combination of cash flows from operating activities, available cash balances, and available credit via our revolving credit facility. Specifically, we anticipate our cost of revenues, funding our R&D activities, and debt obligations to be our primary uses of cash during the year ended September 30, 2020. Should we need to secure additional sources of liquidity, we believe we could finance our needs through the issuance of equity securities or debt offerings. However, we cannot guarantee that we will be able to obtain financing through the issuance of equity securities or debt offerings on reasonable terms in the future. Senior Facilities On October 1, 2019, we incurred substantial indebtedness in the aggregate principal amount of approximately $270.0 million under our Term Loan Facility, which financed the cash distribution to Nuance and provided initial support for the cash flow needs of the Cerence business. We also entered into a $75.0 million Revolving Facility to be drawn on in the event that our working capital and other cash needs are not supported by our operating cash flow. As of December 19, 2019, there were no amounts outstanding under the Revolving Facility. The Revolving Facility matures 54 months after October 1, 2019, with certain extension rights in the discretion of each lender. The Term Loan Facility matures five years after October 1, 2019, with certain extension rights in the discretion of each lender. The Senior Facilities are subject to an interest rate, at our option, of either (a) a base rate determined by reference to the highest of (1) the rate of interest last quoted by The Wall Street Journal as the “prime rate” in the United States, (2) the federal funds effective rate, plus 0.5% and (3) the one month adjusted LIBOR rate, plus 1% per annum, or ABR, or (b) an adjusted LIBOR rate, or LIBOR, (which may not be less than 1% per annum), in each case, plus an applicable margin. The applicable margins for the Senior Facilities are 6.00% per annum (for LIBOR loans) and 5.00% per annum (for ABR loans). Accordingly, the interest rates for the Senior Facilities will fluctuate during the term of the credit agreement based on changes in the ABR or LIBOR. We are obligated to make quarterly principal payments on the last business day of each quarter in an aggregate annual amount equal to 3.5% of the original principal amount of the Term Loan Facility during the first two years of the Term Loan Facility, and 10% of the original principal amount of the Term Lon Facility thereafter. Quarterly principal payments will commence on March 31, 2020. Borrowings under the credit agreement for the Senior Facilities are prepayable at our option without premium or penalty, subject to a 1.00% prepayment premium in connection with any repricing transaction for the Term Loan Facility in the first six months after the closing date. The credit agreement also contains certain mandatory prepayment provisions in the event that we incur certain types of indebtedness, receive net cash proceeds from certain non-ordinary course asset sales or other dispositions of property or generate excess cash flow, starting with the fiscal year ending on September 30, 2020, 75% of excess cash flow on an annual basis (with step-downs to 50%, 25% and 0% subject to compliance with certain net first lien leverage ratios), in each case subject to terms and conditions customary for financings of this kind. The credit agreement contains certain affirmative and negative covenants that, among other things, limit our and our subsidiaries’ ability to incur additional indebtedness or liens, to dispose of assets, to make certain fundamental changes, enter into restrictive agreements, to designate subsidiaries as unrestricted, to make certain investments, loans, advances, guarantees and acquisitions to prepay certain indebtedness and to pay dividends, to make other distributions or redemptions/repurchases, in respect of us and our subsidiaries’ equity interests, to engage in transactions with affiliates or to amend certain material documents. In addition, the credit agreement contains a financial covenant requiring the maintenance of a net first lien leverage ratio of not greater than 6.00 to 1.00. Our obligations under the credit agreement are jointly and severally guaranteed by certain of our existing and future direct and indirect wholly owned domestic subsidiaries, subject to certain exceptions customary for financings of this type. All obligations of the borrowers and the guarantors are secured by certain assets of such borrowers and guarantors, including a perfected first-priority pledge of all (or, in the case of foreign subsidiaries or subsidiaries, or FSHCO, that own no material assets other than equity interests in foreign subsidiaries that are “controlled foreign corporations” or other FSHCOs, 65%) of the equity securities of each wholly owned subsidiary of Cerence held by any loan party, subject to certain customary exceptions and limitations. Cash Flows Cash flows from operating, investing and financing activities for the years ended September 2019, 2018, and 2017, as reflected in the audited consolidated and combined statement of cash flows included in Item 8 of this Form 10-K, are summarized in the following table (dollars in thousands): Net Cash Provided by Operating Activities Net cash provided by operating activities for fiscal year 2019 was $88.1 million, a net decrease of $27.2 million, or 23.6%, from net cash provided by operating activities of $115.3 million for fiscal year 2018. The net decrease in cash provided by operating activities stems from unfavorable changes in working capital, primarily due to the timing of payments, which decreased accrued expenses and other liabilities by $6.7 million and increased prepaid expenses and other assets by $5.9 million. In addition, the timing of billing and collections resulted in a decrease in accounts receivable of $7.6 million compared to the prior year. Deferred revenue represents a significant portion of our net cash provided by operating activities and, depending on the nature of our contracts with customers, this balance can fluctuate significantly from period to period. Due to the evolution of our connected offerings and architecture, trending away from providing legacy infotainment and connected services and a change in our professional services pricing strategies, we expect our deferred revenue balances to decrease in the future, including due to a wind-down of a legacy connected service relationship with a major OEM, since the majority of cash from the contract has been collected. We do not expect any changes in deferred revenue to affect our ability to meet our obligations. Net cash provided by operating activities for fiscal year 2018 was $115.3 million, an increase of $18.5 million, or 19.1%, from $96.8 million for fiscal year 2017. The net increase in cash provided by operating activities stems from favorable changes in working capital, primarily due to the timing of billing and collections which resulted in an increase in accounts receivable of $26.4 million compared to the prior year. This increase was partially offset by other changes in working capital, an increase in operating expenses primarily due to continued investments in R&D, and $7.9 million of separation costs related to establishing the Cerence business as a standalone public company. Net Cash Used in Investing Activities Net cash used in investing activities for the fiscal year 2019 was $4.5 million, a decrease of $81.8 million, or 94.8%, from $86.3 million for fiscal year 2018. The decrease in cash outflows was due to net cash payments of $79.8 million associated with the acquisition of Voicebox during the fiscal year ended September 30, 2018 and a $2.0 million decrease in cash outflows for capital expenditures. Net cash used in investing activities for fiscal year 2018 was $86.3 million, an increase of $81.6 million, from $4.7 million for fiscal year 2017. The increase in cash outflows was due to net cash payments of $79.8 million associated with the acquisition of Voicebox and a $1.8 million increase in cash outflows for capital expenditures. Net Cash Used in Financing Activities Net cash used in financing activities for the fiscal year 2019 was $83.6 million, a net increase of $54.6 million, from cash used in financing activities of $28.9 million for fiscal year 2018. The change is comparable period over period and relates to the cash distributions associated with Nuance’s historical cash management process. Net cash used in financing activities for fiscal year 2018 was $28.9 million, a decrease of $63.2 million, or 68.6%, from net cash used in financing activities of $92.1 million for fiscal year 2017. The net decrease in cash used in financing activities is the result of cash distributions associated with Nuance’s historical cash management process. Business Acquisitions Historically, we have made several acquisitions. We approach the market with a focus on our core technologies and acquire companies based on a careful assessment of potential post-acquisition synergies that will help us expand our software platform and connected car services and advance our technologies. On April 2, 2018, we acquired Voicebox, headquartered in Bellevue, Washington. Voicebox is a provider of conversational artificial intelligence, including voice recognition, natural language understanding, and artificial intelligence services. The aggregate consideration for this transaction was $94.2 million which included $79.8 million paid in cash, net of $6.7 million in cash acquired, a $12.8 million write-off of deferred revenues related to the Cerence business’s pre-existing relationship with Voicebox, and a $1.6 million deferred acquisition payment which would be paid in cash upon the conclusion of an indemnity period. The transaction was accounted for as a business combination and is included in the accompanying historical Combined Financial Statements beginning on the date of acquisition. Refer to Note 4 to the accompanying historical Combined Financial Statements included elsewhere in this Form 10-K for more detail on the acquisition of Voicebox. Contractual Obligations, Contingent Liabilities, and Commitments The table below shows our contractual obligations as of September 30, 2019 (dollars in thousands): Contractual obligations may include lease, pension contribution requirements, and other non-current liabilities that are enforceable and legally binding on the Cerence business, excluding contingent liabilities that may arise from litigation, arbitration, regulatory actions, or income taxes. As of September 30, 2019, the Cerence business was subject to contractual obligations regarding operating and capital leases. Other Matters Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures, or capital resources. Defined Benefit Plans We sponsor certain defined benefit plans that are offered primarily by certain of our foreign subsidiaries. Many of these plans were assumed through our acquisitions or are required by local regulatory requirements. We may deposit funds for these plans with insurance companies, third-party trustees, or into government-managed accounts consistent with local regulatory requirements, as applicable. Our total defined benefit plan pension expense was $0.4 million, $0.4 million, and $0.4 million for fiscal years 2019, 2018, and 2017, respectively. The aggregate projected benefit obligation as of fiscal years 2019, 2018, and 2017 was $7.3 million, $5.0 million and $5.1 million, respectively. The aggregate net liability of our defined benefit plans as of September 30, 2019, 2018, and 2017 was $6.8 million, $4.2 million, and $4.2 million, respectively. Issued Accounting Standards Not Yet Adopted Refer to Note 3 to the accompanying audited Combined Financial Statements included elsewhere in this Form 10-K for a description of certain issued accounting standards that have not been adopted by us and may impact our results of operations in future reporting periods. Critical Accounting Policies, Judgments and 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, 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 period. On an ongoing basis, we evaluate our estimates, assumptions and judgments, including those related to revenue recognition; allowance for doubtful accounts and sales returns; accounting for deferred costs; accounting for internally developed software; the valuation of goodwill and intangible assets; accounting for business combinations; accounting for stock-based compensation; accounting for income taxes, deferred tax assets, and related valuation allowances; and loss contingencies. Our management bases its estimates on historical experience, market participant fair value considerations, projected future cash flows, and various other factors that are believed to be reasonable under the circumstances. Actual results could differ from these estimates. We believe the following critical accounting policies most significantly affect the portrayal of our financial condition and the results of our operations. These policies require our most difficult and subjective judgements. Revenue Recognition We primarily derive revenue from the following sources: (1) royalty-based software license arrangements, (2) connected services, and (3) professional services. Revenue is reported net of applicable sales and use tax, value-added tax and other transaction taxes imposed on the related transaction including mandatory government charges that are passed through to our customers. We account for a contract when both parties have approved and committed to the contract, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. Our arrangements with customers may contain multiple products and services. We account for individual products and services separately if they are distinct-that is, if a product or service is separately identifiable from other items in the contract and if a customer can benefit from it on its own or with other resources that are readily available to the customer. As of October 1, 2018, we adopted ASC 606 using the modified retrospective approach, which requires the results for the current reporting periods be presented under ASC 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting policies in accordance with ASC 605, with a cumulative adjustment recorded to accumulated deficit. For a reconciliation of our old accounting policy and ASC 606, please refer to Note 3 to the accompanying audited Combined Financial Statements included elsewhere in this Form 10-K. We currently recognize revenue after applying the following five steps: • identification of the contract, or contracts, with a customer; • identification of the performance obligations in the contract, including whether they are distinct within the context of the contract; • determination of the transaction price, including the constraint on variable consideration; • allocation of the transaction price to the performance obligations in the contract; and • recognition of revenue when, or as, the performance obligations are satisfied. We allocate the transaction price of the arrangement based on the relative estimated standalone selling price, or SSP, of each distinct performance obligation. In determining SSP, we maximize observable inputs and consider a number of data points, including: • the pricing of standalone sales (in the instances where available); • the pricing established by management when setting prices for deliverables that are intended to be sold on a standalone basis; • contractually stated prices for deliverables that are intended to be sold on a standalone basis; and • other pricing factors, such as the geographical region in which the products are sold and expected discounts based on the customer size and type. We only include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. We reduce transaction prices for estimated returns and other allowances that represent variable consideration under ASC 606, which we estimate based on historical return experience and other relevant factors, and record a corresponding refund liability as a component of accrued expenses and other current liabilities. Other forms of contingent revenue or variable consideration are infrequent. Revenue is recognized when control of these services are transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services. We assess the timing of the transfer of products or services to the customer as compared to the timing of payments to determine whether a significant financing component exists. In accordance with the practical expedient in ASC 606-10-32-18, we do not assess the existence of a significant financing component when the difference between payment and transfer of deliverables is a year or less. If the difference in timing arises for reasons other than the provision of finance to either the customer or us, no financing component is deemed to exist. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our services, not to receive or provide financing from or to customers. We do not consider set-up fees nor other upfront fees paid by our customers to represent a financing component. Performance Obligations License Software and technology licenses sold with non-distinct professional services to customize and/or integrate the underlying software and technology are accounted for as a combined performance obligation. Revenue from the combined performance obligation is recognized over time based upon the progress towards completion of the project, which is measured based on the labor hours already incurred to date as compared to the total estimated labor hours. For income statement presentation purposes, we separate license revenue from professional services revenue based on their SSPs. Revenue from distinct software and technology licenses, which do not require professional service to customize and/or integrate the software license, is recognized at the point in time when the software and technology is made available to the customer and control is transferred. Revenue from software and technology licenses sold on a royalty basis, where the license of intellectual property is the predominant item to which the royalty relates, is recognized in the period the usage occurs in accordance with the practical expedient in ASC 606-10-55-65(A). Connected Services Connected services, which allow our customers to use the hosted software over the contract period without taking possession of the software, are provided on a usage basis as consumed or on a fixed fee subscription basis. Subscription basis revenue represents a single promise to stand-ready to provide access to our connected services. Our connected services contract terms generally range from one to five years. As each day of providing services is substantially the same and the customer simultaneously receives and consumes the benefits as access is provided, we have determined that our connected services arrangements are a single performance obligation comprised of a series of distinct services. These services include variable consideration, typically a function of usage. We recognize revenue as each distinct service period is performed (i.e., recognized as incurred). Our connected service arrangements generally include services to develop, customize, and stand-up applications for each customer. In determining whether these services are distinct, we consider dependence of the cloud service on the up-front development and stand-up, as well as availability of the services from other vendors. We have concluded that the up-front development, stand-up and customization services are not distinct performance obligations, and as such, revenue for these activities is recognized over the period during which the cloud-connected services are provided, and is included within connected services revenue. Professional Services Revenue from distinct professional services, including training, is recognized over time based upon the progress towards completion of the project, which is measured based on the labor hours already incurred to date as compared to the total estimated labor hours. Significant Judgements Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. Our license contracts often include professional services to customize and/or integrate the licenses into the customer’s environment. Judgment is required to determine whether the license is considered distinct and accounted for separately, or not distinct and accounted for together with professional services. Judgments are required to determine the SSP for each distinct performance obligation. When the SSP is directly observable, we estimate the SSP based upon the historical transaction prices, adjusted for geographic considerations, customer classes, and customer relationship profiles. In instances where the SSP is not directly observable, we determine the SSP using information that may include market conditions and other observable inputs. We may 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 as the size of the customer and geographic region in determining the SSP. Determining the SSP for performance obligations which we never sell separately also requires significant judgment. In estimating the SSP, we consider the likely price that would have resulted from established pricing practices had the deliverable been offered separately and the prices a customer would likely be willing to pay. Contract Acquisition Costs In conjunction with the adoption of ASC 606, we are required to capitalize certain contract acquisition costs. The capitalized costs primarily relate to paid commissions. In accordance with the practical expedient in ASC 606-10-10-4, we apply a portfolio approach to estimate contract acquisition costs for groups of customer contracts. We elect to apply the practical expedient in ASC 340-40-25-4 and will expense contract acquisition costs as incurred where the expected period of benefit is one year or less. Contract acquisition costs are deferred and amortized on a straight-line basis over the period of benefit, which we have estimated to be between one and five years. The period of benefit was determined based on an average customer contract term, expected contract renewals, changes in technology and our ability to retain customers, including canceled contracts. We assess the amortization term for all major transactions based on specific facts and circumstances. Contract acquisition costs are classified as current or noncurrent assets based on when the expense will be recognized. The current and noncurrent portions of contract acquisition costs are included in prepaid expenses and other current assets and in other assets, respectively. As of September 30, 2019, we had $2.7 million of contract acquisition costs. We had amortization expense of $0.7 million related to these costs during the fiscal year ended September 30, 2019. There was no impairment related to contract acquisition costs. Capitalized Contract Costs We capitalize incremental costs incurred to fulfill our contracts that (i) relate directly to the contract, (ii) are expected to generate resources that will be used to satisfy our performance obligation under the contract, and (iii) are expected to be recovered through revenue generated under the contract. Our capitalized costs consist primarily of setup costs, such as costs to standup, customize and develop applications for each customer, which are incurred to satisfy our stand-ready obligation to provide access to our connected offerings. These contract costs are expensed to cost of revenue as we satisfy our stand-ready obligation over the contract term which we estimate to be between one and five years, on average. The contract term was determined based on an average customer contract term, expected contract renewals, changes in technology, and our ability to retain customers, including canceled contracts. We classify these costs as current or noncurrent based on the timing of when we expect to recognize the expense. The current and noncurrent portions of capitalized contract fulfillment costs are presented as deferred costs. As of September 30, 2019, we had $41.6 million of capitalized contract costs. We had amortization expense of $10.6 million related to these costs during the fiscal year ended September 30, 2019. There was no impairment related to contract fulfillment costs capitalized. Trade Accounts Receivable and Contract Balances We classify our right to consideration in exchange for deliverables as either a receivable or a contract asset. A receivable is a right to consideration that is unconditional (i.e., only the passage of time is required before payment is due). We present such receivables in accounts receivable, net in our condensed combined balance sheets at their net estimated realizable value. We maintain an allowance for doubtful accounts to provide for the estimated amount of receivables that may not be collected. The allowance is based upon an assessment of customer creditworthiness, historical payment experience, the age of outstanding receivables and other applicable factors. Our contract assets and liabilities are reported in a net position on a contract-by-contract basis at the end of each reporting period. Contract assets include unbilled amounts from long-term contracts when revenue recognized exceeds the amount billed to the customer, and right to payment is not solely subject to the passage of time. Contract assets are included in prepaid expenses and other current assets. As of September 30, 2019, we had $9.2 million of contract assets. Our contract liabilities, or deferred revenue, consist of advance payments and billings in excess of revenues recognized. We classify deferred revenue as current or noncurrent based on when we expect to recognize the revenues. As of September 30, 2019, we had $353.3 million of deferred revenue. Business Combinations We determine and allocate the purchase price of an acquired company to the tangible and intangible assets acquired and liabilities assumed as of the business combination date. Results of operations and cash flows of acquired companies are included in our operating results from the date of acquisition. The purchase price allocation process requires us to use significant estimates and assumptions as of the date of the business acquisition, including fair value estimates such as: • estimated fair values of intangible assets; • estimated fair values of legal performance commitments to customers, assumed from the acquiree under existing contractual obligations (classified as deferred revenue) at the date of acquisition; • estimated income tax assets and liabilities assumed from the acquiree; and • estimated fair value of pre-acquisition contingencies from the acquiree. While we use our best estimates and assumptions to determine the fair values of assets acquired and liabilities assumed at the date of acquisition, our estimates and assumptions are inherently uncertain and subject to refinement. As a result, within the measurement period, which is generally one year from the date of acquisition, we record adjustments to the assets acquired and liabilities assumed against goodwill in the period the amounts are determined. Adjustments identified subsequent to the measurement period are recorded within Acquisition-related costs, net. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Examples of critical estimates in valuing certain of the intangible assets we have acquired or may acquire in the future include but are not limited to: • future expected cash flows from software license sales, support agreements, consulting contracts, connected services, other customer contracts and acquired developed technologies and patents; • expected costs to develop in-process R&D projects into commercially viable products and the estimated cash flows from the projects when completed; • the acquired company’s brand and competitive position, as well as assumptions about the period during which the acquired brand will continue to be used in the combined company’s product portfolio; and • discount rates. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results. In connection with the purchase price allocations for our acquisitions, we estimate the fair market value of legal performance commitments to customers, which are classified as deferred revenue. The estimated fair market value of these obligations is determined and recorded as of the acquisition date. We may identify certain pre-acquisition contingencies. If, during the purchase price allocation period, we are able to determine the fair values of a pre-acquisition contingencies, we will include that amount in the purchase price allocation. If we are unable to determine the fair value of a pre-acquisition contingency at the end of the measurement period, we will evaluate whether to include an amount in the purchase price allocation based on whether it is probable a liability had been incurred and whether an amount can be reasonably estimated. Subsequent to the end of the measurement period, any adjustment to amounts recorded for a pre-acquisition contingency will be included within acquisition-related cost, net in the period in which the adjustment is determined. Goodwill Impairment Analysis Goodwill represents the excess of the purchase price in a business combination over the fair value of net tangible and intangible assets acquired. Goodwill and intangible assets with indefinite lives are not amortized, but rather the carrying amounts of these assets are assessed for impairment at least annually or whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Goodwill is tested for impairment annually on July 1, the first day of the fourth quarter of the fiscal year. In fiscal year 2017, we elected to early adopt ASU 2017-04, “Simplifying the Test for Goodwill Impairment”, or ASU 2017-04, for our annual goodwill impairment test. ASU 2017-04 removes Step 2 of the goodwill impairment test requiring a hypothetical purchase price allocation. Goodwill impairment, if any, is determined by comparing the reporting unit’s fair value to its carrying value. An impairment loss is recognized in an amount equal to the excess of the reporting unit’s carrying value over its fair value, up to the amount of goodwill allocated to the reporting unit. There was no goodwill impairment in any of the periods presented. For the purpose of testing goodwill for impairment, all goodwill acquired in a business combination is assigned to one or more reporting units. A reporting unit represents an operating segment or a component within an operating segment for which discrete financial information is available and is regularly reviewed by segment management for performance assessment and resource allocation. Components of similar economic characteristics are aggregated into one reporting unit for the purpose of goodwill impairment assessment. Reporting units are identified annually and re-assessed periodically for recent acquisitions or any changes in segment reporting structure. Corporate assets and liabilities are allocated to each reporting unit based on the reporting unit’s revenue, total operating expenses or operating income as a percentage of the consolidated amounts. Corporate debt and other financial liabilities that are not directly attributable to the reporting unit’s operations and would not be transferred to hypothetical purchasers of the reporting units are excluded from a reporting unit’s carrying amount. The fair value of a reporting unit is generally determined using a combination of the income approach and the market approach. For the income approach, fair value is determined based on the present value of estimated future after-tax cash flows, discounted at an appropriate risk-adjusted rate. We use our internal forecasts to estimate future after-tax cash flows and estimate the long-term growth rates based on our most recent views of the long-term outlook for each reporting unit. Actual results may differ from those assumed in our forecasts. We derive our discount rates using a capital asset pricing model and analyzing published rates for industries relevant to our reporting units to estimate the weighted average cost of capital. We adjust the discount rates for the risks and uncertainty inherent in the respective businesses and in our internally developed forecasts. For the market approach, we use a valuation technique in which values are derived based on valuation multiples of comparable publicly traded companies. We assess each valuation methodology based upon the relevance and availability of the data at the time we perform the valuation and weight the methodologies appropriately. Long-Lived Assets with Definite Lives Our long-lived assets consist principally of technology, customer relationships, internally developed software, land, building, and equipment. Customer relationships are amortized over their estimated economic lives based on the pattern of economic benefits expected to be generated from the use of the asset. Other definite-lived assets are amortized over their estimated economic lives using the straight-line method. The remaining useful lives of long-lived assets are re-assessed periodically at the asset group level for any events and circumstances that may change the future cash flows expected to be generated from the long-lived asset or asset group. Internally developed software consists of capitalized costs incurred during the application development stage, which include costs related design of the software configuration and interfaces, coding, installation and testing. Costs incurred during the preliminary project stage and post-implementation stage are expensed as incurred. Internally developed software is amortized over the estimated useful life, commencing on the date when the asset is ready for its intended use. Land, building and equipment are stated at cost and depreciated over their estimated useful lives. Leasehold improvements are depreciated over the shorter of the related lease term or the estimated useful life. Depreciation is computed using the straight-line method. Repair and maintenance costs are expensed as incurred. The cost and related accumulated depreciation of sold or retired assets are removed from the accounts and any gain or loss is included in the results of operations for the period. Long-lived assets with definite lives are tested for impairment whenever events or changes in circumstances indicate the carrying value of a specific asset or asset group may not be recoverable. We assess the recoverability of long-lived assets with definite-lives at the asset group level. Asset groups are determined based upon the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. When the asset group is also a reporting unit, goodwill assigned to the reporting unit is also included in the carrying amount of the asset group. For the purpose of the recoverability test, we compare the total undiscounted future cash flows from the use and disposition of the assets with its net carrying amount. When the carrying value of the asset group exceeds the undiscounted future cash flows, the asset group is deemed to be impaired. The amount of the impairment loss represents the excess of the asset or asset group’s carrying value over its estimated fair value, which is generally determined based upon the present value of estimated future pre-tax cash flows that a market participant would expect from use and disposition of the long-lived asset or asset group. There were no long-lived asset impairments in any of the periods presented. Stock-Based Compensation We recognize stock-based compensation expense over the requisite service period, based on the grant date fair value of the awards and the number of the awards expected to be vested based upon service and performance conditions. The fair value of restricted stock units is determined based on the number of shares granted and the quoted price of our common stock, and the fair value of stock options is estimated on the date of grant using the Black-Scholes model. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected dividends, share price volatility, forfeiture rates and the number of performance-based restricted stock units expected to be granted. If actual results differ significantly from these estimates, the actual stock-based compensation expense may significantly differ from our estimates. Income Taxes Income taxes as presented herein attribute current and deferred income taxes of Nuance to the Cerence business’s standalone financial statements in a manner that is systematic, rational, and consistent with the asset and liability method prescribed by ASC No. 740, “Income Taxes”, or ASC 740. Accordingly, the Cerence business’s income tax provision was prepared following the “Separate Return Method.” The Separate Return Method applies ASC 740 to the standalone financial statements of each member of the consolidated group as if the group member were a separate taxpayer and a standalone enterprise. As a result, actual tax transactions included in the consolidated financial statements of Nuance may not be included in the combined financial statements of the Cerence business. Similarly, the tax treatment of certain items reflected in the combined financial statements of Cerence may not be reflected in the consolidated financial statements and tax returns of Nuance; therefore, such items as net operating losses, credit carryforwards and valuation allowances may exist in the standalone financial statements that may or may not exist in Nuance’s consolidated financial statements. The breadth of the Cerence business’s operations and the global complexity of tax regulations require assessments of uncertainties and judgments in estimating taxes that the Cerence business would have paid if it had been a separate taxpayer. The final taxes that would have been paid are dependent upon many factors, including negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation and resolution of disputes arising from federal, state and international tax audits in the normal course of business. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. This method also requires the recognition of future tax benefits relating to net operating loss carryforwards and tax credits, to the extent that realization of such benefits is more likely than not after consideration of all available evidence. The provision for income taxes represents income taxes paid by Nuance or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax basis of the Cerence business’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In assessing the need for a valuation allowance, we consider both positive and negative evidence related to the likelihood of realization of the deferred tax assets. The weights assigned to the positive and negative evidence are commensurate with the extent to which the evidence may be objectively verified. If positive evidence regarding projected future taxable income, exclusive of reversing taxable temporary differences, existed, it would be difficult for it to outweigh objective negative evidence of recent financial reporting losses. In general, the taxable income (loss) of the various Cerence business entities was included in Nuance’s consolidated tax returns, where applicable in jurisdictions around the world. As such, separate income tax returns were not prepared for any Cerence business entities. Consequently, income taxes currently payable are deemed to have been remitted to Nuance, in cash, in the period the liability arose and income taxes currently receivable are deemed to have been received from Nuance in the period that a refund could have been recognized by the Cerence business had the Cerence business been a separate taxpayer. Loss Contingencies Cerence may be subject to legal proceedings, lawsuits and other claims relating to labor, service, intellectual property, and other matters that arise from time to time in the ordinary course of business. On a quarterly basis, we review the status of each significant matter and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. Significant judgments are required for the determination of probability and the range of the outcomes. Due to the inherent uncertainties, estimates are based only on the best information available at the time. Actual outcomes may differ from our estimates. As additional information becomes available, we reassess the potential liability related to our pending claims and litigation and may revise our estimates. Such revisions may have a material impact on our results of operations and financial position.

<s>[INST] Overview Cerence builds automotive cognitive assistance solutions to power natural and intuitive interactions between automobiles, drivers and passengers, and the broader digital world. We possess one of the world’s most popular software platforms for building automotive virtual assistants. Our customers include all major OEMs or their tier 1 suppliers worldwide. We deliver our solutions on a whitelabel basis, enabling our customers to deliver customized virtual assistants with unique, branded personalities and ultimately strengthening the bond between automobile brands and end users. Our vision is to enable a more enjoyable, safer journey for everyone. Our principal offering is our software platform, which our customers use to build virtual assistants that can communicate, find information and take action across an expanding variety of categories. Our software platform has a hybrid architecture combining edge software components with cloudconnected components. Edge software components are installed on a vehicle’s head unit and can operate without access to external networks and information. Cloudconnected components are comprised of certain speech and natural language understanding related technologies, AIenabled personalization and contextbased response frameworks, and content integration platform. We generate revenue primarily by selling software licenses and cloudconnected services. Our edge software components are typically sold under a traditional per unit perpetual software license model, in which a per unit fee is charged for each software instance installed on an automotive head unit. We typically license cloudconnected software components in the form of a service to the vehicle end user, which is paid for in advance. In addition, we generate professional services revenue from our work with our customers during the design, development and deployment phases of the vehicle model lifecycle and through maintenance and enhancement projects. We have existing relationships with all major OEMs or their tier 1 suppliers, and while our customer contracts vary, they generally represent multiyear engagements, giving us visibility into future revenue. Business Trends Under ASC 605, we experienced total revenue growth of 10.7% and 13.2%, during fiscal year 2019 and fiscal year 2018, respectively, primarily driven by our connected and professional services revenues due to increased market penetration of our connected and professional services solutions. License revenues increased slightly during fiscal 2019 due to a higher volume of licensing royalties from new and existing customers. Due to the historical strength of licensed edge technologies and our interpretation of industry trends, we believe license revenues will continue to experience growth into the future. Consistent with the increased revenue and customer demand, fiscal year 2019 was another key investment year for the Cerence business in which we focused on accelerating research and development, or R&D, and expanding our professional services team to improve the end user experience we are able to deliver. Under ASC 605, total cost of revenues increased by 19.2% during fiscal year 2019, primarily driven by the hiring of more professional services staff. Under ASC 605, total operating expenses grew by 23.1% during fiscal year 2019, primarily driven by innovation initiatives in order to increase our competitive position in the market. We hired a significant amount of new engineering and product innovation personnel, resulting in a 15.0% increase in R&D expenses. Our acquisition of Voicebox Technology Corporation, or Voicebox, on April 2, 2018, which provided additional customer relationships and technology, and the incurrence of professional service costs to establish the Cerence business as a standalone public company drove a $11.5 million increase in restructuring and other costs, net. We anticipate that our R&D expenses will continue to represent the majority of our operating expenses as we focus on developing new products and advancing our core technologies. Basis of Presentation The accompanying combined financial data was derived from the consolidated financial statements and accounting records of Nuance. The Combined Financial Statements were prepared for the year ended September 30, 2019 (which we refer to as fiscal year 2019), the year ended September 30, 2018 (which we refer to as fiscal year 2018), and the year ended September 30, 2017 (which we refer to as fiscal year 2017). Cerence was spun off from Nuance, a leading provider of speech and language solutions for businesses and consumers around the world. The preparation of these [/INST] Positive. </s>

1Life Healthcare Inc

2020-03-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read together with our consolidated financial statements and accompanying notes included elsewhere in this Annual Report. This discussion includes both historical information and forward-looking information based upon current expectations that involve risk, uncertainties and assumptions. Our actual results may differ materially from management’s expectations as a result of various factors, including, but not limited to, those discussed in “Risk Factors” and elsewhere in this Annual Report. Impact of Covid-19 on Our Business As of the date of this Annual Report, community self-isolation practices and shelter-in-place requirements related to COVID-19 have negatively impacted our net revenue for the three months ended March 31, 2020. Prolonged community self-isolation practices and shelter-in-place requirements will continue to reduce in-office visits, negatively affecting our net patient service revenue. Given the uncertainty around the duration and extent of the COVID-19 pandemic, we cannot accurately predict at this time the future potential impact on our business, results of operations, financial condition or liquidity. Overview Our vision is to delight millions of members with better health and better care while reducing the total cost of care. Our mission is to transform health care for all through our human-centered, technology-powered model. We are a membership-based primary care platform with seamless digital health and inviting in-office care, convenient to where people work, shop, live and click. We are disrupting health care from within the existing ecosystem by simultaneously addressing the frustrations and unmet needs of key stakeholders, which include consumers, employers, providers, and health networks. As of December 31, 2019, we had approximately 422,000 members in nine markets in the United States and greater than 7,000 employer clients. We have developed a modernized healthcare membership model based on direct consumer enrollment as well as employer sponsorship. Our annual membership model includes seamless access to 24/7 digital health services paired with inviting in-office care routinely covered under health insurance programs. Our technology drives high monthly active usage within our membership, promoting ongoing and longitudinal patient relationships for better health outcomes and high member retention. Our technology also helps our service-minded team in building trust and rapport with our members by facilitating proactive digital health outreach as well as responsive on-demand virtual and in-office care. Our digital health services and our well-appointed offices that are located in highly convenient locations are all serviced by our own clinical team who are employed in a salaried model, free of misaligned fee-for-service compensation incentives prevalent in health care. Additionally, we have developed clinically integrated partnerships with health networks, better coordinating more timely access to specialty care when needed by members, while advancing value-based care for employers through clinical and digital integration. Together, these components of our human-centered and technology-powered model allow us to deliver better results for key stakeholders. Our focus on simultaneously addressing the unfulfilled needs and frustrations of key stakeholders has allowed us to consistently grow the number of members we serve. We were founded in 2007 in San Francisco and have since grown to 422,000 members and 83 medical offices in nine markets across the United States as of December 31, 2019. From December 31, 2014 through December 31, 2019, we grew our membership by 351%. During the twelve months ended December 31, 2019 as compared to the twelve months ended December 31, 2014, our net revenue grew 293%, our digital interactions with our members grew 880%, and the number of in-office visits by our members grew 185%. Our Business Model We have developed a modernized healthcare membership model based on direct consumer enrollment as well as employer sponsorship. Our annual membership model includes seamless access to 24/7 digital health paired with inviting in-office care routinely covered under health insurance programs. Our members join either individually as consumers by paying an annual membership fee or are sponsored by an enterprise client who purchases a subscription for their employees and, increasingly, their dependents. All members have actively registered with us. Digital health services are delivered via our mobile app and website, through such modalities as video and voice encounters, chat and messaging, and our in-office care is delivered at any of our 83 medical offices as of December 31, 2019. We derive net revenue from multiple stakeholders, including consumers, employers, health networks and insurers. We recognize net revenue as (i) membership revenue from annual employer and consumer subscription fees, (ii) partnership revenue predominantly on a PMPM basis from health networks, fixed payments from enterprise clients for on-site medical services, and capitation payments from IPAs and (iii) net patient service revenue on a per visit basis from health insurers and patients. We are in-network with most health insurance plans in all of our markets. We generate a portion of our revenue through membership fees charged to either consumer members or enterprise clients. As of December 31, 2019, our current annual consumer membership fee for new members was $199. Our enterprise clients typically pay a discounted fee collected in advance, based on a rate per employee per month. We have entered into clinically integrated care partnerships with health networks, which generate revenue either through fee-for-service reimbursements for member in-office visits under the health network’s contracts or as fixed PMPM payments independent of office visits or services provided. For our health network arrangements that provide for fixed PMPM payments, when our medical offices provide professional clinical services to covered members, we, as administrator, perform billing and collection services on behalf of the health network, and the health network receives the fees for services provided, including those paid by members’ insurance plans. In those circumstances, we earn PMPM payments in lieu of per visit fees for services from member office visits. See “Business-Our Health Network Partnerships.” We generate partnership revenue from (i) our health network partners on a fixed PMPM basis, (ii) fixed price or fixed price per employee contracts with enterprise clients with on-site medical services, or (iii) capitation payments from IPAs that contract with HMOs for medical services provided to covered participants. Our membership fee revenue and partnership revenue are contractual and recurring in nature. Membership revenue and partnership revenue represented 47%, 32% and 22% of total net revenue for 2019, 2018, and 2017, respectively. The increased percentage of revenue that is contractual and recurring in nature is due to expanded enterprise on-site partnerships in 2018 and new agreements with health network partners in 2019. The remainder of our net revenue is primarily received on a per visit fee-for-service basis from member health insurance plans or patients, and in certain markets, with billing rates based on our agreements with health network partners. We call this patient service revenue. We use historical patient visit rates, our historical mix of services performed, and current reimbursement rates to help us analyze and explain historical patient service revenue from this part of our business. Key Factors Affecting Our Performance • Acquisition of Net New Members and Enterprise Clients. We believe that our ability to increase our membership will enable us to drive financial growth as members drive our membership revenue, partnership revenue and net patient service revenue. We have significant opportunities to increase members in our existing markets through (i) new sales to consumers and enterprise clients, (ii) expansion of the number of enrolled members, including dependents, within our enterprise clients, and (iii) adding other potential services. In our most mature market in the San Francisco Bay Area, we believe we have only captured approximately 3% commercial market share. Our ability to enroll new members either as consumer members or through enterprise clients will impact our results of operations. We define estimated activation rate for any enterprise client at a given time as the percentage of eligible lives enrolled as members. Some of our enterprise clients offer membership benefits to the dependents of their employees, for which we assume eligible lives include one dependent per employee. The levels of activation rates at our enterprise clients may also affect the renewal rates of our enterprise clients. Separately, the percentage of enterprise clients offering us to employee dependents has grown from 55% as of December 31, 2014 to over 65% as of December 31, 2019, and changes to that percentage will also impact our growth in members. While we do not regularly monitor activation rates and related metrics across enterprise clients, we may use these metrics to compare member activation across different enterprise clients and to look for opportunities for additional membership activation within existing enterprise clients. We also intend to acquire members by expanding into new markets, including by entering three new markets in 2020. • Components of Revenue. Our ability to maintain or improve pricing levels under our contracts with health networks will impact our results of operations. We recognize net patient service revenue on a per visit basis at amounts dependent on (i) our billing rates and third-party payer contracted rates, including in certain cases through agreements with health networks, (ii) the mix of members who are commercially insured and (iii) the nature of visits. In addition, we may add additional services in the future for which we may charge in a variety of ways. To the extent the net amounts we charge our members, partners and clients change, our net revenue will also change. • Care Margin. Care margin is driven by net revenue, expansion of new medical offices or new services, average utilization of our services, and provider- and office-related expenses. As we open new medical offices or add new services, our care margin is likely to decrease initially due to a lag in realization of revenue from those new offices or services. In markets where we earn partnership revenue on fixed PMPM contracts, higher patient visits, longer lengths of visits or increased use of medical supplies will lower our care margin. In markets where we earn patient service revenue, increased visits typically result in higher care margin. To the extent we need to increase the compensation for our providers, our care margin may decline. • Investments in Growth. We expect to continue to focus on long-term growth through investments in sales and marketing, technology research and development, and existing and new medical offices. We are working to enhance our digital health and technology offering and increase the potential breadth of our modernized platform solution. As we expand to new markets, we expect to make significant upfront investments in sales and marketing to establish brand awareness and acquire new members. Additionally, we intend to continue to invest in new offices in new and existing markets. Accordingly, in the short term, we expect these activities to increase our operating expenses and cost of care; however, in the long term we anticipate that these investments will positively impact our results of operations. • Seasonality. As a result of seasonal trends, we experience our highest levels of office visits and patient service revenue during the first and fourth quarters of each year when compared to other quarters of the year. Conversely, the second and third quarters of the year have historically been the period of lower office visits, and as a result, lower patient service revenue relative to the other quarters of the year. However, the effects of this seasonality have historically been partially offset by our partnership revenue and membership revenue, which are recognized ratably over the period of each contract and recurring in nature, as well as our period-over-period growth. Key Metrics and Non-GAAP Financial Measures 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 our business plan and make strategic decisions. Members A member is a person who has paid for membership themselves or an employee or dependent whose membership has been paid for by an enterprise client and who has registered with us. Members help drive membership revenue, partnership revenue and patient service revenue. We believe growth in the number of members is a key indicator of the performance of our business. This depends, in part, on our ability to successfully market our services directly to consumers and to employers that are not yet enterprise clients and our activation rate within existing clients. While growth in the number of members is an important indicator of expected revenue growth, it also informs our management of the areas of our business that will require further investment to support expected future member growth. Members (in thousands)* * Number of members is shown as of the end of each period. Care Margin We define care margin as loss from operations excluding depreciation and amortization, general and administrative expense and sales and marketing expense. We consider care margin to be an important measure to monitor our performance, specific to the direct costs of delivering care. We believe this margin is useful to measure whether we are controlling our direct expenses included in the provision of care sufficiently and whether we are effectively pricing our services. Care margin is presented for supplemental informational purposes only and should not be considered a substitute for financial information presented in accordance with GAAP. Care margin is not a financial measure of, nor does it imply, profitability. We have not yet achieved profitability and, even in periods when our net revenue exceeds our cost of care, exclusive of depreciation and amortization, we may not be able to achieve or maintain profitability. The relationship of operating loss to cost of care, exclusive of depreciation and amortization is not necessarily indicative of future performance. Other companies that present care margin may calculate it differently and, therefore, similarly titled measures presented by other companies may not be directly comparable to ours. In addition, care margin has limitations as an analytical tool, including that it does not reflect depreciation and amortization or other overhead allocations. The following table provides a reconciliation of loss from operations, the most closely comparable GAAP financial measure, to care margin: Adjusted EBITDA We define adjusted EBITDA as net loss excluding interest income, interest expense, depreciation and amortization, stock-based compensation, change in the fair value of our redeemable convertible preferred stock warrant liability and provision for income taxes. We include adjusted EBITDA in this Annual Report because it is an important measure upon which our management assesses and believes investors should assess our operating performance. We consider adjusted EBITDA to be an important measure because it helps illustrate underlying trends in our business and our historical operating performance on a more consistent basis. Adjusted EBITDA is presented for supplemental informational purposes only and should not be considered a substitute for financial information presented in accordance with GAAP. Our definition of adjusted EBITDA may differ from the definition used by other companies and therefore comparability may be limited. In addition, other companies may not publish this or similar metrics. Thus, our adjusted EBITDA should be considered in addition to, not as a substitute for, or in isolation from, measures prepared in accordance with GAAP, such as net loss. In addition, adjusted EBITDA has limitations as an analytical tool, including: • although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and adjusted EBITDA does not reflect cash used for capital expenditures for such replacements or for new capital expenditures; • adjusted EBITDA does not include the dilution that results from stock-based compensation or any cash outflows included in stock-based compensation, including from our purchases of shares of outstanding common stock; and • adjusted EBITDA does not reflect interest expense on our debt or the cash requirements necessary to service interest or principal payments. We provide investors and other users of our financial information with a reconciliation of adjusted EBITDA to net loss. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure and to view adjusted EBITDA in conjunction with net loss. The following table provides a reconciliation of net loss, the most closely comparable GAAP financial measure, to adjusted EBITDA: Components of Our Results of Operations Net Revenue We generate net revenue through net patient service revenue, partnership revenue, and membership revenue. Net Patient Service Revenue. We generate net patient service revenue from providing primary care services to patients in our offices when we bill the member or their insurance plan on a fee-for-service basis as medical services are rendered. While substantially all of our patients are members, we occasionally also provide care to non-members. Net patient service revenue accounted for 53%, 68%, and 78% of our net revenue during the years ended December 31, 2019, 2018, and 2017, respectively. Partnership Revenue. Partnership revenue is generated from the following: • Beginning in 2019, contracts with health systems as health network partners, for which the health system pays a fixed price per member per month; • Contracts with enterprise clients for on-site medical services, for which the employer pays a fixed price or a fixed price per employee; and • Capitation payments from IPAs for which IPAs pay a fixed price per IPA participant. Under our partnership arrangements, we generally receive fixed fees regardless of services provided, which services are consistent across the various arrangements. All partnership revenue is recognized during the period in which we are obligated to provide professional clinical services to the member, employee, or participant, as applicable, and associated management, operational and administrative services to the health network partner, enterprise client, or IPA, as applicable. Partnership revenue accounted for 29%, 12% and 3% of our net revenue during the years ended December 31, 2019, 2018, and 2017, respectively. Membership Revenue. Membership revenue is generated from annual membership fees paid by consumer members and from enterprise clients who purchase access to memberships for their employees and dependents. Membership revenue is recognized ratably over the contract period with the individual member or enterprise client. Membership revenue accounted for 19%, 20%, and 19% of our net revenue during the years ended December 31, 2019, 2018, and 2017, respectively. Operating Expenses Cost of Care, Exclusive of Depreciation and Amortization Cost of care, exclusive of depreciation and amortization, primarily includes provider and support employee-related costs for both in-office and virtual care, occupancy costs, medical supplies, insurance and other operating costs. A large portion of these costs are fixed relative to member utilization of our services, such as occupancy costs and insurance costs. As a result, as net revenue increases due to improved pricing, which can result from, for example, higher net revenue per member under agreements with enterprise clients and health network partners, or when we provide services to more members without increasing our infrastructure or related costs, cost of care, exclusive of depreciation and amortization, as a percentage of net revenue typically decreases. Providers include doctors of medicine, doctors of osteopathy, nurse practitioners and physician assistants. Support employees include phlebotomists and administrative assistants assisting our members with all non-medical related services. Virtual care includes video visits and other synchronous and asynchronous communication via our app and website. Our cost of care, exclusive of depreciation and amortization, also excludes allocations of general and administrative expenses. In the near term, as we open new offices, and expand into new markets, we expect cost of care, exclusive of depreciation and amortization, to increase in absolute dollars. Sales and Marketing Sales and marketing expenses consist of employee-related expenses, including salaries and related costs, commissions and stock-based compensation costs for our employees engaged in marketing, sales, account management and sales support. Sales and marketing expenses also include advertising production and delivery costs of communications materials that are produced to generate greater awareness and engagement among our clients and members, third-party independent research, trade shows and brand messages and public relations costs. We expect our sales and marketing expenses to increase as we strategically invest to expand our business. We expect to hire additional sales personnel and related account management and sales support personnel to capture an increasing amount of our market opportunity. We also expect to continue our brand awareness and targeted marketing campaigns. As we scale our sales and marketing, we expect these expenses to increase in absolute dollars. General and Administrative General and administrative expenses include employee-related expenses, including salaries and related costs and stock-based compensation for our executive, product development, technology infrastructure, operations, clinical and quality support, finance, legal, human resources, and real estate and development departments. In addition, general and administrative expenses include all corporate technology and occupancy costs. We expect our general and administrative expenses to increase over time following the closing of this offering due to the additional legal, accounting, insurance, investor relations and other costs that we will incur as a public company, as well as other costs associated with continuing to grow our business. Depreciation and Amortization Depreciation and amortization consist primarily of depreciation of property and equipment and amortization of capitalized software development costs. Other Income (Expense) Interest Income Interest income consists of income earned on our cash and cash equivalents, restricted cash and short-term marketable securities. Interest Expense Interest expense consists of interest costs associated with our notes payable issued pursuant to the LSA. Change in Fair Value of Redeemable Convertible Preferred Stock Warrant Liability Prior to our initial public offering in January 2020, we classified our redeemable convertible preferred stock warrants as a liability on our consolidated balance sheets. We remeasured the redeemable convertible preferred stock warrant liability to fair value at each reporting date and recognized changes in the fair value of the redeemable convertible preferred stock warrant liability as a component of other income (expense), net in our consolidated statements of operations. Upon the closing of our initial public offering, the warrants to purchase shares of redeemable convertible preferred stock became exercisable for shares of common stock, at which time we adjusted the redeemable convertible preferred stock warrant liability to fair value prior to reclassifying the redeemable convertible preferred stock warrant liability to additional paid-in capital. As a result, following the closing of our initial public offering, the warrants will no longer be subject to fair value accounting. Provision for Income Taxes We account for income taxes using an asset and liability approach. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Valuation allowances are provided when necessary to reduce net deferred tax assets to an amount that is more likely than not to be realized. In determining whether a valuation allowance for deferred tax assets is necessary, we analyze both positive and negative evidence related to the realization of deferred tax assets and inherent in that, assess the likelihood of sufficient future taxable income. We also consider the expected reversal of deferred tax liabilities and analyze the period in which these would be expected to reverse to determine whether the taxable temporary difference amounts serve as an adequate source of future taxable income to support the realizability of the deferred tax assets. In addition, we consider whether 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. Net Loss Attributable to Noncontrolling Interests In September 2014, we entered into a joint venture agreement with a healthcare system to jointly operate physician-owned primary care offices in a new market. We have the responsibility for the provision of medical services and for the day-to-day operation and management of the offices, including the establishment of guidelines for the employment and compensation of the physicians. Based upon this and other provisions of the operating agreement that indicate that we direct the economic activities that most significantly affect the economic performance of the joint venture, we determined that the joint venture is a variable interest entity and we are the primary beneficiary. Accordingly, we consolidate the joint venture and the healthcare system’s interest is shown within equity (deficit) as noncontrolling interests. The healthcare system’s share of earnings is recorded in the consolidated statements of operations as net loss attributable to noncontrolling interests. Results of Operations The following tables set forth our results of operations for the periods presented and as a percentage of our net revenue for those periods. Percentages presented in the following tables may not sum due to rounding. Comparison of the Year Ended December 31, 2019 and 2018 (1) Includes stock-based compensation, as follows: Net Revenue Net revenue increased $63.6 million, or 30%, from $212.7 million for the year ended December 31, 2018 to $276.3 million for the year ended December 31, 2019. This increase was primarily due to a 76,000 increase in members, or 22%, from 346,000 as of December 31, 2018 to 422,000 as of December 31, 2019. Our members are the primary driver of our net revenue. Net revenue from patient service and partnerships increased $54.6 million, or 32%, from $169.5 million for the year ended December 31, 2018 to $224.1 million for the year ended December 31, 2019. The increase was primarily due to the 22% increase in members. In addition, net revenue per member increased by 8% as we entered into new partnership relationships with health networks that resulted in a higher net revenue rate per member than the previous fee-for-service contracts with payers, and an increase in flu vaccines in the fourth quarter. During the year ended December 31, 2018, we did not have fixed PMPM contracts with health networks, and partnership revenue only included contracts for on-site medical services and capitation payments. During the year ended December 31, 2019, as a result of new health network partnerships, partnership revenue increased $53.3 million, or 210%, from $25.4 million for the year ended December 31, 2018 to $78.7 million for the year ended December 31, 2019. Correspondingly, net patient service revenue was relatively flat due to the decrease associated with new partnership relationships with health network partners, offset by an increase in rate per visit of 23%, attributable to a higher mix of revenue from payers with higher rates and payer rate increases, and an increase in the number of visits per member of 9%. Membership revenue increased $8.9 million, or 21%, from $43.2 million for the year ended December 31, 2018 to $52.1 million for the year ended December 31, 2019. This increase was primarily due to an increase in members of 76,000, or 22%, partially offset by a decline in membership revenue per member as growth of our enterprise membership, with lower average membership revenue per member, continued to outpace the growth of our consumer members. Operating Expenses Cost of Care, Exclusive of Depreciation and Amortization Year Ended December 31, $ Change % Change (dollar amounts in thousands) Cost of care, exclusive of depreciation and amortization $ 167,618 $ 136,180 $ 31,438 % Cost of care, exclusive of depreciation and amortization, increased $31.4 million, or 23%, from $136.2 million for the year ended December 31, 2018 to $167.6 million for the year ended December 31, 2019. This increase was primarily due to increases in provider employee-related expenses of $16.9 million, support employee-related expense of $5.7 million, medical supply costs of $4.8 million, occupancy costs of $2.8 million, and increases in other expenses of $1.2 million. In addition to growth in our existing offices, we added twelve offices in 2019 bringing our total number of offices to 83. Cost of care, exclusive of depreciation and amortization, as a percentage of net revenue decreased from 64% to 61%. This decrease was due to higher net revenue discussed above, including from health network partners that result in a higher net revenue rate per member with a lower corresponding increase in cost of care, exclusive of depreciation and amortization, an increase in members, and a relatively lower increase in cost of care, exclusive of depreciation and amortization, as we leveraged our existing infrastructure and related costs to accommodate the increase in members. As we incur a certain amount of fixed costs for an office prior to its opening and generally earn lower net revenue in the first year of opening, we expect cost of care, exclusive of depreciation and amortization, as a percentage of net revenue to increase in 2020 as we open a greater number of offices than we opened in 2019. Sales and Marketing Year Ended December 31, $ Change % Change (dollar amounts in thousands) Sales and marketing $ 39,520 $ 25,789 $ 13,731 % Sales and marketing expenses increased $13.7 million, or 53%, from $25.8 million for the year ended December 31, 2018 to $39.5 million for the year ended December 31, 2019 primarily due to an increase in brand marketing and direct advertising of $11.6 million, salaries and benefits of $1.1 million, and stock-based compensation expense of $0.7 million. General and Administrative Year Ended December 31, $ Change % Change (dollar amounts in thousands) General and administrative $ 108,965 $ 85,808 $ 23,157 % General and administrative expenses increased $23.2 million, or 27%, from $85.8 million for the year ended December 31, 2018 to $109.0 million for the year ended December 31, 2019. This increase was primarily due to higher salaries and benefits of $16.4 million, partially offset by lower stock-based compensation expense of $7.0 million, as we expanded our team to support our growth. In addition, we also increased our corporate office occupancy costs by $3.7 million, software-as-a-service costs by $3.6 million, legal and professional services by $2.9 million, travel costs by $1.6 million, business taxes and insurance by $0.7 million, and other costs by $1.3 million. Depreciation and Amortization Year Ended December 31, $ Change % Change (dollar amounts in thousands) Depreciation and amortization $ 14,268 $ 9,947 $ 4,321 % Depreciation and amortization expenses increased $4.3 million, or 43%, from $9.9 million for the year ended December 31, 2018 to $14.3 million for the year ended December 31, 2019. This increase was primarily due to the cost of remodeling our offices, our new corporate office, new medical offices, and capitalization of software development. Other Income (Expense) Interest Income Year Ended December 31, $ Change % Change (dollar amounts in thousands) Interest income $ 4,498 $ 2,251 $ 2,247 % Interest income increased $2.2 million from $2.3 million for the year ended December 31, 2018 to $4.5 million for the year ended December 31, 2019 due to our higher cash, cash equivalents and marketable securities balances resulting from cash received from our Series I redeemable convertible preferred stock issuance that closed in August 2018. Interest Expense Year Ended December 31, $ Change % Change (dollar amounts in thousands) Interest expense $ (474 ) $ (804 ) $ (330 ) % Interest expense decreased $0.3 million from $(0.8) million for the year ended December 31, 2018 to $(0.5) million for the year ended December 31, 2019 due to the declining principal balance on our notes payable. Change in Fair Value of Redeemable Convertible Preferred Stock Warrant Liability Year Ended December 31, $ Change % Change (dollar amounts in thousands) Change in fair value of redeemable convertible preferred stock warrant liability $ (3,519 ) $ (1,877 ) $ 1,642 % The fair value of the redeemable convertible preferred stock warrant liability increased $1.6 million during the year ended December 31, 2019 compared to an increase of $1.9 million for the year ended December 31, 2018. The change in both periods was due to the change in fair value of the underlying redeemable convertible preferred stock. Provision for Income Taxes Year Ended December 31, $ Change % Change (dollar amounts in thousands) Provision for income taxes $ $ $ nm nm-not meaningful Provision for income taxes increased $62 thousand from $25 thousand for the year ended December 31, 2018 to $87 thousand for the year ended December 31, 2019. Net Loss Attributable to Noncontrolling Interests Year Ended December 31, $ Change % Change (dollar amounts in thousands) Net loss attributable to noncontrolling interests $ (1,141 ) $ (1,086 ) $ (55 ) % Net loss attributable to noncontrolling interests increased $55 thousand, from the year ended December 31, 2018 compared to the year ended December 31, 2019 due to an increased net loss of the joint venture. Comparison of the Years Ended December 31, 2018 and 2017 (1) Includes stock-based compensation, as follows: In October 2018, we repurchased 1,553,424 shares of common stock from certain directors, employees and executive officers for net total consideration of $14.8 million, after considering net share settlement. The amount paid in excess of the then-current estimated fair value of our common stock of $7.2 million was recorded as stock-based compensation expense for the year ended December 31, 2018, of which $0.2 million is included in sales and marketing expense and $7.0 million is included in general and administrative expense on our consolidated statements of operations and in the table above. The balance of $7.5 million was recognized in additional paid-in capital. Net Revenue Net revenue increased $35.9 million, or 20%, from $176.8 million for the year ended December 31, 2017, to $212.7 million for the year ended December 31, 2018. This increase was primarily due to a 27% increase in members, from 272,000 as of December 31, 2017, to 346,000 as of December 31, 2018. Net revenue from patient service and partnerships increased $25.8 million, or 18%, from $143.7 million for the year ended December 31, 2017 to $169.5 million for the year ended December 31, 2018. The increase was primarily due to the 27% increase in members, offset by a decrease in net revenue per member of 7%. The decrease in net revenue per member resulted from the majority of net revenue in these years being attributable to net patient service revenue and the decrease in number of visits per member in 2018 compared to 2017. Net patient service revenue increased 4% due to a 3% increase in office visits and a 1% increase in rate per visit, attributable to payer rate increases. Partnership revenue increased primarily due to new contracts with employers for on-site medical services. Membership revenue increased $10.1 million, or 31%, from $33.1 million for the year ended December 31, 2017 to $43.2 million for the year ended December 31, 2018, due to a 27% increase in members and a 3% increase in net revenue per member. Operating Expenses Cost of Care, Exclusive of Depreciation and Amortization Year Ended December 31, $ Change % Change (dollar amounts in thousands) Cost of care, exclusive of depreciation and amortization $ 136,180 $ 120,705 $ 15,475 % Cost of care, exclusive of depreciation and amortization, increased $15.5 million, or 13%, from $120.7 million for the year ended December 31, 2017 to $136.2 million for the year ended December 31, 2018. This increase was primarily due to increases in provider employee-related expenses of $9.0 million related to higher headcount for new office openings, support employee-related expense of $4.6 million, occupancy costs of $1.2 million, and medical supply costs of $0.7 million. During 2018, we opened 12 new offices, and we operated 71 medical offices as of December 31, 2018. Cost of care, exclusive of depreciation and amortization, as a percentage of net revenue decreased from 68% to 64% due to higher net revenue discussed above primarily due to an increase in members and a relatively lower increase in cost of care, exclusive of depreciation and amortization, as we leveraged our existing infrastructure and related costs to accommodate the increase in members. Sales and Marketing Year Ended December 31, $ Change % Change (dollar amounts in thousands) Sales and marketing $ 25,789 $ 19,172 $ 6,617 % Sales and marketing expenses increased $6.6 million, or 35%, from $19.2 million for the year ended December 31, 2017 to $25.8 million for the year ended December 31, 2018. This increase was primarily due to higher brand marketing and direct advertising expense of $4.0 million and higher employee-related salaries and benefits of $2.0 million. General and Administrative Year Ended December 31, $ Change % Change (dollar amounts in thousands) General and administrative $ 85,808 $ 57,964 $ 27,844 % General and administrative expenses increased $27.8 million, or 48%, from $58.0 million for the year ended December 31, 2017 to $85.8 million for the year ended December 31, 2018. This increase was primarily due to higher salaries and benefits of $10.6 million and stock-based compensation expense of $11.3 million, including the stock repurchase program in October 2018 as we expanded our team to support our growth. In addition, we also increased our software-as-a-service costs by $2.1 million, professional services, contractors, and legal costs by $1.9 million, travel costs by $1.8 million, and other costs by $0.1 million. Depreciation and Amortization Year Ended December 31, $ Change % Change (dollar amounts in thousands) Depreciation and amortization $ 9,947 $ 10,686 $ (739 ) % Depreciation and amortization expenses decreased $0.7 million, or 7%, from $10.7 million for the year ended December 31, 2017 to $9.9 million for the year ended December 31, 2018. Our depreciation and amortization expense decreased in 2018, primarily due to new assets placed into service with longer useful lives. Other Income (Expense) Interest Income Year Ended December 31, $ Change % Change (dollar amounts in thousands) Interest income $ 2,251 $ $ 1,865 % Interest income increased $1.9 million, or 483%, from $0.4 million for the year ended December 31, 2017 to $2.3 million for the year ended December 31, 2018. This increase was due to higher average cash, cash equivalents and marketable securities balances resulting from cash received from our Series I redeemable convertible preferred stock financing in August 2018. Interest Expense Year Ended December 31, $ Change % Change (dollar amounts in thousands) Interest expense $ (804 ) $ (834 ) $ % Interest expense decreased $30 thousand from $(0.8) million for the year ended December 31, 2017 to $(0.8) million for the year ended December 31, 2018 due to the declining principal balance on our notes payable, partially offset by increases in the interest rate during 2018. Change in Fair Value of Redeemable Convertible Preferred Stock Warrant Liability Year Ended December 31, $ Change % Change (dollar amounts in thousands) Change in fair value of redeemable convertible preferred stock warrant liability $ (1,877 ) $ $ (2,523 ) nm nm-not meaningful The fair value of the redeemable convertible preferred stock warrant liability decreased $0.6 million for the year ended December 31, 2017 compared to an increase of $1.9 million during the year ended December 31, 2018. For the year ended December 31, 2018, the fair value of our redeemable convertible preferred stock warrants increased as a result of an increase in the fair value of the underlying redeemable convertible preferred stock. Provision for Income Taxes Year Ended December 31, $ Change % Change (dollar amounts in thousands) Provision for income taxes $ $ $ (101 ) % The provision for income taxes decreased $0.1 million, or 80%, from $126 thousand for the year ended December 31, 2017 to $25 thousand for the year ended December 31, 2018, due to lower taxable income in 2018. Net Loss Attributable to Noncontrolling Interests Year Ended December 31, $ Change % Change (dollar amounts in thousands) Net loss attributable to noncontrolling interests $ (1,086 ) $ (889 ) $ (197 ) % Net loss attributable to noncontrolling interests increased $0.2 million, or 22%, from $0.9 million for the year ended December 31, 2017 to $1.1 million for the year ended December 31, 2018, due to increased losses incurred by a joint venture. Liquidity and Capital Resources Since our inception, we have financed our operations primarily with proceeds from the sale of redeemable convertible preferred stock, and to a lesser extent, notes payable under credit facilities. Through December 31, 2019, we had received net proceeds of $401.6 million from our sales of redeemable convertible preferred stock. As of December 31, 2019, we had cash, cash equivalents and short-term marketable securities of $146.5 million. Upon the closing of our initial public offering in February 2020, we received approximately $258.2 million in net proceeds, after deducting underwriting discounts and commissions and offering expenses. We believe that our existing cash and cash equivalents and short-term marketable securities will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months. We may be required to seek additional equity or debt financing. Our future capital requirements will depend on many factors, including our pace of new member growth and expanded enterprise client and health network relationships, our pace and timing of expansion of new medical offices, and the timing and extent of spend to support the expansion of sales, marketing and development activities, and the impact of the COVID-19 pandemic. 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, financial condition and results of operations would be harmed. See Item 1A. “Risk Factors-Risks Related to Our Business and Our Industry-In order to support the growth of our business, we may need to incur additional indebtedness under our existing loan agreement or seek capital through new equity or debt financings, which sources of additional capital may not be available to us on acceptable terms or at all.” As of the date of this Annual Report, community self-isolation practices and shelter-in-place requirements related to COVID-19 have negatively impacted our net revenue for the three months ended March 31, 2020. Prolonged community self-isolation practices and shelter-in-place requirements will continue to reduce in-office visits, negatively affecting our net patient service revenue. In addition, the COVID-19 pandemic has negatively impact global financial markets, resulting in reduced ability to access financing and capital sources. Given the uncertainty around the duration and extent of the COVID-19 pandemic, we cannot accurately predict at this time the future potential impact on our business, results of operations, financial condition or liquidity. Indebtedness In January 2013, we entered into the LSA with Silicon Valley Bank, which, as amended, provides for aggregate borrowings of up to $11.0 million in the form of term loans. In 2016, we drew down the full $11.0 million available to us under the LSA, and no additional amounts remained available for borrowing under the LSA as of December 31, 2019. As of December 31, 2019 and December 31, 2018, the outstanding principal amount under the LSA was $3.3 million and $7.7 million, respectively. Borrowings under the LSA, as amended, bear interest at a rate per annum equal to the greater of 5.56% or the prime rate plus 1.81%. Under the LSA, we were required to make monthly interest-only payments through March 31, 2018 and are required to make 30 equal monthly payments of principal, plus accrued interest, from April 1, 2018 through September 1, 2020, when all unpaid principal and interest becomes due and payable. We may voluntarily prepay all, but not less than all, of the outstanding principal at any time prior to the maturity date, subject to a prepayment fee. Under the terms of the LSA, we must maintain one of two financial covenants: (i) a liquidity ratio of not less than 1.50 to 1.00 or (ii) a fixed charge coverage ratio of not less than 1.25 to 1.00. We have been in compliance with the financial covenants since the inception of the LSA. Borrowings under the LSA are secured by substantially all of our properties, rights and assets, excluding intellectual property. Additionally, the LSA contains certain customary restrictive covenants that limit our ability to incur additional indebtedness and liens, merge with other companies or consummate certain changes of control, acquire other companies, engage in new lines of business, make certain investments, pay dividends, amend the ASAs and transfer or dispose of assets. In addition, we issued to Silicon Valley Bank warrants to purchase 494,833 shares of common stock. Cash Flows The following table summarizes our cash flows: Operating Activities During the year ended December 31, 2019, operating activities used $31.7 million of cash, resulting from our net loss of $53.7 million and net cash used in changes in our operating assets and liabilities of $17.7 million, partially offset by net non-cash charges of $39.7 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $14.5 million increase in accounts receivable, net, an increase in other assets of $4.6 million, and a $8.1 million decrease in operating lease liabilities, partially offset by a $7.4 million increase in accounts payable and accrued expenses, and a $2.1 million increase in deferred revenue. The increase in accounts receivable is primarily due to receivables from health system partners that have longer invoicing and payment cycles than insurance payers. The increase in other assets is primarily associated with $3.6 million in deferred financing costs that will be offset against the proceeds of our initial public offering. The increases in accounts payable and accrued expenses was due to our higher level of operating activities and the timing of vendor invoicing and payments. During the year ended December 31, 2018, operating activities used $18.4 million of cash, resulting from our net loss of $45.5 million and net cash used in changes in our operating assets and liabilities of $0.5 million, partially offset by non-cash charges of $27.6 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $7.2 million increase in accounts receivable and a $1.3 million decrease in other liabilities, partially offset by a $7.0 million increase in accounts payable and accrued expenses, a $0.6 million increase in deferred revenue, a $0.2 million decrease in inventories and a $0.1 million increase in prepaid expenses and other current assets. The increase in accounts receivable is primarily due to higher net patient service revenue. The increases in accounts payable and accrued expenses was due to our higher level of operating activities and the timing of vendor invoicing and payments. During the year ended December 31, 2017, operating activities used $2.7 million of cash, resulting from our net loss of $31.7 million, partially offset by non-cash charges of $23.5 million and changes in operating assets and liabilities of $5.4 million. The changes in operating assets and liabilities were primarily due to increases of $5.4 million in deferred revenue, $3.6 million in accounts payable and accrued expenses and $5.2 million in other liabilities, partially offset by increases of $5.9 million in accounts receivable, $1.7 million prepaid expenses and other current assets and $1.4 million in inventories. The increase in accounts receivable is primarily due to higher net patient service revenue. The increase in accounts payable and accrued expenses was due to our higher level of operating activities and the timing of vendor invoicing and payments. Investing Activities During the year ended December 31, 2019, investing activities provided $23.7 million of cash, resulting from maturities of short-term marketable securities of $324.3 million, offset by purchases of short-term marketable securities of $246.1 million and purchases of property and equipment of $54.4 million due primarily to leasehold improvements, computer equipment, and furniture and fixtures for our new corporate office, new offices and remodels of existing offices, in addition to capitalization of internal-use software development costs. During the year ended December 31, 2018, investing activities used $176.8 million of cash, resulting from purchases of short-term marketable securities of $218.6 million and purchases of property and equipment of $10.8 million, partially offset by maturities of short-term marketable securities of $52.6 million. During the year ended December 31, 2017, investing activities used $4.3 million of cash, resulting from purchases of short-term marketable securities of $49.0 million and purchases of property and equipment of $14.0 million, partially offset by maturities of short-term marketable securities of $58.7 million. Financing Activities During the year ended December 31, 2019, financing activities used $1.4 million of cash, resulting primarily from payment of debt obligation of $4.4 million, partially offset by proceeds from the exercise of stock options of $3.0 million. During the year ended December 31, 2018, financing activities provided $216.6 million of cash, resulting from proceeds from issuance of redeemable convertible preferred stock, net of issuance costs of $216.7 million, and exercise of stock options and warrants of $10.8 million, net of repurchase of common stock of $7.5 million and payment of debt obligation of $3.3 million. During the year ended December 31, 2017, financing activities provided $2.7 million of cash, resulting entirely from proceeds from the exercise of stock options. Contractual Obligations and Commitments The following summarizes our contractual obligations as of December 31, 2019: (1) Amounts in the table reflect the contractually required interest payable pursuant to outstanding borrowings under the LSA. Interest payments in the table above were calculated using an interest rate of 6.6%, which was the interest rate applicable to borrowings under the LSA as of December 31, 2019. (2) This table includes contractual obligations relating to leases that have not yet commenced. In addition, the operating lease amounts presented in this table represent cash payments that are not discounted to the present value. (3) Amounts in the table do not reflect a purchase obligation with a medical supply company entered into in January 2020 pursuant to which we are committed to spend an aggregate of $3.9 million. The contractual commitment amounts in the table and footnotes 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 or footnotes above. 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 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 greater detail in Note 2, “Summary of Significant Accounting Policies,” to our consolidated financial statements included in this report, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition Revenue for the years ended December 31, 2017 and 2018 and the year ended December 31, 2018 is presented under Accounting Standards Codification, or ASC, 605, Revenue Recognition. Under ASC 605, we recognized revenue when all of the following criteria were met: Persuasive evidence of an arrangement exists; the sales price is fixed or determinable; collection is reasonably assured; and services have been rendered. Beginning January 1, 2019, we adopted ASC Topic 606, Revenue from Contracts with Customers, using the modified retrospective method applied to contracts which were not completed upon the adoption date. Under ASC 606, revenue is recognized when a 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, we perform the following five steps: (i) Identify the contract(s) with a customer; (ii) Identify the performance obligations in the contract; (iii) Determine the transaction price; (iv) Allocate the transaction price to the performance obligations in the contract; and (v) Recognize revenue as the entity satisfies a performance obligation. The cumulative effect of initially adopting ASC 606 was immaterial and limited to direct and incremental costs to obtain revenue contracts. The key judgments applicable to revenue recognition under ASC 605 and ASC 606 are similar and are described below. Differences between ASC 605 and ASC 606 were limited to the deferral of incremental commission costs of acquiring a contract. Our policy under ASC 605 was to defer only direct and incremental costs to obtain a contract and amortize those costs over the length of the related contract, including enterprise sales contract renewals, which was generally twelve months. Under ASC 606, we capitalize commission fees related to contracts with customers when the associated revenue is expected to be earned over a period that exceeds one year. For these contracts with an expected duration greater than a year, we capitalize commission fees and amortize them over the period associated with the expected life of the customer. Net Patient Service Revenue Net patient service revenue is generated from providing primary care services pursuant to contracts with patients. We recognize revenue as services are rendered, which are delivered over a period of time but typically within one day, when we provide services to the patient. We receive payments for services from third-party payers as well as from patients who have health insurance where they may bear some cost of the service in the form of co-pays, coinsurance or deductibles. In addition, patients who do not have health insurance are required to pay for their services in full. Providing medical services to patients represents our performance obligation under these contracts, and accordingly, the transaction price is allocated entirely to one performance obligation. Net patient service revenue is reported net of provisions for contractual allowances from third-party payers and patients. We have certain agreements with third-party payers that provide for reimbursement at amounts different from our standard billing rates. The differences between the estimated reimbursement rates and the standard billing rates are accounted for as contractual adjustments, which are deducted from gross revenue to arrive at net patient service revenue. We estimate implicit price concessions related to self-pay balances as part of estimating the original transaction price, which is based on historical experience and other collection indicators. Partnership Revenue Partnership revenue is generated from (i) contracts with employers to provide professional clinical services to employee members at the Company’s on-site clinics, (ii) capitation payments from IPAs to provide professional clinical services to covered participants, and (iii) contracts with health systems as health network partners beginning in 2019. Our performance obligation under the various partnership arrangements is the same-to stand ready to provide professional clinical services and the associated management and administrative services. As the services are provided concurrently over the contract term and have the same pattern of transfer, we have concluded that this represents one performance obligation comprising of a series of distinct services over the contract term. While we can receive either fixed or variable fees from our enterprise clients (i.e., stated fee per employee per month), we generally receive variable fees from IPAs and health networks on a stated fee per member per month basis, based on the number of members (or participants) serviced. We recognize revenue as we satisfy our performance obligation. For fixed-fee agreements, we use a time-based measure to recognize revenue ratably over the contract term. For variable-fee agreements, we allocate the per member per month variable consideration to the month that the fee is earned, correlating with the amount of services it is providing, which is consistent with the allocation objective of the series guidance. From time to time, we may provide discounts and rebates to the customer. We estimate the variable consideration subject to the constraint and recognize such variable consideration over the contract term. Membership Revenue Membership revenue is generated from annual membership fees paid by consumer members and from enterprise clients who purchase access to memberships for their employees and dependents. The terms of service on our website serve as our contract with consumer members. We enter into written contracts with enterprise clients. The transaction price for contracts with enterprise clients is determined on a per employee per month basis, based on the number of employees eligible for membership during the contract period. The transaction price for the contract is fixed at the commencement of the contract, is stated in the contract and is generally collected in advance of the commencement of the contract term. We may provide numerous services under the agreements; however, these services are not considered individually distinct as they are not separately identifiable in the context of the agreement. As a result, our single performance obligation in the transaction constitutes a series for the provision of membership and services as and when requested over the membership term. The transaction price relates specifically to our efforts to transfer the services for a distinct increment of the series. Accordingly, the transaction price is allocated entirely to the one performance obligation. Membership revenue is recognized ratably over the contract period with the individual member or enterprise client. Unrecognized but collected amounts are recorded as deferred revenue and amortized over the remainder of the applicable membership period. Deferred Revenue We record a contract liability, or deferred revenue, when we have an obligation to provide service to the member or enterprise client and payment is received or due in advance of our performance. 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. Generally, we issue stock option awards with only 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 fair value of the underlying common stock, 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. Changes in the following assumptions can materially affect the estimate of fair value and ultimately how much stock-based compensation expense is recognized; and the resulting change in fair value, if any, is recognized in our statement of operations and comprehensive loss during the period the related services are rendered. These inputs are subjective and generally require significant analysis and judgment to develop. 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. Expected Term. We determine the expected term of awards which contain service-only vesting conditions using the simplified method which is used when 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. We use an average historical stock price volatility of a peer group of comparable publicly traded healthcare companies representative of our expected future stock price volatility, as we do not have any trading history for our common stock. For purposes of identifying these peer companies, we consider the industry, stage of development, size and financial leverage of potential comparable companies. For each grant, we measure historical volatility over a period equivalent to the expected term. Expected Dividend Rate. We have not paid and do not anticipate paying any dividends in the foreseeable future. Accordingly, we estimate the dividend yield to be zero. Risk-Free Interest Rate. The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with maturities similar to the expected term of the award. Prior to the adoption of ASC 2018-07, Improvements to Nonemployee Share-Based Accounting, on January 1, 2019, for stock-based awards granted to consultants and non-employees, we recognized compensation expense over the period during which services were 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 was 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 awards based on their fair value on the date of grant and recognize compensation expense for those awards over the requisite service period, which is generally the vesting period of the respective award. Consolidation of Variable Interest Entities GAAP requires variable interest entities, or VIEs, to be consolidated if an entity’s interest in the VIE is a controlling financial interest. Under the variable interest model, a controlling financial interest is determined based on which entity, if any, has (i) the power to direct the activities of the VIE that most significantly impacts the VIEs economic performance and (ii) the obligations to absorb losses that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. We perform ongoing reassessments of whether changes in the facts and circumstances regarding our involvement with a VIE would cause our consolidation conclusion to change. The consolidation status of the VIEs with which we are involved may change as a result of such reassessments. Changes in consolidation status are applied in accordance with applicable GAAP. Please see Note 3, “Variable Interest Entities” to our consolidated financial statements. Valuation of Redeemable Convertible Preferred Stock Warrant Liability Prior to our initial public offering in January 2020, we classified our redeemable convertible preferred stock warrants as a liability on our consolidated balance sheets. We remeasured the redeemable convertible preferred stock warrant liability to fair value at each reporting date and recognized changes in the fair value of the redeemable convertible preferred stock warrant liability as a component of other income (expense), net in our consolidated statements of operations. Upon the closing of our initial public offering, the warrants to purchase shares of redeemable convertible preferred stock became exercisable for shares of common stock, at which time we adjusted the redeemable convertible preferred stock warrant liability to fair value prior to reclassifying the redeemable convertible preferred stock warrant liability to additional paid-in capital. As a result, following the closing of our initial public offering, the warrants will no longer be subject to fair value accounting. Off-Balance Sheet Arrangements We did not have during the periods presented any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. 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 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, 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 will remain an emerging growth company until the earlier to occur of (1) (a) December 31, 2025, (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. Recent Accounting Pronouncements See Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements under Part II, Item 8 of this Annual Report on Form 10-K.

<s>[INST] Impact of Covid19 on Our Business As of the date of this Annual Report, community selfisolation practices and shelterinplace requirements related to COVID19 have negatively impacted our net revenue for the three months ended March 31, 2020. Prolonged community selfisolation practices and shelterinplace requirements will continue to reduce inoffice visits, negatively affecting our net patient service revenue. Given the uncertainty around the duration and extent of the COVID19 pandemic, we cannot accurately predict at this time the future potential impact on our business, results of operations, financial condition or liquidity. Overview Our vision is to delight millions of members with better health and better care while reducing the total cost of care. Our mission is to transform health care for all through our humancentered, technologypowered model. We are a membershipbased primary care platform with seamless digital health and inviting inoffice care, convenient to where people work, shop, live and click. We are disrupting health care from within the existing ecosystem by simultaneously addressing the frustrations and unmet needs of key stakeholders, which include consumers, employers, providers, and health networks. As of December 31, 2019, we had approximately 422,000 members in nine markets in the United States and greater than 7,000 employer clients. We have developed a modernized healthcare membership model based on direct consumer enrollment as well as employer sponsorship. Our annual membership model includes seamless access to 24/7 digital health services paired with inviting inoffice care routinely covered under health insurance programs. Our technology drives high monthly active usage within our membership, promoting ongoing and longitudinal patient relationships for better health outcomes and high member retention. Our technology also helps our serviceminded team in building trust and rapport with our members by facilitating proactive digital health outreach as well as responsive ondemand virtual and inoffice care. Our digital health services and our wellappointed offices that are located in highly convenient locations are all serviced by our own clinical team who are employed in a salaried model, free of misaligned feeforservice compensation incentives prevalent in health care. Additionally, we have developed clinically integrated partnerships with health networks, better coordinating more timely access to specialty care when needed by members, while advancing valuebased care for employers through clinical and digital integration. Together, these components of our humancentered and technologypowered model allow us to deliver better results for key stakeholders. Our focus on simultaneously addressing the unfulfilled needs and frustrations of key stakeholders has allowed us to consistently grow the number of members we serve. We were founded in 2007 in San Francisco and have since grown to 422,000 members and 83 medical offices in nine markets across the United States as of December 31, 2019. From December 31, 2014 through December 31, 2019, we grew our membership by 351%. During the twelve months ended December 31, 2019 as compared to the twelve months ended December 31, 2014, our net revenue grew 293%, our digital interactions with our members grew 880%, and the number of inoffice visits by our members grew 185%. Our Business Model We have developed a modernized healthcare membership model based on direct consumer enrollment as well as employer sponsorship. Our annual membership model includes seamless access to 24/7 digital health paired with inviting inoffice care routinely covered under health insurance programs. Our members join either individually as consumers by paying an annual membership fee or are sponsored by an enterprise client who purchases a subscription for their employees and, increasingly, their dependents. All members have actively registered with us. Digital health services are delivered via our mobile app and website, through such modalities as video and voice encounters, chat and messaging, and our inoffice care is delivered at any of our 83 medical offices as of December 31, 2019. We derive net revenue from multiple stakeholders, including consumers, employers, health networks and insurers. We recognize net revenue as (i) membership revenue from annual employer and consumer subscription fees, (ii) [/INST] Negative. </s>

TheRealReal, Inc.

2020-03-11

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of our financial condition and results of operations should be read together with our financial statements and related notes and other financial information included in this Annual Report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report, particularly in the section titled “Risk Factors.” Our historical results are not necessarily indicative of the results that may be expected for any period in the future. Overview We are the world’s largest online marketplace for authenticated, consigned luxury goods. We are revolutionizing luxury resale by providing an end-to-end service that unlocks supply from consignors and creates a trusted, curated online marketplace for buyers globally. Over the past nine years, we have cultivated a loyal and engaged consignor and buyer base through continuous investment in our technology platform, logistics infrastructure and people. We aggregate and curate unique, pre-owned luxury supply that is exclusive to The RealReal across multiple categories, including women’s, men’s, kids’, jewelry and watches, and home and art. We have built a vibrant online marketplace that we believe expands the overall luxury market, promotes the recirculation of luxury goods and contributes to a more sustainable world. We have transformed the luxury consignment experience by removing the friction and pain points inherent in the traditional consignment model. For consignors, we provide White Glove in-home consultation and pickup, drop off at one of our ten LCOs, four of which are located in our retail stores, or complimentary shipping directly to our merchandising and fulfillment facilities. We leverage our proprietary transactional database and market insights from approximately 12.8 million item sales since inception to deliver optimal pricing and rapid sell-through. For buyers, we offer highly coveted and exclusive authenticated pre-owned luxury goods at attractive values, as well as a high-quality experience befitting the products we offer. Our online marketplace is powered by our proprietary technology platform, including consumer facing applications and purpose-built software that supports our complex, single-SKU inventory model and merchandising operations. The substantial majority of our revenue is generated by consignment sales. We also generate revenue from other services and direct sales. • Consignment and service revenue. When we sell goods through our online marketplace on behalf of our consignors, we retain a percentage of the proceeds, which we refer to as our take rate. Take rates vary depending on the total value of goods sold through our online marketplace on behalf of a particular consignor as well as the category and price point of the items. In 2019 and 2018, our take rate on consigned goods was 36.3% and 35.5% respectively. Additionally, we earn revenue from shipping fees and from our subscription program, First Look, in which we offer buyers early access to the items we sell in exchange for a monthly fee. • Direct revenue. In certain cases, such as when we accept an out of policy returns from buyers, we take ownership of goods and retain 100% of the proceeds when the goods subsequently resell through our online marketplace. We generate revenue from orders processed through our website, mobile app and four retail stores located in New York, Los Angeles, and San Francisco. Our omni-channel experience enables buyers to purchase anytime and anywhere. We have a global base of more than 15 million members as of December 31, 2019. We count as a member any user who has registered an email address on our website or downloaded our mobile app, thereby agreeing to our terms of service. Through December 31, 2019, we have cumulatively paid more than $1.3 billion in commissions to our consignors. In 2019 and 2018, our GMV was $1.0 billion and $710.8 million, respectively, representing an annual growth rate of 42% in 2019. In 2019 and 2018, our total revenue was $318.0 million and $213.7 million, respectively, representing an annual growth rate of 49% in 2019. In 2019 and 2018, our gross profit was $203.2 million and $136.9 million, respectively, representing an annual growth rate of 48% in 2019. Factors Affecting Our Performance To analyze our business performance, determine financial forecasts and help develop long-term strategic plans, we focus on the factors described below. While each of these factors presents significant opportunity for our business, collectively, they also pose important challenges that we must successfully address in order to sustain our growth, improve our operating results and achieve and maintain our profitability. Supply and Demand Consignor growth and retention. We grow our sales by increasing the supply of luxury goods offered through our consignment online marketplace. In 2019 and 2018, approximately 60% and 80% of the products on our online marketplace sold within 30 days and 90 days, respectively. In addition to sales velocity, we measure the ratio of demand versus supply in a given period, which we refer to as our online marketplace sell-through ratio. Sell-through ratio is defined as GMV in the period divided by the aggregate initial value of items added to our online marketplace in the period. In 2019 and 2018, our marketplace sell-through ratios were 94% and 96%, respectively. Our growth has been driven in significant part by repeat sales by existing consignors concurrent with growth of our consignor base. In 2019, repeat consignors accounted for approximately 81% of GMV. Buyer growth and retention. We grow our business by attracting and retaining buyers. We attract and retain buyers by offering highly coveted, authenticated, pre-owned luxury goods at attractive values and delivering a high-quality, luxury experience. We measure our success in attracting and retaining buyers by tracking buyer satisfaction and purchasing activity over time. We have experienced high buyer satisfaction, as evidenced by our buyer net promoter score of 71 in 2019. If we fail to continue to attract and retain our buyer base to our online marketplace, our operating results would be adversely affected. The graph on the left shows trends in purchasing activity for buyer cohorts for each year beginning in 2014. Each cohort represents all buyers that first purchased across our online marketplace in the designated year and the aggregate GMV purchased by such cohort for the initial year and each year thereafter. As illustrated in the graph below, we have seen consistent retention of buyer activity across cohorts for all periods presented. The graph on the right shows the percentage of GMV in each year from our repeat buyers. GMV from repeat buyers reflects purchases made after their initial purchase month. Annual GMV by Buyer Cohort Year ($ in millions) Repeat Buyer (% of GMV) We believe there is substantial opportunity to grow our business by having buyers also become consignors and vice versa. As of December 31, 2019, 13% of our buyers had become consignors and 54% of our consignors had become buyers. The graph below shows the percentage of GMV in each year from buyers who have participated as both buyers and consignors on our online marketplace. GMV attributable to consigning activity of such buyers is not included. Buyers Who Are Also Consignors (% of GMV) Buyer acquisition cost. Our financial performance depends on effectively managing the expenses we incur to attract and retain buyers. We closely monitor our efficiency in acquiring new buyers. Our buyer acquisition cost (“BAC”) for a given period is comprised of our total advertising spend, which is principally the cost of television, digital and direct mail advertising, divided by the number of buyers acquired in that period. We adjust or re-allocate our advertising in real-time to optimize our spend across channels, buyer demographics and geographies to improve our return on advertising spend. Our BAC has declined over time as we have achieved greater efficiency from our marketing spend. Buyer Acquisition Cost We also evaluate the success of our buyer acquisition activity by comparing the lifetime value of buyers (“BLTV”) attracted in a given period to the aggregate BAC in that same period. We calculate BLTV as the cumulative gross profit attributable to purchases by such buyers. The BLTV to BAC ratio in excess of 1.0 for all cohorts presented after 12 months reflects that each cohort has achieved payback at least equal to BAC within 1 year after acquisition. We have observed that BLTV for buyers who are also consignors is significantly higher than for buyers who have not also consigned. The following graphs depict the BLTV to BAC ratio by annual cohort since 2015 in the aggregate and for buyers who are also consignors, respectively. BLTV in the graph on the right includes only gross profit attributable to transactions in which the members participated as buyers who are also consignors and does not include gross profit attributable to transactions in which the member participated as a consignor. BLTV : BAC - All Buyers BLTV : BAC - Buyers who are also Consignors Scaling operations and technology. To support the future growth of our business, we are expanding our capacity through investments in physical infrastructure, talent and technology. We principally conduct our intake, authentication, merchandising and fulfillment operations in our four leased merchandising and fulfillment facilities located in California and New Jersey comprising an aggregate of approximately 1 million square feet of space. We secured leases on more than half of this space in 2018. The market for real estate to support operations centers such as ours is competitive, and we will need to continue to secure and efficiently bring online additional capacity to support future growth. The opening of our retail stores in New York in late 2017 and Los Angeles in mid-2018 significantly contributed to the increase in operations and technology expense in 2018. We opened a second retail store in New York in May 2019. We opened our fourth retail store in San Francisco in March 2020 and we intend to open additional retail stores in the future. In addition to scaling our physical infrastructure, growing our single-SKU business operations requires that we attract, train and retain highly-skilled personnel for purposes of authentication, copywriting, merchandising, pricing and fulfilling orders. We are also investing substantially in technology to automate our operations and support growth. While we expect our operations and technology development expenses to increase in absolute dollars as we continue to grow, we expect such expenses to decrease as a percentage of total revenue over the longer-term. Seasonality. We have observed trends in seasonality of supply and demand in our business that we believe will continue. Specifically, our supply increases in the third and fourth quarters, and our demand increases in the fourth quarter. As a result of this seasonality, we typically see stronger AOV and more rapid sell-through in the fourth quarter. We also incur higher operating expenses in the last four months of the year as we increase advertising spend to attract consignors and buyers and increase headcount in sales and operations to handle the higher volumes. Key Financial and Operating Metrics The key operating and financial metrics that we use to assess the performance of our business are set forth below for 2019, 2018 and 2017. GMV GMV represents the total amount paid for goods across our online marketplace in a given period. We do not reduce GMV to reflect product returns or order cancellations, which totaled 27.5%, 28.7% and 29.0% of GMV in 2019, 2018 and 2017, respectively. GMV includes amounts paid for both consigned goods and our inventory net of platform-wide discounts and excludes the effect of direct buyer incentives, shipping fees and sales tax. Buyer incentives consist of coupons or promotions that offer credits in connection with purchases on our platform. We believe this is the primary measure of the scale and growth of our online marketplace and the key indicator of the health of our consignor ecosystem. We monitor trends in GMV to inform budgeting and operational decisions to support and promote growth in our business and to monitor our success in adapting our business to meet the needs of our consignors and buyers. While GMV is the primary driver of our revenue, it is not a proxy for revenue or revenue growth. NMV NMV, or net merchandise value, represents GMV less product returns and order cancellations and directed buyer incentives. NMV includes amounts paid for both consigned goods and our inventory. We believe NMV is a useful supplemental measure of the scale and growth of our online marketplace as it is the basis for calculating consignor commissions and is therefore an important indicator of the health of our consignor ecosystem for investors. Like GMV, NMV is not a proxy for revenue or revenue growth. Number of Orders Number of orders means the total number of orders placed across our online marketplace in a given period. We do not reduce number of orders to reflect product returns or order cancellations. Take Rate Take rate is a key driver of our revenue and provides comparability to other marketplaces. The numerator used to calculate our take rate is equal to GAAP consignment and service revenue, excluding certain buyer incentives, shipping and subscription service revenue, and other adjustments. The denominator is equal to the numerator plus consignor commissions. We exclude direct revenue from our calculation of take rate because direct revenue represents the sale of inventory owned by us, which costs are included in cost of direct revenue. See the subsection titled “-Components of our Operating Results-Revenue” for further discussion of consignment and service revenue and direct revenue. Our take rate reflects the high level of service that we provide to our consignors across multiple touch points and the consistently high velocity of sales for their goods. Our take rate structure is a tiered commission structure for consignors, where the more they sell the higher percent commission they earn. Consignors start at a 55% commission (which equals a 45% take rate for us) and can earn up to a 70% commission. This tiered structure applies unless it is overridden by a commission exception. Commission exceptions are used to incentivize our sales team, optimize supply and drive take rate changes. Examples of current commission exceptions include a flat 40% commission on all items under $145, and an 85% commission on watches over $2,500. Management assesses changes in take rates by monitoring the volume of GMV and take rate across each discrete commission grouping, encompassing commission tiers and exceptions. Active Buyers Active buyers include buyers who purchased goods through our online marketplace during the 12 months ended on the last day of the period presented, irrespective of returns or cancellations. We believe this metric reflects scale, brand awareness, buyer acquisition and engagement. Average Order Value (“AOV”) Average order value (“AOV”) means the average value of all orders placed across our online marketplace, excluding shipping fees and sales taxes. Our focus on luxury goods across multiple categories drives a consistently high AOV. Our AOV reflects both the average price of items sold as well as the number of items per order. Our high AOV is a key driver of our operating leverage. Adjusted EBITDA Adjusted EBITDA means net loss before interest income, interest expense, net other expense, income tax provision and depreciation and amortization, further adjusted to exclude stock-based compensation and certain one-time expenses. Adjusted EBITDA provides a basis for comparison of our business operations between current, past and future periods by excluding items that we do not believe are indicative of our core operating performance. Adjusted EBITDA is a non-GAAP measure. Please see the section titled “Selected Financial and Other Data-Non-GAAP Financial Measures” for information regarding our use of Adjusted EBITDA and its reconciliation to net loss. Components of our Operating Results Revenue Our revenue is comprised of consignment and service revenue and direct revenue. • Consignment and service revenue. We generate the substantial majority of our revenue from the sale of pre-owned luxury goods through our online marketplace on behalf of consignors. For consignment sales, we retain a percentage of the proceeds received, which we refer to as our take rate. We recognize consignment revenue, net of allowances for product returns, order cancellations and certain buyer incentives. Additionally, we generate revenue from shipping fees we charge to buyers. We also generate service revenue from subscription fees paid by buyers for early access to products, but to date our subscription revenue has not been material. • Direct revenue. We generate direct revenue from the sale of items that we own, which we refer to as our inventory. We generally acquire inventory when we accept returns from buyers after title has transferred for returned goods from the consignor to the buyer. As such, growth in direct sales is generally a byproduct of growth in our consignment business. We recognize direct revenue based on the gross purchase price paid by buyers, net of allowances for product returns and certain buyer incentives. Cost of Revenue Cost of consignment and services revenue consists of shipping costs, credit card fees, packaging, customer service personnel-related costs, and website hosting services. Cost of direct revenue consists of the cost of goods sold, credit card fees, packaging, customer service personnel-related costs, and website hosting services. Marketing Marketing expense comprises the cost of acquiring new consignors and buyers, including the cost of television, digital and direct mail advertising. Marketing expense also includes personnel-related costs for employees engaged in these activities. We intend to increase marketing spend as we invest to drive the growth of our business, though these expenses are expected to decrease as a percentage of revenue over the longer term. Operations and Technology Operations and technology expense principally includes personnel-related costs for employees involved with the authentication, merchandising and fulfillment of goods sold through our online marketplace, as well as our general information technology expense. Operations and technology expense also includes allocated facility and overhead costs, costs related to our retail stores, facility supplies and depreciation of hardware and equipment, as well as research and development expense for technology associated with managing and improving our operations. We capitalize a portion of our proprietary software and technology development costs. As such, operations and technology expense also includes amortization of capitalized technology development costs. We expect operations and technology expense to increase in future periods to support our growth, including bringing on additional merchandising and fulfillment facilities and continuing to invest in automation and other technology improvements to support and drive efficiency in our operations. These expenses may vary from year to year as a percentage of revenue, depending primarily upon when we choose to make more significant investments. We expect these expenses to decrease as a percentage of revenue over the longer term. Selling, General and Administrative Selling, general and administrative expense is principally comprised of personnel-related costs for our sales professionals and employees involved in finance and administration. Selling, general and administrative expense also includes allocated facilities and overhead costs and professional services, including accounting and legal advisors. We expect to increase selling, general and administrative expense as we grow our infrastructure to support operating as a public company and the overall growth in our business. While these expenses may vary from year to year as a percentage of revenue, we expect them to decrease as a percentage of revenue over the longer term. Income Tax Provision Our provision for income taxes consists primarily of state minimum taxes in the United States. We have a full valuation allowance for our net deferred tax assets primarily consisting of net operating loss carryforwards, accruals and reserves. We expect to maintain this full valuation allowance for the foreseeable future. Results of Operations The results of operations presented below should be reviewed in conjunction with the financial statements and notes included elsewhere in the Annual Report. Prior year comparisons are included in our prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended, on June 28, 2019. The following tables set forth our results of operations and such data as a percentage of revenue for the periods presented: Comparison of 2019 and 2018 Consignment and Service Revenue Consignment and service revenue increased by $86.8 million, or 48%, in 2019 compared to 2018. The growth in revenue was driven primarily by a 42% increase in GMV resulting from growth in both active consignors and active buyers in 2019 compared to 2018, as well as an improvement from 35.5% to 36.3% in our take rate due to changes to our commission structure that yielded a higher take rate on lower-priced items. GMV growth was driven by a 40% increase in active buyers, as well as a 2% increase in AOV. Active buyer growth was driven by an increase in new buyers due to the combination of our effective marketing spend and consignors becoming buyers, and an increase in repeat buyer orders as a percentage of total orders. Direct Revenue Direct revenue increased by $17.5 million, or 53%, in 2019 compared to 2018. The increase was driven in part by an increase in our owned-inventory as a result of a higher volume of returns received after title had transferred from the consignor to the buyer. The subsequent sale of our owned-inventory drove the increase in direct revenue both on an absolute basis and as a percent of total revenue. Cost of Consignment and Service Revenue Cost of consignment and service revenue increased by $22.7 million, or 45%, in 2019 compared to 2018. The increase was primarily attributable to the fulfillment of a larger number of orders driven by growth in our business. Cost of Direct Revenue Cost of direct revenue increased by $15.3 million, or 59%, in 2019 compared to 2018, consistent with the increase in direct revenue. As a percentage of direct revenue, cost of direct revenue increased to 81% in 2019 from 78% in 2018. Marketing Marketing expense increased by $5.6 million, or 13%, in 2019 compared to 2018. The increase was primarily due to increases in advertising costs and marketing program expenses as we seek to grow the number of buyers and consignors using our online marketplace. As a percent of revenue, marketing expense decreased to 15% in 2019 from 20% in 2018, reflecting greater scale in our business and efficiency in our buyer and consignor acquisition and retention activities. Operations and Technology Operations and technology expense increased by $38.3 million, or 37%, in 2019 compared to 2018. The increase was primarily due to investments to support our growth and drive long-term operational efficiencies, including investments to significantly expand our merchandising and fulfillment facilities, grow our talent including authentication and technology expertise and support our retail operations. As a percent of revenue, operations and technology expense decreased to 45% in 2019 from 49% in 2018, reflecting improved efficiencies from inbound and outbound operations and fixed expense leverage. We expect these expenses to continue to decrease as a percentage of revenue over the longer term. Selling, General and Administrative Selling, general and administrative expense increased by $46.9 million, or 74%, in 2019 compared to 2018. The increase was due to investments to support the growth of our sales organization and scale our general and administrative functions as necessary to operate as a public company including accounting, consulting and legal fees and insurance costs. The increase also includes a $3.2 million donation to The RealReal Foundation. As a percent of revenue, selling, general and administrative expense increased to 35% in 2019 from 30% in 2018 as we invested in the growth of the sales organization and expanded our administrative functions. We expect these expenses to decrease as a percentage of revenue over the long term. Quarterly Results of Operations and Key Metrics The following tables set forth certain unaudited financial data for each fiscal quarter for the periods indicated in dollars and as a percentage of revenue. The information for each quarter has been prepared on a basis consistent with our audited financial statements included in this Annual Report and reflect all adjustments that we consider necessary for a fair presentation of the financial information contained in those statements. Our historical results are not necessarily indicative of the results that may be expected for the full year or any other period in the future. The following quarterly financial information should be read in conjunction with our audited financial statements and related notes included in this Annual Report. Key Financial and Operating Metrics The following table presents a reconciliation of Adjusted EBITDA from net loss: Liquidity and Capital Resources As of December 31, 2019, we had cash, cash equivalents and short-term investments of $363.3 million and an accumulated deficit of $354.5 million. Since inception, we have generated negative cash flows from operations and have primarily financed our operations through equity financings. In July 2019, we received net proceeds of $315.5 million upon completion of our IPO on July 2, 2019. We expect that operating losses and negative cash flows from operations could continue in the foreseeable future as we continue to invest in expansion activities. We believe our existing cash and cash equivalents and short-term investments as of December 31, 2019 will be sufficient to meet our working capital and capital expenditures needs for at least the next 12 months. Our future capital requirements will depend on many factors, including, but not limited to, our ability to grow our revenues and the timing of investments to support growth in our business, such as the build-out of new fulfillment centers and, to a lesser extent, the opening of new retail stores. We may 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, financial condition and results of operations could be adversely affected. Cash Flows The following table summarizes our cash flows for the periods indicated. Net Cash Used in Operating Activities During 2019, net cash used in operating activities was $54.5 million, which consisted of a net loss of $96.7 million, adjusted by non-cash charges of $25.2 million and cash inflows due to a net change of $17.1 million in our operating assets and liabilities. The net change in our operating assets and liabilities was primarily the result of cash inflows due to increases of $17.6 million in accrued consignor payable, $10.7 million in other accrued and current liabilities, and a $6.2 million in accounts payable as a result of our growth, partially offset by cash outflows due to increases of $13.2 million in inventory and $4.1 million in prepaid expenses and other current assets. During 2018, net cash used in operating activities was $47.2 million, which consisted of a net loss of $75.8 million, partially offset by non-cash charges of $16.5 million and cash inflows due to a net change of $12.1 million in our operating assets and liabilities. The net change in our operating assets and liabilities was primarily the result of cash inflows due to an increases of $15.7 million in other accrued and current liabilities driven by our growth, $6.6 million in accrued consignor payable, and $3.4 million in other non-current liabilities, partially offset by cash outflows due to increases of $5.3 million in prepaid expenses and other current assets and $3.7 million in inventory, net. Net Cash Used in Investing Activities During 2019, net cash used in investing activities was $215.4 million, which consisted of $220.6 million for purchases of investments, $24.8 million for purchases of property and equipment, net, including leasehold improvements, and $9.3 million for capitalized proprietary software costs offset by the proceeds of $39.3 million from maturities of short-term investments. During 2018, net cash used in investing activities was $33.9 million, which consisted of $31.5 million for purchases of short-term investments, $13.4 million for purchases of property and equipment, net, including leasehold improvements, and $5.7 million for capitalized proprietary software costs, partially offset by the proceeds of $9.6 million from maturities on short-term investments and proceeds of $7.0 million from the sale of short-term investments. Net Cash Provided by Financing Activities During 2019, net cash provided by financing activities was $378.7 million, which primarily consisted of proceeds of $315.5 million from the initial public offering, net of issuance costs, $69.8 million from the issuance of redeemable convertible preferred stock and convertible preferred stock, net of issuance costs, and proceeds of $2.7 million from the exercise of stock options and warrants partially offset $9.3 million for repayment of debt. During 2018, net cash provided by financing activities was $106.1 million, which primarily consisted of proceeds of $96.3 million from the issuance of convertible and redeemable convertible preferred stock, net of issuance costs, and proceeds of $14.3 million from the issuance of convertible notes, net of issuance costs, partially offset by $4.5 million for repayments of debt. Contractual Obligations and Commitments The following table summarizes our contractual obligations and commitments as of December 31, 2019: (1) This table does not include the noncancelable operating lease we entered into in January 2020 to extend and expand the existing lease in New York, NY. The additional minimum lease payments over the eight-year term total $14.7 million. (2) In January 2018, we entered into an agreement with the University of Arizona Foundation to endow a gemology degree program in the Department of Geosciences. We committed to endow a total of $2.0 million, of which $1.0 million remained to be funded as of December 31, 2019. 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. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires our management to make judgments and estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated, and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these judgments and estimates under different assumptions or conditions and any such differences may be material. 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 Consignment and Service Revenue We generate the majority of our revenue from consignment services for the sale of pre-owned luxury goods on behalf of consignors through our online consignment marketplace. For consignment sales, we retain a portion of the proceeds received, which we refer to as our take rate, and remit the balance to the consignors. We recognize consignment revenue upon purchase of the goods by the buyer based on our take rate, net of allowances for product returns and order cancellations and certain incentives. We also generate revenue from shipping fees to buyers and have elected to treat shipping and handling activities performed after control transfers to the buyer as fulfillment activities. Accordingly, we recognized shipping fees as revenue upon the first shipment associated with an order. We also generate service revenue from our First Look subscription program, through which buyers pay a monthly fee for early access to our listings. Subscription fees are recognized on a monthly basis. Certain transactions provide consignors with a material right resulting from the tiered consignor commission plan. Under this plan, the amount an individual consignor receives for future sales of consigned goods may be dependent on previous consignment sales for that consignor. Accordingly, in certain consignment transactions, a small portion of our consignment service revenue is allocated to such material right using the portfolio method, as applicable. Such deferred revenue is recorded as deferred revenue and recognized based on the pattern of exercise. We recognize a returns reserve in the period that the related revenue is recorded based on historical experience. Historically, our estimate for returns has not varied materially from our actual returns. We monitor changes in returns activity and they are adjusted prospectively based upon such periodic evaluation. Direct Revenue We also generate revenue from the sales of company-owned inventory. We recognize direct revenue upon shipment of the goods through our online marketplace, based on the gross purchase price net of allowances for product returns and certain buyer incentives. Stock-based Compensation We estimate the fair value of stock options granted to employees, non-employees and directors using the Black-Scholes option-pricing model. The fair value of stock options that is expected to vest is recognized as compensation expense on a straight-line basis over the requisite service period. The Black-Scholes model considers several variables and assumptions in estimating the fair value of stock-based awards. These variables include per share fair value of the underlying common stock, exercise price, expected term, risk-free interest rate, expected annual dividend yield and expected stock price volatility over the expected term. For all stock options granted to date, we calculated the expected term using the simplified method for “plain vanilla” stock option awards. We determine volatility using the historical volatility of the stock price of similar publicly traded peer companies. 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. Prior to our initial public offering, the fair value of the shares of common stock underlying the stock options was determined by our board of directors, with assistance by management and using contemporaneous third-party valuations, as there was no public market for the common stock. Following the closing of our initial public offering, 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. Recent Accounting Pronouncements See Note 2, “Summary of Significant Accounting Policies” to our 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 Annual Report on Form 10-K. 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 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 (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. We can choose to adopt new or revised accounting standards earlier than such time those standards apply to private companies and retain our election for the extended transition period, if early adoption is permitted for all entities. 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 We are the world’s largest online marketplace for authenticated, consigned luxury goods. We are revolutionizing luxury resale by providing an endtoend service that unlocks supply from consignors and creates a trusted, curated online marketplace for buyers globally. Over the past nine years, we have cultivated a loyal and engaged consignor and buyer base through continuous investment in our technology platform, logistics infrastructure and people. We aggregate and curate unique, preowned luxury supply that is exclusive to The RealReal across multiple categories, including women’s, men’s, kids’, jewelry and watches, and home and art. We have built a vibrant online marketplace that we believe expands the overall luxury market, promotes the recirculation of luxury goods and contributes to a more sustainable world. We have transformed the luxury consignment experience by removing the friction and pain points inherent in the traditional consignment model. For consignors, we provide White Glove inhome consultation and pickup, drop off at one of our ten LCOs, four of which are located in our retail stores, or complimentary shipping directly to our merchandising and fulfillment facilities. We leverage our proprietary transactional database and market insights from approximately 12.8 million item sales since inception to deliver optimal pricing and rapid sellthrough. For buyers, we offer highly coveted and exclusive authenticated preowned luxury goods at attractive values, as well as a highquality experience befitting the products we offer. Our online marketplace is powered by our proprietary technology platform, including consumer facing applications and purposebuilt software that supports our complex, singleSKU inventory model and merchandising operations. The substantial majority of our revenue is generated by consignment sales. We also generate revenue from other services and direct sales. Consignment and service revenue. When we sell goods through our online marketplace on behalf of our consignors, we retain a percentage of the proceeds, which we refer to as our take rate. Take rates vary depending on the total value of goods sold through our online marketplace on behalf of a particular consignor as well as the category and price point of the items. In 2019 and 2018, our take rate on consigned goods was 36.3% and 35.5% respectively. Additionally, we earn revenue from shipping fees and from our subscription program, First Look, in which we offer buyers early access to the items we sell in exchange for a monthly fee. Direct revenue. In certain cases, such as when we accept an out of policy returns from buyers, we take ownership of goods and retain 100% of the proceeds when the goods subsequently resell through our online marketplace. We generate revenue from orders processed through our website, mobile app and four retail stores located in New York, Los Angeles, and San Francisco. Our omnichannel experience enables buyers to purchase anytime and anywhere. We have a global base of more than 15 million members as of December 31, 2019. We count as a member any user who has registered an email address on our website or downloaded our mobile app, thereby agreeing to our terms of service. Through December 31, 2019, we have cumulatively paid more than $1.3 billion in commissions to our consignors. In 2019 and 2018, our GMV was $1.0 billion and $710.8 million, respectively, representing an annual growth rate of 42% in 2019. In 2019 and 2018, our total revenue was $318.0 million and $213.7 million, respectively, representing an annual growth rate of 49% in 2019. In 2019 and 2018, our gross profit was $203.2 million and $136.9 million, respectively, representing an annual growth rate of 48% in 2019. Factors Affecting Our Performance To analyze our business performance, determine financial forecasts and help develop longterm strategic plans, we focus on the factors described below. While each of these factors presents significant opportunity for our business, collectively, they also pose important challenges that we must successfully address in order to sustain our growth, improve our operating results and achieve and maintain our profitability. [/INST] Negative. </s>

BrightSphere Investment Group Inc.

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Unless we state otherwise or the context otherwise requires, references in this Annual Report on Form 10-K to “BrightSphere” or “BSIG” refer to BrightSphere Investment Group Inc., references to the “Company” refer to BSIG, and references to “we,” “our” and “us” refer to BSIG and its consolidated subsidiaries and equity-accounted Affiliates, excluding discontinued operations. References to the holding company or “Center” excluding the Affiliates refer to BrightSphere Inc., or BSUS, a Delaware corporation and indirect, wholly owned subsidiary of BSIG. Unless we state otherwise or the context otherwise requires, references in this Annual Report on Form 10-K to “Affiliates” or an “Affiliate” refer to the asset management firms in which we have an ownership interest. References in this Annual Report on Form 10-K to “OM plc” refer to Old Mutual plc, our former parent. None of the information in this Annual Report on Form 10-K constitutes either an offer or a solicitation to buy or sell any of our Affiliates’ products or services, nor is any such information a recommendation for any of our Affiliates’ products or services. The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes which appear in this Annual Report on Form 10-K in Item 8, Financial Statements and Supplementary Data. This discussion contains forward-looking statements that involve risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report on Form 10-K, particularly under Item 1A, Risk Factors. This Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, is designed to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in five sections: • Overview provides a brief description of our Affiliates, a summary of The Economics of Our Business and an explanation of How We Measure Performance using a non-GAAP measure which we refer to as economic net income, or ENI. This section also provides a Summary Results of Operations and information regarding our Assets Under Management by Affiliate, strategy, client type and client location, and net flows by segment, client type and client location. • U.S. GAAP Results of Operations for the years ended December 31, 2019, 2018 and 2017 includes an explanation of changes in our U.S. GAAP revenue, expense, and other items over the last three years as well as key U.S. GAAP operating metrics. • Non-GAAP Supplemental Performance Measure-Economic Net Income and Segment Analysis includes an explanation of the key differences between U.S. GAAP net income and ENI, the key measure management uses to evaluate our performance. This section also provides a reconciliation between U.S. GAAP net income and ENI for the years ended December 31, 2019, 2018, and 2017, as well as a reconciliation of key ENI operating items including ENI revenue and ENI operating expenses. This section also provides key Non-GAAP operating metrics and a calculation of tax on economic net income. In addition, this section provides segment analysis for each of our business segments. • Capital Resources and Liquidity discusses our key balance sheet data. This section discusses Cash Flows from the business; Working Capital and Long-Term Debt; Adjusted EBITDA; Future Capital Needs; and Commitments, Contingencies and Off-Balance Sheet Obligations. The discussion of Adjusted EBITDA includes an explanation of how we calculate Adjusted EBITDA and a reconciliation of Adjusted EBITDA to U.S. GAAP net income attributable to controlling interests. • Critical Accounting Policies and Estimates provides a discussion of the key accounting policies and estimates that we believe are the most critical to an understanding of our results of operations and financial condition that require complex management judgment regarding matters that are highly uncertain at the time policies were applied and estimates were made. Overview We are a diversified, global asset management company headquartered in Boston, Massachusetts. We completed a redomestication process to change our publicly traded parent company from a United Kingdom company to a Delaware corporation on July 12, 2019. We operate our business through three business segments: • Quant & Solutions-comprised of versatile, often highly-tailored strategies that leverage data and technology in a computational, factor-based investment process across a range of asset classes and geographies, including Global, non-U.S., emerging markets and managed volatility equities, as well as multi-asset products. • Alternatives-comprised of illiquid and differentiated liquid investment strategies that include private equity, real estate and real assets, including forestry, as well as a growing suite of liquid alternative capabilities in areas such as long/short, market neutral and absolute return. • Liquid Alpha-comprised of specialized investment strategies with a focus on alpha-generation across market cycles in long-only small-, mid-, and large-cap U.S., global, non-U.S. and emerging markets equities, as well as fixed income. Within our three segments, we have seven affiliate firms to whom we refer in this Annual Report on Form 10-K as our Affiliates. Through our Affiliates, we offer a diverse range of actively-managed investment strategies and products to institutional investors around the globe. While our Affiliates maintain autonomy in the investment process and the day-to-day management of their businesses, our strategy is to work with them to accelerate the growth and profitability of their firms. Under U.S. GAAP, our Affiliates may be consolidated into our operations or may be accounted for under the equity method of accounting. We may also be required to consolidate certain of our Affiliates’ sponsored investment entities, or Funds, due to the nature of our decision-making rights, our economic interests in these Funds or the rights of third party clients in those Funds. Our current Affiliates and their principal strategies include: • Acadian Asset Management LLC (“Acadian”)-a leading quantitative investment manager of active global, international equity, and alternative strategies. • Barrow, Hanley, Mewhinney & Strauss, LLC (“Barrow Hanley”)-a widely recognized value-oriented investment manager of U.S., international and global equities, fixed income and a range of balanced investment management strategies. • Campbell Global, LLC (“Campbell Global”)-a leading sustainable forestry and natural resource investment manager that seeks to deliver superior investment performance by focusing on unique acquisition opportunities, client objectives and disciplined management. • Copper Rock Capital Partners LLC (“Copper Rock”)-a specialized growth equity investment manager of small-cap international, global and emerging markets equity strategies. • Investment Counselors of Maryland, LLC (“ICM”)(1)-a value-driven domestic equity manager with product offerings focused on small- and mid-cap companies. • Landmark Partners, LLC (“Landmark”)-a leading global secondary private equity, real estate and real asset investment firm. • Thompson, Siegel & Walmsley LLC (“TSW”)-a value-oriented investment manager focused on small- and mid-cap U.S. equity, international equity and fixed income strategies. (1) Accounted for under the equity method of accounting. Recent Developments Change in Segments We continually monitor and review our segment reporting structure in accordance with authoritative guidance to determine whether any changes have occurred that would impact our reportable segments. Because of the change in our Chief Operating Decision Maker (“CODM”) at the end of 2018, we underwent a strategic shift in 2019 to refocus our businesses by our various investment strategies. During the third quarter of 2019, we realigned our business and reportable segment information that the CODM regularly reviews to evaluate performance for operating decision-making purposes, including performance assessment and allocation of resources. As a result, our segment reporting structure is based on our various investment strategies. As a result of the change noted above, effective from the quarter ended September 30, 2019, we have the following business segments: • Quant & Solutions-comprised of versatile, often highly-tailored strategies that leverage data and technology in a computational, factor-based investment process across a range of asset classes and geographies, including Global, non-U.S., emerging markets and managed volatility equities, as well as multi-asset products. • Alternatives-comprised of illiquid and differentiated liquid investment strategies that include private equity, real estate and real assets, including forestry, as well as a growing suite of liquid alternative capabilities in areas such as long/short, market neutral and absolute return. • Liquid Alpha-comprised of specialized investment strategies with a focus on alpha-generation across market cycles in long-only small-, mid-, and large-cap U.S., global, non-U.S. and emerging markets equities, as well as fixed income. The Economics of Our Business Our profitability is affected by a variety of factors including the level and composition of our average assets under management, or AUM, fee rates charged on AUM and our expense structure. Our Affiliates earn management fees based on assets under management. Approximately 75% of our management fees are calculated based on average AUM (calculated on either a daily or monthly basis) with the remainder of our management fees calculated based on period-end AUM or other measuring methods. Changes in the levels of our AUM are driven by our investment performance and net client cash flows. Our Affiliates may also earn performance fees, or adjust management fees, when certain accounts differ in relation to relevant benchmarks or exceed or fail to exceed required returns. Approximately $18.2 billion, or 9% of our AUM in consolidated Affiliates, are in accounts with incentive fee or carried interest features in which we participate in the performance fee. The majority of these incentive fees are calculated based on value added over the relevant benchmarks on a rolling three-year basis. Carried interests are features of private equity funds, which are calculated based on long-term cumulative returns. Our largest expense item is compensation and benefits paid to our and our Affiliates’ employees, which consists of both fixed and variable components. Fixed compensation and benefits represents base salaries and wages, payroll taxes and the costs of our employee benefit programs. Variable compensation, calculated as described below, may be awarded in cash, equity or profit interests. The arrangements in place with our Affiliates result in the sharing of economics between BSUS and each Affiliate’s key management personnel using a profit-sharing model, except for ICM, which uses a revenue share model as a result of a legacy economic arrangement that has not been restructured. Profit sharing affects two elements within our earnings: (i) the calculation of variable compensation and (ii) the level of each Affiliate’s equity or profit interests distribution to its employees. Variable compensation is the portion of earnings that is contractually allocated to Affiliate employees as a bonus pool, typically representing a fixed percentage of earnings before variable compensation, which is measured as revenues less fixed compensation and benefits and other operating and administrative expenses. Profits after variable compensation are shared between us and Affiliate key employee equity holders according to our respective equity or profit interests ownership. The sharing of profits in this manner ensures that the economic interests of Affiliate key employees and those of BSUS are aligned, both in terms of generating strong annual earnings as well as investing those earnings back into the business in order to generate growth over the long term. We view profit sharing as an attractive operating model, as it allows us to share in the benefits of operating leverage as the business grows, and ensures all equity and profit interests holders are incentivized to achieve that growth. Equity or profit interests owned by Affiliate key employees are either awarded as part of their variable compensation arrangements, or alternatively, may have originally resulted from BSUS acquiring less than 100% of the Affiliate. Over time, Affiliate key employee-owned equity or profit interests are recycled from one generation of employee owners to the next, either by the next generation purchasing equity or profit interests directly from retiring principals, or by Affiliate key employees forgoing cash bonuses in exchange for the equivalent value in Affiliate equity or profit interests. The recycling of equity or profit interests is often facilitated by BSUS; see "-U.S. GAAP Results of Operations-U.S. GAAP Expenses-Compensation and Benefits Expense" for a further discussion. The diagram below provides an illustrative example of how the profit-sharing model would work initially and over time if the affiliate grew its revenue and profits. In this example, the employees’ variable compensation has been contractually set at 30% of earnings before variable compensation, and the earnings after variable compensation are split 60% to BSUS and 40% to the affiliate key employees. Revenue initially equals $200 and operating expenses equal $100. Therefore, earnings before variable compensation equal $100 and the contractual bonus pool (variable compensation) equals $30. The owners split the $70 profit after variable compensation, with BSUS receiving $42, or 60%, and the Affiliate key employees receiving $28, or 40%. Including both the contractual employee bonus pool and the key employees’ share of profit, the employees receive $58, or 58% of profit before variable compensation. Employee equity is valued at a fixed multiple of this $28 share of profits, so employees have transparency into both their earning potential in any year from the bonus pool and share of profits, as well as the current value of their equity and the long-term potential to realize value from its growth. In this structure, key employees who are managing their business have incentives to manage for profit, but also to manage the business prudently, in the interest of their clients, and invest for growth, since they will benefit over the long term as both employees and equity holders. In this way, each Affiliate is aligned with BSUS and the public shareholders to generate profits and growth over time. Illustrative Structure: Profit-Sharing Economics Figures in parenthesis indicate impact of model after five years if revenue and pre-bonus operating expenses grew 15% and 7% annually, respectively. The alignment of interests is even clearer if we consider the impact of growth on the profit-sharing model. The numbers in parenthesis in the diagram represent the financial results of the illustrative business in five years, assuming revenue has grown at 15% annually and operating expenses have grown at 7% annually. With revenue of $400 and operating expenses of $140, profit before variable compensation has now increased to $260, representing an annual growth rate of 21%. The 30% contractual bonus pool of $78 has also grown 21% annually, as has BSUS’s 60% share of profits, which equals $109, and the affiliate’s 40% share of profits, which equals $73. From this example, it is clear that as profit in the affiliate’s business grows and the operating margin increases, both of the stakeholders-BSUS and the key employees-are benefiting in a proportionate way. This means that both parties are aligned to invest in the business by hiring new investment professionals, developing new products, or establishing new distribution channels. We believe this investment in turn benefits clients and should generate growth over time. The alternative structure common in the industry is the revenue share model. In the revenue share model, the affiliate’s revenue is typically divided into two fixed percentages-the operating allocation and the owners’ allocation. All operating expenses of the business, including employee bonuses, must be covered by the operating allocation. The owners’ allocation can be owned entirely by the affiliate owner or ownership can be divided between the affiliate owner and the affiliate’s key employees. In either case, the affiliate owner effectively owns a fixed percentage of the affiliates’ revenue, which typically does not change as the business grows. While the initial economics of the profit share model and the revenue share model can be similar, over time the economic split and incentive structure can be quite different, leading to less alignment between the affiliate and the affiliate owner. The affiliate owner’s share of profits grows in line with revenue, while any operating leverage in the business is retained entirely by the affiliate’s employees. Likewise, new costs and investments to drive growth are borne entirely by the affiliate employees, while the revenue generated by these investments is shared with the affiliate owner. While the revenue share structure has been successfully implemented by a number of our peers who have a more autonomous strategy, for BSIG, which emphasizes collaborative engagement and joint investment with our Affiliates, the alignment of the profit-sharing model is mutually reinforcing with our overall growth strategy and operating philosophy. How We Measure Performance We manage our business based on three business segments, reflecting how our management assesses the performance of our business. In measuring and monitoring the key components of our earnings, our management uses a non-GAAP financial measure, ENI, to evaluate the financial performance of, and to make operational decisions for, our business. We also use ENI to make resource allocation decisions, determine appropriate levels of investment or dividend payout, manage balance sheet leverage, determine Affiliate variable compensation and equity distributions, and incentivize management. It is an important measure in evaluating our financial performance because we believe it most accurately represents our operating performance and cash generation capability. ENI differs from net income determined in accordance with U.S. GAAP as a result of both the reclassification of certain income statement items and the exclusion of certain non-cash or non-recurring income statement items. In particular, ENI excludes non-cash charges representing the changes in the value of Affiliate equity and profit interests held by Affiliate key employees, the results of discontinued operations which are no longer part of our business, restructuring costs, capital transaction costs, seed capital and co-investment gains, losses and related financing costs, and that portion of consolidated Funds which are not attributable to our shareholders. ENI is also adjusted for amortization of acquisition-related contingent consideration and pre-acquisition retained equity with service components. ENI revenue is primarily comprised of the fee revenues paid to us by our clients for our advisory services and earnings from our equity-accounted Affiliates. Revenue included within ENI differs from U.S. GAAP revenue in that it excludes amounts from consolidated Funds which are not attributable to our shareholders, it excludes reimbursement of certain costs we paid on behalf of our customers and it includes our share of earnings from equity-accounted Affiliates. ENI expenses are calculated to reflect all usual expenses from ongoing continuing operations attributable to our shareholders. Expenses included within ENI differ from U.S. GAAP expenses in that they exclude amounts from consolidated Funds which are not attributable to our shareholders, revaluations of Affiliate key employee owned equity and profit interests, amortization and impairment of acquired intangibles and other acquisition-related items, costs we paid on behalf of our customers which were subsequently reimbursed and certain other non-cash expenses. “Non-controlling interests” is a concept under U.S. GAAP that identifies net components of revenues and expenses that are not attributable to our shareholders. For example, the portion of the net income (loss) of any consolidated Funds that is attributable to the outside investors or clients of the consolidated Funds is included in “Non-controlling interests” in our Consolidated Financial Statements. Conversely, “controlling interests” is the portion of revenue or expense that is attributable to our shareholders. For a more detailed discussion of the differences between U.S. GAAP net income and economic net income, see "-Non-GAAP Supplemental Performance Measure - Economic Net Income and Segment Analysis." Summary Results of Operations The following table summarizes our results of operations for the years ended December 31, 2019, 2018, and 2017: (1) U.S. GAAP operating margin equals operating income from continuing operations divided by total revenue. (2) Economic net income is a non-GAAP measure we use to evaluate the performance of our business. For a reconciliation to U.S. GAAP financial information and a further discussion of economic net income refer to “-Non-GAAP Supplemental Performance Measures-Economic Net Income and Segment Analysis.” (3) Excludes restructuring costs at the Center and Affiliates of $6.7 million ($4.9 million after taxes) and costs associated with the redomicile to the U.S. of $2.5 million for the year ended December 31, 2019. Excludes restructuring charges associated with the 2018 CEO transition of $4.8 million ($3.6 million after taxes) for the year ended December 31, 2018. Excludes restructuring charges associated with the 2017 CEO transition of $9.8 million ($5.7 million after taxes) and $1.0 million related to the Heitman transaction ($0.6 million after taxes) for the year ended December 31, 2017. (4) ENI revenue is the ENI measure which corresponds to U.S. GAAP revenue. (5) Pre-tax economic net income is the ENI measure which corresponds to U.S. GAAP pre-tax income from continuing operations attributable to controlling interests. (6) ENI operating margin is a non-GAAP efficiency measure, calculated based on ENI operating earnings divided by ENI revenue. ENI operating earnings is calculated as ENI revenue, less ENI operating expense, less ENI variable compensation. The ENI operating margin is most comparable to our U.S. GAAP operating margin (excluding the effect of consolidated Funds) of 30% for the year ended December 31, 2019, 9% for the year ended December 31, 2018 and 8% for the year ended December 31, 2017. (7) Economic net income is the ENI measure which corresponds to U.S. GAAP net income from continuing operations attributable to controlling interests. (8) As previously disclosed, in August 2017 we entered into an agreement to sell our stake in Heitman, a real estate manager and former Affiliate, to Heitman’s management for cash consideration totaling $110.0 million. Operational information (including AUM and flows data) excludes Heitman for periods beginning in the third quarter of 2017 (Heitman remained in operational information for the first half of 2017). (9) Net flows and revenue impact of net flows for all periods above have been revised for the inclusion of reinvested income and distributions, and the exclusion of realizations. (10) Annualized revenue impact of net flows represents the difference between annualized management fees expected to be earned on new accounts and net assets contributed to existing accounts, less the annualized management fees lost on terminated accounts or net assets withdrawn from existing accounts, plus revenue impact from reinvested income and distributions, including equity-accounted Affiliates. The annualized management fees are calculated by multiplying the annual gross fee rate for the relevant account by the net assets gained in the account in the event of a positive flow, excluding any current or future market appreciation or depreciation, or the net assets lost in the account in the event of an outflow, excluding any current or future market appreciation or depreciation. In addition, reinvested income and distributions for each segment is multiplied by average fee rate for the respective segment to compute the revenue impact. For a further discussion of the uses and limitations of the annualized revenue impact of net flows, see “Assets Under Management” herein. Assets Under Management In August 2017, we entered into an agreement to sell our stake in Heitman, a real estate manager and former Affiliate, to Heitman’s management for cash consideration totaling $110.0 million. Unless specifically noted, flow information includes flows from Heitman for the first half of 2017, but excludes it thereafter, and AUM data excludes the Heitman AUM at December 31, 2017 and thereafter. Our total assets under management as of December 31, 2019 were $204.4 billion. The following table presents our assets under management by Affiliate as of each of the dates indicated: Our strategies include: i. U.S. equity, which includes small cap through large cap securities and primarily value or blended investment styles; ii. Global / non-U.S. equity, which includes global and international equities including emerging markets; iii. Fixed income, which includes government bonds, corporate bonds and other fixed income investments in the United States; and iv. Alternatives, which consist of illiquid and differentiated liquid investment strategies that include private equity, real estate and real assets, including forestry, as well as a growing suite of liquid alternative capabilities in areas such as long/short, market neutral and absolute return. The following table presents our assets under management by strategy as of each of the dates indicated: The following table shows assets under management by client type as of each of the dates indicated: The following table shows assets under management by client location as of each of the dates indicated: AUM flows and the annualized revenue impact of net flows Net client cash flows and revenue impact of net client cash flows for all periods have been revised for the inclusion of reinvested income and distributions, and the exclusion of realizations. Reinvested income and distributions represent investment yield that is reinvested back into the portfolios as opposed to distributed as cash. Realizations include distributions related to the sale of alternative assets, which represent a return on investment. In the following table, we present our asset flows and market appreciation (depreciation) by segment. We also present a key metric used to better understand our asset flows, the annualized revenue impact of net client cash flows. Annualized revenue impact of net flows represents annualized management fees expected to be earned on new accounts and net assets contributed to existing accounts (inflows), less the annualized management fees lost on terminated accounts or net assets withdrawn from existing accounts (outflows), plus revenue impact from reinvested income and distributions. Annualized management fee for client flow is calculated by multiplying the annual gross fee rate for the relevant account with the inflow or the outflow, including equity-accounted Affiliates. In addition, reinvested income and distributions for each segment is multiplied by average fee rate for the respective segment to compute the revenue impact. The annualized revenue impact of net flows metric is designed to provide investors with a better indication of the potential financial impact of net client cash flows, however it has certain limitations. For instance, it does not include assumptions for the next twelve months' market appreciation or depreciation and investment performance associated with the assets gained or lost. Nor does it account for factors such as future client terminations or additional contributions or withdrawals over the next twelve months. Additionally, the basis points reported are fee rates based on the asset levels at the time of the transactions and do not consider the fact that client fee rates may change over the next twelve months. The following table summarizes our asset flows and market appreciation (depreciation) by segment for each of the periods indicated: (1) We have removed Heitman from our AUM and cash flow metrics as of the beginning of the third quarter 2017. Heitman stopped contributing to our financial results as of November 30, 2018, therefore Heitman’s December 31, 2017 AUM is not reflected in the table above. (2) Net flows and revenue impact of net flows for all periods above have been revised for the inclusion of reinvested income and distributions, and the exclusion of realizations. (3) Average AUM equals average AUM of consolidated Affiliates. (4) Realizations include distributions related to the sale of alternative assets, and represent a return on investments. Other activity primarily relates to the decline in billable AUM as a legacy alternative fund transitioned from billing base on committed AUM to net asset value. We also analyze our asset flows by client type and client location. Our client types include: i. Sub-advisory, which includes assets managed for underlying mutual fund and variable insurance products which are sponsored by insurance companies and mutual fund platforms, where the end client is typically retail; ii. Institutional, which includes assets managed for public / government pension funds, including U.S. state and local government funds and non-U.S. sovereign wealth, local government and national pension funds; also includes corporate and union-sponsored pension plans; and iii. Retail / other, which includes assets managed for mutual funds sponsored by our Affiliates, defined contribution plans and accounts managed for high net worth clients. The following table summarizes our asset flows by client type for each of the periods indicated: (1) Reflects the removal of Heitman beginning in the third quarter of 2017. (2) Reinvested income and distributions is allocated based on consolidated total distribution rate multiplied by the beginning of period AUM of each client type. (3) Net flows for all periods above have been revised for the inclusion of reinvested income and distributions, and the exclusion of realizations. (4) Realizations include distributions related to the sale of alternative assets, and represent a return on investments. Other activity primarily relates to the decline in billable AUM as a legacy alternative fund transitioned from billing base on committed AUM to net asset value. It is a strategic objective to increase our percentage of assets under management sourced from non-U.S. clients. Our categorization by client location includes: i. U.S.-based clients, where the contracting client is based in the United States, and ii. Non-U.S.-based clients, where the contracting client is based outside the United States. The following table summarizes asset flows by client location for each of the periods indicated: (1) Reflects the removal of Heitman beginning in the third quarter of 2017. (2) Reinvested income and distributions is allocated based on consolidated total distribution rate multiplied by the beginning of period AUM of each client location. (3) Net flows for all periods above have been revised for the inclusion of reinvested income and distributions, and the exclusion of realizations. (4) Realizations include distributions related to the sale of alternative assets, and represent a return on investments. Other activity primarily relates to the decline in billable AUM as a legacy alternative fund transitioned from billing base on committed AUM to net asset value. At December 31, 2019, our total assets under management were $204.4 billion, a decrease of $(1.9) billion or (0.9)% compared to $206.3 billion at December 31, 2018. The assets under management at December 31, 2018 represented a decrease of $(36.7) billion or (15.1)% compared to $243.0 billion at December 31, 2017. The change in assets under management during the year ended December 31, 2019 reflects net market appreciation of $32.1 billion, realizations and other of $(1.3) billion and net outflows of $(32.7) billion including reinvested income and distributions of $5.4 billion. The change in assets under management during the year ended December 31, 2018 reflects net market depreciation of $(30.3) billion, realizations and other of $(2.1) billion and net outflows of $(4.3) billion including reinvested income and distributions of $5.7 billion. In addition to the removal of Heitman, which accounted for a decrease in assets under management of $(32.4) billion, the change in assets under management during the year ended December 31, 2017 reflects net market appreciation of $35.8 billion, realizations and other of $(0.8) billion, and net flows of $0.0 billion including reinvested income and distributions of $5.2 billion. These changes align the definition of AUM with management fees charged to clients. For the year ended December 31, 2019, our net outflows were $(32.7) billion compared to net outflows of $(4.3) billion for the year ended December 31, 2018 and net flows of $0.0 billion for the year ended December 31, 2017. The net outflows for the year ended December 31, 2019 were mainly impacted by the $(22.8) billion reallocation of several Vanguard subadvisory strategies. Reinvested income and distributions of $5.4 billion, $5.7 billion, and $5.2 billion are reflected in the net flows for the years ended December 31, 2019, 2018 and 2017, respectively. For the year ended December 31, 2019, the annualized revenue impact of the net flows decreased to $(69.1) million compared to $19.1 million for the year ended December 31, 2018, including $(34.6) million related to the reallocation of several Vanguard subadvisory strategies. Gross outflows of $(58.8) billion in the year ended December 31, 2019 yielded approximately 27 bps compared to $(37.6) billion in the year ended December 31, 2018 yielded approximately 35 bps, and gross outflows of $(36.2) billion in the year ended December 31, 2017 which yielded approximately 34 bps. U.S. GAAP Results of Operations For the Years Ended December 31, 2019, 2018 and 2017 Our U.S. GAAP results of operations were as follows for the years ended December 31, 2019, 2018 and 2017. (1) Certain Funds have been consolidated due to our seed capital or co-investments in the Funds. (2) U.S. GAAP operating margin equals operating income from continuing operations divided by total revenue. The following table reconciles our net income attributable to controlling interests to our pre-tax income from continuing operations attributable to controlling interests: U.S. GAAP Revenues Our U.S. GAAP revenues principally consist of: i. management fees earned based on our overall weighted average fee rate charged to our clients and the level of assets under management; ii. performance fees earned or management fee adjustments when our Affiliates’ investment performance over agreed time periods for certain clients has differed from pre-determined hurdles; iii. other revenue, consisting primarily of consulting services as well as reimbursement of certain Fund expenses our Affiliates paid on behalf of our Funds; and iv. revenue from consolidated Funds, a portion of which is attributable to the holders of non-controlling interests in consolidated Funds. Management Fees Our management fees are a function of the fee rates our Affiliates charge to their clients, which are typically expressed in basis points, and the levels of our assets under management. Excluding assets managed by our equity-accounted Affiliates, average basis points earned on average assets under management were 37.7 bps for the year ended December 31, 2019, 38.9 bps for the year ended December 31, 2018 and 38.2 bps for the year ended December 31, 2017. The greatest driver of increases or decreases in this average fee rate is changes in the mix of our assets under management caused by net inflows or outflows in certain asset classes, net catch-up fees, or disproportionate market movements. Our average basis points by Segment (including only consolidated Affiliates that are included in management fee revenue, unless indicated) over each of the periods indicated were: (1) Amounts shown are equivalent to ENI management fee revenue. (See “ENI Revenues.”) (2) Average AUM including equity-accounted Affiliates excludes Heitman as of the beginning of the third quarter, 2017. Year ended December 31, 2019 compared to year ended December 31, 2018: Management fees decreased $(98.0) million, or (10.8)%, from $905.0 million for the year ended December 31, 2018 to $807.0 million for the year ended December 31, 2019. The decrease was primarily attributable to a decrease in both average assets under management excluding equity-accounted Affiliates and our weighted average fee rate for the year ended December 31, 2019. The decrease in management fee revenue was also caused by net catch-up fees associated with alternative assets earned in 2018 that did not repeat in 2019. Net catch-up fees represent payment of certain Fund management fees back to the initial closing date for certain products with multiple closings, less placement fees paid to third parties related to these funds. Average assets under management excluding equity-accounted Affiliates decreased (8.0)%, from $232.8 billion for the year ended December 31, 2018 to $214.1 billion for the year ended December 31, 2019, mainly due to equity market decline at the end of 2018 and the impact of the $(22.8) billion reallocation of several Vanguard subadvisory strategies in the fourth quarter of 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Management fees increased $47.0 million, or 5.5%, from $858.0 million for the year ended December 31, 2017 to $905.0 million for the year ended December 31, 2018. The increase was due to higher levels of average assets under management excluding equity-accounted Affiliates, net catch-up fees associated with alternative assets earned in 2018 and continued shift to higher fee-rate products. Net catch-up fees represent payment of certain Fund management fees back to the initial closing date for certain products with multiple closings, less placement fees paid to third parties related to these Funds. Average assets under management excluding equity-accounted Affiliates increased 3.6%, from $224.8 billion for the year ended December 31, 2017 to $232.8 billion for the year ended December 31, 2018. Overall, the increase in management fee revenue is reflective of the increases in basis point yields of our assets under management. Excluding equity-accounted Affiliates, the weighted average fee rate earned on our average assets under management was 38.9 basis points in 2018 and 38.2 basis points in 2017 with the increase driven mostly by the mix of flows and market movements in and out of assets with varying fee rates as well as the higher fee-rate assets under management added as a result of Landmark’s fundraising (including catch-up fees). Performance Fees Approximately $18.2 billion, or 9.0% of our AUM in consolidated Affiliates at December 31, 2019, are in accounts with incentive fee or carried interest features in which we participate. Performance fees are typically shared with our Affiliate key employees through various contractual compensation and profit-sharing arrangements. Year ended December 31, 2019 compared to year ended December 31, 2018: Performance fees decreased $(9.9) million, or (101.0)%, from $9.8 million for the year ended December 31, 2018 to $(0.1) million for the year ended December 31, 2019. Performance fees are variable and are contractually triggered based on investment performance results over agreed upon time periods. The decrease was also attributable to lower performance fees earned by alternative products. Year ended December 31, 2018 compared to year ended December 31, 2017: Performance fees decreased $(16.7) million, or (63.0)%, from $26.5 million for the year ended December 31, 2017 to $9.8 million for the year ended December 31, 2018. Performance fees are variable and are contractually triggered based on investment performance results over agreed upon time periods. The decrease was primarily attributable to performance fees earned on certain products in 2017 that were not repeated in 2018. The liquidation of an alternative product may result in the recognition of a performance fee. With respect to liquidations likely to occur in the near term, we do not expect to receive any net performance fees that would be material to our operating results. These projections are based on market conditions and investment performance as of December 31, 2019. Other Revenue Year ended December 31, 2019 compared to year ended December 31, 2018: Other revenue decreased $(3.6) million, or (37.5)%, from $9.6 million for the year ended December 31, 2018 to $6.0 million for the year ended December 31, 2019. The decrease was primarily attributable to the decrease in revenue recorded for certain Fund expenses paid by our Affiliates and subsequently reimbursed by the Fund for the year ended December 31, 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Other revenue increased $8.4 million, or 700.0%, from $1.2 million for the year ended December 31, 2017 to $9.6 million for the year ended December 31, 2018. The increase was primarily attributable to the adoption of new accounting rules effective January 1, 2018 related to revenue recognition that require us to record as separate revenue and expense certain Fund expenses paid by our Affiliates and subsequently reimbursed by the Fund. These reimbursed costs, amounting to $8.0 million for the year ended December 31, 2018, were recorded on a net basis in prior years. U.S. GAAP Expenses Our U.S. GAAP expenses principally consist of: i. compensation paid to our investment professionals and other employees, including base salary, benefits, sales-based compensation, variable compensation, Affiliate distributions, revaluation of key employee owned Affiliate equity and profit interests, and the amortization of acquisition-related consideration and pre-acquisition employee equity; ii. general and administrative expenses; iii. amortization of acquired intangible assets; iv. depreciation and amortization charges; and v. expenses of consolidated Funds, a portion of which is attributable to the holders of non-controlling interests in consolidated Funds. Compensation and Benefits Expense Our most significant category of expense is compensation and benefits awarded to our and our Affiliates’ employees. The following table presents the components of U.S. GAAP compensation expense for the years ended December 31, 2019, 2018 and 2017: (1) Fixed compensation and benefits include base salaries, payroll taxes and the cost of benefit programs provided. For the year ended December 31, 2019, $189.7 million of fixed compensation and benefits (of the $194.1 million above) is included within economic net income, which excludes Fund expenses initially paid by our Affiliates on the Fund’s behalf and subsequently reimbursed. For the year ended December 31, 2018, $181.4 million of fixed compensation and benefits (of the $188.7 million above) is included within economic net income, which excludes Fund expenses initially paid by our Affiliates on the Fund’s behalf and subsequently reimbursed and also excludes the compensation and benefits associated with the 2018 CEO transition. For the year ended December 31, 2017, $172.4 million of fixed compensation and benefits (of the $172.9 million above) is included within economic net income, which excludes the compensation and benefits associated with the 2017 CEO transition. (2) Sales-based compensation is paid to our and our Affiliates’ sales and distribution teams and represents compensation earned by our sales professionals, paid over a multi-year period, related to revenue earned on new sales. Its variability is based upon the structure of sales-based compensation due on inflows of assets under management and market-based movement in both current and prior periods. (3) Variable compensation is contractually set and calculated individually at each Affiliate, plus Center bonuses and compensation paid by our Affiliates on behalf of their Funds that are subsequently reimbursed. Variable compensation is usually awarded based on a contractual percentage of each Affiliate’s ENI profits before variable compensation and may be paid in the form of cash or non-cash Affiliate equity or profit interests. In Affiliates with an agreed split of performance fees between Affiliate employees and BSUS, the Affiliates’ share of performance fees is allocated entirely to variable compensation. Center variable compensation includes cash and BSIG equity. Non-cash variable compensation awards typically vest over several years and are recognized as compensation expense over that service period. The variable compensation ratio at each Affiliate, calculated as variable compensation divided by ENI earnings before variable compensation, will typically be between 25% and 35%. (a) For the year ended December 31, 2019, $184.7 million of variable compensation expense (of the $199.4 million above) is included within economic net income, which excludes the variable compensation associated with restructuring at the Center and the Affiliates, as well as variable compensation subsequently reimbursed by Funds. For the year ended December 31, 2018, $230.7 million of variable compensation expense (of the $235.9 million above) is included within economic net income, which excludes the variable compensation associated with the 2018 CEO transition costs and variable compensation subsequently reimbursed by Funds. For the year ended December 31, 2017, $243.4 million of variable compensation expense (of the $252.2 million above) is included within economic net income, which excludes the variable compensation associated with the 2017 CEO transition costs. (4) Affiliate key employee distributions represent the share of Affiliate profits after variable compensation that is attributable to Affiliate key employee equity and profit interests holders, according to their ownership interests. For the year ended December 31, 2019, Affiliate key employee distributions included within economic net income is $53.1 million, which includes an adjustment of $8.0 million of variable compensation related to restructuring at an Affiliate that will be reimbursed through a reduction of Affiliate key employee distributions. The Affiliate key employee distribution ratio at each Affiliate is calculated as Affiliate key employee distributions divided by ENI operating earnings at that Affiliate. At certain Affiliates with tiered equity structures, BSUS and other classes of employee equity holders are entitled to an initial proportionate preference over profits after variable compensation, structured such that before a preference threshold is reached, there would be no required key employee distributions to the tiered equity holders, whereas for profits above the threshold the key employee distribution amount to the tiered equity holders would be calculated based on the tiered key employee ownership percentages. Based on current economic arrangements, employee distributions range from approximately 20% to 40% of marginal ENI operating earnings at each of our consolidated Affiliates. (5) Non-cash Affiliate key employee equity revaluations represent changes in the value of Affiliate equity and profit interests held by Affiliate key employees. These ownership interests may in certain circumstances be repurchased by BSUS at a value based on a pre-determined fixed multiple of twelve-month earnings and as such a liability is carried on our balance sheet based on the expected cash to be paid. However, any equity or profit interests repurchased by BSUS can be used to fund a portion of future variable compensation awards, resulting in savings in cash variable compensation that offset the negative cash effect of repurchasing the equity. Our Affiliate equity and profit interest plans have been designed to ensure BSUS is not required to repurchase more equity than we can reasonably recycle through variable compensation awards in any given twelve month period. (6) Included in non-cash Affiliate key employee equity revaluations are revaluations as a result of the Landmark transaction related to contingent consideration amounting to $0.0 million for the year ended December 31, 2019, $95.3 million for the year ended December 31, 2018 and $24.3 million for the year ended December 31, 2017, along with the revaluations of Landmark employee equity owned pre-acquisition amounting to $13.3 million for the year ended December 31, 2019, $37.9 million for the year ended December 31, 2018 and $25.9 million for the year ended December 31, 2017. (7) Acquisition-related consideration and pre-acquisition employee equity represents the amortization of acquisition-related contingent consideration created as a result of the Landmark transaction amounting to $0.0 million for the year ended December 31, 2019, $37.1 million for the year ended December 31, 2018 and $37.1 million in the year ended December 31, 2017, along with the amortization of employee equity owned pre-acquisition amounting to $32.3 million for the year ended December 31, 2019, $33.5 million for the year ended December 31, 2018 and $33.5 million for the year ended December 31, 2017. These items have been included in U.S. GAAP compensation expense as a result of ongoing service requirements for employee recipients. Fluctuations in compensation and benefits expense for the periods presented are discussed below. Year ended December 31, 2019 compared to year ended December 31, 2018: Compensation and benefits expense decreased $(280.2) million, or (40.2)%, from $696.4 million for the year ended December 31, 2018 to $416.2 million for the year ended December 31, 2019. Fixed compensation and benefits increased $5.4 million, or 2.9%, from $188.7 million for the year ended December 31, 2018 to $194.1 million for the year ended December 31, 2019. This increase reflects the growth of the investment teams at our Affiliates and cost of living increases. Variable compensation decreased $(36.5) million, or (15.5)%, from $235.9 million for the year ended December 31, 2018 to $199.4 million for the year ended December 31, 2019 due to lower pre-variable compensation earnings in the current period. Sales-based compensation decreased $(6.2) million, or (35.6)%, from $17.4 million for the year ended December 31, 2018 to $11.2 million for the year ended December 31, 2019, as a result of the structure of sales-based compensation and the timing of asset inflows triggering sales-based compensation in both current and prior periods. Affiliate key employee distributions decreased $(31.5) million, or (41.1)%, from $76.6 million for the year ended December 31, 2018 to $45.1 million for the year ended December 31, 2019 as a result of lower earnings before Affiliate key employee distributions at the consolidated Affiliates and the levered structure of distributions at certain Affiliates. Revaluations of Affiliate key employee equity decreased $(173.1) million in 2019. Amortization of acquisition-related consideration and pre-acquisition equity decreased $(38.3) million, or (54.2)% from $70.6 million for the year ended December 31, 2018 to $32.3 million for the year ended December 31, 2019. The decrease in the revaluations of Affiliate equity was driven by lower earnings at the Affiliates in 2019, while the reduction in the amortization of acquisition-related consideration and pre-acquisition equity was primarily due to the Landmark contingent consideration arrangement that was fully accrued as of December 31, 2018. Year ended December 31, 2018 compared to year ended December 31, 2017: Compensation and benefits expense increased $13.6 million, or 2.0%, from $682.8 million for the year ended December 31, 2017 to $696.4 million for the year ended December 31, 2018. Fixed compensation and benefits increased $15.8 million, or 9.1%, from $172.9 million for the year ended December 31, 2017 to $188.7 million for the year ended December 31, 2018. This increase reflects the growth of the investment teams at our Affiliates and cost of living increases. Variable compensation decreased $(16.3) million, or (6.5)%, from $252.2 million for the year ended December 31, 2017 to $235.9 million for the year ended December 31, 2018 due to lower pre-variable compensation earnings in the current period, as well as the impact of higher severance-related payments in the prior year. Sales-based compensation decreased $(1.2) million, or (6.5)%, from $18.6 million for the year ended December 31, 2017 to $17.4 million for the year ended December 31, 2018, as a result of the structure of sales-based compensation and the timing of asset inflows triggering sales-based compensation in both current and prior periods. Affiliate key employee distributions increased $3.5 million, or 4.8%, from $73.1 million for the year ended December 31, 2017 to $76.6 million for the year ended December 31, 2018 as a result of higher underlying operating earnings and the levered structure of distributions at certain Affiliates. Revaluations of Affiliate equity increased $11.8 million, reflecting the appreciation of key employee ownership interests at certain Affiliates. Acquisition-related consideration and pre-acquisition equity remained unchanged at $70.6 million for the years ended December 31, 2018 and December 31, 2017, and represents amortization of the value of contingent consideration and employee-owned equity, related to Landmark, recorded as compensation under U.S. GAAP due to certain service requirements associated with the arrangements. General and Administrative Expense Year ended December 31, 2019 compared to year ended December 31, 2018: General and administrative expense increased $2.8 million, or 2.2%, from $126.0 million for the year ended December 31, 2018 to $128.8 million for the year ended December 31, 2019. The increase in general and administrative expenses primarily reflects new initiatives, additional system costs and continued investment in the business. Year ended December 31, 2018 compared to year ended December 31, 2017: General and administrative expense increased $13.1 million, or 11.6%, from $112.9 million for the year ended December 31, 2017 to $126.0 million for the year ended December 31, 2018. The increase in general and administrative expenses primarily reflects new initiatives and additional system costs. Amortization of Acquired Intangibles Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Amortization of acquired intangibles expense was unchanged at $6.6 million for the year ended December 31, 2019 and $6.6 million for the year ended December 31, 2018. This expense primarily reflects the amortization of intangible assets acquired in the Landmark transaction. Year ended December 31, 2018 compared to year ended December 31, 2017: Amortization of acquired intangibles expense was unchanged at $6.6 million for the year ended December 31, 2018 and $6.6 million for the year ended December 31, 2017. This expense primarily reflects the amortization of intangible assets acquired in the Landmark transaction. Depreciation and Amortization Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Depreciation and amortization expense increased $2.7 million, or 18.6%, from $14.5 million for the year ended December 31, 2018 to $17.2 million for the year ended December 31, 2019. The increase was primarily related to additional software and technology investments in the business. Year ended December 31, 2018 compared to year ended December 31, 2017: Depreciation and amortization expense increased $2.8 million, or 23.9%, from $11.7 million for the year ended December 31, 2017 to $14.5 million for the year ended December 31, 2018. The increase was primarily related to additional software and technology investments in the business. U.S. GAAP Other Non-Operating Items of Income and Expense Other non-operating items of income and expense consist of: i. investment income; ii. interest income; and iii. interest expense. We recorded $20.0 million in the year ended December 31, 2018, and $51.8 million in the year ended December 31, 2017 of non-operating income associated with the revaluation of our DTA deed with OM plc, discussed further in “-U.S. GAAP Income Tax Expense” below. The DTA deed was fully settled in 2019 at the amount recognized as of December 31, 2018, as such, no additional amounts were recorded in 2019. Investment Income Year ended December 31, 2019 compared to year ended December 31, 2018: Investment income decreased $(49.7) million, or (74.7)%, from $66.5 million for the year ended December 31, 2018 to $16.8 million for the year ended December 31, 2019, primarily due to a $65.7 million gain from the sale of our stake in Heitman that was included in 2018 results and not repeated in 2019. Excluding the gain from the sale of our stake in Heitman, investment income increased $16.0 million as a result of higher returns on co-investments and seed capital investments in 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Investment income increased $39.1 million, or 142.7%, from $27.4 million for the year ended December 31, 2017 to $66.5 million for the year ended December 31, 2018, primarily due to a $65.7 million gain from the sale of our stake in Heitman on January 5, 2018, offset by lower earnings from equity-accounted Affiliates as a result of the Heitman sale, and lower returns on co-investments and seed capital investments in 2018. Interest Income Year ended December 31, 2019 compared to year ended December 31, 2018: Interest income decreased $(1.0) million, or (31.3)%, from $3.2 million for the year ended December 31, 2018 to $2.2 million for the year ended December 31, 2019, principally due to lower average cash balances and a decrease in short-term investment returns in 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Interest income increased $2.4 million, or 300.0%, from $0.8 million for the year ended December 31, 2017 to $3.2 million for the year ended December 31, 2018, principally due to higher average cash balances in 2018. Interest Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Interest expense increased $7.3 million, or 29.3%, from $24.9 million for the year ended December 31, 2018 to $32.2 million for the year ended December 31, 2019, primarily reflecting the utilization of our revolving credit facility and non-recourse seed capital facility during 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Interest expense increased $0.4 million, or 1.6%, from $24.5 million for the year ended December 31, 2017 to $24.9 million for the year ended December 31, 2018, reflecting higher drawdowns on the non-recourse seed capital facility during 2018. U.S. GAAP Income Tax Expense Our effective tax rate has been impacted by changes in liabilities for uncertain tax positions, tax effects of stock-based compensation, limitations on executive compensation, the mix of income earned in the United States versus lower-taxed foreign jurisdictions and benefits from intercompany financing arrangements. Our effective tax rate could be impacted in the future by these items as well as further changes in tax laws and regulations in jurisdictions in which we operate. Tax law changes in both the U.S. and U.K. during the fourth quarter of 2017 contributed to the differences in the effective tax rate in 2018 compared to 2017. In addition, the reduction of liabilities for uncertain tax positions in 2019 and 2018 represents the significant portion of the company’s liabilities for uncertain tax positions. Year ended December 31, 2019 compared to year ended December 31, 2018: Income tax expense increased $13.0 million, from $5.0 million for the year ended December 31, 2018 to $18.0 million for the year ended December 31, 2019, primarily due to the increase in the income from continuing operations before taxes. This increase in income tax expense was partially reduced by the reduction to liabilities for uncertain tax positions due to the lapse of statutes of limitation and adjustments to deferred tax assets in 2019. In 2019, deferred tax assets increased in connection with the Redomestication and an increase in state tax obligations. The effective tax rate increased to 7.1% for the year ended December 31, 2019 from 3.7% for the year ended December 31, 2018 primarily due to the increase in income from continuing operations before taxes and a smaller reduction in 2019 to liabilities for uncertain tax positions due to the lapse of statutes of limitations. These increases to the effective tax rate were partially reduced by the impact of the deferred tax adjustments described above. Year ended December 31, 2018 compared to year ended December 31, 2017: Income tax expense decreased $(127.8) million, or (96.2)%, from $132.8 million for the year ended December 31, 2017 to $5.0 million for the year ended December 31, 2018. The decrease relates primarily to the impact of U.S. tax law changes recorded in 2017, the lower U.S. corporate tax rate in 2018 and the reduction to liabilities for uncertain tax positions in 2018 due to lapses of statutes of limitation. These decreases were partially offset by a reduction to interest expense in the fourth quarter of 2017 due to U.K. tax law changes. The effective tax rate decreased to 3.7% for the year ended December 31, 2018 from 93.5% for the year ended December 31, 2017 due to the impacts of 2017 U.K, and U.S. tax law changes and adjustments to liabilities for uncertain tax positions in 2018. In 2018, the Company agreed to terminate the DTA Deed with OM plc. The Company recorded a revaluation gain of $20.0 million in connection with the settlement of the DTA Deed for the year ended December 31, 2018. This is reflected in income from continuing operations before tax, and is comprised of a $12.6 million discount on the DTA Deed payable and a $7.4 million gain relating to the value of the tax insurance policies transferred to the Company by OM plc. This adjustment to the DTA Deed is not subject to U.K. tax, consequently having the effect of reducing our effective tax rate. In the first quarter of 2019, the final cash payment of $32.7 million was made to OM plc to settle the outstanding liability under the Deed. U.S. GAAP Consolidated Funds The net income or loss of all Consolidated Funds, excluding any income or loss attributable to seed capital or co-investments we make in the Funds, is included in non-controlling interests in our Consolidated Financial Statements and is not included in net income attributable to controlling interests or in management fees. Year ended December 31, 2019 compared to year ended December 31, 2018: Consolidated Funds’ revenue increased $2.8 million, from $3.8 million for the year ended December 31, 2018 to $6.6 million for the year ended December 31, 2019. Consolidated Funds’ expense decreased $(0.5) million, from $0.9 million for the year ended December 31, 2018 to $0.4 million for the year ended December 31, 2019. The increase in consolidated Funds’ revenue and decrease in Consolidated Funds’ expense is due to changes in the population of consolidated Funds during the year ended December 31, 2019. Consolidated Funds’ investment gain (loss) increased $34.3 million from $(13.4) million for the year ended December 31, 2018 to $20.9 million for the year ended December 31, 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Consolidated Funds’ revenue increased $2.1 million, from $1.7 million for the year ended December 31, 2017 to $3.8 million for the year ended December 31, 2018. Consolidated Funds’ expense decreased $(1.5) million, from $2.4 million for the year ended December 31, 2017 to $0.9 million for the year ended December 31, 2018. The increase in consolidated Funds’ revenue and decrease in Consolidated Funds’ expense is due to changes in the population of consolidated Funds during the twelve months ended December 31, 2018. Consolidated Funds’ investment gain (loss) decreased $(28.9) million from $15.5 million for the year ended December 31, 2017 to $(13.4) million for the year ended December 31, 2018. Key U.S. GAAP Operating Metrics The following table shows our key U.S. GAAP operating metrics for the years ended December 31, 2019, 2018 and 2017. The second, third and fourth metrics below have each been adjusted to eliminate the effect of consolidated Funds to more accurately reflect the economics of our Company. (1) Excluding the effect of Funds consolidation in the applicable periods, the U.S. GAAP operating margin would be 30.0% for the year ended December 31, 2019, 8.8% for the year ended December 31, 2018 and 8.1% for the year ended December 31, 2017. (2) Excludes consolidated Funds expense of $0.4 million for the year ended December 31, 2019, $0.9 million for the year ended December 31, 2018 and $2.4 million for the year ended December 31, 2017. (3) Excludes the effect of Funds consolidation for the years ended December 31, 2019, 2018 and 2017. (4) Excludes consolidated Funds revenue of $6.6 million for the year ended December 31, 2019 and $3.8 million for the year ended December 31, 2018 and $1.7 million for the year ended December 31, 2017. (5) The following table identifies the components of operating income before variable compensation and Affiliate key employee distributions, as well as operating income before Affiliate key employee distributions: Effects of Inflation For the years ended December 31, 2019, 2018 and 2017, inflation did not have a material effect on our consolidated results of operations. Non-GAAP Supplemental Performance Measure-Economic Net Income and Segment Analysis As supplemental information, we provide a non-GAAP performance measure that we refer to as economic net income, or ENI, which represents our management’s view of the underlying economic earnings generated by us. We define economic net income as ENI revenue less (i) ENI operating expenses, (ii) variable compensation, (iii) key employee distributions, (iv) net interest and (v) taxes, each as further discussed in this section. ENI adjustments to U.S. GAAP include both reclassifications of U.S. GAAP revenue and expense items, as well as adjustments to U.S. GAAP results, primarily to exclude non-cash, non-economic expenses, or to reflect cash benefits not recognized under U.S. GAAP. ENI is an important measure to investors because it is used by the Company to make resource allocation decisions, determine appropriate levels of investment or dividend payout, manage balance sheet leverage, determine Affiliate variable compensation and equity distributions, and incentivize management. It is also an important measure because it assists management in evaluating our operating performance and is presented in a way that most closely reflects the key elements of our profit share operating model with our Affiliates. For a further discussion of how we use ENI and why ENI is useful to investors, see “-Overview-How We Measure Performance.” To calculate economic net income, we re-categorize certain line items on our Consolidated Statements of Operations to reflect the following: • We exclude the effect of Funds consolidation by removing the portion of Fund revenues, expenses and investment return which were not attributable to our shareholders. • We include within management fee revenue any fees paid to Affiliates by consolidated Funds, which are viewed as investment income under U.S. GAAP. • We include our share of earnings from equity-accounted Affiliates within other income in ENI revenue, rather than investment income. • We treat sales-based compensation as a general and administrative expense, rather than part of fixed compensation and benefits. • We identify separately from operating expenses variable compensation and Affiliate key employee distributions, which represent Affiliate earnings shared with Affiliate key employees. • We net the separate revenue and expenses under U.S. GAAP for certain Fund expenses initially paid by our Affiliates on the Funds’ behalf and subsequently reimbursed, to better reflect the economics of our business. We also make the following adjustments to U.S. GAAP results to more closely reflect our economic results: i. We exclude non-cash expenses representing changes in the value of Affiliate equity and profit interests held by Affiliate key employees. These ownership interests may in certain circumstances be repurchased by BSUS at a value based on a pre-determined fixed multiple of trailing earnings and as such this value is carried on our balance sheet as a liability. Non-cash movements in the value of this liability are treated as compensation expense under U.S. GAAP. However, any equity or profit interests repurchased by BSUS can be used to fund a portion of future variable compensation awards, resulting in savings in cash variable compensation that offset the negative cash effect of repurchasing the equity. Our Affiliate equity and profit interest plans have been designed to ensure BSUS is never required to repurchase more equity than we can reasonably recycle through variable compensation awards in any given twelve month period. ii. We exclude non-cash amortization or impairment expenses related to acquired goodwill and other intangibles as these are non-cash charges that do not result in an outflow of tangible economic benefits from the business. We also exclude the amortization of acquisition-related contingent consideration, as well as the value of employee equity owned pre-acquisition, as occurred as a result of the Landmark transaction, where such items have been included in compensation expense as a result of ongoing service requirements for certain employees. Please note that the revaluations related to these acquisition-related items are included in (i) above. iii. We exclude capital transaction costs, including the costs of raising debt or equity, gains or losses realized as a result of redeeming debt or equity and direct incremental costs associated with acquisitions of businesses or assets. iv. We exclude seed capital and co-investment gains, losses and related financing costs. The net returns on these investments are considered and presented separately from ENI because ENI is primarily a measure of our earnings from managing client assets, which therefore differs from earnings generated by our investments in Affiliate products, which can be variable from period to period. v. We include cash tax benefits associated with deductions allowed for acquired intangibles and goodwill that may not be recognized or have timing differences compared to U.S. GAAP. vi. We exclude the results of discontinued operations attributable to controlling interests since they are not part of our ongoing business, and restructuring costs incurred in continuing operations. vii. We exclude deferred tax resulting from changes in tax law and expiration of statutes, adjustments for uncertain tax positions, deferred tax attributable to intangible assets and other unusual items not related to current operating results to reflect ENI tax normalization. We also adjust our income tax expense to reflect any tax impact of our ENI adjustments. Reconciliation of U.S. GAAP Net Income to Economic Net Income for the Years Ended December 31, 2019, 2018 and 2017 The following table reconciles U.S. GAAP net income attributable to controlling interests to economic net income for the years ended December 31, 2019, 2018 and 2017: (1) Included in non-cash key employee-owned equity and profit interest revaluations are revaluations as a result of the Landmark transaction related to contingent consideration amounting to $0.0 million for the year ended December 31, 2019, $95.3 million for the year ended December 31, 2018 and $24.3 million for the year ended December 31, 2017, along with revaluations of Landmark employee equity owned pre-acquisition amounting to $13.3 million for the year ended December 31, 2019, $37.9 million for the year ended December 31, 2018 and $25.9 million for the year ended December 31, 2017. (2) Acquisition-related consideration and pre-acquisition employee equity includes the amortization of acquisition-related contingent consideration created as a result of the Landmark transaction amounting to $37.1 million for the year ended December 31, 2018 and $37.1 million for the year ended December 31, 2017. It also includes the value of employee equity owned pre-acquisition amounting to $32.3 million for the year ended December 31, 2019, $33.5 million for the year ended December 31, 2018 and $33.5 million for the year ended December 31, 2017. The table below summarizes the Landmark-related components included in items (i) and (ii) of the above reconciliation: (3) The net return on seed/co-investment (gains) losses and financings for the years ended December 31, 2019, 2018 and 2017 are shown in the following table. * The blended rate is based first on the interest rate paid on our non-recourse seed capital facility up to the average amount drawn, and thereafter on the weighted average rate of the long-term debt. (4) Included in discontinued operations and restructuring for the year ended December 31, 2019 are costs related to restructuring at the Center and the Affiliates of $6.7 million, as well as costs associated with the redomicile to the U.S. of $2.5 million. Included in discontinued operations and restructuring for the year ended December 31, 2018 is the gain on sale of Heitman of $(65.7) million, a gain related to the Company’s agreement to terminate its deferred tax asset deed with OM plc of $(20.0) million, CEO transition costs of $4.8 million, comprised of $0.1 million of fixed compensation and benefits, $4.4 million of variable compensation and $0.4 million of other CEO transition costs and restructuring costs associated with its redomicile to the U.S. of $1.6 million. Included in discontinued operations and restructuring for the year ended December 31, 2017 is $1.0 million related to the Heitman transaction and $9.8 million related to CEO transition costs, comprised of $0.5 million of fixed compensation and benefits, $8.8 million of variable compensation and $0.5 million of recruiting costs. (5) Includes an adjustment of $40.8 million in the year ended December 31, 2019 to remove the tax benefit resulting from the reduction in liabilities for uncertain tax positions recorded during the year. Includes an adjustment of $44.0 million in the year ended December 31, 2018 to remove the tax benefit resulting from the reduction in liabilities for uncertain tax positions recorded during the year, partially offset by non-taxable gains resulting from the agreement to terminate the Deferred Tax Asset Deed at a discount. Includes $51.8 million in the year ended December 31, 2017 related to the revaluation of the Deferred Tax Asset Deed with OM plc offset by the $122.7 million impact of the Tax Act. (6) Reflects the sum of line items (i), (ii), (iii), (iv) and the restructuring portion of line item (vi) taxed at the 27.3% U.S. statutory rate in 2019 and 2018 (including state tax) and the 40.2% U.S. statutory rate in 2017 (including state tax). The restructuring portion of line item (vi) amounted to $9.2 million for the year ended December 31, 2019, $(79.3) million for the year ended December 31, 2018 and $10.8 million for the year ended December 31, 2017. The following table reconciles U.S. GAAP net income per share to economic net income per share for the years ended December 31, 2019, 2018 and 2017: Limitations of Economic Net Income Economic net income is the key measure our management uses to evaluate the financial performance of, and make operational decisions for, our business. Economic net income is not audited, and is not a substitute for net income or other performance measures that are derived in accordance with U.S. GAAP. Furthermore, our calculation of economic net income may differ from similarly titled measures provided by other companies. Because the calculation of economic net income excludes certain ongoing expenses, including amortization expense and certain compensation costs, it has certain material limitations and should not be viewed in isolation or as a substitute for U.S. GAAP measures of earnings. ENI Revenues The following table reconciles U.S. GAAP Revenue to ENI Revenue for the years ended December 31, 2019, 2018 and 2017: (1) Includes $12.0 million related to Heitman for the year ended December 31, 2017. The following table identifies the components of ENI revenue: (1) ENI management fees correspond to U.S. GAAP management fees. (2) ENI performance fees correspond to U.S. GAAP performance fees. (3) ENI other income is comprised primarily of other revenue under U.S. GAAP, plus our earnings from equity-accounted Affiliates of $2.8 million for the year ended December 31, 2019, $2.7 million for the year ended December 31, 2018 and $14.5 million for the year ended December 31, 2017. Other income also excludes certain Fund expenses initially paid by our Affiliates on the Funds’ behalf that are subsequently reimbursed. Refer to “-Non-GAAP Supplemental Performance Measure-Economic Net Income and Segment Analysis” for a full discussion regarding the items excluded from the calculation of economic net income. (a) Includes $12.0 million related to Heitman for the year ended December 31, 2017. ENI Operating Expenses The largest difference between U.S. GAAP operating expense and ENI operating expense relates to compensation. As shown in the following reconciliation, the Company excludes the impact of key employee equity revaluations. We also exclude the amortization of contingent purchase price and pre-acquisition equity owned by employees, both with a service requirement, associated with the Landmark acquisition. Variable compensation and Affiliate key employee distributions are also segregated out of U.S. GAAP operating expense in order to align with the manner in which these items are contractually calculated at the Affiliate level. The following table reconciles U.S. GAAP operating expense to ENI operating expense for the years ended December 31, 2019, 2018 and 2017: (1) Included in restructuring for the year ended December 31, 2019 are restructuring costs at the Center and the Affiliates of $6.7 million and costs associated with the redomicile to the U.S. of $2.5 million. Included in restructuring for the year ended December 31, 2018 are $1.6 million of costs associated with the planned redomicile to the U.S. and 2018 CEO transition costs of $4.8 million. Included in restructuring for the year ended December 31, 2017 is $1.0 million related to the Heitman transaction and 2017 CEO transition costs of $9.8 million. (2) For the year ended December 31, 2019, excludes variable compensation related to restructuring at the Center and the Affiliates of $6.7 million that is included within Restructuring costs, as well as $8.0 million variable compensation related to restructuring at an Affiliate that will be reimbursed through a reduction of Affiliate key employee distributions. For the year ended December 31, 2018, excludes variable compensation amounts related to CEO transition of $4.4 million that is included within Restructuring costs, and Fund expenses reimbursed by customers of $0.8 million. For the year ended December 31, 2017, excludes variable compensation amounts related to CEO transition of $8.8 million that is included within Restructuring costs. (3) For the year ended December 31, 2019, includes an adjustment of $8.0 million, representing the amount of variable compensation related to restructuring at an Affiliate that will be reimbursed through a reduction in Affiliate key employee distributions. The following table identifies the components of ENI operating expense: (1) Fixed compensation and benefits include base salaries, payroll taxes and the cost of benefit programs provided. The following table reconciles U.S. GAAP compensation expense for the years ended December 31, 2019, 2018 and 2017 to ENI fixed compensation and benefits expense: (a) Compensation related to restructuring for the year ended December 31, 2019 is comprised of $6.7 million of variable compensation associated with restructuring at the Center and the Affiliates. Compensation related to restructuring for the year ended December 31, 2018 is comprised of $4.5 million of compensation associated with the 2018 CEO transition, which includes $0.1 million of fixed compensation and benefits and $4.4 million of variable compensation. Compensation related to restructuring for the year ended December 31, 2017 is comprised of $9.3 million of compensation associated with the 2017 CEO transition, which includes $0.5 million of fixed compensation and benefits and $8.8 million of variable compensation. (2) The following table reconciles U.S. GAAP general and administrative expense to ENI general and administrative expense: (a) Reflects $2.5 million related to our redomicile to the U.S. in the year ended December 31, 2019. Reflects $1.6 million related to our redomicile to the U.S. and $0.4 million of CEO transition costs in the year ended December 31, 2018. Reflects $1.0 million related to the Heitman transaction and $0.5 million of CEO recruiting costs in the year ended December 31, 2017. Key Non-GAAP Operating Metrics The following table shows our key non-GAAP operating metrics for the years ended December 31, 2019, 2018 and 2017. We present these metrics because they are the measures our management uses to evaluate the profitability of our business and are useful to investors because they represent the key drivers and measures of economic performance within our business model. Please see the footnotes below for an explanation of each ratio, its usefulness in measuring the economics and operating performance of our business, and a reference to the most closely related U.S. GAAP measure: (1) ENI operating earnings represents ENI earnings before Affiliate key employee distributions and is calculated as ENI revenue, less ENI operating expense, less ENI variable compensation. It differs from economic net income because it does not include the effects of Affiliate key employee distributions, net interest expense or income tax expense. The following table reconciles U.S. GAAP operating income (loss) to ENI operating earnings: (a) Included in restructuring for the year ended December 31, 2019 are $6.7 million of restructuring costs at the Center and the Affiliates and $2.5 million of costs incurred in connection with the redomicile to the U.S. Included in restructuring for the year ended December 31, 2018 is $4.8 million related to 2018 CEO transition costs and $1.6 million of costs incurred in connection with the redomicile to the U.S. Included in restructuring for the year ended December 31, 2017 is $1.0 million related to the Heitman transaction and $9.8 million related to the 2017 CEO transition costs, comprised of $0.5 million of fixed compensation and benefits, $8.8 million of variable compensation and $0.5 million of recruiting costs. (2) The ENI operating margin, which is calculated before Affiliate key employee distributions, is used by management and is useful to investors to evaluate the overall operating margin of the business without regard to our various ownership levels at each of the Affiliates. The ENI operating margin is most comparable to our U.S. GAAP operating margin (excluding the effect of consolidated Funds) of 30.0% for the year ended December 31, 2019, 8.8% for the year ended December 31, 2018 and 8.1% for the year ended December 31, 2017. The ENI operating margin is important because it gives investors an understanding of the profitability of the total business relative to revenue, irrespective of the ownership position which BSIG has in each of its Affiliates. Management and investors use this ratio when comparing our profitability relative to our peer group and evaluating our ability to manage the cost structure and profitability of our business under different operating environments. (3) ENI Management fee revenue corresponds to U.S. GAAP management fee revenue. (4) The ENI operating expense ratio is used by management and is useful to investors to evaluate the level of operating expense as measured against our recurring management fee revenue. We have provided this ratio since many operating expenses, including fixed compensation and benefits and general and administrative expense, are generally linked to the overall size of the business. We track this ratio as a key measure of scale economies at BSIG because in our profit sharing economic model, scale benefits both the Affiliate employees and BSIG shareholders. The ENI operating expense ratio is most comparable to the U.S. GAAP operating expense / management fee revenue ratio. (5) ENI earnings before variable compensation is calculated as ENI revenue, less ENI operating expense. (6) The ENI variable compensation ratio is used by management and is useful to investors to evaluate consolidated variable compensation as measured against our ENI earnings before variable compensation. Variable compensation is contractually set and calculated individually at each Affiliate, plus Center bonuses. Variable compensation is usually awarded based on a contractual percentage of each Affiliate’s ENI earnings before variable compensation and may be paid in the form of cash or non-cash Affiliate equity or profit interests. Center variable compensation includes cash and BSIG equity. Non-cash variable compensation awards typically vest over several years and are recognized as compensation expense over that service period. The variable compensation ratio at each Affiliate, calculated as variable compensation divided by ENI earnings before variable compensation, will typically be between 25% and 35%. The ENI variable compensation ratio is most comparable to the U.S. GAAP variable compensation ratio. (7) The ENI Affiliate key employee distribution ratio is used by management and is useful to investors to evaluate Affiliate key employee distributions as measured against our ENI operating earnings. Affiliate key employee distributions represent the share of Affiliate profits after variable compensation that is attributable to Affiliate key employee equity and profit interests holders, according to their ownership interests. The Affiliate key employee distribution ratio at each Affiliate is calculated as Affiliate key employee distributions divided by ENI operating earnings at that Affiliate. At certain Affiliates with tiered equity structures, BSUS and other classes of employee equity holders are entitled to an initial proportionate preference over profits after variable compensation, structured such that before a preference threshold is reached, there would be no required key employee distributions to the tiered equity holders, whereas for profits above the threshold the key employee distribution amount to the tiered equity holders would be calculated based on the tiered key employee ownership percentages. Based on current economic arrangements, employee distributions range from approximately 20% to 40% of marginal ENI operating earnings at each of our consolidated Affiliates. The ENI Affiliate key employee distributions ratio is most comparable to the U.S. GAAP Affiliate key employee distributions ratio. Tax on Economic Net Income The following table reconciles the United States statutory tax to tax on economic net income: (1) Includes interest income and third party ENI interest expense, as shown in the following table: (a) Other ENI interest expense exclusions represent cost of financing on seed capital and co-investments. Other ENI interest expense includes $8.8 million related to the cost of seed and co-investment financing and $0.2 million related to the amortization of debt issuance costs for the year ended December 31, 2019. (b) ENI earnings after Affiliate key employee distributions is calculated as ENI operating income (ENI revenue, less ENI operating expense, less ENI variable compensation), less Affiliate key employee distributions. Refer to “-Key Non-GAAP Operating Metrics” for a reconciliation from U.S. GAAP operating income to ENI earnings after Affiliate key employee distributions. (2) Taxed at U.S. Federal and State statutory rate of 27.3% for the years ended December 31, 2019 and 2018, and 40.2% for the year ended December 31, 2017. (3) The economic net income effective tax rate is calculated by dividing the tax on economic net income by pre-tax economic net income. Segment Analysis We conduct our operations through three business segments: Quant & Solutions, Alternatives and Liquid Alpha. Effective for the third quarter 2019, we began reporting the following business segments: • Quant & Solutions-comprised of versatile, often highly-tailored strategies that leverage data and technology in a computational, factor based investment process across a range of asset classes and geographies, including Global, non-U.S., emerging markets and managed volatility equities, as well as multi-asset products. • Alternatives-comprised of illiquid and differentiated liquid investment strategies that include private equity, real estate and real assets, including forestry, as well as a growing suite of liquid alternative capabilities in areas such as long/short, market neutral and absolute return. • Liquid Alpha-comprised of specialized investment strategies with a focus on alpha-generation across market cycles in long-only small-, mid-, and large-cap U.S., global, non-U.S. and emerging markets equities, as well as fixed income. We have a corporate head office that is included in “Other”. The corporate head office supports the segments by providing infrastructure and administrative support in the areas of accounting/finance, operations, information technology, strategy and relationship management, legal, compliance and human resources. The corporate head office expenses are not allocated to the Company’s three reportable segments but the CODM does consider the cost structure of the corporate head office when evaluating the financial performance of the segments. The primary measure used by the CODM in measuring performance and allocating resources to the segments is Economic Net Income ("ENI"). We define economic net income for the segments as ENI revenue less (i) ENI operating expenses, (ii) variable compensation and (iii) key employee distributions. The ENI adjustments to U.S. GAAP include both reclassifications of U.S. GAAP revenue and expense items, as well as adjustments to U.S. GAAP results, primarily to exclude non-cash, non-economic expenses, or to reflect cash benefits not recognized under U.S. GAAP. ENI revenue includes management fees, performance fees and other revenue under U.S. GAAP, adjusted to include management fees paid to Affiliates by consolidated Funds and the Company’s share of earnings from equity-accounted Affiliates. ENI revenue is also adjusted to exclude the separate revenues recorded under U.S. GAAP for certain Fund expenses reimbursed to our Affiliates. ENI operating expenses include compensation and benefits, general and administrative expense, and depreciation and amortization under U.S. GAAP, adjusted to exclude non-cash expenses representing changes in the value of Affiliate equity and profit interests held by Affiliate key employees, non-cash amortization of acquisition-related contingent consideration, as well as the value of employee equity owned pre-acquisition, that occurred as a result of the Landmark transaction, and the separate expenses recorded under U.S. GAAP for certain Fund expenses reimbursed to our Affiliates. Additionally, variable compensation and Affiliate key employee distributions are segregated from ENI operating expenses. ENI segment results are also adjusted to exclude the portion of consolidated Fund revenues, expenses and investment return recorded under U.S. GAAP. Refer to the reconciliations of U.S. GAAP revenue to ENI revenue, U.S. GAAP Operating expense to ENI Operating expense, variable compensation and Affiliate key employee distributions disclosed previously within this section. Segment ENI Revenue The following tables identify the components of segment ENI revenue for the years ended December 31, 2019, 2018 and 2017: Quant & Solutions Segment ENI Revenue Year ended December 31, 2019 compared to year ended December 31, 2018: Quant & Solutions ENI revenue decreased $(8.4) million, or (2.2)%, from $389.0 million for the year ended December 31, 2018 to $380.6 million for the year ended December 31, 2019. The decrease was attributable to (1.7)% lower management fees, driven by lower average AUM resulting from the fourth quarter 2018 non-U.S. equity market depreciation and (15.5)% lower performance fees driven by underperformance in value-tilted global and non-U.S. strategies in the year ended December 31, 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Quant & Solutions ENI revenue increased $20.5 million, or 5.6%, from $368.5 million for the year ended December 31, 2017 to $389.0 million for the year ended December 31, 2018. The increase was attributable to 9.4% higher management fees, driven by higher average AUM resulting from 2017 equity market appreciation. The increase in management fees was slightly offset by the (50.6)% decrease in performance fees driven by large incentive fees for certain strategies not repeating during the year ended December 31, 2018. Alternatives Segment ENI Revenue Year ended December 31, 2019 compared to year ended December 31, 2018: Alternatives ENI revenue decreased $(51.6) million, or (23.7)%, from $218.1 million for the year ended December 31, 2018 to $166.5 million for the year ended December 31, 2019. The decrease was attributable to (20.8)% lower management fees mainly resulting from placement agent fees paid in 2019, and (96.5)% lower performance fees during the year ended December 31, 2019 due to the real assets strategy as the valuation for certain properties increased in the year ended December 31, 2018, but stayed generally flat in the year ended December 31, 2019. Year ended December 31, 2018 compared to year ended December 31, 2017: Alternatives ENI revenue increased $32.0 million, or 17.2%, from $186.1 million for the year ended December 31, 2017 to $218.1 million for the year ended December 31, 2018. The increase was attributable to 21.3% higher management fees resulting from net catch-up fees associated with assets earned in 2018 and the continued shift to higher fee-rate products. The increase was partially offset by (28.0)% lower performance fees during the year ended December 31, 2018 due to performance fees earned on a product in 2017 that was not repeated in 2018. Liquid Alpha Segment ENI Revenue Year ended December 31, 2019 compared to year ended December 31, 2018: Liquid Alpha ENI revenue decreased $(47.8) million, or (15.3)%, from $311.6 million for the year ended December 31, 2018 to $263.8 million for the year ended December 31, 2019. The decrease was attributable to (15.1)% lower management fees driven by fourth quarter 2018 equity market decline and net outflows in 2019. Performance fees were relatively flat for the year ended December 31, 2019 compared to the year ended December 31, 2018. Year ended December 31, 2018 compared to year ended December 31, 2017: Liquid Alpha ENI revenue decreased $(23.5) million, or (7.0)%, from $335.1 million for the year ended December 31, 2017 to $311.6 million for the year ended December 31, 2018. The decrease was attributable to (6.4)% lower management fees driven by lower average AUM. Performance fees decreased (17.0)% for the year ended December 31, 2018 compared to the year ended December 31, 2017 largely due to lower performance fees from certain sub-advisory accounts. Segment ENI Expense The following tables identify the components of segment ENI expense for the years ended December 31, 2019, 2018 and 2017: Quant & Solutions Segment ENI Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Quant & Solutions ENI operating expense increased $14.3 million, or 9.8%, from $146.3 million for the year ended December 31, 2018 to $160.6 million for the year ended December 31, 2019. The increase was driven by 9.1% higher ENI fixed compensation and benefits expense resulting from new hires for initiatives and annual cost of living increases, and 8.4% higher ENI general and administrative expense resulting from new initiatives and additional system costs. Quant & Solutions ENI variable compensation expense, which is based on contractual arrangements, decreased (12.3)%, as a result of lower pre-variable compensation earnings. Affiliate key employee distributions attributable to Quant & Solutions decreased (32.6)%, largely driven by levered distribution structures at certain Affiliates. Year ended December 31, 2018 compared to year ended December 31, 2017: Quant & Solutions ENI operating expense increased $19.7 million, or 15.6%, from $126.6 million for the year ended December 31, 2017 to $146.3 million for the year ended December 31, 2018. The increase was driven by 11.0% higher ENI fixed compensation and benefits expense resulting from new hires for initiatives and annual cost of living increases, and 17.8% higher ENI general and administrative expense resulting from new initiatives, additional system costs and the overall growth of the business. Quant & Solutions ENI variable compensation expense, which is based on contractual arrangements, increased 8.8%, as a result of higher pre-variable compensation earnings. Affiliate key employee distributions attributable to Quant & Solutions increased 10.5%, largely driven by higher profit after variable compensation. Alternatives Segment ENI Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Alternatives ENI operating expense increased $5.1 million, or 8.3%, from $61.8 million for the year ended December 31, 2018 to $66.9 million for the year ended December 31, 2019. The increase was driven by 16.5% higher ENI fixed compensation and benefits expense resulting from new hires and annual cost of living increases. Alternatives ENI variable compensation expense, which is based on contractual arrangements, decreased (37.7)%, as a result of lower pre-variable compensation earnings. Affiliate key employee distributions attributable to Alternatives decreased (32.6)%, largely driven by lower profit after variable compensation. Year ended December 31, 2018 compared to year ended December 31, 2017: Alternatives ENI operating expense increased $4.4 million, or 7.7%, from $57.4 million for the year ended December 31, 2017 to $61.8 million for the year ended December 31, 2018. The increase was driven by 2.7% higher ENI fixed compensation and benefits expense resulting from new hires and annual cost of living increases and by 20.6% higher ENI general and administrative expense resulting from higher system costs. Alternatives ENI variable compensation expense, which is based on contractual arrangements, increased 20.9%, as a result of higher pre-variable compensation earnings. Affiliate key employee distributions attributable to Alternatives increased 27.2%, largely driven by higher profit after variable compensation. Liquid Alpha Segment ENI Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Liquid Alpha ENI operating expense decreased $(5.7) million, or (6.7)%, from $84.5 million for the year ended December 31, 2018 to $78.8 million for the year ended December 31, 2019. The decrease was driven by (1.8)% lower ENI fixed compensation and benefits expense resulting from headcount reduction and (14.4)% lower ENI general and administrative expense mainly resulting from lower commissions and other general expenses. Liquid Alpha ENI variable compensation expense, which is based on contractual arrangements, decreased (15.6)%, as a result of lower pre-variable compensation earnings. Affiliate key employee distributions attributable to Liquid Alpha decreased (28.2)%, largely driven by lower profit after variable compensation. Year ended December 31, 2018 compared to year ended December 31, 2017: Liquid Alpha ENI operating expense increased $2.4 million, or 2.9%, from $82.1 million for the year ended December 31, 2017 to $84.5 million for the year ended December 31, 2018. The increase was driven by 9.2% higher ENI fixed compensation and benefits expense resulting from headcount increase slightly offset by (5.5)% lower ENI general and administrative expense resulting from lower commissions and other general expenses. Liquid Alpha ENI variable compensation expense, which is based on contractual arrangements, decreased (15.0)%, as a result of lower pre-variable compensation earnings. Affiliate key employee distributions attributable to Liquid Alpha decreased (12.5)%, largely driven by levered distribution structures at certain Affiliates. Other ENI Expense Year ended December 31, 2019 compared to year ended December 31, 2018: Other ENI operating expense decreased $(7.7) million or (17.9)%, from $43.1 million for the year ended December 31, 2018 to $35.4 million for the year ended December 31, 2019. The decrease was driven by (19.2)% lower fixed compensation and benefit expense resulting from a reduction in headcount, and (17.4)% lower general and administrative expense resulting from cost-saving initiatives. Other ENI variable compensation expense decreased (14.5)% which was driven by a reduction in headcount. Year ended December 31, 2018 compared to year ended December 31, 2017: Other ENI operating expense decreased $(4.9) million, or (10.2)%, from $48.0 million for the year ended December 31, 2017 to $43.1 million for the year ended December 31, 2018. The decrease was driven by (15.4)% lower fixed compensation and benefit expense resulting from a reduction in headcount, and (5.2)% lower general and administrative expense resulting from cost-saving initiatives. Other ENI variable compensation expense decreased (59.1)% due to lower pre-variable compensation earnings in the year ended December 31, 2018, as well as the impact of higher severance-related payments in the year ended December 31, 2017. Capital Resources and Liquidity Cash Flows The following table summarizes certain key financial data relating to cash flows. All amounts presented exclude consolidated Funds: (1) Excludes consolidated Funds. (2) Cash flow data shown only includes cash flows from continuing operations. Our most significant uses of cash include third-party interest payments, repurchases of shares, payments made to OM plc under the Deferred Tax Asset Deed, seed capital purchased from OM plc, dividends and compensation and general and administrative expenses. Comparison for the Years Ended December 31, 2019, 2018 and 2017 Net cash (used in) provided by operating activities of continuing operations excluding consolidated Funds decreased $(358.9) million, or (142.3)%, from $252.3 million for the year ended December 31, 2018 to $(106.6) million for the year ended December 31, 2019. The decrease was primarily driven by a decrease in operating liabilities as the Landmark earnout was settled in the year ended December 31, 2019. Net cash provided by operating activities of continuing operations excluding consolidated Funds increased $27.4 million, from $224.9 million for the year ended December 31, 2017 to $252.3 million for the year ended December 31, 2018. The increase was primarily driven by net income and non-cash charges, offset by gain on the sale of Heitman and changes in operating assets and liabilities. Net cash (used in) provided by investing activities was $17.7 million, $57.6 million and $(10.8) million for the years ended December 31, 2019, 2018 and 2017, respectively. Net cash (used in) received from the (purchase) and sale of investments was $46.6 million, $(25.7) million and $4.8 million for the years ended December 31, 2019, 2018 and 2017, respectively. Fluctuations are principally due to the timing of investments or redemptions of seed capital as well as acquisitions or disposals of real estate and forestry assets in which we are co-investing. Net cash (used in) the purchase of fixed assets was $(33.9) million, $(21.7) million and $(13.7) million for the years ended December 31, 2019, 2018 and 2017, respectively. Net cash (used in) financing activities, excluding consolidated Funds, consists of share repurchases, payments made to OM plc, third-party borrowings and dividends paid. Cash (used in) financing activities was $(140.4) million, $(155.6) million and $(129.8) million for the years ended December 31, 2019, 2018 and 2017, respectively. We drew net $175.0 million against third party borrowings in 2019, we paid down $(33.5) million against third party borrowings in 2018 and we drew net $33.5 million against third party borrowings in 2017. In 2019 we made payments of $(37.8) million against amounts previously owed to OM plc for the co-investment arrangement, funded $(239.8) million for share repurchases, and paid out $(36.0) million in dividends. In 2018 we paid $(3.9) million against amounts previously owed to OM plc for the co-investment arrangement, funded $(71.2) million for share repurchases, and paid out $(42.5) million in dividends. In 2017 we paid $(42.5) million against third party borrowings, $(50.4) million against amounts previously owed to OM plc (including $(45.6) million for the deferred tax arrangement and $(4.8) million for the co-investment arrangement), funded $(74.1) million for share repurchases and paid out $(38.8) million in dividends. Working Capital and Long-Term Debt The following table summarizes certain key financial data relating to our capital resources and liquid net assets. All amounts presented exclude the non-controlling interest portion of consolidated Funds: (1) Excludes the non-controlling interest portion of consolidated Funds. (2) Excluded from other short-term liabilities for each of the years presented is an income tax reserve relating to net operating losses that does not represent a current obligation of the Company. Puts related to Affiliate equity and profits interests are also excluded on a short-term basis because they are funded through recycling. Working capital is defined as current assets less current liabilities, excluding the non-controlling interest portion of consolidated Funds. Our net working capital has been positive over the past several years and was $204.9 million at December 31, 2019. Our most significant current liabilities have been accounts payable and accrued compensation expense. Accrued compensation expense has primarily consisted of variable compensation accruals made throughout the year based on contractual arrangements. Our cash management practices generally require that working capital be maintained at each Affiliate at a sufficient level to meet short-term operational needs. Periodic distributions of Affiliate earnings to BSUS and Affiliate key employee equity holders are made according to respective Affiliate distribution policies, with BSUS having the ability to access any surplus cash at each Affiliate as necessary during interim periods. Borrowings and Long-Term Debt The following table summarizes our financing arrangements as of the dates indicated: Third party borrowings Revolving Credit Facility On August 20, 2019, we entered into a $450.0 million senior unsecured revolving credit facility with Citibank, as administrative agent and issuing bank, and RBC Capital Markets and BMO Capital Markets Corp. as joint lead arrangers and joint book runners (the “Credit Facility”). Subject to certain conditions, we may borrow up to an additional $150 million under the Credit Facility. The Credit Facility has a maturity date of August 22, 2022. The previous revolving credit facility with Citibank with maturity date of October 15, 2019 was terminated. Upon entry into the Credit Facility, we made an initial drawdown of $210.0 million under the Credit Facility to fully repay the $210.0 million outstanding under its existing credit facility. We paid down $70.0 million of the amount outstanding under the Credit Facility during the third and fourth quarters of 2019. Borrowings under the Credit Facility bear interest, at our option, are at either the per annum rate equal to (a) the greatest of (i) the prime rate, (ii) the federal funds effective rate plus 0.5% and (iii) the one month Adjusted LIBO Rate plus 1.0%, plus, in each case an additional amount based on its credit rating or (b) the London interbank offered rate for a period, at our, equal to one, two, three or six months plus an additional amount ranging from 1.125% to 2.0%, with such additional amount based on its credit rating. In addition, we are charged a commitment fee based on the average daily unused portion of the Credit Facility at a per annum rate ranging from 0.125% to 0.45%, with such amount based on our credit rating. Under the Credit Facility, the ratio of third-party borrowings to trailing twelve months Adjusted EBITDA cannot exceed 3.0x, and the interest coverage ratio must not be less than 4.0x. At December 31, 2019, our ratio of third-party borrowings to trailing twelve months Adjusted EBITDA was 2.1x and our interest coverage ratio was 7.7x. At December 31, 2019 our ratio of third party borrowings net of total cash and cash equivalents to trailing twelve months Adjusted EBITDA was 1.7x. Moody’s Investor Service, Inc. and Standard & Poor’s each assigned an initial investment-grade rating to our senior, unsecured long-term indebtedness. As a result of the assignment of the credit ratings, our interest rate on outstanding borrowings was set at LIBOR + 1.50% and the commitment fee on the unused portion of the revolving credit facility was set at 0.20%. Senior Notes In July 2016, we issued $275.0 million of 4.80% Senior Notes due 2026 (the “2026 Notes”) and $125.0 million of 5.125% Senior Notes due 2031 (the “2031 Notes”). We used the net proceeds of these offerings to finance the acquisition of Landmark in August 2016, purchase seed capital from OM plc, settle a Treasury rate lock contract and pay down the balance of the previous revolving credit facility. 4.80% Senior Notes Due July 2026 The $275.0 million 2026 Notes were sold at a discount of $(0.5) million and we incurred debt issuance costs of $(3.0) million, which are being amortized to interest expense over the ten-year term. The 2026 Notes can be redeemed at any time prior to the scheduled maturity in part or in aggregate, at the greater of 100% of the principal amount at that time or the sum of the remaining scheduled payments discounted at the treasury rate (as defined) plus 0.5%, together with any related accrued and unpaid interest. 5.125% Senior Notes Due August 2031 The $125.0 million 2031 Notes incurred debt issuance costs of $(4.3) million, which are being amortized to interest expense over the fifteen-year term. The 2031 Notes can be redeemed at any time, on or after August 1, 2019, at a redemption price equal to 100.0% of the principal amount together with any related accrued and unpaid interest. Non-recourse seed capital facility In July 2017, we entered into a non-recourse seed capital facility collateralized by our seed capital holdings and can borrow up to $65.0 million, so long as the borrowing does not represent more than 50% of the value of the seed capital collateral. At December 31, 2019, amounts outstanding under this non-recourse seed capital facility amounted to $35.0 million. Since this facility is non-recourse to us beyond the seed investments themselves, drawdowns under this facility are excluded from our third party debt levels for purposes of calculating our credit ratio covenants under the Credit Facility. Other Long-term Liabilities Other long-term liabilities principally consist of cash-settled Affiliate equity and profit interests liabilities held by certain Affiliate key employees, and voluntary deferred compensation plans. The following table summarizes our other long-term liabilities: Share-based payments liability represents the value of Affiliate key employee-owned equity that may under certain circumstances be repurchased by us that is considered an equity award under U.S. GAAP based on the terms and conditions attached to these interests. Profit interests represent the value of Affiliate key employee-owned equity that may under certain circumstances be repurchased by us that is not considered an equity award under U.S. GAAP, but rather a form of compensation arrangement, based on the terms and conditions attached to these interests. Our obligation in any given period in respect of funding these potential repurchases of Affiliate equity is limited to only that portion that may be put to us by Affiliate key employees, which is typically capped annually under the terms of these arrangements such that we are not required to repurchase more than we can reasonably recycle by re-granting the interests in lieu of cash variable compensation owed to Affiliate key employees. Certain of our and our Affiliates’ key employees are eligible to participate in our voluntary deferral plan, or VDP, which provides our senior personnel the opportunity to voluntarily defer a portion of their compensation. There is a voluntary deferral plan investment balance included in investments on the Consolidated Balance Sheets that corresponds to this deferral liability. For additional discussion of our compensation programs, please refer to the compensation discussions contained within our definitive proxy statement for our 2020 annual meeting of shareholders incorporated herein by reference. Supplemental Liquidity Measure-Adjusted EBITDA As supplemental information, we provide information regarding Adjusted EBITDA, which we define as economic net income before interest, income taxes, depreciation and amortization. Adjusted EBITDA is a non-GAAP liquidity measure that we provide in addition to, but not as a substitute for, cash flows from operating activities. It should be noted that our calculation of Adjusted EBITDA may not be consistent with Adjusted EBITDA as calculated by other companies. We believe Adjusted EBITDA is a useful liquidity metric because it indicates our ability to make further investments in our business, service debt and meet working capital requirements. It is also encapsulated in our line of credit as part of our liquidity covenants. The following table reconciles our U.S. GAAP net income attributable to controlling interests to EBITDA to Adjusted EBITDA to economic net income for the years ended December 31, 2019, 2018 and 2017: (1) Included in restructuring for the year ended December 31, 2019 are $6.7 million of restructuring costs at the Center and Affiliates and $2.5 million of costs incurred in connection with our redomicile to the U.S. Included in restructuring for the year ended December 31, 2018 is the gain on the sale of Heitman of $65.7 million, $1.6 million of costs associated with our redomicile and $4.8 million related to the 2018 CEO transition. Included in restructuring for the year ended December 31, 2017 is $1.0 million related to the Heitman transaction and $9.8 million related to CEO transition costs, comprised of $0.5 million of fixed compensation and benefits, $8.8 million of variable compensation and $0.5 million of recruiting costs. For a full discussion regarding the items excluded from Adjusted EBITDA above and the calculation of economic net income, refer to “-Non-GAAP Supplemental Performance Measure-Economic Net Income and Segment Analysis.” Limitations of Adjusted EBITDA As a non-GAAP, unaudited liquidity measure and derivation of EBITDA, Adjusted EBITDA has certain material limitations. It does not include cash costs associated with capital transactions and excludes certain U.S. GAAP expenses that fall outside the definition of EBITDA. Each of these categories of expense represents costs to us of doing business, and therefore any measure that excludes any or all of these categories of expense has material limitations. Future Capital Needs We believe that our available cash and cash equivalents to be generated from operations, supplemented by short-term and long-term financing, as necessary, will be sufficient to fund current operations and capital requirements for at least the next twelve months, as well as our day-to-day operations and future investment requirements. Our ability to secure short-term and long-term financing in the future will depend on several factors, including our future profitability, our relative levels of debt and equity and the overall condition of the credit markets. Commitments, Contingencies and Off-Balance Sheet Obligations Indemnifications In the normal course of business, such as through agreements to enter into business combinations with and divestitures of Affiliates, we occasionally enter into contracts that contain a variety of representations and warranties and which provide general indemnifications. Our maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against us that have not yet occurred. Off-Balance Sheet Obligations Off-balance sheet arrangements, as defined by the SEC, include certain contractual arrangements pursuant to which a company has an obligation, such as certain contingent obligations, certain guarantee contracts, retained or contingent interests in assets transferred to an unconsolidated entity, certain derivative instruments classified as equity or material variable interests in unconsolidated entities that provide financing, liquidity, market risk or credit risk support. Disclosure is required for any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, results of operations, liquidity or capital resources. We generally do not enter into off-balance sheet arrangements, other than those described in “Contractual Obligations” as well as Note 5 to our Consolidated Financial Statements included in Item 8 herein, “Variable Interest Entities.” Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2019: (1) Amounts due to OM plc is comprised of $3.7 million owed under the co-investment deed. (2) Includes an operating lease for office space with expected lease obligations of approximately $7.5 million that was entered into during the fourth quarter of 2019, but has not yet commenced. See Item 8, Financial Statements and Supplementary Data - Note 8, “ Leases”. (3) Represents the mortgage on a building owned by an Affiliate. (4) Represents amortized amounts held by Affiliate key employees. Our actual funding of these potential repurchases of Affiliate equity and profits interests is limited to only that portion that may be put to us by Affiliate key employees or that we decide to call to facilitate succession planning that the Affiliates, which is typically capped annually such that we do not repurchase more than we can reasonably recycle by re-granting the interests in lieu of cash variable compensation owed to Affiliate key employees. Any equity or profits interests repurchased by us are used to fund a portion of variable compensation awards resulting in savings in cash variable compensation that offset the negative cash effect of repurchasing the equity. Critical Accounting Policies and Estimates Our significant accounting policies are disclosed in Item 8, Financial Statements and Supplementary Data -Note 2 , “Significant Accounting Policies." The accounting policies and estimates that we believe are the most critical to an understanding of our results of operations and financial condition are those that require complex management judgment regarding matters that are highly uncertain at the time policies were applied and estimates were made. These accounting policies and estimates are discussed below; however, the additional accounting policy detail in the footnote previously referenced is important to the discussion of each of the topics. Different estimates reasonably could have been used in the current period that would have had a material effect on these Consolidated Financial Statements, and changes in these estimates are likely to occur from period-to-period in the future. Taxation We file tax returns directly with the U.S., U.K., state tax authorities and in other foreign jurisdictions. These tax returns represent our filing positions within each jurisdiction and settle our tax liabilities. Each jurisdiction has the right to audit those tax returns and may take different positions with respect to income and expense allocations and taxable earnings determinations. Because the determinations of our annual provisions are subject to judgments and estimates, it is possible it is possible that actual results will vary from those recognized in our Consolidated Financial Statements. As a result, it is likely that additions to, or reductions of, income tax expense will occur each year for prior reporting periods as actual tax returns and tax audits are settled. Deferred tax assets, net of any associated valuation allowance, have been recognized based on management's belief that taxable income of the appropriate character, more likely than not, will be sufficient to realize the benefits of these assets over time. In the event that actual results differ from our expectations, or if our historical trends of positive operating income changes, we may be required to record a valuation allowance on some or all of these deferred tax assets, which may have a significant effect on our financial condition and results of operations. In assessing whether a valuation allowance should be established against a deferred income tax asset, we consider the nature, frequency and severity of recent losses, forecasts of future profitability, the duration of statutory carryback and carry forward periods, among other factors. We utilize a specific recognition threshold and measurement attribute for the Consolidated Financial Statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The prescribed two-step process for evaluating a tax position involves first determining whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities. If it is, the second step then requires a company to measure this tax position benefit as the largest cumulative amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Unrecognized tax benefits and related interest and penalties, are adjusted periodically to reflect changing facts and circumstances. Goodwill Goodwill represents the future economic benefits arising from assets acquired in a business combination that are not separately recognized. Goodwill is tested annually for impairment. If, after assessing qualitative and quantitative factors, we believe that it is more likely than not that the fair value of the reporting unit is less than its carrying value, we will record the amount of goodwill impairment as the excess of the carrying amount over the fair value. In the quantitative impairment test, fair value of the reporting units is generally determined using an income approach where estimated future cash flows are discounted to arrive at a single present value amount. The income approach includes inputs that require significant management judgment, including AUM growth rates, product mix, effective fee rates and discount rates. The annual goodwill impairment test also includes assumptions updated for current market conditions, including our updated forecasts for changes in AUM due to market gains or losses and long-term net flows and the corresponding changes in revenue and expenses. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. The most sensitive of these assumptions are the estimated cash flows and the use of a weighted average cost of capital as the discount rate to determine present value. We completed our annual goodwill impairment test as of the first business day of the fourth quarter and no impairment was identified. While we believe all assumptions utilized in our assessment are reasonable and appropriate, changes in these estimates could produce different fair value amounts and therefore different goodwill impairment assessments. Consolidation Assessing if an entity is a variable interest entity (VIE) or voting interest entity (VOE) involves judgment and analysis on a structure-by-structure basis. Factors included in this assessment include the legal organization of the entity, the Company’s contractual involvement with the entity and any related party or de facto agent implications of the Company’s involvement with the entity. A VIE, in the context of the company and its managed funds, is a fund that does not have sufficient equity to finance its operations without additional subordinated financial support, or a fund for which the risks and rewards of ownership are not directly linked to voting interests. If the Company is deemed to have the power to direct the activities of the fund that most significantly impact the fund's economic performance, and the obligation to absorb losses/right to receive benefits from the fund that could potentially be significant to the fund, then the Company is deemed to be the fund's primary beneficiary and is required to consolidate the fund. Determining if the Company is the primary beneficiary of a VIE also requires significant judgment involved to assess if the Company has the power to direct the activities that most significantly affect the fund's economic results and to assess if the Company's interests could be deemed significant. If current financial statements are not available for consolidated VIEs or VOEs, estimation of investment valuation is required, which includes assessing available quantitative and qualitative data. Significant changes in these estimates could impact the reported value of the investments held by consolidated Funds and the related offsetting equity attributable to noncontrolling interests in consolidated entities on the Consolidated Balance Sheets and the other gains and losses of consolidated Funds, net, and related offsetting gains and losses attributable to noncontrolling interests in consolidated entities, net, amounts on the Consolidated Statements of Operations. Share-based compensation plans We recognize the cost of all share-based payments to directors, senior management and employees, including grants of restricted stock and stock options, as compensation expense in the Consolidated Statements of Operations over the respective vesting periods. Awards made under the our equity plans are accounted for as equity settled, and the grant date fair value is recognized as compensation expense over the requisite service period, with a corresponding contribution to additional paid-in capital. Valuation of restricted stock awards (“RSAs”) and restricted stock units (“RSUs”) is determined based on our closing share price as quoted on the New York Stock Exchange on the measurement date. For performance-based awards and stock options, a Monte-Carlo simulation model is used to determine the fair value. Key inputs for the model include: assumed reinvestment of dividends, risk-free interest rate and expected volatility. All excess tax benefits and deficiencies on share-based payment awards are recognized as income tax expense or benefit in the Consolidated Statements of Operations. In addition, the tax effects of exercised or vested awards are treated as discrete items in the reporting period in which they occur and excess tax benefits or deficiencies are classified with other income tax cash flows as an operating activity in the Consolidated Statements of Cash Flows. We recognize forfeitures as they occur. We have compensation arrangements with certain of our Affiliates whereby in exchange for continued service, Affiliate equity is either purchased by or granted to Affiliate key employees and may be repurchased either by Affiliate key employees or by us at a future date, subject to service requirements having been met. Awards of equity made to Affiliate key employees are accounted for as cash settled, with the fair value recognized as compensation expense over the requisite service period, with a corresponding liability carried within other compensation liabilities on the Consolidated Balance Sheets until the award is settled by us. The fair values of the liabilities are determined with the assistance of third party valuation specialists using discounted cash flow analyses which incorporate assumptions for the forecasted earnings information, market risk adjustments, discount rates and post-vesting restrictions. While we believe all assumptions used in determining the fair value of the liabilities are reasonable and appropriate, certain assumptions are subjective and changes in these assumptions could result in different fair value amounts. Recent Accounting Developments See discussion of Recent Accounting Developments in Note 2 of the accompanying Consolidated Financial Statements.

<s>[INST] The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes which appear in this Annual Report on Form 10K in Item 8, Financial Statements and Supplementary Data. This discussion contains forwardlooking statements that involve risks and uncertainties. See “Special Note Regarding ForwardLooking Statements” for more information. Our actual results could differ materially from those anticipated in these forwardlooking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report on Form 10K, particularly under Item 1A, Risk Factors. This Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, is designed to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in five sections: Overview provides a brief description of our Affiliates, a summary of The Economics of Our Business and an explanation of How We Measure Performance using a nonGAAP measure which we refer to as economic net income, or ENI. This section also provides a Summary Results of Operations and information regarding our Assets Under Management by Affiliate, strategy, client type and client location, and net flows by segment, client type and client location. U.S. GAAP Results of Operations for the years ended December 31, 2019, 2018 and 2017 includes an explanation of changes in our U.S. GAAP revenue, expense, and other items over the last three years as well as key U.S. GAAP operating metrics. NonGAAP Supplemental Performance MeasureEconomic Net Income and Segment Analysis includes an explanation of the key differences between U.S. GAAP net income and ENI, the key measure management uses to evaluate our performance. This section also provides a reconciliation between U.S. GAAP net income and ENI for the years ended December 31, 2019, 2018, and 2017, as well as a reconciliation of key ENI operating items including ENI revenue and ENI operating expenses. This section also provides key NonGAAP operating metrics and a calculation of tax on economic net income. In addition, this section provides segment analysis for each of our business segments. Capital Resources and Liquidity discusses our key balance sheet data. This section discusses Cash Flows from the business; Working Capital and LongTerm Debt; Adjusted EBITDA; Future Capital Needs; and Commitments, Contingencies and OffBalance Sheet Obligations. The discussion of Adjusted EBITDA includes an explanation of how we calculate Adjusted EBITDA and a reconciliation of Adjusted EBITDA to U.S. GAAP net income attributable to controlling interests. Critical Accounting Policies and Estimates provides a discussion of the key accounting policies and estimates that we believe are the most critical to an understanding of our results of operations and financial condition that require complex management judgment regarding matters that are highly uncertain at the time policies were applied and estimates were made. Overview We are a diversified, global asset management company headquartered in Boston, Massachusetts. We completed a redomestication process to change our publicly traded parent company from a United Kingdom company to a Delaware corporation on July 12, 2019. We operate our business through three business segments: Quant & Solutionscomprised of versatile, often highlytailored strategies that leverage data and technology in a computational, factorbased investment process across a range of asset classes and geographies, including Global, nonU.S., emerging markets and managed volatility equities, as well as multiasset products. Alternativescomprised of illiquid and differentiated liquid investment strategies that include private equity, real estate and real assets, including forestry, as well as a growing suite of liquid alternative capabilities in areas such as long/short, market neutral and absolute return. Liquid Alphacomprised of specialized investment strategies with a focus on alphageneration across market cycles in longonly small, mid, and largecap U.S., global, nonU.S. and emerging markets equities, [/INST] Negative. </s>

Diamond S Shipping 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 our financial condition and results of operations should be read together with our audited consolidated financial statements and related notes which are included elsewhere in this Annual Report on Form 10-K. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in “Item 1A. Risk Factors.” This discussion contains a number of forward-looking statements, all of which are based on our current expectations and all of which could be affected by uncertainties and risks. Our actual results may differ materially from the results contemplated in these forward-looking statements as a result of many factors including, but not limited to, those described under “Cautionary Note Regarding Forward-Looking Statements.” Business Overview Diamond S Shipping Inc. was formed on November 14, 2018 under the laws of the Republic of the Marshall Islands for the purpose of receiving, via contribution from CPLP, the Athena Vessels and combining that business with the business and operations of DSS LP pursuant to the Transaction Agreement. On March 27, 2019, Diamond S and DSS LP and all of its directly owned subsidiaries (the “DSS LP Subsidiaries”) completed a merger pursuant to the Transaction Agreement. Pursuant to the terms of the Transaction Agreement, on March 27, 2019, the DSS LP Subsidiaries merged with and into Diamond S, with Diamond S being the surviving corporation in the merger (the “Merger”). Diamond S and the DSS LP Subsidiaries, which are the consolidated accounts of Diamond S Shipping Inc., are hereinafter referred to collectively as “we,” “us,” “our” or the “Company.” The Merger was accounted for as a reverse acquisition in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 805, “Business Combinations” as the DSS LP Subsidiaries are the accounting acquirer for financial reporting purposes. Accordingly, the historical consolidated financial statements of the DSS LP Subsidiaries for periods prior to the Merger are considered to be our predecessor financial statements. Refer to Note 3 - Merger Transaction to our consolidated financial statements. Further, the Merger was determined to be an asset acquisition as substantially all of the fair value of the gross assets acquired is concentrated in a group of similar identifiable assets. We provide seaborne transportation of crude oil, refined petroleum, and other products in the international shipping industry. As of December 31, 2019, through our wholly owned subsidiaries, we owned and operated 64 tanker vessels: 13 Suezmax crude carriers, one Aframax crude carrier and 50 MR product carriers. As of the same date, we also controlled and operated two Suezmax vessels through a joint venture. Factors to Consider When Evaluating Our Results The Merger The Merger, as described above, closed on March 27, 2019. Our consolidated financial statements include operating results for the 25 acquired Athena Vessels for 278 days during the fiscal year ended December 31, 2019, in addition to the 41 vessels historically owned by us for the full period and the two vessels sold in September 2019. New Credit Facilities and Refinancings In connection with the Merger, we entered into a $360 million five-year Credit Agreement (the “$360 Million Facility”), for the purposes of financing the Merger and refinancing a $30 million line of credit (the “$30 Million Line of Credit”). The $360 Million Facility consists of a term loan of  $300 million and a revolving loan of $60 million, and is collateralized by the Athena Vessels and three vessels that previously collateralized the $30 Million Line of Credit, with reductions based on a 17 year age-adjusted amortization schedule, payable on a quarterly basis. The term loan component of the $360 Million Facility bears interest at the Eurodollar Rate for a three-month interest period, plus a margin of 2.65%. On December 27, 2019, we refinanced certain of our existing indebtedness with the proceeds of the $525 Million Facility, which consists of a $375 million term loan and a revolving loan of  $150 million. The $525 Million Facility matures on December 27, 2024 and bears interest at the Eurodollar Rate for a three-month interest period, plus a margin of 2.5%. The repayment profile reflects a 17-year, age-adjusted amortization and the first amortization period begins on March 31, 2020 and is secured by, inter alia, mortgages over 10 Suezmax vessels and 26 MR vessels. The $525 Million Facility includes covenants relating to, among other things, our ability to incur indebtedness, our ability to pay dividends, maintaining a minimum cash balance, collateral maintenance, maintaining a net debt to capitalization ratio and other customary restrictions and provides for customary events of default. In connection with the Refinancing, effective as of December 27, 2019, we terminated and repaid amounts outstanding under (i) the $460 Million Facility, (ii) the $235 Million Facility, and (iii) the $75 Million Facility. We incurred no termination penalties in connection with the early termination of these facilities but recognized a non-cash charge of approximately $4.0 million representing the write-off of deferred financing costs. Change to Fiscal Year End In January 2019, DSS LP’s board of directors approved changing its fiscal year end to December 31 of each calendar year from March 31. Vessel Dispositions In November 2018, the DSS LP board of directors approved selling the Alpine Minute and Alpine Magic, both 2009-built MR vessels. DSS LP reached an agreement to sell the Alpine Minute for $17.8 million less a 1% broker commission payable to a third party, and reached a separate agreement to sell the Alpine Magic for $17.0 million less a 1% broker commission payable to a third party. In December 2018, DSS LP completed the sale of the Alpine Minute and Alpine Magic. In August 2019, our Board of Directors approved selling the Atlantic Aquarius and Atlantic Leo, both 2009-built MR vessels. We reached an agreement to sell the Atlantic Aquarius and Atlantic Leo, each for $16.0 million less a 1% broker commission payable to a third party. In September 2019, we completed the sale of the Atlantic Aquarius and Atlantic Leo. Other Trends and Factors Affecting Future Results of Operations The principal factors that have affected our results of operations, and may in the future affect results of operations, are the economic, regulatory, financial, credit, political and governmental conditions prevailing in the tanker market and shipping industry generally and in the countries and markets in which our vessels are chartered. The world economy has experienced significant economic and political upheavals in recent history. In addition, credit supply has been constrained and financial markets have been particularly turbulent. Protectionist trends, global growth and demand for the seaborne transportation of goods, including oil and oil products and overcapacity and deliveries of newly-built vessels have affected, and may further affect, the tanker market and shipping industry in general and the business, financial condition, results of operations and cash flows of the Company. Some of the key factors that have affected our business, financial condition, results of operations and cash flows include the following: • levels of oil product demand and inventories; • supply and demand for crude oil and oil products; • charter hire levels (under time and bareboat charters) and the ability to re-charter vessels at competitive rates as their current charters expire; • developments in vessel values, which may affect compliance with covenants under credit facilities and/or debt refinancing; • compliance with covenants in credit facilities, including covenants relating to the maintenance of vessel value ratios; • the level of debt and the related interest expense and amortization of principal; • access to debt and equity and the cost of capital required to acquire additional vessels; • supply and order-book of tanker vessels; • the ability to increase the size of the fleet and make additional acquisitions that are accretive to earnings; • the ability of the commercial and chartering operations to successfully employ vessels at economically attractive rates, particularly as charters expire and the fleet expands; • the continuing demand for crude oil and oil products from China, India, Brazil and Russia and other emerging markets; • the ability to comply with new maritime regulations, the more restrictive regulations for the transport of certain products and cargoes and the increased costs associated therewith; • changes in fuel prices, including as a result of the imposition of IMO 2020; • the effective and efficient technical management of the vessels; • the costs associated with upcoming dry-docking of vessels; • the ability to obtain and maintain major international oil company approvals and to satisfy technical, health, safety and compliance standards; • the strength of and growth in the number of the customer relationships, especially with major international oil companies and major commodity traders; • the prevailing spot market rates and the number of vessels operating in the spot market; and • the ability to acquire and sell vessels at satisfactory prices. Year Ended December 31, 2019 Compared to the Nine Months Ended December 31, 2018 Operating Data The following tables represent the operating data for the year ended December 31, 2019 and the nine months ended December 31, 2018 on a consolidated basis. Results of Operations Voyage revenue Voyage revenue increased by $304.3 million to $579.8 million during the year ended December 31, 2019 as compared to the nine months ended December 31, 2018. The $304.3 million increase was principally driven by a 75.8% increase in revenue days due to an additional 9,134 revenue days during the year ended December 31, 2019, primarily driven by the impact of the acquisition of the Athena Vessels and the additional fiscal quarter of data for the year ended December 31, 2019 compared to the nine months ended December 31, 2018, which only includes three fiscal quarters. Further, freight rates in the crude oil transportation market improved in the fourth quarter of 2019. Voyage Expenses Voyage expenses increased by $92.9 million to $230.7 million during the year ended December 31, 2019 as compared to $137.8 million for the nine months ended December 31, 2018. The $92.9 million increase in voyage expenses was driven by a 52.5% increase in spot revenue days due to the Merger and change in year-end, offset by an increase in short-term time charter activity in the Suezmax fleet during the year ended December 31, 2019, as the bunker and port costs were borne by the charterer. Vessel Expenses Vessel expenses increased by $68.5 million to $153.7 million during the year ended December 31, 2019 as compared to $85.2 million for the nine months ended December 31, 2018. The $68.5 million increase in vessel expenses was driven by an 84.8% increase in vessel operating days, which consists of an increase of 4,177 vessel operating days due to the Merger and an increase of 6,975 vessel operating days due to the change in year-end, offset by a decrease of 198 vessel operating days as a result of the four vessel sales that occurred in December 2018 and September 2019. Vessel Depreciation and Amortization Expense Depreciation and amortization expense increased by $42.6 million to $108.7 million during the year ended December 31, 2019 as compared to $66.1 million during the nine months ended December 31, 2018. The increase in depreciation and amortization expense is due to the increase of 10,467 days in the comparable periods. The increase is primarily due to change in year-end (4,177 vessel operating days), the added depreciation expense for the 25 vessels acquired in the Merger (6,975 vessel operating days), offset by the decrease in the depreciation and amortization expense related to the four vessel sales that occurred in December 2018 and September 2019 (198 vessel operating days). Loss on Sale of Vessels The $18.3 million loss on sale of vessels during the year ended December 31, 2019 is due to selling the Atlantic Aquarius and Atlantic Leo in September 2019. During the nine months ended December 31, 2018, the $20.0 million loss on sale of vessels was due to selling the Alpine Magic and Alpine Minute in December 2018. General and Administrative Expenses For the year ended December 31, 2019 and the nine months ended December 30, 2018, general and administrative expenses were $26.8 million and $11.4 million, respectively. The $15.4 million increase was primarily due to the increase in days in the comparable periods, coupled with having a larger fleet to support and incurring public company-related costs. The main differences are the following costs incurred during the year ended December 31, 2019: $2.2 million related to professional fees in connection with SEC filings, $3.5 million in stock-based compensation expense incurred due to the granting of restricted stock and restricted stock units during the year ended December 31, 2019, $3.3 million incurred for Directors and Officers insurance and related board costs, and $1.5 million in commercial management consultancy fees incurred on the 25 Athena Vessels acquired in the Merger. Other Corporate Expenses Other corporate expenses increased by $2.0 million to $2.7 million in the year ended December 31, 2019 from $0.7 million for the nine months ended December 31, 2018. The increase was primarily driven by professional fees associated with the SEC filings in connection with the Transactions. Total Other Expense, net Total other expense, net, which includes term loan interest, amortization of deferred financing charges and commitment fees, loss on extinguishment, net of interest income, was $49.0 million for the year ended December 31, 2019 compared to $26.9 million for the nine months ended December 31, 2018. The increase of $22.1 million was driven by the change in year-end, as an additional quarter is included in the year ended December 31, 2019 when compared to the prior nine-month period, an increase in the average debt balance due to entering into the $360 Million Facility in connection with the Merger, and a $4.0 million loss on extinguishment of debt charge in connection with terminating the $460 Million Facility, the $235 Million Facility and the $75 Million Facility to enter into the $525 Million Facility. In addition, in 2019, in conjunction with the extinguishment of the aforementioned debt facilities, we paid $2.5 million to terminate the swaps and recognized the unamortized gain of  $5.9 million that resulted from the re-couponing the interest rate swaps in September 2018. Net Loss Attributable to Noncontrolling Interest The net loss attributable to noncontrolling interest was $0.8 million for the year ended December 31, 2019 compared to $0.1 million for the nine months ended December 31, 2018. The net loss attributable to noncontrolling interest primarily represents a 49% interest in NT Suez Holdco LLC, which owns and operates two Suezmax vessels and is 51% owned by the Company. The increase in the net loss of $0.7 million was mainly due to incurring 132 days of off hire during the year ended December 31, 2019, as the two Suezmax vessels owned by NT Suez Holdco LLC were laid up for scrubber installations during the third quarter of 2019, before beginning three-year time charter contracts in late September 2019. Nine Months Ended December 31, 2018 Compared to the Year Ended March 31, 2018 Operating Data The following tables represent the operating data for the nine months ended December 31, 2018 and the year ended March 31, 2018 on a consolidated basis. Results of Operations Our results of operations for the nine months ended December 31, 2018 and the year ended March 31, 2018, respectively, differ primarily due to: • the number of operating and revenue days as a result of the change in fiscal year end; and • lower charter rates as a result of weaker market conditions for product and crude tankers on the back of increased tonnage availability, high oil and oil product inventories and OPEC/Non-OPEC oil production cuts. Total Revenues Total revenues, consisting of time and voyage charter revenues, amounted to $275.5 million for the nine months ended December 31, 2018 and $302.9 million for the year ended March 31, 2018. The decrease of $27.4 million was primarily attributable to the lower operating and revenue days in the nine months ended December 31, 2018 by approximately 4,000 days coupled with lower charter rates as a result weaker market conditions for product and crude tankers. For the nine months ended December 31, 2018, we primarily employed our vessels by voyage charters as compared with the year ended March 31, 2018, with approximately 73% of the fleet operating in pools that provide the benefits of large-scale operations. Voyage Expenses Total voyage expenses amounted to $137.8 million for the nine months ended December 31, 2018, compared to $89.9 million for the year ended March 31, 2018. The increase of  $47.9 million was primarily attributable to the increase in the number of voyage charters under which certain of the vessels were employed in the nine months ended December 31, 2018, compared to the year ended March 31, 2018. Vessel Expenses For the nine months ended December 31, 2018, total vessel expenses amounted to $85.2 million compared to $109.2 million for the year ended March 31, 2018. The $24.0 million decrease in vessel expenses primarily reflects approximately 4,000 less operating days in the nine months ended December 31, 2018 compared to the year ended March 31, 2018. Vessel Depreciation and Amortization Depreciation and amortization amounted to $66.1 million for the nine months ended December 31, 2018, compared to $86.6 million for the year ended March 31, 2018. The decrease was due to the nine-month depreciation and amortization compared with the twelve-month depreciation and amortization for the year ended March 31, 2018. General and Administrative Expenses General and administrative expenses amounted to $11.4 million for the nine months ended December 31, 2018 compared to $14.6 million for the year ended March 31, 2018. The decrease in general and administrative expenses of  $3.2 million was primarily due to lower operating days in the nine months ended December 31, 2018 than the year ended March 31, 2018. Other Corporate Expenses Other corporate expenses increased by $0.2 million to $0.7 million in the nine months ended December 31, 2018 from $0.5 million for the year ended March 31, 2018. The increase was primarily driven by professional fees associated with the SEC filings in connection with the Transactions. Management Fees Management fees, which consist of pool management fees, decreased by $1.0 million from $1.0 million for the year ended March 31, 2018 to zero for the nine months ended December 31, 2018. The decrease was due to the change in employment from pools in the year ended March 31, 2018 to voyage charters in the nine months ended December 31, 2018. Loss on Sale of Assets In December 2018, we sold two vessels, receiving total proceeds of  $34.9 million and repaying debt of $24.7 million. The carrying value of the assets was $20.0 million above the sale price, which was recorded as a loss in the nine months ended December 31, 2018. There were no vessel sales for the year ended March 31, 2018. Total Other Expense, net Total other expense, net, which includes term loan interest, amortization of deferred financing charges and commitment fees, and is net of interest income, was $26.9 million for the nine months ended December 31, 2018 compared to $32.4 million for the year ended March 31, 2018. The decrease of  $5.6 million was primarily a result of the decrease in the number of days of interest expense included in the nine months ended December 31, 2018. Net Income (Loss) Attributable to Noncontrolling Interest The net income (loss) attributable to noncontrolling interest was a net loss of  $0.1 million for the nine months ended December 31, 2018 compared to a net loss of  $0.8 million for the year ended March 31, 2018. The net loss attributable to noncontrolling interest primarily represents a 49% interest in NT Suez Holdco LLC, which owns and operates two Suezmax vessels and is 51% owned by DSS LP. The decreases in the net loss of  $0.7 million was mainly attributable to higher charter rates achieved as a result of better fuel efficiencies from long haul voyages. Liquidity and Capital Resources As of December 31, 2019 and December 31, 2018, total cash, cash equivalents and restricted cash were $89.2 million and $88.2 million, including restricted cash of $5.6 million and $5.1 million, respectively. As of December 31, 2019 and December 31, 2018, we had $15 million and $19.3 million available and undrawn under our credit facilities, respectively. Generally, our primary sources of funds have been cash from operations, undrawn amounts under our credit facilities and vessel sales. We incurred indebtedness under a new term loan and revolving credit facility in connection with the Merger and indebtedness under our previously existing credit facilities. Refer to Note 9 - Long-Term Debt of our consolidated financial statements. In connection with the Merger, we amended our debt covenants whereby consolidated cash is subject to a $50 million minimum above the restricted cash balance. On December 27, 2019, we refinanced (i) the $460 Million Facility, (ii) the $235 Million Facility, and (iii) the $75 Million Facility with the proceeds of the $525 Million Facility. At December 31, 2019, we were in compliance with all financial covenants under each of our credit facilities. Passage of environmental legislation or other regulatory initiatives have in the past had, and may in the future may have, a significant impact on our operations. Regulatory measures can increase required costs related to operating and maintaining our vessels and may require us to retrofit our vessels with new equipment to comply with new or existing regulations. Among other capital expenditures, in connection with IMO 2020, we contracted for the purchase and installation of scrubbers on five of our Suezmax vessels. Two of these scrubbers have been installed and the remaining three are expected to be installed during the first half of 2020. The total aggregate capital expenditures for these five scrubbers is approximately $15.7 million, of which $6.9 million has been paid as of December 31, 2019. We may, in the future, determine to purchase additional scrubbers for installation on other vessels that we own or operate. In addition, with respect to vessels that are not retrofitted with scrubbers, we expect to incur expenditures to ensure those vessels are capable of efficiently using low-sulfur fuel, which expenditures are not expected to be significant or which have not yet been determined. We entered into contracts to install ballast water treatment systems on 15 of our vessels for a total estimated cost of  $16.9 million, of which $12.6 million has been paid as of December 31, 2019. These vessels have compliance dates which require such installations to be completed in 2019 and 2020. We completed drydocking of eight vessels in 2019. The total cost of drydocking as of December 31, 2019 was $11.8 million. In September 2019, we sold two of our 2008-built MR product carriers, the Atlantic Aquarius and Atlantic Leo. The vessels were delivered to the purchaser in September 2019, generating gross cash proceeds to us of  $31.8 million before our repayment of the related debt of  $20.4 million on the two vessels. We believe that we have sufficient capital resources to fund our operations and anticipated capital requirements for the next twelve months. However, should market conditions deteriorate beyond third-party forecasts, we would consider a number of liquidity enhancing measures, which could include refinancing a portion of our senior debt, exploring unsecured debt instruments, asset sales and sale-leaseback transactions on certain of our assets. Cash Flows The following table summarizes our cash and cash equivalents provided by or used in operating, financing and investing activities for the periods presented below (presented in millions): Net Cash Provided by Operating Activities Net cash provided by operating activities during the year ended December 31, 2019 and the nine months ended December 31, 2018 was $63.4 million and $23.5 million, respectively. The increase of  $39.9 million was mainly attributable to, among other factors, higher charter rates increasing our revenues offset by the negative effect of the changes in our operating assets and liabilities of  $61.7 million. The changes in operating assets and liabilities were driven mainly by increases in trade accounts receivable during the year ended December 31, 2019. Net cash provided by operating activities was $23.5 million for the nine months ended December 31, 2018, compared to $34.0 million for the year ended March 31, 2018. The decrease of $10.5 million was mainly attributable to, among other factors, lower charter rates affecting our revenues offset by the positive effect of the changes in our operating assets and liabilities amounting of  $32.7 million. Changes in our operating assets and liabilities were driven mainly by decreases in trade accounts receivable and pool working capital as a result of the change from pool employment to voyage charters. Net Cash (Used in) Provided by Investing Activities Net cash used in investing activities refers primarily to cash used for vessel acquisitions or dispositions and improvements. Net cash used in investing activities refers primarily to cash used for vessel acquisitions and improvements, and the Merger. Net cash (used in) provided by investing activities during the year ended December 31, 2019 and the nine months ended December 31, 2018 was ($294.5) million and $28.0 million, respectively. The increase in cash used in investing activities was primarily driven by the consideration paid in connection with the Merger, with $292.8 million paid to CPLP to acquire the Athena Vessels, and $18.9 million paid in transaction costs during the year ended December 31, 2019. Net cash provided by investing activities for the nine months ended December 31, 2018 was $28.0 million compared to $48.6 million during the year ended March 31, 2018. The decrease of  $20.6 million was primarily attributable to the sale of two product tankers in the nine months ended December 31, 2018 for total proceeds of  $34.9 million offset by $52.5 million in proceeds from the maturities of time deposits in the year ended March 31, 2018. Net Cash Provided by (Used in) Financing Activities Net cash provided by (used in) financing activities during the year ended December 31, 2019 and the nine months ended December 31, 2018 was $232.2 million and ($47.7) million, respectively. The increase in cash provided by financing activities was primarily driven by the following occurrences during the year ended December 31, 2019: (i) borrowings under the $360 Million Facility, the $525 Million Facility and the $235 Million Facility, which totaled $876.0 million, offset by $500.6 million repaid to extinguish the $460 Million Facility, the $235 Million Facility and the $75 Million Facility, (ii) $26.3 million repaid on lines of credit that were cancelled in connection with the Merger, and (iii) $16.4 million in deferred financing costs paid in connection with the $360 Million Facility and the $525 Million Facility. Net cash used in financing activities for the nine months ended December 31, 2018 was $47.7 million compared to $67.7 million during the year ended March 31, 2018. The decrease in $20.0 million of cash used in financing activities was primarily driven by an increase in borrowings under revolving credit facilities in the nine months ended December 31, 2018 offset by the impact of recouponing interest rate swaps. Off-Balance Sheet Arrangements As of December 31, 2019 and December 31, 2018, we had not entered into any off-balance sheet arrangements that have had or are reasonably likely to have current or future material effects on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations and Contingencies The following table summarizes our long-term contractual obligations as of December 31, 2019 (in thousands of U.S. dollars). (1) Interest has been estimated based on the LIBOR forward rates and the prescribed margin for each of our facilities. Please see Note 7 - Long-Term Debt to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Related Party Transactions For a discussion of the Company’s transactions with related parties, see Note 15 - Related Party Transactions to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are those that reflect significant judgments or uncertainties, and which could potentially result in materially different results under different assumptions and conditions. We have described below what our management believes are our most critical accounting policies. For a description of all of our significant accounting policies, see Note 2 - Significant Accounting Policies in our consolidated financial statements. Revenue Recognition During the year ended December 31, 2019, the nine months ended December 31, 2018 and the year ended March 31, 2018, revenues were generated from time charters, pool arrangements and voyage charters. We recognize revenues over the term of the time charter when there is a time charter agreement, where the rate is fixed or determinable, service is provided and collection of the related revenue is reasonably assured. We do not recognize revenue during days the vessel is off-hire. Revenues from pool arrangements are recognized based on our portion of the net distributions reported by the relevant pool, which represents the net voyage revenue of the pool after voyage expenses and pool manager fees. For the year ended December 31, 2018, under a voyage charter agreement, the revenues are recognized on a pro rata basis based on the relative transit time in each period. The period over which voyage revenues are recognized commences at the time the vessel departs from its last discharge port and ends at the time the discharge of cargo at the next discharge port is completed. We do not begin recognizing revenue until a charter has been agreed to by us and the customer, even if the vessel has discharged its cargo and is sailing to the anticipated load port on its next voyage. We do not recognize revenue when a vessel is off-hire. Estimated losses on voyages are provided for in full at the time such losses become evident. For the year ended December 31, 2019, pursuant to the new revenue recognition guidance, which was adopted as of January 1, 2019, and is disclosed in Note 14 - Voyage Revenue of our consolidated financial statements, revenue for spot market voyage charters is recognized ratably over the total transit time of each voyage, which commences at the time the vessel arrives at the loading port and ends at the time the discharge of cargo is completed at the discharge port. Previously, revenue was recognized on the later of when the vessel departed from its last discharge port or when an agreement was entered into with the charterer, and ended at the time the discharge of cargo was completed at the discharge port. In time charters, operating costs including crews, maintenance and insurance are typically paid by the owner of the vessel and specified voyage costs such as fuel and port charges are paid by the charterer. These voyage expenses are borne by us when the vessels are engaged in spot market voyage charters. As such, there are significantly higher voyage expenses for spot market voyage charters as compared to time charters. Vessel Lives and Impairment We follow Accounting Standards Codification (“ASC”) Subtopic 360-10-05, “Accounting for the Impairment or Disposal of Long-lived Assets,” which requires that long-lived assets and certain identifiable intangibles held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. We evaluate the carrying amounts and periods over which long-lived assets are depreciated to determine if events have occurred that would require modification to the carrying values or their useful lives. In evaluating useful lives and carrying values of long-lived assets, management reviews certain indicators of potential impairment, such as undiscounted projected cash flows, appraisals, business plans and overall market conditions. An impairment charge is recognized if the carrying value is in excess of the estimated future undiscounted net operating cash flows. The impairment loss is measured based on the excess of the carrying amount over the fair market value of the asset. Various factors, including forecasted future charter rates, estimated scrap values, future drydocking and operating costs are included in the analysis. In developing estimates of future undiscounted cash flows, we make assumptions and estimates about the vessels’ future performance, with the significant assumptions being related to charter rates, fleet utilization, vessels’ operating expenses, vessels’ capital expenditures and drydocking requirements, vessels’ residual value and the estimated remaining useful life of each vessel. The assumptions used to develop estimates of future undiscounted cash flows are based on historical trends. Specifically, we utilize the rates currently in effect for the duration of their current time charters, without assuming additional profit-sharing. For periods of time where our vessels are not fixed on time charters, we utilize an estimated daily time charter equivalent for our vessels’ unfixed days based on the most recent ten year historical one-year time charter average. Although management believes that the assumptions used to evaluate potential impairment are reasonable and appropriate at the time they were made, such assumptions are highly subjective and likely to change, possibly materially, in the future. There can be no assurance as to how long charter rates and vessel values will remain at their current low levels or whether they will improve by a significant degree. If charter rates were to remain at depressed levels, future assessments of vessel impairment would be adversely affected. In recent years, the market values of vessels have experienced particular volatility, with substantial declines in many of the charter-free market value, or basic market value, of various vessel classes. As a result, the market value of our vessels may have declined below their carrying values, even though we did not impair their carrying values under our impairment accounting policy. This is due to our belief that future undiscounted cash flows expected to be earned by such vessels over their operating lives would exceed such vessels’ carrying amounts. Our estimates of basic market value assume that our vessels are all in good and seaworthy condition without need for repair and, if inspected, would be certified in class without notations of any kind. Our estimates are based on the estimated market values for our vessels that we have received from independent ship brokers, reports by industry analysts and data providers that focus on our industry and related dynamics affecting vessel values and news and industry reports of similar vessel sales. Vessel values are highly volatile and as such, our estimates may not be indicative of the current or future market value of our vessels or prices that we could achieve if we were to sell them. The table set forth below indicates the carrying value of each of our owned vessels as of December 31, 2019 and December 31, 2018. At these balance sheet dates, we were not holding any of the vessels listed in the table below as held for sale. We believe that the future undiscounted cash flows expected to be earned by those vessels, which have experienced a decline in charter-free market value below such vessels’ carrying values, over their operating lives would exceed their carrying values as of December 31, 2019, and accordingly, have not recorded an impairment charge. The following table summarizes key information about our MR product tankers and their associated carrying values as of December 31, 2019 and December 31, 2018: (1) We sold the M/T Atlantic Aquarius and M/T Atlantic Leo and delivered the vessels to the buyer in September 2019. As of December 31, 2019 and December 31, 2018, the carrying value of 43 vessels that we owned exceeded their basic charter-free market value. We estimate that the average carrying value of these vessels exceeded their average basic charter-free market value by $4.4 million as of December 31, 2019 and $8.1 million as of December 31, 2018, or $132.5 million in the aggregate as of December 31, 2019 and $244.0 million in the aggregate as of December 31, 2018. An impairment test was performed as of December 31, 2019, and the carrying values of the vessels as of December 31, 2019 were not impaired. Of the inputs that we use for impairment tests, future time charter rates are the most significant and most volatile. Based on the sensitivity analysis that we performed, as of December 31, 2019, we would impair our vessels if the fifteen-year historical one-year time charter averages decline by more than 21% for the product fleet and 56% for the crude fleet. Deferred Drydocking Costs and Amortization We use the deferral method of accounting for drydocking costs. Under the deferral method, drydocking costs are deferred and amortized on a straight-line basis over the useful life of the drydock, which is estimated to be approximately 30 to 60 months. Management uses judgment when estimating the period between drydocks performed, which can result in adjustments to the estimated amortization of drydock expense if drydocks occur earlier or later than originally estimated. We update our estimate of a vessel’s next scheduled drydock as necessary. If the vessel is disposed of before the next drydock, the remaining balance in deferred drydock is written-off as a component of the gain or loss upon disposal of vessels. We defer the costs associated with drydocking as they occur and amortize these costs on a straight-line basis over the period between drydocking. Deferred drydocking costs include actual costs incurred at the drydock yard, cost of travel, lodging and subsistence of our personnel sent to the drydocking site to supervise, and the cost of hiring a third party to oversee the drydocking. Expenditures for normal maintenance and repairs, whether incurred as part of the drydock or not, are expensed as incurred. If the vessel is drydocked earlier than originally anticipated, any remaining deferred drydock costs that have not been amortized are expensed at the beginning of the next drydock. Recent Accounting Pronouncements New Accounting Standard Adopted In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle is that a company should recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. For the Company, this standard is effective for annual periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019, allowing for earlier adoption as permitted in the ASU, and shall be applied either retrospectively to each period presented or as a cumulative effect adjustment as of the date of adoption (the “modified retrospective transition method”). We adopted ASU 2014-09 on January 1, 2019 using the modified retrospective transition method applied to those spot market voyage charter contracts which were not completed as of January 1, 2019. Upon adoption, we recognized the cumulative effect of adopting this guidance as an adjustment to its Accumulated deficit as of January 1, 2019. Prior periods were not retrospectively adjusted. The adoption of ASU 2014-09 does not have an impact on the timing of recognition of revenue generated from time charter agreements. Refer to Note 14 - Voyage Revenue of our consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business” (“ASU 2017-01”). The objective of ASU 2017-01 is to provide guidance to entities when evaluating whether a transaction should be accounted for as an acquisition or disposal of a business. An entity first determines whether substantially all of the fair value of gross assets acquired is concentrated in a single identifiable asset, or a group of similar identifiable assets. If this threshold is met, the assets acquired would not represent a business, and no further assessment is required. If the initial screen is not met, ASU 2017-01 requires that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to produce output and removes the evaluation of whether a market participant could replace the missing elements. For nonpublic entities, ASU 2017-01 is effective for annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019, allowing for earlier adoption as permitted in the ASUs, and shall be applied prospectively. We early adopted ASU 2017-01, and concluded that the Merger should be accounted for an asset acquisition. Refer to Note 3 - Merger Transaction of our consolidated financial statements. New Accounting Standards to be Implemented In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), which establishes a comprehensive new lease accounting model. ASU 2016-02 clarifies the definition of a lease, requires a dual approach to lease classification similar to current lease classifications, and causes lessees to recognize leases on the balance sheet as a lease liability with a corresponding right-of-use asset for leases with a lease term of more than twelve months. For the Company, ASU 2016-02 is effective for annual periods beginning after December 15, 2020, and interim reporting periods within annual reporting periods beginning after December 15, 2021, with early adoption permitted. The most significant effects of adoption relate to the recognition of right-of-use assets and lease liabilities on the balance sheet for operating leases and providing new disclosures about our leasing activities. We are in the midst of analyzing our contracts and will then calculate the right-of-use assets and lease liabilities as of January 1, 2021 based on the present value of our remaining minimum lease payments, primarily due to the recognition of right-of-use assets and lease liabilities with respect to operating leases. In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326)” (“ASU 2016-13”), which amends several aspects of the measurement of credit losses on financial instruments based on an estimate of current expected credit losses. ASU 2016-13 will apply to loans, accounts receivable, trade receivables, other financial assets measured at amortized cost, loan commitments and other off-balance sheet credit exposures. ASU 2016-13 will also apply to debt securities and other financial assets measured at fair value through other comprehensive income. For the Company, ASU 2016-13 is effective for annual periods beginning after December 15, 2020, and interim reporting periods within annual reporting periods beginning after December 15, 2021, with early adoption permitted. We are currently evaluating the potential impact of this pronouncement on the consolidated financial statements. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk We are exposed to the impact of interest rate changes primarily through floating-rate borrowings that require it to make interest payments based on the Eurodollar Rate. Significant increases in interest rates could adversely affect operating margins, results of operations and our ability to service debt. We may use interest rate swaps to reduce our exposure to market risk from changes in interest rates. The principal objective of these contracts is to minimize the risks and costs associated with floating-rate debt. We would be exposed to the risk of credit loss in the event of non-performance by a counterparty to an interest rate swap agreement. In order to minimize counterparty risk, we would only entered into derivative transactions with counterparties that are rated A- or better by Standard & Poor’s Financial Services LLC or A3 or better by Moody’s Investors Service, Inc. at the time of the transactions. In addition, to the extent possible and practical, interest rate swaps are entered into with different counterparties to reduce concentration risk. From time to time, we have entered into interest rate swap agreements to modify our exposure to interest rate movements and to manage our interest expense. As of December 31, 2019, none of the debt was fixed due to the interest rate swap agreements, and 100% was variable. Based on our December 31, 2019 outstanding variable rate debt balance, a one percentage point increase in annual Eurodollar Rates would increase our annual interest expense by approximately $8.6 million. Inflation Inflation has only a moderate effect on our expenses given current economic conditions. In the event that significant global inflationary pressures appear, these pressures would increase our operating, voyage, general and administrative and financing costs. Foreign Exchange Risk The shipping industry’s functional currency is the U.S. dollar. All of our revenues and most of our operating costs are in U.S. dollars. We incur certain operating expenses, such as vessel and general and administrative expenses, in currencies other than the U.S. dollar, and the foreign exchange risk associated with these operating expenses has historically been immaterial. If foreign exchange risk becomes material in the future, we may seek to reduce our exposure to fluctuations in foreign exchange rates through the use of short-term currency forward contracts and through the purchase of bulk quantities of currencies at rates that management considers favorable. For contracts which qualify as cash flow hedges for accounting purposes, hedge effectiveness would be assessed based on changes in foreign exchange spot rates with the change in fair value of the effective portions being recorded in accumulated other comprehensive loss.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with our audited consolidated financial statements and related notes which are included elsewhere in this Annual Report on Form 10K. Our actual results could differ materially from those anticipated in the forwardlooking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in “Item 1A. Risk Factors.” This discussion contains a number of forwardlooking statements, all of which are based on our current expectations and all of which could be affected by uncertainties and risks. Our actual results may differ materially from the results contemplated in these forwardlooking statements as a result of many factors including, but not limited to, those described under “Cautionary Note Regarding ForwardLooking Statements.” Business Overview Diamond S Shipping Inc. was formed on November 14, 2018 under the laws of the Republic of the Marshall Islands for the purpose of receiving, via contribution from CPLP, the Athena Vessels and combining that business with the business and operations of DSS LP pursuant to the Transaction Agreement. On March 27, 2019, Diamond S and DSS LP and all of its directly owned subsidiaries (the “DSS LP Subsidiaries”) completed a merger pursuant to the Transaction Agreement. Pursuant to the terms of the Transaction Agreement, on March 27, 2019, the DSS LP Subsidiaries merged with and into Diamond S, with Diamond S being the surviving corporation in the merger (the “Merger”). Diamond S and the DSS LP Subsidiaries, which are the consolidated accounts of Diamond S Shipping Inc., are hereinafter referred to collectively as “we,” “us,” “our” or the “Company.” The Merger was accounted for as a reverse acquisition in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 805, “Business Combinations” as the DSS LP Subsidiaries are the accounting acquirer for financial reporting purposes. Accordingly, the historical consolidated financial statements of the DSS LP Subsidiaries for periods prior to the Merger are considered to be our predecessor financial statements. Refer to Note 3  Merger Transaction to our consolidated financial statements. Further, the Merger was determined to be an asset acquisition as substantially all of the fair value of the gross assets acquired is concentrated in a group of similar identifiable assets. We provide seaborne transportation of crude oil, refined petroleum, and other products in the international shipping industry. As of December 31, 2019, through our wholly owned subsidiaries, we owned and operated 64 tanker vessels: 13 Suezmax crude carriers, one Aframax crude carrier and 50 MR product carriers. As of the same date, we also controlled and operated two Suezmax vessels through a joint venture. Factors to Consider When Evaluating Our Results The Merger The Merger, as described above, closed on March 27, 2019. Our consolidated financial statements include operating results for the 25 acquired Athena Vessels for 278 days during the fiscal year ended December 31, 2019, in addition to the 41 vessels historically owned by us for the full period and the two vessels sold in September 2019. New Credit Facilities and Refinancings In connection with the Merger, we entered into a $360 million fiveyear Credit Agreement (the “$360 Million Facility”), for the purposes of financing the Merger and refinancing a $30 million line of credit (the “$30 Million Line of Credit”). The $360 Million Facility consists of a term loan of  $300 million and a revolving loan of $60 million, and is collateralized by the Athena Vessels and three vessels that previously collateralized the $30 Million Line of Credit, with reductions based on a 17 year ageadjusted amortization schedule, payable on a quarterly basis. The term loan component of the $360 Mill [/INST] Positive. </s>

Fox Corp

2019-08-09

2019-06-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Readers should carefully review this document and the other documents filed by Fox Corporation (“FOX” or the “Company”) with the Securities and Exchange Commission (the “SEC”). This section should be read together with the consolidated and combined financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. The consolidated and combined financial statements are referred to as the “Financial Statements” herein. A detailed review of the Company’s fiscal 2019 performance compared to fiscal 2018 appears below under “Results of Operations” and “Liquidity and Capital Resources.” A detailed review of the Company’s fiscal 2018 performance compared to fiscal 2017 appears under “Results of Operations” and “Liquidity and Capital Resources” in Exhibit 99.1 to the Company’s Registration Statement on Form 10, as amended and filed with the SEC on January 7, 2019. INTRODUCTION The Distribution On March 19, 2019, the Company became a standalone publicly traded company through the pro rata distribution by Twenty-First Century Fox, Inc. (now known as TFCF Corporation) (“21CF”) of all of the issued and outstanding common stock of FOX to 21CF stockholders (other than holders that were subsidiaries of 21CF) (the “Distribution”) in accordance with the Amended and Restated Distribution Agreement and Plan of Merger, dated as of June 20, 2018, by and between 21CF and 21CF Distribution Merger Sub, Inc. Following the Distribution, 354,328,270 and 266,173,651 shares of the Company’s Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), and Class B Common Stock, par value $0.01 per share (the “Class B Common Stock” and, together with the Class A Common Stock, the “Common Stock”), respectively, began trading independently on The Nasdaq Global Select Market. In connection with the Distribution, the Company entered into the Separation and Distribution Agreement, dated as of March 19, 2019 (the “Separation Agreement”), with 21CF, which effected the internal restructuring (the “Separation”) whereby 21CF transferred to FOX a portfolio of 21CF’s news, sports and broadcast businesses, including FOX News Media (consisting of FOX News and FOX Business), the FOX Network, FOX Sports, FOX Television Stations, and sports cable networks FS1, FS2, FOX Deportes and Big Ten Network (collectively, the “FOX business”), and certain other assets, and FOX assumed from 21CF the liabilities associated with such businesses and certain other liabilities. The Separation and the Distribution were effected as part of a series of transactions contemplated by the Amended and Restated Merger Agreement and Plan of Merger, dated as of June 20, 2018 (the “21CF Disney Merger Agreement”), by and among 21CF, The Walt Disney Company (“Disney”) and certain subsidiaries of Disney, pursuant to which, among other things, 21CF became a wholly-owned subsidiary of Disney. Pursuant to the 21CF Disney Merger Agreement, immediately prior to the Distribution, the Company paid to 21CF a dividend in the amount of $8.5 billion (the “Dividend”). The final determination of the taxes in respect of the Separation and the Distribution for which the Company is responsible pursuant to the 21CF Disney Merger Agreement and a prepayment of the estimated taxes in respect of divestitures (collectively, the “Transaction Tax”) was $6.5 billion. Following the Distribution, on March 20, 2019 the Company received a cash payment in the amount of $2.0 billion from Disney, which had the net effect of reducing the Dividend the Company paid to 21CF. The Transaction Tax included a prepayment of the Company’s share of the estimated tax liabilities resulting from the anticipated divestitures by Disney of certain assets, principally the FOX Sports Regional Sports Networks. This prepayment was in the amount of approximately $700 million and is subject to adjustment in the future, when the actual amounts of the tax liabilities are reported on the federal income tax returns of Disney or a subsidiary of Disney. As a result of the Separation and the Distribution, which was a taxable transaction for which the estimated tax liability of $5.8 billion was included in the Transaction Tax paid by the Company, FOX obtained a tax basis in its assets equal to their respective fair market values. This will result in estimated annual tax deductions of approximately $1.5 billion, principally over the next 15 years related to the amortization of the additional tax basis. This amortization is estimated to reduce the Company’s annual cash tax liability by $370 million per year at the current combined federal and state applicable tax rate of 25%. Such estimates are subject to revisions, which could be material, based upon the occurrence of future events including, among other things, a refund of the prepayment discussed above. In connection with the Separation, the Company entered into several agreements that govern certain aspects of the Company’s relationship with 21CF and Disney following the Separation. These include the Separation Agreement, a tax matters agreement, a transition services agreement, as well as agreements relating to intellectual property licenses, employee matters, commercial arrangements and a studio lot lease (See Note 1-Description of Business and Basis of Presentation to the accompanying Financial Statements of FOX under the heading “The Distribution” for additional information). Basis of Presentation Prior to the Distribution, the Company’s combined financial statements were prepared on a standalone basis, derived from the consolidated financial statements and accounting records of 21CF. The Company’s Financial Statements as of June 30, 2018 and for the years ended June 30, 2018 and 2017 are presented on a combined basis as the Company was not a separate consolidated group prior to the Distribution. These Financial Statements reflect the combined historical results of operations, financial position and cash flows of 21CF’s domestic news, national sports and broadcast businesses and certain other assets and liabilities associated with such businesses. The Company became a separate consolidated group as a result of the Distribution, and the Company’s Financial Statements as of June 30, 2019 and for the year ended June 30, 2019 are presented on a consolidated basis. The Consolidated and Combined Statements of Operations include allocations for certain support functions that were provided on a centralized basis within 21CF prior to the Distribution and not recorded at the business unit level, such as certain expenses related to finance, legal, insurance, information technology, compliance and human resources management activities, among others. 21CF did not routinely allocate these costs to any of its business units. These expenses have been allocated to FOX on the basis of direct usage when identifiable, with the remainder allocated on a pro rata basis of combined revenues, headcount or other relevant measures. Management believes the assumptions underlying the Financial Statements, including the assumptions regarding allocating general corporate expenses from 21CF, are reasonable. Nevertheless, the Financial Statements may not include all of the actual expenses that would have been incurred by FOX and may not reflect FOX’s consolidated results of operations, financial position and cash flows had it been a standalone company during the entirety of the periods presented. Actual costs that would have been incurred if FOX had been a standalone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. The Company estimates that the total recurring costs beyond the amounts allocated to FOX in these Financial Statements through the Distribution, in accordance with SEC guidance, could range between $225 million and $250 million on an annual basis, which costs include the impact of the initial grant of restricted stock units and stock options under the Fox Corporation 2019 Shareholder Alignment Plan (See Note 11-Equity-Based Compensation to the accompanying Financial Statements of FOX). This range is based on subjective estimates and assumptions and management expects the majority of any incremental costs to be included in the Other, Corporate and Eliminations segment. The Company expects its cash flows from operations, together with its access to capital markets, to be sufficient to fund these expenses. Management’s discussion and analysis of financial condition and results of operations is intended to help provide an understanding of the Company’s financial condition, changes in financial condition and results of operations. This discussion is organized as follows: • Overview of the Company’s Business-This section provides a general description of the Company’s businesses, as well as developments that occurred either during the fiscal year ended June 30, (“fiscal”) 2019 or early fiscal 2020 that the Company believes are important in understanding its results of operations and financial condition or to disclose known trends. • Results of Operations-This section provides an analysis of the Company’s results of operations for fiscal 2019 and 2018. This analysis is presented on both a consolidated/combined and a segment basis. In addition, a brief description is provided of significant transactions and events that impact the comparability of the results being analyzed. • Liquidity and Capital Resources-This section provides an analysis of the Company’s cash flows for fiscal 2019 and 2018, as well as a discussion of the Company’s outstanding debt and commitments that existed as of June 30, 2019. Included in the discussion of outstanding debt is a discussion of the amount of financial capacity available to fund the Company’s future commitments and obligations, as well as a discussion of other financing arrangements. • Critical Accounting Policies-This section discusses accounting policies considered important to the Company’s financial condition and results of operations, and which require significant judgment and estimates on the part of management in application. In addition, Note 2-Summary of Significant Accounting Policies to the accompanying Financial Statements of FOX summarizes the Company’s significant accounting policies, including the critical accounting policy discussion found in this section. • Caution Concerning Forward-Looking Statements-This section provides a description of the use of forward-looking information appearing in this Annual Report on Form 10-K, including in Management’s Discussion and Analysis of Financial Condition and Results of Operations. Such information is based on management’s current expectations about future events which are subject to change and to inherent risks and uncertainties. Refer to Item 1A. “Risk Factors” in this Annual Report for a discussion of the risk factors applicable to the Company. OVERVIEW OF THE COMPANY’S BUSINESS The Company is a news, sports and entertainment company, which manages and reports its businesses in the following segments: • Cable Network Programming, which principally consists of the production and licensing of news and sports content distributed primarily through traditional cable television systems, direct broadcast satellite operators and telecommunication companies (“traditional MVPDs”), and online multi-channel video programming distributors (“digital MVPDs”), primarily in the U.S. • Television, which principally consists of the acquisition, marketing and distribution of broadcast network programming nationally under the FOX brand and the operation of 28 full power broadcast television stations, including 11 duopolies, in the U.S. Of these stations, 17 are affiliated with the FOX Network, 10 are affiliated with MyNetworkTV and one is an independent station. • Other, Corporate and Eliminations, which principally consists of corporate overhead costs, intracompany eliminations and the FOX Studios lot. The FOX Studios lot, located in Los Angeles, California, provides television and film production services along with office space, studio operation services and includes all operations of the facility. Cable Network Programming and Television The Cable Network Programming and Television industries continue to evolve rapidly, with changes in technology leading to alternative methods for the delivery and storage of digital content. These technological advancements have driven changes in consumer behavior and have empowered consumers to seek more control over when, where and how they consume content. Content owners are increasingly delivering their content directly to consumers over the Internet and innovations in distribution platforms have enabled consumers to view Internet-delivered content on televisions and portable devices. These changes in technologies and consumer behavior have contributed to declines in the number of subscribers to traditional MVPD services, and these declines are expected to continue and possibly accelerate in the future. At the same time, expenditures by advertisers are affected by technologies that allow users to view programming from a remote location or on a time-delayed basis and provide users the ability to fast-forward, rewind, pause and skip programming and advertisements. Furthermore, the pricing and volume of advertising may be affected by shifts in spending from more traditional media and toward digital and mobile offerings, which can deliver targeted advertising more promptly, or toward newer ways of purchasing advertising. Given these changes in technology and consumption habits, the Company believes its strength in “appointment-based” content provides the Company with a strategic advantage. FOX differentiates itself from its competitors by focusing on audiences at meaningful scale watching premium content in real time and by attracting sales from advertising customers who want to reach larger audiences within specified time parameters. As the share of live news and sports consumption has increased across television viewing overall from approximately 23% of all live viewership in calendar 2014 to approximately 30% in calendar 2018, FOX has strategically built one of the most-followed news and sports platforms in the country. Real-time consumption of live news and sports programming has increased approximately 9% from 2014 to 2018. FOX’s franchises are leaders in these growing categories, generating strong demand from both advertisers and traditional and digital MVPDs. As viewers increasingly move toward ad-free or delayed viewing, we believe the scale of our live audiences and premium nature of the content we deliver across our channels increasingly differentiate us from our competitors. Audiences engage with FOX’s content in real-time and, as a result, our offerings have become more valuable to distributors and advertisers, leading to higher revenues for FOX. In addition, we have expanded the distribution of our premium content across digital MVPDs. Nearly all of our networks are offered in all major digital MVPD services and we are cultivating direct interactions between FOX brands and consumers outside of traditional linear television. The Company operates in a highly competitive industry and its performance is dependent, to a large extent, on the impact of changes in consumer behavior as a result of new technologies, the sale of advertising on its cable and broadcast networks and television stations, maintenance, renewal and terms of its carriage, affiliation and content agreements and programming rights, the popularity of its content, general economic conditions (including financial market conditions), the Company’s ability to manage its businesses effectively, and its relative strength and leverage in the industry. For more information, see Item 1. “Business” and Item 1A. “Risk Factors” included herein. The Company’s Cable Network Programming and Television segments derive a majority of their revenues from affiliate fees for the transmission of content and advertising sales. For fiscal 2019, the Company generated revenues of $11.4 billion, of which approximately 49% was generated from affiliate fees, 44% was generated from advertising, and 7% was generated from other operating activities. Affiliate fees primarily include (i) monthly subscriber-based license and retransmission consent fees paid by programming distributors that carry our cable networks and our owned and operated television stations; and (ii) fees received from television stations that are affiliated with the FOX Network. U.S. law governing retransmission consent provides a mechanism for the television stations owned by the Company to seek and obtain payment from traditional MVPDs who carry the Company’s broadcast signals. Affiliate fee revenues are net of the amortization of cable distribution investments (capitalized fees paid to U.S. MVPDs typically to facilitate the carriage of a domestic cable network). The Company defers the cable distribution investments and amortizes the amounts on a straight-line basis over the contract period. Traditional MVPDs are currently the predominant means of distribution of the Company’s program services, while digital MVPDs have become an increasingly significant share of overall distribution. Revenues are impacted by rate changes, changes in the number of subscribers to the Company’s content, changes in the expenditures by advertisers, as well as the impact of state, congressional and presidential elections cycles and of special events impacting advertising revenues, such as the National Football League’s (“NFL”) Super Bowl, which is broadcast on the FOX Network on a rotating basis with other networks, Major League Baseball’s (“MLB”) World Series, and the Fédération Internationale de Football Association (“FIFA”) World Cup, which occurs every four years (for each of women and men), and other regular and post-season sporting events delivered to consumers on the Company’s broadcast television and cable networks. The most significant operating expenses of the Cable Network Programming segment and the Television segment are acquisition and production expenses related to programming, marketing and promotional expenses, and expenses related to broadcasting the Company’s programming. Marketing and promotional expenses relate to improving the market visibility and awareness of the cable network or broadcaster and its programming. Additional expenses include salaries, employee benefits, rent and other routine overhead expenses. The profitability of U.S. national sports contracts is based on the Company’s best estimates at June 30, 2019 of attributable revenues and costs; such estimates may change in the future and such changes may be significant. Should revenues decline materially from estimates applied at June 30, 2019, amortization of rights may be accelerated. Should revenues improve as compared to estimated revenues, the Company may have improved results related to the applicable contract, which may be recognized over the remaining contract term. Other Business Developments In August 2019, the Company announced the entry into a definitive merger agreement for the proposed acquisition of 67% of the equity in Credible Labs Inc. (“Credible”), a U.S. consumer finance marketplace, for Australian dollar 390 million (approximately $265 million) in cash (the “Credible Acquisition”). In addition, the Company has agreed to commit up to $75 million of capital to Credible over approximately two years following the closing of the Credible Acquisition. The Credible Acquisition is subject to the receipt of Credible shareholder and regulatory approvals and other customary closing conditions. Subject to the satisfaction or waiver of the closing conditions, the Credible Acquisition is expected to close by December 31, 2019. In May 2019, the Company and The Stars Group Inc. (“The Stars Group”) announced plans to launch FOX Bet, a national media and sports wagering partnership in the U.S. FOX Sports and The Stars Group have entered into a long-term commercial arrangement through which FOX Sports will provide The Stars Group with an exclusive license to use certain FOX Sports trademarks. In addition, the Company invested $236 million to acquire a 4.99% equity interest in The Stars Group. In the first quarter of fiscal 2019, the Company invested, in the aggregate, approximately $100 million in cash for a minority equity interest in Caffeine, Inc. (“Caffeine”), a social broadcasting platform for gaming, entertainment and other creative content, and Caffeine Studio, LLC (“Caffeine Studios”), a newly formed venture that is jointly owned by the Company and Caffeine. RESULTS OF OPERATIONS Results of Operations-Fiscal 2019 versus Fiscal 2018 The following table sets forth the Company’s operating results for fiscal 2019, as compared to fiscal 2018: ** not meaningful Overview-The Company’s revenues increased 12% for fiscal 2019, as compared to fiscal 2018, due to higher affiliate fee, advertising and other revenues. The increase in affiliate fee revenue was primarily attributable to higher average rates per subscriber across all networks, led by contractual rate increases on existing affiliate agreements and from affiliate agreement renewals. The increase in advertising revenue was primarily due to the broadcast of FOX’s inaugural season of NFL Thursday Night Football (“TNF”) and an additional NFL postseason game on the FOX Network, higher cyclical political advertising revenue due to the U.S. midterm elections at the FOX Television Stations and higher digital advertising revenue at FOX News. The increase in other revenues was primarily due to higher digital content licensing revenue at the FOX Network. Operating expenses increased 13% for fiscal 2019, as compared to fiscal 2018, primarily due to higher sports programming rights amortization and production costs, including the additional NFL games, and the recognition of a write-down of approximately $55 million related to entertainment and syndicated programming rights (See Note 5-Inventories, net to the accompanying Financial Statements of FOX). Selling, general and administrative expenses increased 17% primarily due to higher costs in fiscal 2019 related to operating as a standalone public company following the Distribution as compared to allocated costs in fiscal 2018. Also contributing to the increase in selling, general and administrative expenses were higher allocated costs of approximately $50 million for the first three quarters of fiscal 2019, as compared to the corresponding period of fiscal 2018, principally due to an increase in revenues which was the primary measure to allocate on a pro rata basis certain general corporate expenses from 21CF. In addition, fiscal 2019 includes equity-based compensation costs of approximately $15 million related to the initial grant of restricted stock units and stock options under the Fox Corporation 2019 Shareholder Alignment Plan (See Note 11-Equity-Based Compensation to the accompanying Financial Statements of FOX). Depreciation and amortization-Depreciation and amortization expense increased 24% primarily due to higher costs in fiscal 2019 related to operating as a standalone public company following the Distribution as compared to a full year of allocated costs in fiscal 2018. Interest expense-Interest expense increased $160 million for fiscal 2019, as compared to fiscal 2018, primarily due to the issuance of $6.8 billion of senior notes in January 2019 and the effect of the bridge credit agreement commitment letter which was entered into in December 2017, including the write-off of unamortized costs as a result of the termination of the bridge credit agreement in March 2019 (See Note 9-Borrowings to the accompanying Financial Statements of FOX for additional information). Interest income-Interest income increased $41 million for fiscal 2019, as compared to fiscal 2018, primarily due to a higher average cash balance and higher average interest rates. Other, net-See Note 20-Additional Financial Information to the accompanying Financial Statements of FOX under the heading “Other, net.” Income tax (expense) benefit-The Company’s tax provision and related effective tax rate of 26% for fiscal 2019 was higher than the statutory rate of 21% primarily due to the impact of state taxes. The Company’s tax provision and related effective tax rate of (3)% for fiscal 2018 was lower than the statutory rate of 28% primarily due to a provisional $607 million tax benefit which reflects the effects of the legislation in the U.S. passed on December 22, 2017, commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”) (See Note 2-Summary of Significant Accounting Policies to the accompanying Financial Statements of FOX under the heading “U.S. Tax Reform”). Net income-Net income decreased 26% for fiscal 2019, as compared to fiscal 2018, primarily due to the absence of an income tax benefit resulting from the Tax Act in the prior year. Segment Analysis The Company’s operating segments have been determined in accordance with the Company’s internal management structure, which is organized based on operating activities. The Company evaluates performance based upon several factors, of which the primary financial measure is segment operating income before depreciation and amortization, or Segment EBITDA. Due to the integrated nature of these operating segments, estimates and judgments are made in allocating certain assets, revenues and expenses. Beginning with the announcement of the Company’s financial results for the third quarter of fiscal 2019, the Company has renamed as “Segment EBITDA” the measure that it previously referred to as “Segment OIBDA”. The definition of this measure has not changed: Segment EBITDA is defined as Revenues less Operating expenses and Selling, general and administrative expenses. Segment EBITDA does not include: Amortization of cable distribution investments, Depreciation and amortization, Impairment and restructuring charges, Interest expense, Interest income, Other, net and Income tax (expense) benefit. Management believes that Segment EBITDA is an appropriate measure for evaluating the operating performance of the Company’s business segments because it is the primary measure used by the Company’s chief operating decision maker to evaluate the performance of and allocate resources to the Company’s businesses. Management believes that information about Total Segment EBITDA assists all users of the Company’s Financial Statements by allowing them to evaluate changes in the operating results of the Company’s portfolio of businesses separate from non-operational factors that affect net income, thus providing insight into both operations and the other factors that affect reported results. Total Segment EBITDA provides management, investors and equity analysts a measure to analyze the operating performance of the Company’s business and its enterprise value against historical data and competitors’ data, although historical results, including Segment EBITDA and Total Segment EBITDA, may not be indicative of future results (as operating performance is highly contingent on many factors, including customer tastes and preferences). Total Segment EBITDA may be considered a non-GAAP financial measure and should be considered in addition to, not as a substitute for, net income, cash flow and other measures of financial performance reported in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition, this measure does not reflect cash available to fund requirements and excludes items, such as depreciation and amortization and impairment charges, which are significant components in assessing the Company’s financial performance. Total Segment EBITDA may not be comparable to similarly titled measures reported by other companies. Fiscal 2019 versus Fiscal 2018 The following table reconciles Income before income tax (expense) benefit to Total Segment EBITDA for fiscal 2019, as compared to fiscal 2018: ** not meaningful The following table sets forth the computation of Total Segment EBITDA for fiscal 2019, as compared to fiscal 2018: The following tables set forth the Company’s Revenues and Segment EBITDA for fiscal 2019, as compared to fiscal 2018: ** not meaningful Cable Network Programming (47% and 50% of the Company’s revenues in fiscal 2019 and 2018, respectively) Revenues at the Cable Network Programming segment increased for fiscal 2019, as compared to fiscal 2018, primarily due to higher affiliate fee and advertising revenues. The increase in affiliate fee revenue was primarily attributable to higher average rates per subscriber across all networks, led by contractual rate increases on existing affiliate agreements and from affiliate agreement renewals, partially offset by the impact of a lower average number of subscribers across almost all networks. The decrease in the average number of subscribers was due to a reduction in subscribers to traditional MVPDs, partially offset by an increase in digital MVPD subscribers. The increase in advertising revenue was primarily due to higher digital advertising revenue at FOX News and higher ratings for the daily studio programming at FS1, partially offset by the broadcast of two fewer 2018 MLB postseason games at FS1 and the absence of Ultimate Fighting Championship (“UFC”) in the second half of fiscal 2019. Cable Network Programming Segment EBITDA increased for fiscal 2019, as compared to fiscal 2018, primarily due to the revenue increases noted above, partially offset by higher expenses. Operating expenses increased principally due to higher sports programming rights amortization and production costs, including the impact of higher amortization for college sports, National Association of Stock Car Auto Racing (“NASCAR”) and the FIFA World Cup events and the addition of Premier Boxing Champions at FS1, partially offset by the absence of UFC in the second half of fiscal 2019 and the UEFA Champions League. Also contributing to the increase in operating expenses were launch costs incurred in connection with the Company’s direct-to-consumer initiative at FOX News. Selling, general and administrative expenses increased primarily due to higher costs in fiscal 2019 related to operating as a standalone public company following the Distribution as compared to a full year of allocated costs in fiscal 2018. Television (52% and 50% of the Company’s revenues in fiscal 2019 and 2018, respectively) Revenues at the Television segment increased for fiscal 2019, as compared to fiscal 2018, due to higher advertising, affiliate fee and other revenues. The increase in advertising revenue was primarily due to the broadcast of FOX’s inaugural season of TNF and an additional NFL postseason game on the FOX Network and higher cyclical political advertising revenue due to the U.S. midterm elections at the FOX Television Stations. Also contributing to the increase in advertising revenue was higher pricing for entertainment programming at the FOX Network and the broadcast of the FIFA World Cup events, partially offset by two fewer broadcasts of the 2018 MLB World Series games and lower ratings for entertainment programming on the FOX Network. The increase in affiliate fee revenue was primarily due to higher fees received from television stations that are affiliated with the FOX Network. The increase in other revenues was primarily due to higher digital content licensing revenue at the FOX Network. Television Segment EBITDA increased for fiscal 2019, as compared to fiscal 2018, due to the revenue increases noted above, partially offset by higher expenses. Operating expenses increased primarily due to higher sports programming rights amortization and production costs, including the additional NFL games as well as higher amortization for the FIFA World Cup events, and the recognition of a write-down of approximately $55 million related to entertainment and syndicated programming rights (See Note 5-Inventories, net to the accompanying Financial Statements of FOX). Partially offsetting these increases in operating expenses were lower entertainment programming rights amortization and marketing costs as a result of fewer hours of original programming in fiscal 2019 as compared to fiscal 2018. Selling, general and administrative expenses increased primarily due to higher costs in fiscal 2019 related to operating as a standalone public company following the Distribution as compared to a full year of allocated costs in fiscal 2018. LIQUIDITY AND CAPITAL RESOURCES Current Financial Condition Prior to December 31, 2017, substantially all of the cash balances were swept to 21CF on a daily basis and the Company received capital from 21CF for the Company’s cash needs. Effective January 1, 2018, the Company ceased participating in 21CF’s capital and cash management accounts. 21CF continued to provide treasury services to the Company until the Distribution. The Company’s principal source of liquidity is internally generated funds which are highly dependent upon the continuation of affiliate agreements and the state of the advertising markets. The Company has an unused five-year $1.0 billion unsecured revolving credit facility (See Note 9-Borrowings to the accompanying Financial Statements of FOX) and has access to the worldwide capital markets, subject to market conditions. As of June 30, 2019, the Company was in compliance with all of the covenants under the revolving credit facility, and it does not anticipate any noncompliance with such covenants. The principal uses of cash that affect the Company’s liquidity position include the following: the acquisition of rights and related payments for entertainment and sports programming; operational expenditures including marketing and promotional expenses; expenses related to broadcasting the Company’s programming along with investing approximately $150 million to $200 million in establishing standalone technical facilities over the two years following the Distribution; employee and facility costs; capital expenditures; acquisitions; interest and dividend payments; and debt repayments. In addition to the acquisitions, sales and possible acquisitions disclosed elsewhere, the Company has evaluated, and expects to continue to evaluate, possible acquisitions and dispositions of certain businesses and assets. Such transactions may be material and may involve cash, the Company’s securities or the assumption of additional indebtedness. Sources and Uses of Cash-Fiscal 2019 vs. Fiscal 2018 Net cash provided by operating activities for fiscal 2019 and 2018 was as follows (in millions): The increase in net cash provided by operating activities during fiscal 2019, as compared to fiscal 2018, is primarily due to lower cash payments for entertainment programming and higher sports programming rights amortization over cash payments at the Television segment and higher operating results. Net cash (used in) provided by investing activities for fiscal 2019 and 2018 was as follows (in millions): The change in net cash (used in) provided by investing activities during fiscal 2019, as compared to fiscal 2018, was primarily due to the investments in The Stars Group, Caffeine and Caffeine Studios and the absence of cash received from the Federal Communications Commission’s (“FCC”) completed reverse auction for broadcast spectrum (See Note 3-Acquisitions, Disposals and Other Transactions to the accompanying Financial Statements of FOX). Net cash (used in) provided by financing activities for fiscal 2019 and 2018 was as follows (in millions): The change in net cash (used in) provided by financing activities during fiscal 2019, as compared to fiscal 2018, was primarily due to Net transfers to Twenty-First Century Fox, Inc. of $1,233 million in fiscal 2019, as compared to Net transfers from Twenty-First Century Fox, Inc. of $1,113 million in fiscal 2018. Also contributing to the change in net cash (used in) provided by financing activities was the Dividend of $8.5 billion paid to 21CF net of the $2 billion cash payment received from Disney and the semi-annual cash dividend paid to the Company’s stockholders in June 2019, partially offset by the proceeds from the issuance of $6.8 billion of senior notes in January 2019 (See Note 9-Borrowings to the accompanying Financial Statements of FOX for additional information). The nature of activities included in Net transfers (to) from Twenty-First Century Fox, Inc. includes financing activities, capital transfers, cash sweeps, other treasury services and corporate expenses. Prior to December 31, 2017, the majority of the cash balances were swept to 21CF on a daily basis and the Company received capital from 21CF for the Company’s cash needs. Effective January 1, 2018, the Company ceased participating in 21CF’s capital and cash management accounts. Dividends In May 2019, the Company declared a semi-annual dividend of $0.23 per share on both the Class A Common Stock and the Class B Common Stock, which was paid on June 3, 2019 to the stockholders of record on May 20, 2019. Subsequent to June 30, 2019, the Company declared a semi-annual dividend of $0.23 per share on both the Class A Common Stock and the Class B Common Stock, resulting in an expected prospective annual dividend of $0.46 per share. The dividend declared subsequent to June 30, 2019 is payable on October 2, 2019 with a record date for determining dividend entitlements of September 4, 2019. Based on the number of shares outstanding as of June 30, 2019 and the prospective annual dividend rate stated above, the total aggregate cash dividends expected to be paid to stockholders in fiscal 2020 is approximately $285 million. Debt Instruments In January 2019, the Company issued approximately $6.8 billion of senior notes (See Note 9-Borrowings to the accompanying Financial Statements of FOX). Ratings of the senior notes The following table summarizes the Company’s credit ratings as of June 30, 2019: Revolving Credit Agreement In March 2019, the Company entered into an unsecured $1.0 billion revolving credit facility with a maturity date of March 2024 (See Note 9-Borrowings to the accompanying Financial Statements of FOX). Bridge Credit Agreement In March 2019, the Company entered into an unsecured $1.7 billion 364-Day Bridge Term Loan Agreement, which was also terminated in the same month (See Note 9-Borrowings to the accompanying Financial Statements of FOX). Commitments The Company has commitments under certain firm contractual arrangements (“firm commitments”), to make future payments. These firm commitments secure the future rights to various assets and services to be used in the normal course of operations. The following table summarizes the Company’s material firm commitments as of June 30, 2019: For additional details on commitments see Note 13-Commitments and Contingencies to the accompanying Financial Statements of FOX under the headings “Operating leases,” “Sports programming rights” and “Other commitments and contractual obligations.” Pension and other postretirement benefits and uncertain tax benefits The table excludes the Company’s pension, other postretirement benefits (“OPEB”) obligations and the gross unrecognized tax benefits for uncertain tax positions as the Company is unable to reasonably predict the ultimate amount and timing. The Company made contributions of $83 million and $30 million to its direct pension plans in fiscal 2019 and 2018, respectively. The majority of these contributions were voluntarily made to improve the funded status of the plans. Future plan contributions are dependent upon actual plan asset returns, interest rates and statutory requirements. Assuming that actual plan asset returns are consistent with the Company’s expected plan returns in fiscal 2020 and beyond, and that interest rates remain constant, the Company would not be required to make any material contributions to its pension plans for the immediate future. Required pension plan contributions for the next fiscal year are not expected to be material but the Company may make voluntary contributions in future periods. Payments due to participants under the Company’s pension plans are primarily paid out of underlying trusts. Payments due under the Company’s OPEB plans are not required to be funded in advance, but are paid as medical costs are incurred by covered retiree populations, and are principally dependent upon the future cost of retiree medical benefits under the Company’s pension plans. The Company does not expect its net OPEB payments to be material in fiscal 2020 (See Note 14-Pension and Other Postretirement Benefits to the accompanying Financial Statements of FOX for further discussion of the Company’s pension and OPEB plans). Contingencies See Note 13-Commitments and Contingencies to the accompanying Financial Statements of FOX under the heading “Contingencies.” CRITICAL ACCOUNTING POLICIES An accounting policy is considered to be critical if it is important to the Company’s financial condition and results of operations and if it requires significant judgment and estimates on the part of management in its application. The development and selection of these critical accounting policies have been determined by management of the Company and the related disclosures have been reviewed with the Audit Committee of the Company’s Board of Directors. For the Company’s summary of significant accounting policies, see Note 2-Summary of Significant Accounting Policies to the accompanying Financial Statements of FOX. Use of Estimates See Note 2-Summary of Significant Accounting Policies to the accompanying Financial Statements of FOX under the heading “Use of Estimates.” Revenue Recognition Revenue is recognized when control of the promised goods or services is transferred to the Company’s customers in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company considers the terms of each arrangement to determine the appropriate accounting treatment. Cable Network Programming and Television The Company generates advertising revenue from sales of commercial time within the Company’s network programming to be aired by television networks and cable channels, and from sales of broadcast advertising time on the Company’s owned and operated television stations and various digital properties. Advertising revenue from customers, primarily advertising agencies, is recognized as the commercials are aired. Certain of the Company’s advertising contracts have guarantees of a certain number of targeted audience views, referred to as impressions. Revenues for any audience deficiencies are deferred until the guaranteed number of impressions is met, by providing additional advertisements. Advertising contracts, which are generally short-term, are billed monthly for the spots aired during the month, with payments due shortly after the invoice date. The Company generates affiliate fee revenue from affiliate agreements with traditional and digital MVPDs for cable network programming and for the broadcast of the Company’s owned and operated television stations. In addition, the Company generates affiliate fee revenue from affiliate agreements with independently owned television stations that are affiliated with the FOX Network and receive retransmission consent fees from traditional and digital MVPDs for their signals. Affiliate fee revenue is recognized at a point in time when the network programming, a functional license of intellectual property, is made available to the customer which is done on a continuous basis. For contracts with affiliate fees based on the number of the affiliate’s subscribers, revenues are recognized based on the contractual rate multiplied by the estimated number of subscribers each period. For contracts with fixed affiliate fees, revenues are recognized based on the relative standalone selling price of the network programming provided over the contract term, which generally reflects the invoiced amount. Affiliate contracts are generally multi-year contracts with payments due monthly. The Company classifies the amortization of cable distribution investments (capitalized fees paid to MVPDs to facilitate carriage of a cable network) against affiliate fee revenue in accordance with Accounting Standards Codification (“ASC”) 606-10-32-25 through 27, “Revenue Recognition-Consideration Payable to a Customer.” The Company defers the cable distribution investments and amortizes the amounts on a straight-line basis over the contract period. Programming Costs incurred in acquiring program rights or producing programs are accounted for in accordance with ASC 920, “Entertainment-Broadcasters.” Program rights and the related liabilities are recorded at the gross amount of the liabilities when the license period has begun, the cost of the program is determinable and the program is accepted and available for airing. Television broadcast network entertainment programming, which includes acquired series, co-produced series, movies and other programs, are amortized primarily on an accelerated basis. Management regularly reviews, and revises when necessary, its total revenue estimates on a contract basis, which may result in a change in the rate of amortization and/or a write-down of the asset to fair value. As a result of the evaluation of the recoverability of the unamortized costs associated with the Company’s programming rights, the Company recognized a write-down of approximately $55 million related to entertainment and syndicated programming rights at the Television segment, which was recorded in Operating expenses in the Consolidated Statement of Operations for fiscal 2019. The Company has single and multi-year contracts for broadcast rights of programs and sporting events. The costs of multi-year national sports contracts at the FOX Network and the Company’s sports channels are primarily charged to expense and allocated to segments based on the ratio of each current period’s attributable revenue for each contract to the estimated total remaining attributable revenue for each contract. Estimates can change and accordingly, are reviewed periodically and amortization is adjusted as necessary. Such changes in the future could be material. The recoverability of certain sports rights contracts for content broadcast on the FOX Network and the Company’s sports channels is assessed on an aggregate basis. Goodwill and Intangible Assets The Company’s intangible assets include goodwill, FCC licenses, MVPD affiliate agreements and relationships and trademarks and other copyrighted products. Intangible assets acquired in business combinations are recorded at their estimated fair value at the date of acquisition. Goodwill is recorded as the difference between the consideration transferred to acquire entities and the estimated fair values assigned to their tangible and identifiable intangible net assets and is assigned to one or more reporting units for purposes of testing for impairment. The judgments made in determining the estimated fair value assigned to each class of intangible assets acquired, their reporting unit, as well as their useful lives can significantly impact net income. The Company accounts for its business combinations under the acquisition method of accounting. The total cost of acquisitions is allocated to the underlying net assets, based on their respective estimated fair values. The excess of the purchase price over the estimated fair values of the tangible net assets acquired is recorded as intangibles, including goodwill. Amounts recorded as goodwill are assigned to one or more reporting units. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, asset lives and market multiples, among other items. Identifying reporting units and assigning goodwill to them requires judgment involving the aggregation of business units with similar economic characteristics and the identification of existing business units that benefit from the acquired goodwill. The Company allocates goodwill to disposed businesses using the relative fair value method. Carrying values of goodwill and intangible assets with indefinite lives are reviewed at least annually for possible impairment in accordance with ASC 350 “Intangibles-Goodwill and Other.” The Company’s impairment review is based on, among other methods, a discounted cash flow approach that requires significant management judgment. The Company uses its judgment in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change or competitive activities, loss of key personnel and acts by governments and courts, may signal that an asset has become impaired and require the Company to perform an interim impairment test. The Company uses direct valuation methods to value identifiable intangibles for acquisition accounting and impairment testing. The direct valuation method used for FCC licenses requires, among other inputs, the use of published industry data that are based on subjective judgments about future advertising revenues in the markets where the Company owns television stations. This method also involves the use of management’s judgment in estimating an appropriate discount rate reflecting the risk of a market participant in the U.S. broadcast industry. The resulting fair values for FCC licenses are sensitive to these long-term assumptions and any variations to such assumptions could result in an impairment to existing carrying values in future periods and such impairment could be material. During fiscal 2019, the Company determined that the goodwill and indefinite-lived intangible assets included in the accompanying Consolidated Balance Sheet of FOX as of June 30, 2019 were not impaired. The Company determined there are no reporting units with goodwill considered to be at risk and will continue to monitor its goodwill and intangible assets for possible future impairment. See Note 8-Goodwill and Intangible Assets, net to the accompanying Financial Statements of FOX under the heading “Annual Impairment Review” for further discussion. Income Taxes The Company is subject to income tax in various domestic jurisdictions. The Company computes its annual tax rate based on the statutory tax rates and tax planning opportunities available to it in the various jurisdictions in which it earns income. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining the Company’s tax expense and in evaluating its tax positions, including evaluating uncertainties under ASC 740, “Income Taxes.” The Company records valuation allowances to reduce deferred tax assets to the amount that is more likely than not to be realized. In making this assessment, management analyzes future taxable income, reversing temporary differences and ongoing tax planning strategies. Should a change in circumstances lead to a change in judgment about the realizability of deferred tax assets in future years, the Company would adjust related valuation allowances in the period that the change in circumstances occurs, along with a corresponding increase or charge to income. For information regarding the impact of the Tax Act, see Note 2-Summary of Significant Accounting Policies to the accompanying Financial Statements of FOX under the heading “U.S. Tax Reform.” Employee Costs The measurement and recognition of costs of the Company’s pension and OPEB plans require the use of significant management judgments, including discount rates, expected return on plan assets and other actuarial assumptions. The Company participates in and/or sponsors various pension, savings and postretirement benefit plans. Pension plans and postretirement benefit plans are closed to new participants with the exception of a small group covered by collective bargaining agreements. Prior to the Separation and the Distribution, certain of the Company’s employees participated in defined benefit pension and postretirement plans sponsored by 21CF (“Shared Plans”), which include participants of other 21CF subsidiaries. Shared Plans were accounted for as multiemployer benefit plans. Therefore, no asset or liability were recorded to recognize the funded status. In contemplation of the Separation and the Distribution, the pension and other postretirement benefit assets and liabilities of the Shared Plans allocable to the Company’s employees were transferred to the Company in fiscal 2019 (See Note 14-Pension and Other Postretirement Benefits to the accompanying Financial Statements of FOX). For financial reporting purposes, net periodic pension expense is calculated based upon a number of actuarial assumptions, including a discount rate, an expected rate of return on plan assets and mortality. The Company considers current market conditions, including changes in investment returns and interest rates, in making these assumptions. In developing the expected long-term rate of return, the Company considered the pension portfolio’s future return expectations of the various asset classes. The expected long-term rate of return is based on an asset allocation assumption of 50% equity securities, 25% fixed income securities and 25% in other investments. The discount rate reflects the market rate for high-quality fixed income investments on the Company’s annual measurement date of June 30 and is subject to change each fiscal year. The discount rate assumptions used to account for pension and other postretirement benefit plans reflect the rates at which the benefit obligations could be effectively settled. The rate was determined by matching the Company’s expected benefit payments for the plans to a hypothetical yield curve developed using a portfolio of several hundred high-quality non-callable corporate bonds. The key assumptions used in developing the Company’s fiscal 2019 net periodic pension expense for its plans consist of the following: Discount rates are volatile from year to year because they are determined based upon the prevailing rates as of the measurement date. The Company will utilize discount rates of 3.7% and 3.2% in calculating the fiscal 2020 service cost and interest cost, respectively, for its plans. The Company will use a long-term rate of return of 7.0% for fiscal 2020 based principally on future return expectation of the plans’ asset mix. The accumulated net pre-tax losses on the Company’s pension plans as of June 30, 2019 were $385 million which increased from $80 million as of June 30, 2018. This increase of $305 million was primarily due to the transfer of pension benefit plan assets and liabilities allocable to the Company’s employees from 21CF and the change in the discount rate assumption utilized in measuring plan obligations. Lower discount rates increase present values of benefit obligations and increase the Company’s deferred losses and also increase subsequent-year pension expense. Higher discount rates decrease the present values of benefit obligations and reduce the Company’s accumulated net loss and also decrease subsequent-year pension expense. These deferred losses are being systematically recognized in future net periodic pension expense in accordance with ASC 715, “Compensation-Retirement Benefits.” Unrecognized losses in excess of 10% of the greater of the market-related value of plan assets or the plans’ projected benefit obligation (“PBO”) are recognized over the average future service of the plan participants or average future life of the plan participants. The Company made contributions of $83 million, $30 million and $29 million to its pension plans in fiscal 2019, 2018 and 2017, respectively. The majority of these contributions were voluntarily made to improve the funding status of the plans which were impacted by the economic conditions noted above. Future plan contributions are dependent upon actual plan asset returns, statutory requirements and interest rate movements. Assuming that actual plan returns are consistent with the Company’s expected plan returns in fiscal 2020 and beyond, and that interest rates remain constant, the Company would not be required to make any material statutory contributions to its pension plans for the immediate future. The Company will continue to make voluntary contributions as necessary to improve funded status. Changes in net periodic pension expense may occur in the future due to changes in the Company’s expected rate of return on plan assets and discount rate resulting from economic events. The following table highlights the sensitivity of the Company’s pension obligations and expense to changes in these assumptions, assuming all other assumptions remain constant: Fiscal 2020 net periodic pension expense for the Company’s pension plans is expected to be approximately $50 million, which is consistent with fiscal 2019. Recent Accounting Pronouncements See Note 2-Summary of Significant Accounting Policies to the accompanying Financial Statements of FOX under the heading “Recently Adopted and Recently Issued Accounting Guidance and U.S. Tax Reform.” Caution Concerning Forward-Looking Statements This document contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical or current fact are “forward-looking statements” for purposes of federal and state securities laws, including any statements regarding (i) future earnings, revenues or other measures of the Company’s financial performance; (ii) the Company’s plans, strategies and objectives for future operations; (iii) proposed new programming or other offerings; (iv) future economic conditions or performance; (v) estimated annual recurring costs relating to FOX operating as a standalone, publicly traded company; and (vi) assumptions underlying any of the foregoing. Forward-looking statements may include, among others, the words “may,” “will,” “should,” “likely,” “anticipates,” “expects,” “intends,” “plans,” “projects,” “believes,” “estimates,” “outlook” or any other similar words. Although the Company’s management believes that the expectations reflected in any of the Company’s forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any forward- looking statements. The Company’s future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed or incorporated by reference in our filings with the SEC. Important factors that could cause the Company’s actual results, performance and achievements to differ materially from those estimates or projections contained in the Company’s forward-looking statements include, but are not limited to, government regulation, economic, strategic, political and social conditions and the following factors: • recent and future changes in technology, including alternative methods for the delivery and storage of digital content, and in consumer behavior, including changes in when, where and how they consume content; • changes in the Company’s strategies and initiatives and the acceptance thereof by consumers, distributors of the Company’s content, affiliates, advertisers and other parties with which the Company does business; • the highly competitive nature of the industry in which the Company’s businesses operate; • declines in advertising expenditures due to various factors such as the economic prospects of advertisers or the economy in general, technological developments and changes in consumer behavior, and shifts in advertisers’ spending toward digital and mobile offerings and away from more traditional media; • the loss of affiliation or carriage agreements or arrangements where the Company makes its content available for viewing through online video platforms; • the popularity of the Company’s content, including special sports events, and the continued popularity of the sports franchises, leagues and teams for which the Company has acquired programming rights; • the Company’s ability to renew programming rights, particularly sports programming rights, on sufficiently favorable terms; • damage to the Company’s brands or reputation; • the inability to realize the anticipated benefits of the Company’s strategic investments and acquisitions; • a degradation, failure or misuse of the Company’s network and information systems and other technology relied on by the Company that causes a disruption of services or improper disclosure of personal data or other confidential information; • content piracy and signal theft and the Company’s ability to protect its intellectual property rights; • the loss of key personnel; • the effect of labor disputes, including labor disputes involving professional sports leagues whose games or events the Company has the right to broadcast; • changes in tax, federal communications or other laws, regulations, practices or the interpretations thereof; • the impact of any investigations or fines from governmental authorities, including FCC rules and policies and FCC decisions regarding revocation, renewal or grant of station licenses; • the failure or destruction of satellites or transmitter facilities the Company depends on to distribute its programming; • lower than expected valuations associated with one of the Company’s reporting units, indefinite-lived intangible assets, investments or long-lived assets; • changes in GAAP or other applicable accounting standards and policies; • the Company’s very limited operating history as a standalone, publicly traded company and the risk that the Company is unable to make, on a timely or cost-effective basis, the changes necessary to operate effectively as a standalone, publicly traded company; • increased costs in connection with the Company operating as a standalone, publicly traded company following the Distribution and the loss of synergies the Company enjoyed from operating as part of 21CF; • the Company’s reliance on 21CF to provide the Company various services during a transition period under the transition services agreement including broadcast operations, sports production, information and technology, and other services, and the risks that 21CF does not properly provide the services under this agreement or that the Company is unable to provide or obtain such services following the transition period (or during the transition period, if 21CF does not properly provide them in a timely and cost effective manner); • the Company’s ability to secure additional capital on acceptable terms; • the impact of any payments the Company is required to make or liabilities it is required to assume under the Separation Agreement and the indemnification arrangements entered into in connection with the Separation and the Distribution; and • the other risks and uncertainties detailed in Item 1A. “Risk Factors” in this Annual Report on Form 10-K. Forward-looking statements in this Annual Report on Form 10-K speak only as of the date hereof, and forward-looking statements in documents that are incorporated by reference hereto speak only as of the date of those documents. The Company does not undertake any obligation to update or release any revisions to any forward-looking statement made herein or to report any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or to conform such statements to actual results or changes in our expectations, except as required by law.

<s>[INST] Readers should carefully review this document and the other documents filed by Fox Corporation (“FOX” or the “Company”) with the Securities and Exchange Commission (the “SEC”). This section should be read together with the consolidated and combined financial statements and related notes appearing elsewhere in this Annual Report on Form 10K. The consolidated and combined financial statements are referred to as the “Financial Statements” herein. A detailed review of the Company’s fiscal 2019 performance compared to fiscal 2018 appears below under “Results of Operations” and “Liquidity and Capital Resources.” A detailed review of the Company’s fiscal 2018 performance compared to fiscal 2017 appears under “Results of Operations” and “Liquidity and Capital Resources” in Exhibit 99.1 to the Company’s Registration Statement on Form 10, as amended and filed with the SEC on January 7, 2019. INTRODUCTION The Distribution On March 19, 2019, the Company became a standalone publicly traded company through the pro rata distribution by TwentyFirst Century Fox, Inc. (now known as TFCF Corporation) (“21CF”) of all of the issued and outstanding common stock of FOX to 21CF stockholders (other than holders that were subsidiaries of 21CF) (the “Distribution”) in accordance with the Amended and Restated Distribution Agreement and Plan of Merger, dated as of June 20, 2018, by and between 21CF and 21CF Distribution Merger Sub, Inc. Following the Distribution, 354,328,270 and 266,173,651 shares of the Company’s Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), and Class B Common Stock, par value $0.01 per share (the “Class B Common Stock” and, together with the Class A Common Stock, the “Common Stock”), respectively, began trading independently on The Nasdaq Global Select Market. In connection with the Distribution, the Company entered into the Separation and Distribution Agreement, dated as of March 19, 2019 (the “Separation Agreement”), with 21CF, which effected the internal restructuring (the “Separation”) whereby 21CF transferred to FOX a portfolio of 21CF’s news, sports and broadcast businesses, including FOX News Media (consisting of FOX News and FOX Business), the FOX Network, FOX Sports, FOX Television Stations, and sports cable networks FS1, FS2, FOX Deportes and Big Ten Network (collectively, the “FOX business”), and certain other assets, and FOX assumed from 21CF the liabilities associated with such businesses and certain other liabilities. The Separation and the Distribution were effected as part of a series of transactions contemplated by the Amended and Restated Merger Agreement and Plan of Merger, dated as of June 20, 2018 (the “21CF Disney Merger Agreement”), by and among 21CF, The Walt Disney Company (“Disney”) and certain subsidiaries of Disney, pursuant to which, among other things, 21CF became a whollyowned subsidiary of Disney. Pursuant to the 21CF Disney Merger Agreement, immediately prior to the Distribution, the Company paid to 21CF a dividend in the amount of $8.5 billion (the “Dividend”). The final determination of the taxes in respect of the Separation and the Distribution for which the Company is responsible pursuant to the 21CF Disney Merger Agreement and a prepayment of the estimated taxes in respect of divestitures (collectively, the “Transaction Tax”) was $6.5 billion. Following the Distribution, on March 20, 2019 the Company received a cash payment in the amount of $2.0 billion from Disney, which had the net effect of reducing the Dividend the Company paid to 21CF. The Transaction Tax included a prepayment of the Company’s share of the estimated tax liabilities resulting from the anticipated div [/INST] Positive. </s>

CROSSFIRST BANKSHARES, INC.

2020-03-10

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview This section includes a discussion on the financial condition and results of operations of CrossFirst Bankshares, Inc. and its subsidiaries for the past three years. Tables may include additional periods to comply with disclosure requirements or to illustrate trends in greater depth. You should read the following financial data in conjunction with the other information contained in this 10-K, including under ‘‘Risk Factors,’’ ‘‘GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures,’’ and in the financial statements and related notes included elsewhere in this 10-K. The page locations of specific sections that we refer to are presented in the table of contents to this section. Our Company CrossFirst Bankshares, Inc., a Kansas corporation and registered bank holding company, is the holding company for CrossFirst Bank. The Company was initially formed as a limited liability company, CrossFirst Holdings, LLC, on September 1, 2008 to become the holding company for the Bank and converted to a corporation in 2017. The Bank was established as a Kansas state-chartered bank in 2007 and provides a full suite of financial services to businesses, business owners, professionals and their personal networks throughout our five primary markets located in Kansas, Missouri, Oklahoma and Texas. Growth History Since opening our first branch in 2007, we have grown organically primarily by establishing seven offices, attracting new clients and expanding our relationships with existing clients, as well as through two strategic acquisitions. The data below presents the growth of key areas of our business for the past five years and the related compound annual growth rate: Our Strategy Since inception, our strategy has been to build the most trusted bank serving our markets, which we believe has driven value for our stockholders. We remain focused on robust growth and are equally focused on building stockholder value through greater efficiency and increased profitability. We intend to execute our strategic plan through the following: • Continue organic growth; • Selectively pursue opportunities to expand through acquisitions or new market development; • Improve profitability and operating efficiency; • Attract and develop talent; • Maintain a branch-lite business model with strategically placed locations; and • Leverage technology to enhance the client experience and improve profitability. 2019 Highlights: We completed our IPO on August 19, 2019 in which we issued and sold 6,594,362 common shares including 844,362 shares pursuant to the underwriters’ partial exercise of their overallotment option. The common shares were sold at an initial public offering price of $14.50 per share. After deducting the underwriting discounts and offering expenses, the Company received total net proceeds of approximately $87 million. The shares began trading on the Nasdaq Global Select Market under the symbol ‘‘CFB.’’ Balance Sheet Growth • Approached $5 billion in total assets as of December 31, 2019, an increase of $824 million or 20% from year-end 2018. • Gross loans, net of unearned income totaled nearly $4 billion as of December 31, 2019, an increase of $791 million or 26% from the prior year, driven by organic growth. • Deposits increased $716 million or 22% from December 31, 2018 to $4 billion as of December 31, 2019, which resulted in a slight increase to our loan-to-deposit ratio to 98%. • Book value per share was $11.58 at December 31, 2019 compared to $10.21 at December 31, 2018 driven by earnings and our successful IPO. Operating and Financial Performance • Full year 2019 net income of $28.5 million compared to $19.6 million in 2018, a year-over-year increase of $9 million or 45%. The improvement was the result of a $31 million increase in net interest income and a $3 million increase in noninterest income, partially offset by a $2 million increase in operating expenses, a $16 million increase in the provision and a $7 million increase in income tax expense. • Earnings per share (diluted) was $0.58 for the fiscal year ended December 31, 2019 compared to $0.47 in 2018, a year-over-year increase of 23%. • Achieved efficiency ratios of 56% and 58% for the quarter and fiscal year ended December 31, 2019, respectively, compared to efficiency ratios of 60% and 74% for the quarter and fiscal year ended December 31, 2018, respectively. • Tax equivalent net interest margin declined 8 basis points from 3.39% at December 31, 2018 to 3.31% at December 31, 2019 driven by the declining rate environment. Credit Quality • Nonperforming assets to total assets was 0.97% as of December 31, 2019 compared to 0.43% for the year ended December 31, 2018. The rise in nonperforming assets was driven primarily by one nonperforming commercial credit relationship. • The allowance for loan losses to total loans ratio increased to 1.48% at December 31, 2019 from 1.23% at December 31, 2018. The increase was a result of: (i) an increase to the required reserve for impaired loans, including a commercial loan relationship in which the borrower's business and value of the underlying collateral significantly deteriorated during the year; (ii) loan growth; and (iii) changes to credit risk within the loan portfolio after net charge-offs. • Net charge-offs were $11 million for the year ended December 31, 2019 compared to $2 million in the prior year. Current year charge-offs were driven by two commercial loans and one energy loan. Discussion and Analysis - Results of Operations Net Interest Income Our profitability depends in substantial part on our net interest income. Net interest income is the difference between the amounts received on our interest-earning assets and the interest paid on our interest-bearing liabilities. Net interest income is impacted by internal and external factors including: • Changes in the volume, rate, and mix of interest-earning assets and interest-bearing liabilities; • Changes in competition, federal economic, monetary and fiscal policies and economic conditions; and • Changes in credit quality. We present and discuss net interest income on a tax-equivalent basis below. A tax-equivalent basis makes all income taxable at the same rate. For example, $100 of tax-exempt income would be presented as $126, an amount that, if taxed at the statutory federal income tax rate of 21% would yield $100. We believe a tax-equivalent basis provides for improved comparability between the various earning assets. Year Ended December 31, 2019 vs. Year Ended December 31, 2018 Tax-equivalent net interest income was $144 million for the year ended December 31, 2019, an increase of $30 million or 27% from the prior year due to asset growth. Our net interest margin declined 8 basis points to 3.31% from the prior year as our loans repriced more quickly than our cost of funds in the down rate environment. Tax-equivalent interest income increased $59 million or 37% from the prior year. Average loan growth of $1 billion increased interest income by $57 million, while the loan yield improved 18 basis points to 5.52% and resulted in $5 million in interest income. Loan yields in 2019 improved from 2018 due to variable rate assets indexed to market rates that had increased during 2018 before starting a gradual decline in 2019. Interest expense increased $28 million or 61% from 2018. The increase was driven by interest-bearing deposit growth of $763 million to support our asset growth, resulting in a $15 million increase in interest expense and a 50 basis point increase in the cost of interest-bearing deposits that resulted in a $14 million increase in interest expense. The rise in the cost of interest-bearing deposits was driven by market competition, changes in the interest rate environment and short-term time deposits opened during 2019. We anticipate a significant number of time deposits will reprice downward during the first quarter of 2020. In addition, the Company shortened the duration of interest-bearing liabilities during the fourth quarter of 2019 and added some additional short-term brokered funds to the balance sheet to manage interest rate risk. Year Ended December 31, 2018 vs. Year Ended December 31, 2017 Tax-equivalent net interest income was $114 million for the year ended December 31, 2018, an increase of $33 million or 41% from the year ended December 31, 2017. Our net interest margin declined one basis point during the same period as improved yields on loans were offset by increases in deposit costs and a reduction in the tax equivalent yield on tax-exempt securities due to the reduction in the federal income tax rate. Tax-equivalent interest income was driven by $897 million in average loan growth and an increase in interest rates. Loan yield improved 45 basis points, driven by four rate increases made by the Federal Open Market Committee (‘‘FOMC’’) during the year and changes in our mixture of loans and securities. The tax-equivalent yield on tax-exempt securities was impacted by the federal income tax rate change that lowered the tax rate from a maximum of 35.0% to 21.0% between 2017 and 2018. The impact of the tax rate change was a decline in tax equivalent interest income of $2 million in 2018. The increase in interest expense was the result of a $640 million increase in average interest-bearing deposits in order to support our loan growth. We also increased our average other borrowings by $113 million, which resulted in an additional $2 million of interest expense. Interest expense was also impacted by rate increases due to the rising interest rate environment and competition within our markets. Impact of Transition Away from LIBOR The Company has loans, derivative contracts, and other financial instruments that directly or indirectly depend on LIBOR to establish an interest rate and/or value. This included $1 billion in loans tied to LIBOR as of December 31, 2019. LIBOR is expected to cease on December 31, 2021. The impact of alternatives to LIBOR on the valuations, pricing and operation of our financial instruments is not yet known; however, loans, securities, and derivatives indexed to LIBOR that mature after December 31, 2021 may be impacted. As a result, the Company established an internal committee to evaluate potential substitutions and the related financial impact to the Company. The following table presents, for the periods indicated, average balance sheet information, interest income, interest expense and the corresponding average yield earned and rates paid: Changes in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as, changes in average interest rates. The following table sets forth the effects of changing rates and volumes on our net interest income during the period shown. Information is provided with respect to: (i) changes in volume (change in volume times old rate); (ii) changes in rates (change in rate times old volume); and (iii) changes in rate/volume (change in rate times the change in volume): Provision for Loan Losses For the year ended December 31, 2019, the provision for loan losses increased $16 million or 121% from the prior year. The change in the allowance for loan losses was driven by our loan growth, deterioration of a credit relationship, and an increase in nonperforming assets. A full discussion regarding changes to the allowance for loan and lease losses (‘‘ALLL’’) can be found within the Allowance for Loan Losses section below. The allowance as a percentage of loans was 1.48% at December 31, 2019 compared to 1.23% at December 31, 2018. For the year ended December 31, 2018, the provision for loan losses increased $2 million or 13% from 2017. The change in the allowance for loan losses was driven by our loan growth and an increase in nonperforming assets, partially offset by a reduction in the energy portfolio’s qualitative factors due to stabilized oil prices. The allowance as a percentage of loans was 1.23% at December 31, 2018 compared to 1.30% at December 31, 2017. Noninterest Income * Dollars in thousands The components of noninterest income were as follows for the periods shown: The changes in noninterest income were driven by the following: Swap Fee Income, Net The swap fee program was started in 2018. Swap fee income, net includes both swap fees from the execution of new swaps and the credit valuation allowance (‘‘CVA’’). Swap fees on new swaps depend on the size and term of the underlying asset. During 2019, the Company added nineteen back-to-back swap agreements, related to approximately $347 million in loan commitments; compared to nine back-to-back swap agreements, related to approximately $73 million in loan commitments in 2018. The swap program benefited from attractive market conditions during 2019 and became a material piece of our noninterest income. In addition, the 2019 increase included a change in the CVA methodology during the third quarter of 2019. Prior to the third quarter, a more conservative default methodology was used to account for non-performance risk. The Company moved to a review of internal credit analysis performed by the Company. The result was an increase to noninterest income of approximately $800 thousand related to swaps entered in previous quarters. If there is no impact to the credit quality of the swap during its life, the change in methodology will lower future income by the same amount for those swaps impacted by the change. Gain on Sale of Loans The reduction between 2018 and 2019 is due to a reduction in both the activity and size of the SBA guaranteed portion of loans sold. ATM and Credit Card Interchange Income Increased income in 2019 and 2018 was driven by the expansion of our credit card program to our new and existing customers. Service Charges and Fees on Customer Accounts This category includes a rebate program implemented in the second quarter of 2018 that attracted additional funding for the Bank and resulted in the decline between 2017 and 2018. In 2019, our customer base increased while the rebate program costs remained stable, resulting in the increase to service charges and fees on customer accounts as compared to the prior year. Gain on Sale of Available-for-Sale Securities The Company sold $101 million and $184 million of securities during the years ended 2019 and 2018, respectively. The sales were a strategic decision by management to capitalize on attractive market conditions, balance taxable and tax-free municipal securities, and redeploy the proceeds into higher yielding assets. Impairment of Premises and Equipment Held for Sale During the first half of 2019, the Company sold its remaining assets held-for-sale. The assets sold for approximately $3 million resulting in an additional impairment of $424 thousand. During the year ended December 31, 2017, we relocated our services and support teams into a newly acquired headquarters building. As a result, we listed two support buildings for sale. An impairment charge of $2 million in 2017 was made after an evaluation of the market value of both buildings. During the year ended December 31, 2018, we sold one of the two held-for-sale buildings. The sale resulted in an additional $171 thousand in impairment costs. The impairment of premises and equipment held-for-sale improved by $2 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 as a result of these events. Noninterest Expense * Dollars in thousands The components of noninterest expense were as follows for the periods indicated: The changes in noninterest expense were driven by the following: Salary and Employee Benefits Excluding the $5 million management restructuring charge due to the transition of our former CEO in 2018, fiscal year 2019 expense increased $6 million or 12%. The increase was driven by our growth that required us to strategically add employees. At the start of 2019, the Company started with approximately 50 additional full-time equivalent employees compared to the same period in 2018. During 2019, we increased our full-time equivalent count by 4, while increasing assets by $836 million. Salary and employee benefits increased $17 million or 42% to $56 million for the year ended December 31, 2018 from $40 million for the year ended December 31, 2017. $5 million of the increase related to the Chairman Emeritus Agreement with our former CEO. The remaining increase is the result of the addition of approximately 50 full time equivalent employees during 2018 as part of our strategic growth strategy. Deposit Insurance Premiums The 2019 expense was impacted by a $664 thousand assessment credit received in the third quarter. The credit was the result of the DIF Reserve Ratio exceeding the statutorily required minimum reserve ratio in 2018. Excluding the credit, the deposit insurance premium increased $265 thousand in 2019 compared to 2018. The FDIC uses a risk-based premium system to calculate the fees. Between 2018 and 2019, our rate was impacted by our strong asset growth and changes to our loan mix. During 2018, our rate was impacted by our strong asset growth, changes to our loan mix, and a lower leverage ratio prior to our most recent capital raise. Software and Communication Software and communication increased during 2019 and 2018 as a result of our continued strategy to invest in technologies. We invested significant resources over the past two years to improve our support services and increase efficiency in both the short- and long-term by using technology. Our technology resources now cover beginning-to-end loan originations and detailed reporting statements to analyze our performance. We continue to monitor technology innovations and support services that can lead to improved enterprise risk management, improvements to the client experience and reduction in manual processes. Data Processing Data processing includes our core system provided by a third-party and other operational support systems. Our customer base, transaction volume and asset size increased, resulting in higher data processing costs. Other noninterest expense In 2019, other noninterest expense included an increase in commercial card costs that continue to increase as we grow our customer base. In addition, the Company had an increase in operational loan costs due to increased loan volume, types of loans originated or renewed and events related to foreclosed assets. Other noninterest expense also saw an increase in insurance costs due to our transition from a private to public company. During 2018, the increase included credit card service fees, loan preparation and service costs, and ATM costs, which was the result of our loan and deposit growth as well as the number of transactions made by our clients. Income Taxes Income tax expense (benefit) was as follows: Our income tax expense (benefit) differs from the amount that would be calculated using the federal statutory tax rate, primarily from investments in tax advantaged assets, such as bank-owned life insurance and tax-exempt municipal securities, state tax credits, and permanent tax differences from equity-based compensation. Detail behind the differences between the statutory rate and effective tax rate for the years ended December 31, 2019, 2018 and 2017 is provided in Note 12 - Income Taxes within the Notes to the Consolidated Financial Statements. Discussion and Analysis - Financial Condition Loan Portfolio Loans represent our largest portion of earning assets and typically provide higher yields than other assets. The quality and diversification of the loan portfolio is an important consideration when reviewing our financial condition. We established an internal loan policy that outlines a standard lending philosophy and provides consistent direction to achieve goals and objectives, which include maximizing earnings over the short and long term by managing risks through the policy. Internal concentration limits exist on all loans, including commercial real estate, energy, and land development. We established strong underwriting practices and procedures to assess our borrowers, including review of debt service, collateral value, and evaluation of guarantors. Ongoing third-party reviews are performed on our loan portfolio to monitor the health of our borrowers. Appropriate actions are taken when a borrower is no longer able to service its debt. Our loan portfolio consists of various types of loans, primarily made up of commercial and industrial and commercial real estate loans. Commercial and industrial loans are generally paid back through normal business operations. Commercial real estate loans, which include both construction and limited term financing are typically paid back through normal income from operations, the sale of the underlying property or refinancing by other institutional sources. Most of our loans are made to borrowers within the states we operate, which include Kansas, Missouri, Oklahoma and Texas. In addition, we occasionally invest in syndicated shared national credits and participations. Gross loans, net of unearned income grew $791 million from the prior year to $4 billion as of December 31, 2019. Our commercial loan portfolio grew $222 million or 20% as a result of strategic hirings in our Dallas and Kansas City markets and commercial activity in all our markets. Our real estate portfolio experienced substantial growth as well. Commercial real estate loans increased $177 million or 21%, construction and land development increased $188 million or 43% and residential real estate increased $152 million or 62%. Our real estate portfolio growth was driven from $718 million in unfunded commitments at the start of the year, continued activity in commercial real estate and strategic hires to support and expand the growing portfolio. From December 31, 2017 to December 31, 2018, gross loans, net of unearned income increased $1 billion or 53%. Commercial loans increased $363 million or 47% as of December 31, 2018 compared to December 31, 2017. Total real estate loans increased $579 million or 61% and included a $311 million increase in commercial real estate loans and a $185 million increase in construction and land development loans. $251 million of the commercial real estate growth was attributable to our Dallas branch. Energy loans increased $116 million or 48% during the same time period. Gross loans, net of unearned income, at December 31, 2017 increased $699 million from December 31, 2016. Commercial loans increased $351 million or 84%. Total real estate loans increased $322 million or 51%, which included a $139 million increase in commercial real estate loans and a $117 million increase in construction and land development loans. The energy portfolio increased $74 million or 44%. Increases were offset by a $59 million decline in mortgage warehouse lines, which was the result of a strategic management decision to discontinue these participations. Gross loans, net of unearned income, at December 31, 2016 increased $304 million or 31% from the prior year. Commercial loans grew $77 million or 22%. Energy loans increased $31 million or 23%. Real estate loans increased $177 million or 39%, which included a $51 million or 107% increase in residential real estate and an $89 million increase in commercial real estate loans. The following table presents the balance and associated percentage of each major product type within our portfolio as of the dates indicated: For a discussion of the Company’s loan segments refer to the ‘‘Loan Portfolio Segments’’ section within Note 4: Loan and Allowance for Loan Losses within the Notes to the Consolidated Financial Statements. Real Estate Loans Our real estate portfolio is comprised of construction and development loans, 1-4 family loans and commercial real estate loans. A breakdown of our commercial real estate portfolio by type and by geography (based upon location of collateral) as of December 31, 2019 is presented below: Commercial Loans The Company provides a mix of variable- and fixed-rate commercial loans across various industries. We extend commercial loans on an unsecured and secured basis. Unsecured commercial loan balances totaled $153 million as of December 31, 2019 or 4% of the total loan portfolio. A breakdown of the Company’s commercial loan portfolio as of December 31, 2019 by industry is provided below: The following table shows the contractual maturities of our gross loans and sensitivity to interest rate changes: Allowance for Loan Losses The allowance for loan losses is an amount required to cover net loan charge-offs plus the amount which, in the opinion of the Bank’s management, is considered necessary to bring the balance in the allowance to, or maintain the balance in the allowance at, a level adequate to absorb expected loan losses in the existing loan portfolio. Management uses available information to analyze losses on loans; however, future additions to the allowance may be necessary based on changes in economic conditions, the size of the loan portfolio, the composition of the portfolio, or the performance of individual loans. For a discussion on the evaluation of the Company’s allowance for loan losses refer to the ‘‘Allowance for Loan Losses’’ section in Note 1: Nature of Operations and Summary of Significant Accounting Policies within the Notes to the Consolidated Financial Statements. The allowance totaled $57 million at December 31, 2019, an increase of $19 million or 50% from the prior year. The year-over-year change in the allowance was the result of a $791 million increase in gross loans, net of unearned income that increased the required reserve by approximately $9 million. In addition, the allowance included a $13 million increase in the reserve associated with our impaired loans that was primarily the result of one nonperforming commercial loan relationship in which the borrowers business and the value of the underlying collateral continued to deteriorate in the fourth quarter. The Company continues to monitor the loan. The increase was partially offset by a decline in the energy portfolio’s qualitative loss factors due to stabilized oil prices and the current stage of the business cycle that resulted in a $3 million decline in the required reserve. The allowance to loans was at 1.48% at December 31, 2019 compared to 1.23% at December 31, 2018 due to the changes above. Net charge-offs for the year ended December 31, 2019 totaled $11 million. Two commercial loans accounted for $8 million of charge-offs during the year. The commercial loans were partially charged-off and continue to be monitored. In addition, one energy credit accounted for $3 million in charge-offs during the year. The allowance increased $12 million between December 31, 2017 and December 31, 2018 primarily due to our loan growth and included $14 million associated with the provision for loan losses, offset by $2 million in net charge-offs. $1 million of loans charged off in 2018 related to one energy credit. $439 thousand of recoveries related to one commercial and industrial credit. The allowance increased $5 million between December 31, 2016 and December 31, 2017. The increase was driven by our loan growth and included $12 million associated with the provision for loan losses, offset by $7 million in net charge-offs. $1 million of loans charged off in 2017 related to one energy credit and $5 million related to one commercial and industrial credit. The allowance increased $5 million between December 31, 2015 and December 31, 2016 due primarily to our loan growth. The following table provides an analysis of the activity in our allowance for the periods indicated: While no portion of our allowance for loan losses is in any way restricted to any individual loan or group of loans and the entire allowance is available to absorb losses from any and all loans, the following tables represent management’s allocation of our allowance to specific loan categories for the periods indicated: Nonperforming Assets Nonperforming assets consist of nonperforming loans, foreclosed assets held for sale and impaired securities. Nonperforming Loans Nonperforming loans include nonaccrual loans, loans past due 90 days or more and still accruing interest and loans modified under Troubled Debt Restructuring (‘‘TDR’’) that are not performing in accordance with their modified terms. For information regarding nonperforming loans and related accounting policies refer to the‘‘Nonperforming Loans’’ section within Note 1: Nature of Operations and Summary of Significant Accounting Policies within the Notes to the Consolidated Financial Statements. For a breakout of the loan portfolio's nonaccrual loans refer to ‘‘Nonaccrual loans’’ within Note 4: Loans. For information on TDRs, refer to ‘‘Troubled Debt Restructurings’’ section in Note 4: Loans within the Notes to the Consolidated Financial Statements. Securities Nonperforming securities are securities for which we do not accrue interest income. The accrual of interest on securities is discontinued at the time the security does not pay its required interest payment. All interest accrued but not collected for securities placed on nonaccrual are reversed against interest income. The accounting guidance for beneficial interests in securitized financial assets provides incremental impairment guidance for a subset of the debt securities within the scope of the guidance for investments in debt and equity securities. For securities where the security is a beneficial interest in securitized financial assets, the Company uses the beneficial interests in securitized financial asset impairment model. For securities where the security is not a beneficial interest in securitized financial assets, the Company uses the debt and equity securities impairment model. For information regarding other-than-temporary-impairments, refer to the‘‘Securities’’ section within Note 1: Nature of Operations and Summary of Significant Accounting Policies within the Notes to the Consolidated Financial Statements. Discussion of Changes in Nonperforming Assets December 31, 2019 nonperforming assets increased $30 million or 169% from 2018. During 2019, a commercial loan relationship with an outstanding balance of $30 million was restructured as a TDR due to financial problems. The restructured loan extended the maturity date. By December 31, 2019, the commercial TDR was in default of the modified terms as the borrowers business and the value of the underlying collateral continued to deteriorate. The $30 million loan relationship was the primary reason for the increase in nonperforming assets and the increase in the ALLL to period end nonperforming loans. The Company continues to monitor the relationship for deterioration. During the year ended December 31, 2019, the Company foreclosed on $4 million of assets. These assets related to one commercial loan and one commercial real estate loan. For information regarding the foreclosed assets held-for-sale refer to Note 9: Foreclosed Assets within the Notes to the Consolidated Financial Statements. The following table presents the Company’s nonperforming assets for the dates indicated: During the year ended December 31, 2019, $1 million of interest income was recognized related to the $40 million in nonaccrual loans above. If the loans had been current in accordance with their original terms and had been outstanding through the period or since inception, the gross interest income that would have been recorded for the year ended December 31, 2019 would have been $3 million. The majority of actual and potential interest income relates to two loan relationships. During the year ended December 31, 2018, $468 thousand of interest income was recognized related to the $18 million in nonaccrual loans above. If the loans had been current in accordance with their original terms and had been outstanding throughout the period or since inception, the gross interest income that would have been recorded for the year ended December 31, 2018 would have been approximately $1 million. Other Asset Quality Metrics Other asset quality metrics management reviews include loans past due 30 - 89 days and classified loans. The Company defines classified loans as loans categorized as substandard, doubtful or loss. For the definitions of substandard, doubtful and loss, refer to the ‘‘Loans by Risk Rating’’ section within Note 4: Loan and Allowance for Loan Losses in the Notes to the Consolidated Financial Statements. The following table summarizes our loans past due 30 - 89 days, classified assets and related ratios: Investment Portfolio Our investment portfolio is governed by our investment policy that sets our objectives, limits and liquidity requirements among other items. The portfolio is maintained to serve as a contingent, on-balance sheet source of liquidity. The objective of our investment portfolio is to optimize earnings, manage credit risk, ensure adequate liquidity, manage interest rate risk, meet pledging requirements, and meet regulatory capital requirements. Our investment portfolio is generally comprised of government sponsored entity securities and U.S. state and political subdivision securities with limits set on all types of securities. At the date of purchase, all debt and equity securities are classified as available-for-sale securities. Since interest rates move in cycles, having an available-for-sale portfolio allows management to: (i) protect against additional unrealized market valuation losses; (ii) provide more liquidity as rates rise, which often coincides with increasing loan demand and slower deposit growth; and (iii) generate more money to reinvest when rates are higher giving the institution an opportunity to lock in higher yields. In the event the available-for-sale portfolio becomes too large given the constraints set in the policy, investments may be classified as held-to-maturity. Held-to-maturity classification will only be used if we have the intent and ability to hold the investment to its maturity. Our AFS portfolio increased $78 million or 12% from the prior year to $742 million at December 31, 2019. During 2019, the Company purchased $233 million of AFS securities and the unrealized gain increased $25 million, offset by $176 million of sales and maturities. The increase in purchases was managed by our current liquidity position and strategy. In 2018, the Company reduced the AFS security portfolio by $40 million or 6% from the prior year as the Company moved liquid assets to support higher yielding assets. Prior to fiscal year 2018, we purchased securities of states of the U.S. and political subdivisions as part of our tax and liquidity strategies. As a result, our holdings of these types of securities increased $108 million during 2017 and $133 million in 2016. For information related to the book value and fair value of our investment portfolio at December 31, 2019 and 2018 refer to the ‘‘Available-for-Sale Debt and Equity Securities’’ segment in Note 3: Securities within the Notes to the Consolidated Financial Statements. For information related to the investment maturity schedule and weighted average yield for each range of maturities refer to the ‘‘Maturity Schedule’’ segment in Note 3: Securities within the Notes to the Consolidated Financial Statements. At December 31, 2019, the Company did not own any one issuer (other than the U.S. Government and its agencies or sponsored entities) for which aggregate adjusted cost exceeded 10 percent of the consolidated stockholders’ equity at the reporting dates noted. Back-to-Back Swaps During 2018, we started offering our commercial banking clients the ability to execute interest rate swaps to facilitate their respective risk management strategies. Those interest rate swaps were simultaneously offset with like-term derivatives that the Company executed with a third-party, minimizing the net risk exposure resulting from such transactions. Because the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the client derivatives and the offsetting derivatives are recognized directly in earnings. The following table shows the fair value of the Company’s derivatives not designated as hedging instruments as well as their classification on the balance sheet as of the periods presented: Restricted Equity Securities Restricted equity securities are primarily made up of FHLB stock. The FHLB requires members to maintain a certain minimum amount of Class A and Class B common stock depending on borrowings with the FHLB. The FHLB may declare and pay non-cumulative dividends in either cash or Class B common stock. The following table provides the Company’s investment in restricted equity securities, earnings, and yield for the periods indicated: Bank-Owned Life Insurance (‘‘BOLI’’) During 2016, the Company entered into a BOLI program. The Company maintains investments in bank-owned life insurance policies to help control employee benefit costs, as a protection against loss of certain employees and as a tax planning strategy. The decline in yield between December 31, 2018 and December 31, 2019 is attributable to the insurance carrier’s underlying investments and operating costs that decreased overall income on the underlying asset. Yield declined between 2017 and 2018 as a result of the 2017 Tax Act, which lowered the tax rate for corporations. The following table provides the balance of BOLI income earned and tax-equivalent yield for the periods indicated: Deposits Deposits come through our five markets as well as through participation in certain online programs. The Company offers a variety of deposit products including noninterest-bearing demand deposits and interest-bearing deposits that include transaction accounts (including NOW accounts), savings accounts, money market accounts, and certificates of deposit. The Bank also acquires brokered deposits, internet subscription certificates of deposit, and reciprocal deposits through the Promontory network. The reciprocal deposits include both the Certificate of Deposit Account Registry Service and Insured Cash Sweep program. The Company is a member of the Promontory network which effectively allows depositors to receive FDIC insurance on amounts greater than the FDIC insurance limit, which is currently $250 thousand. Promontory allows institutions to break large deposits into smaller amounts and place them in a network of other Promontory institutions to ensure full FDIC insurance is gained on the entire deposit. Our strong asset growth requires us to place a greater emphasis on both interest and noninterest-bearing deposits. Deposit accounts are added by loan cross-selling, client referrals, and involvement within our community. In addition, we attract and retain deposits by aggressively setting our deposit rates within our markets. During 2019, deposits grew $716 million or 22% from the prior year. Transaction deposits increased $177 million or 214% from the prior year due to the offering of a new deposit product and our customer growth through our relationship model. In addition, we continued to see increased interest in our money market accounts, which increased $114 million. Our time deposits increased $230 million moved by attractive interest rates on short-term Certificates of Deposit (‘‘CDs’’). During 2018, the Company introduced a deposit fee reimbursement program. The program attracted customers into our noninterest bearing deposit portfolio and increased our noninterest bearing deposits by $193 million or 66%. The following table sets forth deposit balances by certain categories as of the dates indicated and the percentage of each deposit category to total deposits: The following table summarizes our average deposit balances and weighted average rates for the years ended December 31, 2019, 2018 and 2017: The following table sets forth the maturity of time deposits as of December 31, 2019: Other Borrowed Funds Since it may not be possible to achieve the institution’s overall funding needs through core deposit funding, other borrowings may be used to support asset growth. Management has a funds management policy and committee, which supports the use of other borrowings. The risks associated with other borrowings are addressed in the same fashion as other balance sheet risks incurred by the Bank. Credit risk, interest rate risk, concentration risk, capital adequacy and liquidity are measured for the balance sheet as a whole, including any wholesale funding strategies that have been implemented or are expected to be implemented. The following table sets forth the amounts outstanding and weighted average interest rate as of the dates indicated: For a description and general terms of the other borrowed funds, refer to Note 11: Borrowing Arrangements within the Notes to the Consolidated Financial Statements. The following table sets forth the maximum amount at any month end during the reporting period, the weighted average interest rate and the average balance of other borrowings during the reported period for the years indicated: Liquidity Liquidity is the ability to generate adequate amounts of cash from depositors, stockholders, profits or other funding sources, to meet our needs for cash, including payments to borrowers, operational costs, capital requirements and other strategic cash flow needs. Our liquidity policy in the funds management policy governs our approach to our liquidity position. The objective of our liquidity policy is to maintain adequate, but not excessive, liquidity to meet the daily cash flow needs of our clients while attempting to achieve adequate earnings for our stockholders. Our liquidity position is monitored continuously by our finance department. Liquidity resources can be derived from two sources: (i) on-balance sheet liquidity resources, which represents funds currently on the balance sheet; and (ii) off-balance sheet liquidity resources, which represent funds available from third-party sources. On-balance sheet liquidity resources consist of overnight funds, short-term deposits with other banks, available-for-sale securities, and certain other sources. Off-balance sheet liquidity resources consist of credit lines, wholesale deposits and debt funding and certain other sources. On-balance sheet liquidity resources can be broken down into three sections: (i) primary liquidity resources, which represents liquid funds that are on the balance sheet; (ii) tertiary liquidity resources, which represents assets that can be sold into the secondary market; and (iii) public funds, which represent deposits. Primary liquidity resources include overnight funds plus short-term, interest-bearing deposits with other banks and unpledged available-for-sale securities. Tertiary liquidity resources include loans that can be sold into the secondary market or through participation and unpledged securities classified as held-to-maturity. Public funds are another source of wholesale deposits as they require collateral. Off-balance sheet liquidity resources require sufficient collateral, in the form of loans or securities, and have a larger, negative impact on our capital ratios. As a result, off-balance sheet liquidity has a higher cost on our asset growth compared to deposit growth. Off-balance sheet liquidity exists in several forms including: (i) internet subscription certificates of deposit; (ii) brokered deposits; (iii) borrowing capacity; (iv) repurchase agreements; or (v) other sources. Internet subscription certificates of deposit are deposits made through national, wholesale certificates of deposit funding programs. These programs are designed to provide funding outside of the Bank’s normal market or existing client base and allow the Bank to diversify its wholesale funding resources. This form of funding does not require collateral and generally cannot be redeemed early. Brokered deposits are deposits funded through various broker-dealer relationships. The market for wholesale deposits is well developed. A key feature of this type of funding is that it is generally unsecured and does not require collateral for pledging. Borrowing capacity refers to a form of liability-based funding. Repurchase agreements are another source of short-term funding in which a bank agrees to sell a security to a counterparty and repurchase the same or an identical security from the counterparty at a specified future date and price. Public funds are another source of wholesale deposits as they require collateral. Our short-term and long-term liquidity requirements are primarily met through cash flow from operations, redeployment of prepaying and maturing balances in our loan portfolio and securities portfolio, increases in client deposits, and wholesale deposits. Other alternative sources of funds will supplement these primary sources to the extent necessary to meet additional liquidity requirements on either a short-term or long-term basis. As of December 31, 2019, we had cash and cash equivalents of $187 million compared to $217 million at December 31, 2018. The change in cash and cash equivalents was due to a $74 million increase in cash provided by operating activities, a $759 million increase in cash provided by financing activities and net cash used in investing activities of $862 million. To fund the $806 million increase in loans, we increased deposits by $716 million and issued stock that resulted in $58 million in cash after the payoff of our preferred stock outstanding and payment of dividends. Due to our current liquidity, the Company was able to reduce other borrowings and increase its security portfolio as well. As of December 31, 2018, we had cash and cash equivalents of $217 million compared to $131 million at December 31, 2017. The change in cash and cash equivalents during the year ended December 31, 2018 was due to $46 million of cash provided by operating activities, $1 billion provided by financing activities and net cash used in investing activities of $1 billion. For the year ended December 31, 2017, we used $852 million in cash in investing activities arising primarily from a net increase in loans of $706 million and purchases of available-for-sale securities of $209 million, which was partially offset by $23 million in cash provided by operating activities and $804 million provided by financing activities, including a net increase in deposits of $609 million. As of December 31, 2019, 2018, and 2017, we had the following available funding: Capital Requirements The Company and the Bank 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 direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under U.S. GAAP, regulatory reporting requirements and regulatory capital standards. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Furthermore, the Company’s regulators could require adjustments to regulatory capital not reflected in the Company’s consolidated financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and tier I capital to risk-weighted assets, CET1 capital to risk-weighted assets, and of tier I capital to average assets (each as defined in the applicable banking regulations). After the global financial crisis of 2008 and 2009, capital became more important, as banking regulators concluded that the amount and quality of capital held by banking organizations was insufficient to absorb losses during periods of severely distressed economic conditions. The Dodd-Frank Act and banking regulations promulgated by the U.S. federal banking regulators to implement Basel III have established strengthened capital standards for banks and bank holding companies and require more capital to be held in the form of common stock. These provisions, which generally became applicable to the Bank on January 1, 2015, impose meaningfully more stringent regulatory capital requirements than those applicable to the Bank prior to that date. In addition, the Basel III regulations implement a concept known as the ‘‘capital conservation buffer.’’ In general, banks, bank holding companies with more than $3.0 billion in assets and bank holding companies with publicly-traded equity are required to hold a buffer of CET1 capital equal to 2.5% of risk-weighted assets over each minimum capital ratio by January 1, 2019 in order to avoid being subject to limits on capital distributions (e.g., dividends, stock buybacks, etc.) and certain discretionary bonus payments to executive officers. For community banks, such as us, the capital conservation buffer requirement commenced on January 1, 2016, with a gradual phase-in. Full compliance with the capital conservation buffer was required by January 1, 2019. As of December 31, 2019, the FDIC categorized the Bank as ‘‘well-capitalized’’ under the prompt corrective action framework. There have been no conditions or events since December 31, 2019 that management believes would change this classification. The table below also summarizes the capital requirements applicable to the Company and the Bank in order to be considered ‘‘well-capitalized’’ from a regulatory perspective, as well as the Company’s and the Bank’s capital ratios as of December 31, 2019 and 2018. The Bank exceeded all regulatory capital requirements under Basel III and the Bank was considered to be ‘‘well-capitalized’’ as of the dates reflected in the tables below. Community Bank Leverage Ratio The Economic Growth, Regulatory Relief, and Consumer Protection Act directs the federal banking agencies to develop a specified Community Bank Leverage Ratio, the ratio of a bank’s equity capital to its consolidated assets of not less than 8% and not more than 10%. On November 4, 2019, federal regulators issued final rules that provide certain banks and their holding companies with the option to elect out of complying with the Basel III Capital Rules. Under the new rule, a qualifying community banking organization is eligible to elect the community bank leverage ratio greater than 9% at the time of election. The final rule is effective January 1, 2020, and banking organizations can use the CBLR for purposes of filing call reports commencing with the first quarter of 2020 (i.e., as of March 31, 2020). A qualifying community banking organization, or QCBO, is defined as a bank, a savings association, a bank holding company or a savings and loan holding company with: • a CBLR greater than 9%; • total consolidated assets of less than $10 billion; • total off-balance sheet exposures (excluding derivatives other than credit derivatives and unconditionally cancelable commitments) of 25% or less of total consolidated assets; and • total trading assets and trading liabilities of 5% or less of total consolidated assets. A QCBO may elect out of complying with the Basel III Capital Rules if, at the time of the election, the QCBO has a CBLR above 9%. The CBLR is generally calculated in accordance with the regulations for calculating the Tier 1 leverage ratio under the regulatory capital framework discussed above and below, with certain specified exceptions. As of December 31, 2019, we did not qualify as a QCBO. Stockholders’ Equity The Company completed its IPO in 2019 as discussed within our 2019 Highlights. The Company’s common shares are traded on the Nasdaq under the ticker ‘‘CFB.’’ The following graph presents total stockholders’ equity and tangible book value per share as of the end of the periods indicated: Changes in stockholders’ equity are provided in the Consolidated Statements of Stockholders’ Equity and in Note 24: Stock Offerings within the Notes to the Consolidated Financial Statements. Contractual Obligations The following tables present, as of December 31, 2019, our significant contractual cash obligations to third parties on debt, lease agreements and service obligations: Off-Balance Sheet Arrangements We are subject to off-balance sheet risk in the normal course of business to meet the needs of our clients 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. These off-balance sheet arrangements include commitments to fund loans and standby letters of credit. Commitments to originate loans are agreements to lend to a client as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each client’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the counterparty. The type of collateral that we obtain varies, but may include accounts receivable, inventory, property, plant and equipment, commercial real estate and residential real estate. Lines of credit, included in commitments to fund loans, are agreements to lend to a client as long as there is no violation of any condition established in the contract. Lines of credit generally have fixed expiration dates. Since a portion of the line may expire without being drawn upon, the total unused lines do not necessarily represent future cash requirements. Each client’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, commercial real estate and residential real estate. Management uses the same credit policies in granting lines of credit as it does for on-balance-sheet instruments. Standby letters of credit are irrevocable conditional commitments issued by the Company to guarantee the performance of a client to a third party. Financial standby letters of credit are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Performance standby letters of credit are issued to guarantee performance of certain clients under nonfinancial contractual obligations. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to clients. Fees for letters of credit are initially recorded by the Company as deferred revenue and are included in earnings at the termination of the respective agreements. Should the Company be obligated to perform under the standby letters of credit, the Company may seek recourse from the client for reimbursement of amounts paid. During 2017, the Company entered into a lease agreement for future office space in Kansas City, Missouri. The 15-year lease will begin upon substantial completion of the building or the date the Company takes possession of the premises for business purposes and includes four, five-year renewal terms. The future minimum lease payments for this current commitment are as follows: In association with the lease, the lessor will provide lessee with a construction allowance in the amount of approximately $1 million. The following is a summary of our off-balance sheet commitments outstanding as of the dates presented: Subsequent to year end, the Company entered into a lease agreement for future office space in Frisco, Texas. The information is presented in Note 26: Subsequent Events within the Notes to the Consolidated Financial Statements. Interest Rate Sensitivity A primary component of market risk is interest rate volatility. Managing interest rate risk is a key element of our balance sheet management. Interest rate risk is the risk that net interest margins will be eroded over time due to changing market conditions. Many factors can cause margins to erode: (i) lower loan demand; (ii) increased competition for funds; (iii) weak pricing policies; (iv) balance sheet mismatches; and (v) changing liquidity demands. We manage our sensitivity position using our interest rate risk policy. The management of interest rate risk is a three-step process and involves: (i) measuring the interest rate risk position; (ii) policy constraints; and (iii) strategic review and implementation. Our exposure to interest rate risk is managed by the Bank’s Funds Management Committee in accordance with policies approved by the Bank’s board of directors. The Funds Management Committee (‘‘FMC’’) uses a combination of three systems to measure the balance sheet’s interest rate risk position. Because each system serves a different purpose and provides a different perspective, the three systems in combination are expected to provide a better overall result than a single system alone. The three systems include: (i) gap reports; (ii) earnings simulation; and (iii) economic value of equity. • A gap report measures the repricing volume of assets and liabilities by time period. The difference between repricing assets and repricing liabilities for a particular time period is known as the periodic repricing gap. Using this method, it is possible to estimate the impact on earnings of a given rate change. As a method of evaluating interest rate risk, the gap report is a reasonably accurate method of assessing earnings exposure. However, its reliability diminishes as balance sheet complexity increases. Optionality and other factors complicate the analysis. • An earnings simulation measures the effect of changing interest rates on net interest income and earnings. Earnings simulation is more detailed than gap analysis. Under this approach, the repricing characteristics of each asset and liability instrument are programmed into a computer simulation model. This programming allows the Bank to refine important characteristics such as caps, floors, and time lag. It also allows the Bank to include the impact of new business activity in the analysis. Gap reporting only considers the existing balance sheet position. • Economic value of equity is a valuation approach to measuring long-term interest rate risk exposure. This approach considers all future time periods, which provides an advantage over earnings simulation. However, a negative attribute of Economic Value of Equity (‘‘EVE’’) is that it assumes a sustained change in rates, which is never the case in the long-term. This seeks to compute the financial risk of having a duration mismatch between assets and funding. In addition, the FMC compares the current interest rate risk position to policy limits. This procedure is compliance oriented and results in either a pass or fail outcome. When the balance sheet is in compliance, no further action is necessary. In instances of noncompliance, the committee will develop a plan of action to correct the condition. A summary of the plan and its timing for completion will be forwarded to the Board of Directors each quarter until compliance is reestablished. The FMC also evaluates interest rate risk positioning in light of anticipated interest rates. The purpose of this comparison is to determine whether action steps need to be taken to modify current strategy. The results form a decision-making input for the committee. If it is determined that more asset sensitivity is needed, the committee will either increase rate sensitive assets or reduce rate sensitive liabilities. The opposite will occur if less asset sensitivity is desired. Loan and deposit repricing assumptions are critical in measuring interest rate risk. For loans, management reviews spreads and prepayment assumptions. For deposits, management reviews beta factors and decay assumptions. The FMC reviews and adjusts repricing assumptions at least annually. Model assumptions are included in the output reports and reviewed by the FMC on a periodic basis. When evaluating balance sheet rate sensitivity, a proper analysis of total funding is of critical importance. The funding side of the balance sheet can be segregated into three broad categories, as follows: (i) funding with defined maturity dates; (ii) nonmaturity deposits; and (iii) perpetual funding. • Funding with defined maturity dates includes certificates of deposit and borrowed funds. The repricing analysis requires a twofold statement of behavior for each balance sheet category. It requires a cash flow schedule for principal and interest payments and a repricing schedule of rate adjustments. Once the cash flow and repricing projections are developed, the category can be analyzed for interest rate risk exposure. • Nonmaturity deposits tend to be a longer term, less volatile source of funds. Nonmaturing deposits have very short contractual lives. The Bank uses historical analysis to develop its decay assumptions, but it looks at aggregate account types rather than individual clients. The review analyzes both nonmaturity deposits as a whole and individual deposit categories. • Perpetual funding is the most stable and least costly source of funding. Its main component is equity capital. It has a zero interest rate and cannot be withdrawn by stockholders because of a rate change. In effect, it is a perpetual source of free funding. To ensure a formal evaluation process, periodic independent evaluations will be conducted and documented. Such evaluation will consist primarily of: (i) an assessment of internal controls; (ii) an evaluation of data integrity; (iii) the appropriateness of the risk management system; (iv) the reasonableness of validity scenarios; (v) a review of the FMC policy; and (vi) validation of calculations. In addition, to ensure the model is working as expected a back test of the model will be completed at least annually. All of the assumptions used in our analysis are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies. On a quarterly basis, we run various simulation models including a static balance sheet and dynamic growth balance sheet. These models test the impact on net interest income and fair value of equity from changes in market interest rates under various scenarios. Under the static model and dynamic growth models, rates are shocked instantaneously and ramped rates change over a 12 month horizon based upon parallel and nonparallel yield curve shifts. Parallel shock scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Nonparallel simulation involves analysis of interest income and expense under various changes in the shape of the yield curve. Our internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net interest income at risk for the subsequent one year period should not decline by more than 5% for a -100 basis point shift, 5% for a 100 basis point shift, 10% for a 200 basis point shift, 15% for a 300 basis point shift, and 20% for a 400 basis point shift. The Company has several instruments that can be used to manage interest rate risk, including: (i) modifying the duration of interest-bearing liabilities; (ii) modifying the duration of interest-earning assets, including our investment portfolio; and (iii) entering into on balance sheet derivatives. As of December 31, 2019, we have not entered into instruments such as leveraged derivatives or financial options to mitigate interest rate risk from specific transactions. Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk. The FMC evaluates interest rate risk using a rate shock method and rate ramp method. In a rate shock analysis, rates change immediately and the change is sustained over the time horizon. In a rate ramp analysis, rate changes occur gradually over time. The following tables summarize the simulated changes in net interest income and fair value of equity over a 12 month horizon using a rate shock and rate ramp method as of the dates indicated: The hypothetical change in net interest income as of December 31, 2019 in a down or up 100 basis point shock is mainly due to approximately 67% of earning assets repricing or maturing over the next 12 months. Loans remain the largest portion of our adjustable earning assets, as the mix of adjustable loans or those maturing in one year was 76%. The amount of adjustable loans causes the Company to see an increase in net interest income in a rising rate environment and a decline in net interest income in a declining rate environment. The models the Company uses include assumptions regarding interest rates and balance changes. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions, customer behavior and management strategies, among other factors. Selected Quarterly Financial Data (unaudited) The following table presents selected quarterly financial data for the fiscal years ended December 31, 2019 and 2018: Overview Highlights of our results for the fourth quarter of 2019 are summarized below: • Quarterly net loss of $700 thousand primarily driven by a $19 million provision for loan losses primarily from one impaired, commercial loan relationship that significantly deteriorated during the quarter. An additional discussion regarding the commercial loan relationship was previously discussed in the Allowance for Loan Losses section. • Fourth quarter 2019 loss per share (diluted) was $0.01 compared to income per share of $0.21 in the prior quarter and $0.22 in the fourth quarter of the previous year. • Loan growth for the quarter ended December 31, 2019 was $222 million or 6% from the previous quarter. • December 31, 2019 deposits grew by $266 million or 7% from the previous quarter. Net Interest Income Fourth quarter 2019 tax-equivalent net interest income was $38 million, a $5 million or 15% increase from the prior year and a $1 million or 4% increase from the previous quarter. Tax-equivalent net interest margin declined to 3.23% for the quarter compared to 3.51% for the same quarter in 2018, reflecting the impact of the declining rate environment. The Company produced tax-equivalent interest income of $56 million for the fourth quarter of 2019, an increase of $8 million or 17% from the fourth quarter of 2018 and declined by $302 thousand or 1% from the previous quarter due to the declining interest rate environment. The year-over-year increase was the result of a $927 million increase in quarterly average earning assets that increased interest income by $12 million, but was offset by a decline in yields that reduced interest income by $4 million. Fourth quarter 2019 interest expense was $18 million an increase of $3 million or 22% from the same quarter in 2018 and a $2 million or 9% decline from the prior quarter. The year-over-year increase was the result of a $763 million or 22% increase in the quarterly average of interest-bearing liabilities, which increased interest expense by $3 million. The decline in interest expense from the third quarter of 2019 was the result of changes to the interest-bearing deposit mix and the declining rate environment. Provision for Loan Losses The fourth quarter 2019 provision increased $15 million or 299% from the prior quarter and $15 million or 330% from the fourth quarter of 2018. The fourth quarter provision of $19 million was primarily the result of a previously disclosed, impaired, commercial loan relationship that continued to deteriorate during the quarter and loan growth. Noninterest Income Noninterest income increased $1 million in the fourth quarter of 2019 or 83% compared to the same quarter of 2018 and decreased $1 million or 32% lower compared to the third quarter of 2019. The Company continues to increase fee income due to asset and customer growth. In addition, the Company recorded $520 thousand of AFS gains and $338 thousand of income from the back-to-back swap program. The decline from the prior quarter was primarily due to swap fee activity and the change in methodology that occurred in the third quarter of 2019 related to the CVA adjustment. Prior to the third quarter, a default methodology was used to account for non-performance risk. The Company changed to a review of internal credit analysis performed by the Company. Management believes this change better aligns with the Company’s credit methodology and underwriting standards. This change increased the third quarter swap fees, net line item by approximately $800 thousand related to swaps closed on or before June 30, 2019. Noninterest Expense Noninterest expense for the fourth quarter of 2019 increased $2 million, or 9%, compared to the fourth quarter of 2018 and increased $713 thousand, or 3%, from the third quarter of 2019. Compared to the fourth quarter of 2018, salary and employment-related expenses increased $1 million due to an increase in employee headcount required to support growth, as well as data processing costs that increase based on our balance sheet growth and larger customer base. As compared to the third quarter of 2019, salary and employment-related expenses decreased $438 thousand due to strategic hiring decisions and an adjustment to the bonus accrual. FDIC insurance expense increased as a result of a bank credit received in the third quarter and professional fees increased $614 thousand due to our transition into a public company and activities within our loan portfolio. Incomes Taxes The effective tax rate for the fourth quarter of 2019 was not applicable as a result of a net loss. The effective tax rate was 20% in the third quarter of 2019 and (17)% for the fourth quarter of 2018. Quarter-over-quarter changes included a net loss and permanent tax differences. The year-over-year change was driven by a state tax credit received in the fourth quarter of 2018. 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 complex and subjective estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under current circumstances. These assumptions form the basis for our judgments about the carrying values of assets and liabilities that are not readily available from independent, objective sources. We evaluate our estimates on an ongoing basis. Use of alternative assumptions may have resulted in significantly different estimates. Actual results may differ from these estimates. The Company qualifies as an EGC under the JOBS Act. Section 107 of the JOBS Act provides that an EGC can take advantage of the extended transition period when complying with new or revised accounting standards. This allows an EGC to delay adoption of certain accounting standards until those standards would apply to private companies; however, the EGC can still early adopt new or revised accounting standards, if applicable. We have elected to take advantage of this extended transition period, which means the financial statements in this prospectus, as well as financial statements we file in the future, will be subject to all new or revised accounting standards generally applicable to private companies, unless stated otherwise. This decision will remain in effect until the Company loses its EGC status. Our most significant accounting policies are described in Note 1: Nature of Operations and Summary of Significant Accounting Policies within the Notes to the Consolidated Financial Statements. We 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 our financial statements to those judgments and assumptions, are critical to an understanding of our financial condition and results of operations. Recent Accounting Pronouncements All significant accounting pronouncements are described in Note 1: Nature of Operations and Summary of Significant Accounting Policies within the Notes to the Consolidated Financial Statements. The Company has identified the following accounting pronouncements that due to the impact on the Company’s financial statements are critical to an understanding of our financial condition and results of operations. GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures Our accounting and reporting policies conform to GAAP and the prevailing practices in the banking industry. Some of the financial measures included in this prospectus are not measures of financial performance recognized by GAAP. These non-GAAP financial measures are used by management to evaluate our performance. A financial measure is considered non-GAAP if the measure: (i) excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in its most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows of the issuer; or (ii) includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure calculated and presented in accordance with GAAP. The non-GAAP financial measures that we discuss in this Annual Report on Form 10-K should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate these non-GAAP financial measures may differ from that of other companies reporting measures with similar names. It is important to understand how other banking organizations calculate their financial measures with names similar to the non-GAAP financial measures we have discussed in this prospectus when comparing such non-GAAP financial measures. We calculate ‘‘non-GAAP core operating income’’ as net income adjusted to remove non-recurring or non-core income and expense items related to: • Restructuring charges associated with the transition of our former CEO - In connection with the departure of our former CEO in the second quarter of 2018, we incurred restructuring charges related to the acceleration of certain stock-based compensation and employee costs. • Impairment charges associated with two buildings that were held-for-sale - We acquired a new, larger corporate headquarters to accommodate our business needs, which eliminated the need for two smaller support buildings. The two smaller support buildings had been acquired recently and were extensively remodeled, which resulted in a difference between book and market value for those assets. We sold one of the buildings in 2018. The remaining building was sold during the second quarter of 2019. • State tax credits as a result of the purchase and improvement of our new corporate headquarters − We acquired a new, larger corporate headquarters to accommodate our business needs. Our purchase and improvement of the new headquarters resulted in state tax credits. • One time charge to income related to the 2017 Tax Act - Our corporate income tax rate was reduced as a result of the 2017 Tax Act, which caused a revaluation of our deferred tax assets and liabilities. We were required to write down the value of the net deferred tax assets based upon the difference between the then current tax rate and the new tax rate, resulting in a one time charge to income. The most directly comparable GAAP financial measure for non-GAAP core operating income is net income. We calculate ‘‘non-GAAP core operating return on average assets’’ as non-GAAP core operating income (as defined above) divided by average assets. The most directly comparable GAAP financial measure is return on average assets, which is calculated as net income divided by average assets. We calculate ‘‘non-GAAP core operating return on average common equity’’ as non-GAAP core operating income (as defined above) less preferred dividends divided by average common equity. The most directly comparable GAAP financial measure is return on average common equity, which is calculated as net income less preferred dividends divided by average common equity. Management believes that non-GAAP core operating income, non-GAAP core operating return on average assets and non-GAAP core operating return on average common equity removes events that are not recurring and not part of core business activities and are useful analytical tools for investors to compare periods excluding these non-recurring or non-core expenses and charges. The following tables reconcile, as of the dates set forth below, net income to non-GAAP core operating income, non-GAAP core operating return on average assets and non-GAAP core operating return on average common equity: We calculate ‘‘tangible common stockholders’ equity’’ as total stockholders’ equity less goodwill and other intangible assets and preferred stock. The most directly comparable GAAP financial measure is total stockholders’ equity. We calculate ‘‘tangible book value per share’’ as tangible common stockholders’ equity (as defined above) divided by the number of shares of our common stock outstanding at the end of the relevant period. The most directly comparable GAAP financial measure is book value per share. Management believes that tangible stockholders’ equity and tangible book value per share are important to many investors in the marketplace who are interested in changes from period to period in our stockholders’ equity, exclusive of changes in intangible assets. The following tables reconcile, as of the dates set forth below, total stockholders’ equity to tangible stockholders’ equity and presents tangible book value per share compared to book value per share: During the fourth quarter of 2019, the Company modified the "non-GAAP core operating efficiency ratio" to include the effect of our tax-free municipal security portfolio. The tax-equivalent interest income is broken out as a separate line item within the table below. Management believes the addition of the tax-equivalent interest income will help investors understand the Company's strategy to invest in tax-free municipal securities and how it impacts the non-GAAP core operating efficiency ratio. We calculate ‘‘non-GAAP core operating efficiency ratio - tax-equivalent’’ as noninterest expense adjusted to remove non-recurring noninterest expenses as defined under non-GAAP core operating income divided by the sum of net interest income on a tax-equivalent basis and noninterest income adjusted to remove non-recurring noninterest income as defined under non-GAAP core operating income. Management believes that the non-GAAP core operating efficiency ratio is important to many investors because the ratio removes events that are not recurring or not part of core business activities and is a useful analytical tool. The most directly comparable GAAP financial measure is the efficiency ratio, which is calculated as noninterest expense divided by the sum of net interest income and noninterest income. The following tables provide the calculation of the non-GAAP core operating efficiency ratio- tax-equivalent:

<s>[INST] Overview This section includes a discussion on the financial condition and results of operations of CrossFirst Bankshares, Inc. and its subsidiaries for the past three years. Tables may include additional periods to comply with disclosure requirements or to illustrate trends in greater depth. You should read the following financial data in conjunction with the other information contained in this 10K, including under ‘‘Risk Factors,’’ ‘‘GAAP Reconciliation and Management Explanation of NonGAAP Financial Measures,’’ and in the financial statements and related notes included elsewhere in this 10K. The page locations of specific sections that we refer to are presented in the table of contents to this section. Our Company CrossFirst Bankshares, Inc., a Kansas corporation and registered bank holding company, is the holding company for CrossFirst Bank. The Company was initially formed as a limited liability company, CrossFirst Holdings, LLC, on September 1, 2008 to become the holding company for the Bank and converted to a corporation in 2017. The Bank was established as a Kansas statechartered bank in 2007 and provides a full suite of financial services to businesses, business owners, professionals and their personal networks throughout our five primary markets located in Kansas, Missouri, Oklahoma and Texas. Growth History Since opening our first branch in 2007, we have grown organically primarily by establishing seven offices, attracting new clients and expanding our relationships with existing clients, as well as through two strategic acquisitions. The data below presents the growth of key areas of our business for the past five years and the related compound annual growth rate: Our Strategy Since inception, our strategy has been to build the most trusted bank serving our markets, which we believe has driven value for our stockholders. We remain focused on robust growth and are equally focused on building stockholder value through greater efficiency and increased profitability. We intend to execute our strategic plan through the following: Continue organic growth; Selectively pursue opportunities to expand through acquisitions or new market development; Improve profitability and operating efficiency; Attract and develop talent; Maintain a branchlite business model with strategically placed locations; and Leverage technology to enhance the client experience and improve profitability. 2019 Highlights: We completed our IPO on August 19, 2019 in which we issued and sold 6,594,362 common shares including 844,362 shares pursuant to the underwriters’ partial exercise of their overallotment option. The common shares were sold at an initial public offering price of $14.50 per share. After deducting the underwriting discounts and offering expenses, the Company received total net proceeds of approximately $87 million. The shares began trading on the Nasdaq Global Select Market under the symbol ‘‘CFB.’’ Balance Sheet Growth Approached $5 billion in total assets as of December 31, 2019, an increase of $824 million or 20% from yearend 2018. Gross loans, net of unearned income totaled nearly $4 billion as of December 31, 2019, an increase of $791 million or 26% from the prior year, driven by organic growth. Deposits increased $716 million or 22% from December 31, 2018 to $4 billion as of December 31, 2019, which resulted in a slight increase to our loantodeposit ratio to 98%. Book value per share was $11.58 at December 31, 2019 compared to $10.21 at December 31, 2018 driven by earnings and our successful IPO. Operating and Financial Performance Full year 2019 net income of $28.5 million compared to $19.6 million in 2018, a yearoveryear increase of $9 million or 45%. The improvement was the result of a $31 million increase in net interest income and a $3 million increase in noninterest income, partially offset by a $2 million increase in operating expenses, a $16 million increase in the provision and a $7 million increase in income tax expense. Earnings per share [/INST] Negative. </s>

Vir Biotechnology, 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 in conjunction with our audited consolidated financial statements and notes and other financial information included elsewhere in this Annual Report on Form 10K. Unless the context requires otherwise, references in this Annual Report on Form 10-K to the “Company”, “Vir,” “we,” “us” and “our” refer to Vir Biotechnology, Inc. and its consolidated subsidiaries. Our discussion and analysis below are focused on our financial results and liquidity and capital resources for the years ended December 31, 2019 and 2018, including year-over-year comparisons of our financial performance and condition for these years. Discussion and analysis of the year ended December 31, 2017 specifically, as well as the year-over-year comparison of our financial performance and condition for the years ended December 31, 2018 and 2017, are located in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in the prospectus dated October 10, 2019 that forms a part of the Company’s Registration Statement on Form S-1 (File No. 333-233604), as filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933, as amended, on October 11, 2019. Overview We are a clinical-stage immunology company focused on combining immunologic insights with cutting-edge technologies to treat and prevent serious infectious diseases. Infectious diseases are one of the leading causes of death worldwide and cause hundreds of billions of dollars of economic burden each year. We believe that now is the time to apply the recent and remarkable advances in immunology to combat infectious diseases. Our approach begins with identifying the limitations of the immune system in combating a particular pathogen, the vulnerabilities of that pathogen and the reasons why previous approaches have failed. We then bring to bear powerful technologies that we believe, individually or in combination, will lead to effective therapies. We have assembled four technology platforms, focused on antibodies, T cells, innate immunity and small interfering ribonucleic acid, or siRNA, through internal development, collaborations and acquisitions. Our current development pipeline consists of product candidates targeting hepatitis B virus, or HBV, influenza A, severe acute respiratory syndrome coronavirus 2, or SARS-CoV-2, human immunodeficiency virus, or HIV, and tuberculosis, or TB. VIR-2218, an HBV-targeting siRNA, has completed enrollment in an ongoing Phase 1/2 clinical trial. Initial data have demonstrated substantial reduction of hepatitis B virus surface antigen, or HBsAg, and VIR-2218 has been generally well tolerated. We are next initiating a Phase 2 trial combining VIR-2218 with pegylated interferon-alpha, an approved immune modulatory agent. Additionally, we have initiated a Phase 1/2 clinical trial for VIR-2482, a monoclonal antibody, or mAb, designed for the prevention of influenza A. We have built an industry-leading team that has deep experience in immunology, infectious diseases and product development. Given the global impact of infectious diseases, we are committed to developing cost-effective treatments that can be delivered at scale. We were incorporated in April 2016 and commenced principal operations later that year. To date, we have focused primarily on organizing and staffing our company, business planning, raising capital, identifying, acquiring, developing and in-licensing our technology platforms and product candidates, and conducting preclinical studies and early clinical trials. Prior to our initial public offering, or IPO, we funded our operations to date primarily from the issuance and sale of convertible preferred stock, and to a lesser extent from revenue from grant agreements with government-sponsored and private organizations, as well as research and development services. From our inception through December 31, 2019, we have raised aggregate net cash proceeds of $630.7 million from the sale of our convertible preferred stock. In October 2019, we completed our IPO pursuant to which we issued 7,142,858 shares of our common stock at a price of $20.00 per share. We received net proceeds of $126.4 million from the IPO, after deducting underwriting discounts, commissions and offering expenses. As of December 31, 2019, we had $407.7 million in cash, cash equivalents and investments. Based upon our current operating plan, we believe that our existing cash, cash equivalents and investments as of December 31, 2019 will enable us to fund our operating expenses and capital expenditure requirements through at least the next 12 months from the issuance date of the consolidated financial statements included elsewhere in this Form 10-K. We have incurred significant operating losses since our inception and expect to continue to incur significant operating losses for the foreseeable future. We do not have any products approved for sale, we have not generated any revenue from the sale of products, and we do not expect to generate revenue from the sale of our product candidates until we complete clinical development, submit regulatory filings and receive approvals from the applicable regulatory bodies for such product candidates, if ever. Our net losses were $174.7 million, $115.9 million and $69.9 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $368.5 million. Our primary use of our capital resources is to fund our operating expenses, which consist primarily of expenditures related to identifying, acquiring, developing and in-licensing our technology platforms and product candidates, and conducting preclinical studies and early clinical trials, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. We expect to continue to incur net operating losses for at least the next several years. In particular, we expect our expenses and losses to increase as we continue our research and development efforts, advance our product candidates through preclinical and clinical development, seek regulatory approval, prepare for commercialization, as well as hire additional personnel, protect our intellectual property and incur additional costs associated with being a public company. We also expect to increase the size of our administrative function to support the growth of our business. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and our expenditures on other research and development activities. We are currently manufacturing product candidates from three different platforms: antibodies, T cells and siRNAs. We have established our own internal chemistry, manufacturing and control, or CMC, capabilities and are working with contract development and manufacturing organizations, or CDMOs to supply our early stage product candidates in the near-term. We have completed our internal capacity build in process development, analytical development, quality, manufacturing and supply chain. Specifically, our San Francisco, California and Portland, Oregon facilities include laboratories that support process development, production of human cytomegalovirus, or HCMV research viral seed stock and selected quality control testing for our product candidates. We have established relationships with multiple CDMOs and have produced material to support preclinical studies and Phase 1 and Phase 2 clinical trials. Material for Phase 3 clinical trials and commercial supply will require large-volume, low-cost-of-goods production, and we are in discussions with additional large-scale CDMOs to plan for future scale-up and capacity. Our License, Collaboration and Grant Agreements We have entered into grant, license and collaboration arrangements with various third parties. For details regarding these and other agreements, see the section titled “Business-Our Collaboration, License and Grant Agreements” and Note 6-Grant, License and Collaboration Agreements to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Our Acquisitions We have completed various acquisitions. For details regarding our acquisitions, see the section titled “Business-Our Acquisition Agreements” and Note 4-Acquisitions to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Components of Operating Results Revenue We do not have any products approved for sale, we have not generated any revenue from the sale of our products, and we do not expect to generate revenue from the sale of our product candidates until we complete clinical development, submit regulatory filings and receive approvals from the applicable regulatory bodies for such product candidates, if ever. Our revenue consists of: (i) grant revenue; and (ii) contract revenue. Grant revenue is comprised of revenue derived from grant agreements with government-sponsored and private organizations. Contract revenue is comprised of revenue generated from research and development services. Operating Expenses Research and Development To date, our research and development expenses have related primarily to discovery efforts and preclinical and clinical development of our product candidates. Research and development expenses are recognized as incurred and payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. We do not track research and development expenses by product candidate. Research and development expenses consist primarily of costs incurred for the development of our product candidates, which include: • expenses related to license and collaboration agreements; • personnel-related expenses, including salaries, benefits and stock-based compensation for personnel contributing to research and development activities; • expenses incurred under agreements with third-party contract manufacturing organizations, contract research organizations, and consultants; • clinical costs, including laboratory supplies and costs related to compliance with regulatory requirements; and • other allocated expenses, including expenses for rent and facilities maintenance, and depreciation and amortization. We expect our research and development expenses to increase substantially in absolute dollars for the foreseeable future as we advance our product candidates into and through preclinical studies and clinical trials and pursue regulatory approval of our product candidates. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming. The actual probability of success for our product candidates may be affected by a variety of factors including: the safety and efficacy of our product candidates, early clinical data, investment in our clinical programs, the ability of collaborators to successfully develop our licensed product candidates, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our product candidates. As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of our product candidates. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. We anticipate that we will make determinations as to which product candidates to pursue and how much funding to direct to each product candidate on an ongoing basis in response to the results of ongoing and future preclinical studies and clinical trials, regulatory developments and our ongoing assessments as to each product candidate’s commercial potential. In addition, we cannot forecast which product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. Our clinical development costs may vary significantly based on factors such as: • whether a collaborator is paying for some or all of the costs; • 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; • 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. General and Administrative Our general and administrative expenses consist primarily of personnel-related expenses for personnel in executive, finance and other administrative functions, facilities and other allocated expenses, transaction costs associated related to acquisitions and other expenses for outside professional services, including legal, 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 substantially in absolute dollars for the foreseeable future as we continue to support our continued research and development activities, grow our business and, if any of our product candidates receive marketing approval, commercialization activities. We also anticipate incurring additional expenses associated with operating as a public company, including increased expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with the rules and regulations of the SEC and standards applicable to companies listed on a national securities exchange, additional insurance expenses, investor relations activities and other administrative and professional services. Interest Income Interest income consists of interest earned on our cash, cash equivalents and investments. Other Income (Expense), Net Other income (expense), net consists of gains and losses from foreign currency transactions and from remeasurement of convertible preferred stock warrant liability and contingent consideration. Upon completion of our IPO, the outstanding warrant to purchase shares of our Series A-1 convertible preferred stock automatically converted into a warrant to purchase shares of common stock and therefore, was no longer subject to remeasurement each period. Benefit from (Provision for) Income Taxes Benefit from income taxes consists of the partial release of the valuation allowance on net deferred tax assets triggered by the deferred tax liabilities recorded as a result of the acquisition of Statera in 2018. Provision for income taxes in 2019 consisted of immaterial international income tax. Results of Operations Comparison of Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the periods presented: Revenue Total revenue was $8.1 million and $10.7 million for the years ended December 31, 2019 and 2018, respectively. The decrease in total revenue was primarily due to the Campylo/EPEC/EAEC grant with the Bill & Melinda Gates Foundation, which expired in May 2019, and the timing of research activities under the HIV and TB grants with the Bill & Melinda Gates Foundation. Research and Development Expenses The following table shows the primary components of our research and development expenses for the periods presented: Research and development expenses were $148.5 million and $100.2 million for the years ended December 31, 2019 and 2018, respectively. This increase was primarily due to: • personnel-related expenses increased by $20.1 million, which was primarily attributable to an increase in our headcount; • other research and development expenses increased by $12.2 million, which was primarily attributable to increases of $6.7 million in external research costs, $3.7 million in the allocation of facilities costs, and $1.5 million in supplies and equipment costs to support an increase in our headcount; • clinical costs increased by $7.4 million, which was primarily attributable to the initiation of our first HBV clinical trial in November 2018 and dosing in a Phase 1/2 clinical trial for influenza A in August 2019; • licenses and collaborations expense increased by $3.8 million primarily attributable to increases of $5.4 million related to the change in fair value of the contingent consideration from our acquisition of Humabs Biomed SA, $7.7 million primarily related to our collaboration agreement, or the Alnylam Agreement, with Alnylam Pharmaceuticals, Inc., and $12.4 million related to the fair value of the derivative liability under the Alnylam Agreement. These increases were partially offset by decreases of $14.5 million related to our acquisition of Agenovir Corporation in 2018, $5.0 million related to payments under the 2018 MedImmune Agreement, and $2.6 million related to our license agreement with Visterra, Inc., or the Visterra Agreement, which terminated in the fourth quarter of 2019. No additional expenses were incurred pursuant to the Visterra Agreement during 2019; and • contract manufacturing expenses increased by $4.7 million, which was primarily attributable to an increase of manufacturing cost related to HBV and influenza A production of clinical materials for use in our preclinical studies and clinical trials. General and Administrative Expenses General and administrative expenses were $37.6 million and $29.1 million for the years ended December 31, 2019 and 2018, respectively. The increase was primarily due to an increase in personnel-related expenses related to additional headcount and professional fees. Interest Income Interest income were $8.5 million and $2.5 million for the years ended December 31, 2019 and 2018, respectively. The increase was due to higher cash, cash equivalents and short-term investment balances in 2019 compared to 2018. Other Income (Expense), Net We had other expense, net, of $5.1 million and $0.2 million for the years ended December 31, 2019 and 2018, respectively. The increase in expense was primarily due to the change in fair value of the contingent consideration related to our acquisition of TomegaVax, Inc., and the revaluation of the convertible preferred stock warrant liability. Liquidity, Capital Resources and Capital Requirements Sources of Liquidity As of December 31, 2019, we had $407.7 million in cash, cash equivalents and investments, and an accumulated deficit of $368.5 million. We have financed our operations primarily through sales of our common stock in conjunction with the IPO, convertible preferred securities and payments received under our collaboration agreements. On October 10, 2019, our registration statement on Form S-1 was declared effective by the SEC and our shares began trading on The Nasdaq Global Select Market on October 11, 2019. We sold an aggregate of 7,142,858 shares of our common stock at an initial offering price of $20.00 per share. As a result of the IPO, we received $126.4 million in net proceeds, after deducting underwriting discounts and commissions of approximately $10.0 million and offering expenses of approximately $6.4 million. Our primary use of our capital resources is to fund our operating expenses, which consist primarily of expenditures related to identifying, acquiring, developing and in-licensing our technology platforms and product candidates, and conducting preclinical studies and early clinical trials, and to a lesser extent, general and administrative expenditures. Future Funding Requirements Based upon our current operating plan, we believe that our existing cash, cash equivalents and investments as of December 31, 2019, will enable us to fund our operating expenses and capital expenditure requirements through at least the next 12 months from the issuance date of the consolidated financial statements included elsewhere in this Form 10-K. However, we will still need to raise substantial additional capital to fund the development of our product candidates. We anticipate raising additional capital through the sale of our equity securities, incurring debt, entering into collaboration, licensing or similar arrangements with third parties, or receiving research contributions, grants or other sources of financing to fund our operations. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, licenses and other similar arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. There can be no assurance that sufficient funds will be available to us on attractive terms or at all. 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. 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 of our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of biotechnology 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 timing, progress and results of our ongoing preclinical studies and clinical trials of our product candidates; • the scope, progress, results and costs of preclinical development, laboratory testing and clinical trials of other product candidates that we may pursue; • our ability to establish and maintain collaboration, license, grant and other similar arrangements, and the financial terms of any such arrangements, including the timing and amount of any future milestone, royalty or other payments due thereunder; • the costs, timing and outcome of regulatory review of our product candidates; • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any of our product candidates for which we receive marketing approval; • the revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending any intellectual property-related claims; • any expenses needed to attract, hire and retain skilled personnel; • the costs of operating as a public company; and • the extent to which we acquire or in-license other companies’ product candidates and technologies. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities During the year ended December 31, 2019, net cash used in operating activities was $129.6 million. This consisted primarily of a net loss of $174.7 million, partially offset by a decrease in our net operating assets of $8.2 million and non-cash charges of $36.8 million. The change in our net operating assets of $8.2 million was primarily driven by increases in accrued liabilities related to expenses incurred under the Alnylam Agreement, and employee related expenses due to higher headcount. The non-cash charges of $36.8 million primarily consisted of $12.4 million for the fair value of the derivative liability under the Alnylam Agreement, $8.7 million for stock-based compensation expense, $8.3 million for revaluation of contingent consideration, $4.5 million for depreciation and amortization expense, and $2.0 million for revaluation of convertible preferred stock liability. During the year ended December 31, 2018, net cash used in operating activities was $94.1 million. This consisted primarily of a net loss of $115.9 million, partially offset by a decrease in our net operating assets of $12.5 million and non-cash charges of $9.3 million. The decrease in our net operating assets of $12.5 million was primarily due to an increase in deferred revenue of $7.9 million related to upfront payments received from the Bill & Melinda Gates Foundation grants and increases in accounts payable, accrued liabilities and other long-term liabilities of $8.6 million as we expanded our operations, partially offset by an increase in prepaid expenses and other current assets of $4.2 million. The non-cash charges of $9.3 million primarily consisted of $5.1 million for stock-based compensation expense and $2.8 million for depreciation and amortization expense. Investing Activities During the year ended December 31, 2019, cash used in investing activities was $256.2 million. This consisted of purchases of short and long-term investments of $643.9 million and purchases of property and equipment of $8.9 million, partially offset by $396.7 million in proceeds received from investments which matured during the period. During the year ended December 31, 2018, cash used in investing activities was $60.4 million. This consisted primarily of purchases of short-term investments of $123.1 million and purchases of property and equipment of $8.2 million, partially offset by $72.6 million in proceeds received from short-term investments which matured during the period. Financing Activities During the year ended December 31, 2019, cash provided in financing activities was $449.2 million. This consisted primarily of net proceeds received from the issuance of our Series B convertible preferred stock of $317.3 million in January 2019, issuance of common stock upon completion of our IPO of $126.4 million in October 2019, repayment of promissory notes of $3.3 million, and financing lease obligation of $1.2 million. During the year ended December 31, 2018, cash provided in financing activities was $25.0 million. This consisted primarily of net proceeds received from the issuance of our Series A-1 convertible preferred stock of $14.3 million and advance cash payment of $10.1 million for the issuance of our Series B convertible preferred stock, which closed in January 2019. Contractual Obligations and Commitments The following table summarizes our contractual obligations and commitments as of December 31, 2019: Under our collaboration, license and acquisition agreements, we have payment obligations that are contingent upon future events such as our achievement of specified development, regulatory and commercial milestones and are required to make royalty payments in connection with the sale of products developed under those agreements. We have not included any such milestone or royalty payments in the above table. For additional information regarding these agreements, including our payment obligations thereunder, see the sections titled “Business-Our Collaboration, License and Grant Agreements” and “Business-Our Acquisition Agreements,” as well as Notes 4 and 6 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. We enter into agreements in the normal course of business with contract manufacturing organizations and contract research organizations for clinical trials, preclinical studies, manufacturing, and other services and products for operating purposes, which are generally cancelable upon written notice. These obligations and commitments are also not included in the table above. Off-Balance Sheet Arrangements During the periods presented we did not have, nor do we currently have, any off-balance sheet arrangements as defined under the rules of the SEC. Brii Biosciences Limited, or Brii Bio Parent, and its wholly owned subsidiary Brii Biosciences Offshore Limited, or Brii Bio, are variable interest entities due to their reliance on future financing and insufficient equity at risk. However, we do not have the power to direct activities which most significantly impact the economic success of these entities and are not the primary beneficiary, and therefore we do not consolidate Brii Bio Parent or Brii Bio. 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 to enable us to comply with certain 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. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of our consolidated financial statements requires us to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses and the related disclosures. We base our estimates on historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. The critical accounting policies, estimates and judgments that we believe to have the most significant impacts to our consolidated financial statements are described below. Research and Development Expenses We expense all research and development costs in the periods in which they are incurred. We estimate preclinical and clinical expenses based on the services performed, pursuant to contracts with research institutions that conduct and manage preclinical studies and clinical trials and research services on our behalf. We record the costs of research and development activities based upon the estimated amount of services provided but not yet invoiced and include these costs in accrued liabilities in the consolidated balance sheets. 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. 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 estimated cash flows and development timelines related to acquired 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. Contingent Consideration and Embedded Derivatives Contingent consideration related to business combinations and obligations required to be accounted for as embedded derivative financial instruments under Topic ASC 815, “Derivatives and Hedging” are considered to be Level 3 instruments that are initially measured at their estimated fair values on the transaction date and subsequently remeasured with changes recorded in the consolidated statement of operations each subsequent reporting period. The estimated fair value of the contingent consideration related to the Humabs acquisition was determined by calculating the probability-weighted clinical and regulatory milestone payments based on the assessment of the likelihood and estimated timing that certain milestones would be achieved, as well as the use of Monte Carlo simulation model that includes significant estimates and assumptions pertaining to commercialization events and sales targets. The most significant unobservable inputs are the probabilities of achieving clinical and regulatory approval of the development projects and the subsequent commercial success and discount rates. The estimated fair value of the contingent consideration related to our acquisition of TomegaVax, Inc. was determined based on a Monte Carlo simulation model that includes significant estimates and assumptions pertaining to probability and timing to achieve the required share price of our common stock, expected volatility and discount rate. Although the TomegaVax acquisition was accounted for as an asset acquisition, certain contingent payments met the definition of embedded derivative financial instruments. The estimated fair value of the embedded derivative related to our Alnylam Agreement was determined based on estimates and assumptions over the likelihood and timing to achieve the specified development milestone. Significant changes in the probabilities of the likelihood and timing to achieve the milestones would result in a significantly higher or lower fair value measurement. Stock-Based Compensation We recognize compensation costs related to stock options granted to employees and nonemployees based on the estimated fair value of the awards on the date of grant, and we recognize forfeitures as they occur. We estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is recognized on a straight-line basis over the requisite service period, which is typically the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of highly subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Fair Value of Common Stock-See the subsection titled “-Common Stock Valuations” below. • Expected Term-The expected term represents the period that the stock-based awards are expected to be outstanding. We use the simplified method to determine the expected term, which is based on the average of the time-to-vesting and the contractual life of the options. • Expected Volatility-Because we do not have sufficient trading history for our common stock, the expected volatility is estimated based on the average historical volatilities of common stock of comparable publicly traded entities over a period equal to the expected term of the stock option grants. The comparable companies are chosen based on their size, stage in the product development cycle or area of specialty. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. • Risk-Free Interest Rate-The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant for zero-coupon U.S. Treasury notes with maturities approximately equal to the expected term of the awards. • 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. See Note 12 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for 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 granted in the years ended December 31, 2019, 2018 and 2017. 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. Common Stock Valuations For all periods prior to the IPO, because there was no public market of our common stock, the fair value of the shares of common stock underlying our share-based awards was estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, our board of directors considered, among other things, input from management, valuations of our common stock prepared by unrelated third-party valuation firms 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, and our board of directors’ assessment of additional objective and subjective factors that it believed were relevant, and factors that may have changed from the date of the most recent valuation through the date of the grant. These factors include, but were not limited to: • our results of operations and financial position, including our levels of available capital resources; • our stage of development and material risks related to its business; • progress of our research and development activities; • our business conditions and projections; • the valuation of publicly traded companies in the life sciences and biotechnology sectors, as well as recently completed mergers and acquisitions of peer companies; • the lack of marketability of our common stock as a private company; • the prices at which we sold shares of our convertible preferred stock to outside investors in arms-length transactions; • the rights, preferences, and privileges of our convertible preferred stock relative to those of our common stock; • the likelihood of achieving a liquidity event for our securityholders, such as an initial public offering or a sale of our company, given prevailing market conditions; • the hiring of key personnel and the experience of management; • trends and developments in our industry; and • external market conditions affecting the life sciences and biotechnology industry sectors. For our valuations performed prior to December 31, 2018, we used the option pricing method, or OPM, backsolve method. In an OPM framework, the backsolve method for inferring the equity value implied by a recent financing transaction involves making assumptions for the expected time to liquidity, volatility and risk-free rate and then solving for the value of equity such that value for the most recent financing equals the amount paid. This method was selected as management concluded that the contemporaneous financing transaction was an arms-length transaction. Furthermore, as of the valuation date prior to December 31, 2018, we were at an early stage of development and future liquidity events were difficult to forecast. For our valuations performed on or subsequent to December 31, 2018, we used a hybrid method of the OPM and the Probability-Weighted Expected Return Method, or PWERM. PWERM considers various potential liquidity outcomes. Our approach included the use of different timing of initial public offering scenarios and a scenario assuming continued operation as a private entity. Under the hybrid OPM and PWERM method, the per share value calculated under the OPM and PWERM are weighted based on expected exit outcomes and the quality of the information specific to each allocation methodology to arrive at a final estimated fair value per share value of the common stock before a discount for lack of marketability is applied. In the course of preparing our consolidated financial statements with a retrospective view, we have reassessed the fair value of our common stock in the second half of 2018 and the first quarter of 2019 solely for accounting purposes. For purposes of this determination, we assumed that the reassessed fair value of the common stock increased on a linear basis between the dates of our third-party valuation reports. We believe that a linear interpolation is appropriate as no single event caused the valuation of our common stock to fluctuate. Following the closing of our IPO, our board of directors determined the fair market value of our common stock based on its closing price as reported on The Nasdaq Global Select Market on the date of grant. Recent Accounting Pronouncements Not Yet Adopted See Note 2-Summary of Significant Accounting Policies to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for information about recent accounting pronouncements, the timing of their adoption, and our assessment, to the extent we have made one yet, of their potential impact on our financial condition of results of operations.

<s>[INST] Our discussion and analysis below are focused on our financial results and liquidity and capital resources for the years ended December 31, 2019 and 2018, including yearoveryear comparisons of our financial performance and condition for these years. Discussion and analysis of the year ended December 31, 2017 specifically, as well as the yearoveryear comparison of our financial performance and condition for the years ended December 31, 2018 and 2017, are located in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in the prospectus dated October 10, 2019 that forms a part of the Company’s Registration Statement on Form S1 (File No. 333233604), as filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933, as amended, on October 11, 2019. Overview We are a clinicalstage immunology company focused on combining immunologic insights with cuttingedge technologies to treat and prevent serious infectious diseases. Infectious diseases are one of the leading causes of death worldwide and cause hundreds of billions of dollars of economic burden each year. We believe that now is the time to apply the recent and remarkable advances in immunology to combat infectious diseases. Our approach begins with identifying the limitations of the immune system in combating a particular pathogen, the vulnerabilities of that pathogen and the reasons why previous approaches have failed. We then bring to bear powerful technologies that we believe, individually or in combination, will lead to effective therapies. We have assembled four technology platforms, focused on antibodies, T cells, innate immunity and small interfering ribonucleic acid, or siRNA, through internal development, collaborations and acquisitions. Our current development pipeline consists of product candidates targeting hepatitis B virus, or HBV, influenza A, severe acute respiratory syndrome coronavirus 2, or SARSCoV2, human immunodeficiency virus, or HIV, and tuberculosis, or TB. VIR2218, an HBVtargeting siRNA, has completed enrollment in an ongoing Phase 1/2 clinical trial. Initial data have demonstrated substantial reduction of hepatitis B virus surface antigen, or HBsAg, and VIR2218 has been generally well tolerated. We are next initiating a Phase 2 trial combining VIR2218 with pegylated interferonalpha, an approved immune modulatory agent. Additionally, we have initiated a Phase 1/2 clinical trial for VIR2482, a monoclonal antibody, or mAb, designed for the prevention of influenza A. We have built an industryleading team that has deep experience in immunology, infectious diseases and product development. Given the global impact of infectious diseases, we are committed to developing costeffective treatments that can be delivered at scale. We were incorporated in April 2016 and commenced principal operations later that year. To date, we have focused primarily on organizing and staffing our company, business planning, raising capital, identifying, acquiring, developing and inlicensing our technology platforms and product candidates, and conducting preclinical studies and early clinical trials. Prior to our initial public offering, or IPO, we funded our operations to date primarily from the issuance and sale of convertible preferred stock, and to a lesser extent from revenue from grant agreements with governmentsponsored and private organizations, as well as research and development services. From our inception through December 31, 2019, we have raised aggregate net cash proceeds of $630.7 million from the sale of our convertible preferred stock. In October 2019, we completed our IPO pursuant to which we issued 7,142,858 shares of our common stock at a price of $20.00 per share. We received net proceeds of $126.4 million from the IPO, after deducting underwriting discounts, commissions and offering expenses. As of December 31, 2019, we had $407.7 million in [/INST] Positive. </s>

RATTLER MIDSTREAM LP

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 should be read in conjunction with our consolidated financial statements and notes thereto presented in this Annual Report. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors. See “Item 1A. Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” Our Predecessor financial statements include 100% of the operations of the Operating Company, reflecting the historical ownership of these assets by Diamondback. This Annual Report includes the assets, liabilities and results of operations of our Predecessor for periods prior to May 28, 2019, the date on which we completed the IPO. Our future results of operations may not be comparable to our Predecessor’s historical results of operations. Unless the context otherwise requires, references in this section to “we,” “our,” “us” or like terms, when used in a historical context prior to the completion of our IPO, refer to our Predecessor and, when used in a historical context following the completion of our IPO, the present tense or future tense, these terms refer to the Partnership and its subsidiaries. Overview We are a growth-oriented Delaware limited partnership formed by Diamondback in July 2018 to own, operate, develop and acquire midstream infrastructure assets in the Midland and Delaware Basins of the Permian Basin, one of the most prolific oil producing areas in the world. We have elected to be treated as a corporation for U.S. federal income tax purposes. We provide crude oil, natural gas and water-related midstream services (including water sourcing and transportation and produced water gathering and disposal) to Diamondback under long-term, fixed-fee contracts. As of December 31, 2019, our midstream infrastructure assets include 867 miles of pipeline across the Midland and Delaware Basins with approximately 236,000 Bbl/d of crude oil gathering capacity, 135,000 Mcf/d of natural gas compression capability, 150,000 Mcf/d of natural gas gathering capacity, 3.3 MMBbl/d of produced water disposal capacity and 575,000 Bbl/d of sourced water gathering capacity. In addition to our midstream infrastructure assets, we own equity interests in three long-haul crude oil pipelines, which, upon completion, will run from the Permian to the Texas Gulf Coast. In addition, we own equity interests in third-party operated gathering systems and processing facilities supported by dedications from Diamondback. We are critical to Diamondback’s growth plans because we provide a long-term midstream solution to its increasing crude oil, natural gas and water-related services needs through our robust infield gathering systems and produced water disposal capabilities. As of December 31, 2019, our general partner had a 100% general partner interest in us, and Diamondback owned no common units and all of our 107,815,152 outstanding Class B units, representing approximately 71% of our total units outstanding. Diamondback also owns and controls our general partner. Financial Presentation Our operations are conducted through, and our operating assets are owned by, the Operating Company. Our assets and operations are reported in two operating business segments: (i) midstream services and (ii) real estate operations. As of December 31, 2019, we own a 29% controlling membership interest in the Operating Company and Diamondback owns, through its ownership of the Operating Company units, a 71% economic, non-voting interest in the Operating Company. However, as required by GAAP, we consolidate 100% of the assets and operations of the Operating Company in our financial statements and reflect a non-controlling interest. As such, our results of operations will not differ materially from the results of operations of the Operating Company. The most noteworthy reconciling items between our consolidated financial statements and the Operating Company’s consolidated financial statements primarily relate to (a) the impact of our election to be treated as a corporation for U.S. federal income tax purposes, and (b) the presentation of noncontrolling interests in the Operating Company. The interests in the Operating Company that are not directly or indirectly owned by us will be reflected as being attributable to noncontrolling interests in our consolidated financial statements. The following discussion includes a comparison of our results of operations, including changes in our operating income, and liquidity and capital resources for fiscal years 2019 and 2018. A discussion of changes in our results of operations from fiscal year 2017 to fiscal year 2018 has been omitted from this report, but may be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our final prospectus dated May 22, 2019 and filed with the SEC pursuant to Rule 424(b) under the Securities Act on May 24, 2019. 2019 Transactions and Recent Developments Initial Public Offering Prior to the closing on May 28, 2019 of our IPO, Diamondback owned all of the general and limited partner interests in our Predecessor. On May 22, 2019, we priced 38,000,000 common units in our IPO at a price of $17.50 per unit, and on May 23, 2019 our common units began trading on the Nasdaq Global Select Market under the symbol “RTLR”. On May 30, 2019, the underwriters purchased an additional 5,700,000 common units following the exercise in full of their over-allotment option. We received aggregate net proceeds of $719.4 million from the sale of these common units, after deducting the underwriting discount and offering expenses. At the closing of our IPO, we (i) issued 107,815,152 Class B units representing an aggregate 71% voting limited partner interest in us in exchange for a $1.0 million cash contribution from Diamondback, (ii) issued a general partner interest in us to our general partner in exchange for a $1.0 million cash contribution from our general partner, and (iii) caused the Operating Company to make a distribution of approximately $726.5 million to Diamondback. Diamondback, as the holder of the Class B units, and our general partner, as the holder of our general partner interest, are entitled to receive cash preferred distributions equal to 8% per annum on the outstanding amount of their respective $1.0 million capital contributions, payable quarterly. Ajax and Energen Assets Effective January 1, 2019, Diamondback contributed to our Predecessor certain assets within the Permian Basin that it acquired from Ajax Resources LLC, or Ajax, as part of an upstream acquisition in the fourth quarter of 2018. These assets, which we refer to as the Ajax assets, included 17 water wells, four produced water disposal wells and one related gathering system (35,000 Bbl/d of capacity), a field office, surface land, five hydraulic fracturing pits (4.4 MMBbls of capacity) and one related sourced water transportation system (25,000 Bbl/d of capacity). Prior to their contribution, the Ajax assets were fully integrated into the upstream business acquired from Ajax and used for disposal of produced water generated or obtaining sourced water when drilling. The carrying value of assets included in this contribution was $21.5 million. All of the Ajax assets contributed have estimated remaining useful lives of between 20-30 years. Effective January 1, 2019, Diamondback contributed to our Predecessor certain assets within the Permian Basin that it acquired from Energen Corporation, or Energen, as part of an upstream acquisition in the fourth quarter of 2018. These assets, which we refer to as the Energen assets, included 56 produced water disposal wells (1.2 MMBbl/d of permitted capacity) and related gathering systems (1.0 MMBbl/d of capacity), an office building located in Midland Texas, surface land and an oil gathering system (16,000 Bbl/d of capacity). Prior to their contribution, the Energen assets were fully integrated into the upstream business acquired from Energen and used for disposal of produced water generated or delivering oil under upstream contracts. The carrying value of assets included in this contribution was $279.0 million, net of $3.0 million in associated asset retirement obligations. All of the Energen assets contributed have estimated remaining useful lives of 30 years. EPIC and Gray Oak Pipeline Projects In February 2019, Diamondback funded and our Predecessor acquired a 10% equity interest in each of the EPIC and Gray Oak pipeline projects, which are developing long-haul crude oil pipelines that we expect, following commencement of full commercial operations, will provide us with a steady, oil-weighted cash flow stream. Each of the EPIC and Gray Oak pipelines began interim operations in the second half of 2019, and we expect that both will begin full commercial operations in the second quarter of 2020. These pipelines will provide Diamondback with long-term long-haul transportation for a portion of its Delaware and Midland Basin crude oil production with a total takeaway capacity of up to 200,000 Bbl/d. Our total capital commitment with respect to our 10% interest in the EPIC joint venture is currently anticipated to be approximately $132 million, which includes $117 million that we contributed in 2019. Our total capital commitment with respect to our 10% interest in the Gray Oak venture is currently anticipated to be approximately $145 million, which includes $115 million that we contributed in 2019. Wink to Webster Pipeline Project On July 30, 2019, the Operating Company joined Wink to Webster Pipeline LLC as a 4% member, together with affiliates of ExxonMobil, Plains All American Pipeline, Delek US, MPLX LP and Lotus Midstream. The joint venture is developing a long-haul crude oil pipeline together with an affiliate of Enterprise with origin points at Wink and Midland in the Permian Basin for delivery to multiple Houston area locations. The Wink to Webster pipeline is expected to begin commercial operations in the first half of 2021. Our total capital commitment with respect to our 4% interest in the Wink to Webster joint venture is currently anticipated to be approximately $108 million, which includes $34 million that we contributed in 2019. OMOG Joint Venture On November 7, 2019, we and Oryx Midstream, or Oryx, a portfolio company of Stonepeak Infrastructure Partners, through our newly-formed OMOG joint venture, acquired from Reliance Midstream, LLC and other third-party sellers 100% of Reliance Gathering for $356 million, subject to post-closing purchase price adjustments. In accordance with our membership interests in the OMOG joint venture, we and Oryx paid 60% and 40% of the purchase price, respectively. We funded our portion of the purchase price for the acquisition with cash on hand and borrowings under our credit facility. Following completion of the acquisition, Reliance Gathering was renamed Oryx Midland Oil Gathering LLC. The OMOG joint venture operates a crude oil gathering system with over 230 miles of gathering and regional transportation pipelines and approximately 200,000 barrels of crude oil storage in Midland, Martin, Andrews and Ector Counties, Texas. The system has current throughput of over 100,000 Bbl/d from six oil and gas operators, including Diamondback. Over 160,000 gross acres in Northern Midland Basin are dedicated to the system under long-term, fixed-fee agreements, some of which benefit from minimum volume commitments. Under the OMOG limited liability company agreement, the OMOG joint venture is managed by a management committee consisting of our designees and Oryx’s designees. Decisions of the management committee require the consent of managers representing at least 70% of the membership interests in OMOG, except for certain decisions that require the consent of managers representing 100% of the membership interests. Oryx is the operator of the gathering system under an operating and management services agreement entered into with the OMOG joint venture. Amarillo Rattler Joint Venture On December 20, 2019, we acquired a 50% equity interest in Amarillo Rattler, a joint venture with Amarillo Midstream, LLC, a portfolio company of Arclight Capital Partners. Amarillo Midstream serves as construction manager and operator for this joint venture pursuant to a construction, operations and maintenance agreement entered into with the joint venture. Amarillo Rattler currently owns and operates the Yellow Rose gas gathering and processing system with estimated total processing capacity of 40,000 Mcf/d and over 84 miles of gathering and regional transportation pipelines in Dawson, Martin and Andrews Counties, Texas. This joint venture also intends to construct and operate a new 60,000 Mcf/d cryogenic natural gas processing plant in Martin County, Texas, as well as incremental gas gathering and compression and regional transportation pipelines. The estimated aggregate capital outlay to the joint venture is anticipated to be approximately $100 million to construct the new processing plant, gas gathering and compression, and regional transportation pipelines. We will be responsible for contributing 50% of the construction budget into the joint venture, in accordance with our 50% interest. We anticipate that the new processing plant will commence full commercial operations in the middle of 2021. Diamondback has contracted for 30,000 Mcf/d of the capacity of the new processing plant pursuant to a gas gathering and processing agreement entered into with the joint venture in exchange for Diamondback’s dedication of certain leasehold interests to that agreement. Under the Amarillo Rattler limited liability company agreement, Amarillo Rattler is managed by a board of managers consisting of our designees and Amarillo Midstream’s designees. All decisions of the board require the consent of managers representing more than 50% of the membership interests in Amarillo Rattler, except for certain decisions that require the consent of managers representing at least 66⅔% of the membership interests or 100% of the membership interests, as applicable. As of December 31, 2019, we have not made any capital contributions to Amarillo Rattler other than a contribution of approximately 40 acres of land in Martin County, Texas, on which the new processing plant will be built. As of December 31, 2019, our equity interest in Amarillo Rattler LLC was $0.7 million due to legal expenses associated with the investment. 2019 Highlights Significant Operating Results The following are significant operating results for the year ended December 31, 2019, and such results as compared with the year ended December 31, 2018: • average crude oil gathering volumes were 85,164 Bbl/d, an increase of 80% year over year; • average natural gas gathering volumes were 85,283 MMBtu/d, an increase of 117% year over year; • average produced water gathering and disposal volumes were 806,078 Bbl/d, an increase of 186% year over year; and • average sourced water gathering volumes were 415,939 Bbl/d, an increase of 65% year over year. Pipeline Infrastructure Assets The following tables provide information regarding our gathering, compression and transportation system as of December 31, 2019 and utilization for the quarter ended December 31, 2019: (1) Does not include assets of EPIC, Gray Oak, Wink to Webster, Amarillo Rattler or OMOG joint ventures. Throughput and Crude Oil Volumes The amount of revenue we generate primarily depends on the volumes of crude oil, natural gas and water for which we provide midstream services. These volumes are affected primarily by changes in the supply of and demand for crude oil and natural gas in the markets served directly or indirectly by our assets. By performing routine maintenance and monitoring our infrastructure, we are able to minimize service interruptions on our gathering, transportation and disposal systems. Under our commercial agreements, we provide (i) crude oil gathering services, with approximately 181,000 gross dedicated acres, (ii) natural gas gathering and compression services, with approximately 85,000 gross dedicated acres and firm capacity for natural gas attributable to such acreage, (iii) produced water gathering and disposal services, with approximately 397,000 gross dedicated service acres and firm capacity for produced water and flowback water attributable to such acreage, and (iv) sourced water distribution services, with approximately 283,000 gross dedicated service acres. See “Item 8. Financial Statements and Supplementary Data - Note 3. Revenue from Contracts with Customers” for additional information about our commercial agreements with Diamondback. Because the production rate of a well declines over time, our ability to provide gathering, compression and disposal services, and to maintain or increase the throughput volumes on our midstream systems, is contingent on our customers continually discovering and producing new volumes of crude oil and natural gas and generating produced water. Because sourced water services are largely dependent on well completion, our ability to provide sourced water services is contingent on our customers drilling and completing new wells. We derive substantially all of our revenue from our commercial agreements with Diamondback, which agreements do not contain minimum volume commitments. Our ability to maintain or increase existing throughput volumes on our midstream systems is impacted by: • successful drilling activity by our customers on our dedicated acreage and our ability to fund the capital costs required to connect our infrastructure assets to new wells; • our ability to utilize the remaining uncommitted capacity on, or add additional capacity to, our infrastructure assets; • our ability to increase throughput volumes on our infrastructure assets by making outlet connections to existing or new third-party pipelines or other facilities, primarily driven by the anticipated supply of and demand for crude oil and natural gas; • our ability to identify and execute organic expansion projects to capture incremental volumes from Diamondback and third-parties; • our ability to compete for volumes from successful new wells in the areas in which we operate outside of our dedicated acreage; and • our ability to gather crude oil and natural gas and provide water services with respect to hydrocarbons produced on acreage that has been released from commitments with our competitors. We actively monitor producer activity in the areas served by our infrastructure assets to pursue new supply opportunities. The following table summarizes average throughput and crude oil sales volumes for the periods indicated: (1) Does not include volumes from the EPIC, Gray Oak, Wink to Webster, Amarillo Rattler or OMOG joint ventures. Sources of Our Income Our results are primarily driven by the volumes of crude oil that we gather, transport and deliver; natural gas that we gather, compress, transport and deliver; water that we source, transport and deliver; and produced water that we gather, transport and dispose of, and the fees we charge per unit of throughput for our midstream services. Our crude oil infrastructure assets consist of gathering pipelines and metering facilities, which collectively gather crude oil for our customers. Our facilities gather crude oil from horizontal and vertical wells in Diamondback’s ReWard, Spanish Trail, Pecos and Glasscock areas within the Permian. Our natural gas gathering and compression system consists of gathering pipelines, compression and metering facilities, which collectively service the production from Diamondback’s Pecos area assets within the Permian. Our water sourcing and distribution assets consist of water wells, hydraulic fracturing pits, pipelines and water treatment facilities, which collectively gather and distribute water from Permian aquifers to the drilling and completion sites through buried pipelines and temporary surface pipelines. Our produced water gathering and disposal system spans approximately 474 miles and consists of gathering pipelines along with produced water disposal wells and facilities which collectively gather and dispose of produced water from operations throughout Diamondback’s Permian acreage. We have entered into multiple fee-based commercial agreements with Diamondback, each with an initial term ending in 2034, utilizing our infrastructure assets or our planned infrastructure assets to provide an array of essential services critical to Diamondback’s upstream operations in the Delaware and Midland Basins. Our agreements include substantial acreage dedications. We have indirect exposure to commodity price risk in that persistent low commodity prices may cause Diamondback or other customers to delay drilling or shut in production, which would reduce the volumes available for gathering and processing by our infrastructure assets. If Diamondback delays drilling or temporarily shuts in production due to persistently low commodity prices or for any other reason, our revenue could decrease, as our commercial agreements do not contain minimum volume commitments. Under each of our commercial agreements (other than the FERC-regulated crude oil gathering services agreement), the volumetric fees we charge are adjusted each calendar year by the amount of percentage change, if any, in the consumer price index from the preceding calendar year. No adjustment will be made if the percentage change would result in a fee below the initial fee set forth in the applicable commercial agreement and any adjustment to the volumetric fees shall not exceed 3% of the then-current fee. Further, the total adjustment of the fees shall never result in a cumulative volumetric fee adjustment of more than 30% of the initial fees set forth in the applicable commercial agreement. Principal Components of Our Cost Structure General and Administrative At the closing of our IPO, we entered into to a services and secondment agreement with Diamondback, which we refer to the services and secondment agreement, under which we pay fees to Diamondback with respect to certain operational services Diamondback provides in support of our operations. Our partnership agreement requires us to reimburse our general partner for all direct and indirect expenses incurred or paid on our behalf and all other expenses allocable to us or otherwise incurred by our general partner in connection with operating our business. Our partnership agreement does not set a limit on the amount of expenses for which our general partner and its affiliates may be reimbursed. These expenses include salary, bonus, incentive compensation and other amounts paid to persons who perform services for us or on our behalf and expenses allocated to our general partner by its affiliates. Our general partner is entitled to determine the expenses that are allocable to us. Depreciation, Amortization and Accretion This represents the depreciation, amortization and accretion on the assets and liabilities of the Operating Company. Income Taxes Prior to our IPO, our Predecessor was organized as a disregarded entity for income tax purposes. As a result, our Predecessor’s sole owner, Diamondback, was responsible for federal income taxes on the Predecessor’s taxable income. Subsequent to our IPO, we are subject to federal income taxes at the corporate statutory rate of 21%. We are subject to the Texas margin tax. For the year ended December 31, 2019, we accrued $0.2 million for Texas margin tax payable pursuant to the tax sharing agreement with Diamondback. Other income (expense), net Interest income This represents the interest received on our cash. Interest expense We have financed a portion of our working capital requirements, capital expenditures and acquisitions with borrowings under our revolving credit facility. We incur interest expense that is affected by both fluctuations in interest rates and our financing decisions. We reflect interest paid to our lender in interest expense. In addition, we include the amortization of deferred financing costs (including origination and amendment fees), commitment fees and annual agency fees in interest expense. Income (loss) from equity method investments This represents our proportional income (loss) from our equity method investments. Factors Affecting the Comparability of Our Financial Results Our future results of operations may not be comparable to our Predecessor’s historical results of operations for the reasons described below: Contribution of Midstream Assets During the period from 2014 through 2017, Diamondback constructed and/or acquired various midstream and related assets located in the Delaware and Midland Basins, which Diamondback contributed to our Predecessor during fiscal years 2016 and 2017. These assets included 20 produced water disposal wells and related gathering systems, two oil gathering systems, surface land, and other pipelines not yet placed into service. Prior to their contribution, these assets were fully integrated into Diamondback’s upstream operations. Effective February 28, 2017, Diamondback contributed to our Predecessor certain midstream assets in the Pecos area within the Permian that it acquired from Brigham Resources Operating, LLC, Brigham Resources Midstream, LLC and other unrelated third parties, which we refer to collectively as Brigham. These assets included five produced water disposal wells and seven hydraulic fracturing ponds across one main gathering system, and various pipelines and compression assets related to a gas gathering system and an oil gathering system, the majority of which were not yet in service. Prior to their contribution from Diamondback, these assets were owned by Brigham and were fully integrated into Brigham’s upstream operations where the assets were already in service. All of the assets contributed have estimated remaining useful lives of between 20-30 years. Effective January 1, 2018, Diamondback contributed to our Predecessor the sourced water assets located within the Permian Basin. These assets included numerous sourced water wells and 28 hydraulic fracturing ponds, located across nine sourced water transportation systems, that had previously been used to store and transport sourced water for Diamondback’s drilling operations. All of the Ajax assets contributed have estimated remaining useful lives of between 20-30 years. Throughout 2018, Diamondback continued to assist our Predecessor in the construction of various other gathering assets, which included additional oil and natural gas and produced water pipelines, produced water disposal wells and hydraulic fracturing ponds. These assets were never used as part of upstream operations, but were contributed immediately upon completion. Effective January 1, 2019, Diamondback contributed to our Predecessor the Ajax assets within the Permian Basin that it acquired from Ajax as part of an upstream acquisition in the fourth quarter of 2018. These assets included 17 water wells, four produced water disposal wells and one related gathering system (35,000 Bbl/d of capacity), a field office, surface land, five hydraulic fracturing pits (4.4 MMBbls of capacity) and one related sourced water transportation system (25,000 Bbl/d of capacity). Prior to their contribution, these assets were fully integrated into the upstream business acquired from Ajax and used for disposal of produced water generated or water sourcing when drilling. All of the Ajax assets contributed have estimated remaining useful lives of between 20-30 years. Effective January 1, 2019, Diamondback contributed to our Predecessor the Energen assets within the Permian Basin that it acquired from Energen, as part of an upstream acquisition in the fourth quarter of 2018. These assets included 56 produced water disposal wells (1.2 MMBbl/d of permitted capacity) and related gathering systems (1.0 MMBbl/d of capacity), an office building located in Midland, Texas, surface land and an oil gathering system (16,000 Bbl/d of capacity). Prior to their contribution, these assets were fully integrated into the upstream business acquired from Energen and used for disposal of produced water generated or delivering oil under upstream contracts. All of the Energen assets contributed have estimated remaining useful lives of 30 years. Contribution of Fasken Center Effective January 31, 2018, Diamondback contributed to our Predecessor all of its membership interest in its wholly owned subsidiary, Tall City Towers LLC, or Tall Towers, which acquired from Fasken Midland LLC on January 31, 2018 certain real property consisting of land and two office towers in Midland, Texas, which we refer to as the Fasken Center, for a purchase price of approximately $110.0 million. With the asset contribution, our Predecessor also acquired third-party leases, which were valued as part of Diamondback’s purchase price. All of the assets contributed have estimated remaining useful lives of between 15-30 years. Equity Method Investments In 2019, we acquired equity interests in the EPIC, Gray Oak, Wink to Webster, Amarillo Rattler and OMOG joint ventures. Each of these joint ventures is accounted for using the equity method. The following table sets forth the equity method investment interests acquired during 2019: See “-2019 Transactions and Recent Developments” above for further discussion of the our equity method investments. Revenues Prior to their contribution to our Predecessor, infrastructure assets were part of the integrated operations of Diamondback and were financed from cash flows from operations and funding from Diamondback. Commencing January 1, 2016, our Predecessor began to earn revenues under our long-term commercial agreements with Diamondback and began receiving separate fixed fees for the midstream services that we provide. Our Predecessor’s real estate assets were contributed by Diamondback effective January 31, 2018 and we earn revenue from these assets through various lease agreements. Operating Expenses At the closing of our IPO, we entered into the services and secondment agreement with Diamondback under which we pay fees to Diamondback with respect to certain operational services Diamondback provides in support of our operations. Our Predecessor recorded direct costs of running our businesses as well as certain costs allocated from Diamondback. As such, there are differences in the results of our operations between our Predecessor’s historical financial statements and our financial statements. General and Administrative Expenses Our Predecessor’s general and administrative expense included an allocation of charges for the management and operation of our assets by Diamondback for general and administrative services, such as information technology, treasury, accounting, human resources and legal services and other financial and administrative services. Following the completion of our IPO, Diamondback charges us a combination of direct and allocated charges for general and administrative services pursuant to our partnership agreement and the services and secondment agreement. In addition, as compared to our Predecessor, we incur incremental general and administrative expenses attributable to being a publicly traded partnership, which include expenses associated with annual, quarterly and current reporting with the SEC, tax return preparation, Sarbanes-Oxley compliance, listing on Nasdaq, independent auditor fees, legal fees, investor relations expenses, transfer agent and registrar fees, incremental salary and benefits costs of seconded employees, outside director fees and insurance expenses. These incremental general and administrative expenses and the variable component of the general and administrative costs that we are incurring under the services and secondment agreement are not reflected in our historical financial statements. Financing There are differences in the way we finance our operations as compared to the way our Predecessor historically financed operations. Historically, our Predecessor’s operations were financed as part of Diamondback’s integrated operations. Our sources of liquidity following our IPO include cash generated from operations and borrowings under our revolving credit facility. Income Taxes Income tax expense includes U.S. federal and state taxes on operations, as applicable. Prior to our IPO, our Predecessor was organized as a disregarded entity for income tax purposes. As a result, our Predecessor’s sole owner, Diamondback, was responsible for federal income taxes on our Predecessor’s taxable income. Even though we are organized as a limited partnership under state law, we are treated as a corporation for U.S. federal income tax purposes and are subject to U.S. federal and state income tax at corporate rates, subsequent to the May 24, 2019 effective date of our election to be treated as a corporation. As such, our net income for the year ended December 31, 2019 reflects a provision for income taxes for the period subsequent to our IPO and, for the periods prior to our IPO, net income of the Predecessor reflects on a pro forma basis, a provision for income taxes as if our Predecessor had been treated as a corporation for U.S. federal income tax purposes. Other Factors Impacting Our Business We expect our business to continue to be affected by the following key factors. Our expectations are based on assumptions made by us and information currently available to us. 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. Supply and Demand for Crude Oil and Natural Gas We currently generate a substantial portion of our revenues under fee-based commercial agreements with Diamondback. 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 water that we gather and do not engage in the trading of crude oil or natural gas. However, the volumetric fees we charge are adjusted each calendar year by the amount of percentage change, if any, in the consumer price index from the preceding calendar year. No adjustment will be made if the percentage change would result in a fee below the initial fee set forth in the applicable commercial agreement and any adjustment to the volumetric fees shall not exceed 3% of the then-current fee. Further, the total adjustment of the fees shall never result in a cumulative volumetric fee adjustment of more than 30% of the initial fees set forth in the applicable commercial agreement. Additionally, commodity price fluctuations indirectly influence our activities and results of operations over the long-term, since they can affect production rates and investments by Diamondback and third-parties in the development of new crude oil and natural gas reserves. Generally, drilling and production activity will increase as crude oil and natural gas prices increase. Our throughput volumes depend primarily on the volumes of crude oil and natural gas produced by Diamondback in the Permian and, with respect to sourced water, the number of wells drilled and completed. Commodity prices are volatile and influenced by numerous factors beyond our or Diamondback’s control, including the domestic and global supply of and demand for crude oil and natural gas. The commodities trading markets, as well as other supply and demand factors, may also influence the selling prices of crude oil and natural gas. Furthermore, our ability to execute our growth strategy in the Permian 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. Regulatory Compliance The regulation of crude oil and natural gas gathering and transportation and water services activities by federal and state regulatory agencies has a significant impact on our business. Our operations are also impacted by new regulations, which have increased the time that it takes to obtain required permits. Additionally, increased regulation of crude oil and natural gas producers in our areas of operation, including regulation associated with hydraulic fracturing, could reduce regional supply of crude oil, natural gas and water and, therefore, throughput on our infrastructure assets. Results of Operations for the Year Ended December 31, 2019 and 2018 The following table sets forth selected historical operating data for the periods indicated: (1) Does not include volumes from the EPIC, Gray Oak, Wink to Webster, Amarillo Rattler or OMOG joint ventures. Comparison of the Years Ended December 31, 2019 and 2018 Revenues Revenues for the years ended December 31, 2019 and 2018 were $447.7 million and $184.5 million, respectively. The increase of $263.2 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 relates to increased volumes largely due to the contribution of certain crude oil gathering, produced water disposal wells and land and buildings that Diamondback acquired pursuant to the Ajax acquisition and the Energen acquisition, which Diamondback contributed to us effective on January 1, 2019, as well as the additional build out of historical systems. Produced water gathering and disposal revenues increased by $203.5 million, sourced water gathering revenues increased by $38.2 million, crude oil gathering revenues increased by $11.2 million, natural gas gathering revenues increased by $7.9 million and real estate revenue increased by $2.4 million for year ended December 31, 2019. Direct Operating Expenses Direct operating expenses for the years ended December 31, 2019 and 2018 were $106.3 million and $33.7 million, respectively. The increase of $72.6 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was primarily due to increased volumes largely attributable to the contribution of certain crude oil gathering, produced water disposal wells and land and buildings that Diamondback acquired pursuant to the Ajax acquisition and the Energen acquisition, which Diamondback contributed to us effective January 1, 2019, as well as the additional build out of historical systems. Cost of Goods Sold Cost of goods sold (exclusive of depreciation and amortization) for the years ended December 31, 2019 and 2018 was $62.9 million and $38.9 million, respectively. The increase of $24.0 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 relates to the increased build out of historical sourced water systems of the Operating Company and the increased volumes across existing sourced water systems. Real Estate Operating Expenses Real estate operating expenses for the years ended December 31, 2019 and 2018 were $2.6 million and $1.9 million, respectively. The increase of $0.8 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 primarily relates to the addition of new tenants and the contribution of a field office from Diamondback. Depreciation, Amortization and Accretion Depreciation, amortization and accretion for the years ended December 31, 2019 and 2018 was $42.3 million and $25.1 million, respectively. The increase of $17.2 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was primarily due to asset contributions from Diamondback and further development of existing gathering, transportation and disposal systems. General and Administrative Expenses General and administrative expenses for the years ended December 31, 2019 and 2018 were $12.7 million and $2.0 million, respectively. The increase of $10.7 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was primarily due to increased shared service allocations and additional professional service fees attributable to business growth, the IPO, and the contribution of additional midstream assets. Loss on Disposal of Property, Plant and Equipment Loss on disposal of property, plant and equipment was $1.5 million for the year ended December 31, 2019 due to weather damage at certain produced water disposal facilities. The damage totaled $7.5 million, for which we expect insurance proceeds of $6.0 million. Loss on disposal of property, plant and equipment was $2.6 million for the year ended December 31, 2018 and was due to the exchange of interest in produced water disposal assets. Interest Expense, Net Net interest expense for the year ended December 31, 2019 was $1.0 million. The increase of $1.0 million for the year ended December 31, 2019 from no interest expense for the year ended December 31, 2018 was primarily due to the Operating Company entering into the credit agreement on May 28, 2019 and subsequent borrowings thereunder. Loss from Equity Method Investments Loss from equity method investments was $6.3 million for the year ended December 31, 2019. There was no income or loss from equity method investments for the year ended December 31, 2018. The increase for the year ended December 31, 2019 from the year ended December 31, 2018 was related to interest expense incurred on Gray Oak’s promissory note and expenses incurred on investments not yet in service, partially offset by income from our equity method investments that began initial operations in 2019. Provision for Income Taxes We recorded income tax expense of $26.3 million and $17.4 million for the years ended December 31, 2019 and 2018, respectively. The $8.9 million increase in our income tax provision from the year ended December 31, 2018 to the year ended December 31, 2019 was primarily due to an increase in pre-tax income for the year ended December 31, 2019, partially offset by the impact of net income attributable to the non-controlling interest for the 2019 period subsequent to our IPO. Total income tax expense for the year ended December 31, 2019 differed from amounts computed by applying the federal statutory tax rate to pre-tax income from continuing operations for the period primarily due to net income attributable to the non-controlling interest. Non-GAAP Financial Measures Adjusted EBITDA Adjusted EBITDA is a supplemental non-GAAP financial measure used by management and external users of our financial statements, such as industry analysts, investors, lenders and rating agencies. We believe Adjusted EBITDA is useful because it allows us to more effectively evaluate our operating performance and compare the results of our operations period to period without regard to our financing methods or capital structure. We define Adjusted EBITDA as net income before income taxes, interest expense, net of amount capitalized, interest expense related to equity method investments, non-cash unit-based compensation expense, depreciation, amortization and accretion and other non-cash transactions. Depreciation, amortization and accretion includes depreciation, amortization and accretion on assets and liabilities of the Operating Company, in addition to our proportional interest of depreciation, amortization and accretion on our equity method investments. Interest expense related to equity method investments represents our proportional interest income (expense) from equity method investments. The GAAP measure most directly comparable to Adjusted EBITDA is net income. Adjusted EBITDA should not be considered an alternative to net income or any other measure of financial performance or liquidity presented in accordance with GAAP. Adjusted EBITDA excludes some, but not all, items that affect net income, and these measures may vary from those of other companies. As a result, Adjusted EBITDA as presented below may not be comparable to similarly titled measures of other companies. The following table presents a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP financial measures for each of the periods indicated: Liquidity and Capital Resources Overview Prior to our IPO, our sources of liquidity were based on cash flow from operations and funding from Diamondback. Our sources of liquidity following our IPO include cash generated from operations, borrowings under the credit agreement and, if necessary, the issuance of additional equity or debt securities. We believe that cash generated from these sources will be sufficient to meet our short-term working capital requirements and long-term capital expenditure requirements and to make quarterly cash distributions. We do not have any commitment from Diamondback, our general partner or any of their respective affiliates to fund our cash flow deficits or provide other direct or indirect financial assistance to us. At the closing of the IPO, the board of directors of our general partner adopted a policy for us to distribute cash distributions to common unitholders of record on the applicable record date of $0.25 per common unit after the end of each quarter beginning with the quarter ending September 30, 2019. Our first distribution of $0.34, included available cash for the period from May 28, 2019, the date of the close of our IPO, through September 30, 2019. On February 13, 2020, the board of directors of our general partner revised our cash distribution policy to provide that cash distributions will be made to common unitholders of record on the applicable record date of $0.29 per common unit for each quarter ending after December 31, 2019. The board of directors of our general partner may change our distribution policy at any time and from time to time. Our Class B units are entitled to quarterly aggregate cash preferred distributions of 8% per annum on the $1.0 million capital contribution made in respect of such units, or $0.02 million in aggregate per quarter to all Class B units, and our general partner is entitled to a quarterly cash preferred distribution of 8% per annum on the $1.0 million capital contribution made in respect of its general partner interest, or $0.02 million per quarter. We are required to make these distributions in any quarter before making any distributions on our common units. Other than those amounts, neither our general partner interest nor our Class B units are entitled to receive or participate in distributions made by us. We do not have a minimum quarterly distribution or employ structures intended to consistently maintain or increase distributions over time. The board of directors of our general partner may change our distribution policy at any time. Our partnership agreement does not require us to pay distributions to our common unitholders on a quarterly or other basis. The following table presents cash distributions approved by the board of directors of our general partner for the periods presented: (1) Distributions are shown for the quarter in which they were generated; provided, however, the Q3 2019 distribution also includes amounts attributable to Q2 2019 commencing upon the closing of our IPO. (2) The Q4 2019 distribution is payable on March 10, 2020 to unitholders of record at the close of business on March 3, 2020. The Operating Company’s Credit Agreement We, as parent, and the Operating Company, as borrower, entered into a credit agreement, dated May 28, 2019, with Wells Fargo Bank, National Association, as administrative agent, and a syndicate of banks, including Wells Fargo Bank, National Association, as lenders party thereto, which we refer to as the credit agreement. The credit agreement provides for a revolving credit facility in the maximum amount of $600.0 million. Loan principal may be optionally repaid from time to time without premium or penalty (other than customary LIBOR breakage), and is required to be paid at the maturity date of May 28, 2024. The loan is guaranteed by us and Tall Towers, Rattler OMOG LLC and Rattler Ajax Processing LLC and is secured by substantially all of our, the Operating Company and the other guarantors’ assets. As of December 31, 2019, we had $424.0 million of outstanding borrowings, and $176.0 million available for future borrowings under the credit agreement. The outstanding borrowings under the credit agreement bear interest at a per annum rate elected by us that is based on the prime rate or LIBOR, in each case plus an applicable margin. The applicable margin ranges from 0.250% to 1.250% per annum for prime-based loans and 1.250% to 2.250% per annum for LIBOR loans, in each case depending on the Consolidated Total Leverage Ratio (as defined in the credit agreement). The Operating Company is obligated to pay a quarterly commitment fee ranging from 0.250% to 0.375% per annum on the unused portion of the commitment, which fee is also dependent on the Consolidated Total Leverage Ratio. The credit agreement contains various affirmative and negative covenants. These covenants, among other things, limit additional indebtedness, additional liens, sales of assets, mergers and consolidations, distributions and other restricted payments, transactions with affiliates, and entering into certain swap agreements, in each case with us, the Operating Company and our restricted subsidiaries. The covenants are subject to exceptions set forth in the credit agreement, including an exception allowing the Operating Company or us to issue unsecured debt securities, and an exception allowing payment of distributions if no default exists. The credit agreement may be used to fund capital expenditures, to finance working capital, for general company purposes, to pay fees and expenses related to the credit agreement, and to make distributions permitted under the credit agreement. The credit agreement also contains financial maintenance covenants that require the maintenance of the financial ratios described below: For purposes of calculating the financial maintenance covenants prior to the fiscal quarter ending June 30, 2020, EBITDA (as defined in the credit agreement) will be annualized based on the actual EBITDA for the preceding fiscal quarters starting with the fiscal quarter ending September 30, 2019. As of December 31, 2019, the Operating Company was in compliance with all financial covenants under the credit agreement. The lenders may accelerate all of the indebtedness under the credit agreement upon the occurrence and during the continuance of any event of default. The credit agreement contains customary events of default, including non-payment, breach of covenants, materially incorrect representations, cross-default, bankruptcy and change in control. There are no cure periods for events of default due to non-payment of principal and breaches of negative and financial maintenance covenants and certain affimative covenants, but non-payment of interest and breaches of certain affirmative covenants are subject to customary cure periods. With certain specified exceptions, the terms and provisions of the credit agreement generally may be amended with the consent of the lenders holding a majority of the outstanding loans or commitments to lend. Cash Flows Net cash provided by operating activities, investing activities and financing activities for the years ended December 31, 2019 and 2018 were as follows: Operating Activities Net cash provided by operating activities increased by $44.8 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was due to increased operations as additional assets were placed into service and the contribution of certain crude oil gathering, produced water disposal wells and land and buildings that Diamondback acquired in the Ajax acquisition and the Energen acquisition, which Diamondback contributed to us effective January 1, 2019. Investing Activities Net cash used in investing activities was $578.4 million and $164.9 million during the years ended December 31, 2019 and 2018, respectively, and primarily related to additions to property, plant and equipment and contributions to our EPIC, Gray Oak, Wink to Webster, OMOG and Amarillo Rattler equity method investments. See “Item 8. Financial Statements and Supplementary Data-Note 8. Equity Method Investments.” Financing Activities Net cash used in financing activities was $362.2 million during the year ended December 31, 2019, primarily related to net proceeds of $719.4 million from our IPO of common units, a contribution of $1.0 million from our general partner for its general partner interest in us, a contribution of $1.0 million from Diamondback for its Class B units and borrowings, net of repayment of $424.0 million, partially offset by distributions to our unitholders of $778.1 million during 2019. There was $1 thousand net cash provided by financing activities during the year ended December 31, 2018. Capital Contributions and Capital Expenditures The midstream energy business is capital intensive, requiring the maintenance of existing gathering systems and other midstream assets and facilities and the acquisition or construction and development of new gathering systems and other midstream assets and facilities. For the year ended December 31, 2019, the total capital contributions by Diamondback to the Predecessor were $456.1 million, of which $9.2 million related to an office building located in Midland Texas, $18.1 million related to land, $9.4 million related to sourced water assets, $228.3 million related to produced water disposal assets, $35.8 million related to crude oil assets, $149.5 million related to the equity method investments in the EPIC and Gray Oak joint ventures, $31.1 million related to elimination of current and deferred liabilities, and $(25.3) million in additional assets and liabilities, net, related to operations. During this period, the Operating Company made capital expenditures of $241.8 million, comprised of $152.8 million million related to produced water disposal assets, $27.1 million million were related to crude oil gathering assets, $38.1 million million were related to natural gas gathering assets and $23.8 million million were related to sourced water assets. For the year ended December 31, 2018, the total capital contributions by Diamondback to our Predecessor were $171.2 million, of which $110.0 million related to Tall Towers, $1.3 million related to a field office, $1.5 million related to land, $32.8 million related to sourced water assets, $18.2 million related to produced water disposal assets, $6.0 million related to sourced water inventory and $1.4 million in additional assets and liabilities, net, related to operations. During this period, the Operating Company made capital expenditures of $164.9 million, comprised of $114.7 million related to produced water disposal assets, $16.3 million related to crude oil gathering assets, $30.1 million related to natural gas gathering assets, $3.7 million related to sourced water gathering systems and $0.1 million related to land. We estimate that total capital expenditures related to midstream assets for the year ending December 31, 2020 will be between $200 million and $225 million. Our estimated capital expenditures do not include our anticipated total capital commitments related to our equity method investments of approximately $169.9 million. Contractual Obligations The following table summarizes our contractual obligations and commitments as of December 31, 2019: (1) Includes the outstanding principal amount under the revolving credit facilities, the table does not include interest expense or other fees payable under this floating rate facility as we cannot predict the timing of future borrowings and repayments or interest rates to be charged. (2) This table reflects only the minimum amount of commitment fees due, which as of December 31, 2019 includes a commitment fee equal to 0.250% per year of the unused portion of the borrowing base of our credit agreement. (3) Operating lease obligations represent future commitments for equipment leases. Critical Accounting Policies and Estimates 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. Below, we have provided expanded discussion of our most critical accounting estimates, assumptions, judgments and uncertainties that are inherent in our application of GAAP. We identify certain accounting policies as critical based on, among other things, their impact on the portrayal of our financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. See Note 2. Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report for additional information regarding these accounting policies. Use of Estimates Certain amounts included in or affecting our consolidated financial statements and related disclosures must be estimated by our management, requiring certain assumptions to be made with respect to values or conditions that cannot be known with certainty at the time the consolidated financial statements are prepared. These estimates and assumptions affect the amounts we report for assets and liabilities and our disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Actual results could differ from those estimates. We evaluate these estimates on an ongoing basis, using historical experience, consultation with experts and other methods we consider reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known. Significant items subject to such estimates and assumptions include estimates of revenue accruals, valuation of sourced water inventory, fair value of long-lived assets, including intangible lease assets, asset retirement obligations, and estimate of income taxes. Revenue Recognition We provide gathering and compression and water handling and treatment services under fee-based contracts based on throughput. Under these arrangements, we receive fees for gathering oil and gas products, compression services, and water handling, disposal, and treatment services. The revenue we earn from these arrangements is directly related to (i) in the case of natural gas gathering and compression, the volumes of metered natural gas that we gather, compress, transport and deliver to other transmission delivery points, (ii) in the case of oil gathering, the volumes of metered oil that we gather, transport and deliver to other transmission delivery points, (iii) in the case of sourced water services, the quantities of water that we source, transport, and deliver to our customers for use in their well drilling and completion operations, (iv) in the case of produced water gathering and disposal services, the quantities of produced water gathered, transported and disposed of for our customers. We recognize revenue when we satisfy a performance obligation by delivering a service to a customer. We earn substantially all of its midstream revenues from commercial agreements with Diamondback and its affiliates. We recognize rental revenue from tenants on a straight-line basis over the lease term when collectability is reasonably assured and the tenant has taken possession or controls the physical use of the leased asset. Rental income-related party is comprised of revenues earned from lease agreements with Diamondback and its affiliates. Tenant recoveries related to reimbursement of real estate taxes, insurance, repairs and maintenance and other operating expenses are recognized as revenue in the period the applicable expenses are incurred. The reimbursements are recognized and presented gross, as we are generally the primary obligor with respect to purchasing goods and services from third-party suppliers, and have discretion in selecting the supplier and bear the associated credit risk. Property, Plant and Equipment Property, plant and equipment is recorded at cost upon acquisition and evaluated for potential impairment whenever events or circumstances indicate the carrying amount of the asset may not be recoverable through estimated future undiscounted cash flows. Expenditures which extend the useful lives of existing property, plant and equipment are capitalized. When properties are retired or otherwise disposed, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss on disposition is recognized in the consolidated statement of operations. Depreciation, Amortization and Accretion The determination of estimated useful lives is a significant element in calculating depreciation, amortization and accretion. If the useful lives of assets were found to be shorter than originally estimated, depreciation, amortization and accretion charges would be accelerated. Equity Method Investments An investment in an investee over which the Partnership exercises significant influence but does not control is accounted for using the equity method. Under the equity method, the Partnership’s share of the investee’s earnings or loss is recognized in the statement of operations. The Partnership’s proportionate share of the income or loss from equity method investments is recognized on a one-month lag for all equity method investments. The Partnership reviews its investments to determine if a loss in value which is other than a temporary decline has occurred. If such a loss has occurred, the Partnership recognizes an impairment provision. Judgment regarding the level of influence over each equity method investment includes considering key factors such as ownership interest, representation on the board of directors, participation in policy-making decisions, material intercompany transactions and extent of ownership by an investor in relation to the concentration of other shareholdings. Additionally, an investment in a limited liability company that maintains a specific ownership account for each investor shall be viewed as similar to an investment in a limited partnership for purposes of determining whether a noncontrolling investment shall be accounted for using the cost method or the equity method. Investments of greater than 3% to 5% are considered more than minor and, therefore, should be accounted for using the equity method. For investments where the Partnership has less than a 20% ownership interest, the investment is accounted for as an equity method investment as the Partnership has the ability to exercise significant influence. Asset Retirement Obligations Our asset retirement obligations, or ARO, consist of estimated costs of dismantlement, removal, site reclamation and similar activities associated with our infrastructure assets. We recognize the fair value of a liability for an ARO in the period in which it is incurred, when we have an existing legal obligation associated with the retirement of our infrastructure assets and the obligation can reasonably be estimated. The associated asset retirement cost is capitalized as part of the carrying cost of the infrastructure asset. The recognition of an ARO requires that management make numerous estimates, assumptions and judgments regarding factors such as: the credit-adjusted risk-free rate to be used, inflation rates and estimated probabilities, amounts and timing of settlements. In periods subsequent to initial measurement of the ARO, we recognize period-to-period changes in the liability resulting from the passage of time and revisions to either the timing or the amount of the original estimate of undiscounted cash flows. Revisions also result in increases or decreases in the carrying cost of the asset. Increases in the ARO liability due to passage of time impact net income as accretion expense. The related capitalized cost, including revisions thereto, is charged to expense through depreciation. Income Taxes On May 24, 2019, we elected to be treated as a corporation for U.S. federal income tax purposes. We use the asset and liability method of accounting for income taxes, under which deferred tax assets and liabilities are recognized for the future tax consequences of (i) temporary differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities and (ii) operating loss and tax credit carryforwards. Deferred income tax assets and liabilities are based on enacted tax rates applicable to the future period when those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period the rate change is enacted. A valuation allowance is provided for deferred tax assets when it is more likely than not the deferred tax assets will not be realized. We are subject to margin tax in the state of Texas pursuant to a tax sharing agreement with Diamondback, as discussed further in Note 14-Income Taxes of our consolidated financial statements included elsewhere in this Annual Report. In addition to the 2019 tax year, the Predecessor’s 2016 through 2018 tax years, the periods during which the Predecessor’s sole owner, Diamondback, was responsible for federal income taxes on the Predecessor’s taxable income, remain open to examination by tax authorities. As of December 31, 2019, the Partnership had no unrecognized tax benefits that would have a material impact on the effective tax rate. We are continuing our practice of recognizing interest and penalties related to income tax matters as interest expense and general and administrative expenses, respectively. During the year ended December 31, 2019, there was no interest or penalties associated with uncertain tax positions recognized in our consolidated financial statements. Inflation Inflation in the United States has been relatively low in recent years and did not have a material impact on our results of operations for the years ended December 31, 2019 and 2018. Although the impact of inflation has been insignificant in recent years, it is still a factor in the United States economy. We have experienced inflationary pressure on the cost of labor and equipment as increasing crude oil and natural gas prices have increased development activity in our areas of operations, especially in the Delaware Basin. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, See Note 2-Summary of Significant Accounting Policies included in Notes to the Consolidated Financial Statements included elsewhere in this Annual Report. Off-Balance Sheet Arrangements None.

<s>[INST] The following discussion and analysis should be read in conjunction with our consolidated financial statements and notes thereto presented in this Annual Report. The following discussion contains “forwardlooking statements” that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forwardlooking statements due to a number of factors. See “Item 1A. Risk Factors” and “Cautionary Statement Regarding ForwardLooking Statements.” Our Predecessor financial statements include 100% of the operations of the Operating Company, reflecting the historical ownership of these assets by Diamondback. This Annual Report includes the assets, liabilities and results of operations of our Predecessor for periods prior to May 28, 2019, the date on which we completed the IPO. Our future results of operations may not be comparable to our Predecessor’s historical results of operations. Unless the context otherwise requires, references in this section to “we,” “our,” “us” or like terms, when used in a historical context prior to the completion of our IPO, refer to our Predecessor and, when used in a historical context following the completion of our IPO, the present tense or future tense, these terms refer to the Partnership and its subsidiaries. Overview We are a growthoriented Delaware limited partnership formed by Diamondback in July 2018 to own, operate, develop and acquire midstream infrastructure assets in the Midland and Delaware Basins of the Permian Basin, one of the most prolific oil producing areas in the world. We have elected to be treated as a corporation for U.S. federal income tax purposes. We provide crude oil, natural gas and waterrelated midstream services (including water sourcing and transportation and produced water gathering and disposal) to Diamondback under longterm, fixedfee contracts. As of December 31, 2019, our midstream infrastructure assets include 867 miles of pipeline across the Midland and Delaware Basins with approximately 236,000 Bbl/d of crude oil gathering capacity, 135,000 Mcf/d of natural gas compression capability, 150,000 Mcf/d of natural gas gathering capacity, 3.3 MMBbl/d of produced water disposal capacity and 575,000 Bbl/d of sourced water gathering capacity. In addition to our midstream infrastructure assets, we own equity interests in three longhaul crude oil pipelines, which, upon completion, will run from the Permian to the Texas Gulf Coast. In addition, we own equity interests in thirdparty operated gathering systems and processing facilities supported by dedications from Diamondback. We are critical to Diamondback’s growth plans because we provide a longterm midstream solution to its increasing crude oil, natural gas and waterrelated services needs through our robust infield gathering systems and produced water disposal capabilities. As of December 31, 2019, our general partner had a 100% general partner interest in us, and Diamondback owned no common units and all of our 107,815,152 outstanding Class B units, representing approximately 71% of our total units outstanding. Diamondback also owns and controls our general partner. Financial Presentation Our operations are conducted through, and our operating assets are owned by, the Operating Company. Our assets and operations are reported in two operating business segments: (i) midstream services and (ii) real estate operations. As of December 31, 2019, we own a 29% controlling membership interest in the Operating Company and Diamondback owns, through its ownership of the Operating Company units, a 71% economic, nonvoting interest in the Operating Company. However, as required by GAAP, we consolidate 100% of the assets and operations of the Operating Company in our financial statements and reflect a noncontrolling interest. As such, our results of operations will not differ materially from the results of operations of the Operating Company. The most noteworthy reconciling items between our consolidated financial statements and the Operating Company’s consolidated financial statements primarily relate to (a) the impact of our election to be treated as a corporation for U.S. federal income tax [/INST] Negative. </s>

AGBA Acquisition Ltd

2020-03-31

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. Overview We were formed on October 8, 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. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic region. As of the date of this report, we have not selected any target business for our initial business combination. 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 May 16, 2019, the Company consummated its IPO of 4,600,000 Units, which includes the full exercise of the over-allotment option. Each Unit consists of one ordinary share, one redeemable warrant, and one right to receive one-tenth (1/10) of an ordinary share upon the consummation of a business combination. Each redeemable warrant entitles the holder thereof to purchase one-half (1/2) of one ordinary share, and each ten rights entitle the holder thereof to receive one ordinary share at the closing of a business combination. The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, the Company consummated a Private Placement of 225,000 units at a price of $10.00 per Private Unit, generating total proceeds of $2,250,000. A total of $46,000,000 of the net proceeds from the sale of Units in the IPO (including the over-allotment option units) and the Private Placements were placed in a trust account established for the benefit of the Company’s public shareholders. As of December 31, 2019, a total of $46,603,976 was held in a trust account established for the benefit of the Company’s public shareholders, which included $46,000,000 of the net proceeds from the IPO (including the exercise of the over-allotment option) and the Private Placements and subsequent interest income. Our management has broad discretion with respect to the specific application of the net proceeds of the IPO and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. The outbreak of the COVID-19 coronavirus has resulted in a widespread health crisis that has adversely affected the economies and financial markets worldwide, and potential target companies may defer or end discussions for a potential business combination with us whether or not COVID-19 affects their business operations. The extent to which COVID-19 impacts our search for a business combination will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact, among others. We may be unable to complete a business combination if continued concerns relating to COVID-19 restrict travel, limit the ability to have meetings with potential investors or the target company’s personnel, vendors and services providers are unavailable to negotiate and consummate a transaction in a timely manner. Results of Operations Our entire activity from inception up to May 16, 2019 was in preparation for the IPO. 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 business combination. 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. We expect our expenses to increase substantially after this period. For the year ended December 31, 2019, we had a net income of $167,472 which consisted of interest income from our trust account offset by operating expenses. Operating expenses generally consist of the $10,000 monthly payment to our Sponsor for office and administrative support, monthly professional fees owed to our service providers, travel expenses, Nasdaq market listing fees and amortization of our directors and officers insurance policy. Operating expenses after our initial public offering increased dramatically due to our having commenced operations, and certain professional expenses no longer being charged directly against paid-in-capital on our balance sheet, but now being expensed in the statement of operations. Liquidity and Capital Resources As of December 31, 2019, we had cash outside our trust account of $929,335 available for working capital needs. All remaining cash was held in the trust account and is generally unavailable for our use, prior to the business combination. Our management is of the opinion that we have sufficient funds to meet our working capital requirements and debt obligations as they become due for at least one year from the date of this report. On May 16, 2019, we consummated the IPO of 4,600,000 Units (which includes the full exercise of the underwriter’s over-allotment option), at a price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 225,000 Private Units, at a price of $10.00 per Unit, generating gross proceeds of $2,250,000. Following the IPO and the exercise of the over-allotment option, a total of $46,000,000 was placed in the Trust Account. We incurred approximately $1,533,781 in IPO related costs, including $1,150,000 of underwriting fees and approximately $383,781 of IPO Costs. Our liquidity needs have been satisfied to date through receipt of $25,000 from the sale of the insider shares, advances from our Sponsor and an affiliate of our Sponsor in an aggregate amount of $543,193 outstanding as of December 31, 2019, and the remaining net proceeds from our IPO and Private Placement. 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 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. 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 anticipate that the funds held outside of our trust account will be sufficient to allow us to operate 12 months from the filing date of this Form 10-K, assuming that a business combination is not consummated during that time. Over this time period, we will be using these funds for identifying and evaluating prospective business combination 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 consummate our initial business combination with and structuring, negotiating and consummating the business combination. If our estimates of the costs of undertaking in-depth due diligence and negotiating our initial business combination is less than the actual amount necessary to do so, or the amount of interest available to us from the trust account is less than we expect as a result of the current interest rate environment, 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 consummate 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 consummate such financing simultaneously with the consummation of our initial business combination. 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 As of December 31, 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 December 31, 2019, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. Critical Accounting Policies Basis of presentation These accompanying financial statements have been prepared in U.S. Dollars in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) have been made that are necessary to present fairly the financial position, and the results of its operations and its cash flows. 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 and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. Cash The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. There were $929,335 cash equivalents as of December 31, 2019. Cash and Investments Held in Trust Account At December 31, 2019, the assets held in the Trust Account are held in cash and US Treasury securities. The Company classifies marketable securities as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All marketable securities are recorded at their estimated fair value. Unrealized gains and losses for available-for-sale securities are recorded in other comprehensive loss. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the securities before the recovery of the cost basis. Realized gains and losses and declines in value determined to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the statements of operations. Ordinary Shares Subject To Possible Redemption The Company accounts for its ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Ordinary share subject to mandatory redemption (if any) is classified as a liability instrument and is 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 the Company’s control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2019, 4,044,736 ordinary shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheet. Offering Costs The Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering. Fair Value of Financial Instruments FASB ASC Topic 820 “Fair Value Measurements and Disclosures” defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. FASB ASC Topic 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows: Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment. Level 2 - Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means. Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash and cash equivalents, and other current assets, accrued expenses, due to sponsor are estimated to approximate the carrying values as of December 31, 2019 due to the short maturities of such instruments. The following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2019, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. * included in cash and investments held in trust account on the Company’s balance sheet. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentration of credit risk consist of cash and trust accounts in a financial institution which, at times may exceed the Federal depository insurance coverage of $250,000. The Company has not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts. Net Income (Loss) Per Share The Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” Basic loss per share is computed by dividing the net loss by the weighted-average number of ordinary shares outstanding during the period, excluding ordinary shares subject to possible conversion. Diluted loss per share is computed by dividing net loss by the weighted average number of ordinary shares outstanding, plus to the extent dilutive, the incremental number of ordinary shares to settle rights and other ordinary share equivalents (currently none outstanding), as calculated using the treasury stock method. Ordinary shares subject to possible conversion at December 31, 2019, which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic and diluted loss per share since such shares, if redeemed, only participate in their pro rata share of the Trust Account earnings. The Company has not considered the effect of rights that convert into 276,000 ordinary shares in the unit purchase option sold to the underwriter, in the calculation of diluted loss per share, since the conversion of the rights into ordinary is contingent upon the occurrence of future events. Related Parties Parties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence. Recent Accounting Pronouncements The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on the results of operations, financial condition, or cash flows, based on the current information.

<s>[INST] Overview We were formed on October 8, 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. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic region. As of the date of this report, we have not selected any target business for our initial business combination. 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 May 16, 2019, the Company consummated its IPO of 4,600,000 Units, which includes the full exercise of the overallotment option. Each Unit consists of one ordinary share, one redeemable warrant, and one right to receive onetenth (1/10) of an ordinary share upon the consummation of a business combination. Each redeemable warrant entitles the holder thereof to purchase onehalf (1/2) of one ordinary share, and each ten rights entitle the holder thereof to receive one ordinary share at the closing of a business combination. The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, the Company consummated a Private Placement of 225,000 units at a price of $10.00 per Private Unit, generating total proceeds of $2,250,000. A total of $46,000,000 of the net proceeds from the sale of Units in the IPO (including the overallotment option units) and the Private Placements were placed in a trust account established for the benefit of the Company’s public shareholders. As of December 31, 2019, a total of $46,603,976 was held in a trust account established for the benefit of the Company’s public shareholders, which included $46,000,000 of the net proceeds from the IPO (including the exercise of the overallotment option) and the Private Placements and subsequent interest income. Our management has broad discretion with respect to the specific application of the net proceeds of the IPO and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. The outbreak of the COVID19 coronavirus has resulted in a widespread health crisis that has adversely affected the economies and financial markets worldwide, and potential target companies may defer or end discussions for a potential business combination with us whether or not COVID19 affects their business operations. The extent to which COVID19 impacts our search for a business combination will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID19 and the actions to contain COVID19 or treat its impact, among others. We may be unable to complete a business combination if continued concerns relating to COVID19 restrict travel, limit the ability to have meetings with potential investors or the target company’s personnel, vendors and services providers are unavailable to negotiate and consummate a transaction in a timely manner. Results of Operations Our entire activity from inception up to May 16, 2019 was in preparation for the IPO. 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 business combination. 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. We expect our expenses to increase substantially after this period. For the year ended December 31, 2019, we had a net income of $167,472 which consisted of interest income from our trust account offset by operating expenses. Operating expenses generally consist of the $10,000 monthly payment to our Sponsor for office and administrative support, monthly [/INST] Positive. </s>

Silk Road Medical Inc

2020-03-02

2019-12-31

Item 7. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations You should read the following discussion and analysis of our financial condition and results of operations together with the section entitled “Selected financial data” and our audited financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. This discussion and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions, that are based on the beliefs of our management, as well as assumptions made by, and information currently available to, 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 section of this Annual Report on Form 10-K entitled “Risk Factors.” Overview We are a medical device company focused on reducing the risk of stroke and its devastating impact. We believe a key to stroke prevention is minimally-invasive and technologically advanced intervention to safely and effectively treat carotid artery disease, one of the leading causes of stroke. We have pioneered a new approach for the treatment of carotid artery disease called transcarotid artery revascularization, or TCAR, which we seek to establish as the standard of care. We manufacture and sell in the United States our portfolio of TCAR products, which are designed to provide direct access to the carotid artery, effective reduction in stroke risk throughout the procedure, and long-term restraint of carotid plaque. We began commercializing our products in the United States in late 2015. Our products are currently the only devices cleared and approved by the FDA specifically for transcarotid use. While our current commercial focus is on the U.S. market, our products have obtained CE Mark approval, allowing us to commercialize in Europe in the future. We also intend to pursue regulatory clearances in China, Japan, and other select international markets. TCAR is reimbursed based on established current procedural technology, or CPT, codes and International Classification of Diseases, or ICD-10, codes related to carotid stenting that track to Medicare Severity Diagnosis Related Group, or MS-DRG, classifications. We designed our commercial strategy and built our direct sales force with a particular focus on vascular surgery practices. Vascular surgeons are skilled in endovascular procedures, and our sales and marketing efforts are focused on driving adoption and supporting their practice development by offering them an innovative, safe, effective and minimally-invasive alternative for treating carotid artery disease. We also market to other specialists with experience in CEA or CAS with the appropriate skill set for TCAR, including neurosurgeons, cardiothoracic surgeons and non-surgical interventionalists in radiology, neuroradiology and cardiology. We also work on developing strong relationships with physicians and hospitals that we have identified as key opinion leaders. We consider the hospitals and medical centers where the procedure is performed to be our customers, as they typically are responsible for purchasing our products. We manufacture and distribute the ENROUTE NPS at our facility in Sunnyvale, California, using components and sub-assemblies manufactured both in-house and by third party manufacturers and suppliers. We purchase our other products from third-party contract manufacturers, including our ENROUTE stent. Many of these third-party manufacturers and outside vendors are currently single-source suppliers. While we expect that our existing manufacturing facility will be sufficient to meet our anticipated growth through at least the next four years we intend to supplement our distribution operations with a third-party logistics and warehousing service and/or additional leased facilities. In April 2019, we completed our initial public offering by issuing 6,000,000 shares of common stock, at a public offering price of $20.00 per share, for net proceeds of approximately $109.1 million after deducting underwriting discounts and commissions and expenses. In August 2019, we completed a secondary public offering of 4,200,000 shares of common stock by selling stockholders, and the exercise in full of the underwriters' option to purchase 630,000 additional shares of common stock from selling stockholders, at a public offering price of $39.50 per share. We received no proceeds from the sale of our common stock by the selling stockholders. Prior to our initial public offering in April 2019, our primary sources of capital were private placements of convertible preferred stock, debt financing arrangements and revenue from sales of our products. As of December 31, 2019, we had cash and cash equivalents of $39.2 million, investments of $69.7 million, long-term debt of $44.9 million and an accumulated deficit of $191.5 million. Since inception, we have raised a total of $214.3 million in net proceeds from the sale of equity securities, including net proceeds of approximately $109.1 million from our initial public offering in April 2019. Key Business Metric - Number of U.S. TCAR procedures We regularly review a number of operating and financial metrics, including the number of procedures performed in the United States, to evaluate our business, measure our performance, identify trends affecting our business, formulate our business plan and make strategic decisions. The following table lists the number of procedures performed in each of the three month periods as indicated: We define a procedure as any instance in which our ENROUTE NPS is used and for which we have a record that the procedure was performed. A procedure that is started and then aborted, or converted to a different procedure, after the ENROUTE NPS is used would count as a procedure. The number of procedures is an indicator of our ability to drive adoption and generate revenue, and is helpful in tracking the progress of our business. We believe that it is representative of our current business; however, we anticipate this may be substituted for additional or different metrics as our business grows. Components of our Results of Operations Revenue We currently derive all of our revenue from the sale of our portfolio of TCAR products to hospitals and medical centers in the United States. Each of our products is purchased individually, and the majority of our revenue is derived from sales of the ENROUTE NPS and ENROUTE stent. No single customer accounted for 10% or more of our revenue during the during the years ended December 31, 2019 and 2018. We expect revenue to increase in absolute dollars as we expand our sales territories, new accounts and trained physician base and as existing physicians perform more TCAR procedures. We expect our revenue to fluctuate from quarter-to-quarter due to a variety of factors, including seasonality. For example, in the first quarter, our results can be harmed by adverse weather and by resetting of annual patient healthcare insurance plan deductibles, both of which may cause patients to delay elective procedures. Holiday and summer vacations by physicians and/or their patients can also affect procedure volumes that in turn affect hospital ordering patterns. We have also seen procedure volumes moderate during major medical conferences when significant portions of our customer base are attending the conferences. Cost of Goods Sold and Gross Margin We manufacture the ENROUTE NPS in California at our facility in Sunnyvale. We purchase our other products from third party manufacturers. Cost of goods sold consists primarily of costs related to materials, components and sub-assemblies, direct labor, manufacturing overhead, reserves for excess, obsolete and non-sellable inventories as well as distribution-related expenses. Overhead costs include the cost of quality assurance, material procurement, inventory control, facilities, equipment and operations supervision and management. Cost of goods sold also includes depreciation expense for production equipment and certain direct costs such as those incurred for shipping our products and royalties related to the sale of our ENROUTE stent. We expense all inventory provisions as cost of goods sold. We record adjustments to our inventory valuation for estimated excess, obsolete and non-sellable inventories based on assumptions about future demand, past usage, changes to manufacturing processes and overall market conditions. We expect cost of goods sold to increase in absolute dollars to the extent more of our products are sold. We calculate gross margin as gross profit divided by revenue. Our gross margin has been and will continue to be affected by a variety of factors, primarily average selling prices, product sales mix, production and ordering volumes, manufacturing costs, product yields, headcount and cost-reduction strategies. We expect our gross margin to increase over the long-term as our production and ordering volumes increase and as we spread the fixed portion of our overhead costs over a larger number of units produced. We intend to use our design, engineering and manufacturing know-how and capabilities to further advance and improve the efficiency of our manufacturing processes, which we believe will reduce costs and have a positive long-term impact on our gross margin. However, our gross margin could fluctuate from quarter to quarter as we introduce new products, due to the timing of certain manufacturing engineering projects, as we adopt new manufacturing processes and technologies and as we expand our distribution operations and infrastructure to support long term growth and risk mitigation. Research and Development Expenses Research and development, or R&D, expenses consist primarily of engineering, product development, clinical studies to develop and support our products, regulatory expenses, medical affairs, and other costs associated with products and technologies that are in development. These expenses include employee compensation, including stock-based compensation, supplies, consulting, prototyping, testing, materials, travel expenses, depreciation and an allocation of facility overhead expenses. Additionally, R&D expenses include costs associated with our clinical studies, including clinical trial design, clinical trial site initiation and study costs, data management, related travel expenses and the cost of products used for clinical trials, internal and external costs associated with our regulatory compliance and quality assurance functions and overhead costs. We expect R&D expenses as a percentage of revenue to vary over time depending on the level and timing of our new product development efforts, as well as our clinical development, clinical trial and other related activities. Selling, General and Administrative Expenses Selling, general and administrative, or SG&A, expenses consist primarily of compensation for personnel, including stock-based compensation, related to selling and marketing functions, physician education programs, commercial operations and analytics, reimbursement, finance, information technology and human resource functions. Other SG&A expenses include sales commissions, training, travel expenses, promotional activities, marketing initiatives, market research and analysis, conferences and trade shows, professional services fees (including legal, audit and tax fees), insurance costs, general corporate expenses and allocated facilities-related expenses. We expect SG&A expenses to continue to increase in absolute dollars as we expand our infrastructure to both drive and support the anticipated growth in revenue and due to additional legal, accounting, insurance and other expenses associated with being a public company. In addition, we will continue exploring sales and marketing expansion opportunities in international geographies. Interest Income (Expense), net Interest income (expense), net consists primarily of cash interest incurred on our outstanding indebtedness and non-cash interest related to the amortization of debt discount and issuance costs associated with our term loan agreement. We may, at our election, pay a portion of the interest on our term loan through the incurrence of additional indebtedness as payment-in-kind, or PIK. Our interest expense was partially offset by interest income earned on our investments. Other Income (Expense), net Other income (expense), net primarily consists of gains and losses resulting from the remeasurement of the fair value of our convertible preferred stock warrant liability at each balance sheet date. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until they were exercised in connection with our initial public offering in April 2019. At such time, the final fair value of the warrant liability was reclassified to stockholders’ equity (deficit) and we no longer record any related periodic fair value adjustments. Results of Operations: Comparison of Years Ended December 31, 2019 and 2018 Revenue. Revenue increased $28.8 million, or 83%, to $63.4 million during the year ended December 31, 2019, compared to $34.6 million during the year ended December 31, 2018. The increase in revenue was attributable to an increase in the number of products sold as we expanded our sales territories, increased the number of new accounts, trained more physicians in TCAR and as physicians performed more TCAR procedures. Cost of Goods Sold and Gross Margin. Cost of goods sold increased $5.0 million, or 46%, to $15.9 million during the year ended December 31, 2019, compared to $10.9 million during the year ended December 31, 2018. This increase was attributable to the increase in the number of products sold and additional manufacturing overhead costs as we invested significantly in our operational infrastructure to support anticipated future growth. Gross margin for the year ended December 31, 2019 increased to 75%, compared to 69% in the year ended December 31, 2018. Gross margin increased as our production and ordering volumes increased and we were able to spread the fixed portion of our overhead costs over a larger number of units produced. Research and Development Expenses. R&D expenses increased $2.0 million, or 20%, to $12.3 million during the year ended December 31, 2019, compared to $10.3 million during the year ended December 31, 2018. The increase in R&D expenses was primarily attributable to an increase of $1.4 million in personnel-related expenses including stock-based compensation, an increase of $0.3 million in clinical and regulatory expense, an increase of $0.3 million relating to educational grants, an increase of $0.2 million in product development materials and costs, an increase of $0.2 million in software related expense, and an increase of $0.1 million in outside services, partially offset by a decrease in travel and the allocation of facilities expense. Selling, General and Administrative Expenses. SG&A expenses increased $28.4 million, or 82%, to $63.2 million during the year ended December 31, 2019, compared to $34.8 million during the year ended December 31, 2018. The increase in SG&A expenses is primarily attributable to an increase of $17.9 million in personnel-related expenses, an increase of $2.5 million in consulting, legal and professional fees, an increase of $2.2 million in marketing, tradeshow and promotional costs, an increase of $1.9 million in travel expenses, an increase of $1.3 million in insurance costs, an increase of $1.1 million in physician training and travel related costs, an increase of $0.8 million in software related expense, and an increase of $0.7 million relating to depreciation and the allocation of facilities and related expenses. Personnel-related expenses included stock-based compensation expense of $2.4 million and $0.6 million for the years ended December 31, 2019 and 2018, respectively. Interest Income (Expense), Net. Interest income (expense), net decreased $0.9 million, or 21%, to an expense of $3.3 million during the year ended December 31, 2019, compared to an expense of $4.2 million during the year ended December 31, 2018. This decreased expense was attributable to interest income earned on our investments, partially offset by the additional interest expense associated with the $15.0 million of additional borrowings in September 2018 under our term loan agreement. As of December 31, 2019 and 2018, the aggregate outstanding principal balance (including interest paid-in-kind) under the term loan agreement was $44.9 million and $44.2 million, respectively. Other Income (Expense), Net. Other income (expense), net increased to an expense of $21.1 million during the year ended December 31, 2019, compared to an expense of $12.1 million during the year ended December 31, 2018. The decrease was primarily attributed to the remeasurement of our convertible preferred stock warrants and recognition of the change in fair value. Liquidity and Capital Resources As of December 31, 2019, we had cash and cash equivalents of $39.2 million and investments of $69.7 million, an accumulated deficit of $191.5 million and $44.9 million outstanding under our term loan agreement. No borrowings remain available under this credit facility. In April 2019, we completed our initial public offering by issuing 6,000,000 shares of common stock, at a public offering price of $20.00 per share, for net proceeds of approximately $109.1 million after deducting underwriting discounts and commissions and expenses. In August 2019, we completed a secondary public offering of 4,200,000 shares of common stock by selling stockholders, and the exercise in full of the underwriters' option to purchase 630,000 additional shares of common stock from selling stockholders, at a public offering price of $39.50 per share. We received no proceeds from the sale of the common stock by the selling stockholders. Prior to our initial public offering, our primary sources of capital were private placements of convertible preferred stock, debt financing agreements and revenue from the sale of our products. We believe that our cash and cash equivalents and available-for-sale investments as of December 31, 2019, together with our expected revenue, will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months. Cash Flows The following table summarizes our cash flows for each of the periods presented below: Net Cash Used in Operating Activities Net cash used in operating activities for the year ended December 31, 2019 was $29.6 million, consisting primarily of a net loss of $52.4 million and a decrease in net operating assets of $3.0 million, partially offset by non-cash charges of $25.8 million. The decrease in net operating assets was primarily due to an increase in accounts receivable, inventories and prepaid expenses and other current assets to support the growth of our operations, partially offset by increases in accounts payable and accrued liabilities, due to timing of payments and growth of our operations. The non-cash charges primarily consisted of depreciation, stock-based compensation, non-cash interest expense and other charges related to our term loan agreement, and an increase in the fair value of the convertible preferred stock warrants. Net cash used in operating activities for the year ended December 31, 2018 was $21.7 million, consisting primarily of a net loss of $37.6 million partially offset by an increase in net operating assets of $0.9 million and non-cash charges of $15.0 million. The increase in net operating assets was primarily due to an increase in accounts receivable, inventories and prepaid expenses and other current assets to support the growth of our operations, partially offset by increases in accrued and other liabilities, due to timing of payments and growth of our operations. The non-cash charges primarily consisted of depreciation, stock-based compensation, non-cash interest expense and other charges related to our term loan agreement, and an increase in the fair value of the convertible preferred stock warrants. Net Cash Used in Investing Activities Net cash used in investing activities in the year ended December 31, 2019 was $70.0 million consisting of purchases of available-for-sale investments of $69.4 million and purchases of property and equipment of $535,000. Net cash used in investing activities in the year ended December 31, 2018 was $2.3 million primarily consisting of purchases of property and equipment. Net Cash Provided by Financing Activities Net cash provided by financing activities in the year ended December 31, 2019 was $113.8 million, primarily attributable to proceeds of $109.4 million from our initial public offering, net of issuance costs paid, proceeds of $2.6 million from stock option exercises and purchases under our employee stock purchase plan and warrant exercises of $1.8 million. Net cash provided by financing activities in the year ended December 31, 2018 was $15.4 million primarily attributable to proceeds of $15.0 million from additional borrowings under the term loan agreement, and $0.7 million of proceeds from the exercise of stock options, partially offset by cash paid for deferred initial public offering costs of $0.2 million. Term Loan Agreement In October 2015, we entered into the term loan agreement and related security agreement with Capital Resource Group ("CRG"), providing for a term loan facility of up to $30.0 million, available in tranches on the terms and conditions set forth in the term loan agreement. In September 2018, we entered into a fifth amendment to the term loan agreement, or Fifth Amendment, to increase the aggregate term loan commitments from up to $30.0 million to up to $55.0 million, to extend the commitment period from March 29, 2017 to June 30, 2019, to extend the maturity date from September 30, 2021 to December 31, 2022, and to amend certain other terms. As of December 31, 2019, the aggregate outstanding principal balance (including interest PIK) under the term loan agreement was $44.9 million. Prior to the Fifth Amendment, the term loans bore interest at a rate of 13.0% per annum, which interest rate was reduced to 10.75% on and after the effective date of the Fifth Amendment, and which interest rate was further reduced to 10.00% on and after the consummation of our initial public offering. We may, at our election, pay the interest through a combination of cash and PIK. The interest is payable in cash and PIK as follows: prior to the Fifth Amendment, 8.50% per annum in cash and 4.50% PIK; on or after the Fifth Amendment, 8.0% per annum in cash and 2.75% PIK; and on and after the consummation of our initial public offering, 8.0% per annum in cash and 2.0% PIK. Interest is due and payable quarterly in arrears. The outstanding principal amount under the term loan agreement, together with all accrued and unpaid interest, is due and payable on December 31, 2022. We may prepay the term loan agreement, in whole or in part, at any time. During 2019 and 2018, we incurred $5.0 million and $4.3 million, respectively, in interest expense in connection with the term loan agreement. During 2019 and 2018, we made cash interest payments of $4.2 million and $2.7 million, respectively, and issued $0.3 million and $1.2 million in PIK interest for the year ended December 31, 2019 and 2018, respectively. Our obligations under the term loan agreement are guaranteed by our existing and future subsidiaries, subject to exceptions for certain foreign subsidiaries. Our obligations under the term loan agreement are secured by substantially all of our assets, including our material intellectual property, and the assets of our guarantor subsidiaries, subject to certain exceptions. There are currently no guarantor subsidiaries. Additionally, we and our subsidiaries are subject to customary affirmative and negative covenants, including covenants that limit or restrict the ability of us and our subsidiaries to, among other things, incur indebtedness, grant liens, merge or consolidate, make investments, dispose of assets, make acquisitions, pay dividends or make distributions, repurchase stock and enter into certain transactions with affiliates, in each case subject to certain exceptions. We are also required to maintain minimum liquidity that exceeds the greater of $3.0 million or the minimum cash balance required under any permitted accounts receivable credit facility. In addition, we must achieve minimum annual revenue of $40.0 million in 2020. If we fail to satisfy the minimum annual revenue covenant in any measurement period, we can cure the resulting default by raising the revenue shortfall in additional equity or in subordinated debt within 90 days of such calendar year in which the shortfall occurred. As of the date of this Annual Report on Form 10-K, we were in compliance with all covenants under the term loan agreement. The term loan agreement is subject to customary events of default that include, among other things, non-payment defaults, inaccuracy of representations and warranties, covenant defaults, cross-defaults to material indebtedness and material agreements, bankruptcy and insolvency defaults, material judgment defaults, ERISA defaults, a change of control default and a material adverse change default. The occurrence of an event of default could result in the acceleration of the obligations under the term loan agreement. Under certain circumstances, a default interest rate will apply on all obligations during the existence of an event of default at a per annum rate equal to 4.0% above the applicable interest rate. On November 14, 2018, we entered into a sixth amendment to the term loan agreement to amend a covenant regarding the timeline for provision of audited financial statements. In June 2019, we entered into a seventh amendment to the term loan agreement to amend the definition of permitted cash equivalents to reflect updated flexibility. Cordis License Agreement In December 2010, we entered into a license agreement, or the Cordis License Agreement, with Cordis Corporation, or Cordis, which is now a subsidiary of Cardinal Health. Pursuant to the Cordis License Agreement, Cordis has granted us a worldwide, non-exclusive, royalty-bearing license to certain of its intellectual property related to the PRECISE® carotid stent, or the Licensed IP, for transcervical treatment of carotid artery disease with an intravascular stent for certain applications for accessing blood vessels through the neck and cervical area. Cordis may not license the Licensed IP in our licensed field of use to any other third party during the term of the Cordis License Agreement. We have paid Cordis a one-time license execution fee and are obligated to pay royalties to Cordis on a calendar quarter basis during the term of the Cordis License Agreement, calculated based on net sales of the licensed products we sell during the preceding quarterly period. The license granted under Cordis License Agreement shall remain in full force and effect on a country by country basis until the last to expire of the Licensed IP in such country. The Cordis License Agreement requires us to work exclusively with either Cordis or Confluent Medical Technologies, Inc. (f/k/a Nitinol Devices and Components, Inc.), or Confluent, for the development, manufacture and supply of the licensed products. If either Cordis or Confluent cannot continue to manufacture or supply the licensed products, we can seek a third party manufacturer with the prior written consent of Cordis. We have the right to assign or transfer the Cordis License Agreement to an entity that succeeds all or substantially all of our equity or assets. The Cordis License Agreement may be terminated by either party in the event of uncured material breach by the other party that remains uncured for 60 days (or 30 days for payment related breaches), or bankruptcy of the other party. Cordis Supply Agreement In October 2011, we entered into a supply agreement, or Cordis Supply Agreement, with Cordis and have since entered into four amendments in March and July 2012, April 2013 and April 2018. Pursuant to the Cordis Supply Agreement, Cordis has assisted in the development of a transcarotid stent delivery system according to our specifications with a PRECISE® carotid stent implant, or ENROUTE stent, has supplied the ENROUTE stent through preclinical and clinical trials, and continues to supply the ENROUTE stent for our commercial sale. The Cordis Supply Agreement will continue in full force and effect until the earlier to occur of (i) termination of the Cordis License Agreement; (ii) our election if and when Cordis approves another manufacturer; (iii) mutual written termination; or (iv) termination pursuant to the terms therein. The Cordis Supply Agreement may be terminated by either party in the event of uncured material breach by the other party that remains uncured for 30 days, or bankruptcy of the other party. We are obligated under the Cordis Supply Agreement to purchase a minimum volume of the ENROUTE stent annually. This obligation is binding until the natural expiration of the Cordis License Agreement, due to expiration of the last-to-expire of the Licensed IP, if the Cordis License Agreement remains in effect through such natural expiration. Cordis has the exclusive right to manufacture and supply the ENROUTE stent during the term of the Cordis Supply Agreement. However, if Cordis is not able to supply the ENROUTE stent, upon our election, Cordis shall permit Confluent or a third party manufacturer to provide supply of the ENROUTE stent, provided that Cordis retains the right to manufacture and supply the ENROUTE stent to us to the extent it is able to do so. Notwithstanding the foregoing, we, without Cordis’ consent, may work directly with Confluent for the development and supply of next-generation products that materially expand or change the specification of the ENROUTE stent. Lease Agreements We currently lease our headquarters in Sunnyvale, California pursuant to a lease agreement which terminates in October 2024. We have an additional option to extend the lease term for a period of five years. The option must be exercised no more than 12 months and no less than nine months prior to the expiration of the applicable term. The facility lease is for approximately 31,000 square feet. Off-Balance Sheet Arrangements We currently have no off-balance sheet arrangements, such as structured finance, special purpose entities, or variable interest entities. Contractual Obligations and Commitments Our principal obligations consist of the operating lease for our facility, our term loan agreement and non-cancellable inventory purchase commitments. The following table sets out, as of December 31, 2019, our contractual obligations due by period: The non-cancellable purchase commitments primarily consist of ENROUTE stents and other inventory components. Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, 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 and any such differences may be material. While our significant accounting policies are more fully described in Note 2 of our audited financial statements included in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to our financial condition and results of operations and require our most difficult, subjective and complex judgments. Revenue Recognition We adopted Accounting Standards Codification, or ASC, Topic 606, “Revenue from Contracts with Customers,” using the modified retrospective method applied to contracts which were not completed as of that date effective January 1, 2018. Under ASC 606, revenue is recognized when a 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, we perform the following five steps: (i)identify the contract(s) with a customer; (ii)identify the performance obligations in the contract; (iii)determine the transaction price; (iv)allocate the transaction price to the performance obligations in the contract; and (v)recognize revenue when (or as) the entity satisfies a performance obligation. Our revenue is generated from the sale of our products to hospitals and medical centers in the United States through direct sales representatives. Revenue is recognized when obligations under the terms of a contract with customers are satisfied, which occurs with the transfer of control of our products to customers, either upon shipment of the product or delivery of the product to the customer under our standard terms and conditions. Revenue is measured as the amount of consideration we expect to receive in exchange for transferring the goods. For sales where the sales representative hand delivers product directly to the hospital or medical center from the sales representative’s trunk stock inventory, we recognize revenue upon delivery, which represents the point in time when control transfers to the customer. For sales which are sent directly to hospitals and medical centers, the transfer of control occurs at the time of shipment or delivery of the product. There are no further performance obligations by us or the sales representative to the customer after delivery under either method of sale. We accept product returns at our discretion or if the product is defective as manufactured. We establish estimated provisions for returns based on historical experience and consideration of other factors that we believe could significantly impact our expected returns, which provisions are classified within accrued liabilities on our balance sheet. We have elected to expense shipping and handling costs as incurred and include them within cost of goods sold. In those cases where we invoice shipping and handling costs to customers, we will classify the amounts billed as a component of revenue. JOBS Act Accounting Election As an emerging growth company under the Jumpstart Our Business Startups Act of 2012, 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. We have irrevocably elected not to avail ourselves of the exemption from new or revised accounting standards and, therefore, are subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. Recently Issued Accounting Pronouncements We adopted ASC 842, “Leases,” on January 1, 2019 using the modified retrospective method for all leases not substantially completed as of the date of adoption. We elected to apply the package of practical expedients, which allowed us to not reassess: (i) whether expired or existing contracts contain leases; (ii) lease classification for any expired or existing leases; and (iii) initial direct costs for any existing lease. See Note 3 to our financial statements included elsewhere in this Annual Report on Form 10-K for recently adopted accounting pronouncements. See Note 3 to our financial statements included elsewhere in this Annual Report on Form 10-K for new accounting pronouncements not yet adopted as of the date of this Annual Report on Form 10-K.

<s>[INST] Overview We are a medical device company focused on reducing the risk of stroke and its devastating impact. We believe a key to stroke prevention is minimallyinvasive and technologically advanced intervention to safely and effectively treat carotid artery disease, one of the leading causes of stroke. We have pioneered a new approach for the treatment of carotid artery disease called transcarotid artery revascularization, or TCAR, which we seek to establish as the standard of care. We manufacture and sell in the United States our portfolio of TCAR products, which are designed to provide direct access to the carotid artery, effective reduction in stroke risk throughout the procedure, and longterm restraint of carotid plaque. We began commercializing our products in the United States in late 2015. Our products are currently the only devices cleared and approved by the FDA specifically for transcarotid use. While our current commercial focus is on the U.S. market, our products have obtained CE Mark approval, allowing us to commercialize in Europe in the future. We also intend to pursue regulatory clearances in China, Japan, and other select international markets. TCAR is reimbursed based on established current procedural technology, or CPT, codes and International Classification of Diseases, or ICD10, codes related to carotid stenting that track to Medicare Severity Diagnosis Related Group, or MSDRG, classifications. We designed our commercial strategy and built our direct sales force with a particular focus on vascular surgery practices. Vascular surgeons are skilled in endovascular procedures, and our sales and marketing efforts are focused on driving adoption and supporting their practice development by offering them an innovative, safe, effective and minimallyinvasive alternative for treating carotid artery disease. We also market to other specialists with experience in CEA or CAS with the appropriate skill set for TCAR, including neurosurgeons, cardiothoracic surgeons and nonsurgical interventionalists in radiology, neuroradiology and cardiology. We also work on developing strong relationships with physicians and hospitals that we have identified as key opinion leaders. We consider the hospitals and medical centers where the procedure is performed to be our customers, as they typically are responsible for purchasing our products. We manufacture and distribute the ENROUTE NPS at our facility in Sunnyvale, California, using components and subassemblies manufactured both inhouse and by third party manufacturers and suppliers. We purchase our other products from thirdparty contract manufacturers, including our ENROUTE stent. Many of these thirdparty manufacturers and outside vendors are currently singlesource suppliers. While we expect that our existing manufacturing facility will be sufficient to meet our anticipated growth through at least the next four years we intend to supplement our distribution operations with a thirdparty logistics and warehousing service and/or additional leased facilities. In April 2019, we completed our initial public offering by issuing 6,000,000 shares of common stock, at a public offering price of $20.00 per share, for net proceeds of approximately $109.1 million after deducting underwriting discounts and commissions and expenses. In August 2019, we completed a secondary public offering of 4,200,000 shares of common stock by selling stockholders, and the exercise in full of the underwriters' option to purchase 630,000 additional shares of common stock from selling stockholders, at a public offering price of $39.50 per share. We received no proceeds from the sale of our common stock by the selling stockholders. Prior to our initial public offering in April 2019, our primary sources of capital were private placements of convertible preferred stock, debt financing arrangements and revenue from sales of our products. As of December 31, 2019, we had cash and cash equivalents of $39.2 million, investments of $69.7 million, longterm debt of $44.9 million and an accumulated deficit of $191.5 million. Since inception, we have raised a total of $214.3 million in net proceeds from the sale of equity securities, including net proceeds of approximately $109. [/INST] Negative. </s>

DOMO, INC.

2019-04-15

2019-01-31

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 January 31. References to fiscal 2019, for example, refer to the fiscal year ended January 31, 2019. Overview We founded Domo in 2010 with the vision of digitally connecting everyone within the enterprise with real-time, rich, relevant data and then encouraging all employees to collaborate and act. We realized that many organizations were unable to access the massive amounts of data that they were collecting in siloed cloud applications and on-premise databases. Furthermore, even for organizations that were capable of accessing their data, the process for doing so was time-consuming, costly, and often resulted in the data being out-of-date by the time it reached decision makers. The delivery format, including alert functionality, and devices were not adequate for the connected and real-time mobile workforce. Based on these observations, it was apparent that all organizations, regardless of size or industry, were failing to unlock the power of all of their people, data and systems. Since inception, we have focused on creating a comprehensive platform that connects all the people, data and systems that exist within an organization. In many ways, building Domo was like building seven start-ups in one. A foundational element of our platform is our more than 1,000 powerful first-class connectors, which we define as read/write, API and standards based connectors, as well as a library of very flexible universal connectors, that currently power over four hundred thousand Domo datasets, which integrate directly with data sources in real time on a single, intuitive platform. Adrenaline, our data warehouse and fast query engine, stores massive amounts of data connected from across the business, enabling anyone to quickly access the data they need. To best prepare and transform all of the connected data, a critical step in making that data available and usable for visualizations and analysis, we developed Domo ETL, a self-service toolset that enables users, regardless of technical ability, to cleanse and prepare data for analysis. To facilitate data insights, we developed an analysis and visualization toolkit that enables all employees to analyze, display, share and interact with data across mobile and desktop platforms in real time. Domo Buzz, our collaborative communication platform, helps foster and engage a curious workforce so that anyone in an organization can participate in improving the business. Domo leverages machine learning algorithms, predictive analytics, and other artificial intelligence technologies, to create alerts, detect anomalies, optimize queries, and suggest areas of interest to help people focus on what matters most. We also extended the functionality and effectiveness of our platform, through the introduction of the Domo Appstore and developer toolkits that enable a partner ecosystem to quickly build applications on the platform. We continue to broaden our platform's ease of use and self-service capabilities and enhance security and scalability requirements for the enterprise. We offer our platform to our customers as a subscription-based service. Subscription fees are based on the number of users and the tier of package deployed. Business leaders and managers are typically the initial subscribers to our platform, deploying it for a specific use case or department. Over time, as customers recognize the value of our platform, we increasingly engage with CIOs and other executives to facilitate broad enterprise adoption. A majority of our customers subscribe to our services through one-year contracts, but recently a growing percentage of new and existing customers have entered into multi-year contracts. In the year ended January 31, 2019, 43% of our new customers entered into multi-year contracts compared to 38% and 11% in the years ended January 31, 2018 and 2017, respectively. As of January 31, 2019, 42% of all customers were under multi-year contracts and 58% of all customers were under one-year contracts. By comparison, 32% of all customers were under multi-year contracts and 68% of all customers were under one-year contracts as of January 31, 2018. This transition to a higher percentage of multi-year contracts, among both new and existing customers, has enhanced the predictability of our subscription revenue. We typically invoice our customers annually in advance. Our business model focuses on maximizing the lifetime value of a customer relationship. We recognize subscription revenue ratably over the term of the subscription period. In general, customer acquisition costs and other upfront costs associated with new customers are much higher in the first year than the aggregate revenue we recognize from those new customers in the first year. Over the lifetime of the customer relationship, we also incur sales and marketing costs to renew or increase usage per customer. However, these costs, as a percentage of revenue, are significantly less than those initially incurred to acquire the customer. As a result, the profitability of a customer to our business in any particular period depends in part upon how long a customer has been a subscriber and the degree to which it has expanded its usage of our platform. Our platform addresses the diverse and evolving needs of employees. Historically, our sales and marketing efforts have been concentrated on initiatives, including digital marketing, which allowed us to quickly attract a large number of customers and establish our platform in a crowded market. These initial efforts were primarily targeted toward small and medium sized businesses, with smaller average annual contract values, or ACV, and lower renewal rates. Over time, the breadth of our platform's capabilities attracted an increasing number of enterprise customers, and we have continued to expand our presence within those customers. Given the higher average ACV and renewal rates we experience with larger customers, we are focusing on customers with over $100 million in revenue, with a particular emphasis on enterprise customers, which we define as customers with over $1 billion in revenue. With a view towards improving sales efficiency, we have shifted our strategy from broad-based digital marketing to enterprise-targeted marketing campaigns and user events to increase our growth with enterprise customers. From inception through January 31, 2019, we have invested $395.0 million in the development of our platform. Given our investments, we believe that we are well positioned to expand the number of, and increase contract values with enterprise customers. We have also introduced tools that allow customers to manage their own encryption keys and maintain a broad array of security and compliance certifications that enterprise customers require, particularly those in regulated industries. As of January 31, 2019, we had 236 employees in our research and development organization. While we expect research and development expenses to increase in absolute dollars, we anticipate that it will decrease as a percentage of revenue over time. For the years ended January 31, 2017, 2018 and 2019, we had total revenue of $74.5 million, $108.5 million and $142.5 million, respectively, representing year-over-year growth of 46% and 31% for the years ended January 31, 2018 and 2019, respectively. For the years ended January 31, 2017, 2018 and 2019, no single customer accounted for more than 10% of our total revenue, nor did any single organization when accounting for multiple subsidiaries or divisions which may have been invoiced separately. Revenue from customers with billing addresses in the United States comprised 86%, 82% and 77% of our total revenue for the years ended January 31, 2017, 2018 and 2019, respectively. We are focused on growing our international business and will continue to invest in sales operations outside the United States. We have incurred significant net losses since our inception, including net losses of $183.1 million, $176.6 million and $154.3 million for the years ended January 31, 2017, 2018 and 2019, respectively, and had an accumulated deficit of $912.1 million at January 31, 2019. We expect to incur losses for the foreseeable future and may not be able to achieve or sustain profitability. Recent Developments On July 3, 2018, we closed our initial public offering, or IPO, in which we issued and sold 10,580,000 shares of Class B common stock at $21.00 per share for aggregate net proceeds of $202.5 million, after deducting underwriters' discounts and offering expenses payable by us. In January 2019, we entered into an amendment to our $100.0 million credit facility which extended the maturity date for all outstanding loans to October 1, 2022. The amendment also revised the maximum debt ratio financial covenant, increased the amount of the closing fee to $7.0 million, and increased the number of warrants to purchase Class B common stock. Factors Affecting Performance Continue to Attract New Customers We believe that our ability to expand our customer base is an important indicator of market penetration, the growth of our business, and future business opportunities. We define a customer at the end of any particular quarter as an entity that generated revenue greater than $2,500 during that quarter. In situations where an organization has multiple subsidiaries or divisions, each entity that is invoiced at a separate billing address is treated as a separate customer. In cases where customers purchase through a reseller, each end customer is counted separately. As of January 31, 2019, we had over 1,700 customers. From January 31, 2014 to January 31, 2019, the number of our customers with revenue over $1 billion increased from 36 to 447, representing a 66% compound annual growth rate. For the years ended January 31, 2017, 2018 and 2019, our enterprise customers accounted for 47%, 46% and 45% of our revenue, respectively. We focus our sales and marketing resources on obtaining customers with over $100 million in revenue, with a particular emphasis on enterprise customers. In order to accelerate customer growth, we intend to further develop our partner ecosystem by establishing agreements with more software resellers, systems integrators and implementation partners to provide broader customer and geographic coverage. We believe we are underpenetrated in the overall market and have significant opportunity to expand our customer base over time. Customer Upsell and Retention We employ a land and expand sales model, and our performance depends on our ability to retain customers and expand the number of users and use cases at existing customers over time. It currently takes multiple years for our customers to fully embrace the power of our platform. We believe that as customers deploy greater volumes and sources of data for multiple use cases, the unique features of our platform can address the needs of everyone within their organization. We are still in the early stages of expanding within many of our customers. We have invested in platform capabilities and online support resources that allow our customers to expand the use of our platform in a self-guided manner. Our professional services, customer support and customer success functions also support our sales force by helping customers to successfully deploy our platform and implement additional use cases. In addition, we believe our partner ecosystem will become increasingly important over time. We work closely with our customers to drive increased engagement with our platform by identifying new use cases through our customer success teams, as well as in-platform, self-guided experiences. We actively engage with our customers to assess whether they are satisfied and fully realizing the benefits of our platform. While these efforts often require a substantial commitment and upfront costs, we believe our investment in product, customer support, customer success and professional services will create opportunities to expand our customer relationships over time. Our ability to drive growth and generate incremental revenue depends heavily on our ability to retain our customers and increase their usage of our platform. An important way that we measure our performance in this area is to track the growth in our subscription revenue generated from a cohort of customers over time. With that objective in mind, we allocate our customer success and customer support resources to align with maximizing the retention and expansion of our subscription revenue. Our subscription net revenue retention rate compares the subscription revenue in a given period from the cohort of customers that generated subscription revenue at the beginning of the same period in the prior fiscal year, excluding customers from the cohort who canceled during the prior period. The subscription net revenue retention rate is the quotient obtained by dividing the subscription revenue generated from that cohort in a period, by the subscription revenue generated from that same cohort in the corresponding prior year period. The following table sets forth our subscription net revenue retention rate for each of the eight quarters in the period ended January 31, 2019: Our gross subscription dollars churned is equal to the amount of subscription revenue we lost in the current period from the cohort of customers who generated subscription revenue in the prior year period. In the year ended January 31, 2019, we lost $15.4 million of subscription revenue generated by the cohort in the prior year period, or 18% of subscription revenue for the year ended January 31, 2018. Of this amount, $6.5 million was lost from our cohort of enterprise customers and $8.9 million was lost from our cohort of non-enterprise customers. By comparison, in the year ended January 31, 2018, we lost $12.4 million of subscription revenue generated by the cohort in the prior year period, or 21% of subscription revenue for the year ended January 31, 2017. Of this amount, $5.0 million was lost from our cohort of enterprise customers and $7.4 million was lost from our cohort of non-enterprise customers. As we continue to enhance our product and develop methods to encourage wider and more strategic adoptions, including shifting our sales and marketing activities towards enterprise customers, we expect that our subscription net revenue retention rate will increase over the long term; however, our ability to successfully upsell and the impact of cancellations may vary from period to period, with greater variability on a quarterly basis, particularly among our cohort of enterprise customers, due to fewer customers in this cohort compared to non-enterprise customers, higher average contract values and more significant expansion opportunities. The extent of this variability depends on a number of factors including the size and timing of upsells and cancellations relative to the initial subscriptions. Sales and Marketing Efficiency We are focused on increasing the efficiency of our sales force and marketing activities by enhancing account targeting, messaging, field sales operations and sales training in order to reduce our sales and marketing expense as a percentage of revenue and accelerate the adoption of our platform. Our sales strategy depends on our ability to continue to attract top talent, increasing our pipeline of business, and enhancing sales productivity. We focus on productivity per quota-carrying sales representative and the time it takes our sales representatives to reach full productivity. The ACV per sales representative per year increased by approximately 11% from January 31, 2018 to January 31, 2019 and 14% from January 31, 2017 to January 31, 2018. We manage our pipeline by sales representative to ensure sufficient coverage of our sales targets. Our ability to manage our sales productivity and pipeline are important factors to the success of our business. We also intend to shift marketing spending from broad based initiatives that are better suited to attracting smaller organizations towards enterprise-targeted marketing campaigns and user events that we believe will result in larger initial new customer ACV and more upsell ACV potential. Leverage Research and Development Investments for Future Growth Historically, given building Domo was like building seven start-ups in one, we had to make significant investments in research and development to build a platform that powers a business and provides enterprises with features and functionality that they require. We plan to continue to make investments in areas of our business to continue to expand our platform functionality. However, the amount of new investments required to achieve our plans is expected to decrease as a percentage of revenue compared to historical years. Key Business Metric Billings Billings represent our total revenue plus the change in deferred revenue in a period. Billings reflect sales to new customers plus subscription renewals and upsells to existing customers, and represent amounts invoiced for subscription, support and professional services. We typically invoice customers in advance in annual installments for subscriptions to our platform. Because we generate most of our revenue from customers who are invoiced on an annual basis and have a wide range of annual contract values, we may experience variability due to typical enterprise buying patterns and timing of large renewals. The following table sets forth our billings for the years ended January 31, 2017, 2018 and 2019: Components of Results of Operations Revenue We offer subscriptions to our cloud-based platform. We derive our revenue primarily from subscriptions and professional services. Subscription revenue consists primarily of fees to provide our customers access to our cloud-based platform, which includes online customer support resources at no additional cost. Professional service fees include implementation services, optimization services, and training. Subscription revenue accounted for approximately 79%, 81% and 82% of our revenue for the years ended January 31, 2017, 2018 and 2019, respectively. Subscription revenue is a function of the number of customers, the number of users at each customer, and the price per user. Subscription revenue is recognized ratably over the related contractual term beginning on the date the platform is made available to the customer. Our new business subscriptions typically have a term of one to three years, and we generally invoice our customers in annual installments at the beginning of each year in the subscription period. Amounts that have been invoiced are initially recorded as deferred revenue and are recognized ratably over the subscription period. Professional services and other revenue consists of implementation services sold with new subscriptions, as well as professional services sold separately, including training and education. Professional services are generally billed in advance and revenue from these arrangements is recognized as the services are performed. Our professional services engagements typically span from a few weeks to several months. Cost of Revenue Cost of subscription revenue consists primarily of third-party hosting services and data center capacity; salaries, benefits, bonuses and stock-based compensation, or employee-related costs, directly associated with cloud infrastructure and customer support personnel; amortization expense associated with capitalized software development costs; depreciation expense associated with computer equipment and software; certain fees paid to various third parties for the use of their technology and services; and allocated overhead. Allocated overhead includes items such as information technology infrastructure, rent, and certain employee benefit costs. Cost of professional services and other revenue consists primarily of employee-related costs directly associated with these services, third-party consultant fees, and allocated overhead. Operating Expenses Sales and Marketing. Sales and marketing expenses consist primarily of employee-related costs directly associated with our sales and marketing staff and commissions. Other sales and marketing costs include digital marketing programs and promotional events to promote our brand, including Domopalooza, our annual user conference, as well as tradeshows, advertising and allocated overhead. Contract acquisition costs, including sales commissions, are deferred and then amortized on a straight-line basis over the period of benefit, which we have determined to be approximately four years for initial contracts. Contract acquisition costs related to renewal contracts and professional services are recorded as expense when incurred if the period of benefit is one year or less. Research and Development. Research and development expenses consist primarily of employee-related costs for the design and development of our platform, contractor costs to supplement staff levels, third-party web services, consulting services, and allocated overhead. Our cycle of frequent updates has facilitated rapid innovation and the introduction of new product features throughout our history. We capitalize certain software development costs that are attributable to developing new features and adding incremental functionality to our platform, and amortize such costs as costs of subscription revenue over the estimated life of the new feature or incremental functionality, which is generally three years. General and Administrative. General and administrative expenses consist of employee-related costs for executive, finance, legal, human resources, recruiting and administrative personnel; professional fees for external legal, accounting, recruiting and other consulting services; and allocated overhead costs. Other Income (Expense), Net Other income (expense), net consists primarily of interest expense related to long-term debt and interest income earned on our cash and cash equivalents. It also includes the effect of exchange rates on foreign currency transaction gains and losses as well as foreign currency gains and losses upon remeasurement of intercompany balances. The transactional impacts of foreign currency are recorded as foreign currency losses (gains) in the consolidated statements of operations. Provision for Income Taxes Provision for income taxes consists primarily of income taxes related to foreign and state jurisdictions in which we conduct business. Because of the uncertainty of the realization of the deferred tax assets, we have a full valuation allowance for domestic net deferred tax assets, including net operating loss carryforwards and tax credits related primarily to research and development. Results of Operations The following tables set forth selected consolidated statements 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 amortization of certain intangible assets of $0.3 million, $0.1 million and $0.1 million for the years ended January 31, 2017, 2018 and 2019, respectively. (3) Includes reversal of a contingent tax-related accrual of $3.5 million for the year ended January 31, 2019. Discussion of the Years Ended January 31, 2018 and 2019 Revenue Total revenue was $142.5 million for the year ended January 31, 2019, compared to $108.5 million for the year ended January 31, 2018, an increase of $33.9 million, or 31%. Subscription revenue was $117.2 million, or 82% of total revenue, for the year ended January 31, 2019, compared to $87.5 million, or 81% of total revenue, for the year ended January 31, 2018. The increase in subscription revenue was primarily due to a $23.4 million increase from new customers and a $6.3 million increase from existing customers. Our customer count increased 15% from January 31, 2018 to January 31, 2019. We anticipate that as we continue to close new business and retain our customers that subscription revenue will continue to increase as a percent of total revenue. Professional services and other revenue was $25.3 million, or 18% of total revenue, for the year ended January 31, 2019, compared to $21.1 million, or 19% of total revenue, for the year ended January 31, 2018. This increase is due to a higher volume of implementation and training services provided to our customers. Cost of Revenue, Gross Profit and Gross Margin Cost of subscription revenue was $32.8 million for the year ended January 31, 2019, compared to $32.4 million for the year ended January 31, 2018, an increase of $0.4 million, or 1%. The majority of the increase in cost of subscription revenue was due to employee-related costs, which increased by $2.1 million primarily as a result of salary increases. Other increases included $0.9 million related to our data center and $0.7 million in amortization of capitalized software development costs. These increases were offset by a decrease of $3.3 million related to optimization of our third-party hosting services. Cost of professional services and other revenue was $16.8 million for the year ended January 31, 2019, compared to $12.5 million for the year ended January 31, 2018. This increase is primarily due to a higher volume of services provided by third-party consultants related to implementation and training. Subscription gross margin improved due to economies of scale driven by increased subscription revenue and cost improvements due to more proactive management and optimization of our third-party hosting services. We expect subscription gross margin to improve as we continue to effectively manage our data center operations and third-party hosting services. Services gross margin declined due to heavier use of third-party consultants to perform services for our customers. In addition, rates for these consultants have increased from the prior year. While we expect the cost of professional services will decline as a percentage of total revenue over the long term as our business scales and as we continue to develop our partner ecosystem, such costs could fluctuate from period to period depending on the mix of our customer base, particularly if in a given period we have a concentration of large professional services projects that we delivered which are typically associated with enterprise customers. Operating Expenses Sales and marketing expenses were $131.1 million for the year ended January 31, 2019, compared to $131.8 million for the year ended January 31, 2018, a decrease of $0.7 million, or 1%. The change was primarily due to a $10.2 million decrease in marketing programs and event costs. This decrease was offset by an increase of $8.2 million in employee-related costs, including $5.6 million of stock-based compensation related to the performance vesting condition of certain RSUs, which was deemed probable of being satisfied upon the effectiveness of the registration statement related to our initial public offering, or IPO, and $2.6 million attributable to higher headcount and salary increases. Other increases included commission expense, which increased by $0.7 million due to higher sales, and travel expense, which increased by $0.4 million. Sales and marketing expense as a percentage of total revenue decreased from 121% in the year ended January 31, 2018 to 92% in the year ended January 31, 2019. We expect sales and marketing expense to continue to decline as a percentage of total revenue in the long term. Research and development expenses were $75.7 million for the year ended January 31, 2019, compared to $78.3 million for the year ended January 31, 2018, a decrease of $2.5 million, or 3%. Employee-related costs increased by $4.2 million due to stock-based compensation related to the performance vesting condition of certain RSUs, which was deemed probable of being satisfied upon the effectiveness of the registration statement related to our IPO. This increase was offset by a $3.6 million increase in capitalized software development costs (resulting in decreased expense) and a decrease of $3.0 million in third-party web services for internal use. Research and development expense as a percentage of revenue decreased from 72% in the year ended January 31, 2018 to 53% in the year ended January 31, 2019. We expect research and development expense to continue to decline as a percentage of total revenue in the long term as we leverage previous investments in our research and development organization. General and administrative expenses were $30.2 million for the year ended January 31, 2019, compared to $29.3 million for the year ended January 31, 2018, an increase of $0.9 million, or 3%. Employee-related costs increased by $3.3 million, including $2.4 million of stock-based compensation related to the performance vesting condition of certain RSUs, which was deemed probable of being satisfied upon the effectiveness of the registration statement related to our IPO, and $0.9 million attributable to higher headcount and salary increases. Other increases included $0.8 million in costs associated with being a public company. These increases were offset by a $3.5 million reversal of a contingent tax-related accrual. General and administrative expenses as a percent of revenue decreased from 27% in the year ended January 31, 2018 to 21% in the year ended January 31, 2019. In the long term, we expect general and administrative expense to decline as a percentage of total revenue as we leverage previous investments in our general and administrative organization; however, we expect general and administrative expense to increase in absolute dollars due to additional costs associated with operating as a public company including incremental costs for accounting, compliance, insurance, and investor relations. Other Income (Expense), Net Other income (expense), net increased $8.6 million. This increase is primarily due to an increase in interest expense of $10.0 million related to the credit facility, offset by interest income on IPO proceeds of $2.1 million. In the short term, we expect interest expense to increase due to a higher debt balance and higher interest rates. Provision for Income Taxes Provision for income taxes increased $0.9 million due to the impact of the Tax Cuts and Jobs Act on the income tax provision for the year ended January 31, 2018 and expanded foreign operations during the year ended January 31, 2019. We expect income tax expense to continue to increase in conjunction with growth in our international subsidiaries. Discussion of the Years Ended January 31, 2017 and 2018 Revenue Total revenue was $108.5 million for the year ended January 31, 2018, compared to $74.5 million for the year ended January 31, 2017, an increase of $34.0 million, or 46%. Subscription revenue was $87.5 million, or 81% of total revenue, for the year ended January 31, 2018, compared to $58.7 million, or 79% of total revenue, for the year ended January 31, 2017. The increase in subscription revenue was primarily due to a $15.9 million increase from existing customers and a $12.9 million increase from new customers. Our customer count increased 27% from January 31, 2017 to January 31, 2018. Professional services and other revenue was $21.1 million, or 19% of total revenue, for the year ended January 31, 2018, compared to $15.9 million, or 21% of total revenue, for the year ended January 31, 2017. This increase is due to a higher volume of implementation and training services provided to our customers. Cost of Revenue, Gross Profit and Gross Margin Cost of subscription revenue was $32.4 million for the year ended January 31, 2018, compared to $21.5 million for the year ended January 31, 2017, an increase of $10.9 million, or 51%. The increase in cost of subscription revenue was primarily due to an increase of $5.3 million in expanded use of our third-party hosting services by existing and new customers and $2.6 million in employee-related costs, as the average headcount in our cloud infrastructure and customer support organizations increased from 88 for the year ended January 31, 2017 to 102 for the year ended January 31, 2018. The increase was also attributable to an increase of $1.7 million in amortization of capitalized software developments costs, and an increase of $1.2 million related to allocated overhead and outside services costs driven by our overall growth. Cost of professional services and other revenue was $12.5 million for the year ended January 31, 2018, compared to $11.7 million for the year ended January 31, 2017. This increase is primarily due to a higher volume of services provided by third-party consultants related to implementation and training. Subscription gross margin remained flat, while gross margin for professional services and other increased from 26% for the year ended January 31, 2017 to 41% for the year ended January 31, 2018 due to efficiencies gained in delivering our professional services. Operating Expenses Sales and marketing expenses were $131.8 million for the year ended January 31, 2018, compared to $118.9 million for the year ended January 31, 2017, an increase of $12.9 million, or 11%. The increase was primarily due to an increase of $11.2 million in marketing programs and event costs and $1.5 million in costs related to third party consulting. The increase was also attributable to an increase of $1.1 million in personnel costs as the average sales and marketing headcount increased from 289 for the year ended January 31, 2017 to 300 for the year ended January 31, 2018. The increase is partially offset by a decrease of $1.7 million in commission expense primarily due to a decrease in the average commission rate relating to professional services. Sales and marketing expense as a percentage of total revenue decreased from 160% in the year ended January 31, 2017 to 121% in the year ended January 31, 2018. Research and development expenses were $78.3 million for the year ended January 31, 2018, compared to $76.2 million for the year ended January 31, 2017, an increase of $2.1 million, or 3%. The increase was primarily due to an increase of $2.2 million in employee-related costs as discretionary bonuses increased by $1.4 million and our average research and development headcount increased from 257 during the year ended January 31, 2017 to 266 during the year ended January 31, 2018. The increase was also attributable to a $2.8 million decrease in capitalized software development costs. The increase is partially offset by a decrease of $3.3 million in third-party web services for internal use. Research and development expense as a percentage of revenue decreased from 102% in the year ended January 31, 2017 to 72% in the year ended January 31, 2018. General and administrative expenses were $29.3 million for the year ended January 31, 2018, compared to $29.1 million for the year ended January 31, 2017, an increase of $0.2 million, or 1%. The increase was primarily due to an increase of $1.3 million in employee-related costs as we prepare to operate as a public company. The increase was partially offset by a decrease of $0.9 million in sales and other indirect taxes. General and administrative expenses as a percent of revenue decreased from 39% in the year ended January 31, 2017 to 27% in the year ended January 31, 2018. Other Income (Expense), Net Other income (expense), net increased $0.9 million. This decrease is primarily due to an increase in interest expense of $1.1 million due to the credit facility entered into in December 2017 and as amended in April 2018. The increase in interest expense was slightly offset by an increase in other income due to foreign currency transaction gains. Provision for Income Taxes Provision for income taxes decreased $0.4 million due to effects of the Tax Cuts and Jobs Act. Quarterly Results of Operations The following tables set forth selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended January 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 presentation of the results of operations for these periods in accordance with GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of our operating results for a full year or any future period. ________________ (1) Includes stock-based compensation expense as follows (in thousands): (2) Includes amortization of certain intangible assets as follows (in thousands): (3) Includes reversals of contingent tax-related accruals as follows (in thousands): Quarterly Trends in Revenue Our quarterly revenue increased sequentially for all periods presented primarily due to increases in the number of new customers, average contract value and expanded relationships with existing customers. In some cases, revenue for professional services decreased period over period due to timing of work completed on large projects. Our professional services revenue has experienced significant volatility in the past and we expect this volatility to continue. Quarterly Costs and Expenses Trends Costs of subscription services increased across the first three quarters presented primarily due to the continued expansion of our cloud infrastructure and increased employee headcount. For the three months ended January 31, 2018, April 30, 2018 and October 31, 2018, costs of subscription services decreased compared to the preceding three month period due to optimization of our third-party hosting services. Costs of professional services fluctuated across the quarters presented, primarily due to timing of work completed on large projects. For the three months ended January 31, 2019, costs of professional services decreased compared to the preceding three month period, as we aligned the use of our implementation partner resources with the lower volume of projects delivered during that period. For all three categories of operating expenses (sales and marketing, research and development, and general and administrative), expenses for the three months ended July 31, 2018 were higher than usual due to stock-based compensation related to the vesting of certain RSUs with a performance condition, which was deemed probable of being satisfied upon the effectiveness of the registration statement related to our IPO. Sales and marketing costs fluctuated across the quarters presented, primarily due to the timing of marketing events. These costs were higher than usual during the three months ended April 30, 2017 and 2018 due to increased costs associated with our annual Domopalooza user conference. Sales and marketing costs were also higher than usual during the three months ended October 31, 2017 due to increased tradeshow activity relative to other periods. For the three months ended October 31, 2018 and January 31, 2019, sales and marketing costs were lower relative to the other quarters presented due to lower employee-related costs and reduction of advertising costs. Research and development costs remained relatively flat across the quarters presented, with the exception of the three months ended October 31, 2018 and January 31, 2019, where costs decreased due to lower employee-related costs. General and administrative costs also remained relatively flat across the quarters presented. These costs were lower than usual during the three months ended April 30, 2018 due to the reversal of a contingent tax-related accrual and were higher during the three months ended January 31, 2019 due to costs associated with being a public company. Other income (expense), net has increased in recent quarters due to interest expense associated with the credit facility. Our quarterly operating results may fluctuate due to various factors affecting our performance. In addition, we recognize revenue from subscriptions ratably over the term of the contract. Therefore, changes in our contracting activity in the near term may not impact changes to our reported revenue until future periods. Quarterly Billings The following table sets forth billings for each of the eight quarters in the period ended January 31, 2019. Quarterly Billings Trends The improvement in billings is due to the acquisition of additional customers and sales of larger subscription contracts to existing customers, which are attributable to our continued focus on selling to larger enterprise customers. The increase in billings during the three months ended January 31, 2018 and 2019 is primarily from seasonality due to the buying patterns of our larger customers and the higher concentration of customers renewing their subscriptions in our fiscal fourth quarter. Liquidity and Capital Resources As of January 31, 2019, we had $177.0 million of cash and cash equivalents. Our cash equivalents are comprised primarily of money market funds. On July 3, 2018, we closed our initial public offering of 10,580,000 shares of Class B common stock at an initial price to the public of $21.00 per share, resulting in aggregate net proceeds to us of $202.5 million, after deducting underwriting discounts and offering expenses payable by us. In December 2017, we entered into an $80 million credit facility and drew $50 million. In April 2018, we amended the credit facility pursuant to which we were able to incur an additional $20 million in term loan borrowings, for a total availability of $100 million under the amended facility. We drew the remaining $50 million during April 2018. Since inception, we have financed operations primarily through the periodic sale of convertible preferred stock, cash collected from customers for our subscriptions and services, our IPO and to a lesser extent, debt financing. Our principal uses of cash have consisted of employee-related costs, marketing programs and events, and payments related to hosting our cloud-based platform. We believe our existing cash and cash equivalents will be sufficient to meet our projected operating requirements for at least the next 12 months. We may need to raise additional funds to invest in growth opportunities, product development, sales and marketing, and other purposes. Our future capital requirements will depend on many factors, including our growth rate, the level of investments we make in product development and sales and marketing activities, the continuing market acceptance of our platform, customer retention rates and other investments to support the growth of our business, and may increase materially from those currently planned. We may seek to raise additional funds through equity or debt financings. If we raise additional funds through the incurrence of indebtedness, such indebtedness likely would have rights that are senior to holders of our equity securities and could contain covenants that restrict operations in the same or similar manner as our credit facility. Any additional equity financing likely would be dilutive to existing stockholders. We cannot assure you that any additional financing will be available to us on acceptable terms, or at all. Although we are not currently a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity financing, incur indebtedness, or use cash resources. We have no present understandings, commitments or agreements to enter into any such acquisitions. Credit Facility The credit facility, as amended, permits us to incur up to $100 million in term loan borrowings, all of which had been drawn as of January 31, 2019. Each term loan requires that we pay only interest until the maturity date. A portion of the interest that accrues on the outstanding principal of each term loan is payable in cash on a monthly basis, which portion accrues at a floating rate equal to the greater of (1) 7% and (2) three-month LIBOR plus 5.5% per year. As of January 31, 2019, the interest rate was approximately 8.3%. In addition, a portion of the interest that accrues on the outstanding principal of each term loan is capitalized and added to the principal amount of the outstanding term loan on a monthly basis, which portion accrues at a fixed rate equal to 2.5% per year. In December 2017, we incurred $50 million in term loan borrowings under the credit facility. We incurred the remaining $50 million in term loan borrowing under the amended credit facility in April 2018. The amendment increased the closing fee from $3.6 million to $4.5 million. In addition, under the amended credit facility, we were required to pay a $2 million fee upon the earlier of (1) the closing of a transaction in which we are acquired by a third party and (2) December 4, 2027. The obligation to pay this $2 million fee terminated upon the closing of our initial public offering. In January 2019, we entered into an amendment to this credit facility which extended the maturity date for both outstanding loans to October 1, 2022. The amendment also revised the maximum debt ratio financial covenant and increased the amount of the closing fee from $4.5 million to $7.0 million. The credit facility contains customary conditions to borrowing, events of default and covenants, including covenants that restrict our ability to dispose of assets, make material changes to the nature, control or location of our business, merge with or acquire other entities, incur indebtedness or encumbrances, make distributions to holders of our capital stock, make investments or enter into transactions with affiliates. In addition, we are required to comply with a financial covenant based on the ratio of our outstanding indebtedness to our annualized recurring revenue. As amended, the minimum ratio is 0.85 on January 31, 2019 and April 30, 2019; 0.80 on July 31, 2019 and October 31, 2019; 0.75 on January 31, 2020 and April 30, 2020; 0.70 on July 31, 2020 and October 31, 2020; 0.65 on January 31, 2021 and April 30, 2021; and 0.60 on July 31, 2021 through the maturity date. The credit facility defines our annualized recurring revenue as four times our aggregate revenue for the immediately preceding quarter (net of recurring discounts and discounts for periods greater than one year) less the annual contract value of any customer contracts pursuant to which we were advised during such quarter would not be renewed at the end of the current term plus annual contract value of existing customer contract increases during such quarter. This covenant is measured quarterly on a three-month trailing basis. Upon the occurrence of an event of default, such as non-compliance with covenants, any outstanding principal, interest and fees become due immediately. We were in compliance with the covenant terms of the credit facility at January 31, 2018 and January 31, 2019. The credit facility is secured by substantially all of our assets. Backlog Our new business subscriptions typically have a term of one to three years, and we generally invoice our customers in annual installments at the beginning of each year in the subscription period. Due to this billing pattern, at any point in the contract term, there can be amounts that we have not yet been contractually able to invoice. Until such time as these amounts are invoiced, they are not recorded in revenue, deferred revenue, or elsewhere in our consolidated financial statements, and are considered by us to be backlog. The amount of backlog, which does not include deferred revenue, was $70.3 million and $102.3 million as of January 31, 2018 and 2019, respectively. Of the January 31, 2019 amount, $44.3 million is not reasonably expected to be billed during the year ending January 31, 2020. We expect that the amount of backlog relative to the total value of our contracts will change from year to year for several reasons, including the amount billed early in the contract term, the specific timing and duration of large customer subscription agreements, varying invoicing cycles of subscription agreements, the specific timing of customer renewal, changes in customer financial circumstances, contract amendments and foreign currency fluctuations. Backlog may also vary based on changes in the average non-cancellable term of subscription agreements. The change in backlog that results from changes in the average non-cancellable term of subscription agreements may not be an indicator of the likelihood of renewal or expected future revenue. Accordingly, we believe that fluctuations in backlog are not necessarily a reliable indicator of future revenue, and we do not utilize backlog as a key management metric internally. Historical Cash Flow Trends Operating Activities Net cash used in operating activities is significantly influenced by the amount of cash we invest in our personnel, timing and amounts we use to fund marketing programs and events to expand our customer base, and the costs to provide our cloud-based platform and related outsourced professional services to our customers. These outflows are partially offset by the amount and timing of payments received from our customers. Net cash used in operating activities during the year ended January 31, 2017, consisted of cash outflows of $237.9 million exceeding the $93.8 million of cash collected from customers. Significant components of cash outflows included $134.7 million for personnel costs and $56.9 million for marketing programs and events, third-party costs to provide our platform and outsourced professional services. Net cash used in operating activities during the year ended January 31, 2018 consisted of cash outflows of $274.0 million exceeding the $125.3 million of cash collected from customers. Significant components of cash outflows included $146.4 million for personnel costs and $74.5 million for marketing programs and events, third-party costs to provide our platform and outsourced professional services. Net cash used in operating activities during the year ended January 31, 2019 consisted of cash outflows of $290.6 million exceeding the $159.2 million of cash collected from customers. Significant components of cash outflows included $150.6 million for personnel costs and $74.1 million for marketing programs and events, third-party costs to provide our platform and outsourced professional services. Investing Activities Our investing activities have consisted primarily of property and equipment purchases. Significant components of purchased property and equipment include computer equipment and software for our data center. Net cash used in investing activities during the year ended January 31, 2017 consisted primarily of $6.7 million of purchased property and equipment and $4.9 million of capitalized development costs related to internal-use software. Net cash used in investing activities during the year ended January 31, 2018 consisted primarily of $5.1 million of purchased property and equipment and $2.2 million of capitalized development costs related to internal-use software. Net cash used in investing activities during the year ended January 31, 2019 consisted primarily of $6.3 million of capitalized development costs related to internal-use software and $1.6 million of purchased property and equipment. Financing Activities Our financing activities have consisted primarily of proceeds from our IPO, issuances of convertible preferred stock, proceeds from our credit facility and to a lesser extent, proceeds received from stock option exercises. Net cash used in financing activities for the year ended January 31, 2017 consisted primarily of $4.1 million of issuance costs related to the issuance of convertible preferred stock in the prior year offset in part by $0.7 million from proceeds received from stock option exercises. Net cash provided by financing activities for the year ended January 31, 2018 consisted primarily of $99.1 million of net proceeds from the issuance of convertible preferred stock, $48.9 million of proceeds from our credit facility, net of issuance costs and $1.3 million from proceeds received from stock option exercises. Net cash provided by financing activities for the year ended January 31, 2019 consisted primarily of $202.6 million of IPO proceeds (net of underwriters' discounts and commissions and offering costs paid during the period), $49.6 million of proceeds from our credit facility, net of issuance costs, and $2.3 million from proceeds received from stock option exercises. Contractual Obligations and Commitments Contractual obligations are cash that we are obligated to pay as part of certain contracts that we have entered into during the normal course of business. At January 31, 2019, the future non-cancelable minimum payments under these commitments were as follows: ________________ (1) Includes interest payments of $45.4 million and a closing fee due at maturity of $7.0 million. (2) We lease our facilities under long-term operating leases, which expire at various dates through 2027. (3) Other obligations are associated with non-cancelable contracts primarily for cloud infrastructure services and software subscriptions, including Amazon Web Services. Obligations under contracts that we can cancel without a significant penalty have been excluded. Off-Balance Sheet Arrangements As of January 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. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations would be affected. 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. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss below. Revenue Recognition We derive revenue primarily from subscriptions to our cloud-based platform and professional services. Revenue is recognized when control of these services is transferred to customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those services, net of sales taxes. For sales through channel partners, we consider the channel partner to be the end customer for the purposes of revenue recognition as our contractual relationships with channel partners do not depend on the sale of our services to their customers and payment from the channel partner is not contingent on receiving payment from their customers. Our contractual relationships with channel partners do not allow returns, rebates, or price concessions. Revenue recognition is determined 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, performance obligations are satisfied Subscription Revenue Subscription revenue primarily consists of fees paid by customers to access our cloud-based platform, including support services. Our subscription agreements generally have annual contractual terms and a smaller percentage have multi-year contractual terms. Revenue is recognized ratably over the related contractual term beginning on the date that the platform is made available to a customer. Access to the platform represents a series of distinct services as we continually provide access to and fulfill our obligation to the end customer over the subscription term. The series of distinct services represents a single performance obligation that is satisfied over time. We recognize revenue ratably because the customer receives and consumes the benefits of the platform throughout the contract period. Our contracts are generally non-cancelable. Professional Services and Other Revenue Professional services revenue consists of implementation services sold with new subscriptions as well as professional services sold separately. Other revenue includes training and education. Professional services arrangements are billed in advance, and revenue from these arrangements is recognized as the services are provided, generally based on hours incurred. Training and education revenue is also recognized as the services are provided. Contracts with Multiple Performance Obligations Most of our contracts with new customers contain multiple performance obligations, generally consisting of subscriptions and professional services. For these contracts, individual performance obligations are accounted for separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are determined based on historical standalone selling prices, taking into consideration overall pricing objectives, market conditions and other factors, including contract value, customer demographics and the number and types of users within the contract. As of January 31, 2019, approximately $183.5 million of revenue was expected to be recognized from remaining performance obligations for subscription contracts. We expect to recognize approximately $109.1 million of this amount during the year ending January 31, 2020, with an additional $42.5 million being recognized during the year ending January 31, 2021, and the balance recognized thereafter. As of January 31, 2019, approximately $16.1 million of revenue was expected to be recognized from remaining performance obligations for professional services and other contracts, $14.3 million of which is expected to be recognized during the year ending January 31, 2020, and the balance recognized thereafter. Contract Acquisition Costs Contract acquisition costs, net are stated at cost net of accumulated amortization and primarily consist of deferred sales commissions, which are considered incremental and recoverable costs of obtaining a contract with a customer. Contract acquisition costs for initial contracts are deferred and then amortized on a straight-line basis over the period of benefit, which we have determined to be approximately four years. The period of benefit is determined by taking into consideration contractual terms, expected customer life, changes in our technology and other factors. Contract acquisition costs for renewal contracts are not commensurate with contract acquisition costs for initial contracts and are recorded as expense when incurred if the period of benefit is one year or less. If the period of benefit is greater than one year, costs are deferred and then amortized on a straight-line basis over the period of benefit. Contract acquisition costs related to professional services and other performance obligations with a period of benefit of one year or less are recorded as expense when incurred. Amortization of contract acquisition costs is included in sales and marketing expenses in the accompanying consolidated statements of operations. Capitalized Internal-Use Software Costs We capitalize certain costs related to development of our platform incurred during the application development stage. Costs related to preliminary project activities and post-implementation activities are expensed as incurred. Maintenance and training costs are also expensed as incurred. Capitalized costs are included in property and equipment. Capitalized internal-use software is amortized as subscription cost of revenue on a straight-line basis over its estimated useful life, which is generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. Valuation of Goodwill Goodwill is evaluated for impairment annually on November 1, and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. Triggering events that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate or a significant decrease in expected cash flows. Stock-Based Compensation We have granted stock-based awards, consisting of stock options and restricted stock units, to our employees, certain consultants and certain members of our board of directors. We record stock-based compensation based on the grant date fair value of the awards, which include stock options and restricted stock units, and recognize the fair value of those awards as expense using the straight-line method over the requisite service period of the award. For restricted stock units that contain performance conditions, we recognize expense using the accelerated attribution method if it is probable the performance conditions will be met. We estimate the grant date fair value of stock options using the Black-Scholes option-pricing model. Stock-based compensation expense related to purchase rights issued under the 2018 Employee Stock Purchase Plan, or 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. The determination of the grant date fair value of stock-based awards is affected by the estimated fair value of our common stock as well as other assumptions and judgments, which are estimated as follows: • Fair Value Per Share of Common Stock. Because there was no public market for our common stock prior to the IPO, the board of directors determined the common stock fair value at the grant date by considering numerous objective and subjective factors, including contemporaneous valuations of our common stock, actual operating and financial performance, market conditions, and performance of comparable publicly traded companies, business developments, the likelihood of achieving a liquidity event, and transactions involving preferred and common stock, among other factors. Subsequent to the IPO, we determine the fair value of common stock as of each grant date using the market closing price of our Class B common stock on the date of grant. • Expected Term. The expected term is determined using the simplified method, which is calculated as the midpoint of the option’s contractual term and vesting period. We use this method due to limited stock option exercise history. For the ESPP, the expected term is the beginning of the offering period to the end of each purchase period. • Expected Volatility. Since a public market for our common stock did not exist prior to the IPO and, therefore, we do not have a sufficient trading history of our common stock, expected volatility is estimated based on the volatility of similar publicly held companies over a period equivalent to the expected term of the awards. • Risk-free Interest Rate. The risk-free interest rate is determined using U.S. Treasury rates with a similar term as the expected term of the option. • Expected Dividend Yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero. JOBS Act Accounting Election We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (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 ASU No. 2014-09 In May 2014, the Financial Accounting Standards Board or FASB issued Accounting Standards Update or ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). Topic 606 establishes a principle for recognizing revenue upon the transfer of promised goods or services to customers in an amount that reflects the considerations to which the entity expects to be entitled to in exchange for those goods or services. ASU No. 2014-09 also added Subtopic 340-40, Other Assets and Deferred Costs - Contracts with Customers, which requires the deferral of incremental costs of obtaining a contract with a customer. Topic 606 and Subtopic 340-40 are collectively referred to herein as the "new standard." We elected to early adopt the requirements of the new standard as of February 1, 2017 with an initial application date of February 1, 2016, utilizing the full retrospective method of transition. The primary impact of adopting the new standard is the deferral of incremental costs of obtaining subscription contracts. Prior to adopting the new standard, deferral of commissions was not required and our policy was to expense commission costs as incurred. Under the new standard, all incremental costs to obtain the contract are deferred if the period of benefit is greater than one year. These costs are amortized on a straight-line basis over the period of benefit, the determination of which is discussed in the contract acquisition costs policy above. ASU No. 2016-09 In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which simplifies and improves several aspects of the accounting for employee share-based payment transactions such as the income tax consequences, classification of awards as either equity or liabilities on the balance sheet, and classification of employee taxes paid on statement of cash flows when an employer withholds shares for tax-withholding purposes. The standard also provides an accounting policy election to account for forfeitures as they occur. We elected to early adopt ASU 2016-09 as of February 1, 2016, and as part of the adoption elected to account for forfeitures as they occur. Therefore, stock-based compensation expense for the years ended January 31, 2017, 2018 and 2019 has been calculated based on actual forfeitures in the consolidated statements of operations, rather than the previous approach, which was net of estimated forfeitures. The net cumulative effect of this change of $0.6 million was recorded as a reduction to paid-in capital and accumulated deficit as of February 1, 2016. The other aspects of ASU 2016-09 did not have a material impact on our consolidated financial statements. ASU No. 2016-02 In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which requires lessees to record most leases on the balance sheet and recognize the expenses on the income statement in a manner similar to current practice. ASU 2016-02 states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. For public entities, the new standard is effective for fiscal years beginning after December 15, 2018 and interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2019 and interim periods within annual periods beginning after December 15, 2020. Early adoption is permitted. We expect to adopt this standard as of February 1, 2020, assuming we remain an emerging growth company. We are currently evaluating the impact to our consolidated financial statements and related disclosures, but expect assets and liabilities related to leases to increase as a result of adopting this standard.

<s>[INST] Overview We founded Domo in 2010 with the vision of digitally connecting everyone within the enterprise with realtime, rich, relevant data and then encouraging all employees to collaborate and act. We realized that many organizations were unable to access the massive amounts of data that they were collecting in siloed cloud applications and onpremise databases. Furthermore, even for organizations that were capable of accessing their data, the process for doing so was timeconsuming, costly, and often resulted in the data being outofdate by the time it reached decision makers. The delivery format, including alert functionality, and devices were not adequate for the connected and realtime mobile workforce. Based on these observations, it was apparent that all organizations, regardless of size or industry, were failing to unlock the power of all of their people, data and systems. Since inception, we have focused on creating a comprehensive platform that connects all the people, data and systems that exist within an organization. In many ways, building Domo was like building seven startups in one. A foundational element of our platform is our more than 1,000 powerful firstclass connectors, which we define as read/write, API and standards based connectors, as well as a library of very flexible universal connectors, that currently power over four hundred thousand Domo datasets, which integrate directly with data sources in real time on a single, intuitive platform. Adrenaline, our data warehouse and fast query engine, stores massive amounts of data connected from across the business, enabling anyone to quickly access the data they need. To best prepare and transform all of the connected data, a critical step in making that data available and usable for visualizations and analysis, we developed Domo ETL, a selfservice toolset that enables users, regardless of technical ability, to cleanse and prepare data for analysis. To facilitate data insights, we developed an analysis and visualization toolkit that enables all employees to analyze, display, share and interact with data across mobile and desktop platforms in real time. Domo Buzz, our collaborative communication platform, helps foster and engage a curious workforce so that anyone in an organization can participate in improving the business. Domo leverages machine learning algorithms, predictive analytics, and other artificial intelligence technologies, to create alerts, detect anomalies, optimize queries, and suggest areas of interest to help people focus on what matters most. We also extended the functionality and effectiveness of our platform, through the introduction of the Domo Appstore and developer toolkits that enable a partner ecosystem to quickly build applications on the platform. We continue to broaden our platform's ease of use and selfservice capabilities and enhance security and scalability requirements for the enterprise. We offer our platform to our customers as a subscriptionbased service. Subscription fees are based on the number of users and the tier of package deployed. Business leaders and managers are typically the initial subscribers to our platform, deploying it for a specific use case or department. Over time, as customers recognize the value of our platform, we increasingly engage with CIOs and other executives to facilitate broad enterprise adoption. A majority of our customers subscribe to our services through oneyear contracts, but recently a growing percentage of new and existing customers have entered into multiyear contracts. In the year ended January 31, 2019, 43% of our new customers entered into multiyear contracts compared to 38% and 11% in the years ended January 31, 2018 and 2017, respectively. As of January 31, 2019, 42% of all customers were under multiyear contracts and 58% of all customers were under oneyear contracts. By comparison, 32% of all customers were under multiyear contracts and 68% of all customers were under oneyear contracts as of January 31, 2018. This transition to a higher percentage of multiyear contracts, among both new and existing customers, has enhanced the predictability of our subscription revenue. We typically invoice our customers annually in advance. Our business model focuses on maximizing the lifetime value of a customer relationship. We recognize subscription revenue ratably over the term of the subscription period. In general, customer acquisition costs and other upfront costs associated with new customers are much higher in the first year than the aggregate revenue we recognize from those new customers in the first year. Over the lifetime of the customer relationship, we also incur sales and marketing costs to renew or increase usage per customer. However, these [/INST] Negative. </s>

Akerna Corp.

2019-09-23

2019-06-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated Financial Statements and Notes thereto appearing elsewhere in this document. Business Overview On October 10, 2018 (as amended on April 17, 2019), we (f/k/a MTech Acquisition Holdings Inc.) entered into a definitive merger agreement (the “Merger Agreement”) with MTech Acquisition Corp. (“MTech”), MJ Freeway, LLC (“MJF”), MTech Purchaser Merger Sub Inc., a Delaware corporation and a wholly-owned subsidiary of Akerna (“Purchaser Merger Sub”), MTech Company Merger Sub LLC, a Colorado limited liability company and a wholly-owned subsidiary of Akerna (“Company Merger Sub”), MTech Sponsor LLC (“MTech Sponsor”), a Florida limited liability company, in the capacity as the representative for our equity holders (other than the Sellers) thereunder, and MJF and Jessica Billingsley (as successor to Harold Handelsman), in the capacity as the representative for the Sellers thereunder. The Merger Agreement provided for two mergers: (i) the merger of Purchaser Merger Sub with and into MTech, with MTech continuing as the surviving entity (the “Purchaser Merger”); and (ii) the merger of -Company Merger Sub with and into MJF, with MJF continuing as the surviving entity (the “Company Merger” and together with the Purchaser Merger, the “Business Combination”). On June 17, 2019, MTech and MJF consummated the Business Combination. Pursuant to the Merger Agreement, upon the closing of the Business Combination, the membership units of MJF (including the profits interest units) issued and outstanding immediately prior to the Business Combination automatically converted into the right to receive our shares and the securities of MTech issued and outstanding immediately prior to the Business Combination automatically converted into the right to receive our securities. At such closing, we changed our name from MTech Acquisition Holdings Inc. to “Akerna Corp.” and MJF became our wholly-owned subsidiary. We are a regulatory compliance and inventory management technology company. Our proprietary software platform is adaptable for industries in which interfacing with government regulatory agencies for compliance purposes is required, or where the tracking of organic materials from seed or plant to end products is desired. Nine years ago, we identified a need for organic material tracking and regulatory compliance software a service (“SaaS”) solutions in the growing cannabis and hemp industry. We developed products intended to assist states in monitoring licensed businesses’ compliance with state regulations, and to help state-licensed businesses operate in compliance with such law. We provide our regulatory software platform, Leaf Data Systems®, to state government regulatory agencies, and our business software platform, MJ Platform®, to state-licensed businesses. Although we have helped monitor legal compliance for nearly $16 billion in cannabis sales to date, we do not handle any cannabis related material, does not process sales transactions within the United States, and our revenue generation is not related to the type or amount of sales made by our clients, as revenues are generated by us on a fixed-fee based subscription model. Our core products, Leaf Data Systems and MJ Platform, are highly-versatile platforms that provide our clients with a central data management system for tracking regulated products - from seed to initial plant growth to product - throughout the complete supply chain, using a global unique identifier method. Our platforms also provide clients with integrated security, transparency and scalability capabilities. These capabilities allow our state-licensed clients to control inventory, operate efficiently in a fast-changing industry and comply with state, local, and federal (in countries such as Canada and Colombia) regulation at all times, and allows our government regulatory clients to effectively and cost-efficiently monitor licensees and ensure that commercial businesses are complying with their states’ regulations. We generate revenue in three principal areas: ● Government Regulatory Software - Leaf Data Systems is our SaaS offering for government agencies. Leaf Data Systems is a compliance tracking system designed to give regulators visibility into the activity of licensed cannabis businesses in their jurisdictions. We have been serving two clients for Leaf Data Systems, the State of Washington and the Commonwealth of Pennsylvania. As described above, we recently signed a third Leaf Data Systems client, the state of Utah. ● Commercial Software - MJ Platform is our SaaS offering for state-licensed businesses. MJ Platform is an ERP (Enterprise Resource Planning) compliance system specific to the cannabis and hemp CBD industry. MJ Platform is comprised of integrated modules designed to meet the regulations and inventory management needs of cannabis and hemp CBD cultivators, manufacturers and retailers. ● Consulting Services - We provide consulting services to cannabis industry operators interested in entering the cannabis industry and integrating our platforms into their respective operations and systems. We consult with clients on a wide range of areas to help them operate in the cannabis industry in compliance with state law. We also work with clients to efficiently comply with state requirements in connection with the launch and operations of their cannabis businesses. Our management team and key personnel have broad experience gained form working with numerous cannabis operations. Our consulting team has experience in most aspects of cannabis operations in most verticals (e.g., cultivation, processing, distribution, manufacturing, and retail). Our service providers understand the intricacies of the varying regulations governing cannabis in each jurisdiction and, to the extent necessary, modify the professional services based on the jurisdiction. We provide project-focused consulting services to clients that are initiating or expanding their cannabis businesses or are interested in data consulting engagements with respect to the legal cannabis industry. Our advisory engagements include service offerings focused on compliance requirement assessments, readiness and best practices, compliance monitoring systems, application processes, inspection readiness and business plan and compliance reviews. We typically provide our consulting services to clients in emerging markets that are seeking consultation on newly introduced licensing regimes and assistance with the regulatory compliant build-out of operations in newly legal states. Key Business Metrics In addition to our results determined in accordance with U.S. generally accepted accounting principles, or GAAP, we believe the below non-GAAP measure is useful in evaluating our operating performance. We use the below non-GAAP financial information, 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 the 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. Monthly Billings Monthly Billings consists of our total MJ Platform billings plus or minus the change in our deferred revenue in a given period. The Monthly Billings metric is intended to reflect sales to new MJ Platform customers plus renewals, recurring subscription customers and additional sales to existing customers. Our management uses Monthly Billings to measure and monitor our sales growth because we generally bill our customers at the time of sale but may recognize a portion of the related revenue ratably over time. For subscriptions, we typically invoice our customers at the beginning of the term, in annual, quarterly or monthly installments. Monthly Billings should be reviewed independent of revenue and does not represent our GAAP revenue on a monthly or annualized basis. While we believe that Monthly Billings provides valuable insight into the cash that will be generated from sales of our subscriptions, this metric may vary from period-to-period for a number of reasons, and therefore has a number of limitations as a quarter-over-quarter or year-over-year comparative measure. These reasons include, but are not limited to, the following: (i) a variety of contractual terms could result in some periods having a higher proportion of annual subscriptions than other periods, (ii) as we focus on sales to organizations of varying sizes, the lengthening of our sales cycle, and the variability in the timing of the execution of larger transactions, (iii) fluctuations in payment terms affecting the billings recognized in a particular period, and (iv) seasonality in our billings, with a greater proportion of our billings occurring in our fourth quarter, following typical enterprise software buying patterns. Because of these and other limitations, you should consider Monthly Billings along with revenue and our other GAAP financial measures. The following table presents a reconciliation of revenue, the most directly comparable financial measure calculated in accordance with GAAP, to Monthly Billings, for each of the periods presented: Monthly billings grew from approximately $268,816 in the month of June 2018 to $417,163 in the month of June 2019, an increase of approximately 55%. The increase in monthly billings can be primarily attributed to growth in commercial software subscriptions to MJ Platform. Off-Balance Sheet Arrangements None. Financial Results of Operations Revenue Our software revenue is derived from MJ Platform, our SaaS ERP offering for state-licensed businesses, and Leaf Data Systems, our track-and-trace product for government agencies. MJ Platform contracts are generally annual contracts paid monthly in advance of service and cancellable upon 30 days’ notice, although we do have some multi-year MJ Platform contracts. Leaf Data Systems contracts are generally multi-year contracts payable annually or quarterly in advance of service, although a percentage retainer or holdback fees (generally ranging from 10% to 30%) are common until all initial deliverables are complete. MJ Platform and Leaf Data Systems contracts generally may only be terminated early for breach of contract as defined in the respective agreements. Our Leaf Data Systems contract with the Commonwealth of Pennsylvania is covered under a performance bond. Our consulting revenue is derived throughout the life cycle of a customer. Our other revenue is derived primarily from point of sale hardware and labels. Commercial software revenue growth is driven by us leveraging our reputation and continued cannabis, hemp and CBD industry growth. We believe we are well known in these industries and can leverage our reputation, brand recognition, and wealth of relevant experience to attract existing cultivation, manufacturing and dispensary customers from their current service providers, and attract new market entrants. We believe that the reputation of our existing products and our ability to provide services in all areas of the seed to sale life cycle will attract customers from competitors that are seeking more comprehensive services and will attract new customers as they enter into existing markets and markets that become newly legalized. We also experience revenue growth in mature, established states and countries by providing a solution to operators seeking to vertically integrate their operations and improve their operations. We provide not only a vertically integrated solution across the cannabis, hemp, and CBD supply chain, but also have the business intelligence capture which allows operators to run their businesses in a more informed and efficient manner. This business intelligence capture is derived from the suite of services provided by us and sets us apart from competitors. Consulting Services revenue growth is driven by numerous factors. In new emerging states, we provide proven solutions for aspiring operators in the pre-application of licensures and pre-operational phases of development. These services include application and business plan preparation as they seek licenses to be granted. Consulting services are provided to post operational licensees to consult them during the setup and buildout phases as they open and begin operating their businesses. We also provide business optimization services for established businesses that can benefit from consulting to increase efficiencies as they expand and grow. We contract our consulting services through Statements of Work (SOW) for businesses or entrepreneurs interested in developing operations in the cannabis, hemp and CBD industry. SOW issued and completed during the pre-application phase generally solidify us as the contractor of choice for subsequent operational phases once the operator is granted the license. As a result, our consulting revenue is driven as new emerging states pass legislation and as our client-operators gain licenses. For example, during the second half of our fiscal year 2019, we had numerous clients granted their operator’s license in the states of Ohio and Arkansas, which resulted in subsequent SOWs for additional operational phases, and submitted numerous applications on behalf of clients in Maryland and Missouri, driven primarily by the individual filing deadlines for operational license applications established by the states. These applications submitted on behalf of our clients are currently undergoing state review. We expect to win additional work in the emerging states of Missouri, New Jersey, Illinois and Maryland as we have strong industry reputation in those states. Accordingly, we expect our consulting services to continue to grow as more states emerge with legalization reforms. Cost of Revenue Our cost of revenue is derived from direct costs derived primarily from government contract subcontractor expenses in addition to hosting and infrastructure costs associated with operating MJ Platform and Leaf Data Systems. We record cost of revenue based on the direct cost method. This method requires allocation of direct costs including support services and materials to cost of revenue. Consulting cost of revenue is primarily determined as a result of our employees’ and consultants’ salaries and other related compensation expenses. Product and Development Expenses Our product and development expenses include salaries and benefits, nearshore contractor expenses, technology expenses, and other overhead. These expenses have grown over time, and we expect these expenses to continue to increase with our growth. Selling, General and Administrative Expenses Our selling, general and administrative expenses include salaries and benefits, sales and marketing expenses, public relations and investor relations fees, outage expenses, professional fees, and other overhead. These expenses have grown over time, and we expect these expenses to continue to increase with our growth. Marketing and sales expenses are our largest cost and consist primarily of salaries and related expenses for our sales and marketing staff, including commissions, as well as payments to partners and marketing programs. Marketing programs consist of advertising, events, corporate communications, brand building and product marketing activities. We plan to continue to invest in marketing and sales by expanding our domestic and international selling and marketing activities, building brand awareness, attracting new customers, and sponsoring additional marketing events. The timing of these marketing events will affect our marketing costs in a particular quarter. Results of Operations for the Year Ended June 30, 2019 Compared with the Year Ended June 30, 2018 The following table sets forth information comparing the components of net loss for the years ended June 30, 2019 and 2018: Total Revenue Total revenue increased to approximately $10.9 million for the fiscal year ended June 30, 2019 from approximately $10.5 for the fiscal year ended June 30, 2018, an increase of approximately $0.4 million, or 4%. The increase in total revenue compared to the fiscal year ended June 30, 2018 was driven primarily by growth achieved across our commercial software business, MJ Platform, in addition to our consulting business. These increases were partially offset by a decrease in revenue from our government regulatory software business, Leaf Data Systems. Software Revenue Our total software revenue increased to approximately $8.3 million for the fiscal year ended June 30, 2019 from $8.1 million for the fiscal year ended June 30, 2018, for an increase of approximately $0.2 million, or 2%. Total software revenue accounted for 76% and 77% of total revenue for the years ended June 30, 2019 and 2018, respectively. The increase in software revenue over the fiscal year was primarily driven by growth in the number of commercial software subscriptions to MJ Platform (thus increasing recurring SaaS revenue). Our software revenues generated from government customers under Leaf Data Systems totaled approximately $4.3 million and $4.5 million during the years ended June 30, 2019 and 2018, respectively. Leaf Data Systems revenue decreased for the fiscal year ended June 30, 2019 primarily as a result of a smaller volume of change orders and initial license fees in the current year period. Change orders represent out-of-scope functionality modifications requested by the client. Revenues earned from these change orders are recognized upon successful implementation and delivery of the requested modifications. As a result, revenues from these clients when compared year over year may be impacted by the timing of the agreement relative to the number of requested change orders in one or either period. Consulting Revenue Our consulting revenue includes revenue generated from consulting professional services delivered to prospective and current cannabis, hemp and CBD businesses and business operators. Our consulting revenue was approximately $2.4 million for the fiscal year ended June 30, 2019 compared to $2.2 million for the fiscal year ended June 30, 2018, an increase of approximately $0.1 million, or 5%, as a result of a higher volume of consulting activities and engagements during the second half of our 2019 fiscal year. Consulting services are correlated to state legalizations and other regulatory expansion activity. As a result, individual year-over-year comparisons may experience variability depending on the timing of recent legislative changes. Consulting revenue was 22% of total revenue for the years ended June 30, 2019 and 2018, respectively. Due to the nature of consulting revenue and our dependence on emerging market activity as a driver of demand, the months in which we recognize consulting revenue has varied from year to year depending on whether state legislation has expanded to allow new market entrants or growth of existing market participant operations. For example, while consulting activity appeared to have slowed earlier during this fiscal year, it increased significantly during the three months ended June 30, 2019 due to emerging opportunities in Missouri, Maryland, Utah, New Jersey, and Arkansas as these states have experienced recent state legal changes. Further, five of our clients in Ohio have recently won processing licenses. Other Revenue Our retail/resale revenue represents revenue generated from point of sale hardware and labels. Retail/resale revenue increased to approximately $0.3 million for the fiscal year ended June 30, 2019 from $0.1 million for the fiscal year ended June 30, 2018, an increase of approximately $0.1 million, or 131%. Retail/resale revenue was 2% of total revenue for the fiscal year ended June 30, 2019. Cost of Revenue and Gross Margin Our cost of revenue increased to approximately $4.6 million for the fiscal year ended June 30, 2019 from $4.4 million for the fiscal year ended June 30, 2018, an increase of approximately 6%. The increase compared to the prior fiscal year period was primarily due to an increase in hosting and infrastructure costs incurred to support our Software business. Hosting and infrastructure costs grew from approximately $1.0 million to $1.4 million, an increase of approximately $0.4 million, or 40%, as we continued to increase Amazon Web Services usage as part of both the growth of MJ Platform in addition to the ramp of the contract with WSLCB. Additionally, we incurred higher direct labor costs associated with providing our consulting services of approximately $0.2 million. These increases in cost of revenue were partially offset by fewer third-party subcontractor costs associated with servicing our contract with the Commonwealth of Pennsylvania. Overall, our gross profit margin remained consistent at 58% for both of the years ended June 30, 2019 and June 30, 2018. Additionally, we experienced increased costs of revenue associated with retail hardware sales of approximately $128,000. Since the applications and services available through the Leaf Data System are provided through relationships with third-party service providers at higher costs than those from our MJ Platform contracts, the gross profit margins from the government contracts are generally lower than those from our commercial software clients. Total costs of government revenues incurred by us, which are included in cost of revenues on the statement of operations, were approximately $2.0 million and $2.7 million during the years ended June 30, 2019 and 2018, respectively. The decrease in cost of government revenues incurred by us was due to a smaller volume of ongoing support and maintenance services provided in connection with the contract with the Commonwealth of Pennsylvania. Operating Expenses The following table presents operating expense line items for the years ended June 30, 2019 and 2018 and the period-over-period dollar and percentage changes for those line items: Our operating expenses increased to approximately $18.7 million for the fiscal year ended June 30, 2019 from approximately $8.6 million for the fiscal year ended June 30, 2018, an increase of approximately $10.1 million, or 118%. The increased level of operating expenses for the fiscal year ended June 30, 2019 was driven by increased product development expenses of approximately $2.9 million, or 110% in addition to higher selling, general and administrative expenses of approximately $7.2 million, or 121%. The increased level of operating expenses for the fiscal year ended June 30, 2019 was primarily driven by increases in salary expenses across Engineering, Sales and Marketing and Administrative functions as we continued to add headcount in order to support our growth. Salary expenses for Product Development functions increased by approximately $2.7 million. Salary expenses for Sales and Marketing and Administrative functions increased by approximately $3.5 million. Approximately $3.8 million of salaries in the current fiscal year were paid in the form of non-cash stock-based compensation. No non-cash stock-based compensation was paid during the fiscal year ended June 30, 2018. Non-payroll related expenses within Selling, General and Administrative functions also increased for the fiscal year ended June 30, 2019 by approximately $3.7 million. These are primarily comprised of Sales and Marketing expenses related to our marketing initiatives including payments to partners and marketing programs. Marketing programs consist of advertising, events, corporate communications, brand building and product marketing activities. We plan to continue to invest in marketing and sales by expanding our domestic and international selling and marketing activities, building brand awareness, attracting new customers, and sponsoring additional marketing events. The timing of these marketing events will affect our marketing costs in a particular quarter. Additionally, we incurred professional fees of approximately $1.5 million in connection with the Business Combination and Private Placement discussed below. We also incurred fewer operating expenses during the fiscal year ended June 30, 2018 as a result of insurance proceeds received from our 2017 security breach. Non-payroll related expenses within Product development functions also increased by approximately $0.2 million as we enhanced our cybersecurity and enterprise software capabilities following our 2017 security breach. Liquidity and Capital Resources Liquidity and Capital Resources As of June 30, 2019, we had cash of approximately $21.9 million, excluding restricted cash. We had a working capital balance of approximately $22.1 million as of June 30, 2019, as compared to $1.6 million as of June 30, 2018. Since our inception, we have incurred recurring operating losses, used cash from operations, and relied on capital raising transactions to continue ongoing operations. However, after considering all available evidence, we determined that, due to our current positive working capital and the receipt of cash proceeds as a result of the Business Combination and other financing activities discussed below for net total proceeds of approximately $18 million, such capital and proceeds will be sufficient to meet our capital requirements for a period of at least twelve months from the date that our June 30, 2019 financial statements were issued. Management will continue to evaluate the impact of this standard on our financial statements. The additional capital resources will allow us to pursue an acquisition strategy in order to accelerate growth. The industry in which we participate is highly fragmented, with many small and thinly-capitalized competitors. As part of our growth strategy, we may seek to acquire assets or companies that are synergistic with our business. We believe that we have built a scalable infrastructure to support both rapid organic growth and targeted acquisitions. By providing the full seed-to-sale solution, we believe that we are well-positioned to be an acquirer of cannabis related technology solutions throughout the supply chain. Cash Flows Our cash and restricted cash balance were approximately $22.4 million and $2.6 million as of June 30, 2019 and June 30, 2018, respectively. Cash flow information for the years ended June 30, 2019 and 2018 is as follows: Sources and Uses of Cash for the Years Ended June 30, 2019 and 2018 Net cash used in operating activities increased to approximately $9.0 million during the fiscal year ended June 30, 2019, from approximately $3.7 million during the fiscal year ended June 30, 2018, an increase of approximately $5.3 million. Cash used in operating activities was primarily driven by the net loss of approximately $12.3 million discussed above, in addition to an increase in outstanding receivables, partially offset by non-cash stock-based compensation. Net cash provided by investing activities totaled approximately $18.8 million during the fiscal year ended June 30, 2019, as a result of amounts raised in with respect to the Business Combination and Private Placement. We did not have any net cash used in investing activities during the fiscal year ended June 30, 2018. Net cash provided by financing activities totaled approximately in addition to the $10 million raised in our Series C financing in August 2018. Net cash provided by financing activities totaled $1 million during the fiscal year ended June 30, 2018, as a result of amounts raised in our Series B financing. Upon the consummation of the Business Combination, the Series B and Series C Preferred Units issued in connection with these two transactions were converted into shares of our common stock. The Business Combination On October 10, 2018 (as amended on April 17, 2019), we (f/k/a MTech Acquisition Holdings Inc.) entered into a definitive merger agreement (the “Merger Agreement”) with MTech Acquisition Corp. (“MTech”), MJ Freeway, LLC (“MJF”), MTech Purchaser Merger Sub Inc., a Delaware corporation and a wholly-owned subsidiary of Akerna (“Purchaser Merger Sub”), MTech Company Merger Sub LLC, a Colorado limited liability company and a wholly-owned subsidiary of Akerna (“Company Merger Sub”), MTech Sponsor LLC (“MTech Sponsor”), a Florida limited liability company, in the capacity as the representative for our equity holders (other than the Sellers) thereunder, and MJF and Jessica Billingsley (as successor to Harold Handelsman), in the capacity as the representative for the Sellers thereunder. The Merger Agreement provided for two mergers: (i) the merger of Purchaser Merger Sub with and into MTech, with MTech continuing as the surviving entity (the “Purchaser Merger”); and (ii) the merger of -Company Merger Sub with and into MJF, with MJF continuing as the surviving entity (the “Company Merger” and together with the Purchaser Merger, the “Business Combination”). On June 17, 2019, MTech held a Special Meeting at which the MTech stockholders considered and approved, among other matters, the Merger Agreement. On June 17, 2019, the parties consummated the Business Combination. At the Special Meeting, holders of 4,452,042 shares of MTech’s common stock sold in its initial public offering (the “Public Shares”), or 99 stockholders of MTech, exercised their right to redeem those shares for cash at a price of $10.23841733 per share, for an aggregate of $45,581,864 (which represented 77.98% of the funds held in the trust account of MTech on the date of the Special Meeting). Upon closing of the Business Combination, MTech’s units ceased trading, and our common stock and warrants began trading on The Nasdaq Stock Market under the symbols “KERN” and “KERNW,” respectively, we changed our name from MTech Acquisition Holdings Inc. to “Akerna Corp.”, and MJF became our wholly-owned subsidiary. Immediately after giving effect to the Business Combination (including as a result of the redemptions described above and the transfer of the 100,120 Transferred Sponsor Shares (as defined below) pursuant to the Sponsor Stock Transfer Agreement (as defined below)) and the issuance of an additional 901,074 shares of common stock for an aggregate purchase price of approximately $9.2 million in the Private Placement (as defined below) consummated in connection with the Business Combination, there were 10,400,381 shares of our common stock and warrants to purchase 5,993,750 shares of our common stock issued and outstanding. As of the closing date of the Business Combination, the former securityholders of MJF beneficially owned approximately 62.7% of the outstanding shares of our common stock, the former securityholders of MTech beneficially owned approximately 27.7% of the outstanding shares of our common stock, and the Investors (as defined below) beneficially owned approximately 9.6% of the outstanding shares of our common stock. Upon the closing of the Business Combination, our management and principal stockholders beneficially owned approximately 59.70% of the outstanding shares of our common stock. Pursuant to the Merger Agreement, upon the closing of the Business Combination, the membership units of MJF (including the profits interest units) issued and outstanding immediately prior to the Business Combination automatically converted into the right to receive our shares and the securities of MTech issued and outstanding immediately prior to the Business Combination automatically converted into the right to receive our securities. The Private Placement In connection with the Business Combination, from June 5, 2019, through June 10, 2019, MTech entered into subscription agreements (each, a “Subscription Agreement”) with certain investors, whereby the investors named therein (the “Investors”) committed to purchase an aggregate of 901,074 shares of common stock of MTech for an aggregate purchase price of approximately $9.2 million (the “Private Placement”). Upon the closing of the Business Combination, such shares issued by MTech in the Private Placement (“Private Placement Shares”) were automatically converted into shares of our common stock on a one-for-one basis. Pursuant to the Subscription Agreements, each Investor was granted an option (the “Private Placement Option”) for a period of sixty (60) days starting after the closing of the Business Combination to purchase, subject to certain conditions, additional shares of our common stock (“Option Shares”) at a price of $10.21 per share, up to a number of Option Shares equal to the number of Private Placement Shares purchased and held and not redeemed by such Investor under the Subscription Agreement. The Private Placement Option has expired and no Investor exercised such option. In connection with the execution of the Subscription Agreements, MTech Sponsor and MTech entered into an Agreement to Transfer Sponsor Shares (each, a “Sponsor Stock Transfer Agreement”) with each Investor, pursuant to which MTech Sponsor agreed to transfer to each Investor at the closing of the Private Placement one share of Class B common stock of MTech for each nine Private Placement Shares purchased by such Investor for an aggregate of 100,120 shares of common stock (such shares, the “Transferred Sponsor Shares”). Each Investor agreed to accept its portion of the Transferred Sponsor Shares subject escrow and other restrictions under the Letter Agreement, dated as of January 29, 2018, by and among MTech and EarlyBirdCapital, Inc. The net proceeds from the Business Combination and the Private Placement totaled approximately $18 million, which constituted the majority of our net assets at the closing of the Mergers. Series B Preferred Units Financing During the year ended June 30, 2018, MJF sold an aggregate of approximately $1 million of Series B Preferred Units in private placements to accredited investors. Upon the consummation of the Business Combination, the Series B Preferred Units issued in connection with these two transactions were exchanged for common shares of the Company. Series C Preferred Units Financing In August 2018, we sold an aggregate of approximately $10 million of Series C Preferred Units in private placements to accredited investors. Upon the consummation of the Business Combination, the Series C Preferred Units issued in connection with these two transactions were exchanged for shares of our common stock. Critical Accounting Policies and Significant Judgments and Estimates Please refer to Note 2 - “Summary of Significant Accounting Policies” to the consolidated financial statements for our discussion about new accounting pronouncements adopted and those pending. Recent Accounting Pronouncements Please refer to Note 2 - “Summary of Significant Accounting Policies” to the consolidated financial statements for our discussion about new accounting pronouncements adopted and those pending.

<s>[INST] Business Overview On October 10, 2018 (as amended on April 17, 2019), we (f/k/a MTech Acquisition Holdings Inc.) entered into a definitive merger agreement (the “Merger Agreement”) with MTech Acquisition Corp. (“MTech”), MJ Freeway, LLC (“MJF”), MTech Purchaser Merger Sub Inc., a Delaware corporation and a whollyowned subsidiary of Akerna (“Purchaser Merger Sub”), MTech Company Merger Sub LLC, a Colorado limited liability company and a whollyowned subsidiary of Akerna (“Company Merger Sub”), MTech Sponsor LLC (“MTech Sponsor”), a Florida limited liability company, in the capacity as the representative for our equity holders (other than the Sellers) thereunder, and MJF and Jessica Billingsley (as successor to Harold Handelsman), in the capacity as the representative for the Sellers thereunder. The Merger Agreement provided for two mergers: (i) the merger of Purchaser Merger Sub with and into MTech, with MTech continuing as the surviving entity (the “Purchaser Merger”); and (ii) the merger of Company Merger Sub with and into MJF, with MJF continuing as the surviving entity (the “Company Merger” and together with the Purchaser Merger, the “Business Combination”). On June 17, 2019, MTech and MJF consummated the Business Combination. Pursuant to the Merger Agreement, upon the closing of the Business Combination, the membership units of MJF (including the profits interest units) issued and outstanding immediately prior to the Business Combination automatically converted into the right to receive our shares and the securities of MTech issued and outstanding immediately prior to the Business Combination automatically converted into the right to receive our securities. At such closing, we changed our name from MTech Acquisition Holdings Inc. to “Akerna Corp.” and MJF became our whollyowned subsidiary. We are a regulatory compliance and inventory management technology company. Our proprietary software platform is adaptable for industries in which interfacing with government regulatory agencies for compliance purposes is required, or where the tracking of organic materials from seed or plant to end products is desired. Nine years ago, we identified a need for organic material tracking and regulatory compliance software a service (“SaaS”) solutions in the growing cannabis and hemp industry. We developed products intended to assist states in monitoring licensed businesses’ compliance with state regulations, and to help statelicensed businesses operate in compliance with such law. We provide our regulatory software platform, Leaf Data Systems®, to state government regulatory agencies, and our business software platform, MJ Platform®, to statelicensed businesses. Although we have helped monitor legal compliance for nearly $16 billion in cannabis sales to date, we do not handle any cannabis related material, does not process sales transactions within the United States, and our revenue generation is not related to the type or amount of sales made by our clients, as revenues are generated by us on a fixedfee based subscription model. Our core products, Leaf Data Systems and MJ Platform, are highlyversatile platforms that provide our clients with a central data management system for tracking regulated products from seed to initial plant growth to product throughout the complete supply chain, using a global unique identifier method. Our platforms also provide clients with integrated security, transparency and scalability capabilities. These capabilities allow our statelicensed clients to control inventory, operate efficiently in a fastchanging industry and comply with state, local, and federal (in countries such as Canada and Colombia) regulation at all times, and allows our government regulatory clients to effectively and costefficiently monitor licensees and ensure that commercial businesses are complying with their states’ regulations. We generate revenue in three principal areas: Government Regulatory Software Leaf Data Systems is our SaaS offering for government agencies. Leaf Data Systems is a compliance tracking system designed to give regulators visibility into the activity of licensed cannabis businesses in their jurisdictions. We have been serving two clients for Leaf Data Systems, the State of Washington [/INST] Negative. </s>

ALERUS FINANCIAL CORP

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 “Selected Financial Data” and our audited consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, this discussion and analysis 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 report, 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. Overview We are a diversified financial services company headquartered in Grand Forks, North Dakota. Through our subsidiary, Alerus Financial, National Association, we provide innovative and comprehensive financial solutions to businesses and consumers through four distinct business lines-banking, retirement and benefit services, wealth management and mortgage. These solutions are delivered through a relationship-oriented primary point of contact along with responsive and client-friendly technology. Our primary banking market areas are the states of North Dakota, Minnesota, specifically, the Twin Cities MSA, and Arizona, specifically, the Phoenix MSA. In addition to our offices located in our banking markets, our retirement and benefit services business administers plans in all 50 states through offices located in Michigan, Minnesota and New Hampshire. Our business model produces strong financial performance and a diversified revenue stream, which has helped us establish a brand and culture yielding both a loyal client base and passionate and dedicated employees. We believe our client-first and advice-based philosophy, diversified business model and history of high performance and growth distinguishes us from other financial service providers. We generate a majority of our overall revenue from noninterest income, which is driven primarily by our retirement and benefit services, wealth management and mortgage business lines. The remainder of our revenue consists of net interest income, which we derive from offering our traditional banking products and services. As of December 31, 2019, we had $2.4 billion of total assets, $1.7 billion of total loans, $2.0 billion of total deposits, $285.7 million of stockholders’ equity, $28.9 billion of AUA and $6.1 billion of AUM. For the year ended December 31, 2019 we had $946.4 million of mortgage originations. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income on interest-earning assets, primarily loans and available-for-sale securities. We incur interest expense on interest-bearing liabilities, primarily interest-bearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, available-for-sale securities and other interest-earning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interest-bearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interest-bearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities. Noninterest Income Noninterest income primarily consists of the following: · Our retirement and benefit services business, which includes retirement plan administration, retirement plan investment advisory, HSA, ESOP, payroll and other benefit services, is our Company’s largest source of noninterest income. Over half of our retirement and benefit services fees are transaction or participant based fees and are impacted by the number of plans and participants. The remainder of noninterest income is based on the market value of the related AUA and AUM and impacted by the level of contributions, withdrawals, new business, lost business and fluctuation in market values. · Wealth management includes personal trust, investment and brokerage services. Our Company earns trust, investment, and IRA fees from managing assets, including corporate trusts, personal trusts, and separately managed accounts. Trust and investment management fees are primarily based on a tiered scale relative to the market value of the AUM. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values. · Mortgage noninterest income consists of gains on originating and selling mortgages and origination fees. Mortgage gains are primarily impacted by the level of originations, amount of loans sold, the type of loans sold and market conditions. · Service charges on deposit accounts are comprised of income generated through deposit account related service charges such as: electronic transfer fees, treasury management fees, bill pay fees, and other banking fees. Banking fees are primarily impacted by the level of business activities and cash movement activities of our clients. · Other noninterest income consists of debit card interchange income, income earned on the growth of the cash surrender value of life insurance policies we hold on certain key employees, loan servicing income net of the related amortization, and any other income which does not fit within one of the specific noninterest income lines described above. Other noninterest income is generally impacted by business activities and level of transactions. Noninterest Expense Noninterest expense is comprised primarily of the following: · Compensation and employee taxes and benefits-include all forms of personnel related expenses including salary, commissions, incentive compensation, payroll related taxes, stock-based compensation, benefit plans, health insurance, 401(k) plan match costs, ESOP and other benefit related expenses. Compensation and employee benefit costs are primarily impacted by changes in headcount and fluctuations in benefits costs. · Occupancy and equipment-costs related to owning and leasing our office space, depreciation charges for the furniture, fixtures and equipment, amortization of leasehold improvements, utilities and other occupancy-related expenses. Occupancy and equipment costs are primarily impacted by the number and size of the locations we occupy. · Business services, software and technology-costs related to contracts with core system and third-party data processing providers, software and information technology services to support office activities and internal networks. We believe our technology spending enhances the efficiency of our employees and enables us to provide outstanding service to our clients. Technology and information system costs are primarily impacted by the number of locations we occupy, the number of employees, clients and volume of transactions we have and the level of service we require from our third-party technology vendors. · Intangible amortization expense is the result of acquisitions of fee income and banking companies. Identified intangible assets with definite lives consist of client relationship intangibles and are amortized on a straight-line basis over the period representing the estimated remaining lives of the assets. The amount of expense is impacted by the timing of acquisitions and the estimated remaining lives of the assets. · Professional fees and assessments-costs related to legal, accounting, tax, consulting, personnel recruiting, directors fees, insurance and other outsourcing arrangements. Professional services costs are primarily impacted by corporate activities requiring specialized services. FDIC insurance expense is also included in this line and represents the assessments that we pay to the FDIC for deposit insurance. · Other operational expenses-includes costs related to marketing, donations, promotions, and expenses associated with office supplies, postage, travel expenses, meals and entertainment, dues and memberships, costs to maintain or prepare other real estate owned, or OREO, for sale, and other general corporate expenses that do not fit within one of the specific noninterest expense lines described above. Other operational expenses are generally impacted by our business activities and needs. Operating Segments We measure the overall profitability of business operations based on income before income tax. We allocate costs to our segments, which consist primarily of compensation and overhead expense directly attributable to the products and services within banking, retirement and benefit services, wealth management, and mortgage. We measure the profitability of each segment based on the direct allocations of expense as we believe it better approximates the contribution generated by our reportable operating segments. All indirect overhead allocations and income tax expense is allocated to corporate administration. A description of each segment is provided in Note 21 (Segment Reporting) of the Company’s audited consolidated financial statements included elsewhere in this report. Critical Accounting Policies As a result of the complex and dynamic nature of our business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with current GAAP, but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting our financial performance. It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities as well as disclosures of revenues and expenses during the reporting period. Actual results could differ from these estimates. The most critical of the accounting policies are discussed below. Investment securities-Investment securities can be classified as trading, available-for-sale, and equity. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of stockholders’ equity, and do not affect earnings until realized. The fair values of investment securities are generally determined by reference to quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. Investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than-temporarily impaired. An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an other-than-temporary impairment write-down is recorded in current earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided we do not intend to sell the underlying debt security, and it is not likely that we will be required to sell the debt security prior to recovery of the full value of its amortized cost basis. Allowance for loan losses-The allowance for loan losses reflects management’s best estimate of probable loan losses in our loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, appraisal values of underlying collateral for collateralized loans, and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience, expected duration and consideration of current economic trends, all of which may be susceptible to significant change. Intangible assets-As a result of acquisitions, we carry goodwill and identifiable intangible assets. Goodwill represents the cost of acquired companies in excess of the fair value of net assets at the acquisition date. Goodwill is evaluated at least annually or when business conditions suggest impairment may have occurred. Should impairment occur, goodwill will be reduced to its revised carrying value through a charge to earnings. Core deposits and other identifiable intangible assets are amortized to expense over their estimated useful lives. The determination of whether or not impairment exists is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific performance and risk metrics, all of which are susceptible to change based on changes in economic and market conditions and other factors. Future events or changes in the estimates used to determine the carrying value of goodwill and identifiable intangible assets could have a material impact on our results of operations. Income taxes-Income tax expense or benefit 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 the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. Interest and penalties related to income tax matters are recognized in income tax expense. On December 22, 2017, the U.S government enacted Public Law 115-97, commonly known as, the Tax Cuts and Jobs Act, a comprehensive tax legislation, which reduced the federal income tax rate for C corporations from 35% to 21%, effective January 1, 2018. As a result of the reduction in the U.S corporate income tax rate from 35% to 21%, we re-measured our deferred tax assets and recognized $4.8 million of tax expense in the Consolidated Statement of Income for the year ended December 31, 2017. See Note 20 (Income Taxes) of the Company’s audited consolidated financial statements included elsewhere in this report. 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 judgement may be necessary to estimate fair value. In developing our fair value measurements, we maximize the use of observable inputs and minimize the use of unobservable inputs. Financial assets that are recorded at fair value on a recurring basis include investment securities and derivative financial instruments. As of December 31, 2019 and 2018, $314.8 million or 13.4% and $253.4 million or 11.6%, respectively, of our total assets consisted of financial assets recorded at fair value on a recurring basis and most of these financial assets consisted of available-for-sale investment securities. The fair value of financial assets on a recurring basis are classified in either Levels 1 or 2 of the fair value hierarchy. Financial liabilities that are recorded at fair value on a recurring basis are comprised of derivative financial instruments. As of December 31, 2019 and 2018, $109 thousand and $7 thousand, respectively represented less than 1% of our total liabilities in those years and were classified as Level 2 of the fair value hierarchy. We have no fair value assets or liabilities classified in Level 3 of the fair value hierarchy. A further discussion regarding the fair value of assets and liabilities, and the classification of Level 1, 2, and 3 hierarchies, is disclosed in Note 26 (Fair Value of Assets and Liabilities) of the Company’s audited consolidated financial statements included elsewhere in this report. A summary of the accounting policies used by management is disclosed in Note 1 (Significant Accounting Policies) of the Company’s audited consolidated financial statements included elsewhere in this report. Results of Operations Summary Net income for the year ended December 31, 2019 was $29.5 million, an increase of $3.7 million, or 14.2%, compared to $25.9 million for the year ended December 31, 2018. Diluted earnings per common share was $1.91 in 2019, compared to $1.84 for 2018. Return on average total assets was 1.34% in 2019, compared to 1.21% for 2018. The increase in net income was primarily due to an increase of $11.4 million in noninterest income primarily due to an increase in mortgage banking revenue. We also had a $1.3 million decrease in provision for loan losses due to the improved credit quality of our loan portfolio. These improvements were partially offset by a $6.2 million, or 4.6%, increase in noninterest expense driven by a $4.6 million increase in compensation, $1.9 million in business services, software and technology expense, and $1.6 million in employee taxes and benefits. Net income for the year ended December 31, 2018 was $25.9 million, an increase of $10.9 million, or 72.4%, compared to $15.0 million for the year ended December 31, 2017. Diluted earnings per common share was $1.84 in 2018, compared to $1.07 for 2017. Return on average total assets was 1.21% in 2018, compared to 0.75% for 2017. The increase in net income was primarily driven by a $10.3 million decrease in income taxes, as a result of the impact from the Tax Cuts and Jobs Act. Other contributing factors included a $7.6 million increase in net interest income offset by increases of $5.3 million in provision for loan losses and $1.4 million in noninterest expense. Net Interest Income-With Nontaxable Income Converted to Fully Taxable Equivalent, or FTE Net interest income totaled $74.9 million in 2019, a decrease of $788 thousand, or 1.04%, from 2018. Net interest margin decreased 19 basis points to 3.65%, in 2019, from the 3.84% reported in 2018. The decreases were primarily a result of a $42.7 million, or 3.1%, increase in average interest-bearing liabilities and a 41 basis point increase in the average rate paid on interest-bearing liabilities, partially offset by a $29.1 million, or 1.7%, increase in average total loans and an 8 basis point increase in the average yield on interest earning assets. Net interest income totaled $75.7 million in 2018, an increase of $7.2 million, or 10.4%, from 2017. Net interest margin increased 10 basis points to 3.84% from the 3.74% reported in 2017. The increases were attributable to a $137.0 million, or 7.5% increase in average earning assets and a 31 basis point increase in the earning-asset yield, partially offset by a $77.1 million increase in average interest-bearing liabilities and a 29 basis point increase in the cost of interest-bearing liabilities. The following table sets forth information related to our average balance sheet, average yields on assets, and average rates of liabilities for the periods indicated. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. Average loan balances include loans that have been placed on nonaccrual, while interest previously accrued on these loans is reversed against interest income. In these tables, adjustments are made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis. (1) Includes loans held for sale. (2) Includes deposits held for sale. (3) Fully tax-equivalent adjustment was calculated utilizing a marginal income tax rate of 21.0 percent and 35.0 percent for years prior to 2018. (4) Average balances have been reclassed from noninterest earning assets. Rate/Volume Analysis The table below presents the effect of volume and rate changes on interest income and expense for the periods indicated. Changes in volume are changes in the average balance multiplied by the previous year’s average rate. Changes in rate are changes in the average rate multiplied by the average balance from the previous year. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate. (1) Includes loans held for sale. (2) Includes deposits held for sale. Provision for Loan Losses The provision for loan losses was $7.3 million for the year ended December 31, 2019, compared to $8.6 million for the year ended December 31, 2018. The provision in 2019 was primarily due to $5.6 million of net charge-offs, $1.8 million more provision for pass rated credits, due to loan growth, $1.4 million more provision for specific reserves on impaired loans, and $1.7 million less provision related to the decrease in criticized loan balances. The provision for loan losses was $8.6 million for the year ended December 31, 2018, compared to $3.3 million for the year ended December 31, 2017. The increase of $5.3 million in provision for loan losses in 2018 was primarily due to $3.3 million more provision related to the increase in criticized loan balances, $0.9 million more provision for specific reserves on impaired loans, $0.7 million more provision for net charge-offs, and $0.4 million for pass rated credits due to loan growth. The provision for loan losses on off-balance sheet items, a component of “other expense” in our Consolidated Statements of Income, reflects management’s assessment of the adequacy of the allowance for loan losses on lending-related commitments. See “Financial Condition-Allowance for Loan Losses.” Noninterest Income The following table presents noninterest income for the years ended December 31, 2019, 2018, and 2017. Total noninterest income increased by $11.4 million, or 11.1%, to $114.2 million in 2019 as compared to 2018. The increase in noninterest income was primarily due to an $8.2 million increase in mortgage banking as a result of higher mortgage originations and a transition from best efforts to mandatory delivery. Mortgage originations for 2019 were $946.4 million, a $166.7 million, or 21.4% increase from 2018. In addition, other noninterest income increased $1.9 million compared to 2018, due to a $1.5 million gain on the sale of our Duluth, MN branch and a $542 thousand gain on the sale of a parcel of land in Grand Forks, ND. Total noninterest income decreased by $296 thousand, or 0.3%, to $102.7 million in 2018 as compared to 2017. Retirement and benefit services for 2018 was $63.3 million, an increase of $926 thousand, or 1.5%, from the prior year, due to the combination of expanded business activities from an acquisition of Alliance Benefit Group North Central States, Inc., or ABGNCS, in 2016 and new client generation. Wealth management for 2018 was $14.9 million, an increase of $947 thousand from the prior year. The increase was due to organic growth and through leveraging synergies by retaining terminated retirement and benefit services participants. Mortgage banking for 2018 was $17.6 million, a decrease of $2.1 million or 10.7% from the prior year level. The decrease was primarily driven by a corresponding decrease in origination volume. Mortgage originations for 2018 of $779.7 million decreased $87.3 million or 10.1% as a result of higher home mortgage rates throughout the year. Noninterest income as a percent of total operating revenue, which consists of net interest income plus noninterest income, was 60.5% in 2019, up from 57.7% the prior year. The increase in 2019 was due to an 11.1% increase in noninterest income, while net interest income decreased 0.9%. This ratio decreased from 60.4% in 2017 to 57.7% in 2018, due to net interest income increasing by 11.2%, while noninterest income decreased by 0.3%. Noninterest Expense The following table presents noninterest expense for the years ended December 31, 2019, 2018, and 2017. Total noninterest expense increased $6.2 million, or 4.6%, to $142.5 million for the year ended December 31, 2019, from $136.3 million for 2018. The increase in noninterest expense was primarily due to increases of $4.6 million in compensation, $1.6 million in employee taxes and benefits, $1.9 million in business services, software and technology expense, and $700 thousand in mortgage and lending expenses. These increases were partially offset by decreases of $1.1 million in professional fees and assessments, and $557 in intangible amortization expense. The increase in compensation expense was primarily driven by increased incentives related to mortgage banking due to higher mortgage originations, in addition to usual cost of living adjustments. The increase in employee taxes and benefits was primarily due to the corresponding increase in compensation along with a $448 thousand increase in cost of group insurance. The increase in business services, software and technology expense was due to continued investments in digital delivery solutions for our clients along with the full implementation of our new client relationship management software. The increase in mortgage and lending expenses was directly related to the increase mortgage originations. The decrease in professional fees and assessments was due to a $671 thousand decrease in consulting related expenses and a $490 thousand decrease in regulatory assessments primarily due to small bank assessments credits applied against our quarterly FDIC assessments. The decrease in intangible amortization expense is normal runoff of intangible assets and core deposit premiums from past acquisitions. Total noninterest expense increased $1.4 million, or 1.0%, to $136.3 million for the year ended December 31, 2018, from $134.9 million for 2017. The increase in noninterest expense was primarily due to an increase in compensation of $1.8 million resulting from the addition of 38 full-time equivalent employees in 2018. Employee taxes benefits and taxes increased $1.4 million due in part to the increased number of employees and an increase in group insurance of $690 thousand. Business services, software, and technology expense increased $1.5 million as our Company invested in a new client relationship manager software and digital delivery of solutions to clients. Amortization expense decreased $1.0 million to $4.6 million as a result of past acquisitions being fully amortized during the year. Professional fees and assessments decreased $1.1 million due to legal expenses in 2017 related to litigation and a settlement of the related litigation of $330 thousand received in 2018. Other noninterest expense decreased $1.9 million during 2018 due to expense accruals of $450.0 thousand in 2017 for litigation, which were reversed in 2018. In addition, the true-up liability for the loans covered under the loss share agreement with the FDIC was $3.2 million in 2017 and in 2018 the loss share agreement was terminated for $220 thousand less than the amount recorded as payable to the FDIC. Finally, there was $520 thousand of branch closure expenses recognized in 2017 and no expenses related to branch closures in 2018. Income Taxes For the year ended December 31, 2019, we recognized income tax expense of $9.4 million on $38.9 million of pre-tax income resulting in an effective tax rate of 24.1%, compared to the same period in 2018, in which we recognized an income tax expense of $7.2 million on $33.0 million of pre-tax income, resulting in an effective tax rate of 21.7%. The increase in the effective tax rate was primarily due to a reduction in excess tax benefits from stock-based compensation and a reduction in tax exempt interest income from investment securities. For the year ended December 31, 2018, we recognized income tax expense of $7.2 million on $33.0 million of pre-tax income resulting in an effective tax rate of 21.7%, compared to the same period in 2017, in which we recognized an income tax expense of $17.5 million on $32.5 million of pre-tax income, resulting in an effective tax rate of 53.9%. The increase in the effective rate for 2017 was primarily attributable to one-time expenses from the revaluation of net deferred tax assets related to the enactment of the Tax Cuts and Jobs Act in addition to a $1.4 million impairment of deferred tax assets related to loans acquired in 2014 that we were unable to recognize certain tax benefits. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law. Among other things, the Tax Cuts and Jobs Act lowered the corporate tax rate to 21% from the existing maximum rate of 35.0%, effective for tax years including or commencing January 1, 2018. ASC 740, Income Taxes, requires existing deferred tax assets and liabilities to be measured at the enacted tax rate expected to be applied when the temporary differences are to be realized or settled. Thus, as of the date of enactment, deferred taxes were re-measured based upon the new 21% tax rate. The change in tax rate resulted in a deferred tax expense of $4.8 million from the write-down of the net deferred tax assets. The effect of this change in tax law was recorded as a component of the income tax provision including those deferred assets and liabilities that were established through a financial statement component other than continuing operations. Segment Reporting We determine reportable segments based on the significance of the services offered, the significance of those services to our financial condition and operating results, and our regular review of the operating results of those services. We have four operating segments-banking, retirement and benefit services, wealth management, and mortgage. These segments are components for which financial information is prepared and evaluated regularly by management in deciding how to allocate resources and assess performance. The selected financial information presented for each segment sets forth net interest income, provision for loan losses, noninterest income, and direct noninterest expense before indirect overhead allocations. Corporate administration includes the indirect overhead and is set forth in the table below along with income tax expense and the consolidated net income. The segment net income before taxes represents direct revenue and expense before indirect allocations and income taxes. Certain reclassification adjustments have been made between corporate administration and the various lines of business for consistency in presentation. For additional financial information on our segments see Note 21 (Segment Reporting) of the Company’s audited consolidated financial statements included elsewhere in this report. Banking The banking segment offers a complete line of loan, deposit, cash management, and treasury services through 15 offices in North Dakota, Minnesota, and Arizona. These products and services are supported through various digital applications. The majority of our assets and liabilities are on the banking segment balance sheet. The banking segment reported net income before taxes and indirect allocations of $33.4 million for the year ended December 31, 2019, a decrease of $233 thousand compared to 2018. The decrease was driven primarily by a decrease of $1.0 million in net interest income partially offset by a decrease in provision for loan losses of $1.3 million. Net interest income decreased $1.0 million as average deposits increased $42.2 million while average loans only increased $29.1 million. Noninterest expense increased 1.3%, or $566 thousand in 2019 compared to 2018, primarily due to the $479 thousand increase in intercompany expense which was allocated to the mortgage segment for the residential real estate loans delivered to the Bank’s balance sheet. The banking segment reported net income before taxes and indirect allocations of $33.6 million for 2018, a decrease of $4.6 million compared to the prior period due to a $5.3 million increase in provision expense. Net interest income increased $7.5 million as average loans grew $202.8 million from $1.5 billion to $1.7 billion and average deposits increased $102.9 million from $1.7 billion to $1.8 billion during the period. Noninterest expense rose 18.4% or $6.6 million in 2018 compared to 2017, primarily due to the intercompany expense of $6.3 million which was allocated to the mortgage and retirement and benefit services segments for the residential real estate loans and deposit balances delivered to the Bank’s balance sheet. Retirement and Benefit Services Retirement and benefit services provides the following services nationally: recordkeeping and administration services to qualified retirement plans; ESOP trustee, recordkeeping and administration; investment fiduciary services to retirement plans; HSA, flex spending account, and government health insurance program recordkeeping and administration services to employers; payroll and human resource information system services for employers. The division services approximately 6,700 retirement plans and more than 355,000 plan participants. In addition, the division employs nearly 300 professionals, and operates within our banking markets as well as Albert Lea, Minnesota, Lansing, Michigan, Manchester, New Hampshire and 13 satellite offices. The retirement and benefit services segment reported net income before taxes and indirect allocations of $28.4 million for the year ended December 31, 2019, an increase of $1.5 million from the $26.9 million for 2018. Revenue of $63.8 million, comprised of $28.9 million in asset based revenue and $34.9 million in participant and transaction revenues, increased $495 thousand or 0.8% primarily due to an increase in participant and transaction based revenue of $2.0 million or 6.0%, partially offset by a decrease in asset based revenue of $1.5 million or 4.9%. The decline in the asset based revenue was the result of fee compression and an ongoing shift from asset based fees to participant and transaction based fees. Noninterest expense declined $1.0 million or 2.8% due to the reduction in allocation expense of $1.8 million, as the division was credited for sourcing deposits which are being held on the banking division’s balance sheet, partially offset by an $886 thousand increase in compensation and $375 thousand in employee benefit expenses. The retirement and benefit services segment reported net income before taxes and indirect allocations of $26.9 million for 2018, an increase of $6.5 million from the $20.4 million of net income before taxes and indirect allocations earned in 2017. Revenue of $63.3 million included $30.4 million of asset based revenue and $32.9 million of participant and transaction revenues, and increased $926 thousand or 1.5% due to a $1.2 million decline in asset based revenues and $2.1 million increase in participant and transaction revenues. The shifts in revenue are the result of fee compression and an ongoing shift from asset based fees to participant and transaction based fees. Noninterest expense declined $5.6 million or 13.3%. The reduction in expense was due to a $3.2 million decline in allocation expense as the division is credited for sourcing deposits which are being held on the banking division’s balance sheet. Personnel related expenses also decreased by $1.4 million and intangible amortization expense decreased by $1.0 million. The following table presents changes in the combined assets under administration and asset under management for our retirement and benefit services segment for the periods presented. (1) Inflows include new account assets, contributions, dividends and interest. (2) Outflows include closed account assets, withdrawals and client fees. (3) Market impact reflects gains and losses on portfolio investments. (4) Retirement and benefit services noninterest income divided by simple average ending balances. AUA and AUM for the retirement and benefit services segment were $31.9 billion at December 31, 2019, an increase of $4.1 billion compared to the total at December 31, 2018. The increase was primarily driven by an increase of $4.5 billion related to the market impact and partially offset by outflows outpacing inflows. AUA and AUM were $27.8 billion at December 31, 2018, a decrease of $1.6 billion compared to the total at December 31, 2017. The decrease was the result of a $1.2 billion decline related to the market impact and a $343.6 million decrease due to outflows exceeding inflows for the twelve months ended December 31, 2018. Wealth Management The wealth management division provides advisory and planning services, investment management, and trust and fiduciary services to clients across our Company’s footprint. Wealth management reported net income before taxes and indirect allocations of $8.3 million for the year ended December 31, 2019, an increase of $176 thousand from 2018. Noninterest income increased $602 thousand or 4.0% as compared to 2018, primarily due to an increase in combined assets under administration and assets under management partially offset by a 3 basis points reduction in yield. Wealth management noninterest expense of $7.2 million increased $364 thousand or 5.3% from 2018 primarily due to an increase in compensation expense. Wealth management reported net income before taxes and indirect allocations of $8.1 million for the year ended December 31, 2018, an increase of $1.8 million from 2017.Wealth management noninterest income for 2018 was $14.9 million, an increase of $947 thousand from the prior year. The increase was due to the additional clients generated by both organic growth and through leveraging synergies of retirement and benefit services. Wealth management noninterest expense of $6.8 million decreased $816 thousand from 2017 primarily due to intercompany allocations. The following table presents changes in the wealth management combined assets under administration and assets under management, disaggregated by product, for the periods presented. (1) Inflows include new account assets, contributions, dividends and interest. (2) Outflows include closed account assets, withdrawals and client fees. (3) Market impact reflects gains and losses on portfolio investments. (4) Wealth management noninterest income divided by simple average ending balances. (5) Total wealth management does not include brokerage assets of $690.0 million, $775.0 million, and $775.0 million for the years ending December 31, 2019, 2018 and 2017, respectively. (6) Yield does not include brokerage revenue of $2.1 million, $2.4 million, and $2.3 million for the years ending December 31, 2019, 2018 and 2017, respectively. AUM for the wealth management segment was $2.4 billion, excluding $690.0 million of brokerage assets, at December 31, 2019, an increase of $561.3 million compared to the total at December 31, 2018. The increase was driven by an increase of $273.5 million related to the market impact, in addition to inflows exceeding outflows by $287.8 million. AUM was $1.9 billion, excluding brokerage assets of $775.0 million, at December 31, 2018, a decrease of $75.1 million compared to the total at December 31, 2017. The decrease was the result of a $96.7 million decline related to the market impact and partially offset by a $21.5 increase due to inflows exceeding outflow flows for the twelve months ended December 31, 2018. Mortgage The mortgage division offers first and second mortgage loans through a centralized mortgage unit in Minneapolis, Minnesota as well as through the banking office locations. Mortgage reported net income before taxes and indirect allocations of $5.2 million for the year ended December 31, 2019, an increase of $3.9 million from the $1.3 million reported in 2018. Mortgage noninterest income for 2019 of $25.8 million increased $8.2 million, or 46.4%, from the same period in 2018. The increase was primarily driven by an increase in mortgage originations and the transitions to mandatory delivery of mortgages into the secondary market. Mortgage originations for the year ended December 31, 2019 were $946.4 million, an increase of $166.7 million or 21.4%, from 2018. The increase in noninterest income was partially offset by an increase of $4.7 million in noninterest expense, primarily due to increased incentive compensation directly related to the increase in mortgage originations. Mortgage reported net income before taxes and indirect allocation of $1.3 million for the year ended December 31, 2018, a decrease of $1.8 million from the $3.0 million reported in 2017. Mortgage noninterest income for 2018 of $17.6 million decreased $2.1 million or 10.7% from the prior year level. The decrease was primarily driven by a corresponding decrease in origination volume. Mortgage originations for 2018 of $779.7 million decreased $87.3 million or 10.1% year over year. Mortgage noninterest expense for 2018 decreased $249 thousand or 1.4% from the prior year. The decrease consisted of lower incentive compensation and various lending expenses correlated to the decline in origination volume offset by additional investments in talent and technology. Financial Condition Overview Total assets were $2.4 billion at December 31, 2019, an increase of $177.8 million compared to $2.2 billion at December 31, 2018. The increase in total assets was primarily due to increases of $103.4 million in cash and cash equivalents, $60.2 million in available-for-sale investment securities, $32.4 million in loans held for sale, and $19.4 million in loans, offset by a reduction in loans held for branch sale of $32.0 million. In addition, we recognized an operating lease right-of-use asset which totaled $8.3 million at December 31, 2019. The increase in loans held for sale was primarily due to higher loan originations. The increase in loans was primarily driven by growth in our commercial real estate and commercial and industrial portfolios. The increase in securities available-for-sale was a result of management’s decision to extend the duration while increasing the portfolio yield and harvesting gains on lower yielding and shorter duration securities. The increase in cash and cash equivalents was primarily due to an increase in cash balances held with the Federal Reserve Bank. We maintain a cash balance at the Federal Reserve and manage this liquidity balance on a daily basis as required, and may have significant cash balance fluctuations in the ordinary course of business based on inflows and outflows from changing loan totals, investment activity, and deposit flows. Total assets were $2.2 billion at December 31, 2018, an increase of $43.0 million compared to $2.1 billion at December 31, 2017. The increase was primarily due to an increase of $127.4 million in total loans, offset by an increase of $5.6 million in the allowance for loan losses, partially offset by a decrease of $81.3 million in cash and due from banks, a $16.8 million decrease in securities available-for-sale, and a $4.6 million decrease in other intangible assets. The increase in loans was primarily driven by growth in the residential mortgage portfolio of $92.9 million as well as an increase of $30.1 million in the commercial and industrial portfolio. The decrease in cash and due from banks and securities available-for-sale reflects management’s decision to invest in higher yielding assets. Investment Securities The following table presents the fair value of our investment securities portfolio for the periods indicated: The composition of our investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity for normal operations while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral. At December 31, 2019 total investment securities were $313.2 million compared to $254.9 million at December 31, 2018. Investment securities as a percentage of total assets were 13.3% and 11.7%, as of December 31, 2019 and December 31, 2018, respectively. The increase in securities was primarily in residential agency mortgage backed securities. Securities with a carrying value of $136.2 million were pledged at December 31, 2019, to secure public deposits and for other purposes required or permitted by law. At December 31, 2018, total investment securities were $254.9 million, or 11.7% of total assets, compared to $274.4 million, or 12.8% of total assets, at December 31, 2017. The $19.5 million decrease in securities from December 31, 2017 to December 31, 2018, primarily reflected decreases in obligations of state and political subdivisions and mortgage backed residential agency securities. Securities with a carrying value of $149.0 million were pledged at December 31, 2018, to secure public deposits and for other purposes required or permitted by law. The net pre-tax unrealized market value gain on the available-for-sale investment portfolio as of December 31, 2019 was $2.6 million, as compared to a $4.8 million loss as of December 31, 2018. This increase is indicative of the interest rate movements during the year and the changes in the size and composition of the portfolio. The net pre-tax unrealized market value loss on the available-for-sale investment portfolio as of December 31, 2018 was $4.8 million, as compared to $1.4 million as of December 31, 2017. This increase is indicative of the interest rate movements during the year and the changes in the size and composition of the portfolio. The investment portfolio is principally composed of U.S. Treasury debentures, U.S. Agency mortgage-backed pass-throughs, U.S. Agency, Commercial Mortgage Obligations, or CMOs and municipal bonds. The portfolio does not include any private label mortgage-backed securities or private label collateralized mortgage obligations. As of December 31, 2019, the Bank held 114 tax-exempt state and local municipal securities totaling $49.6 million. As of December 31, 2018, the Bank held 127 tax-exempt state and local municipal securities totaling $58.5 million. Other than the aforementioned investments, at December 31, 2019 and December 31, 2018, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity. As of December 31, 2019 and December 31, 2018, all of the available-for-sale debt securities in an unrealized loss position were investment grade. For the years ended December 31, 2019 and 2018, we evaluated all of our debt securities for credit impairment and determined there were no credit losses evident and we did not record any other-than-temporary impairment. Furthermore, we do not intend to sell and it is more likely than not that we will not be required to sell these debt securities before the anticipated recovery of the amortized cost basis. Periodic reviews are conducted to identify and evaluate each investment that has an unrealized loss for other-than-temporary impairment. An unrealized loss exists when the current estimated fair value of an individual security is less than its amortized cost basis. Unrealized losses that are determined to be temporary in nature are recorded, net of tax, in accumulated other comprehensive income for available-for-sale securities. The securities available-for-sale presented in the following table are reported at fair value and by contractual maturity as of December 31, 2019. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the mortgage backed securities receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax equivalent basis. Loans The loan portfolio represents a broad range of borrowers comprised of commercial and industrial, commercial real estate, residential real estate, and consumer financing loans. Commercial and industrial loans include financing for commercial purposes in various lines of businesses, including manufacturing, service industry and professional service areas. Commercial and industrial loans are generally secured with the assets of the company and/or the personal guarantee of the business owners. Commercial real estate loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, retail shopping centers and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers. Residential real estate loans represent loans to consumers for the purchase or refinance of a residence. These loans are generally financed over a 15- to 30-year term and, in most cases, are extended to borrowers to finance their primary residence with both fixed-rate and adjustable-rate terms. Real estate construction loans are also offered to consumers who wish to build their own homes and are often structured to be converted to permanent loans at the end of the construction phase, which is typically twelve months. Residential real estate loans also include home equity loans and lines of credit that are secured by a first- or second-lien on the borrower’s residence. Home equity lines of credit consist mainly of revolving lines of credit secured by residential real estate. Consumer loans include loans made to individuals not secured by real estate, including loans secured by automobiles or watercraft, and personal unsecured loans. Loans outstanding, by type, as of the dates presented are as follows: Total loans outstanding of $1.7 billion as of December 31, 2019, increased $19.4 million, or 1.1%, from December 31, 2018. The increase in total loans was represented by increases in our commercial real estate loans of $54.7 million, real estate construction of $7.4 million and residential real estate first mortgage loans of $9.0 million. These increases were offset by decreases of $31.6 million in commercial and industrial, $11.5 million in residential real estate junior liens and $8.7 million in other revolving and installment loans. On January 15, 2019, we announced an agreement to sell our branch offices located in Duluth, Minnesota, including loans attributable to those offices, to another financial institution. These loans were classified as held for branch sale in our consolidated financial statements and totaled $32.0 million as of December 31, 2018. The transaction closed on April 26, 2019. Total loans outstanding of $1.7 billion as of December 31, 2018 increased $127.4 million, or 8.1%, from December 31, 2017. The increase in total loans represented increases in residential real estate loans of $92.9 million and commercial and industrial loans of $30.1 million. Our loan portfolio is highly diversified. The long-term goal of the overall portfolio mix is to retain balance with approximately one third of the portfolio in each of the commercial and industrial, commercial real estate, and residential real estate categories. As of December 31, 2019, approximately 27.8% of loans outstanding were commercial and industrial, while 28.8% of loans outstanding were commercial real estate, and 36.9% of loans outstanding were residential real estate. The commercial lending portfolio is also broadly diversified by industry type as demonstrated by the following distributions at December 31, 2019: real estate (33%), retail trade (12%), finance & insurance (10%),wholesale trade (9%), construction (8%), healthcare (6%), manufacturing (5%), professional services (4%), agricultural (4%), transportation (3%), restaurant & lodging (2%), management of companies (2%), and administrative and support (1%). A variety of other industries with less than a 1% share of the total portfolio comprise the remaining 1%. The loan portfolio is also diversified by market distribution with 51.8% of the portfolio in the Twin Cities MSA, 39.4% in the eastern North Dakota cities of Grand Forks and Fargo and 8.8% in the Phoenix MSA, as of December 31, 2019. We originate both fixed and adjustable rate residential real estate loans conforming to the underwriting guidelines of the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation, as well as home equity loans and lines of credit that are secured by first or junior liens. Most of our fixed rate residential loans, along with some of our adjustable rate mortgages are sold to other financial institutions with which we have established a correspondent lending relationship. Our consumer mortgage loans have minimal direct exposure to subprime mortgages as the loans are underwritten to conform to secondary market standards. Volume in this portion of the loan portfolio has been strong over the last few years due to low long-term interest rates and comparatively stable real estate valuations in our primary markets. As of December 31, 2019, our consumer mortgage portfolio was $634.5 million which was a slight decline from $637.0 million as of December 31, 2018. Consumer mortgages had increased $92.9 million, or 17.1%, in 2018. Market interest rates, expected duration, and our overall interest rate sensitivity profile continue to be the most significant factors in determining whether we choose to retain versus sell portions of new consumer mortgage originations. The combined total of general-purpose business lending to commercial, industrial, non-profit and municipal customers, mortgages on commercial property and dealer floor plan financing is characterized as commercial lending activity. As of December 31, 2019, the commercial loan portfolio was $1.0 billion, an increase of $30.6 million, or 3.2%, from $969.6 million as of December 31, 2018. Highly competitive conditions continue to prevail in the small and middle market commercial segments in which we primarily operate. We maintain a commitment to generating growth in our business portfolio in a manner that adheres to our twin goals of maintaining strong asset quality and producing profitable margins. We continue to invest in additional personnel, technology, and business development resources to further strengthen our capabilities in this important product category. The following table shows the maturities and type of interest rates for the loan portfolio as of December 31, 2019: As of December 31, 2019, 57.2% of the loan portfolio bears interest at fixed rates and 42.8% at floating rates. The expected life of our loan portfolio will differ from contractual maturities because borrowers may have the right to curtail or prepay their loans with or without penalties. Consequently, the table above includes information limited to contractual maturities of the underlying loans. Asset Quality Our strategy for credit risk management includes well-defined, centralized credit policies; uniform underwriting criteria; and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The strategy also emphasizes diversification on a geographic, industry, and client level; regular credit examinations; and management reviews of loans experiencing deterioration of credit quality. We strive to identify potential problem loans early, take necessary charge-offs promptly, and maintain adequate reserve levels for probable loan losses inherent in the portfolio. Management performs ongoing, internal reviews of any problem credits and continually assesses the adequacy of the allowance. We utilize an internal lending division, Special Credit Services, to develop and implement strategies for the management of individual nonperforming loans. Nonperforming assets consist of loans 90 days or more past due, nonaccrual loans, foreclosed assets and other real estate owned. We do not consider performing troubled debt restructurings, or TDRs, to be nonperforming assets, but they are included as part of impaired assets. The level of nonaccrual loans is an important element in assessing asset quality. Loans are classified as nonaccrual when principal or interest is in default for 90 days or more, unless in the opinion of management, the loan is well secured and in the process of collection. Exclusive of any delinquency, a loan will be placed in nonaccrual when there is deterioration in the financial condition of the borrower and full payment of principal and interest is not expected. A loan is categorized as a TDR if a concession is granted, such as to provide for the reduction of either interest or principal due to deterioration in the financial condition of the borrower. Typical concessions include reduction of the interest rate on the loan to a rate considered lower than market and other modification of terms including forgiveness of a portion of the loan balance, extension of the maturity date, and/or modifications from principal and interest payments to interest-only payments for a certain period. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. Credit Quality Indicators Loans are categorized into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. A risk rating is assigned to all commercial loans, except pools of homogeneous loans. We periodically perform detailed internal and external reviews of risk rated loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. During the internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which the borrowers operate, and the estimated fair values of collateral securing the loans. These credit quality indicators are used to assign a risk rating to each individual loan. The following definitions are used for risk ratings: Pass. Higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: minimal credit risk, modest credit risk, average credit risk, acceptable credit risk, acceptable with risk and management attention. Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position. Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Criticized loans represent loans that are categorized as special mention, substandard, and doubtful. The following table presents criticized loans by type as of December 31, 2019, 2018, and 2017: The following table presents information regarding nonperforming assets as of the dates presented: (1) Nonaccrual loans included nonperforming TDRs of $0.0 million, $0.2 million, $0.7 million, $1.5 million, and $1.1 million at the respective dates indicated above. Interest income lost on nonaccrual loans approximated $0.4 million, $0.3 million, and $0.2 million for the years ended December 31, 2019, 2018, and 2017, respectively. There was no interest income included in net income related to nonaccrual loans for the years ended December 31, 2019, 2018, and 2017. Allowance for Loan Losses The allowance for loan losses is maintained at a level management believes is sufficient to absorb incurred losses in the loan portfolio given the conditions at the time. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio and other factors. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change. The allowance is increased by provisions charged to expense and decreased by actual charge-offs, net of recoveries. The allowance for loan losses represents management’s assessment of probable credit losses inherent in the loan portfolio. The allowance for loan losses consists of specific components, based on individual evaluation of certain loans, and general components for homogeneous pools of loans with similar risk characteristics. Impaired loans include loans placed on nonaccrual status and TDRs. Loans are considered impaired when, based on current information and events, it is probable that all amounts due, in accordance with the original contractual terms of the loan agreement, will not be collected. When determining if all amounts due in accordance with the original contractual terms of the loan agreement will be collected, the borrower’s overall financial condition, resources and payment record, support from guarantors, and the realizable value of any collateral, are taken into consideration. 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. All impaired loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the discounted expected future cash flows or at the fair value of collateral if repayment is collateral dependent. The allowance for non-impaired loans is based on historical losses adjusted for current qualitative factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history over the most recent five years. This actual loss experience is adjusted for economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment. These portfolio segments include commercial and industrial, real estate construction, commercial real estate, residential real estate first mortgage, residential real estate junior liens, and other revolving and installment. In the ordinary course of business, we enter into commitments to extend credit, including commitments under credit arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. A reserve for unfunded commitments is established using historical loss data and utilization assumptions. This reserve is located under accrued expenses and other liabilities on the Consolidated Balance Sheets. The provision for unfunded commitments was a reversal of $308 thousand for the year ended December 31, 2019 compared to an expense of $540 thousand for the year ended December 31, 2018. The following table presents, by loan type, the changes in the allowance for loan losses for the periods presented. The allowance for loan losses was $23.9 million at December 31, 2019, compared to $22.2 million at December 31, 2018. The $1.8 million increase in the allowance for loan losses was due to additional provision for loan losses of $7.3 million offset by net loan charge-offs of $5.6 million. The level of nonperforming loans to total loans at December 31, 2019 was 0.45%, compared to 0.41% at December 31, 2018. The allowance for loan losses to total loans was 1.39% at December 31, 2019, compared to 1.30% at December 31, 2018. The allowance for loan losses was $22.2 million at December 31, 2018, compared to $16.6 million at December 31, 2017. The $5.6 million increase in the allowance for loan losses year over year was due to additional provision for loan losses of $5.3 million. Net loan charge-offs as a percentage of average loans remained consistent with prior periods at 0.18% in 2018 compared to 0.16% in 2017. The level of nonperforming assets to total loans was also stable at 0.42% as of December 31, 2018, compared to 0.40% at December 31, 2017. The additional provision for loan losses increased the allowance to loan losses to total loans to 1.30% at December 31, 2018, compared to 1.05% at December 31, 2017. The following table presents the allocation of the allowance for loan losses as of the dates presented. Deposits Total deposits were $1.97 billion as of December 31, 2019, an increase of $196.2 million, or 11.1%, from December 31, 2018. The increase was due to an increase of $169.2 million in interest-bearing deposits and an increase of $27.1 million in noninterest-bearing deposits. The increase in interest-bearing deposits was primarily due to a $108.0 million increase in synergistic deposits from our retirement and benefit services and wealth management segments and a $13.6 million increase in HSA deposits. Noninterest-bearing deposits represented 29.3% of total deposits as of December 31, 2019. Deposits decreased $59.9 million between 2018 and 2017. The decrease was due to temporary deposits on the balance sheet held for terminated plans from the retirement division. Time deposits decreased $33.7 million during 2018, as we allowed higher rate single service accounts to roll off the balance sheet. Non-public, core deposits are frequently considered to be a bank’s most attractive source of funding because they are generally stable, do not need to be collateralized, carry a relatively low rate, generate solid fee income and provide a strong client base for which a variety of loan, deposit, and other financial service-related solutions can be provided. Our Company’s funding composition continues to benefit from a high level of non-public, core deposits, which increased $35.0 million or 2.7% in 2018. This increase included $11.1 million or 11.9% of growth in the HSA portfolio which carries an average cost of 0.16%. Interest-bearing deposit costs were 1.03% and 0.56% for the year ended December 31, 2019 and 2018, respectively. The increase in interest-bearing deposit costs has been impacted by the changing mix of deposit types, as well as by the increasing interest rate environment. We compete for local deposits by offering products with competitive rates and rely on the deposit portfolio to fund loans and other asset growth. Management understands the importance of core deposits as a stable source of funding and may periodically implement various deposit promotion strategies to encourage core deposit growth. For periods of rising interest rates, management has modeled the aggregate yields for non-maturity deposits and time deposits to increase at a slower pace than the increase in underlying market rates, which results in net interest margin expansion and projections of an increase in net interest income. The mix of average deposits has been changing throughout the last several years. The weighting of core funds (noninterest checking, interest checking, savings, and money market accounts) has increased, while time deposits’ weighting has decreased. This change in deposit mix reflects our focus on expanding core account relationships and customers’ preference for unrestricted accounts in the low interest rate environment. The following table details composition and percentage composition of our deposit portfolio by category for the periods indicated. (1) Includes deposits held for sale The following table shows the contractual maturity of time deposits, including certificate of deposit account registry services, or CDARS, and IRA deposits of $100 thousand and over, that were outstanding as of the date presented. Borrowings and Subordinated Debt We utilize both short-term and long-term borrowings as part of our asset/liability management and funding strategies. Short-term borrowings consists of FHLB advances and federal funds purchased. We had no short-term borrowings outstanding at December 31, 2019, which was a decrease of $93.5 million from December 31, 2018. Short-term borrowings were $93.5 million at December 31, 2018, an increase of $63.5 million from $30.0 million at December 31, 2017. FHLB advances were secured by specific investment securities and real estate loans with a carrying amount of approximately $881.2 million and $834.6 million at December 31, 2019 and 2018, respectively. Long-term debt is utilized to fund longer term assets and as a source of regulatory capital. At December 31, 2019, we had $50.0 million of outstanding subordinated notes. The notes currently bear interest at a fixed rate of 5.75% per year, payable semi-annually through December 30, 2020, and then convert automatically to floating rate notes that reset quarterly to an interest rate equal to the three-month LIBOR plus 412 basis points. The notes mature on December 30, 2025, and we have the option to redeem or prepay any or all of the subordinated notes without premium or penalty any time after December 30, 2020 or at any time in the event of certain changes that affect the deductibility of interest for tax purposes or the treatment of the notes as Tier 2 Capital. Junior subordinated debentures issued to capital trusts that issued trust preferred securities were $8.5 million as of December 31, 2019, compared to $8.4 million as of December 31, 2018. The increase was due to purchase accounting amortization on the junior subordinated notes assumed in the Beacon Bank acquisition. See Note 13 (Long-Term Debt) of the Company’s audited consolidated financial statements included elsewhere in this report. Selected financial information pertaining to the components of our borrowings and subordinated debt as of the dates indicated is as follows: Capital Resources The following table summarizes the changes in our stockholders’ equity for the periods indicated. Total stockholders’ equity was $285.7 million at December 31, 2019, compared to $197.0 million at December 31, 2018. The increase was primarily due $62.8 million of net proceeds received from our initial public offering, $29.5 million of net income, $5.5 million increase in accumulated other comprehensive income and partially offset by $8.9 million in common stock dividends. We strive to maintain an adequate capital base to support our activities in a safe and sound manner while at the same time attempting to maximize stockholder value. Capital adequacy is assessed against the risk inherent in our balance sheet, recognizing that unexpected loss is the common denominator of risk and that common equity has the greatest capacity to absorb unexpected loss. We are subject to various regulatory capital requirements both at the Company and at the Bank level. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. We have consistently maintained regulatory capital ratios at or above the well-capitalized standards. During the first quarter of 2015, regulations implementing the Basel III regulatory capital framework and the Dodd-Frank Act became effective, which include requirements that were subject to a multi-year phase-in period. These rules modified the calculation of the various capital ratios, added a new ratio, the Common Equity Tier 1 Capital ratio, and revised the adequately and well capitalized thresholds. As of January 1, 2019, the rules require us to maintain a capital conservation buffer of common equity capital that exceeds by more than 2.50% the minimum risk weighted asset ratios. The capital conservation buffer requirement was 2.50%, 1.875%, and 1.25% as of December 31, 2019, 2018, and 2017, respectively, which is not reflected in the tables below. At December 31, 2019, 2018, and 2017, we met all the capital adequacy requirements to which we were subject. The table below sets forth the actual capital amounts and ratios for the Company and the Bank as of the dates indicated, as well as the regulatory capital ratios for the Company and the Bank to meet the minimum capital adequacy standards and for the Bank to be considered well-capitalized under the prompt corrective action framework. See Note 25 (Regulatory Matters) for additional disclosures. (1) Represents a non-GAAP financial measure. See “Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures.” Contractual Obligations and Off-Balance Sheet Arrangements Off-Balance Sheet Arrangements In the normal course of business, we enter into various transactions to meet the financing needs of clients, which, in accordance with GAAP, are not included in the consolidated balance sheets. These transactions include commitments to extend credit, standby letters of credit, and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. Most of these commitments are expected to expire without being drawn upon. All off-balance sheet commitments are included in the determination of the amount of risk-based capital that the Company and the Bank are required to hold. Our exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and commercial letters of credit is represented by the contractual or notional amount of those instruments. We decrease our exposure to losses under these commitments by subjecting them to credit approval and monitoring procedures. We assess the credit risk associated with certain commitments to extend credit and establishes a liability for probable credit losses. Further information related to financial instruments can be found in Note 15 (Financial Instruments with Off-Balance Sheet Risk) in the notes to the consolidated financial statements found elsewhere in this report. Contractual Obligations In the ordinary course of our operations, we enter into certain contractual obligations. The following table presents our contractual obligations as of December 31, 2019. Liquidity Liquidity management is the process by which we manage the flow of funds necessary to meet our financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of our operations, and capital expenditures. Liquidity is monitored and closely managed by our asset and liability committee, or ALCO, a group of senior officers from the finance, enterprise risk management, deposit, investment, treasury, and lending areas. It is ALCO’s responsibility to ensure we have the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for, quickly identified, and management has plans in place to respond. ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources. At December 31, 2019, we had on balance sheet liquidity of $250.7 million, compared to $152.1 million at December 31, 2018 and $195.0 million at December 31, 2017. On balance sheet liquidity includes total due from banks, federal funds sold, interest-bearing deposits with banks, unencumbered securities available-for-sale and over collateralized securities pledging position. The Bank is a member of the FHLB, which provides short- and long-term funding to its members through advances collateralized by real estate-related assets and other select collateral, most typically in the form of debt securities. The actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As of December 31, 2019 we had $881.2 million of collateral pledged to the FHLB. Based on this collateral we are eligible to borrow up to $552.4 million and had $552.2 million available capacity as of December 31, 2019. In addition, we can borrow up to $102.0 million through unsecured lines of credit we have established with four other banks. In addition, because the Bank is “well capitalized,” we can accept wholesale deposits up to 20.0% of total assets based on current policy limits. Management believed that we had adequate resources to fund all of our commitments as of December 31, 2019 and December 31, 2018. Our primary sources of liquidity include liquid assets, as well as unencumbered securities that can be used to collateralize additional funding. At December 31, 2019, we had $144.0 million of cash and cash equivalents of which $107.6 million are interest-earning deposits held at the Federal Reserve, FHLB and other correspondent banks. Though remote, the possibility of a funding crisis exists at all financial institutions. Accordingly, management has addressed this issue by formulating a liquidity contingency plan, which has been reviewed and approved by both the Bank’s board of directors and the ALCO. The plan addresses the actions that we would take in response to both a short-term and long-term funding crisis. A short-term funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly short-term funding operations. Such a crisis would likely be temporary in nature and would not involve a change in credit ratings. A long-term funding crisis would most likely be the result of both external and internal factors and would most likely result in drastic credit deterioration. Management believes that both potential circumstances have been fully addressed through detailed action plans and the establishment of trigger points for monitoring such events.

<s>[INST] Overview We are a diversified financial services company headquartered in Grand Forks, North Dakota. Through our subsidiary, Alerus Financial, National Association, we provide innovative and comprehensive financial solutions to businesses and consumers through four distinct business linesbanking, retirement and benefit services, wealth management and mortgage. These solutions are delivered through a relationshiporiented primary point of contact along with responsive and clientfriendly technology. Our primary banking market areas are the states of North Dakota, Minnesota, specifically, the Twin Cities MSA, and Arizona, specifically, the Phoenix MSA. In addition to our offices located in our banking markets, our retirement and benefit services business administers plans in all 50 states through offices located in Michigan, Minnesota and New Hampshire. Our business model produces strong financial performance and a diversified revenue stream, which has helped us establish a brand and culture yielding both a loyal client base and passionate and dedicated employees. We believe our clientfirst and advicebased philosophy, diversified business model and history of high performance and growth distinguishes us from other financial service providers. We generate a majority of our overall revenue from noninterest income, which is driven primarily by our retirement and benefit services, wealth management and mortgage business lines. The remainder of our revenue consists of net interest income, which we derive from offering our traditional banking products and services. As of December 31, 2019, we had $2.4 billion of total assets, $1.7 billion of total loans, $2.0 billion of total deposits, $285.7 million of stockholders’ equity, $28.9 billion of AUA and $6.1 billion of AUM. For the year ended December 31, 2019 we had $946.4 million of mortgage originations. Net Interest Income Net interest income represents interest income less interest expense. We generate interest income on interestearning assets, primarily loans and availableforsale securities. We incur interest expense on interestbearing liabilities, primarily interestbearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, availableforsale securities and other interestearning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interestbearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interestbearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interestearning assets or pay on interestbearing liabilities. Noninterest Income Noninterest income primarily consists of the following: · Our retirement and benefit services business, which includes retirement plan administration, retirement plan investment advisory, HSA, ESOP, payroll and other benefit services, is our Company’s largest source of noninterest income. Over half of our retirement and benefit services fees are transaction or participant based fees and are impacted by the number of plans and participants. The remainder of noninterest income is based on the market value of the related AUA and AUM and impacted by the level of contributions, withdrawals, new business, lost business and fluctuation in market values. · Wealth management includes personal trust, investment and brokerage services. Our Company earns trust, investment, and IRA fees from managing assets, including corporate trusts, personal trusts, and separately managed accounts. Trust and investment management fees are primarily based on a tiered scale relative to the market value of the AUM. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values. · Mortgage noninterest income consists of gains on originating and selling mortgages and origination fees. Mortgage gains are primarily impacted by the level of originations, amount of loans sold, the type of loans sold and market conditions. · [/INST] Negative. </s>

HarborOne Bancorp, Inc.

2020-03-13

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS All material intercompany balances and transactions have been eliminated in consolidation. When necessary, certain amounts in prior year financial statements have been reclassified to conform to the current year’s presentation. The following discussion and analysis is presented to assist the reader in understanding and evaluating of the Company’s financial condition and results of operations. It is intended to complement the Consolidated Financial Statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-K and should be read in conjunction therewith. Overview The Company’s principal subsidiary is the Bank. The Bank is a state-chartered co-operative bank whose primary subsidiary is a residential mortgage company, HarborOne Mortgage, acquired on July 1, 2015. On August 14, 2019, the Company completed a second step conversion offering (the “Offering”). Prior to the completion of the Offering approximately 53% of the shares of common stock of the Company were owned by HarborOne Mutual Bancshares, a mutual holding company (the “MHC”). The Company raised gross proceeds of $310.4 million and incurred expenses of $6.3 million resulting in net cash proceeds of $304.1 million by selling 31,036,812 shares of common stock at $10.00 per share in the Offering. In addition, each share of the Company common stock owned by shareholders, other than the MHC, prior to the Offering was exchanged for 1.795431 shares of Company common stock, a total of 12,162,763 shares of Company common stock were issued in the exchange. The Company utilized $24.8 million to fund an additional ESOP loan, invested $151.3 million into the Bank’s operations, and retained the remaining amount for general corporate purposes. As a result of the Offering, all shares and per share information has been revised to reflect the 1.795431 exchange ratio. Such revised financial information presented in this Form 10-K is derived from the Consolidated Financial Statements of the Company. On October 5, 2018, the Company completed its acquisition of Coastway Bancorp, Inc., the parent of Coastway Community Bank (“Coastway”), adding nine full service branches in Rhode Island. The acquisition included $703.9 million in loans and $476.5 million in deposits, at fair value, and total cash consideration was $119.4 million. Coastway’s charitable foundation was also acquired and was renamed The HarborOne Foundation of Rhode Island. As described in the Notes to Consolidated Financial Statements, we have two reportable segments: HarborOne Bank and HarborOne Mortgage. The Bank segment provides consumer and business banking products and services to individuals, businesses and municipalities. Consumer products include loan and deposit products, and business banking products include loans for working capital, inventory and general corporate use, commercial real estate construction loans, and deposit accounts. The HarborOne Mortgage segment consists of originating residential mortgage loans primarily for sale in the secondary market and the servicing of those loans. The HarborOne Bank segment generates the significant majority of our consolidated net interest income and requires the provision for loan losses. The HarborOne Mortgage segment generates the majority of our noninterest income. We have provided below a discussion of the material results of operations for each segment on a separate basis for the years ended December 31, 2019 and 2018, that focuses on noninterest income and noninterest expenses. We have also provided a discussion of the consolidated operations of the Company, which includes the operations of HarborOne Bank and HarborOne Mortgage, for the same periods. For additional revenue, net income, assets, and other financial information for each of the Company’s reportable segments, see Part II, Item 8. “Financial Statements and Supplementary Data - Note 23: Segment Reporting.” Critical Accounting Policies Certain of our accounting policies, which are important to the portrayal of our financial condition, require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Our significant accounting policies are discussed in detail in Note 1 of the Notes to our Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. HarborOne Bancorp, Inc. Management’s Discussion and Analysis The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for qualifying public companies. As an “emerging growth company” we have elected to use the extended transition period to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. Accordingly, our Consolidated Financial Statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards. As of December 31, 2019, there is no significant difference in the comparability of the financial statements as a result of the extended transition period. 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 the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. The allowance consists of general, allocated and unallocated components. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: the likelihood of default; the loss exposure at default; the amount and timing of future cash flows on impaired loans; the value of collateral; and the determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, the FDIC and the Massachusetts Commissioner of Banks, as an integral part of their examination process, periodically review our allowance for loan losses and may require us to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect earnings. See Note 6, “Loans” within Notes to Consolidated Financial Statements included in item 8 of this annual report. Goodwill. The assets (including identifiable intangible assets) and liabilities acquired in a business combination are recorded at fair value at the date of acquisition. Goodwill is recognized for the excess of the acquisition cost over the fair values of the net assets acquired and is not subsequently amortized. Identifiable intangible assets include core deposit premium and non-compete contracts and are being amortized on a straight-line basis over their estimated lives. Management assesses the recoverability of goodwill at least on an annual basis and all intangible assets whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The impairment test uses a combined qualitative and quantitative approach. The initial qualitative approach assesses whether the existence of events or circumstances led to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after this assessment, the Company determines that it is more likely than not that the fair value is less than the carrying value, a quantitative impairment test is performed. The quantitative impairment test compares book value to the fair value of the reporting unit. If the carrying amount exceeds fair value, an impairment charge is recorded through earnings. Management has identified two reporting units for purposes of testing goodwill for impairment. The Company’s reporting units are the same as the segments used for segment reporting: the Bank, including the two security corporations and a Rhode Island passive investment corporation; and HarborOne Mortgage. Deferred Tax Assets. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. Management reviews deferred tax assets on a quarterly basis to identify any uncertainties pertaining to realization of such assets. In determining whether a valuation allowance is required against deferred tax assets, management assesses historical and forecasted operating results, including a review of eligible carryforward periods, tax planning opportunities and other relevant considerations. We believe the accounting estimate related to the valuation allowance is a critical estimate because the underlying assumptions can change from period to period. For example, tax law changes or variances in future projected operating performance could result in a change in the valuation allowance. Should actual factors and conditions differ materially from those used by management, the actual realization of net deferred tax assets could differ materially from the amounts recorded in the financial statements. If we were not able to realize all or part of our deferred tax assets in the future, an adjustment to the related valuation allowance would be charged to income tax expense in the period such determination was made and could have a negative impact on earnings. In addition, if actual factors and conditions differ materially from those used by management, we could incur penalties and interest imposed by taxing authorities. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Derivatives. Derivative instruments are used in relation to our mortgage banking activities and require significant judgment and estimates in determining their fair value. We hold derivative instruments, which consist of interest rate lock agreements related to expected funding of fixed-rate mortgage loans to customers and forward commitments to sell mortgage loans. Our objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value, with adjustments recorded in “Mortgage banking income.” Mortgage Servicing Rights. We recognize the rights to service mortgage loans for others as a separate asset referred to as “mortgage servicing rights” or “MSRs.” MSRs are generally recognized when loans are sold and the servicing is retained by us and are recorded at fair value. We base the fair value of our MSRs on a valuation performed by a third-party valuation specialist. This specialist determines fair value based on the present value of estimated future net servicing income cash flows, and incorporates assumptions that market participants would use to estimate fair value, including estimates of prepayment speeds, discount rates, default rates, servicing costs, contractual servicing fee income, and ancillary income. Changes in the fair value of MSRs occur primarily in connection with the collection/realization of expected cash flows, as well as changes in the valuation inputs and assumptions. Moreover, MSRs are significantly impacted by mortgage rates. Decreasing mortgage rates normally encourage increased mortgage refinancing activity, which reduces the life of the loans underlying the mortgage servicing right, therefore reducing the value of mortgage servicing rights. Changes in the fair value of residential MSRs are reported in “Mortgage banking income.” Please see the Notes to the Consolidated Financial Statements for additional discussion of accounting policies. Comparison of Financial Condition at December 31, 2019 and December 31, 2018 Total Assets. Total assets increased $405.8 million, or 11.1%, to $4.06 billion at December 31, 2019 from $3.65 billion at December 31, 2018. Cash and Cash Equivalents. At December 31, 2019 cash and cash equivalents were $211.6 million, an increase of 100.5% from $105.5 million at December 31, 2018. The increase primarily reflects approximately $128.0 million of proceeds from the Offering that are included in short-term investments. Loans Held for Sale. Loans held for sale at December 31, 2019 were $110.6 million, an increase of $68.4 million from $42.1 million at December 31, 2018, primarily reflecting higher residential mortgage loan demand in 2019 as compared to 2018. Loans, net. At December 31, 2019, net loans were $3.15 billion, an increase of $182.6 million, or 6.2%, from $2.96 billion at December 31, 2018. Gross loans increased $185.5 million, reflecting an increase in commercial loans of $259.2 million, partially offset by a decrease in residential real estate loans of $15.0 million and a decrease in consumer loans of $58.7 million. The allowance for loan losses was $24.1 million at December 31, 2019 and $20.7 million December 31, 2018. HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table provides the composition of our loan portfolio at the dates indicated: HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table sets forth our loan originations, sales, purchases and principal repayment activities during the periods indicated: HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table sets forth certain information at December 31, 2019 regarding scheduled contractual maturities during the period indicated. The table does not include any estimate of prepayments. Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less. The following table also sets forth the rate structure of loans scheduled to mature after one year. The amounts shown below exclude net deferred loan fees. Generally, the actual maturity of loans is shorter than their contractual maturity due to prepayments. The average life of residential real estate loans are impacted by the current interest rate environment. The average life tends to increase when current mortgage loan rates are higher than the rates of the loans in the portfolio and decrease when current rates are lower than the rates of the loans in the portfolio. Also, commercial and commercial real estate loans may be renewed at or near maturity resulting in significant differences in principal payments actually received as compared to amounts contractually due in a period. Securities. Total investment securities at December 31, 2019 were $265.8 million, an increase of $11.9 million, or 4.7%, from December 31, 2018. The purchase of $109.3 million of securities was partially offset by $75.2 million in prepayments, maturities, calls and amortization of securities. Securities in the amount of $27.1 million were sold with a gross realized gain of $1.3 million. The total security portfolio was 6.5% of total assets as of December 31, 2019, compared to 7.0% as of December 31, 2018. The following table provides the composition of our securities available for sale and our securities held to maturity at the dates indicated: HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table sets forth the stated maturities and weighted average yields of investment securities at December 31, 2019: Mortgage Servicing Rights. MSRs are created as a result of our mortgage banking origination activities and accounted for at fair value. At December 31, 2019, we serviced mortgage loans for others with an aggregate outstanding principal balance of $1.83 billion. Total MSRs were $17.2 million at December 31, 2019, compared to $22.2 million at December 31, 2018. The $5.1 million decrease was primarily due to changes in market interest rates impacting the valuation and a decrease in additions. The following table represents the activity for mortgage servicing rights and the related fair value changes during the periods noted: HarborOne Bancorp, Inc. Management’s Discussion and Analysis The fair value of our mortgage servicing rights is determined by a third-party provider that determines the appropriate prepayment speed, discount and default rate assumptions based on our portfolio. Any measurement of fair value is limited by the conditions existing and assumptions made at a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time. The following table presents weighted average assumptions utilized in determining the fair value of mortgage servicing rights at December 31, 2019 and 2018: Prepayment speeds are significantly impacted by mortgage rates. Decreasing mortgage rates normally encourage increased mortgage refinancing activity, which reduces the life of the loans underlying the mortgage servicing rights, thereby reducing the value of mortgage servicing rights. Management has made the strategic decision not to hedge mortgage servicing assets at this point. Therefore, any future declines in interest rates would likely cause further decreases in the fair value of the mortgage servicing rights, and a corresponding detriment to earnings, whereas increases in interest rates would result in increases in fair value, and a corresponding benefit to earnings. Management may choose to hedge the mortgage servicing assets in the future or limit the balance of mortgage servicing rights by selling them or selling loans with the servicing released. Deposits. Deposits increased $257.8 million, or 9.6%, to $2.94 billion at December 31, 2019 from $2.69 billion at December 31, 2018. The following table sets forth information concerning the composition of deposits: The deposit growth was driven by an increase of $229.5 million in retail deposits and $31.8 million in municipal deposits, partially offset by a decrease of $3.5 million in wholesale deposits. The increase in retail deposits was due to the increase in regular savings of $138.6 million, an increase of $46.1 million in money market accounts, an increase of $29.0 million in term certificate deposits and an increase of $22.3 million in NOW accounts, partially offset by a decrease of $6.5 million in noninterest-bearing deposits. Deposit growth was enhanced by competitive promotional rates offered on savings, money market and certificate of deposit products during the year. Wholesale deposits includes brokered deposits of $81.1 million, $15.0 million in certificates of deposits from institutional investors and $6.0 million in reciprocal deposits of HarborOne Bancorp at December 31, 2019. The Bank participates in a reciprocal deposit program that converts deposits at the Bank into multiple deposits at other financial institutions. The reciprocal deposit program provides access to FDIC-insured deposit products in aggregate amounts exceeding the current limits for depositors. Total deposits at December 31, 2019 included $277.9 million in reciprocal deposits, including $143.4 million in municipal deposits. The wholesale deposits provide a channel for the Company to seek additional funding outside the Bank’s core market. During the year ended December 31, 2019, we continued to focus on enhancing our deposit mix in order to better manage our cost of funds and to expand our customer relationships. HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table sets forth the average balances and weighted average rates of our deposit products at the dates indicated: The following table sets forth our certificates of deposit classified by interest rate as of the dates indicated: The following table sets forth the amount and maturities of our certificates of deposit by interest rate at December 31, 2019: HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table sets forth the maturity of certificates of deposit, excluding brokered deposits, of $100,000 or more as of December 31, 2019: Borrowings. Total borrowings from the FHLB were $354.1 million at December 31, 2019, a decrease of $165.8 million from $519.9 million at December 31, 2018. We assumed $276.8 million in short-term FHLB borrowings in the Coastway acquisition in 2018. In August 2018, the Company issued $35.0 million in fixed-to-floating rate subordinated notes. The notes bear interest at an annual fixed rate of 5.625% until September 1, 2023 at which time the interest resets quarterly to an interest rate per annum equal to the three month LIBOR plus 278 basis points. The notes are carried on the Consolidated Balance Sheets net of unamortized issuance costs of $1.1 million at December 31, 2019, which are being amortized over the period to maturity date. The following table sets forth information concerning balances and interest rates on our borrowings at the dates and for the periods indicated: Stockholders’ equity. Total stockholders’ equity was $665.8 million at December 31, 2019 compared to $357.6 million at December 31, 2018. The increases from the prior period reflect the Company’s $18.3 million in net income, $304.1 million from the Offering, net of $24.8 million for the additional ESOP funding, $4.8 million from stock-based compensation expense and $2.7 million from ESOP shares committed. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Comparison of Results of Operations for the Years Ended December 31, 2019 and 2018 HarborOne Bancorp, Inc. Consolidated Overview. Consolidated net income for the year ended December 31, 2019 was $18.3 million compared to net income of $11.4 million for the year ended December 31, 2018. The 2019 results include a full year of income and expense from the acquired Coastway branches. Additionally, the 2019 results include $1.3 million in gain on sale of securities and a $482,000 loss on disposal of asset held for sale. The 2018 results include merger expenses of $5.1 million and one quarter of normal operating income and expense from acquired Coastway operations, and a $746,000 life insurance death benefit. Average Balances and Yields. The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated, on a consolidated basis. Interest income on tax-exempt securities has been adjusted to a fully taxable-equivalent, or FTE, basis using a federal tax rate of 21% for the years ended December 31, 2019 and 2018 and 35% for the year ended December 31, 2017. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense. HarborOne Bancorp, Inc. Management’s Discussion and Analysis HarborOne Bancorp, Inc. Management’s Discussion and Analysis Rate/Volume Analysis. The following table presents, on a tax equivalent basis, the effects of changing rates and volumes on our net interest income for the periods indicated, on a consolidated basis. 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 total column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately based on the changes due to rate and the changes due to volume. Interest and Dividend Income. Interest and dividend income increased $39.1 million, or 33.7% in 2019, compared to 2018, primarily reflecting the repositioning of the balance sheet to higher yielding commercial loans and higher interest rates. Loan interest income increased $37.4 million to $145.0 million, average loans increased $652.2 million and the yield increased 29 basis points from a year ago. Loan interest income includes $3.6 million, as compared to $840,000 in 2018, in accretion income from the fair value discount on loans acquired from Coastway. Interest income on other interest-earning assets increased $1.4 million primarily due to proceeds from the Offering that were invested in liquid assets. Interest Expense. Compared to 2018, interest expense for the year ended December 31, 2019 increased $18.9 million, or 70.7% to $45.7 million from $26.8 million. The increase primarily reflects an increase in average interest-bearing deposits of $526.0 million, or 27.3%, combined with a 44 basis point increase in the cost of interest-bearing deposits, resulting in a $16.5 million increase in interest expense on deposits. The cost of deposit funds was significantly impacted by rising rates in a competitive deposit market and the growth in average interest-bearing deposits. Money market accounts and certificates of deposits were the primary drivers of the average balance and rate increases. The cost of FHLB borrowings increased 42 basis points partially offset by a decrease in the average balance resulting in a $1.1 million increase in interest expense on FHLB borrowings. There was also a full year of interest expense on subordinated debentures in 2019. The Company issued $35.0 million in subordinated debentures in the third quarter of 2018 at annual fixed rate of 5.625%. The rate adjusts quarterly after September 30, 2023. The notes are carried on the balance sheet net of issuance costs of $1.1 million, which are being amortized over the period to maturity as an adjustment to the yield. Net Interest and Dividend Income. Compared to 2018, net interest and dividend income for the year ended December 31, 2019 increased $20.1 million, or 22.6%, to $109.1 million from $88.9 million. The tax equivalent net interest spread decreased 18 basis points to 2.81% for the year ended December 31, 2019 from 2.99% for the year ended December 31, 2018, and net interest margin on a tax equivalent basis decreased 8 basis points to 3.14% for the year ended December 31, 2019 from 3.22% for the year ended December 31, 2018. The decrease in margin and spread was offset by the increase in interest-earning assets. Income Tax Provision. The provision for income taxes and effective tax rate for the year ended December 31, 2019 was $4.4 million and 19.4%, respectively, compared to $2.8 million and 19.8%, respectively, for the year ended December 31, 2018. During 2019, federal and state tax refunds of $2.5 million were recognized. The 2018 income tax provision was impacted by an $826,000 tax refund and the impact of nondeductible merger expenses. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Segments. The Company has two reportable segments: HarborOne Bank and HarborOne Mortgage. Revenue from HarborOne Bank consists primarily of interest earned on loans and investment securities and service charges on deposit accounts. Revenue from HarborOne Mortgage is comprised of interest earned on loans and fees received as a result of the residential mortgage origination, sale and servicing process. The table below shows the results of operations for the Company’s segments, HarborOne Bank and HarborOne Mortgage, for the years ended December 31, 2019 and 2018, and the increase or decrease in those results. HarborOne Bank Segment Results of Operations for the Years Ended December 31, 2019 and 2018 Net Income. Bank net income for the year ended December 31, 2019 increased $6.1 million to $20.9 million from $14.8 million for the year ended December 31, 2018. The increase in net income reflects an increase of $20.6 million in net interest income and an increase of $2.0 million in noninterest income, partially offset by a $919,000 increase in provision for loan losses, an increase in noninterest expense of $14.1 million and an increase in provision for income taxes of $1.6 million. Provision for Loan Losses. We recorded a provision for loan losses of $4.7 million for the year ended December 31, 2019 compared to $3.8 million for the year ended December 31, 2018. The provision reflects the continued growth in commercial loans shifting the composition of the loan portfolio to a higher percentage of commercial lending, which requires a higher level of loan loss reserves than loans secured by automobiles and residential property. For the year ended December 31, 2019, the Bank recorded net charge-offs of $1.3 million compared to $1.7 million for the year ended December 31, 2018. Nonaccrual loans increased to $30.3 million at December 31, 2019 from $17.7 million at December 31, 2018. The increase in nonaccrual loans is primarily due to two commercial relationships totaling $13.3 million that were provided forbearance agreements, but require no specific reserves at this time. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Noninterest Income. Compared to the year ended December 31, 2018, total noninterest income for the year ended December 31, 2019 increased $2.0 million, or 9.9%, to $22.2 million from $20.2 million. The following table sets forth the components on non-interest income: The primary reasons for the changes within the noninterest income categories shown in the preceding tables are noted below: · Mortgage banking income reflects the consolidation of the Bank’s residential lending division into HarborOne Mortgage in April 2018. The Bank records an intersegment loss on loans purchased from HarborOne Mortgage that is offset in consolidation. · The increase in interchange fees and other deposit fees reflects increased debit card interchange income due to a higher deposit base. · The loss on asset held for sale is due to the write down to fair value on the transfer of the former Coastway corporate office in Warwick, RI to assets held for sale, in anticipation of closing on the sale in the first half of 2020. · The gain on sale and call of securities primarily reflects gain recognized on the sale of $27.1 million of securities. · The decrease in bank-owned life insurance reflects the receipt of a death benefit in the amount of $746,000 in 2018. · The increase in swap fee income reflects an increase in interest rate swap agreements with commercial borrowers. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Noninterest Expense. Noninterest expense for the year ended December 31, 2019 increased $14.1 million, or 16.3% to $100.7 million from $86.6 million for the year ended December 31, 2018. The following table sets forth the components on noninterest expense: The primary reasons for the significant changes within the noninterest expense categories shown in the preceding table are noted below: · The compensation and benefits increase reflects an increase of $8.0 million in salary expense, employer payroll taxes and wellness benefits primarily as a result of a full year of expense for the Coastway employees. Additionally, ESOP expense increased $1.6 million due to the ESOP funding as part the Offering. · The increase in occupancy and equipment expense primarily reflects increased software licensing costs and other technology and equipment costs as we invested in technologies to support the Bank’s growth and the additional expenses for the properties acquired from Coastway. · The increase in data processing expense primarily reflects increased debit card processing fees due to an increase in accounts with debit cards. · The increases in loan expenses, deposit expenses and postage and printing primarily reflect increased costs due to an increase in customer accounts. · The decrease in deposit insurance reflects the Bank’s FDIC assessment credit awards and a reduction in the assessment rate due to improved capital ratios as a result of the second step conversion. · Fluctuations in marketing and professional expenses are generally due to timing and can fluctuate due to strategic efforts. · The 2018 merger expenses were recorded as result of the acquisition of Coastway. · The increase in other expenses is due an increase of $1.7 million in amortization in core deposit intangible expense and an increase in telephone data expense of $354,000 primarily due to the addition of the Coastway locations. HarborOne Bancorp, Inc. Management’s Discussion and Analysis HarborOne Mortgage Segment Results of Operations for the Year Ended December 31, 2019 and 2018. Net Income. HarborOne Mortgage recorded a net income of $114,000 for the year ended December 31, 2019 as compared to and a net loss of $1.4 million for the year ended December 31, 2018. The HarborOne Mortgage segment’s results are heavily impacted by prevailing rates, refinancing activity and home sales. Noninterest Income. For the years ended December 31, 2019 and 2018, noninterest income totaled $38.8 million and $29.0 million, respectively. Noninterest income is primarily from mortgage banking income for which the following table provides further detail: For the years ended December 31, 2019 and 2018, HarborOne Mortgage originated $1.33 billion and $866.9 million, respectively, of residential mortgage loans. The following tables provide additional loan production detail: HarborOne Mortgage acquired its primary third-party originator, Cumberland Mortgage, in January of 2018 and subsequently discontinued the third-party program due to compressing spreads on third-party originations. The primary reasons for the significant changes in the total mortgage banking income category shown in the preceding tables are noted below: Overall, gain on sale of mortgage loans increased $10.9 million, or 48.6%, due to increased residential mortgage demand as a result of increased refinance and purchase activity in 2019 due to lower mortgage interest rates. Included in the gain on mortgage sales HarborOne Bancorp, Inc. Management’s Discussion and Analysis was $1.2 million of originated mortgage servicing rights for the year ended December 31, 2019 as compared to $1.4 million for the year ended December 31, 2018. Processing, underwriting and closing fees increased, due to volume increases. Secondary market loan servicing fees, net of guarantee fees decreased consistent with a decrease in the average balance of the serviced portfolio. The unpaid balance of the servicing portfolio totaled $1.28 billion and $1.39 billion at December 31, 2019 and 2018, respectively. During the year ended December 31, 2019, the fair value of mortgage servicing rights decreased $4.8 million as compared to a decrease of $1.0 million in 2018. The 10 year Treasury Constant Maturity rate (“10 year CMT”) decreased 77 basis points for the year ended December 31, 2019 as compared to an increase of 29 basis points for the year ended December 31, 2018. Decreasing interest rates generally result in a decrease in mortgage servicing rights fair value as the assumed prepayment speeds of the underlying mortgage loans tend to increase. Conversely, as interest rates rise and prepayment speeds slow, mortgage servicing rights fair value tends to increase. The negative change for the year ended December 31, 2018 despite the higher interest rates reflects reductions from loans paid off being greater than the positive fair value adjustment for the period. At December 31, 2019 and 2018, mortgage servicing rights were $12.4 million and $16.3 million, respectively. Noninterest Expense. Noninterest expense increased $8.1 million or 25.6%, to $39.8 million for the year ended December 31, 2019 from $31.6 million. The following table sets forth the components on noninterest expense: The primary reason for the changes within the noninterest expense categories shown in the preceding tables are noted below: · The increase in compensation and benefits and loan expenses reflects increases consistent with the increase in loan origination volume. · Occupancy and equipment expense increased due to an increase in rent on leased premises. · The increase in professional fees reflects consulting expenses to review the filings effected by the Home Mortgage Disclosure Act. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Comparison of Results of Operations for the Years Ended December 31, 2018 and 2017 Results of Operations for the Years Ended December 31, 2018 and 2017 are included in the December 31, 2018 Annual Report on Form 10-K filed by HarborOne Bancorp’s predecessor company, also named HarborOne Bancorp, Inc., with the Securities and Exchange Commission on March 3, 2019. Asset Quality The following table provides information with respect to our nonperforming assets and troubled debt restructurings at the dates indicated. We did not have any accruing loans past due 90 days or more at the dates presented. Income related to impaired loans included in interest income for the years ended December 31, 2019, 2018 and 2017 amounted to $2.0 million, $1.8 million and $2.3 million, respectively. If nonperforming and restructured loans had been performing in accordance with their original terms, we estimate the income earned on those loans to be $2.5 million, $2.1 million and $2.3 million for the years ended December 31, 2019, 2018 and 2017, respectively. Classified Assets. Federal regulations require us to review and classify assets on a regular basis. In addition, the FDIC and the Massachusetts Commissioner of Banks have the authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. “Doubtful assets” have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as “loss” is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. When management classifies a loan as substandard or doubtful, a specific allowance for loan losses may be established. If management classifies a loan as loss, an amount equal to 100.0% of the portion of the loan classified loss is charged to the allowance for loan losses. The regulations also provide for a “special mention” category, described as loans that do not currently expose us to a sufficient degree of risk to warrant classification, but do possess credit deficiencies or potential weaknesses deserving our close attention. We utilize a ten-grade internal loan rating system for commercial real estate, commercial construction and commercial loans. Loans not rated consist primarily of residential construction loans and certain smaller balance commercial real estate and commercial loans that are managed by exception. HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table presents our risk rated loans considered classified or special mention in accordance with our internal risk rating system: None of the special mention assets at December 31, 2019, 2018 or 2017 were on nonaccrual. The increase in substandard loans at December 31, 2019 was primarily caused by one commercial construction relationship of $11.2 million. The majority of the increase in special mention loans at December 31, 2018 was caused by a $14.5 million commercial construction loan, a $6.2 million commercial real estate loan and a $4.4 million commercial real estate loan acquired from Coastway, which was downgraded after the acquisition. HarborOne Bancorp, Inc. Management’s Discussion and Analysis At December 31, 2019, our allowance for loan losses was $24.1 million, or 0.76% of total loans and 79.35% of nonperforming loans. At December 31, 2018, our allowance for loan losses was $20.7 million, or 0.69% of total loans and 116.62% of nonperforming loans. Nonperforming loans at December 31, 2019 were $30.3 million, or 0.96% of total loans, compared to $17.7 million, or 0.59% of total loans, at December 31, 2018. The increase in nonperforming loans is primarily due to 2 commercial relationships totaling $13.3 million. The allowance for loan losses is maintained at a level that represents management’s best estimate of losses in the loan portfolio at the balance sheet date. However, there can be no assurance that the allowance for loan losses will be adequate to cover losses which may be realized in the future or that additional provisions for loan losses will not be required. Delinquencies. The following table provides information about delinquencies in our loan portfolio at the dates indicated. HarborOne Bancorp, Inc. Management’s Discussion and Analysis The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated: HarborOne Bancorp, Inc. Management’s Discussion and Analysis 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 uncollectability of a loan balance is confirmed and generally do not exceed the time frame provided in the FDIC’s Uniform Retail Credit Classification and Account Management Policy. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of general, allocated and unallocated components, as further described below. General component. The general component of the allowance for loan losses is based on historical and peer loss experience adjusted for qualitative factors stratified by our loan segments. Management uses a rolling average of historical losses based on a time frame appropriate to capture relevant loss data for each loan segment except commercial real estate and commercial loans. Due to the lack of historical loss experience for our commercial real estate and commercial loan portfolio, we utilize peer loss data. Adjustments to loss rates are considered 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 the year ended December 31, 2019. The qualitative factors are determined based on the various risk characteristics of each loan segment. Risk characteristics relevant to each portfolio segment are as follows: Residential real estate - We generally do not originate portfolio loans with a loan-to-value ratio greater than 80 percent without obtaining private mortgage insurance and does not generally grant loans that would be classified as subprime upon origination. We generally have first or second liens on property securing equity lines of credit. Loans in this segment are generally collateralized by 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, can have an effect on the credit quality in this segment. Residential construction - Residential construction loans include loans to build one- to four-family owner-occupied properties, which are subject to the same credit quality factors as residential real estate loans. Commercial real estate - Loans in this segment are primarily secured by income-producing properties and owner-occupied commercial properties in southeastern New England. The underlying cash flows generated by the properties and operations can be adversely impacted by a downturn in the local economy, which can lead to increased vacancy rates and diminished cash flows, which in turn, could have an effect on the credit quality in this segment. Management obtains financial statements annually and continually monitors the cash flows of these loans. Commercial construction - Commercial construction loans may include speculative real estate development loans for which payment is derived from lease or sale of the property. Credit risk is affected by cost overruns, time to lease or 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 or business spending, could have an effect on the credit quality in this segment. Consumer - Loans in this segment are generally secured by automobiles or are unsecured and repayment is dependent on the credit quality of the individual borrower. Allocated component. The allocated component relates to loans that are classified as impaired. Residential real estate, commercial, commercial real estate and construction loans are evaluated for impairment on a loan-by-loan basis. Impairment is determined by nonaccrual status, whether a loan is subject to a troubled debt restructuring agreement or in the case of certain loans, based on the internal credit rating. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, except for troubled debt restructuring, or “TDR,” we do not separately identify individual consumer loans for impairment evaluation. 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 HarborOne Bancorp, Inc. Management’s Discussion and Analysis 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. 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 TDR. All TDRs are initially classified as impaired. Impairment is measured 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 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. Unallocated component. 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. The unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. Additionally, our unseasoned commercial portfolio and use of peer group data to establish general reserves for the commercial portfolio adds another element of imprecision to management’s estimates. Analysis of Loan Loss Experience. The following table sets forth an analysis of the allowance for loan losses for the periods indicated: For the years ended December 31, 2019 and 2018, we recorded a provision for loan losses of $4.7 million and $3.8 million, respectively. This increase primarily reflects loan growth in the commercial real estate, commercial construction and commercial loan portfolios. Management of Market Risk Net Interest Income Analysis. The Bank uses income simulation as the primary tool for measuring interest-rate risk inherent in our balance sheet at a given point in time by showing the effect on net interest income, over specified time frames and using different interest rate shocks and ramps. The assumptions include, but are not limited to, management’s best assessment of the effect of changing interest rates on the prepayment speeds of certain assets and liabilities, projections for account balances in each of the product lines HarborOne Bancorp, Inc. Management’s Discussion and Analysis offered and the historical behavior of deposit rates and balances in relation to changes in interest rates. These assumptions are inherently changeable, and as a result, the model is not expected to precisely measure net interest income or precisely predict the impact of fluctuations in interest rates on net interest income. Actual results will differ from the simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in the balance sheet composition and market conditions. Assumptions are supported with quarterly back-testing of the model to actual market rate shifts. As of December 31, 2019, net interest income simulation results for the Bank indicated that our exposure over one year to changing interest rates was within our guidelines. The following table presents the estimated impact of interest rate changes on our estimated net interest income over one year: Economic Value of Equity Analysis. The Bank also uses the net present value of equity at risk, or “EVE,” methodology. This methodology calculates the difference between the present value of expected cash flows from assets and liabilities. The comparative scenarios assume an immediate parallel shift in the yield curve up 300 basis points and down 100 basis points. The board of directors and management review the methodology’s measurements for both net interest income and EVE on a quarterly basis to determine whether the exposure resulting from the changes in interest rates remains within established tolerance levels and develops appropriate strategies to manage this exposure. The table below sets forth, as of December 31, 2019, the estimated changes in the net economic value of equity that would result from the designated changes in the United States Treasury yield curve under an instantaneous parallel shift for the Bank. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results. Liquidity Management and Capital Resources Liquidity measures the Company’s ability to meet both current and future financial obligations of a short and long term nature. Liquidity planning is necessary for the Company to ensure it has the ability to respond to the needs of its customers as well as opportunities for earnings enhancements. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows, calls of investment securities and prepayments and sales on loans are greatly influenced by general interest rates, economic conditions and competition. HarborOne Bancorp, Inc. Management’s Discussion and Analysis The Company has both a liquidity and contingent liquidity policy. The management of both policies is monitored by ALCO which is responsible for establishing and monitoring liquidity targets as well as strategies to meet these targets. The projected cash flows are stress tested quarterly to estimate the needs for contingent funding outside of the normal course of business. To supplement liquidity, the Company has available collateral at the Federal Home Loan Bank of Boston, or FHLB of Boston, Federal Reserve Bank of Boston and Co-operative Central Bank. At December 31, 2019, the Bank had $300.3 million of additional borrowing capacity available at the FHLB of Boston, $38.9 million at the Federal Reserve Bank of Boston and $5.0 million with the Co-Operative Central Bank. The Bank also has a $25.0 million correspondent bank line of credit available. At December 31, 2019, the Bank had $354.1 million of borrowings outstanding with the FHLB of Boston. Our cash flows are composed of three primary classifications: cash flows from operating activities, investing activities and financing activities as reported in our Consolidated Statements of Cash Flows included in our Consolidated Financial Statements. Our most liquid assets are cash and cash equivalents. The level of these assets is dependent on our operating, financing, lending and investing activities during any given period. At December 31, 2019 cash and cash equivalents totaled $211.6 million. Net cash used by operating activities was $36.1 million for the year ended December 31, 2019 compared to $61.2 million of net cash provided by operating activities for the year ended December 31, 2018. Our primary investing activities are originating loans and purchasing securities. Net cash used in investing activities was $228.8 million and $215.9 million for the years ended December 31, 2019 and 2018, respectively. During the years ended December 31, 2019 and 2018, we had $188.6 million and $197.6 million, respectively, of loan originations and participation-in loan purchases, net of principal payments. We also sold portfolio loans of $105.8 million in 2018. During the year ended December 31, 2019, we purchased $109.3 million of securities and received proceeds from the maturities, prepayments and calls totaling $103.3 million. During the year ended December 31, 2018, those amounts were $67.7 million and $27.7 million, respectively. Net cash provided by financing activities was $371.1 million and $179.5 million for the years ended December 31, 2019 and 2018, respectively. Net cash provided by financing activities included $304.1 million from the offering in 2019. The net increase in deposits was $256.8 million for the year ended December 31, 2019 as compared to a net increase of $194.9 million for the prior year. The net decrease in borrowings was $165.8 million and $13.5 million for the years ended December 31, 2019 and 2018, respectively. HarborOne Bank is subject to various regulatory capital requirements. At December 31, 2019, HarborOne Bank exceeded all regulatory capital requirements and was considered “well capitalized” under regulatory guidelines. See “Supervision and Regulation-Capital Adequacy and Safety and Soundness-Regulatory Capital Requirements” and Note 19 of the Notes to Consolidated Financial Statements. At December 31, 2019, we had outstanding commitments to originate loans of $94.2 million and unadvanced funds on loans of $417.1 million. We anticipate that we will have sufficient funds available to meet our current loan origination commitments. Certificates of deposit that are scheduled to mature in less than one year from December 31, 2019 totaled $717.5 million. Management expects, based on historical experience, that a substantial portion of the maturing certificates of deposit will be renewed. However, if a substantial portion of these deposits is not retained, we may use FHLB advances or raise interest rates on deposits to attract new accounts, which may result in higher levels of interest expense. Off-Balance Sheet Arrangements and Contractual Obligations Commitments. 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 accompanying Consolidated Balance Sheets. The contract amount of these instruments reflects the extent of involvement we have in these particular classes of financial instruments. We use the same credit policies in making commitments as we do for on-balance sheet instruments. Our exposure to credit loss is represented by the contractual amount of the instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments and unadvanced funds on lines-of-credit generally have fixed expiration dates and may expire without being drawn upon. Therefore, the total commitment amount does not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. In addition, from time to time we enter into commitments to sell mortgage loans that we originate. For additional information, see Note 15 of the Notes to Consolidated Financial Statements. HarborOne Bancorp, Inc. Management’s Discussion and Analysis Contractual Obligations. We are obligated to make future payments according to various contracts. The following table presents the expected future payments of contractual obligations aggregated by obligation type at December 31, 2019. FHLB advances payments are assumed to be at call date, subordinated notes are assumed to be a redemption date and certificate of deposits are assumed to occur at maturity. Impact of Inflation and Changing Prices Our Consolidated Financial Statements, including the notes thereto, and related financial data presented herein have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than the effects of inflation.

<s>[INST] Overview The Company’s principal subsidiary is the Bank. The Bank is a statechartered cooperative bank whose primary subsidiary is a residential mortgage company, HarborOne Mortgage, acquired on July 1, 2015. On August 14, 2019, the Company completed a second step conversion offering (the “Offering”). Prior to the completion of the Offering approximately 53% of the shares of common stock of the Company were owned by HarborOne Mutual Bancshares, a mutual holding company (the “MHC”). The Company raised gross proceeds of $310.4 million and incurred expenses of $6.3 million resulting in net cash proceeds of $304.1 million by selling 31,036,812 shares of common stock at $10.00 per share in the Offering. In addition, each share of the Company common stock owned by shareholders, other than the MHC, prior to the Offering was exchanged for 1.795431 shares of Company common stock, a total of 12,162,763 shares of Company common stock were issued in the exchange. The Company utilized $24.8 million to fund an additional ESOP loan, invested $151.3 million into the Bank’s operations, and retained the remaining amount for general corporate purposes. As a result of the Offering, all shares and per share information has been revised to reflect the 1.795431 exchange ratio. Such revised financial information presented in this Form 10K is derived from the Consolidated Financial Statements of the Company. On October 5, 2018, the Company completed its acquisition of Coastway Bancorp, Inc., the parent of Coastway Community Bank (“Coastway”), adding nine full service branches in Rhode Island. The acquisition included $703.9 million in loans and $476.5 million in deposits, at fair value, and total cash consideration was $119.4 million. Coastway’s charitable foundation was also acquired and was renamed The HarborOne Foundation of Rhode Island. As described in the Notes to Consolidated Financial Statements, we have two reportable segments: HarborOne Bank and HarborOne Mortgage. The Bank segment provides consumer and business banking products and services to individuals, businesses and municipalities. Consumer products include loan and deposit products, and business banking products include loans for working capital, inventory and general corporate use, commercial real estate construction loans, and deposit accounts. The HarborOne Mortgage segment consists of originating residential mortgage loans primarily for sale in the secondary market and the servicing of those loans. The HarborOne Bank segment generates the significant majority of our consolidated net interest income and requires the provision for loan losses. The HarborOne Mortgage segment generates the majority of our noninterest income. We have provided below a discussion of the material results of operations for each segment on a separate basis for the years ended December 31, 2019 and 2018, that focuses on noninterest income and noninterest expenses. We have also provided a discussion of the consolidated operations of the Company, which includes the operations of HarborOne Bank and HarborOne Mortgage, for the same periods. For additional revenue, net income, assets, and other financial information for each of the Company’s reportable segments, see Part II, Item 8. “Financial Statements and Supplementary Data Note 23: Segment Reporting.” Critical Accounting Policies Certain of our accounting policies, which are important to the portrayal of our financial condition, require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Our significant accounting policies are discussed in detail in Note 1 of the Notes to our Consolidated Financial Statements included in Part II, Item 8 of this Form 10K. HarborOne Bancorp, [/INST] Negative. </s>

Landcadia Holdings II, Inc.

2020-03-27

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. We consummated our initial Public Offering on May 9, 2019 and are currently in the process of locating suitable targets for our Business Combination. We intend to use the cash proceeds from our public offering and private placement of warrants as well as additional issuances, if any, of our capital stock, debt or a combination of cash, stock and debt to complete the Business Combination. We expect to incur significant costs in the pursuit of our acquisition plans. There can be no assurance that our plans to raise capital or to complete our initial Business Combination will be successful. Liquidity and Capital resources On May 9, 2019 we consummated a $316,250,000 public offering consisting of 31,625,000 units at a price of $10.00 per Unit. Each Unit consists of one share of the Company’s Class A common stock, $0.0001 par value and one-third of one redeemable Public Warrant. Simultaneously, with the closing of the Public Offering, we consummated a $8,825,000 Private Placement of an aggregate of 5,883,333 Sponsor Warrants at a price of $1.50 per warrant. Upon closing of the Public Offering and Private Placement on May 9, 2019, $316,250,000 in proceeds (including $11,068,750 of deferred underwriting commissions) from the public offering and private placement was placed in the Trust Account. The remaining $8,825,000 held outside of trust was used to pay underwriting commissions of $6,325,000, loans to our Sponsors, and deferred offering and formation costs. As of December 31, 2019, we had an unrestricted balance of $1,593,104 as well as cash and accrued interest held in the Trust Account of $319,901,512. Our working capital needs will be satisfied through the funds, held outside of the Trust Account, from the public offering. Interest on funds held in the Trust Account may be used to pay income taxes and franchise taxes, if any. Further, our Sponsors may, but are not obligated to, loan us funds as may be required in connection with the Business Combination. Up to $1,500,000 of these loans may be converted into warrants of the post Business Combination entity at a price of $1.50 per warrant at the option of the lender and would be identical to the Sponsor Warrants. Results of Operations We have neither engaged in any significant business operations nor generated any revenues to date. All activities to date relate to the Company’s formation and its initial Public Offering and search for a suitable Business Combination. We generate non-operating income in the form of interest income on cash, cash equivalents, and marketable securities held in the Trust Account. 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 as we locate a suitable Business Combination. For the years ended December 31, 2019, 2018, and 2017, we had a net income of $2,499,733, $0 and $0, respectively. The income for the year ended December 31, 2019 relates to $3,651,511 in pre-tax earnings on the Trust Account assets offset by $377,292 of general and administrative costs and $110,000 of management fees for administrative services. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements as of December 31, 2019. Contractual Obligations As of December 31, 2019, we did not have any long-term debt, capital, purchase or operating lease obligations or other long-term liabilities. We have recorded deferred underwriting commissions payable upon the completion of the Business Combination. We entered into an administrative services agreement in which the Company pays FEI for office space, secretarial and administrative services provided to members of the Company’s management team, in an amount not to exceed $10,000 per month. Critical Accounting Policies The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The Company has identified the following as its critical accounting policies: Redeemable Shares All of the 31,625,000 Public Shares sold as part of the Public Offering contain a redemption feature as described in the Prospectus. In accordance with FASB ASC 480, “Distinguishing Liabilities from Equity”, redemption provisions not solely within the control of the Company require the security to be classified outside of permanent equity. The Charter provides a minimum net tangible asset threshold of $5,000,001. The Company recognizes changes in redemption value immediately as they occur and will adjust the carrying value of the security to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable shares will be affected by charges against additional paid-in capital. At December 31, 2019, there were 31,625,000 Public Shares, of which 30,181,451 were recorded as redeemable shares, classified outside of permanent equity, and 1,443,549 were classified as Class A common stock. Loss per Common Share Basic loss per common share is computed by dividing net income applicable to common stockholders by the weighted average number of common shares outstanding during the period. All Founders Shares are assumed to convert to shares of Class A common stock on a one-for-one basis. Consistent with FASB ASC 480, shares of Class A common stock subject to possible redemption, as well as their pro rata share of undistributed trust earnings consistent with the two-class method, have been excluded from the calculation of loss per common share for the year ended December 31, 2019. Such shares, if redeemed, only participate in their pro rata share of trust earnings. Diluted loss per share includes the incremental number of shares of common stock to be issued in connection with the conversion of Founders Shares or to settle warrants, as calculated using the treasury stock method. For the years ending December 31, 2019, 2018, and 2017, the Company did not have any dilutive warrants, securities or other contracts that could, potentially, be exercised or converted into common stock. As a result, diluted loss per common share is the same as basic loss per common share for all periods presented. For the year ended December 31, 2019, the Company reported a loss available to common shareholders of $0.02. 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 the accompanying financial statements.

<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. We consummated our initial Public Offering on May 9, 2019 and are currently in the process of locating suitable targets for our Business Combination. We intend to use the cash proceeds from our public offering and private placement of warrants as well as additional issuances, if any, of our capital stock, debt or a combination of cash, stock and debt to complete the Business Combination. We expect to incur significant costs in the pursuit of our acquisition plans. There can be no assurance that our plans to raise capital or to complete our initial Business Combination will be successful. Liquidity and Capital resources On May 9, 2019 we consummated a $316,250,000 public offering consisting of 31,625,000 units at a price of $10.00 per Unit. Each Unit consists of one share of the Company’s Class A common stock, $0.0001 par value and onethird of one redeemable Public Warrant. Simultaneously, with the closing of the Public Offering, we consummated a $8,825,000 Private Placement of an aggregate of 5,883,333 Sponsor Warrants at a price of $1.50 per warrant. Upon closing of the Public Offering and Private Placement on May 9, 2019, $316,250,000 in proceeds (including $11,068,750 of deferred underwriting commissions) from the public offering and private placement was placed in the Trust Account. The remaining $8,825,000 held outside of trust was used to pay underwriting commissions of $6,325,000, loans to our Sponsors, and deferred offering and formation costs. As of December 31, 2019, we had an unrestricted balance of $1,593,104 as well as cash and accrued interest held in the Trust Account of $319,901,512. Our working capital needs will be satisfied through the funds, held outside of the Trust Account, from the public offering. Interest on funds held in the Trust Account may be used to pay income taxes and franchise taxes, if any. Further, our Sponsors may, but are not obligated to, loan us funds as may be required in connection with the Business Combination. Up to $1,500,000 of these loans may be converted into warrants of the post Business Combination entity at a price of $1.50 per warrant at the option of the lender and would be identical to the Sponsor Warrants. Results of Operations We have neither engaged in any significant business operations nor generated any revenues to date. All activities to date relate to the Company’s formation and its initial Public Offering and search for a suitable Business Combination. We generate nonoperating income in the form of interest income on cash, cash equivalents, and marketable securities held in the Trust Account. 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 as we locate a suitable Business Combination. For the years ended December 31, 2019, 2018, and 2017, we had a net income of $2,499,733, $0 and $0, respectively. The income for the year ended December 31, 2019 relates to $3,651,511 in pretax earnings on the Trust Account assets offset by $377,292 of general and administrative costs and $110,000 of management fees for administrative services. OffBalance Sheet Arrangements We did not have any offbalance sheet arrangements as of December 31, 2019. Contractual Obligations As of December 31, 2019, we did not have [/INST] Positive. </s>

TFF Pharmaceuticals, Inc.

2020-03-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations General We were formed as a Delaware corporation on January 24, 2018 for the purpose of developing and commercializing innovative drug products based on our patented Thin Film Freezing, or TFF, technology platform”. Since our formation, we have focused on the development of our initial drug candidates, the establishment of strategic relationships with established pharmaceutical companies for the licensing of our TFF technology platform and the pursuit of additional working capital. We have not commenced revenue-producing operations. Since our organization in 2018, we have engaged in the following financing transactions: Series A Preferred Stock Placements. In March 2018, we conducted a private placement of 5,662,000 shares of our Series A preferred stock, at an offering price of $2.50 per share, for the gross proceeds of approximately $14.2 million, and in May 2019 we conducted a private placement of 3,268,000 shares of our Series A preferred stock, at an offering price of $2.50 per share, for the gross proceeds of approximately $8.2 million. The shares of our Series A preferred stock accumulated dividends at the rate of 6% per annum. The shares of Series A preferred stock, including all accrued but unpaid dividends on the Series A preferred stock, which totalled $1,603,709, automatically converted into 9,571,692 shares of our common stock concurrent with the completion of our initial public offering at the conversion price of $2.50. Initial Public Offering. On October 25, 2019, we conducted an initial public offering of 4,400,000 shares of common stock at a public offering price of $5.00 per share. After the payment of underwriter discounts and offering expenses, and after giving effect to the underwriters’ exercise of its overallotment option on November 20, 2019 to purchase an additional 479,300 shares of our common stock at the offering price of $5.00 per share, we received net proceeds of approximately $21.8 million. Results of Operations We were formed in January 2018 and have not commenced revenue-producing operations. To date, our operations have consisted of the development and early-stage testing of our initial product candidates. In connection with our organization on January 24, 2018, we entered into a Contribution and Subscription Agreement with Lung Therapeutics, Inc., or LTI, our former parent, pursuant to which we agreed to acquire from LTI certain of LTI’s non-core intellectual property rights and other assets, or the Acquired Assets, all of which relate to our Thin Film Freezing technology. We closed on the acquisition of the Acquired Assets concurrent with the close of the initial Series A preferred stock financing in March 2018. The operations surrounding the Acquired Assets are deemed to be our accounting predecessor and the results of operations in the financial summary below for the period January 1, 2018 through January 23, 2018 reflect the results of operations of the Acquired Assets, which were immaterial, as our predecessor. During the fiscal years ended December 31, 2019 and 2018, we incurred $8.8 million and $848,809 of research and development expenses and $3.2 million and $3.0 million of general and administrative expenses, respectively. The increase in research and development expenses during 2019 was due to the ramp-up of research and development activities following the completion of our funding in May 2019. We incurred a net loss applicable to common stockholders of $36.7 million and $4.6 million for the fiscal years ended December 31, 2019 and 2018, respectively. The increase in net loss applicable to common stockholders in 2019 was due to a deemed dividend of $24.0 million upon the conversion of our Series A preferred stock in October 2019. Financial Condition As of December 31, 2019, we had total assets of approximately $29.2 million and working capital of approximately $28.8 million. As of December 31, 2019, our liquidity included approximately $28.1 million of cash and cash equivalents. We believe that our cash on-hand as of the date of this report is sufficient to fund our proposed operating plan for, at least, the 12 months following the date of this report. However, as of the date of this report, we believe that we will ultimately need additional capital to fund our operations through to the marketing approval for TFF Vori and TFF Tac-Lac, assuming such approval can be obtained at all, and to engage in the substantial development of any other of our drug candidates, such as formulation, early stage animal testing and formal toxicology studies. We intend to seek additional funds through various financing sources, including the sale of our equity and debt securities, licensing fees for our technology and co-development and joint ventures with industry partners, with a preference towards licensing fees for our technology and co-development and joint ventures with industry partners. In addition, we will consider alternatives to our current business plan that may enable to us to achieve revenue producing operations and meaningful commercial success with a smaller amount of capital. However, there can be no guarantees that such funds will be available on commercially reasonable terms, if at all. If such financing is not available on satisfactory terms, we may be unable to further pursue our business plan and we may be unable to continue operations, in which case you may lose your entire investment. Cash Flows The following table sets forth a summary of our cash flows for the periods ended December 31, 2019 and 2018: (1) The period from January 1, 2018 through January 23, 2018 was not material The increase in cash used in operating activities is primarily a result of higher operating losses in 2019 due to our business expansion, including additional personnel and increased product candidate development activity. The financing activity primarily consists of the Series A preferred stock private placements in 2018, 2019 and the October 2019 initial public offering, or IPO. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, 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 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 3 to our consolidated financial statements included herein, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Stock-Based Compensation We compute stock-based compensation in accordance with authoritative guidance. We use the Black-Scholes-Merton option-pricing model to determine the fair value of its stock options. The Black-Scholes-Merton option-pricing model includes various assumptions, including the fair market value of our common stock, expected life of stock options, the expected volatility and the expected risk-free interest rate, among others. 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, stock-based compensation cost, as determined in accordance with authoritative guidance, could have been materially impacted. Furthermore, if we use different assumptions on future grants, stock-based compensation cost could be materially affected in future periods. We account for the fair value of equity instruments issued to non-employees using either the fair value of the services received or the fair value of the equity instrument, whichever is considered more reliable. We utilize the Black-Scholes-Merton option-pricing model to measure the fair value of options issued to non-employees. For grants prior to the IPO, the fair value of the common stock was determined by the board of directors based on a variety of factors, including valuations prepared by third parties, our financial position, the status of our development efforts, the current climate in the marketplace and the prospects of a liquidity event, among others. For grants after the IPO, we use the closing stock price on the date of grant as the fair value of the common stock. Research and Development Expenses In accordance with authoritative guidance, we charge research and development costs to operations as incurred. Research and development expenses consist of personnel costs for the design, development, testing and enhancement of our technology, and certain other allocated costs, such as depreciation and other facilities related expenditures. Common Stock Warrants We classify as equity any warrants that (i) require physical settlement or net-share settlement or (ii) provides us with a choice of net-cash settlement or settlement in its own shares (physical settlement or net-share settlement). We classify as assets or liabilities any contracts that (i) require net-cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside our control), (ii) gives the counterparty a choice of net-cash settlement or settlement in shares (physical settlement or net-share settlement) or (iii) that contain reset provisions that do not qualify for the scope exception. We assess classification of its common stock warrants and other freestanding derivatives at each reporting date to determine whether a change in classification between assets and liabilities is required. Our freestanding derivatives consist of warrants to purchase common stock that were issued in connection with services provided to us. We evaluated these warrants to assess their proper classification and determined that the common stock warrants meet the criteria for equity classification in the consolidated balance sheet. Such warrants are measured at fair value, which we determine using the Black-Scholes-Merton option-pricing model. Beneficial Conversion Feature On the date of the IPO, the outstanding Series A preferred stock, and related accrued and unpaid dividends, automatically converted into shares of our common stock. The conversion share calculation was based on the $2.50 initial issuance price for the Series A preferred stock plus any accrued but unpaid dividends and converted to common stock using a stated divisor conversion price equal to 50% of the IPO price to the public, which was $5.00 per share. In accordance with relevant accounting literature, since the stated terms of the conversion option did not permit us to compute the additional number of shares that it would need to issue upon conversion of the Series A preferred stock when the contingent event occurred, we recorded the beneficial conversion amount as a deemed dividend at the date of the IPO. Off Balance Sheet Transactions We do not have any off-balance sheet transactions.

<s>[INST] We were formed as a Delaware corporation on January 24, 2018 for the purpose of developing and commercializing innovative drug products based on our patented Thin Film Freezing, or TFF, technology platform”. Since our formation, we have focused on the development of our initial drug candidates, the establishment of strategic relationships with established pharmaceutical companies for the licensing of our TFF technology platform and the pursuit of additional working capital. We have not commenced revenueproducing operations. Since our organization in 2018, we have engaged in the following financing transactions: Series A Preferred Stock Placements. In March 2018, we conducted a private placement of 5,662,000 shares of our Series A preferred stock, at an offering price of $2.50 per share, for the gross proceeds of approximately $14.2 million, and in May 2019 we conducted a private placement of 3,268,000 shares of our Series A preferred stock, at an offering price of $2.50 per share, for the gross proceeds of approximately $8.2 million. The shares of our Series A preferred stock accumulated dividends at the rate of 6% per annum. The shares of Series A preferred stock, including all accrued but unpaid dividends on the Series A preferred stock, which totalled $1,603,709, automatically converted into 9,571,692 shares of our common stock concurrent with the completion of our initial public offering at the conversion price of $2.50. Initial Public Offering. On October 25, 2019, we conducted an initial public offering of 4,400,000 shares of common stock at a public offering price of $5.00 per share. After the payment of underwriter discounts and offering expenses, and after giving effect to the underwriters’ exercise of its overallotment option on November 20, 2019 to purchase an additional 479,300 shares of our common stock at the offering price of $5.00 per share, we received net proceeds of approximately $21.8 million. Results of Operations We were formed in January 2018 and have not commenced revenueproducing operations. To date, our operations have consisted of the development and earlystage testing of our initial product candidates. In connection with our organization on January 24, 2018, we entered into a Contribution and Subscription Agreement with Lung Therapeutics, Inc., or LTI, our former parent, pursuant to which we agreed to acquire from LTI certain of LTI’s noncore intellectual property rights and other assets, or the Acquired Assets, all of which relate to our Thin Film Freezing technology. We closed on the acquisition of the Acquired Assets concurrent with the close of the initial Series A preferred stock financing in March 2018. The operations surrounding the Acquired Assets are deemed to be our accounting predecessor and the results of operations in the financial summary below for the period January 1, 2018 through January 23, 2018 reflect the results of operations of the Acquired Assets, which were immaterial, as our predecessor. During the fiscal years ended December 31, 2019 and 2018, we incurred $8.8 million and $848,809 of research and development expenses and $3.2 million and $3.0 million of general and administrative expenses, respectively. The increase in research and development expenses during 2019 was due to the rampup of research and development activities following the completion of our funding in May 2019. We incurred a net loss applicable to common stockholders of $36.7 million and $4.6 million for the fiscal years ended December 31, 2019 and 2018, respectively. The increase in net loss applicable to common stockholders in 2019 was due to a deemed dividend of $24.0 million upon the conversion of our Series A preferred stock in October 2019. Financial Condition As of December 31, 2019, we had total assets of approximately $29.2 million and working capital of approximately $28.8 million. As [/INST] Positive. </s>

SpringWorks Therapeutics, Inc.

2020-03-12

2019-12-31

Item 7. Management’s discussion and analysis of financial conditions 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 the consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those identified below and those discussed in the section titled “Risk factors” and in other parts of this Annual Report. Overview We are a clinical-stage biopharmaceutical company applying a precision medicine approach to acquiring, developing and commercializing life-changing medicines for underserved patient populations suffering from devastating rare diseases and cancer. We have a differentiated portfolio of small molecule targeted oncology product candidates and are advancing two potentially registrational clinical trials in rare tumor types, as well as several other programs addressing highly prevalent, genetically defined cancers. Our strategic approach and operational excellence in clinical development have enabled us to rapidly advance our two lead product candidates into late-stage clinical trials while simultaneously entering into multiple shared-value partnerships with industry leaders to expand our portfolio. From this foundation, we are continuing to build a differentiated, global biopharmaceutical company intensely focused on understanding patients and their diseases in order to develop transformative targeted medicines. As described in Part I, Item 1. "Business," we currently have three product candidates in clinical development. Refer to Part I, Item 1. "Business" for a summary of our clinical programs. On September 12, 2019, we completed the initial public offering, or IPO, of our common stock. In connection with the IPO, we issued and sold 10,350,000 shares of our common stock at a price to the public of $18.00 per share. The net proceeds from the IPO were approximately $169.7 million after deducting underwriting discounts and commissions of $13.0 million and offering expenses of approximately $3.5 million. At the closing of the IPO, 196,076,779 shares of outstanding convertible preferred stock were automatically converted into 29,794,359 shares of common stock at a conversion rate of one-for-6.5810. Following the IPO, there were no shares of preferred stock outstanding. We were originally formed as SpringWorks Therapeutics, LLC, a Delaware limited liability company in August 2017. Concurrent with our formation, we acquired exclusive worldwide licenses to nirogacestat and mirdametinib from Pfizer. In September 2018, we announced that we entered into a global clinical collaboration with BeiGene to evaluate the combination of mirdametinib with BeiGene’s RAF dimer inhibitor, lifirafenib. From our inception to March 29, 2019, we conducted our business through SpringWorks Therapeutics, LLC and were treated as a partnership for income tax purposes. Pursuant to the terms of a corporate reorganization that was completed on March 29, 2019, all of the equity interests in SpringWorks Therapeutics, LLC were exchanged for the same number and class of newly issued securities of SpringWorks Therapeutics, Inc., and, as a result, SpringWorks Therapeutics, LLC became a wholly owned subsidiary of SpringWorks Therapeutics, Inc. Following the Reorganization, we now conduct our business as SpringWorks Therapeutics, Inc. Since our inception, our operations have been limited to organizing and staffing our company, business planning, raising capital and performing research and development of our product candidates, including nirogacestat for the treatment of desmoid tumors and mirdametinib for the treatment of NF1-PN. We do not have any products approved for commercial sale and have not generated any revenues. We had cash and cash equivalents of $327.7 million and $45.6 million as of December 31, 2019 and December 31, 2018, respectively. Since inception, we have funded our operations primarily with net proceeds of  $102.3 million from the sale of our Series A convertible preferred units prior to the Reorganization, $124.6 million in net proceeds from the sale of our Series B convertible preferred stock following the Reorganization and net proceeds of $169.7 from our IPO in September 2019. We believe that our cash and cash equivalents will enable us to fund our operational expenses and capital expenditure requirements through 2022. Since inception, we have incurred significant operating losses. Our net losses were $58.3 million, $17.8 million and $4.6 million for the years ended December 31, 2019 and December 31, 2018, and the period from August 18, 2017 (inception) to December 31, 2017, respectively. We had an accumulated deficit of $73.0 million and $22.5 million as of December 31, 2019 and December 31, 2018, respectively. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, we anticipate that our expenses will increase significantly in connection with our ongoing activities, as we: · advance our product candidates through clinical development, including our ongoing potentially registrational Phase 3 clinical trial for nirogacestat and planned potentially registrational Phase 2b clinical trial for mirdametinib; · advance our other preclinical and clinical development programs, including our combination therapies, into and through clinical development; · seek regulatory approvals for any product candidates that successfully complete clinical trials; · increase the amount of research and development activities to identify, acquire and develop product candidates; · hire additional clinical, quality control, medical, scientific and other technical personnel; · expand our operational, financial and management systems and increase personnel, including personnel to support our clinical development, manufacturing, business development and commercialization efforts and our operations as a public company; · maintain, expand and protect our intellectual property portfolio; · complete commercial-scale outsourced manufacturing activities; · establish sales, marketing and distribution capabilities for any product candidates for which we may receive regulatory approval in regions where we choose to commercialize our products on our own or jointly with third parties; and · invest in or in-license other technologies or product candidates. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for our product candidates. In addition, if we obtain regulatory approval for nirogacestat or mirdametinib, we expect to incur significant expenses related to developing our commercialization capabilities to support product sales, marketing and distribution activities, either alone or in collaboration with others. Our license and collaboration agreements Pfizer license agreements In August 2017, we entered into a license agreement, or the Nirogacestat License Agreement, with Pfizer pursuant to which we acquired exclusive worldwide rights to nirogacestat. We subsequently amended the Nirogacestat License Agreement in July of 2019 with regard to certain provisions relating to intellectual property. Pursuant to the Nirogacestat License Agreement, as amended, we are required to pay Pfizer payments of up to an aggregate of $232.5 million upon achievement of certain commercial milestone events. We will pay Pfizer tiered royalties on sales of nirogacestat at percentages ranging from the mid-single digits to the low 20s, which may be subject to deductions for expiration of valid claims, amounts due under third-party licenses and generic competition. In August 2017, we entered into a license agreement, or the Mirdametinib License Agreement, with Pfizer (collectively with the Nirogacestat License Agreement referred to as the “Pfizer License Agreements”) pursuant to which we acquired exclusive worldwide rights to mirdametinib. We subsequently amended the Mirdametinib License Agreement in August of 2019 with regard to certain provisions relating to intellectual property. Pursuant to the Mirdametinib License Agreement, as amended, we are required to pay Pfizer up to an aggregate of $229.8 million upon achievement of certain commercial milestone events. We will pay Pfizer tiered royalties on sales of mirdametinib at percentages ranging from the mid-single digits to the low 20s, which may be subject to deductions for expiration of valid claims, amounts due under third-party licenses and generic competition. In connection with entering into the Pfizer License Agreements, we issued an aggregate of 6,437,500 Junior Series A convertible preferred units to Pfizer, which units were converted into 6,437,500 shares of our Junior Series A convertible preferred stock pursuant to the Reorganization. At the closing of the IPO, the Junior Series A shares were automatically converted into shares of common stock at a conversion rate of 6.5810-for-one (or 978,194 common shares). As of December 31, 2019, we had not made any milestone or royalty payments under the Pfizer License Agreements. BeiGene clinical collaboration agreement In August 2018, we entered into a clinical collaboration agreement with BeiGene, or the BeiGene Collaboration Agreement, to evaluate the safety, tolerability and preliminary efficacy of combining lifirafenib and mirdametinib, in a Phase 1b clinical trial for patients with advanced or refractory solid tumors. Each party will be solely responsible for its costs associated with manufacturing and supply of its compound for the clinical trial. We and BeiGene will share equally the other costs associated with the clinical trial. GSK clinical trial collaboration and supply agreement In June 2019, we entered into the GSK Collaboration Agreement, to evaluate nirogacestat in combination with belantamab mafodotin in patients with relapsed or refractory multiple myeloma, in an adaptive Phase 1b clinical trial. We expect GSK to initiate the adaptive Phase 1b clinical trial evaluating the combination in the first quarter of 2020. GSK will be responsible for the conduct and expenses of the collaboration, which will be governed by a joint development committee with equal representation from each party. Allogene clinical trial collaboration and supply agreement In January 2020, we entered into the Allogene Collaboration Agreement, to evaluate nirogacestat in combination with ALLO-715, Allogene’s investigational allogeneic BCMA-targeted CAR-T cell product, in patients with relapsed or refractory multiple myeloma. Allogene is responsible for administering the Phase 1 clinical trial and is responsible for all costs associated with the direct conduct of the clinical trial, other than the manufacture and supply of nirogacestat and certain expenses related to intellectual property rights. The collaboration is managed by a joint development committee with equal representation by us and Allogene. See “Business-License and collaboration agreements” for more information on our license and collaboration agreements. 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 our current product candidates or additional product candidates that we may develop in the future are successful and can be commercialized, we may generate revenue in the future from product sales. Additionally, we may enter into collaboration and license agreements from time to time that provide for certain payments due to us. Accordingly, we may generate revenue from such collaboration or license agreements in the future. Research and development expenses Our research and development expenses consist of expenses incurred in connection with the development of our product candidates. These expenses include: · employee-related expenses, which include salaries, benefits and stock-based compensation for our research and development personnel; · fees paid to consultants for services directly related to our research and development programs; · expenses incurred under agreements with third-party contract research organizations, investigative clinical trial sites and consultants that conduct research and development activities on our behalf; · costs associated with preclinical studies and clinical trials; · costs associated with the manufacture of drug substance and finished drug product for preclinical testing and clinical trials; · costs associated with technology and intellectual property licenses; and · an allocated portion of facilities and facility-related costs, which include expenses for rent and other facility-related costs and other supplies. Expenditures for clinical development, including upfront licensing fees and milestone payments associated with our product candidates, are charged to research and development expense as incurred. These expenses consist of expenses incurred in performing development activities, including salaries and benefits, materials and supplies, preclinical expenses, clinical trial and related clinical manufacturing expenses, depreciation of equipment, contract services and other outside expenses. Costs for certain development activities, such as manufacturing and clinical trials, are recognized based on an evaluation of the progress to completion of specific tasks using either time-based measures or data such as information provided to us by our vendors on their actual costs incurred. We expect our research and development expenses to increase substantially for the foreseeable future as we continue to invest in activities related to developing our product candidates and our preclinical programs and as certain product candidates advance into later stages of development, including our ongoing potentially registrational Phase 3 clinical trial for nirogacestat and planned potentially registrational Phase 2b clinical trial for mirdametinib. The process of conducting the necessary clinical trials to obtain regulatory approval is costly and time-consuming, and the successful development of our product candidates is highly uncertain. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. General and administrative expenses General and administrative expenses consist primarily of salaries and related costs, including stock-based compensation, 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; and facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support our continued 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 being a public company. Other income (expense) Other income consists primarily of interest income. Interest income consists of interest earned on our cash equivalents, which consist of money market funds. We expect our interest income to increase due to our investment of cash received from the final closing of our last tranche of Series A convertible preferred units in March 2019, the sale of Series B convertible preferred stock in March 2019, as well as the net proceeds from our IPO. Income taxes Income taxes are accounted for using 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 basis and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. Changes in deferred tax assets and liabilities are recorded in the provision for income taxes. We recognize deferred tax assets to the extent that we believe that these assets are more likely than not to be realized. In making such a determination, management considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies and results of recent operations. Valuation allowances are provided, if based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. If management determines that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, management would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. We record uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) management determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, management recognizes the largest amount of tax benefit that is more than 50% likely to be realized upon ultimate settlement with the related tax authority. We provide reserves for potential payments of tax to various tax authorities related to uncertain tax positions. These reserves are based on a determination of whether and how much of a tax benefit taken by us in its filings or positions is more likely than not to be realized following resolution of any potential contingencies related to the tax benefit. Potential interest related to the underpayment of income taxes will be classified as a component of income tax expense and any related penalties will be classified in income tax expenses in the statement of operations. SpringWorks Therapeutics, LLC elected to be treated under the partnership provisions of the Internal Revenue Service Code prior to the reorganization in March 29, 2019. However, its five wholly owned subsidiaries, SpringWorks Operating Company, SpringWorks Subsidiary 1, SpringWorks Subsidiary 2, SpringWorks Subsidiary 3, and SpringWorks Subsidiary 4, or the Combined Subsidiaries, are taxable corporations. Subsequent to the Reorganization, SpringWorks Therapeutics, Inc. became the 100% owner of SpringWorks Therapeutics, LLC, creating a new ultimate parent company, and a consolidated group for income tax reporting. The Reorganization and change in tax status of the reporting entity did not have an impact on the consolidated tax provision. As of December 31, 2019, we had federal, state and city net operating loss carryforwards of $75.7 million, $0.6 million and $3.8 million, respectively, which are available to reduce future taxable income. Federal net operating loss carryforwards of $55.4 million and $16.0 million reported in 2019 and 2018, will be available to offset 80% of taxable income for an indefinite period of time, until fully utilized. Federal net operating loss carryforwards of $4.3 million were reported in 2017 and the state and city net operating loss carryforwards expire at various dates through 2038. The Combined Subsidiaries also have federal tax credits of $0.8 million, which may be used to offset future tax liabilities. These tax credit carryforwards will expire in 2038. 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. Research and development expenses The increase in research and development expense was primarily attributable to the following: · An increase of $25.2 million in external costs related to trial and drug manufacturing costs. · An increase of $6.7 million increase in personnel and related costs due to increased number of employees. A significant portion of our research and development costs have been external costs, which we track on a program-by-program basis after a clinical product candidate has been identified. Our internal research and development costs are primarily personnel-related costs, depreciation and other indirect costs. We do not track our internal research and development expenses on a program-by-program basis as they are deployed across multiple projects under development. These external and internal research and development expenses are summarized by program in the table below: General and administrative expenses General and administrative expenses were $16.7 million and $8.6 million for the years ended December 31, 2019 and December 31, 2018, respectively, as follows: The increase in personnel-related costs of $2.7 million was primarily due to the hiring of additional personnel in our general and administrative functions as we continued to expand our operations to support the organization. The increase in equity-based compensation expense of $1.5 million was primarily due to stock incentive awards granted to employees and directors. The increase in professional and consulting fees of $2.8 million was primarily due to consulting fees for market research and commercial planning efforts. Interest income Interest income was $3.5 million and $0.7 million for the years ended December 31, 2019, and December 31, 2018, respectively, with the increase year over year due to higher cash balances in 2019. Comparison of the year ended December 31, 2018 and the period from August 18, 2017 (inception) to December 31, 2017 We commenced operations in August 2017. Accordingly, our consolidated financial statements and results of operations for the period from our inception through December 31, 2017 reflect only approximately three and a half months of operations. For that reason, there is limited comparability of our results of operations for the year ended December 31, 2018 with the period from inception through December 31, 2017. The following table summarizes our results of operations for the year ended December 31, 2018 and the period from August 18, 2017 (inception) to December 31, 2017: Research and development expenses Research and development expenses were $9.9 million and $2.8 million for the year ended December 31, 2018 and the period from August 18, 2017 (inception) to December 31, 2017, respectively. This increase was primarily related to higher research and manufacturing costs of  $4.1 million to further progress the development activities for our product candidates, including preparations for clinical trials; higher personnel-related costs of $2.6 million; and additional consulting and recruiting fees of  $1.6 million, primarily due to hiring of key positions and consulting expenses. These increases were offset by $2.0 million of expenses incurred in 2017 related to the issuance of Junior Series A convertible preferred units in connection with the execution of the Pfizer License Agreements. We track outsourced development and manufacturing costs as well as personnel costs and other internal costs to specific development of product candidates. These external and internal research and development expenses are summarized by program in the table below: General and administrative expenses General and administrative expenses were $8.6 million and $1.9 million for the year ended December 31, 2018 and the period from August 18, 2017 (inception) to December 31, 2017, respectively. The increase in personnel-related costs of  $2.7 million was primarily due to the hiring of key executives in 2018, including the appointment of our Chief Executive Officer, Chief Business Officer, Chief Medical Officer and General Counsel, as well as additional personnel in our general and administrative functions as we continued to expand our operations to support the organization. The increase in equity-based compensation expense of $0.9 million was primarily due to incentive units granted to certain executives in 2018. The increase in professional and consulting fees of $2.3 million was primarily due to outsourcing various general and administrative activities to third parties. Interest income Interest income for the year ended December 31, 2018 was $0.7 million due to interest earned on invested cash balances. Liquidity and capital resources Sources of Liquidity Since inception, we have funded our operations primarily with net proceeds of  $102.3 million from the sale of our Series A convertible preferred units, net proceeds of  $124.6 million from the sale of our Series B convertible preferred stock, and net proceeds of $169.7 from our initial public offering in September 2019. At December 31, 2019, we had available cash and cash equivalents of $327.7 million. We have incurred operating losses and experienced negative operating cash flows since our inception and anticipate that we will continue to incur losses for at least the foreseeable future. Our net loss was $58.3 million and $17.8 million for the years ended December 31, 2019 and December 31, 2018, respectively. We had an accumulated deficit of $73.0 million and $22.5 million at December 31, 2019 and December 31, 2018, respectively. Funding requirements Our primary use of cash is to fund operating expenses, primarily research and development 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, accrued expenses and prepaid expenses. We believe that our cash and cash equivalents as of December 31, 2019, will be sufficient to fund our operating expenses and capital expenditure requirements through 2022. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Our future funding requirements will depend on many factors, including the following: · the initiation, progress, timing, costs and results of preclinical studies and clinical trials for our product candidates, including our ongoing potentially registrational Phase 3 clinical trial for nirogacestat and planned potentially registrational Phase 2b clinical trial for mirdametinib; · the clinical development plans we establish for these product candidates; · the number and characteristics of product candidates that we develop; · the outcome, timing and cost of meeting regulatory requirements established by the FDA, EMA and other comparable foreign regulatory authorities; · the terms of our existing and any future license or collaboration agreements we may choose to enter into, including the amount of upfront, milestone and royalty obligations; · the other costs associated with in-licensing new technologies, such as any increased costs of research and development and personnel; · the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; · the cost of defending intellectual property disputes, including patent infringement actions brought by third parties against us or our product candidates; · the effect of competing technological and market developments; · the cost and timing of completion of commercial-scale outsourced manufacturing activities; and · the cost of establishing sales, marketing and distribution capabilities for any product candidates for which we may receive regulatory approval in regions where we choose to commercialize our products on our own. · the degree of commercial success achieved following the successful completion of development and regulatory approval activities for a product candidate. We will need additional funds to meet operational needs and capital requirements for clinical trials, other research and development expenditures, and business development activities. 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 clinical studies. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our operations through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, current ownership interests will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of common stockholders. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or drug candidates, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate our research, product development or future commercialization efforts, or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Cash flows The following table summarizes our sources and uses of cash for each of the periods presented: Cash flows used in operating activities Net cash used in operating activities was $47.5 million, $14.2 million, and $2.2 million for the years ended December 31, 2019 and December 31, 2018, and the period from August 18, 2017 (inception) to December 31, 2017, respectively. Cash used in operating activities for the year ended December 31, 2019, was primarily due to our net loss for the year of $58.3 million, adjusted by non-cash charges of $5.9 million and a net change of $4.9 million in our net operating assets and liabilities. The non-cash charges primarily consisted of $3.1 million for equity-based compensation expense and the equity investment loss associated with our investment in MapKure of $2.6 million. The change in our net operating assets and liabilities was primarily due to an increase of $8.3 million in accounts payable and accrued expenses, partially offset by a $3.0 million increase of prepaid expenses and other non-current assets. Cash used in operating activities for the year ended December 31, 2018, was primarily due to our net loss for the year of $17.8 million, adjusted by non-cash charges of $1.1 million and a net change of $2.6 million in our net operating assets and liabilities. The non-cash charges primarily consisted of $1.1 million for equity-based compensation expense. The change in our net operating assets and liabilities was primarily due to an increase of $2.7 million in accounts payable and accrued expenses and a $1.5 million increase in deferred rent, partially offset by a $1.6 million increase of prepaid expenses and other non-current assets. Cash used in operating activities for the period from August 18, 2017 (inception) to December 31, 2017 was primarily due to our net loss for the year of $4.6 million, adjusted by non-cash charges of $2.0 million and net change of $0.4 million in our net operating assets and liabilities. The non-cash charges primarily consisted of $2.0 million for the issuance of Junior Series A convertible preferred units in connection with the execution of the Pfizer licenses. The change in our net operating assets and liabilities was primarily due to an increase of $0.7 million in accounts payable and accrued expenses, partially offset by a $0.3 million increase prepaid expenses. Cash flows from investing activities Cash used in investing activities was $4.3 million for the year ended December 31, 2019, primarily related to the $3.6 million investment in MapKure and $0.7 million related to the purchase of property and equipment. Cash used in investing activities was $0.3 million, for the year ended December 31, 2018, related to purchases of property and equipment. Cash used in investing activities was less than $0.1 million for the period from August 18, 2017 (inception) to December 31, 2017. Cash flows provided by financing activities Net cash provided by financing activities was $333.7 million for the year ended December 31, 2019 and $50.4 million for the year ended December 31, 2018. Net cash provided by financing activities for the year ended December 31, 2019 consisted primarily of proceeds from Series A and B convertible preferred and the IPO. Net cash provided by financing activities for the year ended December 31, 2018 consisted primarily of proceeds from Series A convertible preferred. During the period from August 18, 2017 (inception) to December 31, 2017, cash provided by financing activities was $12.6 million from the issuance of Series A convertible preferred units. Contractual obligations and other commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1) Amounts in the table reflect payments due for our facility in Durham, North Carolina and our headquarters in Stamford, Connecticut under operating lease agreements that expire in August 2023 and November 2022, respectively. We enter into contracts in the normal course of business with third-party contract research organizations for clinical trials, preclinical studies, 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 and they are not included in the table above. We have not included milestone or royalty payments or other contractual payment obligations in the table above if the timing and amount of such obligations are unknown or uncertain. We have not recorded any reserves for uncertain tax positions as of December 31, 2019. Off-balance sheet arrangements We have not entered into any off-balance sheet arrangements and do not have holdings in any variable interest entities. Critical accounting policies and estimates This 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 U.S. 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 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. While our significant accounting policies are described in more detail in Note 3 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 costs We record accrued expenses for estimated costs of our research and development activities conducted by third-party service providers, which include the conduct of clinical trials and preclinical studies. 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 liabilities in the consolidated balance sheets and within research and development expense in the statement of operations. These costs are a significant component of our research and development expenses. We record accrued expenses for these costs based on factors such as estimates of the work completed and in accordance with agreements established with these third-party service providers. Any payments made in advance of services provided are recorded as prepaid assets, which are then expensed as the contracted services are performed. We estimate the amount of work completed based on discussions with internal personnel and external service providers as to the progress or stage of completion of the services and the agreed-upon fee to be paid for such services. We make significant judgments and estimates in determining the accrued balance in each reporting period. As actual costs become known, we adjust our accrued estimates. 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, the number of patients enrolled and the rate of patient enrollment may vary from our estimates and could result in us reporting amounts that are too high or too low in any particular period. Our accrued expenses are dependent, in part, upon the receipt of timely and accurate reporting from clinical research organizations and other third-party service providers. To date, we have experienced no material differences between our accrued expenses and actual expenses. Equity-based compensation We account for employee equity-based compensation in accordance with Financial Accounting Standards Board Accounting Standards Codification Topic (“ASC”) 718, Compensation - Stock Compensation. ASC 718 requires all equity-based awards to employees and non-employee directors to be recognized as expense in the statement of operations based on the grant date fair value of the common and incentive unit, unit option, restricted stock and stock option awards. Equity-based awards vest over a four-year period. Generally, onboarding equity-based awards vest with the first 25% vesting following 12 months of employment or service and the remaining vesting in equal monthly installments over the following 36 months. Certain awards are subject to performance conditions and/or market conditions. Stock compensation expense is recognized using the straight-line method, based on the grant date fair value, over the requisite service period of the award, which is generally the vesting term. For awards subject to performance conditions, as well as awards containing both market and performance conditions, we recognize equity award compensation expense using an accelerated recognition method over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions as of the reporting date. We recognize forfeitures at the time of the actual forfeiture event in accordance with the adoption of the guidance per Accounting Standard Update (“ASU”) No. 2016-09. The grant-date fair value of performance-based awards with market conditions is estimated using a Monte Carlo simulation method that incorporates the probability of the performance conditions being met as of the grant date. For stock options issued, we estimate the grant date fair value and the resulting stock-based compensation expense using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of subjective assumptions which determine the fair value of stock-based awards, including the expected term and the price volatility of the underlying stock. These assumptions include: · Fair value of common stock. · Expected term - The expected term represents the period that the equity-based awards are expected to be outstanding. The expected term for our stock options is calculated using the simplified method. · Expected volatility - We lack company-specific historical and implied volatility information. Therefore, it estimates its expected stock volatility based on the historical volatility of a publicly traded set of peer companies and expects to continue to do so until it has adequate historical data regarding the volatility of its own traded stock. · Risk-free interest rate - The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant for zero-coupon U.S. Treasury notes with maturities approximately equal to the expected term of the awards. · Expected dividend - We have never paid dividends on its common units or stock and has no plans to pay dividends on its common stock. Therefore, the expected dividend yield is zero. For equity-based compensation grants prior to the IPO, the Company estimated the fair value of equity awards granted using the special case of the market approach, including the guideline public company method and precedent transaction method which is known as a backsolve method. This option pricing model was utilized to solve for the implied total equity value that was consistent with the Company’s Series A convertible preferred units “backsolves” to a preferred share price. The backsolve method derives the implied equity value for one type of equity security from a contemporaneous transaction involving another type of security to calculate the equity value. The use of these valuation approaches required management to make assumptions with respect to the expected volatility of its units and stock, time until a liquidity event and risk-free interest rates. Equity value was allocated to the common, incentive and convertible preferred units, and common, restricted and convertible preferred stock using an option-pricing method. Under this method, the common and incentive units and common stock would have had value only if the funds available for distribution exceeded the value of the convertible preferred units’ liquidation preferences at the anticipated time of a liquidity event, such as a strategic sale, merger or IPO. Stock-based compensation expense was $3.1 million, $1.1 million and $0, for the years ended December 31, 2019 and December 31, 2018, and the period from August 18, 2017 (inception) to December 31, 2017, respectively. Recent accounting pronouncements See Note 3 to our consolidated financial statements “Summary of Significant Accounting Policies-Recently Issued Accounting Pronouncements” for more information. Emerging growth company status and JOBS Act accounting election We are an “emerging growth company” or EGC, as defined in the Jumpstart Our Business Startups Act of 2012. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year (a) following the fifth anniversary of the completion of our initial public offering in September 2019, (b) in which we have total annual gross revenue of at least $1.07 billion, or (c) in which we are deemed to be a large accelerated filer, which means we have been subject to the reporting requirements of the Exchange Act for twelve calendar months and the market value of our common stock that is held by non-affiliates exceeded $700.0 million as of the prior June 30th, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period. We refer to the Jumpstart Our Business Startups Act of 2012 in this Annual Report as the “JOBS Act,” and references to “emerging growth company” have the meaning associated with it in the JOBS Act.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company applying a precision medicine approach to acquiring, developing and commercializing lifechanging medicines for underserved patient populations suffering from devastating rare diseases and cancer. We have a differentiated portfolio of small molecule targeted oncology product candidates and are advancing two potentially registrational clinical trials in rare tumor types, as well as several other programs addressing highly prevalent, genetically defined cancers. Our strategic approach and operational excellence in clinical development have enabled us to rapidly advance our two lead product candidates into latestage clinical trials while simultaneously entering into multiple sharedvalue partnerships with industry leaders to expand our portfolio. From this foundation, we are continuing to build a differentiated, global biopharmaceutical company intensely focused on understanding patients and their diseases in order to develop transformative targeted medicines. As described in Part I, Item 1. "Business," we currently have three product candidates in clinical development. Refer to Part I, Item 1. "Business" for a summary of our clinical programs. On September 12, 2019, we completed the initial public offering, or IPO, of our common stock. In connection with the IPO, we issued and sold 10,350,000 shares of our common stock at a price to the public of $18.00 per share. The net proceeds from the IPO were approximately $169.7 million after deducting underwriting discounts and commissions of $13.0 million and offering expenses of approximately $3.5 million. At the closing of the IPO, 196,076,779 shares of outstanding convertible preferred stock were automatically converted into 29,794,359 shares of common stock at a conversion rate of onefor6.5810. Following the IPO, there were no shares of preferred stock outstanding. We were originally formed as SpringWorks Therapeutics, LLC, a Delaware limited liability company in August 2017. Concurrent with our formation, we acquired exclusive worldwide licenses to nirogacestat and mirdametinib from Pfizer. In September 2018, we announced that we entered into a global clinical collaboration with BeiGene to evaluate the combination of mirdametinib with BeiGene’s RAF dimer inhibitor, lifirafenib. From our inception to March 29, 2019, we conducted our business through SpringWorks Therapeutics, LLC and were treated as a partnership for income tax purposes. Pursuant to the terms of a corporate reorganization that was completed on March 29, 2019, all of the equity interests in SpringWorks Therapeutics, LLC were exchanged for the same number and class of newly issued securities of SpringWorks Therapeutics, Inc., and, as a result, SpringWorks Therapeutics, LLC became a wholly owned subsidiary of SpringWorks Therapeutics, Inc. Following the Reorganization, we now conduct our business as SpringWorks Therapeutics, Inc. Since our inception, our operations have been limited to organizing and staffing our company, business planning, raising capital and performing research and development of our product candidates, including nirogacestat for the treatment of desmoid tumors and mirdametinib for the treatment of NF1PN. We do not have any products approved for commercial sale and have not generated any revenues. We had cash and cash equivalents of $327.7 million and $45.6 million as of December 31, 2019 and December 31, 2018, respectively. Since inception, we have funded our operations primarily with net proceeds of  $102.3 million from the sale of our Series A convertible preferred units prior to the Reorganization, $124.6 million in net proceeds from the sale of our Series B convertible preferred stock following the Reorganization and net proceeds of $169.7 from our IPO in September 2019. We believe that our cash and cash equivalents will enable us to fund our operational expenses and capital expenditure requirements through 2022. Since inception, [/INST] Negative. </s>

Insurance Acquisition Corp.

2020-03-25

2019-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. All statements other than statements of historical fact included in this Annual Report on Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding 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 Annual 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 Annual 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 March 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 target businesses. We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of the placement units that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a business combination: ● may significantly dilute the equity interest of investors; ● 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 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 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 and the lender demands payment; ● limitations on our ability to obtain additional financing if the debt security contains covenants restricting our ability to incur debt; ● our inability to pay dividends on our common stock due to covenants limiting or prohibiting dividends; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce, or possibly eliminate, the funds available for use as dividends on our common stock, 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 not generated any revenues to date. Our only activities from inception to December 31, 2019 were organizational activities, those necessary to prepare for the initial public offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities held in the trust account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with completing a business combination. For the year ended December 31, 2019, we had net income of $1,325,822, which consisted of interest income on marketable securities held in the trust account of $2,593,286, offset by operating costs of $764,976 and a provision for income taxes of $502,488. For the period from March 13, 2018 (inception) through December 31, 2018, we had a net loss of $1,669, which consisted of operating costs of $1,669. Liquidity and Capital Resources On March 22, 2019, we consummated the initial public offering of 15,065,000 units, which included the full exercise by the underwriters of their over-allotment option in the amount of 1,965,000 units, at $10.00 per unit, generating gross proceeds of $150,650,000. Simultaneously with the closing of the initial public offering, we consummated the sale of 425,000 placement units to the sponsor and Cantor Fitzgerald at a price of $10.00 per unit, generating gross proceeds of $4,250,000. Following the initial public offering and the sale of the placement units, a total of $150,650,000 was placed in the trust account and we had $1,048,801 of cash held outside of the trust account, after payment of costs related to the initial public offering, and available for working capital purposes. We incurred $9,661,484 in transaction costs, related to the initial public offering, including $2,620,000 of underwriting fees, $6,419,000 of deferred underwriting fees and $622,484 of other costs. For the year ended December 31, 2019, cash used in operating activities was $629,588, which was comprised of our net income of $1,325,822, interest earned on marketable securities held in the trust account of $2,593,286 and changes in operating assets and liabilities, which provided $637,876 of cash for operating activities. As of December 31, 2019, we had marketable securities held in the trust account of $153,238,186 (including approximately $2,588,000 of interest income) 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 withdrew $5,100 of interest earned on the trust account to pay our 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 amounts released to us to pay taxes and deferred underwriting commissions) to consummate our business combination. To the extent that our capital stock or debt is used, in whole or in part, as consideration to consummate 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 $406,724 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, production facilities 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 requirements or finance transaction costs in connection with a business combination, our sponsor or one of its affiliates has committed to loan us funds as may be required up to a maximum of $750,000, and may, but is not obligated to, loan us additional funds to fund our additional working capital requirements and transaction costs. 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 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 to identify and acquire a target business. However, if our estimate of the costs of undertaking due diligence investigations and negotiating a business combination is less than the actual amount necessary to do so, we may have insufficient funds available to pursue and consummate our business combination. Moreover, we may need to obtain additional financing if 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. Subject to compliance with applicable securities laws, we would only obtain such financing simultaneously with the consummation of our 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, 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 March 19, 2019 and will continue to incur these fees monthly until the earlier of the completion of the business combination and our liquidation. In addition, we have an agreement to pay the underwriters a deferred fee of $6,419,000. The deferred fee will become payable to the underwriters’ representative 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 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 loss per common share, basic and diluted for Class A and 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 A and 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 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 our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Annual Report. 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 March 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 target businesses. We intend to effectuate our business combination using cash from the proceeds of our initial public offering and the sale of the placement units that occurred simultaneously with the completion of our initial public offering, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our stock in a business combination: may significantly dilute the equity interest of investors; 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 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 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 and the lender demands payment; limitations on our ability to obtain additional financing if the debt security contains covenants restricting our ability to incur debt; our inability to pay dividends on our common stock due to covenants limiting or prohibiting dividends; using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce, or possibly eliminate, the funds available for use as dividends on our common stock, 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 not generated any revenues to date. Our only activities from inception to December 31, 2019 were organizational activities, those necessary to prepare for the initial public offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate nonoperating 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 $1,325,822, which consisted of interest income on marketable securities held in the trust account of $2,593,286, offset by operating costs of $764,976 and a provision for income taxes of $502,488. [/INST] Negative. </s>

Intelsat S.A.

2020-02-20

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This discussion should be read together with Item 6 - Selected Financial Data and our audited consolidated financial statements and notes thereto included in Item 8 - Financial Statements and Supplementary Data of this Annual Report. Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, and, unless otherwise indicated, the other financial information contained in this Annual Report has also been prepared in accordance with U.S. GAAP. See “Forward-Looking Statements” and Item 1A - Risk Factors, for a discussion of factors that could cause our future financial condition and results of operations to be different from those discussed below. Certain monetary amounts, percentages and other figures included in this Annual Report have been subject to rounding adjustments. Accordingly, figures shown as totals in certain tables may not be the arithmetic aggregation of the figures that precede them, and figures expressed as percentages in the text may not total 100% or, as applicable, when aggregated may not be the arithmetic aggregation of the percentages that precede them. Unless otherwise indicated, all references to “dollars” and “$” in this Annual Report are to, and all monetary amounts in this Annual Report are presented in, U.S. dollars. Overview We operate one of the world’s largest satellite services businesses, providing a critical layer in the global communications infrastructure. We provide diversified communications services to the world’s leading media companies, fixed and wireless telecommunications operators, data networking service providers for enterprise and mobile applications in the air and on the seas, multinational corporations and ISPs. We are also the leading provider of commercial satellite capacity to the U.S. government and other select military organizations and their contractors. Our customers use our global network for a broad range of applications, from global distribution of content for media companies to providing the transmission layer for commercial aeronautical consumer broadband connectivity, to enabling essential network backbones for telecommunications providers in high-growth emerging regions. Our network solutions are a critical component of our customers’ infrastructures and business models. Generally, our customers need the specialized connectivity that satellites provide so long as they are in business or pursuing their mission. In recent years, mobility services providers have contracted for services on our fleet that support broadband connections for passengers on commercial flights and cruise ships, connectivity that in some cases is only available through our network. In addition, our satellite neighborhoods provide our media customers with efficient and reliable broadcast distribution that maximizes audience reach, a technical and economic benefit that is difficult for terrestrial services to match. In developing regions, our satellite solutions often provide higher reliability than is available from local terrestrial telecommunications services and allow our customers to reach geographies that they would otherwise be unable to serve. Revenue Revenue Overview We earn revenue primarily by providing services over satellite transponder capacity to our customers. Our customers generally obtain satellite capacity from us by placing an order pursuant to one of several master customer service agreements. The master customer agreements and related service orders under which we sell services specify, among other things, the amount of satellite capacity to be provided, whether service will be non-preemptible or preemptible and the service term. Most services are full time in nature, with service terms ranging from one year to as long as 16 years. Occasional use services used for video applications can be for much shorter periods, including increments of one hour. Our master customer service agreements offer different service types, including transponder services, managed services, and channel, which are all services that are provided on, or used to provide access to, our global network. We refer to these services as on-network services. Our customer agreements also cover services that we procure from third parties and resell, which we refer to as off-network services. These services can include transponder services and other satellite-based transmission services sourced from other operators, often in frequencies not available on our network, and other operational fees related to satellite operations provided on behalf of third-party satellites. The following table describes our primary service types: Service Type Description On-Network Revenues: Transponder Services Commitments by customers to receive service via, or to utilize capacity on, particular designated transponders according to specified technical and commercial terms. Transponder services also include revenues from hosted payload capacity. Transponder services are marketed to each of our primary customer sets as follows: •Network Services: fixed and wireless telecom operators, data network operators, enterprise operators of private data networks, and value-added network operators for fixed and mobile broadband network infrastructure. •Media: broadcasters (for distribution of programming and full time contribution, or gathering, of content), programmers and DTH operators. •Government: civilian and defense organizations, for use in implementing private fixed and mobile networks, or for the provision of capacity or capabilities through hosted payloads. Managed Services Hybrid services primarily using IntelsatOne, including our IntelsatOne Flex broadband platform, which combine satellite capacity, teleport facilities, satellite communications hardware such as broadband hubs or video multiplexers and fiber optic cable and other ground facilities to provide managed and monitored broadband, trunking, video and private network services to customers. Managed services are marketed to each of our customer sets as follows: •Network Services: enterprises, cellular operators and fixed and mobile value-added service providers which deliver end-services such as private data networks, wireless infrastructure and maritime and aeronautical broadband. •Media: programmers outsourcing elements of their transmission infrastructure and part time occasional use services used primarily by news and sports organizations to gather content from remote locations. •Government: users seeking secured, integrated, end-to-end solutions. Channel Standardized services of predetermined bandwidth and technical characteristics primarily used for point-to-point bilateral services for telecommunications providers. Channel is not considered a core service offering due to changing market requirements and the proliferation of fiber alternatives for point-to-point customer applications. Channel services are exclusively marketed to traditional telecommunications providers in our network services customer set. Transponder, Mobile Satellite Services and Other Capacity for voice, data and video services provided by third-party commercial satellite operators for which the desired frequency type or geographic coverage is not available on our network. These services include L-band MSS, for which Intelsat General is a reseller. In addition, this revenue category includes the sale of customer premises equipment and other hardware, as well as certain fees related to services provided to other satellite operators. These products are primarily marketed as follows: •Government: direct government users, and government contractors working on programs where aggregation of capacity is required. Satellite-related Services Services include a number of satellite-related consulting and technical services that involve the lifecycle of satellite operations and related infrastructure, from satellite and launch vehicle procurement through TT&C services and related equipment sales. These services are typically marketed to other satellite operators. We market our services on a global basis, with almost every populated region of the world contributing to our revenue. The diversity of our revenue allows us to benefit from changing market conditions and lowers our risk from revenue fluctuations in our service applications and geographic regions. Trends Impacting Our Revenue Our revenue at any given time is dependent upon a number of factors, including, but not limited to, demand for our services from existing and emerging applications; the supply of capacity available on our fleet and those of our competitors in a given region, and the substitution of competing technologies such as fiber optic cable networks. See Item 1 - Business-Our Sector for a discussion of the global trends creating demand for our services. Trends in revenue can be impacted by: • Growth in demand from wireless telecommunications companies seeking to complete or enhance broadband infrastructure, particularly those operating in developing regions or regions with geographic challenges; • Growth in demand for broadband connectivity for enterprises and government organizations, providing fixed and mobile services and value-added applications on a global basis; • Lower overall pricing for satellite-based services, resulting from oversupply of wide beam capacity or due to the introduction of high-throughput technology, which is designed to achieve a lower cost per unit; • Lower demand for satellite-based solutions, resulting from fiber substitution; • Satellite capacity needed to provide broadband connectivity for mobile networks on ships, planes and oil and gas platforms; • Global demand for television content in SD, HD and UHD television formats, which uses our satellite network and IntelsatOne terrestrial services for distribution, in some regions offset by next generation compression technologies; • Increased popularity of OTT content distribution, which will increase the demand for broadband infrastructure in the developing world, but could decrease demand in developed markets over the mid to long-term as niche and ethnic programming transitions from satellite to internet distribution; • Use of commercial satellite services by governments for military and other operations, which has partially slowed as a result of the tempo of military operations and recent changes in the U.S. budget; and • Our use of third-party or off-network services to satisfy government demand for capacity not available on our network. These services are low risk in nature, with no required upfront investment and terms and conditions of the procured capacity which typically match the contractual commitments from our customers. Demand for certain of these off-network services has declined with reductions in troop deployment in regions of conflict. See Item 1 - Business-Our Customer Sets and Growing Applications for a discussion of our customers’ uses of our services and see Item 1 - Business-Our Strategy for a discussion of our strategies with respect to marketing to our various customer sets. Customer Applications Our transponder services, managed services, MSS and channel are used by our customers for three primary customer applications: network service applications, media applications and government applications. Pricing Pricing of our services is based upon a number of factors, including, but not limited to, the region served by the capacity, the power and other characteristics of the satellite beam, the amount of demand for the capacity available on a particular satellite and the total supply of capacity serving any particular region. In 2019, pricing trends varied by application, but were fairly stable throughout the year overall. Slight declines in network services were fueled by lower pricing on high volume commitments leveraging our global wide beam and Intelsat Epic fleets for large mobile network operators, balanced by relatively stable pricing for mobility customers. Government applications commanded competitive prices due to lowest price technically acceptable policies in some regions, but continued to command a premium in coverage areas with limited capacity. Media application pricing was stronger in 2019 as compared to 2018, but demand faces pressure from competing lower-cost terrestrial alternatives. According to Euroconsult, the annual average price per transponder for regular capacity is forecasted to be on a slight downward trend globally from $1.20 million to $1.03 million per 36 MHz transponder over the period from 2019 to 2024, reflecting increasing supply from new satellite entrants, among other factors. HTS capacity, which is designed to attain a lower cost point, facilitating market expansion into new applications, is expected to have similar rates of yield decline over time as increased supply enters the market. The pricing of our services is generally fixed for the duration of the service commitment. New and renewing service commitments are priced to reflect regional demand and other factors as discussed above. Operating Expenses Direct Costs of Revenue (Excluding Depreciation and Amortization) Direct costs of revenue relate to costs associated with the operation and control of our satellites, our communications network and engineering support, and the purchase of off-network capacity. Direct costs of revenue consist principally of salaries and related employment costs, in-orbit insurance, earth station operating costs and facilities costs. Our direct costs of revenue fluctuate based on the number and type of services offered and under development, particularly as sales of off-network transponder services and sales of customer premises equipment fluctuate. We expect our direct costs of revenue to increase as we add customers and expand our managed services and use of off-network capacity. Selling, General and Administrative Expenses Selling, general and administrative expenses relate to costs associated with our sales and marketing staff and our administrative staff, which include legal, finance, corporate information technology and human resources. Staff expenses consist primarily of salaries and related employment costs, including stock compensation, travel costs and office occupancy costs. Selling, general and administrative expenses also include building maintenance and rent expenses and the provision for uncollectible accounts. Selling, general and administrative expenses generally fluctuate with the number of customers served and the number and types of services offered. These expenses also include research and development expenses, and fees for professional services. Depreciation and Amortization Our capital assets consist primarily of our satellites and associated ground network infrastructure. Included in capitalized satellite costs are the costs for satellite construction, satellite launch services, insurance premiums for satellite launch and the in-orbit testing period, the net present value of deferred satellite performance incentives payable to satellite manufacturers, and capitalized interest incurred during the satellite construction period. Capital assets are depreciated or amortized on a straight-line basis over their estimated useful lives. The remaining depreciable lives of our satellites range from less than one year to 16 years as of December 31, 2019. Contracted Backlog We benefit from strong visibility of our future revenues. Our contracted backlog is our expected future revenue under existing customer contracts and includes both cancelable and non-cancelable contracts. As of December 31, 2019, our contracted backlog was approximately $7.0 billion. Approximately 88% of this backlog related to contracts that were non-cancelable and approximately 11% related to contracts that were cancelable subject to substantial termination fees. The remaining 1% of backlog related to contracts with little or no termination fees, and represented the difference between our contracted backlog and remaining performance obligations. As of December 31, 2019, the weighted average remaining customer contract life was approximately 4.2 years. We expect to deliver services associated with approximately $1.6 billion, or approximately 23%, of our December 31, 2019 contracted backlog during the year ending December 31, 2020. The amount included in backlog represents the full service charge for the duration of the contract and does not include termination fees. The amount of the termination fees, which is not included in the backlog amount, is generally calculated as a percentage of the remaining backlog associated with the contract. In certain cases of breach for non-payment or customer financial distress or bankruptcy, we may not be able to recover the full value of certain contracts or termination fees. Our contracted backlog includes 100% of the backlog of our consolidated ownership interests, which is consistent with the accounting for our ownership interest in these entities. Our contracted backlog as of December 31, 2019 was as follows (in millions): Our contracted backlog by service type as of December 31, 2019 was as follows (in millions, except percentages): We believe this backlog and the resulting predictable cash flows in the FSS sector make our results less volatile than that of typical companies outside our industry. Operating Results Years Ended December 31, 2018 and 2019 The following table sets forth our comparative statements of operations for the periods shown with the increase (decrease) and percentage changes, except those deemed not meaningful (“NM”), between the periods presented (in thousands, except percentages): Revenue The following table sets forth our comparative revenue by service type, with Off-Network and Other Revenues shown separately from On-Network Revenues for the periods below (in thousands, except percentages): Total revenue for the year ended December 31, 2019 decreased by $99.7 million, or 5%, as compared to the year ended December 31, 2018. By service type, our revenues increased or decreased due to the following: On-Network Revenues: • Transponder services- an aggregate decrease of $101.5 million, primarily due to a $53.0 million net decrease in revenue from network services customers and a $48.8 million decrease from media customers. The decline from network services customers was primarily due to non-renewals, renewals at lower pricing or lower capacity, and service contractions for enterprise and wireless infrastructure applications mainly in the Latin America, North America, and Europe regions. This decline includes approximately $22.5 million in lost revenue resulting from the failure of Intelsat 29e, a portion of which services were restored with off-network services. Revenue from network services customers also declined in part due to non-renewals and pricing declines related to Europe-to-Africa connectivity. These declines were partially offset by increased revenues from maritime and aeronautical mobility customers and increased revenues from customers for telecommunications infrastructure in the Asia-Pacific region. The decline from media customers was primarily due to non-renewals relating to distribution services. • Managed services-an aggregate decrease of $19.2 million, largely due to a $12.5 million decrease in revenue from government customers and a $6.6 million decrease in revenue from media customers mainly due to non-renewals and renewals at lower pricing. This decline includes approximately $12.6 million in lost revenue resulting from the failure of Intelsat 29e, a portion of which services were restored with off-network services. These declines were partially offset by increased revenues from maritime mobility services. Off-Network and Other Revenues: • Transponder, MSS and other off-network services-an aggregate increase of $25.4 million, primarily due to a $27.3 million increase in revenue from network services customers largely relating to revenue recognized in the first quarter of 2019 accounted for as a sales-type lease under ASC 842 as well as the transfer of certain Intelsat 29e customer services to off-network capacity. This was partially offset by a $2.5 million decrease in revenue from government customers. • Satellite-related services-an aggregate decrease of $2.6 million, reflecting decreased revenues from professional services supporting third-party satellites. Operating Expenses Direct Costs of Revenue (Excluding Depreciation and Amortization) Direct costs of revenue increased by $75.3 million, or 23%, to $406.2 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase was primarily due to the following: • an increase of $48.7 million in costs incurred in connection with the purchase of capacity from two uncapitalized satellites, Intelsat 38 and Horizons 3e, that entered into service in 2019; • an increase of $16.2 million in equipment and third-party capacity costs recognized under ASC 842; • an increase of $13.2 million in third-party capacity costs incurred as part of the Intelsat 29e customer restoration process; and • an increase of $9.7 million in staff-related expenses; partially offset by • a decrease of $5.7 million in costs largely due to the write-off of uncollectible revenue related to Horizons 2 that is payable to JSAT as part of a revenue sharing agreement; • a decrease of $3.9 million in third-party costs for off-network services; and • a decrease of $3.0 million in satellite-related insurance costs. Selling, General and Administrative Selling, general and administrative expenses increased by $26.1 million, or 13%, to $226.9 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase was primarily due to the following: • an increase of $18.0 million in bad debt expense largely related to certain customers in the Europe, Latin America and Africa regions; • an increase of $16.8 million in staff-related expenses; and • an increase of $3.2 million in costs for licenses and fees; partially offset by • a decrease of $15.1 million in professional fees largely due to higher costs incurred in 2018 relating to financing transactions and the reorganization of ownership of certain assets among our subsidiaries that was implemented in 2018 (the "2018 Internal Reorganization"). Depreciation and Amortization Depreciation and amortization expense decreased by $29.4 million, or 4%, to $658.2 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. Significant items impacting depreciation and amortization included: • a decrease of $27.0 million in depreciation expense due to the write-off of Intelsat 29e; • a decrease of $21.9 million in depreciation expense due to the timing of certain satellites becoming fully depreciated; and • a decrease of $4.1 million in amortization expense primarily due to changes in the pattern of consumption of amortizable intangible assets, as these assets primarily include acquired backlog, which relates to contracts covering varying periods that expire over time, and acquired customer relationships, for which the value diminishes over time; partially offset by • an increase of $14.3 million in depreciation expense resulting from the impact of satellites placed in service; and • an increase of $9.2 million in depreciation expense resulting from the impact of certain ground segment assets placed in service. Satellite Impairment Loss We recognized an impairment charge of $381.6 million for the year ended December 31, 2019 relating to the failure of Intelsat 29e (see Note 8-Satellites and Other Property and Equipment). The impairment charge consisted of approximately $377.9 million related to the write-off of the carrying value of the satellite and associated deferred satellite performance incentive obligations and approximately $3.7 million related to prepaid regulatory fees. No comparable amounts were recognized for the year ended December 31, 2018. Interest Expense, Net Interest expense, net consists of gross interest expense incurred together with gains and losses on the interest rate cap contracts we hold (which reflect the changes in their fair values), offset by interest income earned and interest capitalized related to assets under construction. As of December 31, 2019, we held interest rate cap contracts with an aggregate notional amount of $2.4 billion to mitigate the risk of interest rate increases on the floating-rate term loans under our senior secured credit facilities. The interest rate cap contracts have not been designated as hedges for accounting purposes. Interest expense, net increased by $60.7 million, or 5%, to $1.3 billion for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase in interest expense, net was principally due to the following: • an increase of $37.4 million corresponding to the decrease in fair value of the interest rate cap contracts; • a net increase of $30.1 million primarily resulting from our refinancing activities in 2018 and incremental debt raise in 2019; and • an increase of $5.2 million from lower capitalized interest primarily resulting from decreased levels of satellites and related assets under construction; partially offset by • a decrease of $6.9 million resulting from increased interest income largely due to higher cash balances; and • a decrease of $3.4 million from lower interest expense associated with deferred satellite performance incentives. The non-cash portion of total interest expense, net was $150.4 million and $179.1 million for the years ended December 31, 2018 and 2019, respectively, primarily consisting of interest expense related to the significant financing component identified in customer contracts, the gain or loss resulting from the change in fair value of the interest rate cap contracts we hold, amortization and accretion of discounts and premiums and amortization of deferred financing fees. Loss on Early Extinguishment of Debt No gain or loss on early extinguishment was recognized for the year ended December 31, 2019, as compared to a loss of $199.7 million for the year ended December 31, 2018, consisting of the difference between the carrying value of the debt repurchased and the total cash amount paid (including related fees and expenses), together with write-offs of unamortized debt issuance costs and unamortized debt discount or premium. Other Income (Expense), Net Other expense, net was $34.1 million for the year ended December 31, 2019, as compared to other income, net of $4.5 million for the year ended December 31, 2018. The decrease of $38.6 million was primarily driven by a net loss of $43.8 million related to the change in value of certain investments in third parties and loans held-for-investment with no comparative amounts in 2018, partially offset by lower foreign exchange fluctuation losses of $4.9 million mainly related to our business conducted in Brazilian reais and Euros. Provision for (Benefit from) Income Taxes Our income tax expense decreased by $137.5 million to a benefit of $7.4 million for the year ended December 31, 2019, as compared to a provision of $130.1 million for the year ended December 31, 2018. The decrease was primarily attributable to the 2018 Internal Reorganization and a decrease in valuation allowance recorded for our U.S. subsidiaries, offset by the impact of the final Base Erosion Anti-Abuse Tax regulations released by the U.S. Department of Treasury and the U.S. Internal Revenue Service. Cash paid for income taxes, net of refunds, totaled $33.6 million and $57.1 million for the years ended December 31, 2019 and 2018, respectively. Net Loss Attributable to Intelsat S.A. Net loss attributable to Intelsat S.A. was $913.6 million for the year ended December 31, 2019, as compared to net loss attributable to Intelsat S.A. of $599.6 million for the year ended December 31, 2018. The change reflects the various items discussed above. Operating Results Years Ended December 31, 2017 and 2018 We have omitted discussion of the earliest of the three years covered by our consolidated financial statements presented in this Annual Report because that disclosure was already included in our Annual Report on Form 20-F for the fiscal year ended December 31, 2018, filed with the SEC on February 20, 2019, in Part I, Item 5 under the heading "Operating Results Years Ended December 31, 2017 and 2018." You are encouraged to reference that disclosure for a discussion of our operating results for the year ended December 31, 2017 compared to the year ended December 31, 2018. EBITDA EBITDA consists of earnings before net interest, loss (gain) on early extinguishment of debt, taxes and depreciation and amortization. Given our high level of leverage, refinancing activities are a frequent part of our efforts to manage our costs of borrowing. Accordingly, we consider loss (gain) on early extinguishment of debt an element of interest expense. EBITDA is a measure commonly used in the FSS sector, and we present EBITDA to enhance the understanding of our operating performance. We use EBITDA as one criterion for evaluating our performance relative to that of our peers. We believe that EBITDA is an operating performance measure, and not a liquidity measure, that provides investors and analysts with a measure of operating results unaffected by differences in capital structures, capital investment cycles and ages of related assets among otherwise comparable companies. However, EBITDA is not a measure of financial performance under U.S. GAAP, and our EBITDA may not be comparable to similarly titled measures of other companies. EBITDA should not be considered as an alternative to operating income (loss) or net income (loss) determined in accordance with U.S. GAAP, as an indicator of our operating performance, or as an alternative to cash flows from operating activities determined in accordance with U.S. GAAP, as an indicator of cash flows, or as a measure of liquidity. A reconciliation of net loss to EBITDA for the periods shown is as follows (in thousands): Adjusted EBITDA In addition to EBITDA, we calculate a measure called Adjusted EBITDA to assess the operating performance of Intelsat S.A. Adjusted EBITDA consists of EBITDA of Intelsat S.A. as adjusted to exclude or include certain unusual items, certain other operating expense items and certain other adjustments as described in the table and related footnotes below. Our management believes that the presentation of Adjusted EBITDA provides useful information to investors, lenders and financial analysts regarding our financial condition and results of operations because it permits clearer comparability of our operating performance between periods. By excluding the potential volatility related to the timing and extent of non-operating activities, such as impairments of asset value and other non-recurring items, our management believes that Adjusted EBITDA provides a useful means of evaluating the success of our operating activities. We also use Adjusted EBITDA, together with other appropriate metrics, to set goals for and measure the operating performance of our business, and it is one of the principal measures we use to evaluate our management’s performance in determining compensation under our incentive compensation plans. Adjusted EBITDA measures have been used historically by investors, lenders and financial analysts to estimate the value of a company, to make informed investment decisions and to evaluate performance. Our management believes that the inclusion of Adjusted EBITDA facilitates comparison of our results with those of companies having different capital structures. Adjusted EBITDA is not a measure of financial performance under U.S. GAAP and may not be comparable to similarly titled measures of other companies. Adjusted EBITDA should not be considered as an alternative to operating income (loss) or net income (loss) determined in accordance with U.S. GAAP, as an indicator of our operating performance, as an alternative to cash flows from operating activities determined in accordance with U.S. GAAP, as an indicator of cash flows, or as a measure of liquidity. A reconciliation of net loss to EBITDA and EBITDA to Adjusted EBITDA is as follows (in thousands): ____________________________ (1) Reflects non-cash expenses incurred relating to our equity compensation plans. (2) Reflects certain non-recurring expenses, gains and losses and non-cash items, including the following: professional fees related to our liability, business strategy and tax management initiatives; costs associated with our C-band spectrum solution proposal; severance, retention and relocation payments; changes in fair value of certain investments; certain foreign exchange gains and losses; and other various non-recurring expenses. These costs were partially offset by non-cash income related to the recognition of deferred revenue on a straight-line basis for certain prepaid capacity service contracts. (3) Reflects a non-cash impairment charge recorded in connection with the Intelsat 29e satellite loss. (4) Reflects adjustments related to our interest in Horizons-3 Satellite LLC ("Horizons 3"). See Item 8, Note 9(b)-Investments-Horizons-3 Satellite LLC. (5) Adjusted EBITDA included $100.6 million and $102.2 million for the years ended December 31, 2018 and 2019, respectively, of revenue relating to the significant financing component identified in customer contracts in accordance with the adoption of ASC 606. These impacts are not permitted to be reflected in the applicable consolidated and Adjusted EBITDA definitions under our debt agreements. (6) For the year ended December 31, 2019, Intelsat S.A. Adjusted EBITDA reflected $12.5 million of Adjusted EBITDA attributable to Intelsat Horizons-3 LLC, its subsidiaries and its proportionate share of Horizons 3, with a nominal amount for the comparative period in 2018. These entities are considered to be unrestricted subsidiaries under the definitions set forth in our applicable debt agreements. Liquidity and Capital Resources Overview We are a highly leveraged company and our contractual obligations, commitments and debt service requirements over the next several years are significant. At December 31, 2019, the aggregate principal amount of our debt outstanding not held by affiliates was $14.7 billion. Our interest expense, net for the year ended December 31, 2019 was $1.3 billion, which included $179.1 million of non-cash interest expense. We also expect to make significant capital expenditures in 2020 and future years, as set forth below in-Capital Expenditures. Our primary source of liquidity is and will continue to be cash generated from operations, as well as existing cash. At December 31, 2019, cash, cash equivalents and restricted cash amounted to approximately $830.9 million. We currently expect to use cash on hand, cash flows from operations and refinancing of our third-party debt to fund our most significant cash outlays, including debt service requirements and capital expenditures, in the next twelve months and beyond, and expect such sources to be sufficient to fund our requirements over that time and beyond. In past years, our cash flows from operations and cash on hand have been sufficient to fund interest obligations ($1.1 billion in each of the years ended December 31, 2018 and 2019), and significant capital expenditures ($255.7 million and $229.8 million for the years ended December 31, 2018 and 2019, respectively). Our total capital expenditures are expected to range from $200 million to $250 million in 2020, $225 million to $300 million in 2021, and $225 million to $325 million in 2022. However, an inability to generate sufficient cash flow to satisfy our debt service obligations or to refinance our obligations on commercially reasonable terms would have an adverse effect on our business, financial position, results of operations and cash flows, as well as on our and our subsidiaries’ ability to satisfy their obligations in respect of their respective debt. See Item 1A - Risk Factors-Risk Factors Relating to Our Business-We have a substantial amount of indebtedness, which may adversely affect our cash flow and our ability to operate our business, remain in compliance with debt covenants and make payments on our indebtedness. We also continually evaluate ways to simplify our capital structure and opportunistically extend our maturities and reduce our costs of debt. In addition, we may from time to time retain any future earnings and cash to repurchase, repay, redeem or retire any of our outstanding debt securities in privately negotiated or open market transactions, by tender offer or otherwise. Cash Flow Items Our cash flows consisted of the following for the periods shown (in thousands): Net Cash Provided by Operating Activities Net cash provided by operating activities decreased by $88.6 million to $255.5 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The decrease was due to a $176.5 million increase in net loss and changes in non-cash items offset by a $87.9 million increase from changes in operating assets and liabilities. The increase in operating assets and liabilities was primarily due to higher inflows from customer receivables and deferred revenue and contract liabilities, partially offset by higher outflows related to other long-term liabilities. Net Cash Used in Investing Activities Net cash used in investing activities increased by $9.1 million to $292.7 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase was primarily due to increased purchases of investments and origination of loans held-for-investment and lower insurance proceeds received related to Intelsat 33e, partially offset by lower capital expenditures and capital contributions to a joint venture. Net Cash Provided by Financing Activities Net cash provided by financing activities increased by $453.2 million to $362.9 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase was primarily due to an add-on offering of $400.0 million aggregate principal amount of Intelsat Jackson's 9.75% Senior Notes due 2025 (the "2025 Jackson Notes") completed in 2019, as compared to net cash outflows of $283.9 million in connection with our refinancing activities in 2018. The increase was partially offset by $224.3 million in net proceeds from a common shares offering in 2018. Restricted Cash As of December 31, 2019, $20.2 million of cash was legally restricted, being held as a compensating balance for certain outstanding letters of credit. Long-Term Debt This section describes the changes to our long-term debt for the years ended December 31, 2018 and 2019. For details regarding our outstanding long-term indebtedness as of December 31, 2019, see Note 11-Long-Term Debt to our consolidated financial statements included in Item 8 - Financial Statements and Supplementary Data of this Annual Report. Senior Secured Credit Facilities Intelsat Jackson Senior Secured Credit Agreement On January 12, 2011, Intelsat Jackson entered into a secured credit agreement (the “Intelsat Jackson Secured Credit Agreement”), which included a $3.25 billion term loan facility and a $500.0 million revolving credit facility, and borrowed the full $3.25 billion under the term loan facility. The term loan facility required regularly scheduled quarterly payments of principal equal to 0.25% of the original principal amount of the term loan beginning six months after January 12, 2011, with the remaining unpaid amount due and payable at maturity. On October 3, 2012, Intelsat Jackson entered into an Amendment and Joinder Agreement (the “Jackson Credit Agreement Amendment”), which amended the Intelsat Jackson Secured Credit Agreement. As a result of the Jackson Credit Agreement Amendment, interest rates for borrowings under the term loan facility and the revolving credit facility were reduced. In April 2013, our corporate family rating was upgraded by Moody’s, and as a result, the interest rate for the borrowing under the term loan facility and revolving credit facility were further reduced to LIBOR plus 3.00% or the Above Bank Rate (“ABR”) plus 2.00%. On November 27, 2013, Intelsat Jackson entered into a Second Amendment and Joinder Agreement (the “Second Jackson Credit Agreement Amendment”), which further amended the Intelsat Jackson Secured Credit Agreement. The Second Jackson Credit Agreement Amendment reduced interest rates for borrowings under the term loan facility and extended the maturity of the term loan facility. In addition, it reduced the interest rate applicable to $450 million of the $500 million total revolving credit facility and extended the maturity of such portion. As a result of the Second Jackson Credit Agreement Amendment, interest rates for borrowings under the term loan facility and the new tranche of the revolving credit facility were (i) LIBOR plus 2.75%, or (ii) the ABR plus 1.75%. The LIBOR and the ABR, plus applicable margins, related to the term loan facility and the new tranche of the revolving credit facility were determined as specified in the Intelsat Jackson Secured Credit Agreement, as amended by the Second Jackson Credit Agreement Amendment, and the LIBOR was not to be less than 1.00% per annum. The maturity date of the term loan facility was extended from April 2, 2018 to June 30, 2019 and the maturity of the new $450 million tranche of the revolving credit facility was extended from January 12, 2016 to July 12, 2017. The interest rates and maturity date applicable to the $50 million tranche of the revolving credit facility that was not amended did not change. The Second Jackson Credit Agreement Amendment further removed the requirement for regularly scheduled quarterly principal payments under the term loan facility. In June 2017, Intelsat Jackson terminated all remaining commitments under its revolving credit facility. On November 27, 2017, Intelsat Jackson entered into a Third Amendment and Joinder Agreement (the “Third Jackson Credit Agreement Amendment”), which further amended the Intelsat Jackson Secured Credit Agreement. The Third Jackson Credit Agreement Amendment extended the maturity date of $2.0 billion of the existing floating rate B-2 Tranche of term loans (the “B-3 Tranche Term Loans”), to November 27, 2023, subject to springing maturity in the event that certain series of Intelsat Jackson’s senior notes are not refinanced prior to the dates specified in the Third Jackson Credit Agreement Amendment. The B-3 Tranche Term Loans have an applicable interest rate margin of 3.75% for LIBOR loans and 2.75% for base rate loans (at Intelsat Jackson’s election as applicable). The B-3 Tranche Term Loans were subject to a prepayment premium of 1.00% of the principal amount for any voluntary prepayment of, or amendment or modification in respect of, the B-3 Tranche Term Loans prior to November 27, 2018 in connection with prepayments, amendments or modifications that have the effect of reducing the applicable interest rate margin on the B-3 Tranche Term Loans, subject to certain exceptions. The Third Jackson Credit Agreement Amendment also (i) added a provision requiring that, beginning with the fiscal year ending December 31, 2018, Intelsat Jackson apply a certain percentage of its Excess Cash Flow (as defined in the Third Jackson Credit Agreement Amendment), if any, after operational needs for each fiscal year towards the repayment of outstanding term loans, subject to certain deductions, (ii) amended the most-favored nation provision with respect to the incurrence of certain indebtedness by Intelsat Jackson and its restricted subsidiaries, and (iii) amended the covenant limiting the ability of Intelsat Jackson to make certain dividends, distributions and other restricted payments to its shareholders based on its leverage level at that time. On December 12, 2017, Intelsat Jackson further amended the Intelsat Jackson Secured Credit Agreement by entering into a Fourth Amendment and Joinder Agreement (the “Fourth Jackson Credit Agreement Amendment”), which, among other things, (i) permitted Intelsat Jackson to establish one or more series of additional incremental term loan tranches if the proceeds thereof are used to refinance an existing tranche of term loans, and (ii) added a most-favored nation provision applicable to the B-3 Tranche Term Loans for further extensions of the existing floating rate B-2 Tranche Term Loans under certain circumstances. On January 2, 2018, Intelsat Jackson entered into a Fifth Amendment and Joinder Agreement (the “Fifth Jackson Credit Agreement Amendment”), which further amended the Intelsat Jackson Secured Credit Agreement. The Fifth Jackson Credit Agreement Amendment refinanced the remaining $1.095 billion B-2 Tranche Term Loans, through the creation of (i) a new incremental floating rate tranche of term loans with a principal amount of $395.0 million (the “B-4 Tranche Term Loans”), and (ii) a new incremental fixed rate tranche of term loans with a principal amount of $700.0 million (the “B-5 Tranche Term Loans”). The maturity date of both the B-4 Tranche Term Loans and the B-5 Tranche Term Loans is January 2, 2024, subject to springing maturity in the event that certain series of Intelsat Jackson’s senior notes are not refinanced or repaid prior to the dates specified in the Fifth Jackson Credit Agreement Amendment. The B-4 Tranche Term Loans have an applicable interest rate margin of 4.50% per annum for LIBOR loans and 3.50% per annum for base rate loans (at Intelsat Jackson’s election as applicable). We entered into interest rate cap contracts in December 2017 and amended them in May 2018 to mitigate the risk of interest rate increases on the B-3 and B-4 Tranche Term Loans. The B-5 Tranche Term Loans have an interest rate of 6.625% per annum. The Fifth Jackson Credit Agreement Amendment also specified make-whole and prepayment premiums applicable to the B-4 Tranche Term Loans and the B-5 Tranche Term Loans at various dates. Intelsat Jackson’s obligations under the Intelsat Jackson Secured Credit Agreement are guaranteed by ICF and certain of Intelsat Jackson’s subsidiaries. Intelsat Jackson’s obligations under the Intelsat Jackson Secured Credit Agreement are secured by a first priority security interest in substantially all of the assets of Intelsat Jackson and the guarantors party thereto, to the extent legally permissible and subject to certain agreed exceptions, and by a pledge of the equity interests of the subsidiary guarantors and the direct subsidiaries of each guarantor, subject to certain exceptions, including exceptions for equity interests in certain non-U.S. subsidiaries, existing contractual prohibitions and prohibitions under other legal requirements. The Intelsat Jackson Secured Credit Agreement following a further amendment in November 2018 includes one financial covenant: Intelsat Jackson must maintain a consolidated secured debt to consolidated EBITDA ratio equal to or less than 3.50 to 1.00 at the end of each fiscal quarter, measured based on the trailing 12 months, as such financial measure is defined in the Intelsat Jackson Secured Credit Agreement. Intelsat Jackson was in compliance with this financial maintenance covenant ratio with a consolidated secured debt to consolidated EBITDA ratio of 3.20 to 1.00 as of December 31, 2019. 2019 Debt Transaction June 2019 Intelsat Jackson Senior Notes Add-On Offering In June 2019, Intelsat Jackson completed an add-on offering of $400.0 million aggregate principal amount of its 2025 Jackson Notes. The notes are guaranteed by all of Intelsat Jackson's subsidiaries that guarantee its obligations under the Intelsat Jackson Secured Credit Agreement and senior notes, as well as by certain of Intelsat Jackson's parent entities. 2018 Debt and Other Capital Markets Transactions March 2018/May 2018 ICF Tender Offer for Intelsat Luxembourg Notes and Redemption In March 2018, ICF commenced a cash tender offer to purchase any and all of the outstanding aggregate principal amount of the 6.75% Senior Notes due 2018 (the "2018 Luxembourg Notes"). ICF purchased a total of $31.2 million aggregate principal amount of the 2018 Luxembourg Notes at par value in March 2018 and April 2018. In May 2018, pursuant to a previously issued notice of redemption, Intelsat Luxembourg redeemed $46.0 million aggregate principal amount of the 2018 Luxembourg Notes at par value together with accrued and unpaid interest thereon. June 2018 Intelsat S.A. Senior Convertible Notes Offering and Common Shares Offering In June 2018, we completed an offering of 15,498,652 Intelsat S.A. common shares, nominal value $0.01 per share (the “Common Shares”), at a public offering price of $14.84 per common share, and we completed an offering of $402.5 million aggregate principal amount of our 4.5% Convertible Senior Notes due 2025 (the "2025 Convertible Notes"). These notes are guaranteed by a direct subsidiary of Intelsat Luxembourg, Intelsat Envision. The net proceeds from the Common Shares offering and 2025 Convertible Notes offering were used to repurchase approximately $600 million aggregate principal amount of Intelsat Luxembourg's 7.75% Senior Notes due 2021 (the “2021 Luxembourg Notes”) in privately negotiated transactions with individual holders in June 2018. We used the remaining net proceeds of the Common Shares offering and 2025 Convertible Notes offering for further repurchases of 2021 Luxembourg Notes and for other general corporate purposes, including repurchases of other tranches of debt of Intelsat S.A.’s subsidiaries. August 2018 Intelsat Connect Senior Notes Refinancing and Exchange of Intelsat Luxembourg Senior Notes In August 2018, Intelsat Connect completed an offering of $1.25 billion aggregate principal amount of 9.5% Senior Notes due 2023 (the "2023 ICF Notes"). These notes are guaranteed by Intelsat Envision and Intelsat Luxembourg. Intelsat Connect used the net proceeds from the offering to repurchase or redeem all $731.9 million outstanding aggregate principal amount of Intelsat Connect 12.5% Senior Notes due 2022 (the "2022 ICF Notes"). The remaining net proceeds from the offering were used to repurchase approximately $448.9 million aggregate principal amount of Intelsat Jackson's 7.25% Senior Notes due 2020 (the "2020 Jackson Notes") and $30.0 million aggregate principal amount of other unsecured notes of Intelsat Jackson, and to pay related fees and expenses. Also in August 2018, Intelsat Connect and Intelsat Envision completed debt exchanges receiving new notes issued by Intelsat Luxembourg, which mature in August 2026 and have an interest rate of 13.5%, in exchange for $1.58 billion aggregate principal amount of 2021 Luxembourg Notes that were previously held by Intelsat Connect and Intelsat Envision. September 2018 Intelsat Jackson Senior Notes Offering and Tender Offer In September 2018, Intelsat Jackson completed an offering of $2.25 billion aggregate principal amount of 8.5% Senior Notes due 2024 (the "2024 Jackson Senior Unsecured Notes"). The notes are guaranteed by all of Intelsat Jackson’s subsidiaries that guarantee its obligations under the Intelsat Jackson Secured Credit Agreement, as well as by certain of Intelsat Jackson’s parent entities. Intelsat Jackson used the net proceeds from the offering to repurchase through a tender offer and redeem all remaining outstanding 2020 Jackson Notes. The remaining net proceeds from the 2024 Jackson Senior Unsecured Notes offering were used to repurchase and redeem approximately $441.3 million aggregate principal amount of Intelsat Jackson's 7.5% Senior Notes due 2021 (the "2021 Jackson Notes") in September 2018 and October 2018, and to pay related fees and expenses. October 2018 Intelsat Jackson Senior Notes Add-On Offering and Redemption of 2021 Jackson Notes In October 2018, Intelsat Jackson completed an add-on offering of $700 million aggregate principal amount of its 2024 Jackson Senior Unsecured Notes. The net proceeds from the add-on offering, together with cash on hand, were used to repurchase and redeem all the remaining approximately $708.7 million aggregate principal amount of outstanding 2021 Jackson Notes in October 2018 that were not earlier repurchased or redeemed, and to pay related fees and expenses. Satellite Performance Incentives Our cost of satellite construction includes an element of deferred consideration to satellite manufacturers referred to as satellite performance incentives. We are contractually obligated to make these payments over the lives of the satellites, provided the satellites continue to operate in accordance with contractual specifications. We capitalize the present value of these payments as part of the cost of the satellites and record a corresponding liability to the satellite manufacturers. This asset is amortized over the useful lives of the satellites, interest expense is recognized on the deferred financing and the liability is reduced as the payments are made. Our total satellite performance incentive payment liability as of December 31, 2018 and 2019 was $245.6 million and $218.7 million, respectively. Capital Expenditures Our capital expenditures depend on our business strategies and reflect our commercial responses to opportunities and trends in our industry. Our actual capital expenditures may differ from our expected capital expenditures if, among other things, we enter into any currently unplanned strategic transactions. Levels of capital spending from one year to the next are also influenced by the nature of the satellite life cycle and by the capital-intensive nature of the satellite industry. For example, we incur significant capital expenditures during the years in which satellites are under construction. We typically procure a new satellite within a timeframe that would allow the satellite to be deployed at least one year prior to the end of the service life of the satellite to be replaced. As a result, we frequently experience significant variances in our capital expenditures from year to year. The following table compares our satellite-related capital expenditures to total capital expenditures from 2015 through 2019 (in thousands). Payments for satellites and other property and equipment for the year ended December 31, 2019 were $229.8 million. We intend to fund our capital expenditure requirements through cash on hand and cash provided from operating activities. Capital expenditure guidance for 2020 through 2022 (the “Guidance Period”) assumes investment in five satellites, two of which are currently in the manufacturing phase. Of the remaining three satellites, no manufacturing contracts have yet been signed. Off-Balance Sheet Arrangements We have revenue sharing agreements with JSAT related to services sold on the Horizons 1, Horizons 2 and Horizons 3 satellites. We are responsible for billing and collection for such services and we remit 50% of the revenue, less applicable fees and commissions, to JSAT. Refer to Note 9-Investments for disclosures relating to the revenue sharing agreements with JSAT. Tabular Disclosure of Contractual Obligations The following table sets forth our contractual obligations and capital and certain other commitments as of December 31, 2019, and the expected year of payments (in thousands): (1) Obligations related to our pension and postretirement medical benefit obligations are excluded from the table. We maintain a noncontributory defined benefit retirement plan covering substantially all of our employees hired prior to July 19, 2001. We expect that our future contributions to the defined benefit retirement plan will be based on the minimum funding requirements of the Internal Revenue Code and on the plan’s funded status. The impact on the funded status is determined based upon market conditions in effect when we completed our annual valuation. In the first quarter of 2015, we amended the defined benefit retirement plan to cease the accrual of additional benefits for the remaining active participants effective March 31, 2015. We anticipate that our contributions to the defined benefit retirement plan in 2020 will be approximately $4.0 million. We fund the postretirement medical benefits throughout the year based on benefits paid. We anticipate that our contributions to fund postretirement medical benefits in 2020 will be approximately $2.9 million. See Note 7-Retirement Plans and Other Retiree Benefits to our consolidated financial statements included in Item 8 - Financial Statements and Supplementary Data of this Annual Report. (2) Represents estimated interest payments to be made on our fixed and variable rate debt. Interest payments for variable rate debt and incentive obligations have been estimated based on the current interest rates. (3) This amount includes commitments to make capital contributions to and purchase satellite capacity from Horizons 3. See Note 9(b)-Investments-Horizons-3 Satellite LLC. (4) Includes obligations under satellite construction and launch contracts, estimated payments to be made on performance incentive obligations related to certain satellites that are currently under construction, and commitments under customer and vendor contracts. (5) The timing of future cash flows from income tax contingencies cannot be reasonably estimated and therefore is reflected in the other column. See Note 14-Income Taxes to our consolidated financial statements included in Item 8 - Financial Statements and Supplementary Data of this Annual Report for further discussion of income tax contingencies. Satellite Construction and Launch Obligations As of December 31, 2019, we had approximately $461.5 million of expenditures remaining under our existing satellite construction and launch contracts, including expected orbital performance incentive payments for satellites currently in the construction phase. These contracts typically require that we make progress payments during the period of the satellites’ construction, and contain provisions that allow us to cancel the contracts for or without cause. If cancelled without cause, we could be subject to substantial termination penalties, including the forfeiture of progress payments made to-date and additional penalty payments. If cancelled for cause, we are entitled to recover progress payments made to-date and liquidated damages as specified in the contracts. See Item 1 - Business-Our Network-Satellite Systems-Future Satellites for details relating to certain of our satellite construction and launch contracts. Satellite Performance Incentive Obligations Satellite construction contracts also typically require that we make orbital incentive payments (plus interest, as defined in each agreement with the satellite manufacturer) over the orbital life of the satellite. The incentive obligations may be subject to reduction or refund if the satellite fails to meet specific technical operating standards. As of December 31, 2019, we had $308.0 million of satellite performance incentive obligations, including future interest payments, for satellites currently in orbit. Customer and Vendor Contracts We have contracts with certain of our customers which require us to provide equipment, services and other support during the term of the related contracts. We also have long-term contractual obligations with service providers primarily related to the operation of certain of our satellites. As of December 31, 2019, we had commitments under these customer and vendor contracts which totaled approximately $416.4 million related to the provision of equipment, services and other support. Operating Leases We have commitments for operating leases primarily relating to equipment and office facilities. These leases contain escalation provisions for payment increases. As of December 31, 2019, minimum annual rental payments due under all leases (net of sublease income on leased facilities) totaled approximately $151.9 million, exclusive of potential increases in real estate taxes, operating assessments and future sublease income. Critical Accounting Policies The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. We consider an accounting estimate to be critical if: (1) it requires assumptions to be made that were uncertain at the time the estimate was made; and (2) changes in the estimate, or selection of different estimates, could have a material effect on our consolidated results of operations or financial condition. We believe that some of the more important estimates and related assumptions that affect our financial condition and results of operations are in the areas of revenue recognition, the allowance for doubtful accounts, asset impairments, income taxes and pension and other postretirement benefits. In January 2018, we adopted ASC 606 using the modified retrospective method. We recognized the cumulative effect of initially applying the new standard as an adjustment to the opening balance of accumulated deficit. The comparative information as of and for the year ended December 31, 2017 has not been restated and continues to be reported under the accounting standards in effect for that year. Based on our assessment, the adoption of the new standard impacts the total consideration for prepayment contracts, accounting of incremental costs for obtaining a contract, allocation of the transaction price to performance obligations and accounting for contract modifications, and requires additional disclosures. While we believe that our estimates, assessments, assumptions, and judgments are reasonable, they are based on information presently available. Actual results may differ significantly. Additionally, changes in our estimates, assessments, assumptions, or judgments as a result of unforeseen events or otherwise could have a material impact on our financial position or results of operations. Revenue Recognition, Accounts Receivable and Allowance for Doubtful Accounts Revenue Recognition. We earn revenue primarily from satellite utilization services and, to a lesser extent, from providing managed services to our customers. The Company’s contracts for satellite utilization services often contain multiple service orders for the provision of capacity on or over different beams, satellites, frequencies, geographies or time periods. Under each separate service order, the Company’s satellite services, comprised of transponder services, managed services, channel services, and occasional use managed services, are delivered in a series of time periods that are distinct from each other and have the same pattern of transfer to the customer. In each period, the Company’s obligation is to make those services available to the customer. Throughout each period of services being provided, the customer simultaneously receives and consumes the benefits, resulting in revenue recognition over time. Our contract assets include unbilled amounts typically resulting from sales under our long-term contracts when the total contract value is recognized on a straight-line basis and the revenue recognized exceeds the amount billed to the customer. Contract liabilities consist of advance payments and collections in excess of revenue recognized and deferred revenue. While the majority of our revenue transactions contain standard business terms and conditions, there are certain transactions that contain non-standard business terms and conditions. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting for these transactions, including but not limited to: • whether contracts with a prepayment contain a significant financing component; • whether an arrangement should be reported gross as a principal versus net as an agent; and • whether an arrangement contains a service contract or a lease. In addition, our revenue recognition policy requires an assessment as to whether collection is reasonably assured, which requires us to evaluate the creditworthiness of our customers. Changes in judgments in making these assumptions and estimates could materially impact the timing and/or amount of revenue recognition. Allowance for Doubtful Accounts. Our allowance for doubtful accounts is determined through a subjective evaluation of the aging of our accounts receivable, and considers such factors as the likelihood of collection based upon an evaluation of the customer’s creditworthiness, the customer’s payment history and other conditions or circumstances that may affect the likelihood of payment, such as political and economic conditions in the country in which the customer is located. If our estimate of the likelihood of collection is not accurate, we may experience lower revenue or a change in our provision for doubtful accounts. Asset Impairment Assessments Goodwill. We account for goodwill and other intangible assets in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC” or the “Codification”) Topic 350-Intangibles-Goodwill and Other. Under this topic, goodwill acquired in a business combination and determined to have an indefinite useful life is not amortized but is tested for impairment annually or more often if an event or circumstances indicate that an impairment loss has been incurred. We are required to identify reporting units for impairment analysis. We have identified only one reporting unit for the goodwill impairment test. Additionally, our identifiable intangible assets with estimable useful lives are amortized based on the expected pattern of consumption for each respective asset. Assumptions and Approach Used. We make our qualitative evaluation considering, among other things, general macroeconomic conditions, industry and market considerations, cost factors, overall financial performance and other relevant entity-specific events. Based on our qualitative assessment performed at each of December 31, 2018 and 2019, we concluded that there was not a likelihood of more than 50% that the fair value of our reporting unit was less than its carrying value; therefore, no further testing of goodwill was required. Orbital Locations and Trade Name. Intelsat is authorized by governments to operate satellites at certain orbital locations-i.e., longitudinal coordinates along the Clarke Belt. The Clarke Belt is the part of space approximately 35,800 kilometers above the plane of the equator where geostationary orbit may be achieved. Various governments acquire rights to these orbital locations through filings made with the ITU, a sub-organization of the United Nations. We will continue to have rights to operate satellites at our orbital locations so long as we maintain our authorizations to do so. See “Part I-Item 1A - Risk Factors-Risk Factors Relating to Regulation”. Our rights to operate at orbital locations can be used and sold individually; however, since satellites and customers can be and are moved from one orbital location to another, our rights are used in conjunction with each other as a network that can be adapted to meet the changing needs of our customers and market demands. Due to the interchangeable nature of orbital locations, the aggregate value of all of the orbital locations is used to measure the extent of impairment, if any. At December 31, 2018 and 2019, we determined, based on an examination of qualitative factors, that there was no impairment of our orbital locations and trade name. Long-Lived and Amortizable Intangible Assets. We review our long-lived and amortizable intangible assets to assess whether an impairment has occurred in accordance with the guidance provided under ASC 360-Property, Plant and Equipment, whenever events or changes in circumstances indicate, in our judgment, that the carrying amount of an asset may not be recoverable. These indicators of impairment can include, but are not limited to, the following: • satellite anomalies, such as a partial or full loss of power; • under-performance of an asset as compared to expectations; and • shortened useful lives due to changes in the way an asset is used or expected to be used. The recoverability of an asset to be held and used is measured by a comparison of the carrying amount of the asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds its fair value, determined by either a quoted market price, if any, or a value determined by utilizing discounted cash flow techniques. Additionally, when assets are expected to be used in future periods, a shortened depreciable life may be utilized if appropriate, resulting in accelerated depreciation. Assumptions and Approach Used. We employ a discounted future cash flow approach to estimate the fair value of our long-lived intangible assets when an impairment assessment is required. Income Taxes We account for income taxes in accordance with ASC 740, Income Taxes. We are subject to income taxes in Luxembourg, as well as the United States and a number of other foreign jurisdictions. Significant judgment is required in the calculation of our tax provision and the resulting tax liabilities and in the recoverability of our deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense and net operating loss and credit carryforwards. We regularly assess the likelihood that our deferred tax assets can be recovered. A valuation allowance is required when it is more likely than not that all or a portion of the deferred tax asset will not be realized. We evaluate the recoverability of our deferred tax assets based in part on the existence of deferred tax liabilities that can be used to realize the deferred tax assets. During the ordinary course of business, there are transactions and calculations for which the ultimate tax determination is uncertain. We evaluate our tax positions to determine if it is more likely than not that a tax position is sustainable, based solely on its technical merits and presuming the taxing authorities have full knowledge of the position and access to all relevant facts and information. When a tax position does not meet the more likely than not standard, we record a liability or contra asset for the entire amount of the unrecognized tax impact. Additionally, for those tax positions that are determined more likely than not to be sustainable, we measure the tax position at the largest amount of benefit more likely than not (determined by cumulative probability) to be realized upon settlement with the taxing authority. Pension and Other Postretirement Benefits We maintain a noncontributory defined benefit retirement plan covering substantially all of our employees hired prior to July 19, 2001. The cost of providing benefits to eligible participants under the defined benefit retirement plan is calculated using the plan’s benefit formulas, which take into account the participants’ remuneration, dates of hire, years of eligible service, and certain actuarial assumptions. In addition, as part of the overall medical plan, we provide postretirement medical benefits to certain current retirees who meet the criteria under the medical plan for postretirement benefit eligibility. Expenses for our defined benefit retirement plan and for postretirement medical benefits that are provided under our medical plan are developed from actuarial valuations. Any significant decline in the fair value of our defined benefit retirement plan assets or other adverse changes to the significant assumptions used to determine the plan’s funded status would negatively impact its funded status and could result in increased funding in future periods. Key assumptions, including discount rates used in determining the present value of future benefit payments and expected return on plan assets, are reviewed and updated on an annual basis. The discount rates reflect market rates for high-quality corporate bonds. We consider current market conditions, including changes in interest rates, in making assumptions. The Society of Actuaries (“SOA”) issued new mortality and mortality improvement tables and modified those tables in 2017, 2018 and 2019. Our December 31, 2019 valuation used mortality and improvement tables based on the SOA tables, adjusted to reflect (1) an ultimate rate of mortality improvement consistent with both historical experience and U.S. Social Security long-term projections, and (2) a shorter transition period to reach the ultimate rate, which is consistent with historical patterns. In establishing the expected return on assets assumption, we review the asset allocations considering plan maturity and develop return assumptions based on different asset classes. The return assumptions are established after reviewing historical returns of broader market indexes, as well as historical performance of the investments in the plan. Recently Adopted and Recently Issued Accounting Pronouncements Refer to Note 1-Background and Summary of Significant Accounting Policies included in Item 8 of this Form 10-K for further information about recently adopted and recently issued accounting pronouncements.

<s>[INST] This discussion should be read together with Item 6 Selected Financial Data and our audited consolidated financial statements and notes thereto included in Item 8 Financial Statements and Supplementary Data of this Annual Report. Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, and, unless otherwise indicated, the other financial information contained in this Annual Report has also been prepared in accordance with U.S. GAAP. See “ForwardLooking Statements” and Item 1A Risk Factors, for a discussion of factors that could cause our future financial condition and results of operations to be different from those discussed below. Certain monetary amounts, percentages and other figures included in this Annual Report have been subject to rounding adjustments. Accordingly, figures shown as totals in certain tables may not be the arithmetic aggregation of the figures that precede them, and figures expressed as percentages in the text may not total 100% or, as applicable, when aggregated may not be the arithmetic aggregation of the percentages that precede them. Unless otherwise indicated, all references to “dollars” and “$” in this Annual Report are to, and all monetary amounts in this Annual Report are presented in, U.S. dollars. Overview We operate one of the world’s largest satellite services businesses, providing a critical layer in the global communications infrastructure. We provide diversified communications services to the world’s leading media companies, fixed and wireless telecommunications operators, data networking service providers for enterprise and mobile applications in the air and on the seas, multinational corporations and ISPs. We are also the leading provider of commercial satellite capacity to the U.S. government and other select military organizations and their contractors. Our customers use our global network for a broad range of applications, from global distribution of content for media companies to providing the transmission layer for commercial aeronautical consumer broadband connectivity, to enabling essential network backbones for telecommunications providers in highgrowth emerging regions. Our network solutions are a critical component of our customers’ infrastructures and business models. Generally, our customers need the specialized connectivity that satellites provide so long as they are in business or pursuing their mission. In recent years, mobility services providers have contracted for services on our fleet that support broadband connections for passengers on commercial flights and cruise ships, connectivity that in some cases is only available through our network. In addition, our satellite neighborhoods provide our media customers with efficient and reliable broadcast distribution that maximizes audience reach, a technical and economic benefit that is difficult for terrestrial services to match. In developing regions, our satellite solutions often provide higher reliability than is available from local terrestrial telecommunications services and allow our customers to reach geographies that they would otherwise be unable to serve. Revenue Revenue Overview We earn revenue primarily by providing services over satellite transponder capacity to our customers. Our customers generally obtain satellite capacity from us by placing an order pursuant to one of several master customer service agreements. The master customer agreements and related service orders under which we sell services specify, among other things, the amount of satellite capacity to be provided, whether service will be nonpreemptible or preemptible and the service term. Most services are full time in nature, with service terms ranging from one year to as long as 16 years. Occasional use services used for video applications can be for much shorter periods, including increments of one hour. Our master customer service agreements offer different service types, including transponder services, managed services, and channel, which are all services that are provided on, or used to provide access to, our global network. We refer to these services as onnetwork services. Our customer agreements also cover services that we procure from third parties and resell, which we refer to as offnetwork services. These services can include transponder services and other satellitebased transmission services sourced from other operators, often in frequencies not available on our network, and other operational fees related to satellite operations provided on behalf of thirdparty satellites. The following table describes our primary service types: Service Type Description OnNetwork Revenues: Transponder Services Commitments by customers to receive service via, or to utilize capacity on, particular designated transponders according to specified technical and commercial terms. Transponder services also include revenues from hosted payload capacity. Transponder services are marketed to each of our primary customer sets as follows: Network Services: [/INST] Positive. </s>

Healthcare Merger 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 September 19, 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 our initial public offering and the sale of the placement units, 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 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. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from September 19, 2019 (inception) through December 31, 2019 were organizational activities, those necessary to prepare for our initial public offering, described below, and, after our initial public offering, identifying a target company for an 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. For the period from September 19, 2019 (inception) through December 31, 2019, we had net income of $22,272, which consists of interest income on marketable securities held in the trust account of $137,528, offset by unrealized loss on marketable securities held in our trust account of $12,966, formation and operating costs of $96,257, and a provision for income taxes of $6,033. Liquidity and Capital Resources On December 17, 2019, we consummated our initial public offering of 25,000,000 Units at a price of $10.00 per unit, which includes the partial exercise by the underwriters of the over-allotment option to purchase an additional 3,000,000 units, at $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 700,000 placement units to the sponsor at a price of $10.00 per unit, generating gross proceeds of $7,000,000. Following our initial public offering the partial exercise of the over-allotment option and the sale of the placement units, a total of $250,000,000 was placed in the trust account. We incurred $14,354,733 in transaction costs, including $5,000,000 of underwriting fees, $8,750,000 of deferred underwriting fees and $604,733 of other costs. As of December 31, 2019, we had marketable securities held in the trust account of $250,124,562 (including approximately $125,000 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 December 31, 2019, we did not withdraw any interest earned on the trust account. For the period from September 19, 2019 (inception) through December 31, 2019, cash used in operating activities was $271,256. Net income of $22,272 was affected by interest earned on marketable securities held in the trust account of $137,528 and an unrealized loss on marketable securities held in our trust account of $12,966. Changes in operating assets and liabilities used $168,966 of cash for operating activities. 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 initial business combination. 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 cash of $1,149,011. 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 our initial business combination. In order to fund working capital deficiencies or finance transaction costs in connection with our initial business combination, the initial stockholders or their affiliates may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we will 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 units identical to the placement units, at a price of $10.00 per unit at the option of the lender. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating 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 initial 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 our initial 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 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 services to the Company. We began incurring these fees on December 13, 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 of the gross proceeds from the units sold in our initial business combination, or $8,750,000 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 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 conversion 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 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 September 19, 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 our initial public offering and the sale of the placement units, 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 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. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from September 19, 2019 (inception) through December 31, 201 [/INST] Negative. </s>

Adaptive Biotechnologies Corp

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 together with our financial statements and related notes and the other financial information appearing elsewhere in this Annual Report on Form 10-K, as well as the other financial information we file with the SEC from time to time. Some of the information contained in this discussion and analysis includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. This section 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 may be found in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of our prospectus for our initial public offering, dated June 26, 2019 filed with the SEC on June 27, 2019. Overview We are advancing the field of immune-driven medicine by harnessing the inherent biology of the adaptive immune system to transform the diagnosis and treatment of disease. Our immune medicine platform applies our proprietary technologies to read the diverse genetic code of a patient’s immune system and understand precisely how it detects and treats disease in that patient. We capture these insights in our dynamic clinical immunomics database, which is underpinned by computational biology and machine learning, and use them to develop and commercialize clinical products and services that we are tailoring to each individual patient. We have two commercial products and services and a robust pipeline of clinical products and services that we are designing to diagnose, monitor and enable the treatment of diseases such as cancer, autoimmune conditions and infectious diseases. Our immune medicine platform is the foundation for our expanding suite of products and services. The cornerstone of our platform and core immunosequencing product, immunoSEQ, serves as our underlying research and development engine and generates revenue from academic and biopharmaceutical customers. Our first clinical diagnostic product, clonoSEQ, is the first test authorized by the FDA for the detection and monitoring of MRD in patients with MM and ALL and is being validated for patients with other blood cancers. Leveraging our collaboration with Microsoft to create the TCR-Antigen Map, we are also developing a diagnostic product, immunoSEQ Dx, that may enable early detection of many diseases from a single blood test. We have established proof of concept for immunoSEQ Dx in acute Lyme disease, such that we can proceed to clinical validation, and continue to pursue signals for other disease states. Our therapeutic product candidates, being developed under the Genentech Agreement, leverage our platform to identify specific immune cells to develop into cellular therapies in oncology. Since our inception, we have devoted a majority of our resources to research and development activities to develop our immune medicine platform, which enables the delivery of our products and services for life sciences research, clinical diagnostics and drug discovery customers. For our life science research customers, we provide two categories of products and services using immunoSEQ, our core sequencing and immunomics tracking technology. First, we provide immunosequencing services, the revenue from which we record as sequencing revenue. Second, we provide certain research customers professional support, for which we may receive payments upon those customers achieving specified milestones. We record these support activities as development revenue. For our clinical diagnostics customers, we sell our clonoSEQ diagnostic tests, which include our immunosequencing services and are thus recorded as sequencing revenue. In the future, we intend to sell other diagnostics products and services, which we also expect to record as sequencing revenue. For our current drug discovery collaborator, Genentech, we screen, identify and characterize TCRs in support of our collaboration. We record revenue from this collaboration as development revenue. Historically, we have sold immunoSEQ as a fee-for-service offering to academic centers and biopharmaceutical customers and further deepened those relationships over time by supporting their development initiatives. These research offerings have comprised the majority of our revenue to date, although our business is pursuing broader opportunities. As we continue to expand the use of our clonoSEQ diagnostic tests, develop and commercialize immunoSEQ Dx and develop and commercialize therapeutic product candidates with our drug discovery collaborator, we expect our mix of revenue to shift to clinical products and services, which we believe will become our largest sources of revenue. We are actively pursuing opportunities to deepen our relationships with current customers and initiate relationships with new customers. We have an experienced, specialty salesforce that is targeting department heads, laboratory directors, principal investigators, core facility directors, clinicians, payors and research scientists and pathologists at leading academic institutions, biopharmaceutical companies, research institutions and contract research organizations. As MRD assessment becomes standard practice for patient management across a range of blood cancers, we believe it will be essential for clinicians and patients to have access to a highly accurate, sensitive and standardized MRD assessment tool. We are focused on establishing and maintaining collaborative relationships with payors, developing health economic evidence and building billing and patient access infrastructure to expand reimbursement coverage for our clinical diagnostics. We continue to seek expanded coverage of our clonoSEQ diagnostic test and, in 2019, we successfully expanded coverage through contractual agreements or positive medical policies with Medicare and several of the largest national private health insurers in the United States. We generated revenue of $85.1 million and $55.7 million for the years ended December 31, 2019 and 2018, respectively. Our net losses were $68.6 million and $46.4 million for the years ended December 31, 2019 and 2018, respectively. We have funded our operations to date principally from the sale of convertible preferred stock and common stock, including the sale of common stock in our initial public offering, and, to a lesser extent, sequencing and development revenue. As of December 31, 2019 and 2018, we had cash, cash equivalents and marketable securities of $682.3 million and $165.0 million, respectively. In December 2018, we entered into the Genentech Agreement pursuant to which we received a $300.0 million initial upfront payment in February 2019, may be eligible to receive approximately $1.8 billion over time, including payments upon achievement of specified development, regulatory and commercial milestones, and may receive additional royalties on sales of products commercialized under this agreement. Initial Public Offering On July 1, 2019, we completed our initial public offering in which we issued and sold 17,250,000 shares of common stock, including shares issued upon the exercise in full of the underwriters’ over-allotment option, at a public offering price of $20.00 per share. We received $315.9 million in net proceeds, after deducting underwriting discounts and commissions of $24.1 million and offering expenses of $5.0 million. Immediately prior to the completion of our initial public offering, 93,039,737 shares of convertible preferred stock then outstanding converted into an equivalent number of shares of common stock. Components of Results of Operations Revenue We derive our revenue from two sources: (1) sequencing revenue and (2) development revenue. Sequencing revenue. Sequencing revenue reflects the amounts generated from providing sequencing services through immunoSEQ to research customers and from providing testing services through clonoSEQ to clinical and research customers. For our research customers, which include biopharmaceutical customers and academic institutions, delivery of the sequencing results may include some level of professional support and analysis. Terms with biopharmaceutical customers generally include non-refundable upfront payments, which we record as deferred revenue. For all customers, we recognize revenue as we deliver sequencing results. From time to time, we offer discounts in order to gain rights and access to certain datasets. Revenue is recognized net of these discounts and costs associated with these services are reflected in cost of revenue. For our clinical customers, we derive revenue from providing our clonoSEQ test report to ordering physicians. We bill commercial payors and medical institutions based on tests delivered to ordering physicians. Amounts paid for clonoSEQ diagnostic tests by commercial payors and medical institutions vary based on respective reimbursement rates and patient responsibilities, which may vary from our targeted list price. To date, the majority of our clonoSEQ diagnostic test revenue has been received from medical institutions. We recognize clinical revenue by evaluating customer payment history, contracted reimbursement rates, if applicable, and other adjustments to estimate the amount of revenue that is collectible. Until 2019, we did not have reimbursement available to us through any government payors for clonoSEQ. In January 2019, clonoSEQ received Medicare coverage aligned with the FDA label and NCCN guidelines for longitudinal monitoring in MM and ALL. We bill Medicare for an episode of treatment when we deliver the first eligible test results. This billing contemplates all necessary tests required during a patient’s treatment cycle, which is currently estimated at approximately four tests per patient, including the initial sequence identification test. Revenue is recognized at the time the initial billable test result is delivered and is based upon cumulative tests delivered to date. Any unrecognized revenue from the initial billable test is recorded as deferred revenue and recognized as we deliver the remaining tests in a patient’s treatment cycle. Development revenue. Development revenue primarily represents regulatory or development support services, other than sequencing revenue, that we provide to biopharmaceutical customers who seek access to our platform to support their therapeutic development activities. Additionally, we generate development revenue from the achievement of regulatory milestones. We enter into collaboration and similar agreements with these customers. When these agreements include sequencing activities, we separately classify those activities as sequencing revenue. These agreements may also include substantial non-refundable upfront payments, which we recognize as development revenue over time as we perform the respective services. We expect revenue to increase over the long term, particularly as the mix of revenue migrates to clinical diagnostics and drug discovery. The pace by which this mix migrates will be determined by the level of customer adoption and frequency of use of our products and services. Our revenue may fluctuate from period to period due to the uncertain nature of delivery of our products and services, the achievement of milestones by us or our customers, timing of expenses incurred, changes in estimates of total anticipated costs related to our Genentech Agreement and other events not within our control, such as the delivery of customer samples or customer decisions to no longer pursue their development initiatives. Cost of Revenue Cost of revenue includes the cost of materials, personnel-related expenses (comprised of salaries, benefits and share-based compensation), shipping and handling, equipment and allocated facility costs associated with processing samples and professional support for our sequencing revenue. Allocated facility costs include depreciation of laboratory equipment, allocated facility occupancy and information technology costs. Costs associated with processing samples are recorded as expense, regardless of the timing of revenue recognition. As such, cost of revenue and related volume does not always trend in the same direction as revenue recognition and related volume. Additionally, costs to support our Genentech Agreement are a component of our research and development activities. We expect cost of revenue to increase in absolute dollars as we grow our sequencing volume but the cost per sample to decrease over the long term due to the efficiencies we may gain as sequencing volume increases from improved utilization of our laboratory capacity, automation and other value engineering initiatives. Research and Development Expenses Research and development expenses consist of laboratory materials costs, personnel-related expenses, allocated facility costs, information technology and contract service expenses. Research and development activities support further development and refinement of existing assays and products, discovery of new technologies and investments into our immune medicine platform. We also include in research and development expenses the costs associated with software development activities to support laboratory scaling and workflow, as well as development of applications to support future commercial opportunities. We are currently conducting research and development activities for several products and services, and we typically use our laboratory materials, personnel, facilities, information technology and other development resources across multiple development programs. Additionally, certain of these research and development activities benefit more than one of our product opportunities. We do not track research and development expenses by specific product candidates. A component of our research and development activities is supporting clinical and analytical validations to obtain regulatory approval for future clinical products and services. Additionally, the costs to support our Genentech Agreement are a component of our research and development activities. Some of these activities have generated and may in the future generate development revenue. We expect our research and development expenses to continue to increase in absolute dollars as we innovate and expand the application of our platform. However, we expect research and development expenses to decrease as a percentage of revenue in the long term, although the percentage may fluctuate from period to period due to the timing and extent of our development and commercialization efforts. Sales and Marketing Expenses Sales and marketing expenses consist primarily of personnel-related expenses for commercial sales, account management, marketing, reimbursement, medical education and business development personnel that support commercialization of our platform products. In addition, these expenses include external costs such as advertising expenses, customer education and promotional expenses, market analysis expenses, conference fees, travel expenses and allocated facility costs. We expect our sales and marketing expenses to increase in absolute dollars as we expand our commercial sales, marketing and business development teams and increase marketing activities to drive awareness and adoption of our products and services. However, we expect sales and marketing expenses to decrease as a percentage of revenue in the long term, subject to fluctuations from period to period due to the timing and magnitude of these expenses. General and Administrative Expenses General and administrative expenses consist primarily of personnel-related expenses, including share-based compensation, salaries and benefits for our personnel in executive, legal, finance and accounting, human resources and other administrative functions, including third-party billing services. In addition, these expenses include insurance costs, external legal costs, accounting and tax service expenses, consulting fees and allocated facilities costs. We expect our general and administrative expenses to continue to increase in absolute dollars as we increase headcount and incur costs associated with operating as a public company, including expenses related to legal, accounting, regulatory matters, maintaining compliance with exchange listing and requirements of the SEC, director and officer insurance premiums and investor relations. Though expected to increase in absolute dollars, we expect these expenses to decrease as a percentage of revenue in the long term as revenue increases. Results of Operations The following table sets forth our results of operations for the periods presented: Comparison of the Years Ended December 31, 2019 and 2018 Revenue Total revenue was $85.1 million for the year ended December 31, 2019 compared to $55.7 million for the year ended December 31, 2018, representing an increase of $29.4 million, or 53%. Sequencing revenue increased to $43.5 million for the year ended December 31, 2019, representing an increase of $10.5 million, or 32%. The increase in sequencing revenue was attributable to an increase of approximately $6.3 million in revenue generated from biopharmaceutical and academic customers, inclusive of a decrease in revenue recognized from cancelled customer projects of $1.5 million, and a $4.2 million increase in revenue generated from clinical customers. Research sequencing volume increased by 18% to 35,491 sequences delivered in the year ended December 31, 2019 from 30,200 sequences delivered in the year ended December 31, 2018. Clinical sequencing volume increased by 48% to 10,168 clinical tests delivered in the year ended December 31, 2019 from 6,867 clinical tests delivered in the year ended December 31, 2018. Development revenue increased to $41.6 million for the year ended December 31, 2019, representing an increase of $18.9 million, or 83%. The increase was primarily attributable to $35.1 million of revenue generated from the Genentech Agreement, which generated no revenue in 2018, partially offset by a $7.1 million decrease in development revenue generated from translational agreements and a $9.1 million decrease in development revenue generated from MRD agreements, which includes an $8.0 million decrease in regulatory milestones. Cost of Revenue Cost of revenue was $22.3 million for the year ended December 31, 2019, compared to $19.7 million for the year ended December 31, 2018, representing an increase of $2.6 million, or 13%. The increase in cost of revenue was primarily attributable to an increase of $1.5 million in the cost of overhead due to the production laboratory expansion and a $1.0 million increase in the cost of materials due to increased sample volumes. Research and Development The following table presents disaggregated research and development expenses by cost classification for the periods presented: Research and development expenses were $70.7 million for the year ended December 31, 2019, compared to $39.2 million for the year ended December 31, 2018, representing an increase of $31.5 million, or approximately 81%. The increase was primarily attributable to $17.4 million in additional cost of materials and allocated production laboratory expenses, which primarily related to supporting our TCR drug discovery efforts, TCR-Antigen Map development and clonoSEQ development. Sales and Marketing Sales and marketing expenses were $38.5 million for the year ended December 31, 2019, compared to $24.5 million for the year ended December 31, 2018, representing an increase of $14.0 million, or 57%. The increase was primarily attributable to $8.2 million in additional personnel costs, $2.9 million in additional travel, entertainment and customer event related expenses and $2.4 million in additional consulting and marketing fees. General and Administrative General and administrative expenses were $30.3 million for the year ended December 31, 2019, compared to $20.4 million for the year ended December 31, 2018, representing an increase of $9.9 million, or 49%. The increase was primarily attributable to $4.3 million in additional personnel costs, $1.2 million in additional business taxes, largely due to the Genentech upfront payment received in February 2019, and a $2.0 million increase in insurance expense primarily related to public company director and officer coverage. Interest and Other Income, Net Interest and other income, net was $9.8 million for the year ended December 31, 2019, compared to $3.3 million for the year ended December 31, 2018, representing an increase of $6.5 million, or approximately 196%. The increase was primarily attributable to an $8.8 million increase in interest earned on and investment amortization of a larger portfolio, partially offset by the $2.3 million impact of revaluing a convertible preferred stock warrant liability in 2019. Quarterly Results of Operations The following tables set forth our unaudited condensed quarterly statements of operations data for each of the eight quarters in the 24-month period ended December 31, 2019. The information for each of these quarters has been prepared in accordance with GAAP and on the same basis as our audited financial statements included elsewhere in this Annual Report on Form 10-K. In the opinion of management, the financial information reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of results of operations data for these periods. This data should be read in conjunction with our audited financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Our historical quarterly operating results are not necessarily indicative of our operating results for the full year or any future period. Liquidity and Capital Resources We have incurred losses since inception and have incurred negative cash flows from operations from inception through December 31, 2018. As of December 31, 2019, we had an accumulated deficit of $365.5 million. We have funded our operations to date principally from the sale of convertible preferred stock and common stock, including the sale of common stock in our initial public offering, and, to a lesser extent, sequencing and development revenue. In December 2018, we entered into the Genentech Agreement pursuant to which we received a $300.0 million initial upfront payment in February 2019, may receive approximately $1.8 billion over time, including payments upon achievement of specified development, regulatory and commercial milestones, and may receive additional royalties on sales of products commercialized under this agreement. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $682.3 million. We believe our cash flows from operations and our existing cash, cash equivalents and marketable securities will be sufficient to fund our operating expenses and capital expenditure requirements through at least the next 12 months. We may consider raising additional capital to expand our business, to pursue strategic investments, to take advantage of financing opportunities or for other reasons. We plan to utilize the existing cash, cash equivalents and marketable securities on hand primarily to fund our commercial and marketing activities associated with our clinical products and services, continued research and development initiatives for our pipeline candidates and drug discovery initiatives, ongoing investments into our immune medicine platform and scaling of our laboratory operations with our anticipated growth. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. Currently, our funds are held in money market funds and marketable securities consisting of U.S. government debt securities, commercial paper and corporate bonds. As revenue from sales of immunoSEQ and clonoSEQ is expected to grow, we expect our accounts receivable and inventory balances to increase. Any increase in accounts receivable and inventory may not be completely offset by increases in accounts payable and accrued expenses, which could result in greater working capital requirements. Moreover, we expect to incur additional costs associated with operating as a public company, including expenses related to legal, accounting, regulatory matters and exchange listing and SEC compliance matters, as well as director and officer insurance premiums and investor relations. If our available cash, cash equivalents and marketable securities balances and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or convertible debt securities, enter into a credit facility or another form of third-party funding or seek other debt financing. The sale of equity and convertible debt securities may result in dilution to our shareholders 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. Cash Flows The following table summarizes our uses and sources of cash for the years ended December 31, 2019 and 2018 (in thousands): Operating Activities Cash provided by operating activities during the year ended December 31, 2019 was $205.4 million, which was primarily attributable to a net change in our operating assets and liabilities of $254.9 million, non-cash share-based compensation of $13.1 million, non-cash depreciation and amortization of $3.3 million and a $2.3 million fair value adjustment of our convertible preferred stock warrant liability due to an increase in valuation of our common stock, partially offset by a net loss of $68.6 million. The net change in our operating assets and liabilities reflects an increase in deferred revenue of $266.9 million, primarily due to the $300.0 million upfront payment by Genentech, and an increase in accounts payable and accrued liabilities of $6.1 million, primarily due to increased headcount and the growth in operating expenditures and timing of vendor payments. These increases were partially offset by an increase in accounts receivable of $7.8 million, primarily due to an increase in clinical billings, as well as an increase in revenue paid in arrears rather than upfront by biopharmaceutical customers, an increase in prepaid expenses and other current assets of $8.6 million, primarily due to prepaid software, prepaid insurance and interest receivables, an increase in inventory of $1.2 million to support growth in lab operations and $0.6 million in security deposits. Cash used in operating activities during the year ended December 31, 2018 was $32.3 million, which was primarily attributable to a net loss of $46.4 million, partially offset by non-cash share-based compensation of $11.1 million and non-cash depreciation and amortization of $4.8 million, and a net change in our operating assets and liabilities of $1.7 million. The net change in our operating assets and liabilities reflects an increase in inventory of $3.0 million to support growth in our laboratory, an increase in accounts payable and accrued liabilities of $2.2 million due to increased headcount, a decrease of $0.6 million in deferred revenue due to increased development revenue and a decrease of $0.5 million in deferred rent due to increases in cash rental payments. Investing Activities Cash used in investing activities during the year ended December 31, 2019 was $481.7 million, which was primarily attributable to purchases of marketable securities of $884.2 million and purchases of property and equipment of $11.2 million, partially offset by proceeds from maturities of marketable securities of $413.7 million. Cash provided by investing activities during the year ended December 31, 2018 was $0.7 million, which was primarily attributable to proceeds from maturities of marketable securities of $153.5 million, partially offset by purchases of marketable securities of $146.5 million and purchases of property and equipment of $6.3 million. Financing Activities Cash provided by financing activities during the year ended December 31, 2019 was $319.9 million, which was primarily attributable to proceeds from the initial public offering, net of underwriting discounts and commissions, of $320.9 million and proceeds from the exercise of stock options of $4.1 million, partially offset by payment of deferred initial public offering costs of $5.0 million. Cash provided by financing activities during the year ended December 31, 2018 was $1.2 million, which was primarily attributable to proceeds from the exercise of stock options. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019, which represents contractually committed future obligations (in thousands): (1) Operating lease obligations reflect remaining minimum commitments for our office and laboratory spaces in Seattle, Washington and South San Francisco, California and a commitment to an office lease in New York City, New York. Please see Note 10 of our financial statements for additional information pertaining to operating lease commitments. (2) Purchase commitments include commitments for cloud data storage through our collaboration with Microsoft, commitments to support clinical trials utilizing clonoSEQ, software and service license commitments, and minimum commitments for laboratory material suppliers. Furthermore, in connection with one of our lease agreements, we entered into a letter of credit of $2.1 million with one of our existing financial institutions. Net Operating Loss Carryforwards Utilization of our NOL carryforwards and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by Section 382 of the Internal Revenue Code of 1986 (“Section 382”) and similar state provisions. The annual limitation may result in the expiration of NOL carryforwards and credits before utilization. If there should be an ownership change, our ability to utilize our NOL carryforwards and credits could be limited. We have completed a Section 382 analysis and have determined there are no permanent limitations on the utilization of approximately $225.4 million of our federal NOLs as of December 31, 2018. Under the newly enacted federal income tax law, federal net operating losses incurred in 2018 and future years may be carried forward indefinitely, but the deductibility of such federal NOL is subject to an annual limitation. Net operating losses generated prior to 2018 are eligible to be carried forward up to 20 years. Based on the available objective evidence, management determined that it was more likely than not that the net deferred tax assets would not be realizable as of December 31, 2019. Accordingly, management applied a full valuation allowance against net deferred tax assets as of December 31, 2019. Off-Balance Sheet Arrangements As of December 31, 2019, we have not had any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Critical Accounting Policies and Estimates We have prepared our financial statements in accordance with GAAP. Our preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities and related disclosures at the date of the financial statements, as well as revenue and expense recorded during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and or other relevant assumptions that we believe to be reasonable under the circumstances. Estimates are used in several areas, including, but not limited to, estimates of progress to date for certain performance obligations and transaction price for certain contracts with customers, share-based compensation, including the fair value of stock, the provision for income taxes, including related reserves, and goodwill, among others. These estimates generally involve complex issues and require judgments, involve the analysis of historical results and prediction of future trends, can require extended periods of time to resolve and are subject to change from period to period. Actual results may differ materially from management’s estimates. While our significant accounting policies are described in more detail in Note 2 to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements. Revenue Recognition Our development and sequencing revenue arrangements may include upfront payments for the performance of services in the future, which have both fixed and variable consideration. Non-refundable upfront fees and funding for related development services are generally considered fixed consideration, while milestone payments are identified as variable consideration. In determining the appropriate amount of revenue to recognize as we fulfill our obligations under these agreements, we perform the following steps to determine the amount of revenue to be recognized: (1) identification of contract or contracts; (2) determination of whether the promised goods or services are performance obligations, including whether they are distinct in the context of the contract; (3) measurement of the transaction price, including the constraint on variable consideration; (4) allocation of the transaction price to the performance obligations based on estimated selling prices; and (5) recognition of revenue when (or as) we satisfy each performance obligation. 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 Accounting Standard Codification (“ASC”) Topic 606, Revenue from Contracts with Customers. Our performance obligations include sequencing services and services associated with regulatory submission and approval processes. Significant management judgment is applied to determine (1) the measurement of the transaction price, including the constraint on variable consideration, (2) the allocation of the transaction price to the performance obligations and (3) the appropriate input or output based method to recognize revenue and the extent of progress to date. We include the unconstrained amount of estimated variable consideration in the transaction price. The amount included in the transaction price is constrained to the amount for which 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, adjust our estimate of the overall transaction price. To determine the allocation of the transaction price to the performance obligations, we apply the adjusted market assessment approach. Using this approach, we evaluate the market in which we sell the services and estimate the price that a customer in that market would be willing to pay for those services. To select the measure of progress, we consider the expectations of the performance period which may be based on customer-dependent estimates of samples or internal estimates of the performance period based on both the customer and our expected development timeframes. We regularly review our expectations of the extent of progress, including whether any variable consideration is no longer constrained, and, if any changes in estimates are made, we recognize revenue using the cumulative catch-up method. Share-Based Compensation We measure share-based compensation expense for stock options granted to our employees and non-employee directors on the date of grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We estimate the fair value of stock options granted to our employees and non-employee directors on the grant date, and the resulting share-based compensation expense, using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of assumptions regarding a number of variables that are complex, subjective and generally require significant judgment to determine. The assumptions used to calculate the fair value of our stock options were: Fair value of common stock Prior to the closing of our initial public offering, the fair value of our common stock issuable upon exercise of stock options was determined by our board of directors, with input from management and independent third-party valuations, as discussed in “-Common Stock Valuations” below. For valuations of option grants made after the closing of our initial public offering, our board of directors determines the fair value of each share of common stock based on the closing price of our common stock on the date of grant or other relevant determination date, as reported on The Nasdaq Global Select Market. Expected term Our expected term represents the period that our stock options are expected to be outstanding. The expected term of options granted to employees and non-employee directors is determined using the “simplified” method, as illustrated in ASC Topic 718, Compensation-Stock Compensation, as we do not have sufficient exercise history to determine a better estimate of expected term. Under this approach, the expected term is based on the midpoint between the vesting date and the end of the contractual term of the option. Expected volatility As we do not have sufficient trading history for our common stock, the expected volatility is based on the historical volatility of our publicly traded industry peers utilizing a period of time consistent with our estimate of the expected term. The comparable companies are chosen based on their similar size, stage in the life cycle or area of specialty. Risk-free interest rate We utilize a risk-free interest rate in the option valuation model based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term of the options. Expected dividend yield We do not anticipate paying any cash dividends in the foreseeable future and, therefore, use an expected dividend yield of zero in the option valuation model. Black-Scholes assumptions The estimated fair value of options granted during the periods presented was estimated using the Black-Scholes option-pricing model with the following assumptions: As of January 1, 2018, we adopted Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718) and elected to account for forfeitures as they occur rather than estimate expected forfeitures over the vesting period of the respective grant. We use judgment in evaluating the assumptions related to our share-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 share-based compensation expense. At December 31, 2019, unrecognized share-based compensation expense related to unvested stock options was $33.3 million, which was expected to be recognized over a remaining weighted-average period of 2.9 years. Common Stock Valuations For periods prior to the closing of our initial public offering, the estimated fair value of the common stock issuable upon exercise of our stock options was determined by our board of directors, with input from management, considering our most recently available third-party valuations of common stock and our board of directors’ assessment of additional objective and subjective factors that it believed were relevant, and factors that may have changed from the date of the most recent valuation through the date of the grant, which intended all options granted to be exercisable at a price per share not less than the fair value per share of our common stock issuable upon exercise of those options on the date of grant. We believe our board of directors had the relevant experience and expertise to determine the fair value of our common stock. Prior to our initial public offering, given the absence of a public trading market for our common stock, 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 used in the valuation model were based on future expectations combined with management’s judgment. 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: • independent valuations performed at periodic intervals by an independent third-party valuation firm; • the prices, rights, preferences and privileges of our convertible preferred stock relative to our common stock; • our operating and financial performance, forecasts and capital resources; • current business conditions; • the hiring of key personnel; • our stage of commercialization; • the status of research and development efforts; • the likelihood of achieving a liquidity event for the shares of common stock issuable upon exercise of these stock options, such as an initial public offering or sale of our company, given prevailing market conditions; • any adjustment necessary to recognize a lack of marketability for our common stock; • trends and developments in our industry; • the market performance of comparable publicly traded technology companies; and • the U.S. and global economic and capital market conditions. In valuing our common stock prior to the closing of our initial public offering, we utilized a hybrid methodology that includes a probability-weighted expected return method (“PWERM”) and an option pricing method (“OPM”), which is a highly complex and subjective valuation methodology. Under a PWERM, the fair market value of the common stock is estimated based upon an analysis of future values for the enterprise assuming various future outcomes. Within one of those potential outcomes, we utilized the OPM. The OPM treats the rights of the holders of convertible preferred stock and common stock as equivalent to that of call options on any value of the enterprise above certain break points of value based upon the liquidation preferences of the holders of preferred stock, as well as their rights to participation and conversion. Based on the timing and nature of an assumed liquidity event in each scenario, a discount for lack of marketability either was or was not applied to each scenario, as appropriate. We then probability-weighted the value of each expected outcome to arrive at an estimate of fair value per share of common stock. For valuations after the closing of our initial public offering, our board of directors determines the fair value of each share of common stock based on the closing price of our common stock on the date of grant or other relevant determination date, as reported on The Nasdaq Global Select Market. Goodwill Goodwill represents the excess of the purchase price over the net amount of identifiable assets acquired and liabilities assumed in a business combination measured at fair value. We assess goodwill for impairment annually on October 1 and upon any occurrence of triggering events or substantive changes in circumstances that could indicate a potential impairment. We evaluate goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount. We evaluate certain qualitative factors such as macroeconomic conditions, the market and industry in which we operate, cost factors, overall financial performance and other relevant entity-specific events to determine if there are any negative trends or events that could indicate impairment. Key assumptions in this analysis include anticipated demand for our products and services, including industry and regulatory changes, future revenue growth and cash, cash equivalents and marketable securities on hand. These assumptions are determined based on our historical performance and management’s forecasted results. Management’s estimates of forecasted results 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. If we determine that it is more likely than not that the fair value of our reporting unit is less than its carrying amount, or if we choose to bypass the qualitative assessment, we perform a quantitative goodwill impairment test. Goodwill impairment exists when the estimated fair value of our one reporting unit is less than its carrying value. If impairment exists, the carrying value of the goodwill is reduced to fair value through an impairment charge recorded in our statements of operations. To date, we have not recognized any impairment of goodwill. JOBS Act Accounting Election We are an “emerging growth company” within the meaning of the JOBS Act. The JOBS Act allows an emerging growth company 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. We have elected to use this extended transition period and, as a result, our financial statements may not be comparable to companies that comply with public company effective dates. We also intend to rely on other exemptions provided by the JOBS Act, including not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act. We will remain an emerging growth company until the earliest 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” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock held by non-affiliates exceeded $700.0 million as of the last business day of the second fiscal quarter of such year or (4) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. Recent Accounting Pronouncements See Note 2 to the financial statements included elsewhere in this Annual Report on Form 10-K for more information.

<s>[INST] This section generally discusses 2019 and 2018 items and yeartoyear comparisons between 2019 and 2018. Discussions of 2017 items and yeartoyear comparisons between 2018 and 2017 may be found in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of our prospectus for our initial public offering, dated June 26, 2019 filed with the SEC on June 27, 2019. Overview We are advancing the field of immunedriven medicine by harnessing the inherent biology of the adaptive immune system to transform the diagnosis and treatment of disease. Our immune medicine platform applies our proprietary technologies to read the diverse genetic code of a patient’s immune system and understand precisely how it detects and treats disease in that patient. We capture these insights in our dynamic clinical immunomics database, which is underpinned by computational biology and machine learning, and use them to develop and commercialize clinical products and services that we are tailoring to each individual patient. We have two commercial products and services and a robust pipeline of clinical products and services that we are designing to diagnose, monitor and enable the treatment of diseases such as cancer, autoimmune conditions and infectious diseases. Our immune medicine platform is the foundation for our expanding suite of products and services. The cornerstone of our platform and core immunosequencing product, immunoSEQ, serves as our underlying research and development engine and generates revenue from academic and biopharmaceutical customers. Our first clinical diagnostic product, clonoSEQ, is the first test authorized by the FDA for the detection and monitoring of MRD in patients with MM and ALL and is being validated for patients with other blood cancers. Leveraging our collaboration with Microsoft to create the TCRAntigen Map, we are also developing a diagnostic product, immunoSEQ Dx, that may enable early detection of many diseases from a single blood test. We have established proof of concept for immunoSEQ Dx in acute Lyme disease, such that we can proceed to clinical validation, and continue to pursue signals for other disease states. Our therapeutic product candidates, being developed under the Genentech Agreement, leverage our platform to identify specific immune cells to develop into cellular therapies in oncology. Since our inception, we have devoted a majority of our resources to research and development activities to develop our immune medicine platform, which enables the delivery of our products and services for life sciences research, clinical diagnostics and drug discovery customers. For our life science research customers, we provide two categories of products and services using immunoSEQ, our core sequencing and immunomics tracking technology. First, we provide immunosequencing services, the revenue from which we record as sequencing revenue. Second, we provide certain research customers professional support, for which we may receive payments upon those customers achieving specified milestones. We record these support activities as development revenue. For our clinical diagnostics customers, we sell our clonoSEQ diagnostic tests, which include our immunosequencing services and are thus recorded as sequencing revenue. In the future, we intend to sell other diagnostics products and services, which we also expect to record as sequencing revenue. For our current drug discovery collaborator, Genentech, we screen, identify and characterize TCRs in support of our collaboration. We record revenue from this collaboration as development revenue. Historically, we have sold immunoSEQ as a feeforservice offering to academic centers and biopharmaceutical customers and further deepened those relationships over time by supporting their development initiatives. These research offerings have comprised the majority of our revenue to date, although our business is pursuing broader opportunities. As we continue to expand the use of our clonoSEQ diagnostic tests, develop and commercialize immunoSEQ Dx and develop and commercialize therapeutic product candidates with our drug discovery collaborator, we expect our mix of revenue to shift to clinical products and services, which we believe will become our largest sources of revenue. We are actively pursuing opportunities to deepen our relationships with current customers and initiate relationships with new customers. We have an experienced, specialty salesforce that is targeting department heads, laboratory directors, principal investigators, [/INST] Negative. </s>

BLUE RIDGE BANKSHARES, INC.

2020-04-14

2019-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following presents management’s discussion and analysis of the Company’s consolidated financial condition and the results of the Company’s operations. This discussion should be read in conjunction with the Company’s consolidated financial statements and the notes thereto presented in Item 8, Financial Statements and Supplementary Information, of this Form 10-K. Cautionary Note About Forward-Looking Statements We make certain forward-looking statements in this Form 10-K that are subject to risks and uncertainties. These forward-looking statements represent plans, estimates, objectives, goals, guidelines, expectations, intentions, projections and statements of our beliefs concerning future events, business plans, objectives, expected operating results and the assumptions upon which those statements are based. Forward-looking statements include without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and are typically identified with words such as “may,” “could,” “should,” “will,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “aim,” “intend,” “plan,” or words or phases of similar meaning. We caution that the forward-looking statements are based largely on our expectations and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are, in many instances, beyond our control. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements. The following factors, among others, could cause our financial performance to differ materially from that expressed in such forward-looking statements: • the strength of the United States economy in general and the strength of the local economies in which we conduct operations; • geopolitical conditions, including acts or threats of terrorism, or actions taken by the United States or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the United States and abroad; • the occurrence of significant natural disasters, including severe weather conditions, floods, health related issues (including the recent COVID-19 outbreak and the associated efforts to limit the spread of the disease), and other catastrophic events; • our management of risks inherent in our real estate loan portfolio, and the risk of a prolonged downturn in the real estate market, which could impair the value of our collateral and our ability to sell collateral upon any foreclosure; • changes in consumer spending and savings habits; • technological and social media changes; • the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rate, market and monetary fluctuations; • changing bank regulatory conditions, policies or programs, whether arising as new legislation or regulatory initiatives, that could lead to restrictions on activities of banks generally, or our subsidiary bank in particular, more restrictive regulatory capital requirements, increased costs, including deposit insurance premiums, regulation or prohibition of certain income producing activities or changes in the secondary market for loans and other products; • the impact of changes in financial services policies, laws and regulations, including laws, regulations and policies concerning taxes, banking, securities and insurance, and the application thereof by regulatory bodies; • the impact of changes in laws, regulations and policies affecting the real estate industry; • the effect of changes in accounting policies and practices, as may be adopted from time to time by bank regulatory agencies, the SEC, the Public Company Accounting Oversight Board (the “PCAOB”), the FASB or other accounting standards setting bodies; • the timely development of competitive new products and services and the acceptance of these products and services by new and existing customers; • the willingness of users to substitute competitors' products and services for our products and services; • the effect of acquisitions we may make, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions; • changes in the level of our nonperforming assets and charge-offs; • our involvement, from time to time, in legal proceedings and examination and remedial actions by regulators; • potential exposure to fraud, negligence, computer theft and cyber-crime. The foregoing factors should not be considered exhaustive and should be read together with other cautionary statements that are included in this Form 10-K, including those discussed in the section entitled "Risk Factors" in Item 1A above. If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Form 10-K. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. We will not update the forward-looking statements to reflect actual results or changes in the factors affecting the forward-looking statements. New risks and uncertainties may emerge from time to time, and it is not possible for us to predict their occurrence or how they will affect us. Critical Accounting Policies General The accounting principles Blue Ridge applies under GAAP are complex and require management to apply significant judgment to various accounting, reporting and disclosure matters. Management must use assumptions, judgments and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from initial estimates. The accounting policies Blue Ridge views as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, the fair value measurements of certain assets and liabilities, and accounting for other real estate owned. Allowance for Loan Losses The allowance for loan losses is maintained at a level believed to be adequate by Blue Ridge to absorb probable losses inherent in the portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans and actual loss experience, current economic events in specific industries and other pertinent factors such as regulatory guidance and general economic conditions. The allowance is established through a provision for loan losses charged to earnings. Loans identified as losses and deemed uncollectible by management are charged to the allowance. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management. The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired, for which an allowance is established when the fair value of the loan is lower than its carrying value. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. Historical losses are categorized into risk-similar loan pools and a loss ratio factor is applied to each group’s loan balances to determine the allocation. Qualitative and environmental factors include external risk factors that Blue Ridge believes affects its overall lending environment. Environmental factors that Blue Ridge routinely analyzes include levels and trends in delinquencies and impaired loans, levels and trends in charge-offs and recoveries, trends in volume and terms of loans, effects of changes in risk selection and underwriting practices, experience, ability, depth of lending management and staff, national and local economic trends, conditions such as unemployment rates, housing statistics, banking industry conditions, and the effect of changes in credit concentrations. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change. Credit losses are an inherent part of the Company’s business and, although Blue Ridge believes the methodologies for determining the allowance for loan losses and the current level of the allowance are appropriate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Additional provisions for such losses, if necessary, would be recorded, and would negatively impact earnings. Allowance for Loan Losses-Acquired Loans Acquired loans accounted for under Accounting Standards Codification (“ASC”) 310-30 For our acquired loans, to the extent that we experience a deterioration in borrower credit quality resulting in a decrease in our expected cash flows subsequent to the acquisition of the loans, an allowance for loan losses would be established based on our previously described allowance methodology Acquired loans accounted for under ASC 310-20 Subsequent to the acquisition date, we establish our allowance for loan losses through a provision for loan losses based upon an evaluation process that is similar to our evaluation process used for originated loans. This evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers, among other factors, the estimated fair value of the underlying collateral, economic conditions, historical net loan loss experience, carrying value of the loans, which includes the remaining net purchase discount or premium, and other factors that warrant recognition in determining our allowance for loan losses. Purchased Credit-Impaired Loans Purchased credit-impaired ("PCI") loans, which are the loans acquired in our acquisition of Virginia Community Bank, are loans acquired at a discount (that is due, in part, to credit quality). These loans are initially recorded at fair value (as determined by the present value of expected future cash flows) with no allowance for loan losses. We account for interest income on all loans acquired at a discount (that is due, in part, to credit quality) based on the acquired loans' expected cash flows. The acquired loans may be aggregated and accounted for as a pool of loans if the loans being aggregated have common risk characteristics. A pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flow. The difference between the cash flows expected at acquisition and the investment in the loans, or the "accretable yield," is recognized as interest income utilizing the level-yield method over the life of each pool. Increases in expected cash flows subsequent to the acquisition are recognized prospectively through adjustment of the yield on the pool over its remaining life, while decreases in expected cash flows are recognized as impairment through a loss provision and an increase in the allowance for loan losses. Therefore, the allowance for loan losses on these impaired pools reflect only losses incurred after the acquisition (representing the present value of all cash flows that were expected at acquisition but currently are not expected to be received). We periodically evaluate the remaining contractual required payments due and estimates of cash flows expected to be collected. These evaluations, performed quarterly, require the continued use of key assumptions and estimates, similar to the initial estimate of fair value. Changes in the contractual required payments due and estimated cash flows expected to be collected may result in changes in the accretable yield and non-accretable difference or reclassifications between accretable yield and the non-accretable difference. On an aggregate basis, if the acquired pools of PCI loans perform better than originally expected, we would expect to receive more future cash flows than originally modeled at the acquisition date. For the pools with better than expected cash flows, the forecasted increase would be recorded as an additional accretable yield that is recognized as a prospective increase to our interest income on loans. Fair Value Measurements Blue Ridge determines the fair values of financial instruments based on the fair value hierarchy, which 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. the Company’s investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs. Depending on the availability of observable inputs and prices, different valuation models could produce materially different fair value estimates. The values presented may not represent future fair values and may not be realizable. Other Real Estate Owned Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at fair value of the property, less estimated disposal costs, if any. Any excess of cost over the fair value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The fair value is reviewed periodically by management and any write downs are charged against current earnings. Emerging Growth Company Blue Ridge qualifies as an “emerging growth company,” as defined in the federal securities laws. For as long as it continues to be an emerging growth company, Blue Ridge may take advantage of 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(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. In addition, as an emerging growth company, Blue Ridge has elected to take advantage of the extended transition period for complying with new or revised accounting standards until those standards would otherwise apply to a company that is not an issuer (as defined under Section 2(a) of the Sarbanes-Oxley Act), if such standards apply to companies that are not issuers. This may make the Company’s financial statements not comparable with other public companies that are not emerging growth companies or that are emerging growth companies that have opted out of the extended transition period because of the potential differences in accounting standards used. Blue Ridge could be an emerging growth company for up to five years, although it could lose that status sooner if its gross revenues exceed $1.07 billion, if it issues more than $1.0 billion in non-convertible debt in a three-year period, or if the market value of its common stock held by non-affiliates exceeds $700 million as of any June 30 before that time, in which case Blue Ridge would no longer be an emerging growth company as of the following December 31. Comparison of Results of Operations for the Years Ended December 31, 2019 and 2018 For the year ended December 31, 2019, Blue Ridge reported net income of $4.8 million, compared to $4.6 million reported for 2018. Basic and diluted earnings per share were $1.14 in 2019 compared to $1.64 in 2018. Net Interest Income. Net interest income is the excess of interest earned on loans and investments over the interest paid on deposits and borrowings and is the Company’s primary revenue source. Net interest income is thereby affected by overall balance sheet growth, changes in interest rates and changes in the mix of investments, loans, deposits and borrowings. Net interest income was $21.4 million for the year ended December 31, 2019, compared to $17.3 million for the year ended December 31, 2018. Net interest margin was 3.48% for the year ended December 31, 2019 compared to 3.88% for the year ended December 31, 2018. The increase in net interest income in 2019 was primarily due to continued growth in the loan portfolio in addition to significant growth in the investment portfolio. The following table shows the average balance sheets for each of the years ended December 31, 2019, 2018 and 2017. In addition, the amounts of interest earned on interest-earning assets, with related yields, and interest expense on interest-bearing liabilities, with related rates, are shown. (1) Computed on a fully taxable equivalent basis. (2) Non-accrual loans have been included in the computations of average loan balances. Interest income and expense are affected by changes in interest rates, by changes in the volumes of earning assets and interest-bearing liabilities, and by changes in the mix of these assets and liabilities. The following rate-volume variance analysis shows the year-to-year changes in the components of net interest income: Provision for Loan Losses. The provision for loan losses was $1.7 million during the year ended December 31, 2019 as compared to $1.2 million during the year ended December 31, 2018. Net charge-offs amounted to $750 thousand during the year ended December 31, 2019 and $448 thousand for the year ended December 31, 2018. The increase in the provision for loan losses during 2019 compared to the like period in 2018 was due to overall loan portfolio growth as well as changes in portfolio mix. Non-Interest Income. The Company’s non-interest income sources include deposit service charges and other fees, gains/losses on sales of mortgages, and income from bank owned life insurance. Non-interest income totaled $18.8 million for the year ended December 31, 2019, compared to $10.1 million for the like period in 2018. The increase in non-interest income was largely due to an increase of $7.2 million related to the origination and sale of held for sale mortgages. Additionally, earnings on investment in life insurance increased $735 thousand largely due to Blue Ridge receiving life insurance proceeds. The following table provides detail for non-interest income for the years ended December 31, 2019 and 2018: Non-Interest Expense. Non-interest expense totaled $32.8 million for the year ended December 31, 2019 as compared to $20.5 million for the same period in 2018, a 60.5% increase. This was primarily due to an increase in salaries and employee benefits of $7.5 million, or 63.2%, which was a result of Blue Ridge hiring individuals in key positions to expand its team, in addition to hiring individuals to lead its new branch in Greensboro, North Carolina, and expanding its mortgage operations in Northern Virginia. Additionally, occupancy expenses increased $924 thousand, or 57.2%, due to additional leased locations for the expanded mortgage division, and a full year of lease expense for the branch in Greensboro, North Carolina. Legal and other professional fees increased $1.4 million, or 329.8%, as a result of expenses associated with the acquisition of VCB. Data processing costs increased $791 thousand, or 71.3%, a majority of which is related to the fees associated with integrating VCB’s core processing system with Blue Ridge. The following table provides detail for non-interest expense for the years ended December 31, 2019 and 2018: Income Tax Expense. During the year ended December 31, 2019, Blue Ridge recognized a provision for income taxes of $826 thousand, for an effective tax rate of 14.8%, as compared to a provision of $1.1 million, for an effective tax rate of 20.1% for the year ended December 31, 2018. Analysis of Financial Condition Loan Portfolio. Blue Ridge makes loans to individuals as well as to commercial entities. Specific loan terms vary as to interest rate, repayment and collateral requirements based on the type of loan requested and the creditworthiness of the prospective borrower. Credit risk tends to be geographically concentrated in that a majority of the loan customers are located in the markets serviced by Blue Ridge. All loans are underwritten within specific lending policy guidelines that are designed to maximize the Company’s profitability within an acceptable level of business risk. The following table sets forth the distribution of the Company’s loan portfolio at the dates indicated by category of loan and the percentage of loans in each category to total loans. The following table sets forth the repricing characteristics and sensitivity to interest rate changes of our loan portfolio at December 31, 2019 and December 31, 2018: Blue Ridge prepares a quarterly analysis of the allowance for loan losses, with the objective of quantifying portfolio risk into a dollar amount of inherent losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged against income and decreased by loans charged-off (net of recoveries, if any). Management’s periodic evaluation of the adequacy of the allowance is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions. While management uses the best information available to make evaluations, future adjustments may be necessary, if economic or other conditions differ substantially from the assumptions used. The allowance consists of specific and general components. The specific component relates to loans that are identified as impaired. For loans that are classified as impaired, an allowance is established when the discounted cash flows or the net realizable value, which is equal to the estimated fair value less estimated costs to sell, of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and those loans classified that are not impaired and is based on historical loss experience adjusted for other internal or external influences on credit quality that are not fully reflected in the historical data. Blue Ridge follows applicable guidance issued by FASB. This guidance requires that losses be accrued when they are probable of occurring and can be estimated. It also requires that impaired loans, within its scope, be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. Loans are evaluated for non-accrual status when principal or interest is delinquent for 90 days or more and are placed on non-accrual status when a loan is specifically determined to be impaired. Any unpaid interest previously accrued on those loans is reversed from income. Any interest payments subsequently received are recognized as income or amortized over the life of the refinanced loan depending on the specific circumstances. Interest payments received on loans, where management believes a potential for loss remains, are applied as a reduction of the loan principal balance. Management believes that the allowance for loan losses is adequate. There can be no assurance, however, that adjustments to the provision for loan losses will not be required in the future. Changes in the economic assumptions underlying management’s estimates and judgments; adverse developments in the economy, on a national basis or in the Company’s market area; or changes in the circumstances of particular borrowers are criteria that could change and make adjustments to the provision for loan losses necessary. The following table presents a summary of the provision and allowance for loan losses for the periods indicated: The allowance for loan losses includes specific and additional allowances for impaired loans and a general allowance applicable to all loan categories; however, management has allocated the allowance by loan type to provide an indication of the relative risk characteristics of the loan portfolio. The allocation is an estimate and should not be interpreted as an indication that charge-offs will occur in these amounts, or that the allocation indicates future trends, and does not restrict the usage of the allowance for any specific loan or category. The allocation of the allowance at the end of the period indicated, and as a percent of the applicable loan segment, is as follows: Non-performing Assets. Non-performing assets consist of non-accrual loans, loans past due 90 days and still accruing interest, and other real estate owned (foreclosed properties). The level of non-performing assets decreased by $2.5 million during 2019 to $5.2 million at December 31, 2019, compared to $7.7 million at December 31, 2018 and $7.8 million at December 31, 2017. Blue Ridge has established specific loan loss reserves on impaired loans equal to the estimated collateral deficiency (if any), plus the cost of sale of the underlying collateral, as applicable. Loans are placed in non-accrual status when in the opinion of management the collection of additional interest is unlikely or a specific loan meets the criteria for non-accrual status established by regulatory authorities. No interest is taken into income on non-accrual loans. A loan remains on non-accrual status until the loan is current as to both principal and interest or the borrower demonstrates the ability to pay and remain current, or both. Foreclosed real properties include properties that have been substantively repossessed or acquired in complete or partial satisfaction of debt. Such properties, which are held for resale, are carried at fair value, including a reduction for the estimated selling expenses. The following is a summary of information pertaining to risk elements and non-performing assets at the dates indicated: Investment Securities. The investment portfolio is used as a source of interest income, credit risk diversification and liquidity, as well as to manage rate sensitivity and provide collateral for short-term borrowings. Securities in the investment portfolio classified as securities available-for-sale may be sold in response to changes in market interest rates, changes in the securities’ prepayment risk, increased loan demand, general liquidity needs, and other similar factors, and are carried at estimated fair value. The fair value of the Company’s investment securities available-for-sale was $108.6 million at December 31, 2019, an increase of $70.5 million, or 185.4%, from $38.0 million at December 31, 2018. Investment securities held-to-maturity at December 31, 2019 totaled $12.2 million, $15.6 million at December 31, 2018, and $13.2 million at December 31, 2017. Securities in the investment portfolio classified as held-to-maturity are those securities that Blue Ridge has the ability to hold to maturity and are carried at amortized cost. At December 31, 2018, Blue Ridge had total investment securities available-for-sale of $38.0 million, an increase of $5.4 million, or 16.8%, from $32.6 million at December 31, 2017. Blue Ridge purchased $11.6 million in investment securities available-for-sale to offset redemptions and sales of $5.3 million and to enhance the yield of the portfolio during 2018. As of December 31, 2019 and 2018, the majority of the investment securities portfolio consisted of securities rated A to AAA by a leading rating agency. Investment securities which carry a AAA rating are judged to be of the best quality and carry the smallest degree of investment risk. Investment securities that were pledged to secure public deposits totaled $11.8 million and $16.6 million at December 31, 2019 and December 31, 2018, respectively. Blue Ridge completes reviews for other-than-temporary impairment at least quarterly. At December 31, 2019 and December 31, 2018, only investment grade securities were in an unrealized loss position. Investment securities with unrealized losses are a result of pricing changes due to recent and negative conditions in the current market environment and not as a result of permanent credit impairment. Contractual cash flows for the agency mortgage-backed securities are guaranteed and/or funded by the U.S. government. Municipal securities show no indication that the contractual cash flows will not be received when due. Blue Ridge does not intend to sell nor does it believe that it will be required to sell any of its temporarily impaired securities prior to the recovery of the amortized cost. No other-than-temporary impairment has been recognized for the securities in the Company’s investment portfolio as of December 31, 2019 and December 31, 2018. Blue Ridge holds restricted investments in equities of the Federal Reserve Bank of Richmond (“FRB”), FHLB, and through its correspondent bank, Community Banker’s Bank (“CBB”). At December 31, 2019, Blue Ridge owned $6.0 million of FHLB stock, $963 thousand of FRB stock, and $248 thousand of CBB stock. At December 31, 2018, Blue Ridge owned $3.5 million of FHLB stock, $813 thousand of FRB stock, and $168 thousand of CBB stock. At December 31, 2017, Blue Ridge owned $1.9 million of FHLB stock, $813 thousand of FRB stock, and $168 thousand of CBB stock. The following table reflects the composition of the Company’s investment portfolio, at amortized cost, at December 31, 2019, 2018 and 2017: The following tables present the amortized cost of the Company’s investment portfolio by their stated maturities, as well as the weighted average yields for each of the maturity ranges at December 31, 2019 and December 31, 2018. Deposits. The principal sources of funds for Blue Ridge are core deposits (demand deposits, interest-bearing transaction accounts, money market accounts, savings deposits and certificates of deposit) from its market area. the Company’s deposit base includes transaction accounts, time and savings accounts and other accounts that customers use for cash management purposes and which provide Blue Ridge with a source of fee income and cross-marketing opportunities as well as a low-cost source of funds. Time and savings accounts, including money market deposit accounts, also provide a relatively stable low-cost source of funding. Please refer to the average balance tables under “Net Interest Income” for information regarding the average balance of deposits, and average rates paid. Approximately 36.1% of the Company’s deposits at December 31, 2019 were made up of time deposits, which are generally the most expensive form of deposit because of their fixed rate and term, as compared to 40.9% and 47.8% at December 31, 2018 and December 31, 2017, respectively. The following tables provide a summary of the Company’s deposit base at the dates indicated and the maturity distribution of certificates of deposit of $100,000 or more as of the end of the periods indicated: Maturities of Time Deposits ($100,000 or greater) Brokered and listing service deposits made up of both certificate of deposits and money market demand accounts totaled $49.8 million at December 31, 2019, an increase of $26.3 million from $23.5 million at December 31, 2018. At December 31, 2017, these third-party deposits totaled $25.0 million. Borrowings: The following table provides information on the balances and interest rates on total borrowings at the dates indicated: FHLB advances are secured by collateral consisting of a blanket lien on qualifying loans in the Company’s residential, multifamily and commercial real estate mortgage loan portfolios as well as selected investment portfolio securities. Liquidity. Liquidity in the banking industry is defined as the ability to meet the demand for funds of both depositors and borrowers. Blue Ridge must be able to meet these needs by obtaining funding from depositors or other lenders or by converting non-cash items into cash. The objective of the Company’s liquidity management program is to ensure that it always has sufficient resources to meet the demands of depositors and borrowers. Stable core deposits and a strong capital position provide the base for the Company’s liquidity position. Blue Ridge believes it has demonstrated its ability to attract deposits because of the Company’s convenient branch locations, personal service, technology and pricing. In addition to deposits, Blue Ridge has access to the different wholesale funding markets. These markets include the brokered certificate of deposit market, listing service deposit market, and the federal funds market. Blue Ridge is a member of the Promontory Interfinancial Network, which allows banking customers to access FDIC insurance protection on deposits through Blue Ridge which exceed FDIC insurance limits. Blue Ridge also has one-way authority with Promontory for both their Certificate of Deposit Account Registry Service and Insured Cash Swap Service products which provides Blue Ridge the ability to access additional wholesale funding as needed. Blue Ridge also maintains secured lines of credit with the FRB and the FHLB for which Blue Ridge can borrow up to the allowable amount for the collateral pledged. Having diverse funding alternatives reduces the Company’s reliance on any one source for funding. Cash flow from amortizing assets or maturing assets also provides funding to meet the needs of depositors and Cash flow from amortizing assets or maturing assets also provides funding to meet the needs of depositors and borrowers. Blue Ridge has established a formal liquidity contingency plan which provides guidelines for liquidity management. For the Company’s liquidity management program, it first determines current liquidity position and then forecasts liquidity based on anticipated changes in the balance sheet. In this forecast, Blue Ridge expects to maintain a liquidity cushion. Blue Ridge also stress tests its liquidity position under several different stress scenarios, from moderate to severe. Guidelines for the forecasted liquidity cushion and for liquidity cushions for each stress scenario have been established. Blue Ridge believes that it has sufficient resources to meet its liquidity needs. Blue Ridge had a credit line available of $220.6 million with the FHLB with an outstanding balance of $134.8 million, inclusive of a $10 million letter of credit for use as pledging to the Commonwealth of Virginia for public deposits, as of December 31, 2019, leaving the remaining credit availability of $85.8 million at December 31, 2019. As of December 31, 2018, the outstanding balance of borrowings with the FHLB totaled $73.1 million. Blue Ridge had four unsecured federal fund lines available with correspondent banks for overnight borrowing totaling $21 million at December 31, 2019 and December 31, 2018. These lines were not drawn upon at December 31, 2019 or 2018. Liquidity is essential to the Company’s business. the Company’s liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that Blue Ridge may be unable to control, such as general market disruption, negative views about the financial services industry generally, or an operational problem that affects a third party or Blue Ridge. the Company’s ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events. Blue Ridge monitors its liquidity position daily through cash flow forecasting and monthly testing against minimum policy ratios and believes its level of liquidity and capital is adequate to conduct the business of Blue Ridge. Capital. Capital adequacy is an important measure of financial stability and performance. the Company’s objectives are to maintain a level of capitalization that is sufficient to sustain asset growth and promote depositor and investor confidence. Regulatory agencies measure capital adequacy utilizing a formula that considers the individual risk profile of the financial institution. The minimum capital requirements for the Bank are: (i) a common equity Tier 1 (“CET1”) capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6%; (iii) a total risk-based capital ratio of 8%; and (iv) a Tier 1 leverage ratio of 4%. Additionally, a capital conservation buffer requirement of 2.5% of risk-weighted assets is designed to absorb losses during periods of economic stress and is applicable to the Bank’s CET1 capital, Tier 1 capital and total capital ratios. Including the conservation buffer, the Bank’s minimum capital ratios are as follows: 7.00% for CET1; 8.50% for Tier 1 capital; and 10.50% for Total Risk-Based capital. Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation. Blue Ridge Bank was considered “well capitalized” for regulatory purposes at December 31, 2019 and December 31, 2018. On September 17, 2019, the federal banking agencies jointly issued a final rule required by the EGRRCPA that permits qualifying banks and bank holding companies that have less than $10 billion in consolidated assets to elect to be subject to the CBLR. Under the rule, which became effective on January 1, 2020, banks and bank holding companies that opt into the CBLR framework and maintain a CBLR of greater than 9% are not subject to other risk-based and leverage capital requirements under the Basel III Capital Rules and would be deemed to have met the well capitalized ratio requirements under the “prompt corrective action” framework. The Company is evaluating whether to opt into the CBLR framework. As noted above, regulatory capital levels for the Bank meet those established for "well capitalized" institutions. While the Bank is currently considered "well capitalized," it may from time to time find it necessary to access the capital markets to meet the Company’s growth objectives or capitalize on specific business opportunities. The following table shows the minimum capital requirement and the capital position at December 31, 2019 and December 31, 2018 for the Bank. (1) Except with regard to the Bank’s Tier 1 to average assets ratio, the minimum capital requirement includes the phased-in portion of the Basel III Capital Rules capital conservation buffer as of the applicable date. Off-Balance Sheet Activities Standby letters of credit are conditional commitments issued by Blue Ridge to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers; Blue Ridge generally holds collateral supporting these commitments. In the event the customer does not perform in accordance with the terms of the agreement with the third party, Blue Ridge would be required to fund the commitment. The maximum potential amount of future payments Blue Ridge could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, Blue Ridge would be entitled to seek recovery from the customer. The maximum potential amount of future advances on standby letters of credit available through Blue Ridge at December 31, 2019 and 2018, totaled $641 thousand and $1.6 million, respectively. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Blue Ridge evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Blue Ridge upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include real estate and income producing commercial properties. The approved commitments to extend credit that was available but unused at December 31, 2019 and 2018 totaled $107.7 million and $65.2 million, respectively. Interest Rate Risk Management As a financial institution, Blue Ridge is exposed to various business risks, including interest rate risk. Interest rate risk is the risk to earnings and value arising from volatility in market interest rates. Interest rate risk arises from timing differences in the repricing and maturities of interest-earning assets and interest-bearing liabilities, changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers' ability to prepay loans and depositors' ability to redeem certificates of deposit before maturity, changes in the shape of the yield curve where interest rates increase or decrease in a nonparallel fashion, and changes in spread relationships between different yield curves, such as U.S. Treasuries and LIBOR. the Company’s goal is to maximize net interest income without incurring excessive interest rate risk. Management of net interest income and interest rate risk must be consistent with the level of capital and liquidity that Blue Ridge maintains. Blue Ridge manages interest rate risk through an asset and liability committee (“ALCO”). ALCO is responsible for managing the Company’s interest rate risk in conjunction with liquidity and capital management. Blue Ridge employs an independent consulting firm to model its interest rate sensitivity. Blue Ridge uses a net interest income simulation model as its primary tool to measure interest rate sensitivity. Many assumptions are developed based on expected activity in the balance sheet. For maturing assets, assumptions are created for the redeployment of these assets. For maturing liabilities, assumptions are developed for the replacement of these funding sources. Assumptions are also developed for assets and liabilities that could reprice during the modeled time period. These assumptions also cover how Blue Ridge expects rates to change on non-maturity deposits such as interest checking, money market checking, savings accounts as well as certificates of deposit. Based on inputs that include the current balance sheet, the current level of interest rates and the developed assumptions, the model then produces an expected level of net interest income assuming that market rates remain unchanged. This is considered the base case. Next, the model determines what net interest income would be based on specific changes in interest rates. The rate simulations are performed for a two-year period and include rapid rate changes of down 100 basis points to 200 basis points and up 100 basis points to 400 basis points. In both the up and down scenarios, the model assumes a parallel shift in the yield curve. The results of these simulations are then compared to the base case. Stress testing the balance sheet and net interest income using instantaneous parallel shock movements in the yield curve of 100 to 400 basis points is a regulatory and banking industry practice. However, these stress tests may not represent a realistic forecast of future interest rate movements in the yield curve. In addition, instantaneous parallel interest rate shock modeling is not a predictor of actual future performance of earnings. It is a financial metric used to manage interest rate risk and track the movement of the Company’s interest rate risk position over a historical time frame for comparison purposes. At December 31, 2019, the Company’s asset/liability position was considered to be slightly asset sensitive based on its interest rate sensitivity model. the Company’s net interest income would increase by 12.0% in an up 100 basis point scenario and would increase 14.2% in an up 200 basis point scenario over a one-year time frame. In the two-year time horizon, the Company’s net interest income would increase by 3.6% in an up 100 basis point scenario and would increase by 13.5% in an up 400 basis point scenario. At December 31, 2019, all interest rate risk stress tests measures were within the Company’s board policy established limits in each of the increased rate scenarios. Additional information on the Company’s interest rate sensitivity for a static balance sheet over a one-year time horizon as of December 31, 2019 can be found below. Economic value of equity (“EVE”), measures the period end market value of assets less the market value of liabilities and the change in this value as rates change. It models simultaneous parallel shifts in market interest rates, implied by the forward yield curve. The EVE model calculates the market value of capital by taking the present value of all asset cash flows less the present value of all liability cash flows. The interest rate risk to capital at December 31, 2019 is shown below and reflects that the Company’s market value of capital is in a slightly asset sensitive position in which an increase in short-term interest rates is expected to generate higher market values of capital. At December 31, 2019, all EVE stress tests measures were within the Company’s board policy established limits.

<s>[INST] Cautionary Note About ForwardLooking Statements We make certain forwardlooking statements in this Form 10K that are subject to risks and uncertainties. These forwardlooking statements represent plans, estimates, objectives, goals, guidelines, expectations, intentions, projections and statements of our beliefs concerning future events, business plans, objectives, expected operating results and the assumptions upon which those statements are based. Forwardlooking statements include without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and are typically identified with words such as “may,” “could,” “should,” “will,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “aim,” “intend,” “plan,” or words or phases of similar meaning. We caution that the forwardlooking statements are based largely on our expectations and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are, in many instances, beyond our control. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forwardlooking statements. The following factors, among others, could cause our financial performance to differ materially from that expressed in such forwardlooking statements: the strength of the United States economy in general and the strength of the local economies in which we conduct operations; geopolitical conditions, including acts or threats of terrorism, or actions taken by the United States or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the United States and abroad; the occurrence of significant natural disasters, including severe weather conditions, floods, health related issues (including the recent COVID19 outbreak and the associated efforts to limit the spread of the disease), and other catastrophic events; our management of risks inherent in our real estate loan portfolio, and the risk of a prolonged downturn in the real estate market, which could impair the value of our collateral and our ability to sell collateral upon any foreclosure; changes in consumer spending and savings habits; technological and social media changes; the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rate, market and monetary fluctuations; changing bank regulatory conditions, policies or programs, whether arising as new legislation or regulatory initiatives, that could lead to restrictions on activities of banks generally, or our subsidiary bank in particular, more restrictive regulatory capital requirements, increased costs, including deposit insurance premiums, regulation or prohibition of certain income producing activities or changes in the secondary market for loans and other products; the impact of changes in financial services policies, laws and regulations, including laws, regulations and policies concerning taxes, banking, securities and insurance, and the application thereof by regulatory bodies; the impact of changes in laws, regulations and policies affecting the real estate industry; the effect of changes in accounting policies and practices, as may be adopted from time to time by bank regulatory agencies, the SEC, the Public Company Accounting Oversight Board (the “PCAOB”), the FASB or other accounting standards setting bodies; the timely development of competitive new products and services and the acceptance of these products and services by new and existing customers; the willingness of users to substitute competitors' products and services for our products and services; the effect of acquisitions we may make, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions; changes in the level of our nonperforming assets and chargeoffs; our involvement, from time to time, in legal proceedings and examination and remedial actions by regulators; potential exposure to fraud, negligence, computer theft and cybercrime. The foregoing factors should not be considered exhaustive and should be read together with other cautionary statements that are included in this Form 10K, including those discussed in the section entitled "Risk Factors" in Item 1A above. If one or more of the factors affecting our forwardlooking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forwardlooking information and statements contained in this Form 10K. Therefore, we [/INST] Negative. </s>

ShockWave Medical, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes included in Part II, Item 8 of this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (“the Exchange Act”). Forward-looking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forward-looking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in this report in Part I, Item 1A - “Risk Factors,” and elsewhere in this report. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Company Overview We are a medical device company focused on developing and commercializing products intended to transform the way calcified cardiovascular disease is treated. We aim to establish a new standard of care for medical device treatment of atherosclerotic cardiovascular disease through our differentiated and proprietary local delivery of sonic pressure waves for the treatment of calcified plaque, which we refer to as intravascular lithotripsy (“IVL”). Our IVL system (our “IVL System”), which leverages our IVL technology (our “IVL Technology”), is a minimally invasive, easy-to-use and safe way to significantly improve patient outcomes. Our Shockwave M5 IVL catheter (“M5 catheter”) was CE-Marked in April 2018 and cleared by the U.S. Food and Drug Administration (“FDA”) in July 2018 for use in our IVL System for the treatment of peripheral artery disease (“PAD”). Our Shockwave C2 IVL catheter (“C2 catheter”), which we are currently marketing in Europe, was CE-Marked in June 2018 for use in our IVL System for the treatment of coronary artery disease (“CAD”). In August 2019, we received the Breakthrough Device Designation from the FDA for our C2 catheters using our IVL System for the treatment of CAD. The second version of our Shockwave S4 IVL catheter (“S4 catheter”) was cleared by the FDA in August 2019. We also have ongoing clinical programs across several products and indications, which, if successful, will allow us to expand commercialization of our products into new geographies and indications. Importantly, we are undertaking ongoing clinical trials of our C2 catheter intended to support a pre-market application (“PMA”) in the United States and a Shonin submission in Japan for the treatment of CAD. In October 2018, we received staged investigational drug exemption (“IDE”) approval for our DISRUPT CAD III global study, which began enrollment in 2019. This study is designed to support U.S. PMA approval for our C2 catheters. We anticipate having final data from these ongoing clinical trials intended to support a U.S. launch of our C2 catheter in the first half of 2021 and a Japan launch in 2022. The first two indications we are targeting with our IVL System are PAD, the narrowing or blockage of vessels that carry blood from the heart to the extremities, and CAD, the narrowing or blockage of the arteries that supply blood to the heart. In the future, we see significant opportunity in the potential treatment of aortic stenosis (“AS”), a condition where the heart’s aortic valve becomes increasingly calcified with age, causing it to narrow and obstruct blood flow from the heart. We have adapted the use of lithotripsy to the cardiovascular field with the aim of creating what we believe can become the safest, most effective means of addressing the growing challenge of cardiovascular calcification. Lithotripsy has been used to successfully treat kidney stones (deposits of hardened calcium) for over 30 years. By integrating lithotripsy into a device that resembles a standard balloon catheter, physicians can prepare, deliver and treat calcified lesions using a familiar form factor, without disruption to their standard procedural workflow. Our differentiated IVL System works by delivering shockwaves through the entire depth of the artery wall, modifying calcium in the medial layer of the artery, not just at the superficial most intimal layer. The shockwaves crack this calcium and enable the stenotic artery to expand at low pressures, thereby minimizing complications inherent to traditional balloon dilations, such as dissections or tears. Preparing the vessel with IVL facilitates optimal outcomes with other therapies, including stents and drug-eluting technologies. Using IVL also avoids complications associated with atherectomy devices such as dissection, perforation and embolism. When followed by an anti-proliferative therapy such as a drug-coated balloons or drug-eluting stents, the micro-fractures may enable better drug penetration into the arterial wall and improve drug uptake, thereby improving the effectiveness of the combination treatment. We market our products to hospitals whose interventional cardiologists, vascular surgeons and interventional radiologists treat patients with PAD and CAD. We have dedicated meaningful resources to establish a direct sales capability in the United States, Germany, Austria and Switzerland, which we have complemented with distributors in more than 35 countries. We are actively expanding our international field presence through new distributors, additional sales and clinical personnel and are adding new U.S. sales territories. For the years ended December 31, 2019, 2018 and 2017, we generated product revenue of $42.9 million, $12.3 million and $1.7 million, respectively, and a $51.8 million, $41.2 million and $30.9 million loss from operations for the years ended December 31, 2019, 2018 and 2017, respectively. For the years ended December 31, 2019, 2018 and 2017, 47%, 43% and 44%, respectively, of our product revenue was generated from customers located outside of the United States. Our sales outside of the United States are denominated principally in Euros. As a result, we have foreign exchange exposure. We have not entered into any material foreign currency hedging contracts, although we may do so in the future. Since inception, we have incurred significant net losses and expect to continue to incur net losses for the foreseeable future. To date, our principal sources of liquidity have been the net proceeds we received through the sale of our common stock in our initial public offering, private sales of equity securities and payments received from customers using our products. As of December 31, 2019, we had $195.3 million in cash, cash equivalents and short-term investments and an accumulated deficit of $178.0 million. Public Offerings of Common Stock On March 11, 2019, we closed on our initial public offering ("IPO") of 6,555,000 shares of common stock at an offering price of $17.00 per share, which included the full exercise of the underwriters’ over-allotment option to purchase 855,000 additional shares of our common stock. We raised a total of $111.4 million in gross proceeds from the IPO, or approximately $99.9 million in net proceeds after deducting underwriters’ discounts and commissions of $7.1 million and offering costs of $4.4 million. Concurrent with the IPO, we issued 588,235 shares of common stock in a private placement (the “Private Placement”) for net proceeds of $10.0 million. On November 15, 2019, we completed an underwritten public offering (“Follow-On Offering) of 2,854,048 shares of our common stock, including 372,267 shares sold pursuant to the underwriters’ exercise of their option to purchase additional shares at a public offering price of $36.25 per share. We raised a total of $103.5 million in gross proceeds from the Follow-On Offering, or approximately $96.7 million in net proceeds after deducting underwriters’ discounts and commissions of $6.2 million and offering costs of $0.6 million. New Lease In December 2019, we entered into a lease for office and laboratory space in two buildings located in Santa Clara, California. The purpose and effect of the lease agreement is to extend the existing Santa Clara office and laboratory premises of 35,000 square foot to approximately 85,200 square feet of rentable space. Factors Affecting Our Business There are a number of factors that have impacted, and we believe will continue to impact, our results of operations and growth. These factors include: • Market acceptance. The growth of our business depends on our ability to gain broader acceptance of our current products by continuing to make physicians and other hospital staff aware of the benefits of our products to generate increased demand and frequency of use, and thus increase sales to our hospital customers. Our ability to grow our business will also depend on our ability to expand our customer base in existing or new target end markets. Although we are attempting to increase the number of patients treated with procedures that use our products through our established relationships and focused sales efforts, we cannot provide assurance that our efforts will increase the use of our products. • Regulatory approvals/clearances and timing and efficiency of new product introductions. We must successfully obtain timely approvals or clearances and introduce new products that gain acceptance with physicians, ensuring adequate supply while avoiding excess inventory of older products and resulting inventory write-downs or write-offs. For our sales to grow, we will also need to receive FDA approval for the use of our C 2 catheters in our IVL System for the treatment of CAD in the United States, and will need to obtain regulatory clearance or approval of our other pipeline products in the United States and in international markets. In addition, as we introduce new products, we expect to build our inventory of components and finished goods in advance of sales, which may cause quarterly fluctuations in our results of operations. • Sales force size and effectiveness. The rate at which we grow our sales force and the speed at which newly hired salespeople become effective can impact our revenue growth or our costs incurred in anticipation of such growth. We intend to continue to make significant investments in our sales and marketing organization by increasing the number of U.S. sales representatives and expanding our international marketing programs to help facilitate further adoption among existing hospital accounts as well as broaden awareness of our products to new hospital accounts. • Competition. Our industry is intensely competitive and, in particular, we compete with a number of large, well-capitalized companies. We must continue to successfully compete in light of our competitors’ existing and future products and related pricing and their resources to successfully market to the physicians who use our products. • Reimbursement. The level of reimbursement from third-party payors for procedures performed using our products could have a substantial impact on the prices we are able to charge for our products and how widely our products are accepted. The level at which reimbursement is set for procedures using our products, and any increase in reimbursement for procedures using our products, will depend substantially on our ability to generate clinical evidence, to gain advocacy in the respective physician societies and to work with the Centers for Medicare & Medicaid Services and payors. • Clinical results. Publications of clinical results by us, our competitors and other third parties can have a significant influence on whether, and the degree to which, our products are used by physicians and the procedures and treatments those physicians choose to administer for a given condition. • Product and Geographic Mix; Timing. Our financial results, including our gross margins, may fluctuate from period to period based on the timing of customer orders or medical procedures, the number of available selling days in a particular period, which can be impacted by a number of factors, such as holidays or days of severe inclement weather in a particular geography, the mix of products sold and the geographic mix of where products are sold. In particular, our distributors for international sales receive a distribution margin on sales of our IVL catheters, which affects our gross margin. • Seasonality. We expect to experience a seasonal slowing of demand for our products in our fourth quarters due to year-end clinical treatment patterns, such as the postponement of elective surgeries around the winter holidays. In addition, we have experienced some seasonality during summer months, which we believe is attributable to the postponement of elective surgeries for summer vacation plans of physicians and patients. We expect these seasonal factors to become more pronounced in the future as our business grows. In addition, we have experienced and expect to continue to experience meaningful variability in our quarterly revenue and gross profit/loss as a result of a number of factors, including, but not limited to: inventory write-offs and write-downs; costs, benefits and timing of new product introductions; the availability and cost of components and raw materials; and fluctuations in foreign currency exchange rates. Additionally, we experience quarters in which operating expenses, in particular research and development expenses, fluctuate depending on the stage and timing of product development. While these factors may present significant opportunities for us, they also pose significant risks and challenges that we must address. Components of Our Results of Operations Product revenue Product revenue is primarily from the sale of our IVL catheters. We sell our products to hospitals, primarily through direct sales representatives, as well as through distributors in selected international markets. For products sold through direct sales representatives, control is transferred upon delivery to customers. For products sold to distributors internationally and certain customers that purchase stocking orders in the United States, control is transferred upon shipment or delivery to the customer’s named location, based on the contractual shipping terms. Additionally, a significant portion of our revenue is generated through a consignment model under which inventory is maintained at hospitals. For consignment inventory, control is transferred at the time the catheters are consumed in a procedure. Cost of product revenue Cost of product revenue consists primarily of costs of components for use in our products, the materials and labor that are used to produce our products, the manufacturing overhead that directly supports production and the depreciation relating to the equipment used in our IVL System that we loan to our hospital customers without charge to facilitate the use of our IVL catheters in their procedures. We depreciate equipment over a three-year period. We expect cost of product revenue to increase in absolute terms as our revenue grows. Our gross margin has been and will continue to be affected by a variety of factors, primarily production volumes, the cost of direct materials, product mix, geographic mix, discounting practices, manufacturing costs, product yields, headcount and cost-reduction strategies. We expect our gross margin percentage to increase over the long term to the extent we are successful in increasing our sales volume and are therefore able to leverage our fixed costs. We intend to use our design, engineering and manufacturing capabilities to further advance and improve the efficiency of our manufacturing processes, which, if successful, we believe will reduce costs and enable us to increase our gross margin percentage. While we expect gross margin percentage to increase over the long term, it will likely fluctuate from quarter to quarter as we continue to introduce new products and adopt new manufacturing processes and technologies. Research and development expenses Research and development (“R&D”) expenses consist of applicable personnel, consulting, materials and clinical trial expenses. R&D expenses include: • certain personnel-related expenses, including salaries, benefits, bonus, travel and stock-based compensation; • cost of clinical studies to support new products and product enhancements, including expenses for clinical research organizations (“CROs”) and site payments; • materials and supplies used for internal R&D and clinical activities; • allocated overhead including facilities and information technology expenses; and • cost of outside consultants who assist with technology development, regulatory affairs, clinical affairs and quality assurance. R&D costs are expensed as incurred. In the future, we expect R&D expenses to increase in absolute dollars as we continue to develop new products, enhance existing products and technologies and perform activities related to obtaining additional regulatory approval. Sales and marketing expenses Sales and marketing expenses consist of personnel-related expenses, including salaries, benefits, sales commissions, travel and stock-based compensation. Other sales and marketing expenses include marketing and promotional activities, including trade shows and market research, and cost of outside consultants. We expect to continue to grow our sales force and increase marketing efforts as we continue commercializing products based on our IVL Technology. General and administrative expenses General and administrative expenses consist of personnel-related expenses, including salaries, benefits, bonus, travel and stock-based compensation. Other general and administrative expenses include professional services fees, including legal, audit and tax fees, insurance costs, cost of outside consultants and employee recruiting and training costs. Moreover, we expect to incur additional expenses associated with operating as a public company, including legal, accounting, insurance, exchange listing and SEC compliance and investor relations. Interest expense Interest expense consists of interest on our debt and amortization of associated debt discount. In February 2018, we entered into a Loan and Security Agreement with Silicon Valley Bank for a term loan and a revolving line of credit, as described in Note 7 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K (the “Loan and Security Agreement”). In June 2018 and December 2018, we drew an aggregate of $15.0 million in borrowings under the term loan facility. As of December 31, 2019, we had $13.3 million outstanding under the term loan and no amounts outstanding under the revolving line of credit. As described in Note 13 to our audited consolidated financial statements elsewhere in this Annual Report on Form 10-K, on February 11, 2020, the Company entered into the First Amendment (the “Amended Credit Facility”) to the Loan and Security Agreement, to refinance the existing term loan. The Amendment provided us with a supplemental term loan in the amount of $16.5 million. The Company used $13.2 million of the proceeds from the supplemental term loan to repay in full all amounts due under the existing term loan and to pay related expenses. In addition, the Amendment terminated the Company’s revolving line of credit. Change in fair value of warrant liability We accounted for our freestanding warrants to purchase shares of our convertible preferred stock prior to the initial public offering as liabilities at fair value primarily because the shares underlying the warrants contained contingent redemption features outside our control. The warrants were subject to re-measurement at each balance sheet date with gains and losses reported through our consolidated statements of operations and comprehensive loss. On the completion of the initial public offering, all of our outstanding preferred stock warrants were converted into 54,903 common stock warrants, which resulted in the reclassification of the convertible preferred stock warrant liability to additional paid-in capital. Other income, net Other income consists primarily of interest earned on our cash equivalents and short-term investments. Income tax provision Income tax provision consists primarily of income taxes in certain foreign jurisdictions in which we conduct business. We have a full valuation allowance for deferred tax assets, including net operating loss carryforwards and tax credits related primarily to R&D. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018: Product revenue. Product revenue increased by $30.7 million, or 250%, from $12.3 million in 2018 to $42.9 million in 2019. The change was due to an increase in the number of customers and an increase in the purchase volume of our products both within the United States and internationally. Product revenue consisted primarily of the sale of our IVL catheters. Product revenue, classified by the major geographic areas in which our products are shipped, was $22.7 million within the United States and $20.2 million for all other countries in 2019 compared to $7.0 million within the United States and $5.3 million for all other countries in 2018. Cost of product revenue and gross margin percentage. Cost of product revenue increased by $9.9 million, or 137%, from $7.3 million in 2018 to $17.2 million in 2019. The increase was primarily due to growth in sales volume. Gross margin percentage improved to 60.0% in 2019, compared to 40.9% in 2018. This change in gross margin percentage was primarily due to lower fixed costs per unit from increased production volume of our IVL catheters and increased efficiencies from improvements to operations and production. Research and development expenses. The following table summarizes our R&D expenses incurred during the periods presented: R&D expenses increased by $10.2 million, or 45%, from $22.7 million in 2018 to $32.9 million in 2019. The increase was primarily due to a $7.3 million increase in clinical-related costs and a $2.7 million increase in compensation and personnel-related costs to support clinical trials. Clinical-related costs in 2019 were primarily related to the CAD II, CAD III CAD IV and PAD III clinical trials. There was also a $0.7 million increase in facilities and other allocated costs due to increased rent and building expenditures. These increases were partially offset by a $0.4 million decrease in materials and supplies for R&D. Sales and marketing expenses. Sales and marketing expenses increased by $13.1 million, or 75%, from $17.5 million in 2018 to $30.6 million in 2019. The increase was primarily due to a $10.4 million increase in compensation and personnel-related costs, which included a $4.0 million increase in commission expense, as a result of a higher headcount and increased sales of our products. Marketing and promotional expenses increased by $1.6 million to support the commercialization of our products. General and administrative expenses. General and administrative expenses increased by $8.2 million, or 136%, from $6.0 million in 2018 to $14.1 million in 2019. The change was primarily due to a $2.6 million increase in professional services and general corporate expenses incurred in connection with our operations as a public company, a $2.8 million increase in compensation and personnel-related costs, a $2.0 million increase in legal fees, and a $0.8 million increase in costs associated with outside consultants. Interest expense. Interest expense increased by $0.5 million, or 135%, from $0.4 million in 2018 to $0.9 million in 2019. The increase in interest expense was attributable to incurring a full year of interest expense in 2019 compared to us incurring only a partial year’s worth of interest expense in 2018 due to the Loan and Security Agreement being funded in June 2018 and December 2018. Change in fair value of warrant liability. The change in fair value of warrant liability of $0.6 million in 2019 from $0.1 million in 2018 was due to the fair value of our convertible warrant liability increasing by $0.5 million in 2019 up to the final measurement on the date of our initial public offering. Other income, net. Other income, net increased by $1.8 million, or 298%, to $2.3 million in 2019 from $0.6 million in 2018. The increase was primarily due to a $1.7 million increase in interest income from increased investment balances and a $0.1 million increase in other income primarily due to net foreign currency gains. Income tax provision. The income tax provision increased by $24,000, or 63%, to $62,000 in 2019 from $38,000 in 2018. This increase was primarily due to an increase in foreign income tax expense. Years Ended December 31, 2018 and 2017 Comparison of the Years Ended December 31, 2018 and 2017 Product revenue. Product revenue increased by $10.5 million, or 613%, from $1.7 million in 2017 to $12.3 million in 2018. The increase was primarily due to an increase in the number of customers and an increase in purchase volume of our products per customer both within the United States and internationally. Product revenue consisted primarily of the sale of our IVL catheters. Product revenue, classified by the major geographic areas in which our products are shipped, was $1.0 million within the United States and $0.7 million for all other countries in 2017 and $7.0 million within the United States and $5.3 million for all other countries in 2018. Cost of product revenue and gross margin percentage. Cost of product revenue increased by $4.4 million, or 156%, from $2.8 million in 2017 to $7.3 million in 2018. The increase was primarily due to growth in sales volume. Gross margin percentage was negative 65% for the year ended December 31, 2017. Gross margin percentage improved to 41% for the year ended December 31, 2018. This change in gross margin percentage was primarily due to increased sales volume of our catheters. Research and development expenses. The following table summarizes our R&D expenses incurred during the periods presented: R&D expenses increased by $4.7 million, or 26%, from $18.0 million in 2017 to $22.7 million in 2018. The increase was primarily due to a $2.3 million increase in clinical-related costs and a $0.6 million increase in costs associated with outside consultants to support clinical trials. There was also a $0.7 million increase in materials and supplies for R&D and a $0.4 million increase in facilities and other allocated costs due to higher rent and building expenditures. Sales and marketing expenses. Sales and marketing expenses increased by $11.2 million, or 176%, from $6.4 million in 2017 to $17.5 million in 2018. The increase was primarily due to a $9.5 million increase in compensation and personnel-related costs, which includes a $3.1 million increase in commission expense, as a result of increased headcount and increased business development related activities to expand the domestic and international customer base. Marketing and promotional expenses increased by $0.8 million to support the commercialization of our products. General and administrative expenses. General and administrative expenses increased by $0.6 million, or 10%, from $5.4 million in 2017 to $6.0 million in 2018. The increase was primarily due to a $0.8 million increase in professional services and general corporate expenses incurred in connection with our preparation to become a public company, partially offset by a $0.3 million decrease in recruiting and training expenses. Interest expense. Interest expense increased by $0.3 million, or 591%, from $0.1 million in 2017 to $0.4 million in 2018. The increase in interest expense was attributable to us entering into the Loan and Security Agreement and drawing down on the first tranche of the term loan in June 2018 of $10.0 million and the second tranche of the term loan in December 2018 of $5.0 million. Change in fair value of warrant liability. The change in fair value of warrant liability was $32,000 in 2017 and $0.1 million in 2018, reflecting an increase in the convertible preferred stock warrant liability of $0.2 million from changes to the Black-Scholes option pricing model assumptions used to value the warrant liability, partially offset by a decrease in the convertible preferred stock warrant liability of $0.1 million related to the expiration of 46,102 of our Series A-1 convertible preferred stock warrants in 2018. Other income, net. Other income, net increased by $0.2 million, or 61%, from $0.4 million in 2017 to $0.6 million in 2018. The increase was primarily due to a $0.3 million increase in interest income on our cash, cash equivalents and short-term investments due to increases in interest rates on balances held in interest-earning instruments, partially offset by a $0.1 million increase in other expenses. Income tax provision. Income tax provision increased by $12,000, or 46%, from $26,000 in 2017 to $38,000 in 2018. This increase was primarily due to an increase in foreign income tax expense. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2019. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Liquidity and Capital Resources Sources of liquidity To date, our principal sources of liquidity have been the net proceeds we received through the sales of our common stock in our public offerings, private sales of our equity securities, payments received from customers using our products and to a lesser extent proceeds from our debt financings. On March 11, 2019, we completed our initial public offering, including the underwriters’ full exercise of their over-allotment option, selling 6,555,000 shares of our common stock at $17.00 per share. Upon completion of our initial public offering, we received net proceeds of $99.9 million, after deducting underwriting discounts and commissions and offering expenses. Concurrent with the initial public offering, we issued 588,235 shares of common stock in our Private Placement for net proceeds of $10.0 million. On November 15, 2019, we completed a Follow-On Offering of 2,854,048 shares of our common stock, including 372,267 shares sold pursuant to the underwriters’ exercise of their option to purchase additional shares at a public offering price of $36.25 per share. Upon completion of our Follow-On Offering, we received net proceeds of $96.7 million, after deducting underwriting discounts and commissions and offering expenses. We have a number of ongoing clinical trials, and expect to continue to make substantial investments in these trials and in additional clinical trials that are designed to provide clinical evidence of the safety and efficacy of our products. We intend to continue to make significant investments in our sales and marketing organization by increasing the number of U.S. sales representatives and expanding our international marketing programs to help facilitate further adoption among existing hospital accounts and physicians as well as broaden awareness of our products to new hospitals. We also expect to continue to make investments in R&D, regulatory affairs and clinical studies to develop future generations of products based on our IVL Technology, support regulatory submissions and demonstrate the clinical efficacy of our products. Moreover, we expect to incur additional expenses associated with operating as a public company, including legal, accounting, insurance, exchange listing and SEC compliance, investor relations and other expenses. Because of these and other factors, we expect to continue to incur substantial net losses and negative cash flows from operations for the foreseeable future. Our future capital requirements will depend on many factors, including: • the cost, timing and results of our clinical trials and regulatory reviews; • the cost and timing of establishing sales, marketing and distribution capabilities; • the terms and timing of any other collaborative, licensing and other arrangements that we may establish including any contract manufacturing arrangements; • the timing, receipt and amount of sales from our current and potential products; • the degree of success we experience in commercializing our products; • the emergence of competing or complementary technologies; • the cost of preparing, filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights; 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. We believe that our cash, cash equivalents and short-term investments as of December 31, 2019 will be sufficient to fund our operations for at least the next 12 months from the date the audited consolidated financial statements are filed with the SEC. As of December 31, 2019, we had $195.3 million in cash, cash equivalents and short-term investments and an accumulated deficit of $178.0 million. Debt obligations Loan and Security Agreement. In February 2018, we entered into our Loan and Security Agreement with Silicon Valley Bank (“the Loan and Security Agreement”). The terms of the Loan and Security Agreement included a term loan of $15.0 million and a revolving line of credit of $2.0 million. The term loan is available in two tranches, of which the first tranche of $10.0 million was drawn down in June 2018 and the second tranche of $5.0 million was drawn down in December 2018. In connection with the execution of the Loan and Security Agreement, we issued Silicon Valley Bank a warrant to purchase 34,440 shares of our common stock, with a term of ten years. In April 2019, all of these common stock warrants were net exercised into 29,887 shares of common stock. On February 11, 2020, we entered into the Amended Credit Facility to the Loan and Security Agreement, to refinance our existing term loan. The Amended Credit Facility provided us with a supplemental term loan in the amount of $16.5 million. We used $13.2 million of the proceeds from the supplemental term loan to repay in full all amounts due under the existing term loan and to pay related expenses. In addition, the Amended Credit Facility terminated the Company’s revolving line of credit. The principal amount outstanding under the supplemental term loan accrues interest, payable monthly in arrears, at a floating per annum rate equal to the greater of (A) the Wall Street Journal prime rate minus 1.25% and (B) 3.50%. No principal payments are due on the supplemental term loan until June 30, 2021; provided that such interest only period shall be extended to December 31, 2021 if we achieve specified revenue milestones and shall be extended further to June 30, 2022 if we achieve specified revenue and regulatory milestones (the date that such interest only period ends, the “Amortization Date”). Following the Amortization Date, the principal amount of the supplemental term loan shall be due in equal monthly installments through the maturity date, December 1, 2023. There is also a final payment equal to 9.5% of the original principal amount of the supplemental term loan, or $1.6 million, due at maturity (or any earlier date of optional pre-payment or acceleration of principal due to an event of default). We may, at our option, prepay the supplemental term loan in full, subject to an additional prepayment fee ranging between 0% and 3% of the original principal amount of the supplemental term loan. The prepayment fee would also be due and payable in the event of an acceleration of the principal amount of the supplemental term loan due to an event of default. The supplemental term loan is secured by all of the Company’s assets, excluding intellectual property and certain other assets. The supplemental term loan is subject to customary affirmative and restrictive covenants, including with respect to our ability to enter into fundamental transactions, incur additional indebtedness, grant liens, pay any dividend or make any distributions to stockholders, make investments and merge or consolidate with any other person or engage in transactions with affiliates, but is not subject to any financial covenants. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating activities In 2019, cash used in operating activities was $48.1 million, attributable to a net loss of $51.1 million and a net change in our net operating assets and liabilities of $3.5 million, partially offset by non-cash charges of $6.5 million. Non-cash charges primarily consisted of $3.6 million in stock-based compensation, $1.3 million in depreciation and amortization, $0.9 million in amortization of right-of-use assets, $0.6 million in the change in fair value of our warrant liability, $0.4 million in amortization of debt issuance costs and $0.1 million of a loss due to the write down of fixed assets, partially offset by $0.5 million in accretion of discount on available-for-sale securities. The change in our net operating assets and liabilities was primarily due to a $6.8 million increase in inventory and $4.5 million increase in accounts receivable due to an increase in sales, a $0.8 million increase in prepaid expenses and other current assets and a $1.0 million decrease in lease liabilities. These changes were partially offset by a $9.6 million increase in accrued and other current liabilities and accounts payable resulting primarily from the expansion in our operating activities and accrued bonuses and commissions. In 2018, cash used in operating activities was $41.5 million, attributable to a net loss of $41.1 million and a net change in our net operating assets and liabilities of $2.6 million, partially offset by non-cash charges of $2.3 million. Non-cash charges primarily consisted of $1.3 million in stock-based compensation, $0.7 million in depreciation and amortization and $0.2 million in amortization of debt issuance costs. The change in our net operating assets and liabilities was primarily due to a $2.6 million increase in inventory and $2.2 million increase in accounts receivable due to an increase in sales, and a $0.9 million increase in other assets from deferred offering costs. These changes were partially offset by a $3.1 million increase in accrued and other current liabilities and accounts payable resulting primarily from increases in our operating activities and accrued professional services fees. In 2017, cash used in operating activities was $30.3 million, attributable to a net loss of $30.6 million and a net change in our net operating assets and liabilities of $1.3 million, partially offset by non-cash charges of $1.5 million. Non-cash charges primarily consisted of $1.0 million in stock-based compensation and $0.5 million in depreciation. The change in our net operating assets and liabilities was primarily due to a $1.9 million increase in inventory for anticipated growth in our business, a $0.6 million increase in accounts receivable due to increase in sales, and a $0.4 million increase in prepaid expenses and other current assets. These changes were partially offset by a $1.6 million increase in accrued and other current liabilities and accounts payable resulting primarily from increases in our operating activities. Investing activities In 2019, cash used in investing activities was $59.5 million, attributable to the purchase of available-for-sale securities of $119.5 million and the purchase of property and equipment of $3.8 million, partially offset by proceeds from the maturity of available-for-sale investments of $63.8 million. In 2018, cash used in investing activities was $0.2 million, attributable to the purchase of property and equipment of $2.0 million, partially offset by the maturity of available-for-sale investments of $1.8 million. In 2017, cash used in investing activities was $2.2 million, attributable to purchases of investments of $17.7 million and purchase of property and equipment of $0.4 million, partially offset by maturity of available-for-sale investments of $15.9 million. Financing activities In 2019, cash provided by financing activities was $208.1 million, attributable to net proceeds of $100.5 million received in the IPO in March 2019, net proceeds of $96.9 million from our Follow-On Offering in November 2019, net proceeds of $10.0 million from the concurrent Private Placement in March 2019, and proceeds of $2.2 million from stock option exercises and $0.1 million from warrant exercises. These changes were offset by payments of our term loan of $1.7 million. In 2018, cash provided by financing activities was $29.8 million, attributable to proceeds of $15.0 million from borrowings on the Loan and Security Agreement, net proceeds of $14.9 million from the issuance of our Series D convertible preferred stock and proceeds from stock option exercises and warrant exercises of $0.5 million, partially offset by deferred offering cost payments of $0.6 million. In 2017, cash provided by financing activities was $33.7 million, attributable to net proceeds of $34.9 million from the issuance of our Series C convertible preferred stock and proceeds from stock option exercises and warrant exercises of $0.3 million, partially offset by the principal payment of our term loan of $1.6 million. Contractual Obligations and Commitments The following table summarizes our contractual obligations and commitments as of December 31, 2019: (1) In December 2019, we entered into a lease for office and laboratory space in two buildings located in Santa Clara, California. The lease term for the first building began in December 2019 and the lease term for the second building will begin in September 2022. Operating lease obligations in the above table includes lease expense for both buildings. (2) In June 2018 and December 2018, we borrowed $10.0 and $5.0 million, respectively, pursuant to a term loan under the Loan and Security Agreement. The term loan matures in December 2021. Principal payments associated with the term loan are included in the above table. Interest expense incurred on the term loan is included in the above table based on obligations outstanding and rates effective as of December 31, 2019, including a final one-time payment of $1.0 million in December 2021. In February 2020, we refinanced the term loan that provides us with a supplemental term loan in the amount of $16.5 million. We used $13.2 million of the proceeds from our new supplemental term loan to repay in full all amounts due under the existing term loan and to pay related expenses. Refer to Note 13 for details on our refinancing. Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently have, any off-balance sheet arrangements as defined in the rules and regulations of the SEC. Critical Accounting Policies and Estimates 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 U.S. generally accepted accounting principles (“GAAP”). The preparation of these consolidated financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, 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 and any such differences may be material. While our significant accounting policies are more fully described in the Note 2 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to our financial condition and results of operations and require our most difficult, subjective and complex judgments. Revenue recognition We adopted Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers, effective January 1, 2018 using the modified retrospective method. The adoption of ASC 606 did not have a material effect on our revenue recognition. We sell our products to hospitals, primarily through direct sales representatives, as well as through distributors in selected international markets. For products sold through direct sales representatives, control is transferred upon delivery to customers. For products sold to distributors internationally and certain customers that purchase stocking orders in the United States, control is transferred upon shipment or delivery to the customer’s named location, based on the contractual shipping terms. Additionally, a significant portion of our revenue is generated through a consignment model under which inventory is maintained at hospitals. For consignment inventory, control is transferred at the time the catheters are consumed in a procedure. Under agreements with our customers, we generally provide for the use of an IVL generator and connector cable at no charge to facilitate the use of our IVL catheters. These agreements do not contain contractually enforceable minimum commitments and are generally cancellable by either party with 30 days’ notice. Accrued research and development costs We accrue liabilities for estimated costs of R&D activities conducted by our third-party service providers, which include the conduct of preclinical and clinical studies. We record the estimated costs of R&D activities based upon the estimated amount of services provided but not yet invoiced, and include these costs in accrued liabilities on the consolidated balance sheet and within R&D expense on the consolidated statements of operations and comprehensive loss. We accrue for these costs based on factors, such as estimates of the work completed and budget provided and in accordance with agreements established with our third-party service providers. 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 since our inception. Recent Accounting Pronouncements Please refer to Note 2 to our consolidated financial statements appearing under Part 2, Item 8 for a discussion of new accounting standards updates that may impact us.

<s>[INST] This Annual Report on Form 10K contains forwardlooking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended (“the Exchange Act”). Forwardlooking statements are identified by words such as “believe,” “will,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “could,” “potentially” or the negative of these terms or similar expressions. You should read these statements carefully because they discuss future expectations, contain projections of future results of operations or financial condition, or state other “forwardlooking” information. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forwardlooking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include, but are not limited to, those discussed in this report in Part I, Item 1A “Risk Factors,” and elsewhere in this report. Forwardlooking statements are based on our management’s beliefs and assumptions and on information currently available to our management. These statements, like all statements in this report, speak only as of their date, and we undertake no obligation to update or revise these statements in light of future developments. We caution investors that our business and financial performance are subject to substantial risks and uncertainties. Company Overview We are a medical device company focused on developing and commercializing products intended to transform the way calcified cardiovascular disease is treated. We aim to establish a new standard of care for medical device treatment of atherosclerotic cardiovascular disease through our differentiated and proprietary local delivery of sonic pressure waves for the treatment of calcified plaque, which we refer to as intravascular lithotripsy (“IVL”). Our IVL system (our “IVL System”), which leverages our IVL technology (our “IVL Technology”), is a minimally invasive, easytouse and safe way to significantly improve patient outcomes. Our Shockwave M5 IVL catheter (“M5 catheter”) was CEMarked in April 2018 and cleared by the U.S. Food and Drug Administration (“FDA”) in July 2018 for use in our IVL System for the treatment of peripheral artery disease (“PAD”). Our Shockwave C2 IVL catheter (“C2 catheter”), which we are currently marketing in Europe, was CEMarked in June 2018 for use in our IVL System for the treatment of coronary artery disease (“CAD”). In August 2019, we received the Breakthrough Device Designation from the FDA for our C2 catheters using our IVL System for the treatment of CAD. The second version of our Shockwave S4 IVL catheter (“S4 catheter”) was cleared by the FDA in August 2019. We also have ongoing clinical programs across several products and indications, which, if successful, will allow us to expand commercialization of our products into new geographies and indications. Importantly, we are undertaking ongoing clinical trials of our C2 catheter intended to support a premarket application (“PMA”) in the United States and a Shonin submission in Japan for the treatment of CAD. In October 2018, we received staged investigational drug exemption (“IDE”) approval for our DISRUPT CAD III global study, which began enrollment in 2019. This study is designed to support U.S. PMA approval for our C2 catheters. We anticipate having final data from these ongoing clinical trials intended to support a U.S. launch of our C2 catheter in the first half of 2021 and a Japan launch in 2022. The first two indications we are targeting with our IVL System are PAD, the narrowing or blockage of vessels that carry blood from the heart to the extremities, and CAD, the narrowing or blockage of the arteries that supply blood to the heart. In the [/INST] Negative. </s>

Cloudflare, Inc.

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 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. In addition to historical financial information, the following discussion contains forward-looking statements that are based upon current plans, expectations, and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the section titled “Risk Factors” included elsewhere in this Annual Report on Form 10-K. Our fiscal year end is December 31. Overview Cloudflare’s mission is to help build a better Internet. We have built a global cloud platform that delivers a broad range of network services to businesses of all sizes and in all geographies-making them more secure, enhancing the performance of their business-critical applications, and eliminating the cost and complexity of managing individual network hardware. Our platform serves as a scalable, easy-to-use, unified control plane to deliver security, performance, and reliability across their on-premise, hybrid, cloud, and software-as-a-service (SaaS) applications. Our Business Model Our business model benefits from our ability to serve the needs of all customers ranging from individual developers to the largest enterprises, in a cost-effective manner. Our products are easy to deploy and allow for rapid and efficient onboarding of new customers and expansion of our relationships with customers over time. Given the large customer base we have and the immense amount of Internet traffic that we manage, we are able to negotiate mutually beneficial agreements with Internet Service Providers (ISPs) that allow us to place our equipment directly in their data centers, which dramatically drives down our bandwidth and co-location expenses. This symbiotic relationship that we have with ISPs and the efficiency of our serverless network architecture allows us to introduce new products on our platform at low marginal cost. We generate revenue primarily from sales to our customers of subscriptions to access our platform. We offer a variety of plans to our free and paying customers depending on their required features and functionality. •Pay-As-You-Go Customers. For our pay-as-you-go customers (and which we previously referred to as self-serve customers), we offer Pro and Business subscription plans through our website per registered domain, and it is common for customers to purchase subscriptions to cover multiple Internet properties (e.g., domains, websites, application programming interfaces (APIs), and mobile applications). Our Pro plan provides basic functionality to improve the security, performance, and reliability of applications, such as enhanced web application firewall and image and mobile optimization. Our Business plan includes additional functionality often required by larger organizations, including service level agreements of up to 100% uptime, dynamic content acceleration, and enhanced customer support. Our implementation period for pay-as-you-go customers is extremely short with most customers implementing our services within a matter of minutes. While our Pro and Business plans offer significant value to customers, customers can subscribe to add-on products and platform functionality we offer to meet their more advanced needs. Our pay-as-you-go customers typically pay with a credit card on a monthly basis. •Contracted Customers. Our contracted customers, which consist of customers that enter into contracts for our Enterprise subscription plan (and which we previously referred to as enterprise customers), have contracts that range from one to three years and are typically billed on a monthly basis. Our contracted customer sales cycle typically lasts less than one quarter. Our agreements with contracted customers are tailored and priced to meet their varying needs and requirements. Enterprise subscription plan agreements for our contracted customers generally include a base subscription and a smaller portion based on usage. Key elements of our business model include: •Free customer base. Free customers are an important part of our business. These customers, like our pay-as-you-go customers, sign up for our service through our website and are typically individual developers, early stage startups, hobbyists, and other users. Our free customers create scale, serve as efficient brand marketing, and help us attract developers, customers, and potential employees. These free customers expose us to diverse traffic, threats, and problems, often allowing us to see potential security, performance, and reliability issues at the earliest stage. This knowledge allows us to improve our products and deliver more effective solutions to our paid customers. In addition, the added scale and diversity of this traffic makes us valuable to a diverse set of global ISPs, improving the breadth and economic terms of our interconnections, bandwidth costs, and co-location expenses. Finally, the enthusiastic engagement of our free customer base represents a "virtual quality assurance" function that allows us to maintain a high rate of product innovation, while ensuring our products are extensively tested in real world environments before they are deployed to enterprise customers. •Significant investment in ongoing product development. We invest significantly in research and development. Our focus on research and development allows us to continually enhance the capabilities and functionality of our global cloud platform with new products that are innovative and powerful and can be quickly adopted by our customers and helps us grow our free and paying customer base, which allows us to serve a greater portion of the world's Internet traffic. That in turn provides us with greater knowledge and insight into the challenges that Internet users face every day. •Investments in our network for growth. We believe that the size, sophistication, and distributed nature of our network provide us with a significant competitive advantage. We intend to continue to make substantial investments in network infrastructure to support the growth of our business. As we invest in our network, we believe the service that we can provide our customers and the insight and knowledge that we can gain will continue to grow. •Efficient go-to-market model. We have built an efficient go-to market model that reflects the flexibility and ease of use our platform offers to our customers around the world. This has enabled us to acquire new customers as well as to expand within our existing customer base in a rapid, cost-effective manner. In particular, we have invested heavily in our contracted customer sales efforts. ◦New customer acquisition. We believe that any person or business that relies on the Internet to deliver products, services or content can be a Cloudflare customer. As such, we are focused on driving an increased number of customers on our platform to support our long-term growth. Through our pay-as-you-go offering, a customer can subscribe to one of our many plans and begin using our platform within minutes, with minimal technical skill and no professional services. This has allowed us to acquire a large portion of paying customers very rapidly and at significantly lower customer acquisition costs. Additionally, we continue to invest to build our direct sales force and improve the sophistication of our sales operations. ◦Expansion of our existing customers. We believe that our platform enables a large opportunity for growth within our existing customer base given the breadth of products we offer on our platform. Our relationships with customers often start with servicing a portion of their overall network needs and expand over time as they realize the significant value we deliver. Once a customer has adopted one product on our platform it can easily add additional products with a single click. As we add more products and functionality to our platform, we see opportunities to drive upsell as customers seek to consolidate onto one platform to meet all of their security, performance, and reliability network requirements. ◦International reach. Our global network, with a presence in 200 cities in over 90 countries, has helped to foster our strong international growth. International markets represented at least 50% of our revenue in the years ended December 31, 2019, 2018, and 2017, and we intend to continue to invest in our international growth as a strategy to expand our customer base around the world. Initial Public Offering In September 2019, we completed an Initial Public Offering (IPO) in which we issued and sold 40,250,000 shares of Class A common stock, which included 5,250,000 shares sold pursuant to the exercise by the underwriters of an option to purchase additional shares, at the public offering price of $15.00 per share. We received net proceeds of $570.5 million from sales of our shares in the IPO, after deducting underwriting discounts and commissions, but before deducting offering costs of $5.5 million. The net proceeds included proceeds of $74.4 million, net of underwriters' discounts and commissions, from the exercise of the underwriters' option to purchase an additional 5,250,000 shares of our Class A common stock. Upon completion of the IPO, 31,381,152 shares of redeemable convertible preferred stock were automatically converted into an equal number of shares of Class A common stock, 134,276,690 shares of redeemable convertible preferred stock were automatically converted into an equal number of shares of Class B common stock, outstanding warrants to purchase shares of redeemable convertible preferred stock were automatically converted into outstanding warrants to purchase shares of Class B common stock, and 15,198,587 shares of Class B common stock held by former employees were automatically converted into an equal number of shares of Class A common stock. Opportunities, Challenges, and Risks We believe that the growth of our business and our future success are dependent upon many factors, including growing our customer base, expanding our relationships with existing paid customers, developing and successfully launching new products, expanding into additional market segments, expanding our base of free customers, and developing and maintaining favorable peering and co-location relationships. Each of these factors presents significant opportunities for us, but also poses material challenges and risks that we must successfully address in order to grow our business and improve our operating results. We expect that addressing these challenges and risks will increase our operating expenses significantly over the next several years. The timing of our future profitability, if we achieve profitability at all, will depend upon many variables, including the success of our growth strategies and the timing and size of investments and expenditures that we choose to undertake, as well as market growth and other factors that are not within our control. In addition, we must comply with complex, uncertain, and evolving laws, rules, and regulatory requirements across federal, state, and international jurisdictions. If we fail to successfully address these challenges, risks, and variables, our business, operating results, financial condition, and prospects may be adversely affected. Refer to Part I, Item 1A “Risk Factors” of this Annual Report on Form 10-K for additional information on the challenges and risks we face. Key Business Metrics and Non-GAAP Financial Measures We review a number of operating and financial metrics, including the following key metrics and non-GAAP financial measures to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. Non-GAAP Financial Measures In addition to our results determined in accordance with generally accepted accounting principles in the United States (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 provided by (used in) operating activities. Additionally, the utility of free cash flow as a measure of our 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 U.S. GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable U.S. GAAP financial measures, and not to rely on any single financial measure to evaluate our business. Non-GAAP Loss from Operations and Non-GAAP Operating Margin We define non-GAAP loss from operations and non-GAAP operating margin as U.S. GAAP loss from operations and U.S. GAAP operating margin, respectively, excluding stock-based compensation expense and amortization of acquired intangible assets. We exclude stock-based compensation expense, which is a non-cash expense, from certain of our non-GAAP financial measures because we believe that excluding this item provides meaningful supplemental information regarding operational performance. We exclude amortization of intangible assets, which is a non-cash expense, related to business combinations from certain of our non-GAAP financial measures because such expenses are related to business combinations and have no direct correlation to the operation of our business. Free Cash Flow and Free Cash Flow Margin Free cash flow is a non-GAAP financial measure that we calculate as net cash provided by (used in) operating activities less cash used for purchases of property and equipment and capitalized internal-use software. Free cash flow margin is calculated as free cash flow divided by 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 operations that, after the investments in property and equipment and capitalized internal-use software, can be used for strategic initiatives, including investing in our business, and strengthening our financial position. We 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. Key Business Metrics Paying Customers We believe our ability to grow the number of paying customers on our platform provides a key indicator of the growth of our business and our future business opportunities. We define a paying customer at the end of any period as a person or entity who has been billed for our services in the last month of the period, excluding (i) Baidu, (ii) other customers that were not acquired through ordinary sales channels, and (iii) customers using our consumer products, such as 1.1.1.1 and Warp. An entity is defined as a company, a government institution, a non-profit organization, or a distinct business unit of a large company that has an active contract with us or one of our partners. The number of paying customers was 82,882, 67,899, and 49,309 as of December 31, 2019, 2018, and 2017, respectively. Paying Customers (> $100,000 Annualized Billings) While we continue to grow customers across all sizes, over time, our large customers have contributed an increasing share of our revenue. We view the number of customers with Annualized Billings greater than $100,000 as indicative of our penetration within large enterprise accounts. To measure Annualized Billings, we take the billings for each customer in the final month of a period and multiply that amount by 12. Our Annualized Billings calculation excludes (i) our strategic agreement with Baidu, (ii) other agreements that were not entered into through our ordinary sales channels, and (iii) customers using our consumer products, such as 1.1.1.1 and Warp, and that together represent an insignificant amount of our revenue. We include both month-to-month subscriptions and longer-term agreements with our contracted customers in the calculation of Annualized Billings. Our Annualized Billings metric also includes any usage charges by a customer during a period, which represent a small portion of our total billings and may not be recurring. As a result, Annualized Billings may be higher than actual billings over the course of the year. For example, if we signed a new customer that was billed for $200 in December, that customer would account for $2,400 of Annualized Billings for that year. The number of paying customers with Annualized Billings greater than $100,000 was 550, 313, and 184 as of December 31, 2019, 2018, and 2017, respectively. We believe this trend will continue as customers increasingly adopt cloud technology and we are able to compete with an increasing share of our customers’ legacy hardware solutions by adding new capabilities to our global cloud platform. Dollar-Based Net Retention Rate Our ability to maintain long-term revenue growth and achieve profitability is dependent on our ability to retain and grow revenue generated from our existing paid customers. We believe that we will achieve these objectives by continuing to focus on customer loyalty and adding additional products and functionality to our platform. Our dollar-based net retention rate is a key way we measure our performance in these areas. Dollar-based net retention measures our ability to retain and expand recurring revenue from existing customers. To calculate dollar-based net retention for a period, we compare the Annualized Billings from paid customers 12 months prior to the Annualized Billings from the same set of customers in the last month of the current period. Our dollar-based net retention includes any expansion and is net of contraction and attrition, but excludes Annualized Billings from new customers in the current period. Our dollar-based net retention excludes the benefit of free customers that upgrade to a paid subscription between the prior and current periods, even though this is an important source of incremental growth. We believe this provides a more meaningful representation of our ability to add incremental business from existing paid customers as they renew and expand their contracts. Our dollar-based net retention rates for the trailing twelve months ended December 31, 2019, 2018, and 2017 were 112%, 111%, and 113%, respectively. Components of Our Results of Operations Revenue We generate revenue primarily from sales to our customers of subscriptions to access our platform, together with related support services. Arrangements with customers generally do not provide the customer with the right to take possession at any time of our software operating our global cloud platform. Instead, customers are granted continuous access to our platform and products over the contractual period. A time-elapsed output method is used to measure progress because we transfer control evenly over the contractual period. Accordingly, the fixed consideration related to subscription and support revenue is generally recognized on a straight-line basis over the contract term beginning on the date that the service is made available to the customer. Usage-based consideration is primarily related to fees charged for our customer’s use of excess bandwidth when accessing our platform in a given period and is recognized as revenue in the period in which the usage occurs. The typical subscription and support term for our contracted customers is one year and subscription and support term lengths range from one to three years. Most of our contracts with contracted customers are non-cancelable over the contractual term. Customers typically have the right to terminate their contracts for cause if we fail to perform in accordance with the contractual terms. For our pay-as-you-go customers, subscription and support terms are typically monthly. Cost of Revenue Cost of revenue consists primarily of expenses that are directly related to providing our service to our paying customers. These expenses include expenses related to operating in co-location facilities, network and bandwidth costs, depreciation of our equipment located in co-location facilities, certificate authority services costs for paying customers, related overhead costs, the amortization of our capitalized internal-use software, and the amortization of acquired developed technologies. Cost of revenue also includes employee-related costs, including salaries, bonuses, benefits, and stock-based compensation for employees whose primary responsibilities relate to supporting our paying customers and delivering paid customer support. Other costs included in cost of revenue include credit card fees related to processing customer transactions and allocated overhead costs. As our customers expand and increase the use of our global cloud platform driven by additional applications and connected devices, we expect that our cost of revenue will increase due to higher network and bandwidth costs and expenses related to operating in additional co-location facilities. However, we expect to continue to benefit from economies of scale as our customers increase the use of our global cloud platform. We intend to continue to invest additional resources in our global cloud platform and our customer support organizations as we grow our business. The level and timing of investment in these areas could affect our cost of revenue in the future. Gross Profit and Gross Margin Gross profit is revenue less cost of revenue and gross margin is gross profit as a percentage of revenue. Our gross profit and gross margin have and are expected to continue to fluctuate from period to period due to the timing of acquisition of new customers and our renewals with existing customers, expenses related to operating in co-location facilities and network and bandwidth costs to operate and expand our global cloud platform, and amortization of costs associated with capitalized internal-use software. We expect our gross profit to increase in absolute dollars and our gross margin to remain consistent over the long term, although our gross margin could fluctuate from period to period depending on the interplay of all of these factors. Operating Expenses Sales and Marketing Sales and marketing expenses consist primarily of employee-related costs, including salaries, benefits, and stock-based compensation expense, sales commissions that are recognized as expenses over the period of benefit, marketing programs, certificate authority services costs for free customers, travel-related expenses, bandwidth and co-location costs for free customers, and allocated overhead costs. Sales commissions earned by our sales force and the associated payroll taxes that are direct and incremental to the acquisition of channel partner and direct customer contracts are deferred and amortized over an estimated period of benefit of three years for the initial acquisition of a contract and over the contractual term of the renewals for renewal contracts. We plan to continue to invest in sales and marketing to grow our customer base and increase our brand awareness, including marketing efforts to continue to drive our pay-as-you-go business model. As a result, we expect our sales and marketing expenses to increase in absolute dollars for the foreseeable future. We also incurred a significant increase in sales and marketing expenses from the stock-based compensation expense related to RSUs that have both service-based and performance vesting conditions. However, we expect our sales and marketing expenses to decrease as a percentage of our revenue over the long term, although 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 costs consist primarily of employee-related costs, including salaries, bonuses, benefits, and stock-based compensation expense, consulting costs, depreciation of equipment used in research and development, and allocated overhead costs. Research and development costs support our efforts to add new features to our existing offerings and to ensure the security, performance, and reliability of our global cloud platform. We expect our research and development expenses to increase in absolute dollars for the foreseeable future as we continue to invest in research and development efforts to enhance the functionality of our global cloud platform. We also incurred a significant increase in research and development expenses from the stock-based compensation expense related to RSUs that have both service-based and performance vesting conditions. However, we expect our research and development expenses to decrease as a percentage of our revenue over the long term, although 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 consist primarily of employee-related costs, including salaries, bonuses, benefits, and stock-based compensation expense for our finance, legal, human resources, and other administrative personnel, professional fees for external legal services, accounting, and other consulting services, bad debt expense, and allocated overhead costs. We expect our general and administrative expenses to continue to increase in absolute dollars for the foreseeable future to support our growth as well as due to additional costs associated with legal, accounting, compliance, insurance, investor relations, and other costs as a result of operating as a public company. We also incurred a significant increase in general and administrative expenses from the stock-based compensation expense related to RSUs that have both service-based and performance vesting conditions. However, we expect our general and administrative expenses to decrease as a percentage of our revenue over the long term, although 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. Non-Operating Income (Expense) Interest Income Interest income consists primarily of interest earned on our cash, cash equivalents, and our investment holdings. Interest Expense Interest expense consists primarily of interest related to our built-to-suit lease financing obligation and interest on our notes payable. Other Income (Expense), Net Other income (expense), net consists primarily of expenses resulting from the revaluation of our redeemable convertible preferred stock warrant liability and foreign currency transaction gains and losses. Provision for Income Taxes Provision for income taxes consists primarily of income taxes in certain foreign jurisdictions in which we conduct business, as well as state income taxes in the United States. 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 tax assets will not be realized. Results of Operations The following tables set forth our consolidated results of operations for the periods presented in dollars and as a percentage of our revenue for those periods: _______________ (1)Includes stock-based compensation expense as follows: We have granted qualified event options (QE Options) and qualified event restricted stock units (QE RSUs) to employees and contractors which vest on the satisfaction of both a service-based condition and a performance condition. For QE Options, the performance condition was deemed satisfied upon our Class A common stock being listed on a public exchange. For QE Options, the service-based condition is satisfied by rendering service from the date of grant through the qualifying event, as well as a four-year vesting period commencing with the qualifying event. For QE RSUs, the performance condition was deemed satisfied upon the effective date of our registration statement on Form S-1 filed with the SEC in connection with the IPO. The QE RSUs have a service-based vesting condition satisfied over a four-year vesting period. The listing of equity securities event and effectiveness of a registration statement event are not deemed probable until consummated. In connection with our IPO, we recognized $21.0 million of cumulative stock-based compensation expense for the QE Options for the service period rendered from the date of grant through the equity securities listing date and for the QE RSUs that vested in connection with the effective date of our registration statement on Form S-1 and began recording the remaining unrecognized stock-based compensation expense over the remainder of the requisite service period. We incurred a $23.3 million stock-based compensation expense charge related to a secondary sale of our common stock in September 2018. Comparison of the Years Ended December 31, 2019 and 2018 Revenue Revenue increased by $94.3 million, or 49%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. Of this increase, 38% was due to sales to new customers, and the remaining increase was due to increased sales to existing customers. Cost of Revenue and Gross Margin Cost of revenue increased by $19.9 million, or 46%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase in cost of revenue was primarily due to an increase of $7.5 million in expenses related to operating in co-location facilities and network and bandwidth costs for operating our global cloud platform for our expanded customer base as well as increased capacity to support our growth, an increase of $3.5 million related to the amortization of capitalized internal-use software costs, an increase of $3.3 million in depreciation expense related to purchases of equipment located in co-location facilities, and an increase of $3.2 million in employee-related costs due to a 37% increase in headcount in our customer support and technical operations organizations. The remainder of the increase was primarily attributable to an increase of $0.9 million in payment processing fees and third-party technology services. Gross margin did not significantly fluctuate during the year ended December 31, 2019 as compared to the year ended December 31, 2018. Operating Expenses Sales and Marketing Sales and marketing expenses increased by $64.9 million, or 69%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily driven by $39.3 million in increased employee-related costs due to a 58% increase in headcount in our sales and marketing organization from December 31, 2018 to December 31, 2019, including an increase of $7.7 million in stock-based compensation expense primarily due to the recognition of expense related to RSUs with a performance condition that was satisfied upon the effective date of our registration statement on Form S-1 filed with the SEC in connection with the IPO. The remainder of the increase was due primarily to increased expenses of $9.6 million in marketing programs due to investments in brand awareness advertising, third-party industry events, and digital performance marketing, aimed at driving overall revenue growth, $7.3 million related to allocated overhead costs, $4.5 million related to increased travel-related costs and third-party technology services, and an increase of $3.5 million in co-location and bandwidth expenses for free customers. Research and Development Research and development expenses increased by $36.2 million, or 66%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily driven by $34.8 million in increased employee-related costs due to a 33% increase in headcount in our research and development organization from December 31, 2018 to December 31, 2019, including an increase of $13.3 million in stock-based compensation expense primarily due to the recognition of expense related to RSUs with a performance condition that was satisfied upon the effective date of our registration statement on Form S-1 filed with the SEC in connection with the IPO. The remainder of the increase was due to $5.0 million of increased allocated overhead costs primarily related to rent and office-related expenses due to expansion of office space, and $2.4 million of increased travel-related costs and consulting expenses. These increases were partially offset by decreased expenses of $6.4 million as a result of increased capitalized internal-use software development costs. General and Administrative General and administrative expenses decreased by $3.6 million, or 4%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily driven by $8.1 million of decreased professional fees for third-party accounting, consulting, and legal services, $5.6 million of decreased allocated overhead costs, and $0.8 million in decreased employee-related costs. The decrease in employee-related costs primarily consisted of $10.6 million in decreased stock-based compensation expense related to the secondary stock sales in 2018 described in Note 13 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, partially offset by a 56% increase in headcount in our general and administrative organization from December 31, 2018 to December 31, 2019, as well as increased stock-based compensation expense related to QE options and QE RSUs with performance conditions that were satisfied upon our Class A common stock being listed on a public exchange and the effective date of our registration statement on Form S-1 filed with the SEC in connection with the IPO. These decreases were partially offset by $3.1 million of increased depreciation expense, $2.8 million of increased expenses for insurance, fees, and taxes, $1.7 million of increased third-party technology services costs, $1.7 million of increased company-wide event and travel-related costs, and $1.4 million of bad debt expense. Non-Operating Income (Expense) Interest Income Interest income increased by $3.9 million, or 205%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily driven by a higher invested balance in cash and cash equivalents and available-for-sale securities as a result of the IPO proceeds. Interest Expense Interest expense did not significantly fluctuate during the year ended December 31, 2019 as compared to the year ended December 31, 2018. Other Expense, net Other expense, net decreased by $0.6 million, or 31%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily driven by an increase of $1.0 million in rental income from sublease activities. This decrease was partially offset by increased expense of $0.3 million as a result of the increased fair value of our redeemable convertible preferred stock warrant liability and fluctuations in foreign currency transaction gains and losses. Provision for Income Taxes The provision for income taxes did not significantly fluctuate during the year ended December 31, 2019 as compared to the year ended December 31, 2018. Comparison of the Years Ended December 31, 2018 and 2017 Revenue Revenue increased by $57.8 million, or 43%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. Of this increase, 42% was due to increased sales to existing customers, and the remaining increase was due to sales to new customers. Cost of Revenue and Gross Margin Cost of revenue increased by $14.7 million, or 51%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in cost of revenue was primarily due to an increase of $6.4 million in expenses related to operating in co-location facilities and network and bandwidth costs for operating our global cloud platform for our expanded customer base as well as increased capacity to support our growth, and an increase of $2.5 million in depreciation expense related to purchases of equipment located in co-location facilities. The remainder of the increase was primarily attributable to an increase of $2.3 million related to the amortization of capitalized internal-use software costs, an increase of $1.9 million in employee-related costs due to a 60% increase in headcount in our customer support and technical operations organizations, and an increase of $1.1 million related to third-party technology services and payment processing fees. Gross margin decreased to 77% from 79% during the year ended December 31, 2018 compared to the year ended December 31, 2017, respectively. The decrease in gross margin was driven by higher network and bandwidth costs and expenses related to operating in additional co-location facilities, as we invested in additional co-location facilities and additional equipment within existing co-location facilities to support our global cloud platform. Our gross margin may fluctuate or decline in the near-term as we seek further expansion of our global cloud platform. Operating Expenses Sales and Marketing Sales and marketing expenses increased by $32.5 million, or 52%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily driven by $24.6 million in increased employee-related costs due to a 61% increase in headcount in our sales and marketing organization from December 31, 2017 to December 31, 2018, including an increase of $5.4 million in sales commissions expense including the amortization of contract acquisition costs. The remainder of the increase was due primarily to increased costs of marketing programs of $4.6 million due to investments in brand awareness advertising, third-party industry events, and digital performance marketing, aimed at driving overall revenue growth, increased expenses of $3.1 million related to co-location and bandwidth expenses for free customers due to an increase in free customers, $2.2 million of increased allocated overhead costs primarily related to rent and office-related expenses due to expansion of office space, increased expenses of $2.1 million related to third-party technology services, consulting services, and company-wide event costs, and $1.9 million of increased travel-related costs. These increases were partially offset by decreased expenses of $6.3 million as a result of decreased certificate authority services costs for free customers due to re-negotiating rates with vendors. Research and Development Research and development expenses increased by $20.8 million, or 62%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily driven by $20.9 million in increased employee-related costs due to a 58% increase in headcount in our research and development organization from December 31, 2017 to December 31, 2018, $2.9 million of increased allocated overhead costs primarily related to rent and office-related expenses due to expansion of office space, $1.0 million of increased travel-related costs, and $1.0 million of increased third-party services and technology costs. These increases were partially offset by decreased expenses of $5.4 million as a result of increased capitalized internal-use software development costs. General and Administrative General and administrative expenses increased by $64.9 million, or 319%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily driven by $32.1 million in increased employee-related costs, inclusive of an increase of $23.3 million in non-cash stock-based compensation expense related to the secondary stock sales during the year ended December 31, 2018 described in Note 13 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The increase in employee-related costs was also driven by a 63% increase in headcount in our general and administrative organization from December 31, 2017 to December 31, 2018 as we prepared to operate as a public company. The remainder of the increase was primarily due to an increase of $22.8 million of professional fees for third-party accounting, consulting, and legal services as we invested in preparing to be a public company, $8.0 million of professional fees for information technology as we scaled our systems to operate as a public company, $1.9 million of increased recruiting, travel, and company-wide event costs, $1.1 million of bad debt expense, $1.0 million of increased third-party technology services costs, and $0.8 million of increased depreciation expense. These increases were partially offset by $3.0 million of decreased allocated overhead costs. Non-Operating Income (Expense) Interest Income Interest income increased by $1.1 million, or 149%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily driven by a higher invested balance in cash and cash equivalents and available-for-sale securities. Interest Expense Interest expense did not significantly fluctuate during the year ended December 31, 2018 as compared to the year ended December 31, 2017. Other Income (Expense), net _______________ * Not meaningful Other income (expense), net decreased by $2.2 million, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease was primarily driven by increased expense of $1.2 million as a result of the increased fair value of our redeemable convertible preferred stock warrant liability. The remainder of the decrease was primarily driven by fluctuations in foreign currency transaction gains and losses. Provision for Income Taxes The provision for income taxes did not significantly fluctuate during the year ended December 31, 2018 as compared to the year ended December 31, 2017. Quarterly Results of Operations The following tables set forth our unaudited quarterly statements of operations data for each of the quarters indicated, as well as the percentage that each line item represents of our revenue for each quarter presented. 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, include all adjustments, which consist only of normal recurring adjustments, that are necessary for the fair statement of such data. Our historical results are not necessarily indicative of our future results, and the results for any quarter are not necessarily indicative of the 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 related notes thereto included elsewhere in this Annual Report on Form 10-K. _______________ (1)Includes stock-based compensation expense as follows: Quarterly Revenue Trends Our quarterly revenue generally increased sequentially in each of the quarters presented due primarily to increases in sales to new customers as well as increases in sales to existing customers. Quarterly Cost of Revenue Trends Cost of revenue increased sequentially in each of the quarters presented, consistent with the growth of revenue and primarily driven by expenses related to operating in co-location facilities, network and bandwidth costs, and related overhead costs for operating our global cloud platform to support the expanded adoption of our global cloud platform by existing and new customers. Quarterly Gross Profit Trends The overall increase in gross profit during the quarters presented was primarily due to increases in revenue, and was due in part to the increased efficiency of our network infrastructure and co-location facilities. Quarterly Operating Expense Trends Operating expenses generally have increased sequentially in the quarters presented primarily due to increases in headcount and other related expenses to support our growth. Sales and marketing expenses increased as we expanded our sales team to acquire new customers, and we intend to continue to make significant investments in our sales and marketing organization. We also intend to invest in research and development efforts to add new features and enhance the functionality of our existing global cloud platform, and to ensure the security, performance, and reliability of our global cloud platform. General and administrative expenses increased in recent quarters due to costs related to preparing to be a public company. The increase in total operating expenses during the three months ended September 30, 2019 in absolute dollars and as a percentage of revenue is primarily due to cumulative stock-based compensation expense of $21.0 million for the QE Options for the service period rendered from the date of grant through the equity securities listing date and for the QE RSUs that vested in connection with the effective date of our registration statement on Form S-1 filed with the SEC in connection with the IPO, as described in Note 10 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The increase in general and administrative expenses during the three months ended September 30, 2018 in absolute dollars and as a percentage of revenue is primarily due to a $23.3 million increase in stock-based compensation expense related to the secondary stock sale described in Note 13 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Liquidity and Capital Resources Since our inception, we have financed our operations primarily through net proceeds from the sale of our equity securities as well as payments received from customers using our global cloud platform. In September 2019, we completed our IPO in which we issued and sold 40,250,000 shares of Class A common stock at a price per share to the public of $15.00. We received net proceeds of $565.0 million from sales of our shares in the IPO, net of underwriters' discounts and commissions, after deducting offering costs of $5.5 million. As of December 31, 2019, we had cash and cash equivalents of $139.0 million, including $2.4 million held by our foreign subsidiaries. We do not expect to incur material taxes in the event we repatriate any of these amounts. Our cash and cash equivalents primarily consist of highly liquid money market funds, commercial paper, and U.S. government agency securities. We also had available-for-sale securities of $498.0 million consisting of U.S. treasury securities, U.S. government agency securities, commercial paper, and corporate bonds. We have generated significant operating losses from our operations as reflected in our accumulated deficit of $301.7 million as of December 31, 2019 and negative cash flows from operations. 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 make in our business, 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, cash equivalents, and available-for-sale securities will be sufficient to meet our working capital and capital expenditure 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 near- and long-term future capital requirements will depend on, many factors, including our growth rate, subscription renewal activity, the timing and extent of spending to support our infrastructure and research and development efforts, the expansion of sales and marketing activities, the timing of new introductions of products or features, and the continuing market adoption of our global cloud platform. 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 our estimates 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. In July 2015 and November 2015, we entered into three separate Installment Purchase Agreements (IPA) totaling $1.7 million for computer equipment and maintenance with one of our suppliers. The agreements were collateralized by the equipment purchased from the supplier and bear interest ranging from 2.9% to 5.0%. We had an aggregate of $0.3 million outstanding in principal and interest under the IPA note payable as of December 31, 2018 and zero as of December 31, 2019. Cash Flows The following table summarizes our cash flows for the periods presented: Operating Activities Net cash used in operating activities during the year ended December 31, 2019 was $38.9 million, which resulted from a net loss of $105.8 million, adjusted for non-cash charges of $79.8 million and net cash outflow of $12.9 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $36.6 million for stock-based compensation expense, $29.5 million for depreciation and amortization expense, and $10.8 million for amortization of deferred contract acquisition costs. The net cash outflow from changes in operating assets and liabilities was primarily the result of a $14.6 million increase in deferred revenue, and a $13.5 million increase in accounts payable, accrued expenses, and other liabilities, partially offset by a $20.1 million increase in deferred contract acquisition costs due to increased sales commissions from the addition of new customers, a $11.2 million increase in accounts receivable, net, which increased due to our growing customer base and timing of collections from our customers, and a $9.2 million increase in prepaid expenses and other assets. Net cash used in operating activities during the year ended December 31, 2018 was $43.3 million, which resulted from a net loss of $87.2 million, adjusted for non-cash charges of $55.5 million and net cash outflow of $11.6 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $27.3 million for stock-based compensation expense, $18.9 million for depreciation and amortization expense, and $7.1 million for amortization of deferred contract acquisition costs. The net cash outflow from changes in operating assets and liabilities was primarily the result of a $14.8 million increase in accounts receivable, net which increased due to our growing customer base and timing of collections from our customers, a $12.2 million increase in deferred contract acquisition costs due to increased sales commissions due to the addition of new customers, a $6.3 million increase in prepaid expenses and other assets, partially offset by a $14.6 million increase in accounts payable, accrued expenses, and other liabilities, a $4.9 million increase in deferred revenue, and a $2.2 million decrease in contract assets due to timing of invoicing. Net cash provided by operating activities during the year ended December 31, 2017 was $3.2 million, which resulted from a net loss of $10.7 million, adjusted for non-cash charges of $19.1 million and net cash outflow of $5.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $12.2 million for depreciation and amortization expense, $4.0 million for amortization of deferred contract acquisition costs, and $2.8 million for stock-based compensation expense. The net cash outflow from changes in operating assets and liabilities was primarily the result of a $9.0 million increase in deferred contract acquisition costs due to increased sales commissions due to the addition of new customers and the expansion of existing customers, a $3.1 million increase in contract assets due to timing of invoicing, and a $2.1 million increase in accounts receivable, net due to our growing customer base and timing of collections from our customers, partially offset by a $5.5 million increase in deferred revenue and a $4.7 million increase in accrued expenses and other liabilities due to growth in our business and higher headcount. Investing Activities Net cash used in investing activities during the year ended December 31, 2019 of $417.6 million resulted primarily from the purchases of available-for-sale securities of $537.4 million, capital expenditures of $43.3 million, and the capitalization of internal-use software development costs of $14.0 million. These activities were offset by proceeds from the sales and maturities of available-for-sale securities of $177.0 million. Net cash used in investing activities during the year ended December 31, 2018 of $120.8 million resulted primarily from the purchases of available-for-sale securities of $145.3 million, capital expenditures of $25.5 million, and the capitalization of internal-use software development costs of $9.4 million. These activities were partially offset by proceeds from maturities of available-for-sale securities of $59.2 million. Net cash provided by investing activities during the year ended December 31, 2017 of $9.5 million resulted primarily from proceeds from maturities of available-for-sale securities of $79.8 million. This was partially offset by capital expenditures of $19.0 million, the capitalization of internal-use software development costs of $3.9 million, and purchases of available-for-sale securities of $47.1 million. Financing Activities Net cash provided by financing activities of $570.8 million during the year ended December 31, 2019 was primarily due to $570.5 million in net proceeds from the IPO, after deducting underwriting discounts and commissions, and $6.0 million of proceeds from the exercise of vested and unvested stock options, partially offset by $5.3 million of payments of deferred offering costs. Net cash provided by financing activities of $168.6 million during the year ended December 31, 2018 was primarily due to $150.0 million of proceeds from the issuance of Series D redeemable convertible preferred stock and $18.9 million of proceeds from the exercise of vested and unvested stock options. Net cash used in financing activities of $0.1 million during the year ended December 31, 2017 was primarily due to $2.2 million of proceeds from the build-to-suit lease financing obligation drawdown and $2.8 million of proceeds from the exercise of vested and unvested stock options, partially offset by the use of $4.8 million to repay the related party promissory note payable. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: (1)Open purchase commitments are for the purchase of services under non-cancelable contracts. They were not recorded as liabilities on the consolidated balance sheet as of December 31, 2019 as we had not yet received the related services. (2)Long-term commitments for bandwidth usage and co-location with various networks and Internet service providers. The costs for services not yet received were not recorded as liabilities on the consolidated balance sheet as of December 31, 2019. (3)Office space and equipment under non-cancelable operating leases, primarily due to our headquarters in San Francisco, California and for our offices in Austin, Texas; San Jose, California; Miramar, Florida; London, United Kingdom; Lisbon, Portugal; and Singapore. Total payments listed represent total minimum future lease payments. 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 tables above. Purchase orders issued in the ordinary course of business are not included in the tables above, as our purchase orders represent authorizations to purchase rather than binding agreements. In addition to the contractual obligations set forth above, as of December 31, 2019, we had $6.7 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 2028. For additional discussion on our leases and other commitments, refer to Note 7 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. 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, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies, Significant Judgments and Use of 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, revenue and expenses, and related disclosures. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances, and we evaluate our estimates and assumptions on an ongoing basis. Our actual results could differ from these estimates. 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 In accordance with Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers (ASC 606), revenue is recognized when a customer obtains control of promised services. The amount of revenue recognized reflects the consideration that we expect to be entitled to receive in exchange for these services. To achieve this standard, we apply the following five steps: 1. Identify the contract with a customer We consider the terms and conditions of the contracts and our customary business practices in identifying our contracts under ASC 606. We determine 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, we have determined that collectibility is probable, and the contract has commercial substance. We apply judgment in determining that collectibility is probable, which is based on a variety of factors, including the customer’s historical payment experience or, in the case of a new customer, credit and financial information relevant to the customer. 2. Identify the performance obligations in the contract Performance obligations promised in a contract 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 to 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 obligation primarily consists of subscription and support services, as they are provided over the same service period. 3. Determine the transaction price The transaction price is determined based on the consideration to which we expect to be entitled in exchange for transferring services to the customer. Usage-based variable consideration is recognized in the period it is incurred. None of our contracts contain a significant financing component. 4. Allocate the transaction price to performance obligations in the contract The subscription and support services in our contracts are considered a single performance obligation, and thus the entire transaction price is allocated to the single performance obligation. 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 service to a customer. Revenue is recognized when control of the services is transferred to our customers, in an amount that reflects the consideration that we expect to be entitled to receive in exchange for those services. We generate sales directly through our sales team and through our channel partners. Revenue from sales to channel partners are recorded once all revenue recognition criteria above are met. 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. We have determined that we are acting as an agent in these arrangements and record this revenue on a net basis. Subscription and Support Revenue We generate revenue primarily from sales to our customers of subscriptions to access our platform, together with related support services. Arrangements with customers generally do not provide the customer with the right to take possession of our software operating our global cloud platform at any time. Instead, customers are granted continuous access to our global cloud platform over the contractual period. Access to our platform and products is considered a monthly series comprising one performance obligation. A time-elapsed output method is used to measure progress because we transfer control evenly over the contractual period. Accordingly, the fixed consideration related to subscription and support revenue is generally recognized on a straight-line basis over the contract term beginning on the date that our service is made available to the customer. Usage-based consideration is primarily related to fees charged for our customer’s use of excess bandwidth when accessing our platform in a given period and is recognized as revenue in the period in which the usage occurs. The typical subscription and support term for our contracted customers, which consist of customers that enter into contracts for our Enterprise subscription plan (and which we previously referred to as enterprise customers), is one year and subscription and support term lengths range from one to three years. Most of our contracts with contracted customers are non-cancelable over the contractual term. Customers typically have the right to terminate their contracts for cause if we fail to perform in accordance with the contractual terms. For our pay-as-you-go customers, which consist of customers that sign up for our Pro or Business subscription plans through our website (and which we previously referred to as self-serve customers), subscription and support terms are typically monthly. Costs to Obtain and Fulfill a Contract We capitalize sales commission and associated payroll taxes paid to internal sales personnel that are incremental to the acquisition of channel partner and direct customer contracts. These costs are recorded as deferred contract acquisition costs on the consolidated balance sheets. We determine whether costs should be deferred based on our 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 not considered commensurate with the commissions paid for the acquisition of the initial contract. Commissions paid upon the initial acquisition of a contract are amortized over an estimated period of benefit of three years while commissions paid for renewal contracts are amortized over the contractual term of the renewals. Amortization of deferred contract acquisition costs is recognized on a straight-line basis commensurate with the pattern of revenue recognition and included in sales and marketing expense in the consolidated statements of operations. We determine the period of benefit for commissions paid for the acquisition of the initial contract by taking into consideration the expected subscription term and expected renewals of our customer contracts, the duration of our relationships with our customers, customer retention data, our technology development lifecycle, and other factors. 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 losses of deferred contract acquisition costs during the periods presented. Stock-based Compensation We recognize stock-based compensation expense based on the grant date fair value of the awards. We estimate the fair value of each stock-based award on the grant date using the Black-Scholes option pricing model. Stock-based compensation expense for awards with service-based vesting only is recognized on a straight-line basis over the requisite service period of the awards, which is generally four years. We account for forfeitures as they occur. The Black-Scholes option pricing model requires the use of highly subjective assumptions. The assumptions used to determine the fair value of the stock-based awards are management’s best estimates and involve inherent uncertainties and the application of judgment. If any of the assumptions used in the Black-Scholes option pricing model change significantly, stock-based compensation expense for future awards may differ materially compared with the awards granted previously. These assumptions and estimates are as follows: •Fair value of common stock-Prior to our IPO, the fair value of our common stock was historically determined by our Board of Directors, with assistance from management and contemporaneous third-party valuations. Because there had been no public trading market for our common stock, our Board of Directors exercised reasonable judgment and considered numerous objective and subjective factors, including, but not limited to, our operating and financial performance, current business conditions and projections, the market performance of comparable publicly-traded software and technology companies, and the U.S. and global economic and capital market conditions and outlook to determine the best estimate of the fair value of our common stock at each grant date. After our IPO, we used the publicly quoted price of our Class A common stock as reported on the New York Stock Exchange as the fair value per share of our common stock; •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 awards. The expected term was estimated using the simplified method allowed under U.S. GAAP; •Volatility-We determine the expected volatility based on historical volatilities of similar publicly traded companies corresponding to the expected term of the awards; •Risk free interest rates-The risk-free interest rate is based on the implied yield currently available on U.S. treasury notes with terms approximately equal to the expected term of the award; and •Dividend yield-Our expected dividend rate is zero as we currently have no history or expectation of declaring dividends on our common stock. The following weighted-average assumptions were used for the periods presented: We have granted qualified event options (the QE Options) and qualified event RSUs (the QE RSUs) to employees and contractors which vest on the satisfaction of both a service-based condition and a performance condition. For QE Options, the performance condition was deemed satisfied upon our Class A common stock being listed on a public exchange. For QE Options, the service-based condition is satisfied by rendering service from the date of grant through the qualifying event, as well as a four-year vesting period commencing with the qualifying event. For QE RSUs, the performance condition was deemed satisfied upon the effective date of our registration statement on Form S-1 filed with the SEC in connection with the IPO. The QE RSUs have a service-based vesting condition satisfied over a four-year vesting period. Awards which contain both service-based and performance conditions are recognized using the accelerated attribution method once the performance condition is probable of occurring. The listing of equity securities event and effectiveness of a registration statement event are not deemed probable until consummated. In connection with our IPO, we recognized $21.0 million of cumulative stock-based compensation expense for the QE Options for the service period rendered from the date of grant through the equity securities listing date and for the QE RSUs that vested in connection with the effective date of our registration statement on Form S-1 and began recording the remaining unrecognized stock-based compensation expense over the remainder of the requisite service period. Capitalized Internal-Use Software Development Costs Certain development costs related to our global cloud platform during the application development stage are capitalized. Costs incurred in the preliminary stages of development are analogous to research and development activities and are expensed as incurred. The preliminary stage includes such activities as conceptual formulation of alternatives, evaluation of alternatives, determination of existence of needed technology, and final selection of alternatives. Once the application development stage is reached, internal and external costs 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. Capitalized internal-use software is amortized on a straight-line basis over its estimated useful life, which is generally three years, and is recorded as cost of revenue in the 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. JOBS Act Accounting Election We meet the definition of an emerging growth company under the JOBS Act, which permits 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 until we are no longer an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period. As a result, our consolidated financial statements may not be comparable to companies that comply with new or revised accounting pronouncements applicable to public companies. Recent Accounting Pronouncements Refer to Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information regarding recently issued accounting pronouncements.

<s>[INST] Overview Cloudflare’s mission is to help build a better Internet. We have built a global cloud platform that delivers a broad range of network services to businesses of all sizes and in all geographiesmaking them more secure, enhancing the performance of their businesscritical applications, and eliminating the cost and complexity of managing individual network hardware. Our platform serves as a scalable, easytouse, unified control plane to deliver security, performance, and reliability across their onpremise, hybrid, cloud, and softwareasaservice (SaaS) applications. Our Business Model Our business model benefits from our ability to serve the needs of all customers ranging from individual developers to the largest enterprises, in a costeffective manner. Our products are easy to deploy and allow for rapid and efficient onboarding of new customers and expansion of our relationships with customers over time. Given the large customer base we have and the immense amount of Internet traffic that we manage, we are able to negotiate mutually beneficial agreements with Internet Service Providers (ISPs) that allow us to place our equipment directly in their data centers, which dramatically drives down our bandwidth and colocation expenses. This symbiotic relationship that we have with ISPs and the efficiency of our serverless network architecture allows us to introduce new products on our platform at low marginal cost. We generate revenue primarily from sales to our customers of subscriptions to access our platform. We offer a variety of plans to our free and paying customers depending on their required features and functionality. PayAsYouGo Customers. For our payasyougo customers (and which we previously referred to as selfserve customers), we offer Pro and Business subscription plans through our website per registered domain, and it is common for customers to purchase subscriptions to cover multiple Internet properties (e.g., domains, websites, application programming interfaces (APIs), and mobile applications). Our Pro plan provides basic functionality to improve the security, performance, and reliability of applications, such as enhanced web application firewall and image and mobile optimization. Our Business plan includes additional functionality often required by larger organizations, including service level agreements of up to 100% uptime, dynamic content acceleration, and enhanced customer support. Our implementation period for payasyougo customers is extremely short with most customers implementing our services within a matter of minutes. While our Pro and Business plans offer significant value to customers, customers can subscribe to addon products and platform functionality we offer to meet their more advanced needs. Our payasyougo customers typically pay with a credit card on a monthly basis. Contracted Customers. Our contracted customers, which consist of customers that enter into contracts for our Enterprise subscription plan (and which we previously referred to as enterprise customers), have contracts that range from one to three years and are typically billed on a monthly basis. Our contracted customer sales cycle typically lasts less than one quarter. Our agreements with contracted customers are tailored and priced to meet their varying needs and requirements. Enterprise subscription plan agreements for our contracted customers generally include a base subscription and a smaller portion based on usage. Key elements of our business model include: Free customer base. Free customers are an important part of our business. These customers, like our payasyougo customers, sign up for our service through our website and are typically individual developers, early stage startups, hobbyists, and other users. Our free customers create scale, serve as efficient brand marketing, and help us attract developers, customers, and potential employees. These free customers expose us to diverse traffic, threats, and problems, often allowing us to see potential security, performance, and reliability issues at the earliest stage. This knowledge allows us to improve our products and deliver more effective solutions to our paid customers. In addition, the added scale and diversity of this traffic makes us valuable to a diverse set of global ISPs, improving the breadth and economic terms of our interconnections, bandwidth costs, and colocation expenses. Finally, the enthusiastic engagement of our free customer base represents a "virtual quality assurance" function that allows us to maintain a high rate of product innovation, while ensuring our products are extensively tested in real world environments before they are deployed to enterprise customers. Significant investment in ongoing product development. We invest significantly in research and development. Our focus on research and development allows us to continually enhance the capabilities and functionality of our global cloud platform with new products that are innovative and powerful and can be quickly adopted by our customers and helps us grow our free and paying customer base, which allows us to serve a greater portion of the world's Internet traffic [/INST] Positive. </s>

Ovintiv Inc.

2020-02-21

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The MD&A is intended to provide a narrative description of the Company’s business from management’s perspective. This MD&A should be read in conjunction with the audited Consolidated Financial Statements and accompanying notes for the period ended December 31, 2019 (“Consolidated Financial Statements”), which are included in Item 8 of this Annual Report on Form 10-K. On January 24, 2020, Encana Corporation (“Encana”) completed a corporate reorganization, which included a Share Consolidation, as described in Items 1 and 2 of this Annual Report on Form 10-K, Note 1 of the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K and the Subsequent Event section of this MD&A. Subsequent to the corporate reorganization, Ovintiv Inc. and its subsidiaries (collectively, “Ovintiv”) continue to carry on the business which was previously conducted by Encana and its subsidiaries. References to the “Company” are to Encana Corporation and its subsidiaries prior to the completion of the Reorganization and to Ovintiv Inc. and its subsidiaries following the completion of the Reorganization. Common industry terms and abbreviations are used throughout this MD&A and are defined in the Definitions, Conversions and Conventions sections of this Annual Report on Form 10-K. This MD&A includes the following sections: • Executive Overview • Results of Operations • Liquidity and Capital Resources • Accounting Policies and Estimates • Non-GAAP Measures Executive Overview Strategy By executing on its strategy as outlined in Items 1 and 2 of this Annual Report on Form 10-K, Ovintiv focuses on enhancing long-term shareholder value and generating cash flow growth from high margin, scalable, top tier assets located in some of the best plays in North America, referred to as the “Core Assets”. As at December 31, 2019, the Core Assets comprised Permian and Anadarko in the U.S., and Montney in Canada. These top tier assets form a multi-basin portfolio of oil, NGLs and natural gas producing plays enabling flexible and efficient investment of capital that support sustainable cash flow generation. The Company’s other upstream assets, including Eagle Ford, Duvernay, Bakken (previously referred to as Williston) and Uinta, continue to deliver operating cash flows for the Company. In executing its strategy, Ovintiv focuses on its core values of One, Agile and Driven, which guide the organization to be flexible, responsive, innovative and determined. The Company is committed to excellence with a passion to drive corporate financial performance and succeed as a team. For additional information on reporting segments and the plays in which the Company operates, refer to Items 1 and 2 of this Annual Report on Form 10-K. On February 13, 2019, the Company completed the acquisition of Newfield Exploration Company (“Newfield”); as such, the post-acquisition results of operations of Newfield are included in the Company’s consolidated results beginning February 14, 2019. For additional information on the business combination and segmented results, refer to Notes 8 and 2, respectively, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. In evaluating its operations and assessing its leverage, Ovintiv reviews performance-based measures such as Non-GAAP Cash Flow, Non-GAAP Cash Flow Margin, Total Costs and debt-based metrics such as Debt to Adjusted Capitalization and Net Debt to Adjusted EBITDA, which are non-GAAP measures and do not have any standardized meaning under U.S. GAAP. These measures may not be similar to measures presented by other issuers and should not be viewed as a substitute for measures reported under U.S. GAAP. Additional information regarding these measures, including reconciliations to the closest GAAP measure, can be found in the Non-GAAP Measures section of this MD&A. For the period ended December 31, 2019, the Company elected to exclude from this MD&A the discussion of the results of operations for the period ended December 31, 2017, being the earliest of the three years included in the Consolidated Financial Statements, as set forth in the SEC’s amendment to Item 303 of Regulation S-K, which was effective May 2, 2019. For additional information on the Company’s financial condition, changes in financial condition and results of operations for the period ended December 31, 2017, refer to Item 7 of the 2018 Annual Report on Form 10-K. Highlights During 2019, the Company met or exceeded all of the targets set in its full year 2019 guidance by executing its 2019 capital plan, generating cash from operating activities and returning capital to shareholders through dividends and share buybacks. Subsequent to the successful completion of the Newfield acquisition, the Company fully integrated the businesses and captured synergies that exceeded previously announced expectations. Higher upstream product revenues in 2019 compared to 2018 resulted from higher production volumes, partially offset by lower average realized prices, excluding the impact of risk management activities. Total production volumes increased 56 percent compared to 2018 primarily due to the Newfield acquisition and successful drilling programs. Decreases in average realized liquids and natural gas prices of 20 percent and 12 percent, respectively, were primarily due to lower benchmark prices. The Company continued to focus on optimizing realized prices from the diversification of the Company’s downstream markets. Significant Developments • Completed the acquisition of all issued and outstanding shares of common stock of Newfield on February 13, 2019, whereby the Company issued approximately 543.4 million common shares, on a pre-Share Consolidation basis. The acquired operations are focused on the development of oil-rich properties primarily located in the Anadarko Basin in Oklahoma. Following the acquisition, Newfield’s senior notes totaling $2.45 billion remain outstanding. • Purchased, for cancellation, approximately 196.7 million common shares, on a pre-Share Consolidation basis, for total consideration of approximately $1,250 million, thereby fully executing the Company’s previously announced NCIB and substantial issuer bid. • Terminated the production sharing contract with China National Offshore Oil Corporation (“CNOOC”), which governed the Company’s China Operations, effective July 31, 2019. Subsequently, the Company no longer has operations in China. • Completed the sale of the Company’s Arkoma natural gas assets on August 27, 2019, comprising approximately 140,000 net acres in Oklahoma, for proceeds of $155 million, after closing adjustments. Financial Results • Reported net earnings of $234 million, including a net loss on risk management in revenues of $361 million, before tax, restructuring charges of $138 million, before tax, net foreign exchange gains of $119 million, before tax, and acquisition costs of $33 million, before tax. • Generated cash from operating activities of $2,921 million, Non-GAAP Cash Flow of $2,931 million and Non-GAAP Cash Flow Margin of $14.21 per BOE. Cash from operating activities exceeded capital expenditures by $295 million. • Held cash and cash equivalents of $190 million and had $4.0 billion in available credit facilities, of which the Company’s $2.5 billion revolving credit facility supported the issuance of $698 million of commercial paper at year end. • Achieved Net Debt to Adjusted EBITDA of 2.0 times. • Returned capital to shareholders through the purchase, for cancellation, of approximately 196.7 million common shares, on a pre-Share Consolidation basis. The Company also paid dividends of $0.075 per common share, on a pre-Share Consolidation basis, totaling $102 million. Capital Investment • Reported total capital spending of $2,626 million which was within the full year 2019 guidance of $2.55 billion to $2.65 billion. • Directed $2,030 million, or 77 percent, of total capital spending to the Core Assets. • Reduced well costs in Anadarko through the deployment of cube development by approximately $1.9 million per well in 2019 compared to Newfield’s 2018 well costs, exceeding the Company’s previously announced expected savings of $1 million per well. • Focused on highly efficient capital activity and short-cycle high margin projects providing flexibility to respond to fluctuations in commodity prices. Production • Average liquids and natural gas production volumes exceeded the full year 2019 guidance ranges of 297.0 Mbbls/d to 301.0 Mbbls/d and 1,560 MMcf/d to 1,575 MMcf/d, respectively. • Produced average liquids volumes of 301.9 Mbbls/d which accounted for 53 percent of total production volumes. Average oil and plant condensate production volumes of 217.3 Mbbls/d were 72 percent of total liquids production volumes. • Produced average natural gas volumes of 1,577 MMcf/d which accounted for 47 percent of total production volumes. Revenues and Operating Expenses • Focused on market diversification to optimize realized commodity prices and revenues through a combination of derivative financial instruments and physical transportation contracts. • Continued to utilize pipeline transportation capacity to the Houston and Dawn markets, thereby benefiting from reduced exposure to Midland, Waha and AECO differentials. • Incurred Total Costs of $12.59 per BOE, a decrease compared to 2018 of $0.41 per BOE, outperforming the expected full year 2019 guidance range of $12.60 per BOE to $12.90 per BOE. Total Costs includes production, mineral and other property taxes, upstream transportation and processing expense, upstream operating expense and administrative expense. Total Costs excludes the impact of long-term incentive and restructuring costs. Significant items impacting Total Costs in 2019 include: o Lower upstream transportation and processing expense in 2019 compared to 2018 of $0.80 per BOE primarily due to the higher proportion of total production volumes from the USA Operations, which benefit from lower than average per BOE transportation and processing costs. Production volumes in the USA Operations were higher in 2019 compared to 2018 due to the Newfield acquisition; and o Higher administrative expense, excluding long-term incentive costs and restructuring costs, in 2019 compared to 2018 of $0.16 per BOE primarily due to the change in accounting treatment for The Bow office building. Additional information on the adoption of ASC Topic 842 can be found in Notes 1 and 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. • Reduced operating and administrative costs through workforce reductions and operating efficiencies by $200 million on an annualized basis, compared to the combined costs of Newfield and the Company prior to the acquisition. These synergies surpass the Company’s original estimate of $125 million and exclude restructuring costs incurred in 2019. Total restructuring costs incurred were $138 million. Subsequent Event On January 24, 2020, Encana completed a corporate reorganization, which included a plan of arrangement (the “Arrangement”) that involved, among other things, a share consolidation by Encana on the basis of one post-consolidation share for each five pre-consolidation shares (the “Share Consolidation”), and Ovintiv Inc. ultimately acquired all of the issued and outstanding common shares of Encana in exchange for shares of common stock of Ovintiv Inc. on a one-for-one basis. Following completion of the Arrangement, Ovintiv Inc. migrated from Canada and became a Delaware corporation, domiciled in the U.S. (the “U.S. Domestication”). The Arrangement and the U.S. Domestication together are referred to as the “Reorganization”. Ovintiv continues to carry on business previously conducted by Encana and its subsidiaries prior to the completion of the Reorganization. Additional information on the Reorganization can be found in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. 2020 Outlook Industry Outlook The oil and gas industry is cyclical and commodity prices are inherently volatile. Oil prices during 2020 are expected to reflect global supply and demand dynamics as well as the geopolitical and macroeconomic environment. At a meeting in December 2019, OPEC and certain non-OPEC countries (collectively “OPEC”) agreed to deepen and extend crude oil production cuts, originally instated in January 2019, through the first quarter of 2020 seeking to balance the global oil market in response to changing fundamentals. Risks to the global economy, including trade disputes, U.S. sanctions policy, U.S. production growth and potential oil supply outages in major producing countries resulting from geopolitical instability, could further contribute to price volatility in 2020. OPEC is scheduled to meet again in March 2020 to review production levels which could potentially result in other supply adjustments and contribute to price fluctuations. Natural gas prices in 2020 will be affected by the timing of supply and demand growth and the effects of seasonal weather. Potential for improvement in longer-term U.S. natural gas prices remains limited as production growth continues to create additional downward pressure on U.S. natural gas prices. Despite a strengthening AECO price relative to NYMEX, natural gas prices in western Canada are expected to remain low due to the weak NYMEX price environment. Company Outlook Ovintiv is well positioned in the current price environment to balance liquids growth while generating cash flows in excess of capital expenditures. The Company enters into derivative financial instruments which mitigate price volatility and help sustain revenues during periods of lower prices. A portion of the Company’s production is sold at prevailing market prices which also allows Ovintiv to participate in potential price increases. As at December 31, 2019, the Company has hedged approximately 165 Mbbls/d of expected crude oil and condensate production and 1,188 MMcf/d of expected natural gas production for 2020. Additional information on the Company’s hedging program can be found in Note 25 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Markets for crude oil and natural gas are exposed to different price risks. While the market price for crude oil tends to move in the same direction as the global market, regional differentials may develop. Natural gas prices may vary between geographic regions depending on local supply and demand conditions. Ovintiv proactively utilizes transportation contracts to diversify the Company’s sales markets, thereby reducing significant exposure to any given market. Through a combination of derivative financial instruments and transportation capacity, Ovintiv continues to limit exposure to regional pricing in 2020. Capital Investment Total anticipated 2020 capital investment of approximately $2.7 billion is expected to be funded from 2020 cash generated from operating activities. Capital investment is expected to be primarily allocated to the Core Assets with a focus on maximizing returns from high margin liquids and to other upstream assets to optimize operating free cash flows. In 2020, the Company expects to generate cash flows in excess of capital expenditures. Ovintiv continually strives to improve well performance and lower costs through innovative techniques. The Company's large-scale cube development model utilizes multi-well pads and advanced completion designs to maximize returns and resource recovery from its reservoirs. The impact of Ovintiv’s disciplined capital program and continuous innovation create flexibility to allocate capital in changing commodity markets and to continue growing cash flows. Production In 2020, Ovintiv expects liquids production volumes of 318.0 Mbbls/d to 332.0 Mbbls/d and natural gas production volumes of 1,520 MMcf/d to 1,580 MMcf/d. Operating Expenses For 2020, Ovintiv expects Total Costs of $12.20 per BOE to $12.50 per BOE which includes production, mineral and other taxes, upstream transportation and processing expense, upstream operating expense and administrative expense. Total Costs excludes the impact of long-term incentive costs. Ovintiv expects to continue pursuing innovative ways to reduce upstream operating and administrative expenses and expects efficiency improvements and effective supply chain management, including favorable price negotiations, to offset any inflationary pressures. Additional information on Ovintiv’s 2020 Corporate Guidance can be accessed on the Company’s website at www.ovintiv.com. Results of Operations Selected Financial Information (1) Total Operating Expenses include non-cash items such as DD&A, accretion of asset retirement obligations and long-term incentive costs. Subsequent to the completion of the Newfield acquisition on February 13, 2019, the post-acquisition results of the operations of Newfield are included in the Company’s consolidated results beginning February 14, 2019. As a result of the business combination and the addition of the Anadarko asset to the Company’s portfolio, the Core Assets were redefined to include Permian and Anadarko in the U.S. and Montney in Canada. The 2018 Core Assets production presentation has been updated to align with the Company’s 2019 Core Assets and reflects Permian and Montney. Revenues Ovintiv’s revenues are substantially derived from sales of oil, NGLs and natural gas production. Increases or decreases in Ovintiv’s revenue, profitability and future production are highly dependent on the commodity prices the Company receives. Prices are market driven and fluctuate due to factors beyond the Company’s control, such as supply and demand, seasonality and geopolitical and economic factors. The USA Operations realized prices generally reflect WTI and NYMEX benchmark prices, as well as other downstream oil benchmarks, including Houston. The Canadian Operations realized prices are linked to Edmonton Condensate and AECO, as well as other downstream natural gas benchmarks, including Dawn. The other downstream benchmarks reflect the diversification of the Company’s markets. Recent trends in benchmark prices relevant to the Company are shown in the table below. Benchmark Prices Production Volumes and Realized Prices (1) Average daily. (2) Average per-unit prices, excluding the impact of risk management activities. (3) The Company acquired its China Operations as part of the Newfield business combination on February 13, 2019. Subsequently, the Company terminated its production sharing contract with CNOOC and exited its China Operations effective July 31, 2019. Production from China Operations is presented for the period from February 14, 2019 through July 31, 2019. (4) Includes production impacts of acquisitions and divestitures. (5) Core Assets production presentation aligns with the Company’s 2019 Core Assets, which include Permian, Anadarko and Montney. Core Assets production for 2018 has been updated and reflects Permian and Montney. Upstream Product Revenues ($ millions) Oil NGLs - Plant Condensate NGLs - Other Natural Gas Total (1) 2018 Upstream Product Revenues $ 2,100 $ $ $ $ 4,204 Increase (decrease) due to: Sales prices (184 ) (85 ) (205 ) (129 ) (603 ) Production volumes 1,460 2,233 2019 Upstream Product Revenues $ 3,376 $ $ $ 1,136 $ 5,834 (1) Revenues for 2019 exclude certain other revenue and royalty adjustments with no associated production volumes of $13 million (2018 - royalty adjustments of $19 million). Oil Revenues 2019 versus 2018 Oil revenues increased $1,276 million compared to 2018 primarily due to: • Higher average oil production volumes of 74.5 Mbbls/d increased revenues by $1,460 million. Higher volumes were primarily due to the Newfield acquisition (64.9 Mbbls/d) and successful drilling programs in Anadarko, Permian and Bakken (15.6 Mbbls/d), partially offset by natural declines in Eagle Ford (3.2 Mbbls/d) and the sale of the San Juan assets in the fourth quarter of 2018 (2.3 Mbbls/d); and • Lower average realized oil prices of $7.73 per bbl, or 12 percent, decreased revenues by $184 million. The decrease reflected lower WTI and Houston benchmark prices which were down 12 percent and 10 percent, respectively, partially offset by strengthening regional pricing relative to the WTI benchmark price in the USA Operations. NGL Revenues 2019 versus 2018 NGL revenues increased $170 million compared to 2018 primarily due to: • Higher average plant condensate production volumes of 13.9 Mbbls/d increased revenues by $259 million. Higher volumes were primarily due to successful drilling programs in Montney and Anadarko (9.4 Mbbls/d) and the Newfield acquisition (4.9 Mbbls/d); and • Higher average other NGL production volumes of 45.4 Mbbls/d increased revenues by $201 million. Higher volumes were primarily due to the Newfield acquisition (31.3 Mbbls/d) and successful drilling programs in Anadarko, Montney and Permian (15.3 Mbbls/d); partially offset by: • Lower average realized other NGL prices of $13.42 per bbl, or 54 percent, decreased revenues by $205 million reflecting lower other NGL benchmark prices and lower regional pricing; and • Lower average realized plant condensate prices of $5.67 per bbl, or 10 percent, decreased revenues by $85 million. The decrease reflected lower WTI and Edmonton Condensate benchmark prices which were down 12 percent and 11 percent, respectively, partially offset by fluctuations in regional pricing relative to the WTI and Edmonton Condensate benchmark prices. Natural Gas Revenues 2019 versus 2018 Natural gas revenues increased $184 million compared to 2018 primarily due to: • Higher average natural gas production volumes of 419 MMcf/d increased revenues by $313 million primarily due to the Newfield acquisition (368 MMcf/d) and successful drilling programs in Montney, Anadarko, Permian and Bakken (82 MMcf/d), partially offset by lower production in Other Upstream Operations primarily due to natural declines (23 MMcf/d) and the sale of the San Juan assets in the fourth quarter of 2018 (8 MMcf/d); and • Lower average realized natural gas prices of $0.28 per Mcf, or 12 percent, decreased revenues by $129 million reflecting lower Dawn and NYMEX benchmark prices which were down 22 percent and 15 percent, respectively, partially offset by a higher proportion of total production volumes in the USA Operations with higher regional pricing resulting from the Newfield acquisition and a higher AECO benchmark price which was up six percent. Gains (Losses) on Risk Management, Net As a means of managing commodity price volatility, Ovintiv enters into commodity derivative financial instruments on a portion of its expected oil, NGL and natural gas production volumes. The Company’s commodity price mitigation program reduces volatility and helps sustain revenues during periods of lower prices. Additional information on the Company’s commodity price positions as at December 31, 2019 can be found in Note 25 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The following table provides the effects of the Company’s risk management activities on revenues. (1) Includes realized gains and losses related to the USA and Canadian Operations. (2) Other primarily includes realized gains or losses from Market Optimization and other derivative contracts with no associated production volumes. Ovintiv recognizes fair value changes from its risk management activities each reporting period. The changes in fair value result from new positions and settlements that occur during each period, as well as the relationship between contract prices and the associated forward curves. Realized gains or losses on risk management activities related to commodity price mitigation are included in the USA Operations, Canadian Operations and Market Optimization revenues as the contracts are cash settled. Unrealized gains or losses on fair value changes of unsettled contracts are included in the Corporate and Other segment. Market Optimization Revenues Market Optimization product revenues relate to activities that provide operational flexibility and cost mitigation for transportation commitments, product type, delivery points and customer diversification. The Company also purchases and sells third-party volumes under long-term marketing arrangements associated with the Company’s previous divestitures. 2019 versus 2018 Market Optimization product revenues decreased $65 million compared to 2018 primarily due to: • Lower benchmark prices ($232 million) and lower sales of third-party purchased natural gas volumes ($44 million); partially offset by: • Higher sales of third-party purchased liquids volumes ($211 million) due to: o Changing market conditions resulting in additional third-party purchases to meet sales commitments in the Canadian Operations in the first quarter of 2019; and o Price optimization activities and additional third-party purchases to meet sales commitments in the USA Operations in the third quarter of 2019. Sublease Revenues Sublease revenues primarily include amounts related to the sublease of office space in The Bow office building recorded in the Corporate and Other segment. Additional information on office sublease income can be found in Note 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Operating Expenses Production, Mineral and Other Taxes Production, mineral and other taxes include production and property taxes. Production taxes are generally assessed as a percentage of oil, NGLs and natural gas production revenues. Property taxes are generally assessed based on the value of the underlying assets. 2019 versus 2018 Production, mineral and other taxes increased $107 million compared to 2018 primarily due to: • Higher production volumes and property values resulting from the Newfield acquisition ($115 million) and higher production volumes and assessed property values in Permian ($14 million); partially offset by: • Lower production tax mainly as a result of lower commodity prices ($16 million) and the sale of the San Juan assets in the fourth quarter of 2018 ($6 million). Transportation and Processing Transportation and processing expense includes transportation costs incurred to move product from production points to sales points including gathering, compression, pipeline tariffs, trucking and storage costs. Ovintiv also incurs costs related to processing provided by third parties or through ownership interests in processing facilities to bring raw production to sales-quality product. 2019 versus 2018 Transportation and processing expense increased $475 million compared to 2018 primarily due to: • Higher production volumes resulting from the Newfield acquisition and successful drilling in Anadarko and Bakken ($341 million), rate escalation in certain transportation contracts relating to previously divested assets and incremental transportation costs associated with third-party purchased volumes ($99 million), successful drilling in Montney and Permian ($82 million) and higher costs relating to the diversification of the Company’s downstream markets ($21 million); partially offset by: • Lower commodity prices ($21 million), lower U.S./Canadian dollar exchange rate ($18 million) and lower activity in Deep Panuke where the Company ceased production in the second quarter of 2018 ($11 million). Upstream transportation and processing decreased $0.80 per BOE compared to 2018 primarily due to a higher proportion of total production volumes in the USA Operations resulting from the Newfield acquisition. Operating Operating expense includes costs paid by the Company, net of amounts capitalized, to operate oil and natural gas properties in which the Company has a working interest. These costs primarily include labor, service contract fees, chemicals, fuel, water hauling and workovers. (1) The Company acquired its China Operations as part of the Newfield business combination on February 13, 2019. Subsequently, the Company terminated its production sharing contract with CNOOC and exited its China Operations effective July 31, 2019. Upstream Operating Expense for China Operations is presented for the period from February 14, 2019 through July 31, 2019. (2) 2019 Upstream Operating Expense per BOE includes long-term incentive costs of $0.06/BOE (2018 - recovery of long-term incentive costs of $0.06/BOE). 2019 versus 2018 Operating expense increased $278 million compared to 2018 primarily due to: • The Newfield acquisition and successful drilling in Anadarko ($249 million), the impact of changes in capital programs primarily in Montney and Other Upstream Operations ($30 million), long-term incentive costs in 2019 compared to a recovery in 2018 resulting from a larger decrease in the share price in 2018 compared to 2019 ($29 million) and higher activity in Permian ($21 million); partially offset by: • Lower activity in Eagle Ford and Montney ($15 million), lower salaries and benefits due to reduced headcount in Eagle Ford, Montney and Deep Panuke ($10 million) and the sale of the San Juan assets in the fourth quarter of 2018 ($10 million). Additional information on the Company’s long-term incentives can be found in Note 22 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Purchased Product Purchased product expense includes purchases of oil, NGLs and natural gas from third parties that are used to provide operational flexibility and cost mitigation for transportation commitments, product type, delivery points and customer diversification. The Company also purchases and sells third-party volumes under long-term marketing arrangements associated with the Company’s previous divestitures. 2019 versus 2018 Purchased product expense decreased $57 million compared to 2018 primarily due to: • Lower benchmark prices ($227 million) and lower third-party purchased natural gas volumes ($41 million); partially offset by: • Higher third-party purchased liquids volumes ($211 million) due to: o Changing market conditions resulting in additional third-party purchases to meet sales commitments in the Canadian Operations in the first quarter of 2019; and o Price optimization activities and additional third-party purchases to meet sales commitments in the USA Operations in the third quarter of 2019. Depreciation, Depletion & Amortization Proved properties within each country cost centre are depleted using the unit-of-production method based on proved reserves as discussed in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Depletion rates are impacted by impairments, acquisitions, divestitures and foreign exchange rates, as well as fluctuations in 12-month average trailing prices which affect proved reserves volumes. Corporate assets are carried at cost and depreciated on a straight-line basis over the estimated service lives of the assets. In 2019, the 12-month average trailing prices have generally declined. Further declines in the 12-month average trailing commodity prices could reduce proved reserves values and result in the recognition of future ceiling test impairments. Future ceiling test impairments can also result from changes to reserves estimates, future development costs, capitalized costs and unproved property costs. Proceeds received from oil and natural gas divestitures are generally deducted from the Company’s capitalized costs and can reduce the risk of ceiling test impairments. Additional information can be found under Upstream Assets and Reserve Estimates in the Critical Accounting Estimates section of this MD&A. 2019 versus 2018 DD&A increased $743 million compared to 2018 primarily due to: • Higher production volumes in the USA and Canadian Operations ($1,053 million and $26 million, respectively), partially offset by lower depletion rates in the USA Operations ($319 million). The depletion rate in the USA Operations decreased $3.24 per BOE compared to 2018 primarily due to higher reserve volumes mainly in Permian, as well as additional reserve volumes acquired with the Newfield acquisition. Administrative Administrative expense represents costs associated with corporate functions provided by Ovintiv staff. Costs primarily include salaries and benefits, general office, information technology, restructuring and long-term incentive costs. (1) 2019 includes $92 million of operating lease expense related to The Bow office building (2018 - nil). 2019 versus 2018 Administrative expense in 2019 increased $332 million compared to 2018 primarily due to restructuring costs ($138 million), the impact from adopting ASC Topic 842, “Leases”, as discussed further below ($116 million) and administrative costs associated with the Newfield acquisition ($39 million), including non-recurring integration expenses of $12 million and long-term incentive costs in 2019 compared to a recovery in 2018 resulting from a larger decrease in the share price in 2018 compared to 2019 ($56 million). During 2019, the Company completed workforce reductions in conjunction with the Newfield acquisition to better align staffing levels and the organizational structure. Additional information on restructuring charges can be found in Note 21 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. On January 1, 2019, the Company adopted ASC Topic 842 which requires all operating leases to be recognized on the balance sheet. As a result, The Bow office building was determined to be an operating lease with the lease payments recorded in administrative expense starting in 2019. Previously, payments related to The Bow office building were recognized as interest expense and principal repayment. Prior periods have not been restated and are reported in accordance with ASC Topic 840, “Leases”. Additional information on the adoption of ASC Topic 842 can be found in Notes 1 and 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Other (Income) Expenses Interest Interest expense primarily includes interest on the Company’s long-term debt arising from U.S. dollar denominated unsecured notes. Additional information on changes in interest can be found in Note 4 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. 2019 versus 2018 Interest expense increased $31 million compared to 2018 primarily due to: • Higher interest expense on long-term debt primarily relating to Newfield’s outstanding senior notes and issuances under the Company’s U.S. commercial paper (“U.S. CP”) program ($112 million), and an interest recovery due to the resolution of certain tax items relating to prior taxation years in 2018 ($17 million); partially offset by: • The change in accounting treatment for The Bow office building as a result of the adoption of ASC Topic 842 ($63 million), lower interest expense resulting from the repayment of the Company’s $500 million senior note in the second quarter of 2019 ($20 million) and capitalized interest ($10 million). Additional information on the adoption of ASC Topic 842 can be found in Notes 1 and 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Foreign Exchange (Gain) Loss, Net Foreign exchange gains and losses primarily result from the impact of fluctuations in the Canadian to U.S. dollar exchange rate. Additional information on changes in foreign exchange gains or losses can be found in Note 5 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Additional information on foreign exchange rates and the effects of foreign exchange rate changes can be found in Items 6 and 7A of this Annual Report on Form 10-K. Following the completion of the Reorganization, including the U.S. Domestication, on January 24, 2020, as described in the Subsequent Event section of this MD&A, the U.S. dollar denominated unsecured notes issued by Encana Corporation were assumed by Ovintiv Inc., a company incorporated in Delaware with a U.S. dollar functional currency. Accordingly, these U.S. dollar denominated unsecured notes, along with certain intercompany notes, will no longer attract foreign exchange translation gains or losses. 2019 versus 2018 In 2019, the Company recorded a net foreign exchange gain of $119 million compared to a loss in 2018 of $168 million primarily due to: • Unrealized foreign exchange gains on the translation of U.S. dollar financing debt and risk management contracts issued from Canada compared to losses in 2018 ($601 million) and realized foreign exchange gains on the settlement of U.S. dollar financing debt issued from Canada compared to losses in 2018 ($28 million); partially offset by: • Unrealized foreign exchange losses on the translation of intercompany notes compared to gains 2018 ($345 million). Other (Gains) Losses, Net Other (gains) losses, net, primarily includes other non-recurring revenues or expenses and may also include items such as interest income, interest received from tax authorities, transaction costs relating to acquisitions, reclamation charges relating to decommissioned assets and adjustments related to other assets. Other losses in 2019 primarily includes legal fees and transaction costs related to the Newfield acquisition of $33 million, partially offset by interest income on short-term investments of $10 million. Other losses in 2018 primarily included the write-down of long-term receivables relating to Other Upstream Operations of $20 million, acquisition costs relating to the merger agreement with Newfield of $7 million, and reclamation charges relating to decommissioned assets of $4 million, partially offset by interest income on short-term investments of $8 million and the recovery of sales taxes relating to previously divested investments of $7 million. Income Tax Income Tax Expense (Recovery) 2019 versus 2018 Total income tax expense in 2019 decreased $13 million compared to 2018, primarily due to lower net earnings before income tax of $848 million in 2019 compared to 2018, partially offset by the impact of the foreign jurisdictional tax rates relative to the Canadian statutory tax rate applied to jurisdictional earnings, the impact of the Alberta corporate tax rate reduction discussed below and the current income tax recovery in 2018 of $55 million resulting from the resolution of certain tax items relating to prior taxation years. On June 28, 2019, Alberta Bill 3, the Job Creation Tax Cut (Alberta Corporate Tax Amendment) Act, was signed into law resulting in a reduction of the Alberta corporate tax rate from 12 percent to 11 percent effective July 1, 2019, with further one percent rate reductions to take effect every year on January 1 until the general corporate tax rate is eight percent on January 1, 2022. During 2019, the deferred tax expense of $94 million includes an adjustment of $55 million resulting from the re-measurement of the Company’s deferred tax position due to the Alberta corporate tax rate reduction. Effective Tax Rate The Company’s annual effective income tax rate is primarily impacted by earnings, income tax related to foreign operations, the effect of legislative changes, including the Alberta corporate tax rate reduction discussed above, non-taxable capital gains and losses, tax differences on divestitures and transactions, and partnership tax allocations in excess of funding. Additional information on income taxes can be found in Note 6 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The Company’s effective tax rate for 2019 of 25.7 percent is slightly lower than the Canadian statutory tax rate of 26.6 percent primarily due to partnership tax allocations in excess of funding, as well as the resolution of certain tax items relating to prior taxation years, partially offset by the remeasurement of the Company’s deferred tax position resulting from the Alberta corporate tax rate reduction discussed above. The effective tax rate for 2018 of 8.1 percent was lower than the Canadian statutory rate of 27 percent primarily due to the impact of the foreign jurisdictional tax rates relative to the Canadian statutory tax rate applied to jurisdictional earnings, partnership tax allocations in excess of funding and the successful resolution of certain tax items relating to prior taxation years. The determination of income and other tax liabilities of the Company and its subsidiaries requires interpretation of complex domestic and foreign tax laws and regulations, that are subject to change. The Company’s interpretation of taxation laws may differ from the interpretation of the tax authorities. As a result, there are tax matters under review for which the timing of resolution is uncertain. The Company believes that the provision for income taxes is adequate. Following the U.S. Domestication, the applicable statutory rate will be the U.S. Federal income tax rate. Liquidity and Capital Resources Sources of Liquidity The Company has the flexibility to access cash equivalents and a range of funding alternatives at competitive rates through committed revolving credit facilities as well as debt and equity capital markets. The Company closely monitors the accessibility of cost-effective credit and ensures that sufficient liquidity is in place to fund capital expenditures and dividend payments. In addition, the Company may use cash and cash equivalents, cash from operating activities, or proceeds from asset divestitures to fund its operations or to manage its capital structure as discussed below. At December 31, 2019, $57 million in cash and cash equivalents was held by U.S. subsidiaries. The Company’s capital structure consists of total shareholders’ equity plus long-term debt, including the current portion. The Company’s objectives when managing its capital structure are to maintain financial flexibility to preserve Ovintiv’s access to capital markets and its ability to meet financial obligations and finance internally generated growth, as well as potential acquisitions. The Company has a practice of maintaining capital discipline and strategically managing its capital structure by adjusting capital spending, adjusting dividends paid to shareholders, issuing new shares, purchasing shares for cancellation, issuing new debt or repaying existing debt. (1) Includes available credit facilities of $2.5 billion in Canada and $1.5 billion in the U.S. (collectively, the “Credit Facilities”). (2) Long-Term Debt as at December 31, 2019, includes outstanding U.S. CP totaling $698 million and the senior notes acquired in conjunction with the Newfield business combination on February 13, 2019, totaling $2,450 million. (3) Shareholders’ Equity reflects the common shares issued to Newfield shareholders on February 13, 2019, totaling $3,478 million and the common shares purchased, for cancellation, under the Company’s NCIB and substantial issuer bid programs. (4) Calculated as long-term debt, including the current portion, divided by shareholders’ equity plus long-term debt, including the current portion. (5) A non-GAAP measure which is defined in the Non-GAAP Measures section of this MD&A. As at December 31, 2019, the Company had $698 million of commercial paper outstanding under its U.S. CP program to provide for short-term funding requirements, which is supported by the Company’s $2.5 billion revolving credit facility. Further details on the U.S. CP program can be found in the Sources and Uses of Cash section of this MD&A. Ovintiv is currently in compliance with, and expects that it will continue to be in compliance with, all financial covenants under the Credit Facilities. Management monitors Debt to Adjusted Capitalization, which is a non-GAAP measure defined in the Non-GAAP Measures section of this MD&A, as a proxy for the Company’s financial covenant under the Credit Facilities, which requires debt to adjusted capitalization to be less than 60 percent. As at December 31, 2019, the Company’s Debt to Adjusted Capitalization was 28 percent. The definitions used in the covenant under the Credit Facilities adjust capitalization for cumulative historical ceiling test impairments recorded in conjunction with the Company’s January 1, 2012 adoption of U.S. GAAP. Additional information on financial covenants can be found in Note 15 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The Company’s debt-based metrics have increased over the prior year due to the increase in long-term debt resulting from the Newfield acquisition. Further details on the Company’s debt-based metrics can be found in the Non-GAAP Measures section of this MD&A. Sources and Uses of Cash During 2019, the Company primarily generated cash through operating activities. The following table summarizes the sources and uses of the Company’s cash and cash equivalents. Operating Activities Cash from operating activities in 2019 was $2,921 million and was primarily a reflection of the impacts from the Newfield acquisition, increases in production volumes, the effects of the commodity price mitigation program and changes in non-cash working capital, partially offset by lower average realized commodity prices. Additional detail on changes in non-cash working capital can be found in Note 26 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Ovintiv expects it will continue to meet the payment terms of its suppliers. Non-GAAP Cash Flow in 2019 was $2,931 million and was primarily impacted by the items affecting cash from operating activities which are discussed below and in the Results of Operations section of this MD&A. 2019 versus 2018 Net cash from operating activities increased $621 million compared to 2018 primarily due to: • Higher production volumes ($2,233 million) and realized gains on risk management in revenues in 2019 compared to realized losses in 2018 ($473 million); partially offset by: • Lower realized commodity prices ($603 million), higher transportation and processing expense ($475 million), higher operating and administrative expense, excluding non-cash long-term incentive costs ($265 million and $167 million, respectively), changes in non-cash working capital ($158 million), restructuring costs ($138 million), higher interest on long-term debt ($118 million), higher production, mineral and other taxes ($107 million), lower current tax recovery in 2019 compared to 2018 ($42 million) and acquisition costs ($33 million). Investing Activities Capital expenditures, divestitures and acquisitions have been the Company’s primary investing activities over the past two years and are summarized in Notes 2, 8 and 9 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. 2019 and 2018 Cash used in investing activities in 2019 was $2,556 million primarily due to capital expenditures. Capital expenditures increased $651 million compared to 2018 due to an increase in the Company’s capital program for 2019 relating to the Anadarko asset acquired in the Newfield acquisition ($712 million). Cash from operating activities exceeded capital expenditures by $295 million. Corporate acquisition in 2019 was $94 million which reflected the net cash acquired upon the Newfield business combination. Acquisitions in 2019 were $65 million, which primarily included seismic purchases, water rights and property purchases with liquids-rich potential. Acquisitions in 2018 were $17 million, which primarily included property purchases with liquids-rich potential. Divestitures in 2019 were $197 million, which primarily included the sale of the Company’s Arkoma natural gas assets in Oklahoma, comprising approximately 140,000 net acres. Proceeds from the sale of the Arkoma natural gas assets were used to reduce the Company’s long-term debt. Divestitures in 2018 were $493 million, which primarily included the sale of the San Juan assets in New Mexico, comprising approximately 182,000 net acres. Financing Activities Net cash used in financing activities over the past two years has been impacted by the Company’s strategy to enhance liquidity, strengthen its balance sheet and return value to shareholders through the purchase of common shares. The Company has paid dividends each of the past two years and increased its dividend in the first quarter of 2019. 2019 versus 2018 Net cash used in financing activities in 2019 increased $842 million compared to 2018 primarily due to the purchase of common shares under a NCIB ($787 million) and substantial issuer bid ($213 million) as discussed below, repayment of long-term debt ($500 million), as well as increased dividends paid ($46 million) in 2019 compared to 2018, partially offset by the net issuance of commercial paper under the Company’s U.S. CP program ($698 million). Further detail on the Company’s U.S. CP program can be found below. The transactions affecting the changes in financing activities are discussed in more detail below. 2019 and 2018 The Company’s long-term debt totaled $6,974 million at December 31, 2019 (2018 - $4,198 million). On May 15, 2019, the Company repaid the $500 million 6.50 percent senior note using proceeds from the U.S. CP program. Following the completion of the Newfield acquisition on February 13, 2019, Newfield’s senior notes totaling $2.45 billion remained outstanding as at December 31, 2019. These include a $750 million 5.75 percent senior note due January 30, 2022, a $1.0 billion 5.625 percent senior note due July 1, 2024 and a $700 million 5.375 percent senior note due January 1, 2026. For additional information on long-term debt, refer to Note 15 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The increase in long-term debt resulting from the Newfield acquisition increased the Company’s debt-based metrics. Further details on the Company’s debt-based metrics can be found in the Non-GAAP Measures section of this MD&A. At December 31, 2019, the Company had access to two credit facilities, one available in Canada for $2.5 billion and one available in the U.S. for $1.5 billion, totaling $4.0 billion. At December 31, 2019, no amounts were outstanding under the Credit Facilities. The Credit Facilities provide financial flexibility and allow the Company to fund its operations, development activities or capital programs. Subsequent to the Reorganization as described in the Subsequent Event section of this MD&A, the Credit Facilities were replaced with committed revolving U.S. dollar denominated credit facilities totaling $4.0 billion, which include a $2.5 billion revolving credit facility for Ovintiv Inc. and a $1.5 billion revolving credit facility for a Canadian subsidiary. These facilities mature in July 2024, and are fully revolving up to maturity. At December 31, 2019, the Company had $698 million of commercial paper outstanding under its U.S. CP program with an average term of 49 days and a weighted average interest rate of approximately 2.28 percent, which was supported by the Company’s $2.5 billion revolving credit facility. Subsequent to the Reorganization, Ovintiv has access to two U.S. commercial paper programs, which include a $1.5 billion program for Ovintiv Inc. and a $1.0 billion program for a Canadian subsidiary. At December 31, 2019, the Credit Facilities, together with cash and cash equivalents less any outstanding commercial paper, provided the Company with total liquidity of $3.5 billion. The Company also had approximately $149 million in undrawn letters of credit issued in the normal course of business primarily as collateral security, to support future abandonment liabilities and for transportation arrangements. At December 31, 2019, the Company had a U.S. shelf registration statement and a Canadian shelf prospectus under which the Company had the ability to issue from time to time, debt securities, common shares, Class A preferred shares, subscription receipts, warrants, units, share purchase contracts and share purchase units in the U.S. and/or Canada. At December 31, 2019, $6.0 billion was accessible under the Canadian shelf prospectus. Following completion of the Reorganization, the Company intends to renew its U.S. shelf registration statement and Canadian shelf prospectus. Dividends The Company pays quarterly dividends to shareholders at the discretion of the Board of Directors. (1) Dividend payments per share reflect the Share Consolidation. Accordingly, the comparative period has been restated. On a pre-Share Consolidation basis, dividend payments were $0.075 per common share for 2019 and $0.06 per common share for 2018. The Company increased its dividend by 25 percent in the first quarter of 2019 as part of the Company’s commitment to returning capital to shareholders. Dividends paid in 2019 increased $45 million compared to 2018 due to additional common shares issued as part of the Newfield acquisition, in addition to the 25 percent increase in the dividend per share, partially offset by common shares purchased, for cancellation, under the Company’s substantial issuer bid and NCIB programs. On February 19, 2020, the Board of Directors declared a dividend of $0.09375 per Ovintiv common share payable on March 31, 2020 to common stockholders of record as of March 13, 2020. The dividends paid in 2018 included $1 million in common shares issued in lieu of cash dividends under the Company’s Dividend Reinvestment Plan (“DRIP”). On February 28, 2019, the Company announced the suspension of its DRIP effective immediately and in conjunction with the Reorganization, the DRIP was terminated. Substantial Issuer Bid On August 29, 2019, the Company used cash on hand and issued commercial paper totaling approximately $213 million to purchase, for cancellation, approximately 47.3 million of its outstanding common shares, on a pre-Share Consolidation basis or 9.5 million common shares on a post-Share Consolidation basis, under its previously announced substantial issuer bid. For additional information on the substantial issuer bid, refer to Note 18 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Normal Course Issuer Bid On February 27, 2019, the Company received approval from the TSX to purchase, for cancellation, up to approximately 149.4 million common shares, on a pre-Share Consolidation basis, pursuant to a NCIB over a 12-month period commencing March 4, 2019 and ending March 3, 2020. In 2019, the Company used cash on hand of approximately $1,037 million to purchase, for cancellation, approximately 149.4 million common shares, on a pre-Share Consolidation basis or approximately 29.9 million common shares on a post-Share Consolidation basis. In 2018, the Company used cash on hand of approximately $250 million to purchase, for cancellation, approximately 20.7 million common shares, on a pre-Share Consolidation basis or approximately 4.1 million common shares on a post-Share Consolidation basis, under the previous NCIB which commenced on February 28, 2018 and expired on February 27, 2019. For additional information on the NCIB, refer to Note 18 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Off-Balance Sheet Arrangements The Company may enter into off-balance sheet arrangements and transactions that can give rise to material off-balance sheet obligations. The Company’s material off-balance sheet arrangements include transportation and processing agreements, and short-term leases and non-lease components associated with drilling rigs and building leases, as outlined in the Contractual Obligations table below, as well as undrawn letters of credit and minimum volumes sales contracts, all of which are customary agreements in the oil and gas industry. Other than the items discussed above, there are no other transactions, arrangements, or relationships with unconsolidated entities or persons that are reasonably likely to materially affect the Company’s liquidity or the availability of, or requirements for, capital resources. Contractual Obligations Contractual obligations arising from long-term debt, operating and finance leases, risk management liabilities and asset retirement obligations are recognized on the Company’s Consolidated Balance Sheet. The following table outlines the Company’s undiscounted obligations and commitments at December 31, 2019: (1) Includes The Bow office building. (2) Includes interest payments totaling $22 million. (3) Includes short-term leases with terms less than 12 months and non-lease operating cost components. Interest Payments on Long-Term Debt and Finance Leases represent scheduled cash payments on the respective obligations. Additional information can be found in Notes 15 and 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Operating leases include drilling rigs, compressors, marine vessels, camps, office and buildings, certain land easements and various equipment utilized in the development and production of oil, NGLs and natural gas. Upon transition to ASC Topic 842 on January 1, 2019, The Bow office building was determined to be an operating lease. The Company has subleased approximately 50 percent of The Bow office space under the lease agreement. The Bow Office Building Sublease Recoveries in the table above include the amounts expected to be recovered from the sublease. Additional information on the change in accounting treatment for The Bow office building upon transition to ASC Topic 842 and subleases can be found in Notes 1 and 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Finance Leases relates to an office building and the obligation related to the Deep Panuke Production Field Centre. Additional information can be found in Note 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Risk Management Liabilities represents Ovintiv’s net liability position with counterparties. Additional information can be found in Note 25 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Asset Retirement Obligation represents estimated costs arising from the obligation to fund the disposal of long-lived assets upon their abandonment. The majority of Ovintiv’s asset retirement obligations relate to the plugging of wells and related abandonment of oil and gas properties including an offshore production platform, processing plants and land or seabed restoration. Revisions to estimated retirement obligations can result from changes in regulatory requirements, changes in retirement cost estimates, revisions to estimated inflation rates and estimated timing of abandonment. Additional information can be found in Note 17 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Transportation and Processing commitments relate to contractual obligations for capacity rights with third-party pipelines and processing facilities. Drilling and Field Services commitments represent minimum future expenditures for drilling, well servicing and equipment commitment rights. Significant development commitments with joint venture partners are partially satisfied by Commitments included in the table above. Building Leases consist of various field and office building leases used in Ovintiv’s daily operations. Drilling and Field Services, and Building Leases include short-term leases with terms less than 12 months and non-lease operating cost components. Additional information can be found in Notes 1 and 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Ovintiv has two minimum volume sales contracts related to its Uinta oil production in Utah. Under the terms of the agreements, the Company is committed to deliver approximately 15 Mbbls/d through May 2020 and approximately 20 Mbbls/d through August 2025. During 2019, the Company incurred deficiency fees of approximately $24 million. Deficiency fees ranging from $3.50 to $6.50 per barrel may be incurred during the remaining term of the commitment periods. Based on forecasted production levels, $15 million in deficiency fees are expected to be incurred related to these delivery commitments in 2020. For additional information on these commitments, refer to the Marketing Activities section included in Items 1 and 2 of this Annual Report on Form 10-K. Further to the commitments disclosed above, Ovintiv also has various obligations that become payable if certain events occur including variable interests arising from gathering and compression agreements and guarantees on transportation commitments resulting from completed property divestitures as described in Notes 20, 25 and 27, respectively, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. In addition, Ovintiv has purchase orders for the purchase of inventory and other goods and services, which typically represent authorization to purchase rather than binding agreements. The Company also has obligations to fund its defined benefit pension and other post-employment benefit plans, as well as unrecognized tax benefits where the settlement is not expected within the next 12 months as described in Notes 23 and 6, respectively, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Ovintiv may have potential exposures related to previously divested properties where the purchasers typically assume all obligations to plug, abandon, and decommission the associated wells, structures, and facilities acquired. One or more of the counterparties in these transactions could, either as a result of the severe decline in oil and natural gas prices or other factors related to the historical or future operations of their respective businesses, face financial problems that may have a significant impact on their solvency and ability to continue as a going concern. If a purchaser becomes the subject of a proceeding under relevant insolvency laws or otherwise fails to perform required abandonment obligations, Ovintiv could be required to perform such actions under applicable federal laws and regulations. While the Company believes that the risk of such event occurring is low, the Company could be forced to use available cash to cover the costs of such liabilities and obligations should they arise. Contingencies For information on contingencies, refer to Note 27 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Accounting Policies and Estimates Critical Accounting Estimates The preparation of financial statements in accordance with U.S. GAAP requires management to make informed judgments and estimates that affect the reported amounts of assets, liabilities, revenues, and expenses. For a discussion of the Company’s significant accounting policies refer to Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. Management considers the following to be its most critical accounting estimates that involve judgment. The following discussion outlines the accounting policies and practices involving the use of estimates that are critical to determining Ovintiv’s financial results. Changes in the estimates and assumptions discussed below could materially affect the amount or timing of the financial results of the Company. Description Judgments and Uncertainties Upstream Assets and Reserve Estimates As Ovintiv follows full cost accounting for oil, NGL and natural gas activities, reserves estimates are a key input to the Company’s depletion, gain or loss on divestitures and ceiling test impairment calculations. In addition, these reserves are the basis for the Company’s supplemental oil and gas disclosures. Due to the inter-relationship of various judgments made to reserve estimates and the volatile nature of commodity prices, it is generally not possible to predict the timing or magnitude of ceiling test impairments. Ovintiv estimates its proved oil and gas reserves according to the definition of proved reserves provided by the SEC. The Company’s estimates of proved reserves are made using available geological and reservoir data as well as production performance data and must demonstrate with reasonable certainty to be economically producible in future periods from known reservoirs under existing economic conditions, operating methods and government regulations. The estimation of reserves is a subjective process. Revisions to reserve estimates are necessary due to changes in and among other things, development plans, projected future rates of production, the timing of future expenditures, reservoir performance, economic conditions, governmental restrictions as well as changes in the expected recovery associated with infill drilling, all of which are subject to numerous uncertainties and various interpretations. Downward revisions in proved reserve estimates due to changes in reserve estimates may increase depletion expense and may also result in a ceiling test impairment. Reserves are calculated using an unweighted arithmetic average of commodity prices in effect on the first day of each of the previous 12 months, held flat for the life of the production, except where prices are defined by contractual arrangements. Decreases in prices may result in reductions in certain proved reserves due to reaching economic limits at an earlier projected date and impact earnings through depletion expense and ceiling test impairments. Ovintiv manages its business using estimates of reserves and resources based on forecast prices and costs as it gives consideration to probable and possible reserves and future changes in commodity prices. Ovintiv believes that the discounted after-tax future net cash flows from proved reserves required to be used in the ceiling test calculation are not indicative of the fair market value of Ovintiv’s oil and natural gas properties or the future net cash flows expected to be generated from such properties. Business Combinations Ovintiv follows the acquisition method of accounting for business combinations. Assets acquired and liabilities assumed are recognized at the date of acquisition at their respective estimated fair values. Any excess of the purchase price over the fair value amounts assigned to assets and liabilities is recorded as goodwill. Any deficiency of the purchase price over the estimated fair values of the net assets acquired is recorded as a gain in net earnings. The most significant assumptions relate to the estimated fair values assigned to proved and unproved oil and natural gas properties. The assumptions made in performing these valuations include discount rates, future commodity prices and costs, the timing of development activities, projections of oil and gas reserves, estimates to abandon and reclaim producing wells and tax amortization benefits available to a market participant. Changes in key assumptions may cause the acquisition accounting to be revised, including the recognition of additional goodwill or discount on acquisition. There is no assurance the underlying assumptions or estimates associated with the valuation will occur as initially expected. Fair value estimates are determined based on information that existed at the time of the acquisition, utilizing expectations and assumptions that would be available to and made by a market participant. When market-observable prices are not available to value assets and liabilities, the Company may use the cost, income, or market valuation approaches depending on the quality of information available to support management’s assumptions. Estimated fair values assigned to assets acquired can have a significant effect on results of operations in the future through impairments of goodwill. In addition, differences between the future commodity prices when acquiring assets and the historical 12-month average trailing price to calculate ceiling test impairments of upstream assets may impact net earnings. Description Judgments and Uncertainties Goodwill Impairments Goodwill is assessed for impairment at least annually in December, at the reporting unit level which are Ovintiv’s country cost centres. To assess whether goodwill is impaired, the carrying amount of each reporting unit is determined and compared to the fair value of the reporting unit. If the carrying amount of the reporting unit is higher than its related fair value, then goodwill is measured and written down to the reporting unit’s implied fair value of goodwill. The implied fair value of goodwill is determined by deducting the fair value of the reporting unit’s assets and liabilities from the fair value of the reporting unit as if the reporting entity had been acquired in a business combination. Any excess of the carrying value of goodwill over the implied fair value of goodwill is recognized as an impairment and charged to net earnings. The most significant assumptions used to determine a reporting unit’s fair value include estimations of oil and natural gas reserves, including both proved reserves and risk-adjusted unproved reserves, estimates of market prices considering forward commodity price curves as of the measurement date, market discount rates and estimates of operating, administrative, and capital costs adjusted for inflation. In addition, management may support fair value estimates determined with comparable companies that are actively traded in the public market, recent comparable asset transactions, and transaction premiums. This would require management to make certain judgments about the selection of comparable companies utilized. Because quoted market prices for the Company’s reporting units are not available, management applies judgment in determining the estimated fair value of reporting units for purposes of performing goodwill impairment tests. Ovintiv may use a combination of the income and the market valuation approaches. Downward revisions of estimated reserves quantities, increases in future cost estimates, sustained decreases in oil or natural gas prices, or divestiture of a significant component of the reporting unit could reduce expected future cash flows and fair value estimates of the reporting units and possibly result in an impairment of goodwill in future periods. The Company has assessed its goodwill for impairment at December 31, 2019 and no impairment was recognized. The reporting units’ fair values were substantially in excess of the carrying values and as a result was not at risk of failing step one of the impairment test as at December 31, 2019. Asset Retirement Obligation Asset retirement obligations are those legal obligations where the Company will be required to retire tangible long-lived assets such as producing well sites, an offshore production platform, processing plants, and restoring land or seabed at the end of oil and gas production operations. The fair value of estimated asset retirement obligations is recognized on the Consolidated Balance Sheet when incurred and a reasonable estimate of fair value can be made. The asset retirement cost, equal to the initially estimated fair value of the asset retirement obligation, is capitalized as part of the cost of the related long-lived asset. Changes in the estimated obligation are recognized as a change in the asset retirement obligation and the related asset retirement cost. Actual expenditures incurred are charged against the accumulated asset retirement obligation. Accretion expense is recognized over time as the discounted liability is accreted to its expected settlement value. Asset removal technologies and costs are constantly changing, as are regulatory, political, environmental, safety, and public relations considerations. The asset retirement obligation is estimated by discounting the expected future cash flows of the settlement. The discounted cash flows are based on estimates of such factors as reserves lives, retirement costs, timing of settlements, credit-adjusted risk-free rates and inflation rates. Changes in these estimates impact net earnings through accretion of the asset retirement obligation in addition to depletion of the asset retirement cost included in property, plant and equipment. Derivative Financial Instruments Ovintiv uses derivative financial instruments to manage its exposure to market risks relating to commodity prices, foreign currency exchange rates and interest rates. The Company’s policy is not to utilize derivative financial instruments for speculative purposes. Realized gains or losses from financial derivatives are recognized in net earnings as the contracts are settled. Unrealized gains and losses are recognized in net earnings at the end of each respective reporting period based on the changes in fair value of the contracts. Ovintiv’s derivative financial instruments primarily relate to commodities including oil, NGLs and natural gas. The most significant assumptions used in determining the fair value to the Company’s commodity derivatives financial instruments include estimates of future commodity prices, implied volatilities of commodity prices, discount rates and estimates of counterparty credit risk. These pricing and discounting variables are sensitive to the period of the contract and market volatility as well as regional price differentials. Changes in these estimates and assumptions can impact net earnings through decreased revenues or increased expenses. Derivative financial instruments are measured at fair value with changes in fair value recognized in net earnings. Fair value estimates are determined using quoted prices in active markets, inferred based on market prices of similar assets and liabilities or valued using internally developed estimates. The Company may use various valuation techniques including the discounted cash flow or option valuation models. As Ovintiv has chosen not to elect hedge accounting treatment for the Company’s derivative financial instruments, changes in the fair values of derivative financial instruments can have a significant impact on Ovintiv’s results of operations. Generally, changes in fair values of derivative financial instruments do not impact the Company’s liquidity or capital resources. Settlements of derivative financial instruments do have an impact on the Company’s liquidity and results of operation. Description Judgments and Uncertainties Income Taxes Ovintiv follows the liability method of accounting for income taxes. Under this method, deferred income taxes are recorded for the effect of any temporary difference between the accounting and income tax basis of an asset or liability, using the enacted income tax rates and laws expected to apply when the assets are realized and liabilities are settled. Current income taxes are measured at the amount expected to be recoverable from or payable to the taxing authorities based on the income tax rates and laws enacted at the end of the reporting period. The effect of a change in the enacted tax rates or laws is recognized in net earnings in the period of enactment. Tax interpretations, regulations and legislation, including U.S. Tax Reform, and potential Treasury Department regulations and guidance, in the various jurisdictions in which the Company and its subsidiaries operate are subject to change and interpretation. As such, income taxes are subject to measurement uncertainty and the interpretations can impact net earnings through the income tax expense arising from the changes in deferred income tax assets or liabilities. Deferred income tax assets are routinely assessed for realizability. If it is more likely than not that deferred tax assets will not be realized, a valuation allowance is recorded to reduce the deferred tax assets. Ovintiv considers available positive and negative evidence when assessing the realizability of deferred tax assets, including historic and expected future taxable earnings, available tax planning strategies and carry forward periods. Numerous judgments and assumptions are inherent in the determination of future taxable income, including factors such as future operating conditions, particularly related to oil and gas prices. As a result, the assumptions used in determining expected future taxable earnings are consistent with those used in the goodwill impairment assessment. Ovintiv’s interim income tax expense is determined using an estimated annual effective income tax rate applied to year-to-date net earnings before income tax plus the effect of legislative changes and amounts in respect of prior periods. The estimated annual effective income tax rate is impacted by expected annual earnings, statutory rate and other foreign differences, non-taxable capital gains and losses, tax differences on divestitures and transactions, and partnership tax allocations in excess of funding. Ovintiv recognizes the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination by a taxing authority. A recognized tax position is initially and subsequently measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority. Liabilities for unrecognized tax benefits that are not expected to be settled within the next 12 months are included in other liabilities and provisions. The Company routinely assesses potential uncertain tax positions and, if required, establishes accruals for such amounts. The accruals are adjusted based on changes in facts and circumstances. Material changes to Ovintiv’s income tax accruals may occur in the future based on the progress of ongoing audits, changes in legislation or resolution of pending matters. The Company’s unremitted earnings from its foreign subsidiaries are considered to be permanently reinvested, as a result the Company does not calculate a deferred tax liability for domestic income taxes on these foreign earnings. Determination of unrecognized deferred income tax liabilities is not practicable due to the significant uncertainty in assumptions that would be required including determining the nature of any future remittances, that could be distributions in the form of non-taxable returns of capital or taxable earnings and associated withholding taxes, or determining the tax rates on any future remittances that could vary significantly depending on the available approaches to repatriate the earnings. Contingent Liabilities Ovintiv is subject to various legal proceedings, environmental remediation, commercial and regulatory claims and liabilities that arise in the ordinary course of business. The Company accrues losses when such losses are probable and reasonably estimable, except for contingencies acquired in a business combination which are recorded at fair value at the time of the acquisition. If a loss is probable but the Company cannot estimate a specific amount for that loss, the best estimate within the range is accrued and if no amount is better within the range, the minimum amount is accrued. The establishment and evaluation of a contingent loss is based on advice from legal counsel, advisors or consultants and management’s judgement. Actual costs can vary from such estimates for various reasons including: i) differing interpretation of the law, opinions on responsibility and assessments on the amount of damages; ii) changes in status of litigation or claims and information available; iii) differing interpretation of regulations by regulators or the courts; iv) changes in laws and regulations; and v) additional or developing information relating to extent and nature of environmental remediation and technology improvements. The Company continually monitors known and potential legal, environmental and other claims or contingencies based on available information. Future changes in facts and circumstances not currently foreseeable could result in the actual liabilities recorded exceeding the estimated amounts accrued. Recent Accounting Pronouncements For recently issued accounting policies, refer to Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Non-GAAP Measures Certain measures in this document do not have any standardized meaning as prescribed by U.S. GAAP and, therefore, are considered non-GAAP measures. These measures may not be comparable to similar measures presented by other issuers and should not be viewed as a substitute for measures reported under U.S. GAAP. These measures are commonly used in the oil and gas industry and by Ovintiv to provide shareholders and potential investors with additional information regarding the Company’s liquidity and its ability to generate funds to finance its operations. Non-GAAP measures include: Non-GAAP Cash Flow, Non-GAAP Cash Flow Margin, Total Costs, Debt to Adjusted Capitalization and Net Debt to Adjusted EBITDA. Management’s use of these measures is discussed further below. Non-GAAP Cash Flow and Non-GAAP Cash Flow Margin Non-GAAP Cash Flow is a non-GAAP measure defined as cash from (used in) operating activities excluding net change in other assets and liabilities, net change in non-cash working capital and current tax on sale of assets. Non-GAAP Cash Flow Margin is a non-GAAP measure defined as Non-GAAP Cash Flow per BOE of production. Management believes these measures are useful to the Company and its investors as a measure of operating and financial performance across periods and against other companies in the industry, and are an indication of the Company’s ability to generate cash to finance capital programs, to service debt and to meet other financial obligations. These measures are used, along with other measures, in the calculation of certain performance targets for the Company’s management and employees. (1) 2019 includes restructuring costs of $138 million and acquisition costs of $33 million. Total Costs Total Costs is a non-GAAP measure defined as the summation of production, mineral and other taxes, upstream transportation and processing expense, upstream operating expense and administrative expense, excluding the impact of long-term incentive and restructuring costs. Management believes this measure is useful to the Company and its investors as a measure of operational efficiency across periods. (1) Calculated using whole dollars and volumes. Debt to Adjusted Capitalization Debt to Adjusted Capitalization is a non-GAAP measure which adjusts capitalization for historical ceiling test impairments that were recorded as at December 31, 2011. Management monitors Debt to Adjusted Capitalization as a proxy for the Company’s financial covenant under the Credit Facilities which require debt to adjusted capitalization to be less than 60 percent. Adjusted Capitalization includes debt, total shareholders’ equity and an equity adjustment for cumulative historical ceiling test impairments recorded as at December 31, 2011 in conjunction with the Company’s January 1, 2012 adoption of U.S. GAAP. The increase in Debt to Adjusted Capitalization is primarily due to the increase in long-term debt resulting from the Newfield acquisition. Net Debt to Adjusted EBITDA Net Debt to Adjusted EBITDA is a non-GAAP measure whereby Net Debt is defined as long-term debt, including the current portion, less cash and cash equivalents and Adjusted EBITDA is defined as trailing 12-month net earnings (loss) before income taxes, DD&A, impairments, accretion of asset retirement obligation, interest, unrealized gains/losses on risk management, foreign exchange gains/losses, gains/losses on divestitures and other gains/losses. Management believes this measure is useful to the Company and its investors as a measure of financial leverage and the Company’s ability to service its debt and other financial obligations. This measure is used, along with other measures, in the calculation of certain financial performance targets for the Company’s management and employees. The increase in Net Debt is primarily due to the increase in long-term debt resulting from the Newfield acquisition, whereas Adjusted EBITDA only includes Newfield’s results of operations for the post-acquisition period from February 14, 2019 to December 31, 2019.

<s>[INST] On January 24, 2020, Encana Corporation (“Encana”) completed a corporate reorganization, which included a Share Consolidation, as described in Items 1 and 2 of this Annual Report on Form 10K, Note 1 of the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10K and the Subsequent Event section of this MD&A. Subsequent to the corporate reorganization, Ovintiv Inc. and its subsidiaries (collectively, “Ovintiv”) continue to carry on the business which was previously conducted by Encana and its subsidiaries. References to the “Company” are to Encana Corporation and its subsidiaries prior to the completion of the Reorganization and to Ovintiv Inc. and its subsidiaries following the completion of the Reorganization. Common industry terms and abbreviations are used throughout this MD&A and are defined in the Definitions, Conversions and Conventions sections of this Annual Report on Form 10K. This MD&A includes the following sections: Executive Overview Results of Operations Liquidity and Capital Resources Accounting Policies and Estimates NonGAAP Measures Executive Overview Strategy By executing on its strategy as outlined in Items 1 and 2 of this Annual Report on Form 10K, Ovintiv focuses on enhancing longterm shareholder value and generating cash flow growth from high margin, scalable, top tier assets located in some of the best plays in North America, referred to as the “Core Assets”. As at December 31, 2019, the Core Assets comprised Permian and Anadarko in the U.S., and Montney in Canada. These top tier assets form a multibasin portfolio of oil, NGLs and natural gas producing plays enabling flexible and efficient investment of capital that support sustainable cash flow generation. The Company’s other upstream assets, including Eagle Ford, Duvernay, Bakken (previously referred to as Williston) and Uinta, continue to deliver operating cash flows for the Company. In executing its strategy, Ovintiv focuses on its core values of One, Agile and Driven, which guide the organization to be flexible, responsive, innovative and determined. The Company is committed to excellence with a passion to drive corporate financial performance and succeed as a team. For additional information on reporting segments and the plays in which the Company operates, refer to Items 1 and 2 of this Annual Report on Form 10K. On February 13, 2019, the Company completed the acquisition of Newfield Exploration Company (“Newfield”); as such, the postacquisition results of operations of Newfield are included in the Company’s consolidated results beginning February 14, 2019. For additional information on the business combination and segmented results, refer to Notes 8 and 2, respectively, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10K. In evaluating its operations and assessing its leverage, Ovintiv reviews performancebased measures such as NonGAAP Cash Flow, NonGAAP Cash Flow Margin, Total Costs and debtbased metrics such as Debt to Adjusted Capitalization and Net Debt to Adjusted EBITDA, which are nonGAAP measures and do not have any standardized meaning under U.S. GAAP. These measures may not be similar to measures presented by other issuers and should not be viewed as a substitute for measures reported under U.S. GAAP. Additional information regarding these measures, including reconciliations to the closest GAAP measure, can be found in the NonGAAP Measures section of this MD&A. For the period ended December 31, 2019, the Company elected to exclude from this MD&A the discussion of the results of operations for the period ended December 31, 2017, being the earliest of the three years included in the Consolidated Financial Statements, as set forth in the SEC’s amendment to Item 303 of Regulation SK, which was effective May 2, 2019. For additional information on the Company’s financial condition, changes in financial condition and results of operations for the period ended December 31, 2 [/INST] Negative. </s>

Brigham Minerals, 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 should be read in conjunction with “Selected Historical Financial Data” and the accompanying consolidated and combined financial statements and related notes included elsewhere in this Annual Report. The following discussion contains forward-looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward-looking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, market prices for oil, natural gas and NGLs, production volumes, estimates of proved, probable and possible reserves, mineral acquisition capital, economic and competitive conditions, regulatory changes and other uncertainties, as well as those factors discussed below and elsewhere in this Annual Report, particularly in “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements,” all of which are difficult to predict. In light of these risks, uncertainties and assumptions, the forward-looking events discussed may not occur. We do not undertake any obligation to publicly update any forward-looking statements except as otherwise required by applicable law. Overview Brigham Minerals was formed to acquire and actively manage a portfolio of mineral and royalty interests in the core of what we view as the most active, highly economic, liquids-rich resource plays across the continental United States. Our primary business objective is to maximize risk-adjusted total return to our shareholders through (i) the growth of our free cash flow generated from our existing portfolio of approximately 82,200 net royalty acres, and (ii) the continued sourcing and execution of accretive mineral acquisitions in the core of highly economic, liquids-rich resource plays. As of December 31, 2019, we owned 82,200 net royalty acres across 39 counties within the Permian Basin in West Texas and New Mexico, the SCOOP/STACK plays in the Anadarko Basin of Oklahoma, the DJ Basin in Colorado and Wyoming and the Williston Basin in North Dakota. Operational Update Mineral and Royalty Interest Ownership Update During the twelve months ended December 31, 2019, the Company completed 216 transactions acquiring 13,400 net royalty acres (standardized to a 1/8th royalty interest) for $218.1 million, in the Permian, SCOOP/STACK/Merge, Williston and DJ Basins. The Company deployed approximately 71% of its mineral acquisition capital in 2019 to the Permian Basin (62% Delaware and 9% Midland), 23% to the Anadarko Basin, 5% to the Williston Basin and 1% to the DJ Basin. The acquired minerals are expected to deliver near-term production and cash flow growth with the addition of 210 gross DUCs (2.0 net DUCs) and 99 gross permits (0.5 net permits) to its inventory counts. As of December 31, 2019, the Company owned roughly 82,200 net royalty acres, encompassing 12,777 gross (112 net) undeveloped horizontal locations, across 39 counties in what the Company views as the core of the Permian Basin in West Texas and New Mexico, the SCOOP/STACK plays in the Anadarko Basin of Oklahoma, the DJ Basin in Colorado and Wyoming and the Williston Basin in North Dakota. The table below summarizes the Company’s mineral and royalty interest ownership as of the dates indicated and changes in such ownership on a quarter over quarter (“Q/Q”) and year-to-date (“YTD”) basis. Operating Activity Update DUC Conversions The Company saw significant conversion of its DUC inventory during the fourth quarter with over 376 gross (2.6 net) horizontal wells identified that had been converted to production, which represented 38% of its gross DUC inventory as of Q3 2019 (42% of net DUCs). In 2019, the Company converted 697 gross DUCs (5.6 net DUCs) to PDP, 86% of its gross DUC inventory (92% of its net DUCs) as of year-end 2018. 2019 conversions of gross wells by status are summarized in the graph below: Drilling Activity During 2019 the Company averaged 65 rigs running on its mineral and royalty interests with approximately 2,700 net royalty acres under development. During the fourth quarter 2019, the Company averaged approximately 60 rigs running on its mineral and royalty interests with approximately 2,500 net royalty acres under development as compared to 57 rigs and 2,900 net royalty acres under development on average over the prior six quarters. During 2019 the Company had an average of 29 rigs operating on its Permian Basin minerals and 16 on its SCOOP minerals. During the fourth quarter 2019 the Company had an average of 32 rigs operating on its Permian Basin minerals and 16 rigs on its SCOOP minerals. Key Operators running rigs on Brigham’s mineral position during 2019 included Continental (14 rigs), ExxonMobil (8 rigs), Occidental Petroleum (4 rigs), Marathon Oil (3 rigs) and Concho Resources (2 rigs). Key Operators running rigs on Brigham’s mineral position during the fourth quarter included Continental (10 rigs), ExxonMobil (9 rigs), Occidental Petroleum (4 rigs), Marathon Oil (3 rigs) and Hess Corporation (3 rigs). Brigham’s rig activity over the past eight quarters is summarized in the graph below: DUC and Permit Inventory The Company expects near-term production growth will be driven by the continued conversion of its DUC and permit inventory. Brigham’s DUC and permit inventory as of December 31, 2019 by basin is outlined in the table below: (1) Individual amounts may not total due to rounding. How We Evaluate Our Operations We use a variety of operational and financial measures to assess our performance. Among the measures considered by management are the following: • volumes of oil, natural gas and NGLs produced; • number of rigs on location, permits, spuds, completions and wells turned-in-line; • commodity prices; and • Adjusted EBITDA and Adjusted EBITDA ex lease bonus. Volumes of Oil, Natural Gas and NGLs Produced In order to track and assess the performance of our assets, we monitor and analyze our production volumes from the various resource plays that comprise our portfolio of mineral and royalty interests. We also regularly compare projected volumes to actual reported volumes and investigate unexpected variances. Number of Rigs on Location, Permits, Spuds, Completions and Wells Turned-In-Line In order to track and assess the performance of our assets, we monitor and analyze the number of rigs currently drilling our properties. We also constantly monitor the number of permits, spuds, completions and wells on production that are applicable to our mineral and royalty interests in an effort to evaluate near-term production growth from the various basins and resource plays that comprise our asset base. Commodity Prices Historically, oil, natural gas and NGL prices have been volatile and may continue to be volatile in the future. During the past five years, the posted price for WTI has ranged from a low of $26.19 per barrel in February 2016 to a high of $77.41 per barrel in June 2018. The Henry Hub spot market price for natural gas has ranged from a low of $1.49 per MMBtu in March 2016 to a high of $6.24 per MMBtu in January 2018. As of December 31, 2019, the posted price for oil was $61.14 per barrel and the Henry Hub spot market price of natural gas was $2.09 per MMBtu. Lower prices may not only decrease our revenues, but also potentially the amount of oil, natural gas and NGLs that our operators can produce economically. The prices we receive for oil, natural gas and NGLs vary by geographical area. The relative prices of these products are determined by factors affecting global and regional supply and demand dynamics, such as economic and geopolitical conditions, production levels, availability of transportation, weather cycles and other factors. In addition, realized prices are influenced by product quality and proximity to consuming and refining markets. Any differences between realized prices and NYMEX prices are referred to as differentials. All of our production is derived from properties located in the United States. Oil. The substantial majority of our oil production is sold at prevailing market prices, which fluctuate in response to many factors that are outside of our control. NYMEX light sweet crude oil, commonly referred to as WTI, is the prevailing domestic oil pricing index. The majority of our oil production is priced at the prevailing market price with the final realized price affected by both quality and location differentials. The chemical composition of crude oil plays an important role in its refining and subsequent sale as petroleum products. As a result, variations in chemical composition relative to the benchmark crude oil, usually WTI, will result in price adjustments, which are often referred to as quality differentials. The characteristics that most significantly affect quality differentials include the density of the oil, as characterized by its API gravity, and the presence and concentration of impurities, such as sulfur. Location differentials generally result from transportation costs based on the produced oil’s proximity to consuming and refining markets and major trading points. Natural Gas. The NYMEX price quoted at Henry Hub is a widely used benchmark for the pricing of natural gas in the United States. The actual volumetric prices realized from the sale of natural gas differ from the quoted NYMEX price as a result of quality and location differentials. Quality differentials result from the heating value of natural gas measured in Btus and the presence of impurities, such as hydrogen sulfide, carbon dioxide and nitrogen. Natural gas containing ethane and heavier hydrocarbons has a higher Btu value and will realize a higher volumetric price than natural gas that is predominantly methane, which has a lower Btu value. Natural gas with a higher concentration of impurities will realize a lower volumetric price due to the presence of the impurities in the natural gas when sold or the cost of treating the natural gas to meet pipeline quality specifications. Natural gas, which currently has a limited global transportation system, is subject to price variances based on local supply and demand conditions and the cost to transport natural gas to end-user markets. NGLs. NGL pricing is generally tied to the price of oil, but varies based on differences in liquid components and location. Hedging We may enter into certain derivative instruments to partially mitigate the impact of commodity price volatility on our cash flow generated from operations. From time to time, such instruments may include variable-to-fixed-price swaps, fixed-price contracts, costless collars and other contractual arrangements. The impact of these derivative instruments could affect the amount of cash flows we ultimately realize. Historically, we have only entered into minimal fixed-price swap contracts. Under fixed-price swap contracts, a counterparty is required to make a payment to us if the settlement price is less than the swap strike price. Conversely, we are required to make a payment to the counterparty if the settlement price is greater than the swap strike price. We may employ contractual arrangements other than fixed-price swap contracts in the future to mitigate the impact of price fluctuations. If commodity prices decline in the future, our hedging contracts may partially mitigate the effect of lower prices on our future revenue. For the year ended December 31, 2019, 2018 and 2017, we recorded a loss on commodity derivative instruments, net of $0.6 million, a gain of $0.4 million and a loss of $0.1 million, respectively. We had no crude oil swaps and no natural gas derivative contracts in place as of December 31, 2019. Our open oil and natural gas derivative contracts as of December 31, 2018 are detailed in “Note 5.-Derivative Instruments” to the consolidated and combined financial statements of Brigham Minerals as of December 31, 2019 included elsewhere in this Annual Report. In addition, our revolving credit facility allows us to hedge up to 85% of our reasonably anticipated projected production from our proved reserves of oil and natural gas, calculated separately, for up to 60 months in the future. As of December 31, 2019, we had no crude oil swaps and as of December 31, 2018, we had in place crude oil swaps through December 2019 covering 1% of our projected crude oil production from proved reserves. We had no natural gas derivative contracts in place as of December 31, 2019 and December 31, 2018. Adjusted EBITDA and Adjusted EBITDA Ex Lease Bonus Adjusted EBITDA and Adjusted EBITDA ex lease bonus are non-GAAP supplemental financial measures used by our management and by external users of our financial statements such as investors, research analysts and others to assess the financial performance of our assets and their ability to sustain dividends over the long term without regard to financing methods, capital structure or historical cost basis. We define Adjusted EBITDA as net income (loss) before depreciation, depletion and amortization, share based compensation expense, interest expense, gain or loss on sale and distribution of equity securities, gain or loss on derivative instruments, loss on extinguishment of debt, and income tax expense, less other income and gain or loss on sale of oil and gas properties. We define Adjusted EBITDA ex lease bonus as Adjusted EBITDA further adjusted to eliminate the impacts of lease bonus revenue we receive due to the unpredictability of timing and magnitude of the revenue. Adjusted EBITDA and Adjusted EBITDA ex lease bonus do not represent and should not be considered alternatives to, or more meaningful than, net income, income from operations, cash flows from operating activities or any other measure of financial performance presented in accordance with GAAP as measures of our financial performance. Adjusted EBITDA and Adjusted EBITDA ex lease bonus have important limitations as analytical tools because they exclude some but not all items that affect net income, the most directly comparable GAAP financial measure. Our computation of Adjusted EBITDA and Adjusted EBITDA ex lease bonus may differ from computations of similarly titled measures of other companies. For further discussion, please read “Item 6.-Selected Financial Data-Non-GAAP Financial Measures.” Sources of Our Revenues Our revenues are primarily derived from the mineral and royalty payments we receive from our operators based on the sale of oil, natural gas and NGLs produced from our properties, as well as from lease bonus payments. Mineral and royalty revenues may vary significantly from period to period as a result of changes in volumes of production sold by our operators, production mix and commodity prices. Lease bonus revenues vary from period to period as a result of leasing activity on our mineral interests. The following table presents the breakdown of our revenues for the following periods: Principle Components of Our Cost Structure The following is a description of the principle components of our cost structure. However, as an owner of mineral and royalty interests, we are not obligated to fund drilling and completion capital expenditures to bring a horizontal well on line, lease operating expenses to produce our oil, natural gas and NGLs nor the plugging and abandonment costs at the end of a well’s economic life. All of the aforementioned costs are borne entirely by the exploration and production companies that have leased our mineral and royalty interests. Gathering, Transportation and Marketing Expenses Gathering, transportation and marketing expenses include the costs to process and transport our production to applicable sales points. Generally, the terms of the lease governing the development of our properties permits the operator to pass through these expenses to us by deducting a pro rata portion of such expenses from our production revenues. Severance and Ad Valorem Taxes Severance taxes are paid on produced oil, natural gas or NGLs based on either a percentage of revenues from production sold or the number of units of production sold at fixed rates established by federal, state or local taxing authorities. In general, the production taxes we pay correlate to changes in our oil, natural gas and NGL revenues, which is driven by our production volumes and prices received for our oil, natural gas and NGLs. We are also subject to ad valorem taxes in the counties where our production is located. Ad valorem taxes are generally based on the state or local government’s appraisal of the value of our oil, natural gas and NGL properties, which also trend with anticipated production, as well as oil, natural gas and NGL prices. Rates, methods of calculating property values and timing of payments vary across the different counties in which we own mineral and royalty interests. Depreciation, Depletion and Amortization Depreciation, depletion and amortization (“DD&A”) is the systematic expensing of the capitalized costs incurred to acquire evaluated oil and natural gas properties. We use the full cost method of accounting, and, as such, all acquisition-related costs to acquire evaluated properties are capitalized and amortized in aggregate based on the estimated economic productive lives of our properties. Depletion is the expense recorded based on the cost basis of our properties and the volume of hydrocarbons extracted during each respective period, calculated on a units-of-production basis. Estimates of proved reserves are a major component of our calculation of depletion. We adjust our depletion rates quarterly based upon the quarter-end internally generated reserve reports unless circumstances indicate that there has been a significant change in reserves or costs. The year-end reserve reports are audited by CG&A. General and Administrative General and administrative (“G&A”) expenses are costs incurred for overhead, including payroll and benefits for our staff, share-based compensation expense, costs of maintaining our headquarters, costs of managing our properties, audit and other fees for professional services and legal compliance. As a result of becoming a public company, we incurred incremental G&A expenses including, but not limited to, costs associated with hiring new personnel, implementation of compensation programs that are competitive with our public company peer group including share-based compensation, annual and quarterly reports to stockholders, tax return preparation, independent and internal auditor fees, investor relations activities, registrar and transfer agent fees, incremental director and officer liability insurance costs and independent director compensation. These incremental G&A expenses are not reflected in our historical financial statements before the IPO date. Interest Expense We finance a portion of our working capital requirements and acquisitions with borrowings under our revolving credit facility. As a result, we incur interest expense that is affected by both fluctuations in interest rates and our financing decisions. We reflect interest paid to the lenders under our debt arrangements (currently, our revolving credit facility) in interest expense. In connection with the closing of our IPO, we fully repaid the outstanding borrowings under our Owl Rock credit facility. Please see “Note 7.-Long-Term Debt” to the consolidated financial statements of Brigham Minerals as of December 31, 2019 included elsewhere in this Annual Report. Income Tax Expense Brigham Minerals is subject to U.S. federal and state income taxes as a corporation. Texas imposes a franchise tax (commonly referred to as the Texas margin tax) at a rate of up to 1.00% on gross revenues less certain deductions, as specifically set forth in the Texas margin tax statute. A portion of our mineral and royalty interests are located in Texas basins. Our predecessor was treated as a flow-through entity, and is currently treated as a disregarded entity, for U.S. federal income tax purposes and, as such, is generally not subject to U.S. federal income tax at the entity level. Results of Operations Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table provides the components of our revenues and expenses for the periods indicated, as well as each period’s respective average prices and production volumes: (1) Hedge prices reflect the effect of our commodity derivative transactions on our average sales prices. Our calculation of such effects include realized gains and losses on cash settlements for commodity derivatives, which we do not designate for hedge accounting. *** A percentage calculation is not meaningful due to change in signs, zero-value denominator or a change greater than 300. Revenues Total revenues for the twelve months ended December 31, 2019 increased by 51%, or $34.2 million, compared to the year ended December 31, 2018. The increase was attributable to a $38.1 million increase in mineral and royalty revenue during the period, partially offset by a $3.9 million decrease in lease bonus revenue. The increase in mineral and royalty revenue was primarily the result of increased drilling and completion activity on our mineral and royalty interests, which resulted in a 91% increase in production volumes to 7,414 Boe/d and a corresponding increase in revenue of $54.4 million. Realized commodity prices decreased 14% resulting in a $16.3 million decrease in mineral and royalty revenue. Oil revenues for the year ended December 31, 2019 increased by 74%, or $35.0 million, compared to the year ended December 31, 2018. Oil production volumes increased 95% to 4,151 barrels per day resulting in a $44.7 million increase in oil revenues. The increase in oil production volumes for the period was primarily attributable to increased drilling and completion activity on our properties in Texas, Oklahoma, North Dakota and New Mexico. Realized oil prices decreased 11% to $54.16 per barrel resulting in a decrease in revenue of $9.7 million. Natural gas revenues for the year ended December 31, 2019 increased by 39%, or $2.7 million compared to the year ended December 31, 2018. Natural gas production volumes increased 88% to 12,896 Mcf/d resulting in a $6.1 million increase in natural gas sales. The increase in natural gas production volumes for the period was primarily attributable to increased drilling and completion activity on our properties in Oklahoma, Colorado, North Dakota, Texas and New Mexico. Realized natural gas prices decreased by 26% to $2.07 per Mcf resulting in a decrease in revenue of $3.4 million. NGL revenues for the year ended December 31, 2019 increased by 7%, or $0.4 million compared to the year ended December 31, 2018. NGL production volumes increased by 83% to 1,114 Boe/d resulting in a $4.8 million increase in NGL sales, while realized NGL prices decreased by 42% to $15.03 per barrel resulting in a decrease in revenue of $4.4 million. Lease bonus revenue for the year ended December 31, 2019 decreased by 52%, or $3.9 million compared to the year ended December 31, 2018. The decrease was primarily attributable to a decrease in leasing activity on our interests in Oklahoma, partially offset by an increase in leasing activity in Texas. Other revenues include payments for right-of-way and surface damages and were not a significant portion of the overall amount. Operating and other expenses Gathering, transportation, and marketing expenses for the year ended December 31, 2019 increased by 26%, or $1.0 million, as compared to the year ended December 31, 2018, which was largely driven by the increase in our production volumes, partially offset by lower gathering, transportation and marketing rates. Severance and ad valorem taxes for the year ended December 31, 2019 increased by 81%, or $2.9 million, as compared to the year ended December 31, 2018, which was primarily due to higher severance taxes associated with oil revenue as a result of higher oil production volumes and higher oil prices, as well as higher ad valorem taxes in Texas. Depreciation, depletion and amortization (DD&A) expense for the year ended December 31, 2019 increased by 122%, or $17.0 million, compared to the year ended December 31, 2018, which was primarily due to an increase in depletion expense of $17.1 million. Higher production volumes increased our depletion expense by $12.1 million, and a higher depletion rate increased our depletion expense by $5.0 million. General and administrative expense (before share-based compensation expense) for the year ended December 31, 2019 increased by 79%, or $5.3 million, compared to the year ended December 31, 2018. Increases to G&A expense are a result of: (i) $0.7 million of incremental audit and tax fees, (ii) $0.7 million of additional salaries due to increase in headcount, (iii) $1.1 million of incremental D&O insurance expenses, (iv) $1.1 million of legal and professional fees and (v) $1.7 million of other incremental expenses as a result of becoming a publicly traded company. Share-based compensation expense for the year ended December 31, 2019 was $10.0 million net of $3.8 million of share-based compensation cost capitalized to unevaluated property. At IPO, we recognized a cumulative effect adjustment of $2.0 million of share-based compensation cost related to the Incentive Units, pertaining to the period from the grant date through the IPO. Additionally, in April of 2019, in connection with the IPO, we adopted the Brigham Minerals, Inc. 2019 LTIP and granted restricted stock awards ("RSAs"), restricted stock units ("RSUs") and performance-based vesting units ("PSUs") to our employees and executives. Certain of the RSAs vested immediately and we recognized $3.2 million of share-based compensation cost related to the RSAs. Also, subsequent to the IPO and prior to December 31, 2019, we recognized an additional $8.6 million of share-based compensation cost related to the Incentive Units and the awards granted under the LTIP. No share-based compensation expenses were recognized prior to the IPO because the IPO was not considered probable. See “Note 10.-Share-Based Compensation” to the consolidated and combined financial statements of Brigham Minerals, Inc. as of December 31, 2019 included elsewhere in this Annual Report for further discussion. Interest expense for the year ended December 31, 2019 decreased $1.8 million, compared to the year ended December 31, 2018 due to lower average outstanding borrowings and lower average interest rates. For the year ended December 31, 2019, our weighted average debt outstanding on our Owl Rock credit facility and revolving credit facility combined was $55.0 million. For the year ended December 31, 2018, our weighted average debt outstanding on our Owl Rock credit facility and prior revolving credit facility combined was $86.9 million. Our weighted-average interest was 7.29% and 8.10% for the years ended December 31, 2019 and 2018, respectively. In July 2018, proceeds from the Owl Rock credit facility were used to fully repay the outstanding balance of the prior revolving credit facility. In May 2019, a portion of the net proceeds received from the IPO were used to fully repay the outstanding borrowings under the Owl Rock credit facility. In December 2019, a portion of the net proceeds received from the December 2019 Offering were used to fully repay the outstanding borrowings under our revolving credit facility. See “Note 7.-Long-Term Debt” and “Note 1.-Business” to the consolidated and combined financial statements of Brigham Minerals, Inc. as of December 31, 2019 included elsewhere in this Annual Report for further discussion of this transaction. Loss on extinguishment of debt. As a result of the full repayment of the outstanding balance of the Owl Rock credit facility of $200.0 million in May 2019, we recognized a loss on extinguishment of debt of approximately $6.9 million. The loss on extinguishment of debt consisted of a $4.0 million write-off of capitalized debt issuance costs, a $2.1 million prepayment fee and legal fees of $0.8 million. See “Note 7.-Long-Term Debt” to the consolidated and combined financial statements of Brigham Minerals, Inc. as of December 31, 2019 included elsewhere in this Annual Report for further discussion of these transactions. For the year ended December 31, 2019, we recognized a loss on derivative instruments, net of $0.6 million, which is attributable to oil derivative instruments. We realized $0.5 million of gains on our settled derivative instruments during the year ended December 31, 2019. For the year ended December 31, 2018, we recognized a net gain on derivative instruments of $0.4 million, which is attributable to derivative instruments based on the price of oil. We realized $0.8 million of losses on our settled derivative instruments during the year ended December 31, 2018. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The following table provides the components of our revenues and expenses for the periods indicated, as well as each period’s respective average prices and production volumes: (1) Hedged prices reflect the effect of our commodity derivative transactions on our average sales prices. Our calculation of such effects include realized gains and losses on cash settlements for commodity derivatives, which we do not designate for hedge accounting. (2) Note: Individual variance amount may not calculate due to rounding. *** Calculation is not meaningful. Revenues Total revenues for the twelve months ended December 31, 2018 increased by 64%, or $26.4 million, compared to the year ended December 31, 2017. The increase was attributable to a $29.7 million increase in mineral and royalty revenue during the period, partially offset by a $3.3 million decrease in lease bonus revenue. The increase in mineral and royalty revenue was primarily the result of increased drilling and completion activity on our mineral and royalty interests, which resulted in a 65% increase in production volumes to 3,881 Boe/d and a corresponding increase in revenue of $19.5 million. Realized commodity prices increased 20% resulting in an additional $10.2 million increase in mineral and royalty revenue. Oil revenue for the year ended December 31, 2018 increased by 113%, or $24.9 million, compared to the year ended December 31, 2017. Oil production volumes increased 71% to 2,128 barrels per day resulting in a $15.7 million increase in oil revenue. The increase in oil production volumes for the period was primarily attributable to increased drilling and completion activity on our properties in Colorado, Texas, North Dakota and Oklahoma. Realized oil prices increased 25% to $60.56 per barrel, resulting in an additional increase in revenue of $9.2 million. Natural gas revenue for the year ended December 31, 2018 increased by 28%, or $1.5 million, compared to the year ended December 31, 2017. Natural gas production volumes increased 42% to 6,869 Mcf/d resulting in a $2.3 million increase in natural gas sales. The increase in natural gas production volumes for the period was primarily attributable to increased drilling and completion activity on our properties in Texas, Colorado, North Dakota and Oklahoma. Realized natural gas prices decreased by 10% to $2.80 per Mcf resulting in an offsetting decrease in revenue of $0.8 million. NGL revenue for the year ended December 31, 2018 increased by 130%, or $3.2 million compared to the year ended December 31, 2017. NGL production volumes increased by 103% to 608 Boe/d, resulting in a $2.5 million increase in NGL sales, while realized NGL prices increased by 13% to $25.72 per barrel, resulting in an additional increase in revenue of $0.7 million. Lease bonus revenue for the year ended December 31, 2018 decreased by 31%, or $3.3 million, compared to the year ended December 31, 2017. The decrease was primarily attributable to a decrease in leasing activity on our interests in Oklahoma, partially offset by an increase in leasing activity in Texas. Other revenues include payments for right-of-way and surface damages and were not a significant portion of the overall amount. Other operating income Gain on sale of oil and gas properties, net. On February 28, 2017, Brigham Operating and Brigham Resources Midstream, LLC, wholly owned subsidiaries of Brigham Resources, closed on the sale of substantially all of their Southern Delaware Basin leasehold and related assets, including certain mineral and royalty interests owned by Brigham Resources, to a third-party public entity. The proceeds for mineral and royalty interests represented $156.7 million of the net adjusted sales price and consisted of cash of $111.1 million and shares valued at $45.6 million. The mineral and royalty interests sold represented approximately 12% in aggregate of Brigham Resources’ total proved reserves as of December 31, 2016. As a result of the sale, the relationship between capitalized costs and proved reserves was altered significantly and Brigham Resources recorded a gain of $94.6 million. Operating and other expenses Gathering, transportation and marketing expenses for the year ended December 31, 2018 increased by 125%, or $2.2 million, as compared to the year ended December 31, 2017, which was largely driven by the 65% increase in our production volumes. Severance and ad valorem taxes for the year ended December 31, 2018 increased by 121%, or $1.9 million, as compared to the year ended December 31, 2017, which was primarily due to higher severance taxes associated with oil revenue as a result of higher oil production volumes and higher oil prices. Depreciation, depletion and amortization (DD&A) expense for the year ended December 31, 2018 increased by 100%, or $7.0 million, compared to the year ended December 31, 2017, which was primarily due to an increase in depletion expense of $7.1 million. Higher production volumes increased our depletion expense by $4.1 million, and a higher depletion rate increased our depletion expense by $3.0 million. General and administrative expense for the year ended December 31, 2018 increased by 69%, or $2.7 million, compared to the year ended December 31, 2017 as a result of increased headcount and incremental business development expenses. Interest expense for the year ended December 31, 2018 increased $6.9 million compared to the year ended December 31, 2017 due to greater average outstanding borrowings and higher interest rates under our Owl Rock credit facility. The need for greater borrowings was driven by our increased acquisition pace in 2018 relative to 2017. For the year ended December 31, 2018, we recognized a gain on derivative instruments, net of $0.4 million, which is attributable to oil derivative instruments. We realized $0.8 million of losses on our settled derivative instruments during the year ended December 31, 2018. For the year ended December 31, 2017, we recognized a net loss on derivative instruments of $0.1 million, which is attributable to derivative instruments based on the price of oil. Factors Affecting the Comparability of Our Results of Operations to Our Historical Results of Operations Our future results of operations may not be comparable to our historical results of operations for the periods presented, primarily for the reasons described below. Corporate Reorganization The historical consolidated and combined financial statements included in this Annual Report for periods on or before April 23, 2019 are based on the financial statements of our predecessor and Brigham Minerals prior to our corporate reorganization consummated in connection with our IPO. As a result, such historical consolidated and combined financial data may not give you an accurate indication of what our actual results would have been if the corporate reorganization had been completed at the beginning of the periods presented or of what our future results of operations are likely to be. Brigham Minerals acquired an indirect interest in Brigham Resources on July 16, 2018 in a series of restructuring transactions pursuant to which certain entities affiliated with Warburg Pincus contributed all of their respective interests in the entities through which they held interests in Brigham Resources to Brigham Minerals in exchange for all of the outstanding shares of common stock of Brigham Minerals (the “July 2018 restructuring”). As a result of such restructuring transactions, Brigham Minerals became wholly owned by an entity affiliated with Warburg Pincus, and Brigham Minerals indirectly owned a 16.5% membership interest in Brigham Resources. The remaining outstanding membership interests of Brigham Resources remained with the Original Owners. On November 20, 2018, Brigham Resources underwent a second series of restructuring transactions that are collectively referred to in this Annual Report as the “November 2018 restructuring.” In connection with the November 2018 restructuring, Brigham Resources became a wholly owned subsidiary of Brigham LLC. In April 2019, Brigham Minerals completed the IPO of 16,675,000 shares of Class A common stock at a price to the public of $18.00 per share. As a result of the IPO, Brigham Minerals became a holding company whose sole material asset consisted of a 43.3% interest in Brigham LLC, which wholly owns Brigham Resources. Brigham Resources continues to wholly own the Minerals Subsidiaries, which own all of Brigham Resources’ operating assets. In connection with the IPO, Brigham Minerals became the sole managing member of Brigham LLC and is responsible for all operational, management and administrative decisions relating to Brigham LLC’s business and consolidates the financial results of Brigham LLC and its wholly-owned subsidiary, Brigham Resources. On December 16, 2019, Brigham Minerals completed an offering of 12,650,000 shares of its Class A common stock (the "December 2019 Offering"), including 6,000,000 shares issued and sold by Brigham Minerals and an aggregate of 6,650,000 shares sold by certain shareholders of the Company, of which 5,496,813 represents shares issued upon redemption of an equivalent number of their Brigham LLC units, at a price to the public of $18.10 per share. Following the completion of the December 2019 Offering and certain redemptions of shares of Class B common stock and an equivalent number of Brigham LLC units for shares of Class A common stock completed between November 2019 and January 2020, Brigham Minerals owned a 60.1% interest in Brigham LLC and the Sponsors collectively owned 39.1% of the outstanding voting stock of Brigham Minerals as of February 27, 2020. The corporate reorganization that was completed contemporaneously with the closing of the IPO provided a mechanism by which the Brigham LLC Units to be allocated amongst the Original Owners, including the holders of our management incentive units, was determined. As a result, the satisfaction of all conditions relating to the vesting of certain management incentive units held in Brigham Equity Holdings, LLC (“Brigham Equity Holdings”) by our management and employees became probable. Accordingly, at IPO, we recognized a cumulative effect adjustment to share-based compensation cost of approximately $2.0 million pertaining to the period from the grant date through the IPO date, related to the estimated fair value of the Incentive Units (as defined in “Executive Compensation”) at grant, all of which was non-cash. From the IPO date through December 31, 2019, we recognized an additional $11.9 million in non-cash, share-based compensation cost related to the Incentive Units, RSAs, RSUs, and PSUs. Additionally, from the IPO date through December 31, 2019, we capitalized $3.8 million of the share-based compensation cost to unevaluated oil and gas properties. In addition, as the vesting conditions of the unvested Incentive Units, RSAs, RSUs and PSAs, are satisfied we will recognize additional non-cash charges for share compensation expense of approximately $19.3 million, a portion of which will be capitalized. Public Company Expenses As a result of the IPO, we incur direct, incremental G&A expenses as a result of being a publicly traded company, including, but not limited to, costs associated with hiring new personnel, implementation of compensation programs that are competitive with our public company peer group, including share-based compensation, preparing annual and quarterly reports to stockholders, tax return preparation, independent and internal auditor fees, investor relations activities, registrar and transfer agent fees, incremental director and officer liability insurance costs and independent director compensation. These direct, incremental G&A expenses are not included in our results of operations prior to the IPO. Income Taxes Brigham Minerals is subject to U.S. federal and state income taxes as a corporation. Our predecessor was treated as a flow-through entity, and is currently treated as a disregarded entity, for U.S. federal income tax purposes and, as such, is generally not subject to U.S. federal income tax at the entity level. Rather, the tax liability with respect to its taxable income is passed through to its members, including Brigham Minerals. Accordingly, the financial data of our predecessor contains no provision for U.S. federal income taxes or income taxes in any state or locality (other than franchise tax in the State of Texas). Capital Requirements and Sources of Liquidity Historically, our primary sources of liquidity have been capital contributions from our Original Owners, borrowings under our debt arrangements, proceeds from our IPO and the December 2019 Offering (as defined below) and cash flows from operations. Going forward, we expect our primary sources of liquidity to be the net proceeds retained from the December 2019 Offering, cash flows from operations, borrowings under our revolving credit facility that we entered into in May 2019 (as described below) or any other credit facility we enter into in the future and proceeds from any future issuances of debt or equity securities. We expect our primary use of capital will be for the payment of dividends to our stockholders and for investing in our business, specifically the acquisition of additional mineral and royalty interests. As a mineral and royalty interest owner, we incur the initial cost to acquire our interests, but thereafter do not incur any development capital expenditures or lease operating expenses, which are entirely borne by the operator. As a result, the vast majority of our capital expenditures are related to our acquisition of additional mineral and royalty interests. The amount and allocation of future acquisition-related capital expenditures will depend upon a number of factors, including the number and size of acquisition opportunities, our cash flows from operations, investing and financing activities and our ability to assimilate acquisitions. For the year ended December 31, 2019, we incurred approximately $221.9 million for acquisition-related capital expenditures, inclusive of a $3.8 million capitalized share-based compensation cost. We periodically assess changes in current and projected free cash flows, acquisition and divestiture activities, debt requirements and other factors to determine the effects on our liquidity. Based upon our current oil, natural gas and NGL price expectations for the year ended December 31, 2020, we believe that our cash flow from operations, additional borrowings under our revolving credit facility and the proceeds from the December 2019 Offering will provide us with sufficient liquidity to execute our current strategy. However, our ability to generate cash is subject to a number of factors, many of which are beyond our control, including commodity prices, weather and general economic, financial, competitive, legislative, regulatory and other factors. If we require additional capital for acquisitions or other reasons, we may seek such capital through additional borrowings, joint venture partnerships, asset sales, offerings of equity and debt securities or other means. If we are unable to obtain funds when needed or on acceptable terms, we may not be able to complete acquisitions that may be favorable to us. As of December 31, 2019, we had $150.0 million available under the borrowing base of our revolving credit facility. We fully repaid our outstanding borrowings under the Owl Rock credit facility and revolving credit facility, which were $200.0 million as of May 7, 2019 and $80.0 million as of December 16, 2019, respectively. As of December 31, 2019, we had liquidity of $201.1 million. On February 25, 2020, the borrowing base on our revolving credit facility was increased to $180.0 million. See "Item 9B.-Other Information and "Note 14.-Subsequent Events" to the consolidated and combined financial statements of Brigham Minerals included elsewhere in this Annual Report for further discussion. Working Capital Our working capital, which we define as current assets minus current liabilities, totaled $71.6 million at December 31, 2019, as compared to $53.5 million at December 31, 2018. Our collection of receivables has historically been timely, and losses associated with uncollectible receivables have historically not been significant. When new wells are turned to sales, our collection of receivables has lagged approximately six months from initial production as operators complete the division order process, at which point we are paid in arrears and then kept current. Our cash and cash equivalents balance totaled $51.1 million and $32.0 million at December 31, 2019 and December 31, 2018, respectively. The increase in cash and cash equivalents was primarily due to the IPO and December 2019 Offering partially offset by an increase in acquisitions pace for the year ended December 31, 2019 relative to the year ended December 31, 2018. We expect that the proceeds from the December 2019 Offering, our cash flows from operations and additional borrowings under our revolving credit facility will be sufficient to fund our working capital needs. We expect that the pace of our operators’ drilling of our undeveloped locations, production volumes, commodity prices and differentials to WTI and Henry Hub prices for our oil, natural gas and NGL production will be the largest variables affecting our working capital. Cash Flows The following table summarizes our cash flows for the periods indicated: Analysis of Cash Flow Changes Between the Years Ended December 31, 2019, 2018 and 2017 Net cash provided by operating activities Net cash provided by operating activities is primarily affected by production volumes, the prices of oil, natural gas and NGLs, lease bonus revenue and changes in working capital. The increase in net cash provided by operating activities for the year ended December 31, 2019 as compared to the year ended December 31, 2018 is primarily due to: (i) 91% increase in production volumes partially offset by the 14% decrease in realized prices during the year ended December 31, 2019 discussed above; (ii) increases in operating expenses and (iii) lower lease bonus revenues. The increase in net cash provided by operating activities for the year ended December 31, 2018 as compared to the year ended December 31, 2017 is primarily due to: (i) 65% increase in production volumes and the 20% increase in realized prices during the year ended December 31, 2018 discussed above; (ii) increases in operating expenses and (iii) lower lease bonus revenues. Net cash used in investing activities Net cash used in investing activities is primarily comprised of acquisitions of mineral and royalty interests, net of dispositions. For the year ended December 31, 2019, our net cash used in investing activities was primarily a result of acquisitions of mineral and royalty interests totaling $219.5 million and other fixed assets totaling $0.4 million, offset by sales of mineral and royalty interests totaling $3.1 million. For the year ended December 31, 2018, our net cash used in investing activities was primarily a result of acquisitions of mineral and royalty interests totaling $195.6 million and additions to other fixed assets of $0.7 million. Our cash flows from investing activities for the year ended December 31, 2018 also reflects $0.9 million of proceeds from the sale of equity securities. For the year ended December 31, 2017, our net cash provided by investing activities was primarily a result of divestiture proceeds of $111.0 million from the February 2017 sale of mineral and royalty interests and proceeds of $17.9 million from a sale of equity securities, which was partially offset by the acquisition of mineral and royalty interests totaling $101.4 million. Net cash provided by financing activities Net cash provided by financing activities for the year ended December 31, 2019 included the combined net proceeds generated from the IPO and December 2019 Offering of $379.8 million offset by the combined full repayment of the outstanding balances of the Owl Rock credit facility and revolving credit facility of $175.0 million (net of additional borrowings of $105.0 million incurred during the year), dividends paid to holders of our Class A common stock of $14.7 million, distributions to holders of temporary equity of $20.1 million, payment of debt extinguishment fees of $2.1 million and payment of loan closing costs of $1.3 million. Net cash provided by financing activities for the year ended December 31, 2018 included $46.0 million in net capital contributions from the Original Owners and $213.4 million in additional borrowings under our prior revolving credit facility and the Owl Rock credit facility combined, net of $4.6 million in associated loan closing costs. This was partially offset by payment of $70.0 million to pay off and terminate the prior revolving credit facility on July 28, 2018 using funds from the new term loan facility. Net cash used in financing activities for the year ended December 31, 2017 included $94.5 million in net capital distributions to the Original Owners, partially offset by $11.9 million in net borrowings under our prior revolving credit facility, net of $0.1 million in associated closing costs. Owl Rock Credit Facility On July 27, 2018, we entered into a credit agreement with Owl Rock Capital Corporation, as administrative agent and collateral agent (our “Owl Rock credit facility”). Our Owl Rock credit facility was subject to customary fees, guarantees of subsidiaries, restrictions and covenants, including certain restricted payments, and was collateralized by certain of our royalty and mineral properties. Our Owl Rock credit facility provided for a $125.0 million initial term loan and a $75.0 million delayed draw term loan (“DDTL”). Also, a $10.0 million revolving credit facility was available for general corporate purposes, which was undrawn as of May 7, 2019. In addition, as of May 7, 2019, we had $200.0 million of term loans and DDTL borrowings outstanding under our Owl Rock credit facility. We used a portion of the proceeds from the IPO to repay the outstanding borrowings under the term loan portion and DDTL portion of our Owl Rock credit facility and terminated the Owl Rock credit facility on May 7, 2019. Our Owl Rock credit facility bore interest at a rate per annum equal to, at our option, (a) the base rate plus 4.50%, or (b) the adjusted LIBOR rate for such interest period (subject to a 1.00% floor) plus 5.50%. Our Owl Rock credit facility required us to maintain compliance with customary financial and collateral coverage ratios. See “Note 7.-Long-Term Debt” to the consolidated and combined financial statements of Brigham Minerals as of September 30, 2019 contained elsewhere in this Annual Report for further discussion. Prior Revolving Credit Facility Prior to entering into our Owl Rock credit facility (which was terminated in May 2019), we maintained a revolving credit facility (our “prior revolving credit facility”) with Wells Fargo Bank, N.A., as administrative agent, and certain lenders party thereto with commitments of $150.0 million (subject to a borrowing base). We repaid the $70.0 million outstanding balance under our prior revolving credit facility with proceeds from our Owl Rock credit facility and terminated the prior revolving credit facility. The borrowing base at the time of termination was $70.0 million. Revolving Credit Facility On May 16, 2019 (the “closing date”), Brigham Resources entered into a credit agreement with Wells Fargo Bank, N.A., as administrative agent for the various lenders from time to time party thereto, providing for a revolving credit facility (our “revolving credit facility”). Our revolving credit facility is guaranteed by Brigham Resources’ domestic subsidiaries and is collateralized by a lien on substantial portion of Brigham Resources and its domestic subsidiaries’ assets, including substantial portion of their respective royalty and mineral properties. Availability under our revolving credit facility is governed by a borrowing base, which was subject to redetermination on February 1, 2020 and semi-annually thereafter on May 1 and November 1 of each year, commencing with May 1, 2020. In addition, lenders holding two-thirds of the aggregate commitments may request one additional redetermination each year. Brigham Resources can also request one additional redetermination each year, and such other redeterminations as appropriate when significant acquisition opportunities arise. The borrowing base is subject to further adjustments for asset dispositions, material title deficiencies, certain terminations of hedge agreements and issuances of permitted additional indebtedness. Increases to the borrowing base require unanimous approval of the lenders, while decreases only require approval of lenders holding two-thirds of the aggregate commitments at such time. As of December 31, 2019, the borrowing base was $150.0 million and we had no outstanding borrowings. On February 25, 2020, the borrowing base on our revolving credit facility was increased to $180.0 million. See "Item 9B.-Other Information" and "Note 14.-Subsequent Events" to the consolidated and combined financial statements of Brigham Minerals included elsewhere in this Annual Report for further discussion. Our revolving credit facility bears interest at a rate per annum equal to, at our option, the adjusted base rate or the adjusted LIBOR rate plus an applicable margin. The applicable margin is based on utilization of our revolving credit facility and ranges from (a) in the case of adjusted base rate loans, 0.750% to 1.750% and (b) in the case of adjusted LIBOR rate loans, 1.750% to 2.750%. Brigham Resources may elect an interest period of one, two, three, six, or if available to all lenders, twelve months. Interest is payable in arrears at the end of each interest period, but no less frequently than quarterly. A commitment fee is payable quarterly in arrears on the daily undrawn available commitments under our revolving credit facility in an amount ranging from 0.375% to 0.500% based on utilization of our revolving credit facility. Our revolving credit facility is subject to other customary fee, interest and expense reimbursement provisions. Our revolving credit facility matures on May 16, 2024. Loans drawn under our revolving credit facility may be prepaid at any time without premium or penalty (other than customary LIBOR breakage) and must be prepaid in the event that exposure exceeds the lesser of the borrowing base and the elected availability at such time. The principal amount of loans that are prepaid are required to be accompanied by accrued and unpaid interest and fees on such amounts. Loans that are prepaid may be reborrowed. In addition, Brigham Resources may permanently reduce or terminate in full the commitments under our revolving credit facility prior to maturity. Any excess exposure resulting from such permanent reduction or termination must be prepaid. Upon the occurrence of an event of default under our revolving credit facility, the administrative agent acting at the direction of the lenders holding a majority of the aggregate commitments at such time may accelerate outstanding loans and terminate all commitments under our revolving credit facility, provided that such acceleration and termination occurs automatically upon the occurrence of a bankruptcy or insolvency event of default. December 2019 Offering On December 16, 2019, Brigham Minerals completed an offering of 12,650,000 shares of its Class A common stock (the “December 2019 Offering”), including 6,000,000 shares issued and sold by Brigham Minerals and an aggregate of 6,650,000 shares sold by certain shareholders of the Company (the “Selling Shareholders”), at a price to the public of $18.10 per share ($17.376 per share net of underwriting discounts and commissions). After deducting underwriting discounts and commissions and offering expenses, Brigham Minerals received net proceeds of approximately $102.7 million. Brigham Minerals did not receive any proceeds from the sale of shares of Class A common stock by the Selling Shareholders. Following the December 2019 Offering and prior to December 31, 2019, Brigham Minerals (i) fully repaid the $80.0 million outstanding balance under our revolving credit facility on December 16, 2019 and (ii) applied capitalized issuance cost of $1.6 million as a reduction of additional paid-in-capital. Contractual Obligations A summary of our contractual obligations as of December 31, 2019 is provided in the following table: Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated and combined financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated and combined financial statements requires it to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. A complete list of our significant accounting policies are described in the notes to our audited consolidated and combined financial statements for the year ended December 31, 2019 included elsewhere in this Annual Report. Use of Estimates The preparation of consolidated and combined financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in the consolidated and combined financial statements and accompanying notes. Although management believes these estimates are reasonable, actual results could differ from these estimates. Changes in estimates are recorded prospectively. Our consolidated and combined financial statements are based on a number of significant estimates including quantities of oil, natural gas and NGL reserves that are the basis for the calculations of DD&A and impairment of oil and natural gas properties. Reservoir engineering is a subjective process of estimating underground accumulations of oil and natural gas and there are numerous uncertainties inherent in estimating quantities of proved oil and natural gas reserves. The accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. As a result, reserve estimates may differ from the quantities of oil and natural gas that are ultimately recovered. Our reserve estimates are audited by CG&A, an independent petroleum engineering firm. Other items subject to significant estimates and assumptions include the carrying amount of oil and natural gas properties, valuation of derivative instruments and revenue accruals. Receivables Receivables consist of mineral and royalty income due from operators for oil and gas sales to purchasers. Those purchasers remit payment for production to the operator of the properties and the operator, in turn, remits payment to us. Receivables from third parties for which we did not receive actual information, either due to timing delays or due to the unavailability of data at the time when revenues are recognized, are estimated. Volume estimates for wells with available historical actual data are based upon (i) the historical actual data for the months the data is available, or (ii) engineering estimates for the months the historical actual data is not available. We do not recognize revenues for wells with no historical actual data because we cannot conclude that it is probable that a significant revenue reversal will not occur in future periods. Pricing estimates are based upon actual prices realized in an area by adjusting the market price for the average basis differential from market on a basin-by-basin basis. We routinely review outstanding balances, assess the financial strength of our operators and record a reserve for amounts not expected to be fully recovered. We recorded an allowance for doubtful accounts for $0.6 million and $0.4 million for the years ended December 31, 2019 and 2018. We did not record any allowance for doubtful accounts for the year ended December 31, 2017. Derivative Instruments In the normal course of business, we are exposed to certain risks, including changes in the prices of oil, natural gas and NGLs and interest rates. We have historically entered into derivative contracts to manage our exposure to these risks. Our risk management activity is generally accomplished through over-the-counter derivative contracts with large financial institutions. We do not enter into derivative instruments for speculative purposes. Derivative instruments are recognized at fair value. If a right of offset exists under master netting arrangements and certain other criteria are met, derivative assets and liabilities with the same counterparty are netted on the consolidated and combined balance sheets. We do not specifically designate derivative instruments as cash flow hedges, even though they reduce our exposure to changes in oil and natural gas prices; therefore, gains and losses arising from changes in the fair value of derivatives are recognized on a net basis in our consolidated and combined statements of operations within (loss) gain on derivative instruments, net. Oil and Gas Properties We use the full cost method of accounting for our oil and natural gas properties. Under this method, all acquisition costs incurred for the purpose of acquiring mineral and royalty interests and certain related employee costs are capitalized into a full cost pool. Costs associated with general corporate activities are expensed in the period incurred. Capitalized costs are amortized using the units-of-production method. Under this method, the provision for depletion is calculated by multiplying total production for the period by a depletion rate. The depletion rate is determined by dividing the total unamortized cost base by the net equivalent proved reserves at the beginning of the period. Costs associated with unevaluated properties are excluded from the amortizable cost base until a determination has been made as to the existence of proved reserves. Unevaluated properties are reviewed periodically to determine whether the costs incurred should be reclassified to the full cost pool and subjected to amortization. The costs associated with unevaluated properties primarily consist of acquisition and leasehold costs and capitalized interest. Unevaluated properties are assessed for impairment on an individual basis or as a group if properties are individually insignificant. The assessment includes consideration of the following factors, among others: expectation of future drilling activity; past drilling results and activity; geological and geophysical evaluations; the assignment of proved reserves; and the economic viability of development if proved reserves are assigned. During any period in which these factors indicate an impairment, the cumulative acquisition costs incurred to date for such property are transferred to the full cost pool and are then subject to amortization. There was no impairment recorded for unevaluated properties for the years ended December 31, 2019, 2018 and 2017. Sales and abandonments of oil and natural gas properties being amortized are accounted for as adjustments to the full cost pool, with no gain or loss recognized unless the adjustments would significantly alter the relationship between capitalized costs and proved reserves. A significant alteration would not ordinarily be expected to occur upon the sale of reserves involving less than 25% of the reserve quantities of a cost center. Natural gas volumes are converted to Boe at the rate of six thousand Mcf of natural gas to one Bbl of oil. This convention is not an equivalent price basis and there may be a large difference in value between an equivalent volume of oil versus an equivalent volume of natural gas. Under the full cost method of accounting, total capitalized costs of oil and natural gas properties, net of accumulated depletion, may not exceed an amount equal to the present value of future net revenues from proved reserves, discounted at 10% per annum, plus the lower of cost or fair value of unevaluated properties (the ceiling limitation). A ceiling limitation is calculated at each reporting period. If total capitalized costs, net of accumulated DD&A, are greater than the ceiling limitation, a write-down or impairment of the full cost pool is required. A write-down of the carrying value of the full cost pool is a noncash charge that reduces earnings and impacts equity in the period of occurrence and typically results in lower depletion expense in future periods. Once incurred, a write-down cannot be reversed at a later date. The ceiling limitation calculation is prepared using the 12-month first day of the month oil and natural gas average prices, as adjusted for basis or location differentials, held constant over the life of the reserves (net wellhead prices). If applicable, these net wellhead prices would be further adjusted to include the effects of any fixed price arrangements for the sale of oil and natural gas. As of December 31, 2019, 2018 and 2017, the full cost ceiling value of our reserves was calculated based on the unweighted arithmetic average first-day-of-the-month price for the 12 months ended December 31, 2019, 2018 and 2017 of $55.65, $65.66, and $51.34, respectively, per barrel for oil, adjusted by area for energy content, transportation fees and regional price differentials, and the unweighted arithmetic average first-day-of-the-month price for the 12 months ended December 31, 2019, 2018 and 2017 of $2.60, $3.12, and $2.99, respectively, per MMBtu for natural gas, adjusted by area for energy content, transportation fees and regional price differentials. Using these prices, the net book value of oil and natural gas was above the ceiling limitation and no write-off was necessary. Revenue from Contracts with Customers On December 31, 2019, we adopted Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, ("ASC 606") using the modified retrospective approach, which only applied to contracts that were in effect as of the date of adoption. The adoption did not require an adjustment to opening retained earnings for the cumulative effect adjustment and did not impact our previously reported results of operations, nor our ongoing consolidated and combined balance sheets, statements of cash flow or statements of changes in shareholders' and members' equity. Overall, there were no material changes in the timing of the satisfaction of our performance obligations or the allocation of the transaction price to our performance obligations in applying the guidance in ASC 606 as compared to legacy U.S. GAAP. Oil and natural gas sales Oil, natural gas and NGLs sales revenues are generally recognized when control of the product is transferred to the customer, the performance obligations under the terms of the contracts with customers are satisfied and collectability is reasonably assured. As a non-operator, we have limited visibility into the timing of when new wells start producing and production statements may not be received for 30 to 90 days or more after the date production is delivered. As a result, we are required to estimate the amount of production delivered to the purchaser and the price that we will receive for the sale of the product. The expected sales volumes and prices for these properties are estimated and recorded within the Accounts receivable line item in the accompanying consolidated and combined balance sheets. The difference between our estimates and the actual amounts received for oil and natural gas sales is recorded in the month that payment is received from the third party. Lease bonus and other income We earn revenue from lease bonuses, delay rentals, and right-of-way payments. We generate lease bonus revenue by leasing our mineral interests to exploration and production companies. A lease agreement represents our contract with a customer and generally transfers the rights to any oil or natural gas discovered, grants us a right to a specified royalty interest, and requires that drilling and completion operations commence within a specified time period. We recognizes lease bonus revenues when the lease agreement has been executed, payment has been received, and we have no further obligation to refund the payment. At the time we execute the lease agreement, we expect to receive the lease bonus payment within a reasonable time, though in no case more than one year, such that we have not adjusted the expected amount of consideration for the effects of any significant financing component per the practical expedient in ASC 606. Share-Based Compensation Brigham Minerals accounts for its share-based compensation, including grants of the Incentive Units, restricted stock awards, time-based restricted stock units and performance-based stock units, in the condensed consolidated and combined statements of operations based on their estimated fair values at grant date. Brigham Minerals uses a Monte Carlo simulation to determine the fair value of performance-based stock units. Brigham Minerals recognizes expense on a straight-line basis over the vesting period of the respective grant, which is generally the requisite service period. Brigham Minerals capitalizes a portion of the share-based compensation cost to oil and gas properties on the consolidated and combined balance sheets. Share-based compensation expense is included in general and administrative expenses in Brigham Minerals’ consolidated and combined statements of operations included within this Annual Report. There was approximately $19.3 million of unamortized compensation expense relating to outstanding awards at December 31, 2019, a portion of which will be capitalized. The unrecognized compensation expense will be recognized on a straight-line basis over the remaining vesting periods of the awards. Brigham Minerals accounts for forfeitures as they occur. Income Taxes Brigham Minerals accounts for income taxes using 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. Deferred tax assets and liabilities are calculated by applying existing tax laws and the rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. We periodically assess whether it is more likely than not that we will generate sufficient taxable income to realize our deferred income tax assets, including net operating losses. In making this determination, we consider all available positive and negative evidence and make certain assumptions. We consider, among other things, our deferred tax liabilities, the overall business environment, our historical earnings and losses, current industry trends and our outlook for future years. Temporary Equity Brigham Minerals accounts for the Original Owners’ 40.2% interest in Brigham LLC (as of December 31, 2019) as temporary equity as a result of certain redemption rights held by the Original Owners as discussed in “Note 9.-Temporary Equity” to the condensed, consolidated and combined financial statements as of December 31, 2019 contained elsewhere in this Annual Report. As such, Brigham Minerals adjusts temporary equity to its maximum redemption amount at the balance sheet date, if higher than the carrying amount. The redemption amount is based on the 10-day volume-weighted average closing price (“VWAP”) of Class A shares at the end of the reporting period. Changes in the redemption value are recognized immediately as they occur, as if the end of the reporting period was also the redemption date for the instrument, with an offsetting entry to additional paid-in capital. Recently Issued Accounting Pronouncements See “Note 2.-Significant Accounting Policies-Recently Issued Accounting Standards” in our consolidated and combined financial statements as of December 31, 2019 included elsewhere in this Annual Report, for a discussion of recent accounting pronouncements. We are an “emerging growth company,” under the JOBs Act, which allows us to take advantage of an extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act. Internal Controls and Procedures Upon becoming a public company, we were required to comply with the SEC’s rules implementing Section 302 and Section 404 of the Sarbanes-Oxley Act, which requires our management to certify financial and other information in our quarterly and annual reports, and, beginning with the year following the first fiscal year for which we are required to file an annual report with the SEC, provide an annual management report on the effectiveness of our internal control over financial reporting. In addition, we will be required to have our independent registered public accounting firm attest to the effectiveness of our internal control over financial reporting under Section 404 beginning with our first annual report subsequent to our ceasing to be an “emerging growth company” within the meaning of Section 2(a)(19) of the Securities Act. Material Weaknesses and Remediation Prior to the completion of the IPO, Brigham Resources had been a private company that had required fewer accounting personnel to execute its accounting processes and supervisory resources to address its internal control over financial reporting, which we believed were adequate for a private company of its size and industry. In preparation for ongoing operations of a public company, we engaged third-party consultants to assist with the documentation, implementation and testing of enhanced accounting processes and control procedures required to meet the financial reporting requirements of a public company. Nevertheless, the design and execution of our controls had not been sufficiently tested by individuals with financial reporting oversight roles or by our third party consultants. In connection with the preparation and review of our unaudited consolidated and combined financial statements for the nine months ended September 30, 2018, our management identified certain material weaknesses related to our risk assessment processes and certain controls related to revenues and certain recent transactions. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. After identifying such material weaknesses, which resulted in errors in our unaudited condensed consolidated financial statements for the three and six months ended June 30, 2018, we reviewed our audited financial statements for the years ended December 31, 2017 for additional potential accrual and presentation errors, which resulted in an immaterial correction of the presentation of gains and losses on sales of assets to include such gains and losses in other operating income for all periods presented. Management has taken steps to remediate the material weaknesses in our internal control over financial reporting described above. These steps include engaging a third-party consultant to develop a plan for remediation and ongoing monitoring of the previously identified material weaknesses, implementing additional review procedures, employing additional finance and accounting personnel and reevaluating our internal reporting procedures with respect to revenue recognition. Due to the material weaknesses described above, management performed additional analysis and procedures in order to conclude that our consolidated and combined financial statements for the years ended December 31, 2018 and 2019, respectively, are fairly presented, in all material respects, in accordance with GAAP. Additionally, the third-party consultants tested multiple occurrences of the operating effectiveness of the newly implemented controls. As a result of the remediation efforts discussed above, management believes that all previously identified material weaknesses have been remediated. Inflation Inflation in the United States has been relatively low in recent years and did not have a material impact on our results of operations for the years ended December 31, 2019, 2018 and 2017. Although the impact of inflation has been insignificant in recent years, it is still a factor in the United States economy and our operators tend to experience inflationary pressure on the cost of oilfield services and equipment as increasing oil and natural gas prices increase drilling activity in the areas in which our properties are located. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any material off-balance sheet arrangements.

<s>[INST] The following discussion contains forwardlooking statements that reflect our future plans, estimates, beliefs and expected performance. The forwardlooking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to such differences include, but are not limited to, market prices for oil, natural gas and NGLs, production volumes, estimates of proved, probable and possible reserves, mineral acquisition capital, economic and competitive conditions, regulatory changes and other uncertainties, as well as those factors discussed below and elsewhere in this Annual Report, particularly in “Risk Factors” and “Cautionary Statement Regarding ForwardLooking Statements,” all of which are difficult to predict. In light of these risks, uncertainties and assumptions, the forwardlooking events discussed may not occur. We do not undertake any obligation to publicly update any forwardlooking statements except as otherwise required by applicable law. Overview Brigham Minerals was formed to acquire and actively manage a portfolio of mineral and royalty interests in the core of what we view as the most active, highly economic, liquidsrich resource plays across the continental United States. Our primary business objective is to maximize riskadjusted total return to our shareholders through (i) the growth of our free cash flow generated from our existing portfolio of approximately 82,200 net royalty acres, and (ii) the continued sourcing and execution of accretive mineral acquisitions in the core of highly economic, liquidsrich resource plays. As of December 31, 2019, we owned 82,200 net royalty acres across 39 counties within the Permian Basin in West Texas and New Mexico, the SCOOP/STACK plays in the Anadarko Basin of Oklahoma, the DJ Basin in Colorado and Wyoming and the Williston Basin in North Dakota. Operational Update Mineral and Royalty Interest Ownership Update During the twelve months ended December 31, 2019, the Company completed 216 transactions acquiring 13,400 net royalty acres (standardized to a 1/8th royalty interest) for $218.1 million, in the Permian, SCOOP/STACK/Merge, Williston and DJ Basins. The Company deployed approximately 71% of its mineral acquisition capital in 2019 to the Permian Basin (62% Delaware and 9% Midland), 23% to the Anadarko Basin, 5% to the Williston Basin and 1% to the DJ Basin. The acquired minerals are expected to deliver nearterm production and cash flow growth with the addition of 210 gross DUCs (2.0 net DUCs) and 99 gross permits (0.5 net permits) to its inventory counts. As of December 31, 2019, the Company owned roughly 82,200 net royalty acres, encompassing 12,777 gross (112 net) undeveloped horizontal locations, across 39 counties in what the Company views as the core of the Permian Basin in West Texas and New Mexico, the SCOOP/STACK plays in the Anadarko Basin of Oklahoma, the DJ Basin in Colorado and Wyoming and the Williston Basin in North Dakota. The table below summarizes the Company’s mineral and royalty interest ownership as of the dates indicated and changes in such ownership on a quarter over quarter (“Q/Q”) and yeartodate (“YTD”) basis. Operating Activity Update DUC Conversions The Company saw significant conversion of its DUC inventory during the fourth quarter with over 376 gross (2.6 net) horizontal wells identified that had been converted to production, which represented 38% of its gross DUC inventory as of Q3 2019 (42% of net DUCs). In 2019, the Company converted 697 gross DUCs (5.6 net DUCs) to PDP, 86% of its gross DUC inventory (92% of its net DUCs) as of yearend 2018. 2019 conversions of gross wells by status are summar [/INST] Positive. </s>

Stoke Therapeutics, 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 consolidated results of operations together with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10K, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. You should carefully read the section entitled “Risk factors” to gain an understanding of the important factors that could cause actual results to differ materially from our forward-looking statements. Overview We are pioneering a new way to treat the underlying causes of severe genetic diseases by precisely upregulating protein expression. We are developing novel antisense oligonucleotide, or ASO, medicines that target ribonucleic acid, or RNA, and modulate precursor-messenger RNA, or pre-mRNA, splicing to upregulate protein expression where needed and with appropriate specificity to near normal levels. We utilize our proprietary technology platform, Targeted Augmentation of Nuclear Gene Output, or TANGO, to design ASOs to upregulate the expression of protein by individual genes in a patient. Our approach is designed to allow us to deliver in a highly precise, durable and controlled manner disease-modifying therapies to a wide range of relevant tissues, including the central nervous system, or CNS, eye, kidney and liver. We designed our lead product candidate, STK-001, to treat Dravet syndrome, a severe and progressive genetic epilepsy. With a well-defined patient population based on routine genetic testing and learnings from drugs approved for the treatment of Dravet syndrome to inform the clinical and regulatory pathways for STK-001, we anticipate an efficient clinical program for STK-001. We submitted an investigational new drug application, or IND, for STK-001 to U.S. Food and Drug Administration, or the FDA, in late 2019. In the first quarter of 2020, we received communication from the FDA confirming that we may proceed with clinical dosing in the planned Phase 1/2a clinical trial called Monarch. The single ascending dose portion of this trial is in two parts, A and B, and is designed to evaluate STK-001 in children and adolescents ages 2 to 18 years of age with Dravet syndrome. Part A allows dosing of two cohorts. We expect to enroll and begin dosing patients in Part A of the study in the second half of 2020. Part B of the study will evaluate the higher doses of STK-001. The FDA has placed a partial clinical hold for the doses planned in Part B of the study. The partial clinical hold was not due to any identified manufacturing or safety issue, but rather was because additional safety information is needed from preclinical testing to determine the safety profile of doses higher than the current no observed adverse effect level or NOAEL. The NOAEL was determined using data from a pivotal non-human primate study that evaluated intrathecal delivery of single dose levels of STK-001. The highest dose administered in this study was equivalent to a human dose that is higher than what we plan to administer in Part B of our Phase 1/2a clinical study and did not demonstrate effects that were considered adverse. It is the FDA’s position that in order to support administration of STK-001 doses above those planned in Part A, additional nonclinical data to identify any potential safety issues of STK-001 at higher doses will need to be provided. We have initiated single-dose toxicology studies to more fully characterize the safety profile at higher doses, in order to facilitate the removal of the partial clinical hold and proceed to Part B of the study. Upon FDA clearance, we will plan to proceed with the higher dosing cohorts planned in Part B of the study. We are working to minimize any potential delay to continued clinical testing of STK-001. We still anticipate preliminary data from the study in 2021. We intend to nominate a second candidate for preclinical development in the second half of 2020. We were incorporated in June 2014. In July 2015 and April 2016, we entered into worldwide license agreements with Cold Spring Harbor Laboratory, or CSHL, and the University of Southampton, respectively, with respect to certain licensed patents and applications relating to TANGO. TANGO exploits non-productive splicing events to effect targeted enhancement of protein expression. Since our inception through December 31, 2019, our operations have been financed by net proceeds of $280.4 million from the sale of convertible notes payable and our convertible preferred stock as well as our IPO. As of December 31, 2019, we had $222.7 million in cash, cash equivalents and restricted cash. On June 21, 2019, we completed an initial public offering (“IPO”) of our common stock and issued and sold 9,074,776 shares of common stock at a public offering price of $18.00 per share, which included 1,183,666 shares sold upon full exercise of the underwriters’ option to purchase additional shares of common stock resulting in net proceeds of $151.9 million after deducting underwriting discounts and commissions but before deducting offering costs of approximately $2.5 million. Since inception, we have had operating losses, the majority of which are attributable to research and development activities. Our net losses were $32.3 million and $12.5 million for the years ended December 31, 2019 and 2018, respectively, and as of December 31, 2019, we had an accumulated deficit of $58.0 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. We expect to continue to incur net losses for the foreseeable future, and we expect our research and development expenses, general and administrative expenses, and capital expenditures will continue to increase. In particular, we expect our expenses and losses to increase as we continue our development of, and seek regulatory approvals for, our product candidates, and begin to commercialize any approved products, as well as hire additional personnel, develop commercial infrastructure, pay fees to outside consultants, lawyers and accountants, and incur increased costs associated with being a public company such as expenses related to services associated with maintaining compliance with Nasdaq listing rules and SEC requirements, insurance and investor relations costs. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials and our expenditures on other research and development activities. Based upon our current operating plan, we believe that our existing cash, cash equivalents and restricted cash as of December 31, 2019, will enable us to fund our operating expenses and capital expenditure requirements into 2023. To date, we have not had any products approved for sale and have not generated any product sales. We do not expect to generate any revenues from product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. As a result, until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. If we are unable to raise capital, we will need to delay, reduce or terminate planned activities to reduce costs. License agreements Cold Spring Harbor Laboratory In July 2015, we entered into a worldwide license agreement with CSHL, or the CSHL Agreement, with respect to the TANGO patents. Under the CSHL Agreement, we receive an exclusive (except with respect to certain government rights and non-exclusive licenses), worldwide license under certain patents and applications relating to TANGO. As part of the CSHL Agreement, we granted CSHL 164,927 shares of common stock. The CSHL Agreement obligates us to make additional payments that are contingent upon certain milestones being achieved as well as royalties on future product sales. These royalty obligations last on a product-by-product and country-by-country basis until the latest of (i) the expiration of the last valid claim of a patent covering a subject product or (ii) the expiration of any regulatory exclusivity for the subject product in a country. In addition, if we sublicense rights under the CSHL Agreement, we are required to pay a percentage of the sublicense revenue to CSHL, which may be reduced upon achievement of certain milestones for the applicable subject product. The maximum aggregate potential milestone payments payable total approximately $900,000. Additionally, certain licenses under the CSHL Agreement require us to reimburse CSHL for certain past and ongoing patent related expenses, however there were no expenses related to these reimbursable patent costs during the years ended December 31, 2019 and 2018. For more information, please see “Business-License agreements.” University of Southampton In April 2016, we entered into an exclusive, worldwide license agreement with the University of Southampton, or the Southampton Agreement, whereby we acquired rights to foundational technologies related to our TANGO technology. Under the Southampton Agreement, we receive an exclusive, worldwide license under certain licensed patents and applications relating to TANGO. As part of the Southampton Agreement, we paid 55,000 pounds sterling (approximately $73,000 as of the date thereof) as an up-front license fee. Under the Southampton Agreement, we may be obligated to make additional payments that are contingent upon certain milestones being achieved, as well as royalties on future product sales. These royalty obligations survive until the latest of (i) the expiration of the last valid claim of a licensed patent covering a subject product or (ii) the expiration of any regulatory exclusivity for the subject product in a country. In addition, if we sublicense our rights under the Southampton Agreement, we are required to pay a percentage of the sublicense revenue to the University of Southampton. The maximum aggregate potential milestone payments payable by us total approximately 400,000 pounds sterling (approximately $530,000 as of December 31, 2019). As of December 31, 2019, and 2018, we have recorded no liabilities under the Southampton Agreement. For more information, please see “Business-License agreements.” Financial operations overview Revenue We currently do not have any products approved for sale and have not generated any revenue since inception. If we are able to successfully develop, receive regulatory approval for and commercialize any of our current or future product candidates alone or in collaboration with third parties, we may generate revenue from the sales of these product candidates. Operating expenses Research and development Research and development expenses consist primarily of costs incurred for the development of our discovery work and preclinical programs, which include: • personnel costs, which include salaries, benefits and stock-based compensation expense; • expenses incurred under agreements with consultants, third-party contract organizations that conduct research and development activities on our behalf, costs related to production of preclinical material and laboratory and vendor expenses related to the execution of preclinical studies; • scientific consulting, collaboration and licensing fees; • laboratory equipment and supplies; and • facilities costs, depreciation and other expenses related to internal research and development activities. We use our personnel and infrastructure resources across multiple research and development programs directed toward identifying and developing product candidates. Our direct research and development expenses are tracked on a program-by-program basis from the point a program becomes a clinical candidate for us and consists primarily of external costs, such as fees paid to consultants, central laboratories and contractors in connection with our preclinical activities. We do not allocate employee costs, costs associated with our technology or facility expenses, including depreciation or other indirect costs, to specific programs because these costs are currently deployed across multiple product development programs and, as such, are not separately classified. We use internal resources to manage our development activities and our employees work across multiple development programs and, therefore, we do not track their costs by program. The table below summarizes our research and development expenses incurred by development program: 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 expect that our expenses will increase substantially in connection with our planned discovery work, preclinical and clinical development activities in the near term and our planned clinical trials in the future. At this time, we cannot reasonably estimate the costs for completing the preclinical and clinical development of any of our other product candidates. 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 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. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. Because of the numerous risks and uncertainties associated with product development, we cannot determine with certainty the duration and completion costs of the 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, including: • successful completion of preclinical studies and investigational new drug-enabling studies; • successful enrollment in, and completion of, clinical trials; • receipt of regulatory approvals from applicable regulatory authorities; • furthering our commercial manufacturing capabilities and arrangements with third-party manufacturers; • obtaining and maintaining patent and trade secret protection and non-patent exclusivity; • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others; • acceptance of our product candidates, if and when approved, by patients, the medical community and third-party payors; • effectively competing with other therapies and treatment options; • a continued acceptable safety profile following approval; • enforcing and defending intellectual property and proprietary rights and claims; and • achieving desirable medicinal properties for the intended indications. A change in the outcome of any of these factors could mean a significant change in the costs and timing associated with the development of our current and future preclinical and clinical product candidates. 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, or if we experience significant delays in execution of or enrollment in any of our preclinical studies or clinical trials, we could be required to expend significant additional financial resources and time on the completion of preclinical and clinical development. We expect our research and development expenses to increase for the foreseeable future as we continue the development of product candidates. General and administrative expenses General and administrative expenses consist primarily of personnel costs, costs related to maintenance and filing of intellectual property, expenses for outside professional services, including legal, human resources, information technology, audit and accounting services, and facilities and other expenses. Personnel costs consist of salaries, benefits and stock-based compensation expense. We expect our general and administrative expenses to increase over the next several years to support our continued research and development activities, manufacturing activities, increased costs of operating as a public company and the potential commercialization of our product candidates. These increases are anticipated to include increased costs related to the hiring of additional personnel, developing commercial infrastructure, fees to outside consultants, lawyers and accountants, and increased costs associated with being a public company such as expenses related to services associated with maintaining compliance with Nasdaq listing rules and SEC requirements, insurance and investor relations costs. Interest Income Interest income consists primarily of interest received on our invested funds. Other income (expense) Our other income (expense), includes (i) interest income earned on cash reserves in our operating money-market fund investment accounts and (ii) other items of income (expense), net. Results of operations for the years ended December 31, 2019 and 2018 The following table sets forth our results of operations: Research and development expenses Research and development expenses were $23.8 million for the year ended December 31, 2019 as compared to $8.4 million for the year ended December 31, 2018, an increase of $15.4 million. The table below summarizes our research and development expenses: The increases in research and development expenses were primarily attributable to an increase of $8.8 million on our STK-001 program, comprised primarily of third-party services and scientific consulting fees, an increase of $3.2 million in personnel costs resulting from an increase in headcount, and an increase of $3.4 million in facilities and other costs resulting from the growth in our research and development personnel. General and administrative expenses General and administrative expenses were $11.9 million for the year ended December 31, 2019 as compared to $4.4 million for the year ended December 31, 2018, an increase of $7.5 million. The increases in general and administrative expenses were primarily attributable to an increase of $1.8 million in personnel costs resulting from an increase in headcount, an increase of $1.6 million in third-party services to support our in-house personnel in various aspects of developing and supporting the business including human resources, information technology, audit, tax, public relations, communications and other general and administrative activities and an increase of $4.1 million in facilities and other costs resulting from the growth in our general and administrative personnel. Other income (expense) The change in our other income (expense) for the year ended December 31, 2019 as compared to the year ended December 31, 2018 principally reflects returns on higher levels of cash reserves. Liquidity and capital resources Since our inception through December 31, 2019, our operations have been financed by net proceeds of $280.4 million from the sale of convertible notes payable and our convertible preferred stock as well as our IPO. As of December 31, 2019, we had $222.7 million in cash, cash equivalents and restricted cash. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation. We have incurred losses since our inception in June 2014 and, as of December 31, 2019, we had an accumulated deficit of $58.0 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. Our product candidates may never achieve commercialization and we anticipate that we will continue to incur losses for the foreseeable future. We expect that our research and development expenses, general and administrative expenses, and capital expenditures will continue to increase. As a result, 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 or other capital sources, including potentially collaborations, licenses and other similar arrangements. Our primary uses of capital are, and we expect will continue to be, compensation and related expenses, third-party clinical research and development services, costs relating to the build-out of our headquarters and manufacturing facility, license payments or milestone obligations that may arise, laboratory and related supplies, clinical costs, manufacturing costs, legal and other regulatory expenses and general overhead costs. Based upon our current operating plan, we believe that our existing cash, cash equivalents and restricted cash as of December 31, 2019, 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 currently expect. We will continue to require additional financing to advance our current product candidates through clinical development, to develop, acquire or in-license other potential product candidates and to fund operations for the foreseeable future. We will continue to seek funds through equity offerings, debt financings or other capital sources, including potentially collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. 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. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. If we are unable to raise capital, we will need to delay, reduce or terminate planned activities to reduce costs. 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 nonclinical studies and clinical trials; • the timing of, and the costs involved in, obtaining regulatory approvals or clearances for our lead product candidates or any future product candidates; • the number and characteristics of any additional product candidates we develop or acquire; • the timing of any cash milestone payments if we successfully achieve certain predetermined milestones; • 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 manufacturing capabilities; • 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 expenses needed to attract and retain skilled personnel; • the costs associated with being a public company; and • the timing, receipt and amount of sales of any future approved or cleared products, if any. 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. Cash flows The following table summarizes our cash flows: Operating activities During the year ended December 31, 2019, cash used in operating activities was $31.1 million and was attributable to a net loss of $32.3 million, a net change of $1.1 million in our operating assets and liabilities, partially offset by non-cash charges of $2.3 million for share-based compensation and depreciation. During the year ended December 31, 2018, cash used in operating activities was $11.0 million and was attributable to a net loss of $12.5 million, partially offset by non-cash charges of $0.5 million and a net change of $1.0 million in our net operating assets and liabilities. Investing activities Our investing activities during the years ended December 31, 2019 and 2018 have consisted principally of purchases of property and equipment. Financing activities Our financing activities during the year ended December 31, 2019 included primarily net proceeds of $149.4 million from our Initial Public Offering in June 2019. Our financing activities during the year ended December 31, 2018 included net proceeds of $115.6 million from closings on our Series A-2 convertible preferred stock financing in January and September 2018 and the sale of Series B convertible preferred stock in October 2018. Contractual obligations and commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: In August 2018, we entered into an agreement to lease approximately 23,000 square feet of space for a term of three years. Lease terms are triple net lease commencing at $0.9 million per year, then with 3% annual base rent increases plus operating expenses, real estate taxes, utilities and janitorial fees. The lease commencement date was December 10, 2018. In December 2018, we entered into an agreement to lease 2,485 square feet of space for a term of three years. The lease includes one renewal option for an additional two years. Lease terms commence at $0.2 million per year, with 2.5% annual base rent increases plus operating expenses, real estate taxes, utilities and janitorial fees. We occupied this space in May 2019. Commitments Our commitments primarily consist of obligations under our agreements with CSHL and the University of Southampton. As of December 31, 2019, we were unable to estimate the timing or likelihood of achieving the milestones or making future product sales. For additional information regarding our agreements, see “Business-License agreements.” Additionally, we have entered into agreements with third-party contract manufacturers for the manufacture and processing of certain of our product candidates for preclinical testing purposes, and we have entered and will enter into other contracts in the normal course of business with contract research organizations for clinical trials and other vendors for other services and products for operating purposes. These agreements generally provide for termination or cancellation, other than for costs already incurred. Off-balance sheet arrangements During the periods presented, we did not have, nor do we currently have, any off-balance sheet arrangements as defined under SEC rules. Critical accounting policies and significant judgments and estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities 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. While our significant accounting policies are more fully described in Note 2 to our consolidated financial statements appearing elsewhere in this annual report on Form 10-K, we believe that the following accounting policies are the most critical in order to fully understand and evaluate our financial condition and results of operations. Accrued Research and Development Expenses As part of the process of preparing financial statements, we are required to estimate and accrue research and development expenses. This process involves the following: • 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 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 investigative sites in connection with clinical studies; • fees paid to contract manufacturing organizations in connection with non-clinical development, preclinical research, and the production of clinical study materials; and • professional service fees for consulting and related services. We base our expense accruals related to non-clinical development, preclinical studies, and clinical trials on our estimates of the services received and efforts expended pursuant to contracts with organizations/consultants 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 may depend on many factors, such as the successful enrollment of patients, site initiation, and the completion of clinical study milestones. Our service providers 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. 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 you 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 We recognize compensation costs related to share-based awards granted to employees and directors, including stock options and vesting restricted stock, based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Fair value of common stock-Historically, for all periods prior to our initial public offering, the fair value of the shares of common stock underlying our share-based awards was estimated on each grant date by our board of directors. 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, or the Practice Aid. Since becoming a public company we have used our stock price to determine fair value of our common stock. • 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 expected term to be the midpoint between the vesting date and the contractual life of the stock-based awards. • Expected volatility-As a privately held company we did not have any trading history for our common stock; accordingly 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. As a public company we have computed the historical volatility of our own stock price and will continue to use the historical volatility data of our common stock. • 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. The following table presents the weighted-average assumptions used to estimate the fair value of share-based awards granted: We will continue to use judgment in evaluating the assumptions utilized for our share-based compensation expense calculations on a prospective basis. In addition to the assumptions used in the Black-Scholes option-pricing model, the amount of stock-based compensation expense we recognize in our consolidated financial statements includes actual stock option forfeitures. Other Information Net Operating Loss Carryforwards As of December 31, 2019 and 2018, we had federal net operating loss carryforwards of $54.5 million and $24.4 million, respectively, which may be available to reduce future taxable income, and expire at various dates beginning in 2034, for those net operating loss carryforwards generated prior to 2018. Net operating losses generated in 2018 and beyond have no expiration. As of December 31, 2019 and 2018, we had state net operating loss carry forwards of $56.3 million and $24.0 million, respectively, which may be available to reduce future taxable income and expire at various dates beginning in 2034. In addition, at December 31, 2019 and 2018, we had federal research and development tax credit carryforwards of $1.5 million and $0.4 million, respectively, and state research and development tax credit carry forwards of $0.8 million and $0.4 million, respectively. Both federal and state research and development tax credit carry forwards may be available to reduce future tax liabilities and expire at various dates beginning in 2030. In accordance with Statement of Accounting Standards Codification (ASC) 740, Accounting for Income Taxes, our management has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets, which are comprised principally of net operating loss carryforwards. Management has determined that it is more likely than not that we will not recognize the benefits of federal and state deferred tax assets and, as a result, a full valuation allowance of $17.9 million and $7.6 million was established at December 31, 2019 and 2018, respectively. The change in the valuation allowance was an increase of $10.3 million and $3.5 million in 2019 and 2018, respectively. Utilization of the net operating loss carryforwards and research and development tax credit carryforwards may be subject to a substantial annual limitation under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended, or the Code due to ownership changes that have occurred previously or that could occur in the future. These ownership changes may limit the amount of carryforwards that can be utilized annually to offset future taxable income. We have not conducted a formal study to assess whether a change of control has occurred or whether there have been multiple changes of control since inception due to the significant complexity and cost associated with such a study. If we have experienced a change of control, as defined for purposes of Section 382 and 383 of the Code, at any time since inception, utilization of the net operating loss carryforwards or research and development tax credit carryforwards may be subject to an annual limitation under Section 382 and 383 of the Code, which is determined by first multiplying the value of our stock at the time of the ownership change by the applicable long-term tax-exempt rate, and then could be subject to additional adjustments, as required. Any limitation may result in expiration of a portion of the net operating loss carryforwards or research and development tax credit carryforwards before utilization. We apply ASC 740 related to accounting for uncertainty in income taxes. Our reserves related to income taxes are based on a determination of whether, and how much of, a tax benefit taken by us in our tax filings or positions is more likely than not to be realized following resolution of any potential contingencies present related to the tax benefit. At December 31, 2019, and 2018 we had no unrecognized tax benefits. Interest and penalty charges, if any, related to unrecognized tax benefits would be classified as income tax expense in the accompanying consolidated statements of operations and comprehensive loss. Emerging growth company and smaller reporting 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 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 consolidated financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (i) the last day of our first fiscal year (a) following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenues of at least $1.07 billion, or (c) when 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 million as of the prior June 30th and (ii) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. We are also a “smaller reporting company,” meaning that the market value of our stock held by non-affiliates plus the proposed aggregate amount of gross proceeds to us as a result of our IPO was 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 after our IPO if either (i) the market value of our 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 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. Recently issued accounting pronouncements In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Updates (ASU) No. 2016-02, Leases (Topic 842). This standard established a right-of-use model that requires all lessees to recognize right-of-use assets and lease liabilities on their balance sheet that arise from leases as well as provide disclosures with respect to certain qualitative and quantitative information related to a company's leasing arrangements. For Income Statement purposes, a dual model was retained requiring leases to be classified as either operating or finance. Operating leases result in straight line expense while finance leases results in a front-loaded expense pattern. In July 2018, the FASB issues ASU 2018-11, which provided for an alternative transition method by allowing entities to apply Topic 842 as of the adoption date. We adopted Topic 842 on January 1, 2020 using the modified retrospective approach and elected to apply the transition method that allows companies to continue applying guidance under the lease standard in effect at that time in the comparative period financial statements and recognize a cumulative-effect adjustment to retained earnings (accumulated deficit) on the date of adoption. We have also elected the package of practical expedients to not reassess our prior conclusions about lease identification, lease classification and indirect costs and to not separate lease and non-lease components Upon adoption of Topic 842 on January 1, 2020, we recorded right-of-use assets of $2.2 million, operating lease liabilities of $2.2 million and the elimination of deferred rent of $0.03 million. Adoption of the standard did not result in us recording a cumulative effect adjustment to retained earnings (accumulated deficit). In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and 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. 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. Current accounting guidance creates cost and complexity for entities that issue financial instruments (such as warrants and convertible instruments) with down round features that require fair value measurement of the entire instrument or conversion option. 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 do not have an accounting effect. For public business entities, the amendments in Part I of ASU-2017-11 are effective for fiscal years and interim periods within those years beginning after December 15, 2018. For all other entities, the amendments in Part I of this update are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. We intend to adopt Part I of this update on January 1, 2020. Early adoption is permitted for all entities, including adoption in an interim period. We are currently assessing the potential impact of adopting ASU 2017-11 on its consolidated financial statements and financial statement disclosures and do not expect that the adoption of this update will have a material impact on our consolidated financial statements. 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”. This ASU removed the following disclosure requirements: (1) the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy; (2) the policy for timing of transfers between levels; and (3) the valuation processes for Level 3 fair value measurements. Additionally, this update added the following disclosure requirements: (1) the changes in unrealized gains and losses for the period included in other comprehensive income and loss for recurring Level 3 fair value measurements held at the end of the reporting period; (2) the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. For certain unobservable inputs, an entity may disclose other quantitative information (such as the median or arithmetic average) in lieu of the weighted average if the entity determines that other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 will be effective for all entities, for fiscal years beginning after December 15, 2019 with early adoption permitted. We intend to adopt this standard on January 1, 2020 and we do not expect that the adoption of this update will have a material impact on our consolidated financial statements. Quantitative and Qualitative disclosures about market risk Interest rate risk We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate sensitivities. We held cash, cash equivalents and restricted cash of $222.7 million and $105.6 million as of December 31, 2019 and 2018 respectively. We generally hold our cash in interest-bearing money market accounts. Our primary exposure to market risk is interest rate sensitivity, which is affected by changes in the general level of U.S. interest rates. An immediate 100 basis point change in interest would affect the fair market value of our cash equivalents by approximately $2.2 million.

<s>[INST] Overview We are pioneering a new way to treat the underlying causes of severe genetic diseases by precisely upregulating protein expression. We are developing novel antisense oligonucleotide, or ASO, medicines that target ribonucleic acid, or RNA, and modulate precursormessenger RNA, or premRNA, splicing to upregulate protein expression where needed and with appropriate specificity to near normal levels. We utilize our proprietary technology platform, Targeted Augmentation of Nuclear Gene Output, or TANGO, to design ASOs to upregulate the expression of protein by individual genes in a patient. Our approach is designed to allow us to deliver in a highly precise, durable and controlled manner diseasemodifying therapies to a wide range of relevant tissues, including the central nervous system, or CNS, eye, kidney and liver. We designed our lead product candidate, STK001, to treat Dravet syndrome, a severe and progressive genetic epilepsy. With a welldefined patient population based on routine genetic testing and learnings from drugs approved for the treatment of Dravet syndrome to inform the clinical and regulatory pathways for STK001, we anticipate an efficient clinical program for STK001. We submitted an investigational new drug application, or IND, for STK001 to U.S. Food and Drug Administration, or the FDA, in late 2019. In the first quarter of 2020, we received communication from the FDA confirming that we may proceed with clinical dosing in the planned Phase 1/2a clinical trial called Monarch. The single ascending dose portion of this trial is in two parts, A and B, and is designed to evaluate STK001 in children and adolescents ages 2 to 18 years of age with Dravet syndrome. Part A allows dosing of two cohorts. We expect to enroll and begin dosing patients in Part A of the study in the second half of 2020. Part B of the study will evaluate the higher doses of STK001. The FDA has placed a partial clinical hold for the doses planned in Part B of the study. The partial clinical hold was not due to any identified manufacturing or safety issue, but rather was because additional safety information is needed from preclinical testing to determine the safety profile of doses higher than the current no observed adverse effect level or NOAEL. The NOAEL was determined using data from a pivotal nonhuman primate study that evaluated intrathecal delivery of single dose levels of STK001. The highest dose administered in this study was equivalent to a human dose that is higher than what we plan to administer in Part B of our Phase 1/2a clinical study and did not demonstrate effects that were considered adverse. It is the FDA’s position that in order to support administration of STK001 doses above those planned in Part A, additional nonclinical data to identify any potential safety issues of STK001 at higher doses will need to be provided. We have initiated singledose toxicology studies to more fully characterize the safety profile at higher doses, in order to facilitate the removal of the partial clinical hold and proceed to Part B of the study. Upon FDA clearance, we will plan to proceed with the higher dosing cohorts planned in Part B of the study. We are working to minimize any potential delay to continued clinical testing of STK001. We still anticipate preliminary data from the study in 2021. We intend to nominate a second candidate for preclinical development in the second half of 2020. We were incorporated in June 2014. In July 2015 and April 2016, we entered into worldwide license agreements with Cold Spring Harbor Laboratory, or CSHL, and the University of Southampton, respectively, with respect to certain licensed patents and applications relating to TANGO. TANGO exploits nonproductive splicing events to effect targeted enhancement of protein expression. Since our inception through December 31, 2019, our operations have been financed by net proceeds of $280.4 million from the sale of convertible notes payable and our convertible preferred stock as well as our [/INST] Negative. </s>

Galera Therapeutics, Inc.

2020-03-10

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes and other financial information included elsewhere in this 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 Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described below. A discussion of the year ended December 31, 2018 compared to the year ended December 31, 2017 has been reported previously in our final prospectus, dated November 6, 2019, filed with the SEC pursuant to Rule 424(b) under the Securities Act relating to our Registration Statement on Form S-1 (File No. 333-234184), under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Overview We are a clinical stage biopharmaceutical company focused on developing and commercializing a pipeline of novel, proprietary therapeutics that have the potential to transform radiotherapy in cancer. We leverage our expertise in superoxide dismutase mimetics to design drugs to reduce normal tissue toxicity from radiotherapy and to increase the anti-cancer efficacy of radiotherapy. Our lead product candidate, GC4419, is a potent and highly selective small molecule dismutase mimetic we are initially developing for the reduction of severe oral mucositis, or SOM. SOM is a common, debilitating complication of radiotherapy in patients with head and neck cancer, or HNC. In February 2018, the U.S. Food and Drug Administration, or FDA, granted Breakthrough Therapy Designation to GC4419 for the reduction of SOM induced by radiotherapy with or without systemic therapy. In October 2018, we began evaluating GC4419 in a Phase 3 registrational trial and we expect to report top-line data from this trial in the first half of 2021. We believe GC4419, which to date is not approved for any indication, has the potential to be the first FDA-approved drug and the standard of care for the reduction in the incidence of SOM in patients with HNC receiving radiotherapy, and we plan to further evaluate its use in other radiotherapy-induced toxicities, including esophagitis. In January 2020, we announced that the first patient was dosed in a Phase 2a trial evaluating the efficacy of GC4419 in reducing the incidence of radiotherapy-induced esophagitis in patients with lung cancer. We are also developing a second dismutase mimetic product candidate, GC4711, to increase the anti-cancer efficacy of stereotactic body radiation therapy, or SBRT. Since our inception, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring and developing product and technology rights, and conducting research and development. We have incurred recurring losses and negative cash flows from operations and have funded our operations primarily through the sale and issuance of equity and proceeds received under the Royalty Agreement with Clarus, receiving aggregate gross proceeds of $253.1 million through December 31, 2019. On November 12, 2019, we completed our initial public offering, or IPO, which resulted in the issuance and sale of 5,000,000 shares of common stock at the IPO price of $12.00 per share, generating net proceeds of $53.0 million after deducting underwriting discounts and other offering costs. On December 9, 2019, in connection with the partial exercise of the over-allotment option granted to the underwriters of our IPO, 445,690 additional shares of common stock were sold at the IPO price of $12.00 per share, generating net proceeds of $5.0 million after deducting underwriting discounts and other offering costs. 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 loss was $51.9 million and $23.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had $112.3 million in cash, cash equivalents and short-term investments and an accumulated deficit of $161.4 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future as we operate as a public company, advance our product candidates through all stages of development and clinical trials and, ultimately, seek regulatory approval. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. As a result, we will need to raise substantial additional capital 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 plan 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. There is no assurance that we will be successful in obtaining an adequate level of financing as and when needed to finance our operations on terms acceptable to us or at all. If we are unable to secure adequate additional funding as and when needed, we may have to significantly delay, scale back or discontinue the development and commercialization of one or more 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. We expect our existing cash, cash equivalents and short-term investments, including the $20.0 million payment received from Clarus in February 2020 for the achievement of the third clinical milestone in our Phase 3 Reduction in Oral Mucositis with Avasopasem Manganese Trial, or ROMAN trial, under the Royalty Agreement with Clarus, together with the $20.0 million payment from Clarus expected to be received upon the achievement of the remaining specified clinical milestone in our ROMAN trial, will enable us to fund our operating expenses and capital expenditure requirements into 2022. Critical Accounting Policies Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements 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 financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses and stock-based compensation. We base our estimates on historical experience, known trends and events, and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 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 the following accounting policies are the most critical to the judgments and estimates used in the preparation of our financial statements. In-Process Research and Development and Goodwill Intangible assets acquired in a business combination are recognized separately from goodwill and are initially recognized at their fair value at the acquisition date. Intangible assets related to in-process research and development, or IPR&D, are treated as indefinite lived intangible assets and not amortized until they are placed into service, typically upon regulatory approval. At that time, we will determine the useful life of the intangible asset and begin amortization. IPR&D assets are reviewed for impairment annually or more frequently if indicators of potential impairment exist. There were no impairments of IPR&D assets for the years ended December 31, 2019 and 2018. Goodwill represents the excess of the purchase price over the estimated fair value of the identifiable assets acquired and liabilities assumed in a business combination. We evaluate goodwill for impairment annually or more frequently upon the occurrence of triggering events or substantive changes in circumstances that could indicate a potential impairment. An impairment loss is recognized when the fair value of the reporting unit to which the goodwill relates is below its carrying value for the difference between the fair value and its carrying amounts. There was no impairment of goodwill for the years ended December 31, 2019 and 2018. Royalty Purchase Liability Pursuant to our Royalty Agreement with Clarus, we received a cash payment of $20.0 million in each of November 2018, April 2019 and February 2020 and are eligible to receive up to an additional $20.0 million from Clarus based upon the achievement of the remaining specified clinical milestone in our ROMAN Trial. We have accounted for the Royalty Agreement under Accounting Standards Codification Topic 470, Debt. The proceeds received are recorded as long-term debt obligations. Interest expense on such obligation is imputed by estimating risk adjusted future royalty payments over the term of the Royalty Agreement which takes into consideration the probability of obtaining FDA approval. Other significant assumptions include adjustments to estimated gross revenues to arrive at net product sales from which a royalty payment can be estimated. The non-cash interest expense recorded increases the balance of our royalty obligation. The royalty obligation will be reduced when royalty payments are made, if any. However, actual royalty payments are highly uncertain and may change depending on a number of factors, including our ability to obtain FDA approval, successfully commercialize our product candidates and the timing of future royalty payments. We impute interest expense on our royalty purchase obligations based on such factors at each reporting period. As these factors change, we will adjust our estimate of the imputed interest expense accordingly. Research and Development Expenses Research and development expenses consist primarily of costs incurred in connection with the development of our product candidates. We expense research and development costs as incurred. We accrue an expense for manufacturing, pre-clinical studies and clinical trial activities performed by third parties based upon estimates of the proportion of work completed over the term of the individual trial and patient enrollment rates in accordance with agreements with CMOs, CROs and clinical trial sites. We determine the estimates by reviewing contracts, vendor agreements and purchase orders, and through discussions with our internal research and development personnel and external service providers as to the progress or stage of completion of trials or services and the agreed-upon fee to be paid for such services. However, actual costs and timing of these activities are highly uncertain, subject to risks and may change depending upon a number of factors, including our clinical development plan. We make estimates of our accrued expenses as of each balance sheet date in our consolidated financial statements based on facts and circumstances known at that time. If the actual timing of the performance of services or the level of effort varies from the estimate, we will adjust the accrual accordingly. Nonrefundable advance payments for goods and services, including fees for process development or manufacturing and distribution of clinical supplies that will be used in future research and development activities, are deferred and recognized as expense in the period that the related goods are consumed or services are performed. Recent Accounting Pronouncements See Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a description of recent accounting pronouncements applicable to our consolidated financial statements. JOBS Act Transition Period In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we have chosen to opt out of such extended transition period and, as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable. However, we may take advantage of the other exemptions discussed below. Subject to certain conditions, as an emerging growth company we may rely on certain exemptions and reduced reporting requirements, including, without limitation, (1) not being required to provide an auditor’s attestation report on our system of internal control over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act and (2) not being required to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. We will remain an emerging growth company until the earlier to occur of (a) the last day of the fiscal year in which we have total annual gross revenues 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 IPO (December 31, 2024), (c) the date on which we have issued more than $1 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, which means 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. Components of Results of Operations Research and Development Expense Research and development expenses consist primarily of costs incurred in connection with the discovery and development of our product candidates. We expense research and development costs as incurred. These expenses include: • expenses incurred to conduct the necessary pre-clinical studies and clinical trials required to obtain regulatory approval; • personnel expenses, including salaries, benefits and share-based compensation expense for employees engaged in research and development functions; • costs of funding research performed by third parties, including pursuant to agreements with CROs, as well as investigative sites and consultants that conduct our pre-clinical studies and clinical trials; • expenses incurred under agreements with CMOs, including manufacturing scale-up expenses and the cost of acquiring and manufacturing pre-clinical study and clinical trial materials; • fees paid to consultants who assist with research and development activities; • expenses related to regulatory activities, including filing fees paid to regulatory agencies; and • allocated expenses for facility costs, including rent, utilities, depreciation and maintenance. We track our external research and development expenses on a program-by-program basis, such as fees paid to CROs, CMOs and research laboratories in connection with our pre-clinical development, process development, manufacturing and clinical development activities. However, we do not track our internal research and development expenses on a program-by-program basis as they primarily relate to compensation, early research and other costs which are deployed across multiple projects under development. The following table summarizes our research and development expenses by program for the years ended December 31, 2019 and 2018 (in thousands): Research and development activities are central to our business model. Product candidates in later stages of clinical development, such as GC4419, generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to increase significantly over the next several years as we increase personnel costs, including stock-based compensation, conduct our later-stage clinical trials for GC4419 and GC4711 and conduct other clinical trials for current and future product candidates and prepare regulatory filings for our product candidates. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate or know the nature, timing and costs of the efforts that will be necessary to complete the remainder of the development of our product candidates, or when, if ever, material net cash inflows may commence from our product candidates. This uncertainty is due to the numerous risks and uncertainties associated with the duration and cost of clinical trials, which vary significantly over the life of a project as a result of many factors, including: • delays in regulators or institutional review boards authorizing us or our investigators to commence our clinical trials, or in our ability to negotiate agreements with clinical trial sites or CROs; • our ability to secure adequate supply of our product candidates for our trials; • the number of clinical sites included in the trials; • the ability and the length of time required to enroll suitable patients; • the number of patients that ultimately participate in the trials; • the number of doses patients receive; • any side effects associated with our product candidates; • the duration of patient follow-up; • the results of our clinical trials; • significant and changing government regulations; and • launching commercial sales of our product candidates, if and when approved, whether alone or in collaboration with others. Our expenditures are subject to additional uncertainties, including the terms and timing of regulatory approvals. We may never succeed in achieving regulatory approval for our product candidates. We may obtain unexpected results from our clinical trials. We may elect to discontinue, delay or modify clinical trials of our product candidates. A change in the outcome of any of these variables with respect to the development of a product candidate could mean a significant change in the costs and timing associated with the development of that product candidate. For example, if the FDA or other regulatory authorities were to require us to conduct clinical trials beyond those that we currently anticipate, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on the completion of clinical development. Product commercialization will take several years, and we expect to spend a significant amount in development costs. General and Administrative Expense General and administrative expense consists primarily of personnel expenses, including salaries, benefits and share-based compensation expense for employees in executive, finance, accounting, information technology, business development and human resource functions. General and administrative expense also includes corporate facility costs, including rent, utilities, depreciation and maintenance, not otherwise included in research and development expense, as well as legal fees related to intellectual property and corporate matters and fees for accounting and consulting services. We expect that our general and administrative expense will increase in the future to support our continued research and development activities, potential commercialization efforts and to enable us to operate as a public company. These increases will likely include increased costs related to the hiring of additional personnel, fees to outside consultants, lawyers and accountants and expenses related to services associated with maintaining compliance with the requirements of Nasdaq and the SEC, insurance and investor relations costs. If any of our current or future product candidates obtains U.S. regulatory approval, we expect that we would incur significantly increased expenses associated with building a sales and marketing team. Interest Income Interest income consists of amounts earned on our cash, cash equivalents and short-term investments held with large institutional banks, U.S. Treasury obligations and a money market mutual fund invested in U.S. Treasury obligations, and our short-term investments in U.S. Treasury obligations. Interest Expense Interest expense consists of non-cash interest on proceeds received under the Royalty Agreement with Clarus. Foreign Currency Losses Foreign currency losses consist primarily of exchange rate fluctuations on transactions denominated in a currency other than the U.S. dollar. Income Tax Benefit Since inception, we have incurred significant net losses, and until 2017 we had not recorded any U.S. federal or state income tax benefits for the losses as they had been offset by valuation allowances. We recognized an income tax benefit for the revaluation of our deferred tax liability as a result of the Tax Act, which reduced our corporate tax rate to 21% during the year ended December 31, 2017. As a result of the change in the net operating loss carryforward period associated with the Tax Act, we recognized an income tax benefit to utilize indefinite deferred tax liabilities as a source of income against indefinite lived portions of our deferred tax assets during the year ended December 31, 2018. Net Operating Loss and Research and Development Tax Credit Carryforwards As of December 31, 2019, we had federal and state tax net operating loss carryforwards of $91.5 million and $113.6 million, respectively, which each begin to expire in 2032 unless previously utilized. We also had foreign net operating loss carryforwards of $1.2 million which do not expire. As of December 31, 2019, we also had federal, state and foreign research and development tax credit carryforwards of $5.1 million. The federal research and development tax credit carryforwards will begin to expire in 2032 unless previously utilized. Utilization of the federal and state net operating losses and credits may be subject to a substantial annual limitation. The annual limitation may result in the expiration of our net operating losses and credits before we can use them. We have recorded a valuation allowance on substantially all of our deferred tax assets, including our deferred tax assets related to our net operating loss and research and development tax credit carryforwards. Results of Operations for the Years Ended December 31, 2019 and 2018 The following table sets forth our results of operations for the years ended December 31, 2019 and 2018 (in thousands): Research and Development Expense Research and development expense increased by $23.7 million from $18.7 million for the year ended December 31, 2018 to $42.3 million for the year ended December 31, 2019. The increase was primarily attributable to increases of $16.9 million and $3.0 million for GC4419 and GC4711 development costs, respectively, as we initiated our ROMAN trial in October 2018, began additional toxicology studies of GC4419 and began a new clinical trial and additional toxicology studies of GC4711. Personnel related and share-based compensation expense increased by $2.7 million primarily due to increased employee headcount. General and Administrative Expense General and administrative expense increased by $2.8 million from $5.6 million for the year ended December 31, 2018 to $8.4 million for the year ended December 31, 2019. The increase was primarily due to increased employee headcount and increased insurance, professional fees and other operating costs as a result of becoming a public company. Interest Income Interest income increased by $1.2 million from $0.6 million for the year ended December 31, 2018 to $1.8 million for the year ended December 31, 2019. The increase was primarily due to higher average invested cash balances. Interest Expense We recognized $3.0 million and $0.2 million in non-cash interest expense during the years ended December 31, 2019 and 2018, respectively, in connection with the Royalty Agreement with Clarus. Income Tax Benefit We recorded an income tax benefit of $0.2 million during the year ended December 31, 2018 as a result of the change in the net operating loss carryforward period to reflect the adjustment allowed by the Tax Act to utilize indefinite deferred tax liabilities as a source of income against indefinite lived portions of our deferred tax assets. Liquidity and Capital Resources Through December 31, 2019, we have funded our operations primarily through the sale and issuance of equity and proceeds received under the Royalty Agreement with Clarus, receiving aggregate gross proceeds of $253.1 million. On November 12, 2019, we completed our IPO, which resulted in the issuance and sale of 5,000,000 shares of common stock at a public offering price of $12.00 per share, generating net proceeds of $53.0 million after deducting underwriting discounts and other offering costs. On December 9, 2019, in connection with the partial exercise of the over-allotment option granted to the underwriters of our IPO, 445,690 additional shares of common stock were sold at the IPO price of $12.00 per share, generating net proceeds of approximately $5.0 million after deducting underwriting discounts and other offering costs. As of December 31, 2019, we had $112.3 million in cash, cash equivalents and short-term investments and an accumulated deficit of $161.4 million. We have no ongoing material financing commitments, such as lines of credit or guarantees, that are expected to affect our liquidity over the next five years. Cash Flows The following table shows a summary of our cash flows for the periods indicated (in thousands): Operating Activities During the year ended December 31, 2019, we used $46.7 million of net cash in operating activities. Cash used in operating activities reflected our net loss of $51.9 million and a $0.5 million net decrease in our operating assets and liabilities, partially offset by non-cash charges of $5.7 million related to share-based compensation, interest expense on our Royalty Agreement with Clarus and depreciation expense. The primary use of cash was to fund our operations related to the development of our product candidates. During the year ended December 31, 2018, we used $22.2 million of net cash in operating activities. Cash used in operating activities reflected our net loss of $23.7 million and a $0.3 million net increase in our operating assets and liabilities, partially offset by non-cash charges of $1.2 million related to share-based compensation, interest expense on our Royalty Agreement with Clarus and depreciation expense. The primary use of cash was to fund our operations related to the development of our product candidates. Investing Activities During the year ended December 31, 2019, we used $27.8 million of net cash in investing activities, primarily attributable to the $27.2 million in net purchases of our short-term investments and $0.6 million for the purchase of property and equipment. During the year ended December 31, 2018, we used $59.0 million of net cash in investing activities, primarily attributable to $58.7 million in net purchases of our short-term investments and $0.3 million for the purchase of property and equipment. Financing Activities During the year ended December 31, 2019, financing activities provided $78.0 million in net cash proceeds, primarily attributable to $58.0 million of net proceeds from the issuance of common stock in connection with the IPO and $20.0 million in proceeds received in connection with the Royalty Agreement with Clarus. During the year ended December 31, 2018, financing activities provided $89.8 million in net cash proceeds, primarily attributable to $69.8 million in net proceeds from the sale of our Series C redeemable convertible preferred stock and $20.0 million in proceeds received in connection with the Royalty Agreement with Clarus. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we continue the research and development of, continue or initiate clinical trials of, and seek marketing approval for, our product candidates. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Furthermore, we expect to incur additional costs associated with operating as a public company. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce or eliminate our research and development programs or future commercialization efforts. We anticipate that our expenses will increase substantially as we: • complete clinical development of GC4419 for the reduction of SOM in patients with locally advanced HNC, including our ongoing Phase 3 clinical trial; • prepare and file for regulatory approval of GC4419 for the reduction of SOM in patients with HNC; • advance our ongoing Phase 2a clinical trial of GC4419 for the reduction in the incidence of radiotherapy-induced esophagitis; • initiate and advance our planned Phase 1b/2a clinical trial for GC4711 to increase the anti-cancer efficacy of SBRT, in patients with NSCLC; • seek to discover and develop additional clinical and pre-clinical product candidates; • scale up our clinical and regulatory capabilities; • adapt our regulatory compliance efforts to incorporate requirements applicable to marketed products; • establish a sales, marketing and distribution infrastructure and scale up external manufacturing capabilities to commercialize any product candidates for which we may obtain regulatory approval; • maintain, expand and protect our intellectual property portfolio; • hire additional internal or external clinical, manufacturing and scientific personnel or consultants; • add operational, financial and management information systems and personnel, including personnel to support our product development efforts; and • incur additional legal, accounting, insurance and other expenses in operating as a public company. We expect our existing cash, cash equivalents and short-term investments, including the $20.0 million payment received from Clarus in February 2020 for the achievement of the third clinical milestone in our ROMAN trial under the Royalty Agreement with Clarus, together with the $20.0 million payment from Clarus expected to be received upon the achievement of the remaining specified clinical milestone in our ROMAN trial, will enable us to fund our operating expenses and capital expenditure requirements into 2022. 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 pre-clinical studies and clinical trials; • the scope, prioritization and number of our research and development programs; • the costs, timing and outcome of regulatory review of our product candidates; • our ability to establish and maintain collaborations on favorable terms, if at all; • the extent to which we are obligated to reimburse, or entitled to reimbursement of, clinical trial costs under collaboration agreements, if any; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • the extent to which we acquire or in-license other product candidates and technologies; • the costs of securing manufacturing arrangements for commercial production; and • the costs of establishing or contracting for sales and marketing capabilities if we obtain regulatory approvals to market our product candidates. Identifying potential product candidates and conducting pre-clinical studies and clinical trials is a time-consuming, expensive and uncertain process that takes many years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of product candidates that we do not expect to be commercially available for the next couple of years, if at all. Accordingly, we will need to continue to rely on additional financing to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. Until such time, if ever, as we can generate substantial product revenues, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our existing stockholders’ rights. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds 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. Royalty Agreement with Clarus In November 2018, we entered into an Amended and Restated Purchase and Sale Agreement, or the Royalty Agreement, with Clarus IV Galera Royalty AIV, L.P., Clarus IV-A, L.P., Clarus IV-B, L.P., Clarus IV-C, L.P. and Clarus IV-D, L.P., or, collectively, Clarus. Pursuant to the Royalty Agreement, Clarus agreed to pay us, in the aggregate, up to $80.0 million, or the Royalty Purchase Price, in four tranches of $20.0 million each upon the achievement of specified clinical milestones in our ROMAN Trial. We agreed to apply the proceeds from such payments primarily to support clinical development and regulatory activities for GC4419, GC4711 and any pharmaceutical product comprising or containing GC4419 or GC4711, or, collectively, the Products, as well as to satisfy working capital obligations and for general corporate expenses. We achieved the first milestone under the Royalty Agreement and received the first tranche of the Royalty Purchase Price in November 2018, received the second tranche of the Royalty Purchase Price in April 2019 in connection with the achievement of the second milestone under the Royalty Agreement, and received the third tranche of the Royalty Purchase Price in February 2020 in connection with the achievement of the third milestone under the Royalty Agreement. In connection with the payment of each tranche of the Royalty Purchase Price, we have agreed to sell, convey, transfer and assign to Clarus all of our right, title and interest in a mid-single digit percentage of (i) the gross amount from the worldwide net sale of the Products and (ii) all amounts received by us or our affiliates, licensees and sublicensees (collectively, the Product Payments) during the Royalty Period. The Royalty Period means, on a Product-by-Product and country-by-country basis, the period of time commencing on the commercial launch of such Product in such country and ending on the latest to occur of (i) the 12th anniversary of such commercial launch, (ii) the expiration of all valid claims of our patents covering such Product in such country, and (iii) the expiration of regulatory data protection or market exclusivity or similar regulatory protection afforded by the health authorities in such country, to the extent such protection or exclusivity effectively prevents generic versions of such Product from entering the market in such country. The Royalty Agreement will remain in effect until the date on which the aggregate amount of the Product Payments paid to Clarus exceeds a fixed single-digit multiple of the actual amount of the Royalty Purchase Price received by us, unless earlier terminated pursuant to the mutual written agreement of us and Clarus. Off-Balance Sheet Arrangements We do not have 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. We do not engage in off-balance sheet financing arrangements. In addition, we do not engage in trading activities involving non-exchange traded contracts. We therefore believe that we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships. Effect of Inflation Inflation did not have a significant impact on our net loss for the years ended December 31, 2019 or 2018.

<s>[INST] Overview We are a clinical stage biopharmaceutical company focused on developing and commercializing a pipeline of novel, proprietary therapeutics that have the potential to transform radiotherapy in cancer. We leverage our expertise in superoxide dismutase mimetics to design drugs to reduce normal tissue toxicity from radiotherapy and to increase the anticancer efficacy of radiotherapy. Our lead product candidate, GC4419, is a potent and highly selective small molecule dismutase mimetic we are initially developing for the reduction of severe oral mucositis, or SOM. SOM is a common, debilitating complication of radiotherapy in patients with head and neck cancer, or HNC. In February 2018, the U.S. Food and Drug Administration, or FDA, granted Breakthrough Therapy Designation to GC4419 for the reduction of SOM induced by radiotherapy with or without systemic therapy. In October 2018, we began evaluating GC4419 in a Phase 3 registrational trial and we expect to report topline data from this trial in the first half of 2021. We believe GC4419, which to date is not approved for any indication, has the potential to be the first FDAapproved drug and the standard of care for the reduction in the incidence of SOM in patients with HNC receiving radiotherapy, and we plan to further evaluate its use in other radiotherapyinduced toxicities, including esophagitis. In January 2020, we announced that the first patient was dosed in a Phase 2a trial evaluating the efficacy of GC4419 in reducing the incidence of radiotherapyinduced esophagitis in patients with lung cancer. We are also developing a second dismutase mimetic product candidate, GC4711, to increase the anticancer efficacy of stereotactic body radiation therapy, or SBRT. Since our inception, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, acquiring and developing product and technology rights, and conducting research and development. We have incurred recurring losses and negative cash flows from operations and have funded our operations primarily through the sale and issuance of equity and proceeds received under the Royalty Agreement with Clarus, receiving aggregate gross proceeds of $253.1 million through December 31, 2019. On November 12, 2019, we completed our initial public offering, or IPO, which resulted in the issuance and sale of 5,000,000 shares of common stock at the IPO price of $12.00 per share, generating net proceeds of $53.0 million after deducting underwriting discounts and other offering costs. On December 9, 2019, in connection with the partial exercise of the overallotment option granted to the underwriters of our IPO, 445,690 additional shares of common stock were sold at the IPO price of $12.00 per share, generating net proceeds of $5.0 million after deducting underwriting discounts and other offering costs. 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 loss was $51.9 million and $23.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had $112.3 million in cash, cash equivalents and shortterm investments and an accumulated deficit of $161.4 million. We expect to continue to incur significant expenses and operating losses for the foreseeable future as we operate as a public company, advance our product candidates through all stages of development and clinical trials and, ultimately, seek regulatory approval. In addition, if we obtain marketing approval for any of our product candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. As a result, we will need to raise substantial additional capital to support our continuing operations and pursue our growth strategy. Until such time as we can generate significant revenue from product sales, if ever, [/INST] Negative. </s>

Anchiano Therapeutics Ltd.

2020-03-17

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 included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis, particularly with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. You should read “Risk Factors” in Item 1A of 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 in or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are an early-stage preclinical biopharmaceutical company dedicated to the discovery, development, and commercialization of novel targeted therapies to treat cancer in areas of significant clinical need. Throughout most of 2019, we ran a Phase 2 study, designated Codex, evaluating the gene therapy inodiftagene in patients with BCG-unresponsive NMIBC. However, in November 2019, after a thorough evaluation of data, we determined there was a low probability of surpassing the pre-defined futility threshold at the planned interim analysis of the study, and announced the discontinuation of the study and of active clinical development of inodiftagene. We recently acquired two developmental programs targeting oncogenic pathways (small-molecule pan-RAS inhibitors and inhibitors of PDE10 and the β-catenin pathway) pursuant to the Collaboration Agreement into which we entered with ADT on September 20, 2019. Our operations are focused on the successful development, regulatory approval and commercialization of products derived from the compounds contemplated thereby, which are in the concept, research and preclinical stages. Under the agreement, we are primarily responsible for the research, development, manufacturing and regulatory activities with respect to the Compounds. For further information regarding our business and operations, see “Item 1. Business.” Our corporate structure consists of a parent company, Anchiano Therapeutics Ltd. (formerly BioCancell Ltd.), incorporated in Israel, which wholly owns a subsidiary, Anchiano Therapeutics Israel Ltd. (formerly BioCanCell Therapeutics Israel Ltd.), incorporated in Israel, which itself wholly owns a subsidiary, Anchiano Therapeutics, Inc. (formerly BioCanCell USA, Inc.), incorporated in Delaware. We currently maintain offices in Cambridge, MA and an office and laboratory in Jerusalem, Israel. However in January 2020, our board of directors approved our management’s recommendation to close our Israeli office and laboratories in 2020, with our operations to continue from our Cambridge office. Acquisition Agreement In September 2019, we announced that we had entered into the option to license Agreement with ADT. Pursuant to the terms and conditions set forth in the agreement, we have mutually agreed to use commercially reasonable efforts to conduct research and development activities of novel small-molecule inhibitors (RAS and PDE10/β-catenin) . As part of the arrangement, we will be primarily responsible for the research, development, manufacturing and regulatory activities and ADT will assist with the research activities as necessary in exchange for a quarterly fee. In connection with the agreement, ADT also granted us exclusive rights to research, develop, manufacture and commercialize the aforementioned compounds relating to patents owned by ADT and any products containing such compounds worldwide. In consideration for the rights granted under the agreement, we will pay ADT (i) a $3 million upfront fee; (ii) a fee upon transfer of the know-how and intellectual property rights to us; and (iii) additional payments, including milestone and royalty payments. We may terminate the agreement at any time in its entirety or on a compound-by-compound basis after providing 90 days written notice to ADT. The upfront fee was paid in 2019. Since there is no alternative future use for the upfront fee, we accounted for it as a research and development expense. Transition to U.S. GAAP As of June 30, 2019, we have no longer met the requirements to qualify as a foreign private issuer under the Exchange Act. As a result, we began reporting as a domestic issuer as of January 1, 2020 and we are now required under SEC rules to prepare our financial statements in accordance with U.S. GAAP, rather than IFRS. The main impact of the transition from consolidated financial statements under IFRS to U.S. GAAP on our consolidated financial statements as at December 31, 2018 included the treatment of our 2018 financing round. In our IFRS financials, the warrants and the price protection rights were accounted for as two derivative financial instruments. Accordingly, such derivatives were measured initially at fair value on the date of the transaction with the remaining balance, representing the issued shares, being allocated to equity. In the current US GAAP financials, on initial measurement, both of the freestanding instruments (warrants and shares together with their price protections) were classified as equity instruments that are not subsequently measured at fair value, Functional currency Items included in the financial statements of our entities are measured using the currency of the primary economic environment in which we operate. Our functional currency from inception through December 31, 2018 was the New Israeli Shekel (“NIS”), as this was the functional currency of its significant operations. Effective January 1, 2019, we, including our Israeli subsidiary, reassessed our functional currency and determined to change our functional currency to the U.S. dollar (“dollar”, “USD” or “$”) from the NIS. The change in functional currency was accounted for prospectively from January 1, 2019, and the financial statements prior to and including the period ended December 31, 2018 were not restated for the change in functional currency. In late 2018 and the beginning of 2019, we went through significant business developments and changes in its economic circumstances, that clearly indicate that the functional currency has changed, beginning January 2019, include the following: - There has been a significant increase in our activities in the USA, resulting from our management’s strategic decision to shift our development, financing and ongoing operations from Israel to the USA, as evidenced, inter alia, by the transfer of our operations and development activities, including our management, to the USA; - The initiation of a pivotal clinical trial in the USA, which was substantially larger than any previous clinical trial that we had performed, all of which result in a significant increase in expenses and financing denominated in USD relative to other currencies; - Our recent initial public offering on the Nasdaq Capital Market in USD, with additional funding going forward also expected to be denominated in USD. The Nasdaq listing has involved a significant increase in related USD expenses; and - Our U.S. subsidiary entering into a license agreement with ADT Pharmaceuticals, LLC (“ADT”), which will be managed solely in dollars. Moreover, the discontinuation of the Codex study in November 2019 led to the closure of our Israeli operations and the focus of our resources on programs related to the ADT agreement. In effecting the change in functional currency to the U.S. dollar, as of January 1, 2019, monetary assets and liabilities denominated in foreign currencies have been translated into U.S. dollars using exchange rates in effect at the balance sheet date. Opening balances related to non-monetary assets and liabilities were based on prior period translated amounts, and non-monetary assets acquired and non-monetary liabilities incurred after January 1, 2019 were translated at the approximate exchange rate prevailing at the date of the transaction. Expenses were translated at the approximate exchange rate in effect at the time of the transaction. Foreign exchange gains and losses were included in the consolidated statement of operations and comprehensive loss as foreign exchange gain (loss). The exchange rate on the date of the change became the historical rate for subsequent re-measurement of non-monetary assets and liabilities into USD, our new functional currency. For periods prior to January 1, 2019, the effects of exchange-rate fluctuations on translating foreign currency monetary assets and liabilities into NIS were included in the statement of operations and comprehensive loss as foreign exchange gain/loss. Expense were translated into USD reporting currency at the balance sheet date at average exchange rates during the period, and assets and liabilities were translated at period-end exchange rates, except for equity transactions, which were translated at historical exchange rates. Translation gains and losses from the application of USD as our reporting currency, while NIS was the functional currency, are included as part of the cumulative foreign currency translation adjustment, which is reported as a component of shareholders’ equity under accumulated other comprehensive loss. Components of Operating Results Revenues To date, we have not generated any revenue. We do not expect to receive any revenue unless and until we obtain regulatory approval and commercialize a future product candidate, or until we receive revenue from a collaboration such as a co-development or out-licensing agreement. There can be no assurance that we will receive such regulatory approvals, and if a future product candidate is approved, that we will be successful in commercializing it. Research and Development Expenses Research and development activities are our primary focus. 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 do not believe that it is possible at this time to accurately project total expenses required for us to reach commercialization of our product candidates. Due to the inherently unpredictable nature of preclinical and clinical development, we are unable to estimate with certainty the costs we will incur and the timelines that will be required in the continued development and approval of our product candidates. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. In addition, we cannot forecast which product candidates may be subject to future collaborations, if and when such arrangements will be entered into, if at all, and to what degree such arrangements would affect our development plans and capital requirements. We expect our research and development expenses to increase over the next several years as our clinical programs progress and as we seek to initiate clinical trials of additional product candidates. We also expect to incur increased research and development expenses as we selectively identify and develop additional product candidates. Research and development expenses include the following: · employee-related expenses, such as salaries and share-based compensation; · expenses relating to outsourced and contracted services, such as CROs, external laboratories and consulting, research and advisory services; · supply, development and manufacturing costs relating to clinical trial materials; · expenses incurred in operating our laboratories and small-scale equipment; · preclinical study expenses and related developmental costs; and · costs associated with regulatory compliance. We recognize research and development expenses as we incur them. General and Administrative Expenses General and administrative expenses consist primarily of personnel costs, including share-based compensation related to directors and employees, facility costs, patent application and maintenance expenses, and external professional service costs, including legal, accounting, audit, finance, business development, investor relations and human resource services, and other consulting fees. Finance Expenses, Net Finance expenses, net, consisted primarily of finance expenses recorded due to revaluation of investor warrants at fair value during a period where these could not be classified within equity (for more details, see Note 6c in “

<s>[INST] Overview We are an earlystage preclinical biopharmaceutical company dedicated to the discovery, development, and commercialization of novel targeted therapies to treat cancer in areas of significant clinical need. Throughout most of 2019, we ran a Phase 2 study, designated Codex, evaluating the gene therapy inodiftagene in patients with BCGunresponsive NMIBC. However, in November 2019, after a thorough evaluation of data, we determined there was a low probability of surpassing the predefined futility threshold at the planned interim analysis of the study, and announced the discontinuation of the study and of active clinical development of inodiftagene. We recently acquired two developmental programs targeting oncogenic pathways (smallmolecule panRAS inhibitors and inhibitors of PDE10 and the βcatenin pathway) pursuant to the Collaboration Agreement into which we entered with ADT on September 20, 2019. Our operations are focused on the successful development, regulatory approval and commercialization of products derived from the compounds contemplated thereby, which are in the concept, research and preclinical stages. Under the agreement, we are primarily responsible for the research, development, manufacturing and regulatory activities with respect to the Compounds. For further information regarding our business and operations, see “Item 1. Business.” Our corporate structure consists of a parent company, Anchiano Therapeutics Ltd. (formerly BioCancell Ltd.), incorporated in Israel, which wholly owns a subsidiary, Anchiano Therapeutics Israel Ltd. (formerly BioCanCell Therapeutics Israel Ltd.), incorporated in Israel, which itself wholly owns a subsidiary, Anchiano Therapeutics, Inc. (formerly BioCanCell USA, Inc.), incorporated in Delaware. We currently maintain offices in Cambridge, MA and an office and laboratory in Jerusalem, Israel. However in January 2020, our board of directors approved our management’s recommendation to close our Israeli office and laboratories in 2020, with our operations to continue from our Cambridge office. Acquisition Agreement In September 2019, we announced that we had entered into the option to license Agreement with ADT. Pursuant to the terms and conditions set forth in the agreement, we have mutually agreed to use commercially reasonable efforts to conduct research and development activities of novel smallmolecule inhibitors (RAS and PDE10/βcatenin) . As part of the arrangement, we will be primarily responsible for the research, development, manufacturing and regulatory activities and ADT will assist with the research activities as necessary in exchange for a quarterly fee. In connection with the agreement, ADT also granted us exclusive rights to research, develop, manufacture and commercialize the aforementioned compounds relating to patents owned by ADT and any products containing such compounds worldwide. In consideration for the rights granted under the agreement, we will pay ADT (i) a $3 million upfront fee; (ii) a fee upon transfer of the knowhow and intellectual property rights to us; and (iii) additional payments, including milestone and royalty payments. We may terminate the agreement at any time in its entirety or on a compoundbycompound basis after providing 90 days written notice to ADT. The upfront fee was paid in 2019. Since there is no alternative future use for the upfront fee, we accounted for it as a research and development expense. Transition to U.S. GAAP As of June 30, 2019, we have no longer met the requirements to qualify as a foreign private issuer under the Exchange Act. As a result, we began reporting as a domestic issuer as of January 1, 2020 and we are now required under SEC rules to prepare our financial statements in accordance with U.S. GAAP, rather than IFRS. The main impact of the transition from consolidated financial statements under IFRS to U.S. GAAP on our consolidated financial statements as at December 31, 2018 included the treatment of our 2018 financing round. In our IFRS financials, the warrants and the price protection rights were accounted for as two derivative financial instruments. Accordingly, such derivatives were measured initially at fair value [/INST] Positive. </s>

Morphic Holding, Inc.

2020-02-27

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. You should read the following discussion of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes and other financial information included elsewhere in this Annual Report on Form 10-K. This Annual Report on Form 10-K, including the following sections, contains forward-looking statements within the meaning of the federal securities laws. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those expressed or implied by such forward-looking statements. For a detailed discussion of these risks and uncertainties, see the “Risk Factors” section in Item 1A of this Annual Report on Form 10-K. We caution the reader not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Form 10-K. We undertake no obligation to update forward-looking statements, which reflect events or circumstances occurring after the date of this Form 10-K. Overview We are a biopharmaceutical company applying our proprietary insights into integrins to discover and develop a pipeline of potentially first-in-class oral small-molecule integrin therapeutics. Integrins are a target class with multiple approved injectable blockbuster drugs for the treatment of serious chronic diseases, including autoimmune, cardiovascular and metabolic diseases, fibrosis and cancer. To date, no oral small-molecule integrin therapies have been approved by the FDA. Despite significant unsuccessful efforts, we believe tremendous untapped potential remains for us to develop oral integrin therapies. We created the Morphic integrin technology platform, or MInT Platform, by leveraging our unique understanding of integrin structure and biology to develop novel product candidates designed to achieve the potency, high selectivity, and pharmaceutical properties required for oral administration. We are advancing our preclinical pipeline, including our wholly-owned program MORF-057, a α4β7 specific integrin inhibitor affecting inflammation, into clinical development for the treatment of inflammatory bowel disease, or IBD. We are also developing MORF-720, our selective oral αvβ6 specific integrin inhibitor affecting fibrosis, toward an Investigational New Drug application, or IND. We intend to advance MORF-057 and MORF-720 toward IND submissions by the middle of 2020 and the end of 2020, respectively. Beyond our current targets, we are using our MInT Platform to create a broad pipeline of programs across a variety of therapeutic areas, all of which aim to harness the potential of inhibition or activation. We were formed as a limited liability company under the laws of the State of Delaware in August 2014 under the name Integrin Rock, LLC. We subsequently changed our name to Morphic Rock Holding, LLC in October 2014 and then to Morphic Holding, LLC in June 2016, and we subsequently converted to a corporation under the name Morphic Holding, Inc. in December 2018. In connection with the conversion to a Delaware corporation, or the Reorganization, each of the outstanding units of the members of the limited liability company were converted into shares of capital stock. Upon consummation of the Reorganization, the historical consolidated financial statements of Morphic Holding, LLC became the historical consolidated financial statements of Morphic Holding, Inc. All information included in this Annual Report is presented after giving effect to the Reorganization. On July 1, 2019, we completed the initial public offering, or IPO, of our common stock and issued and sold 6,900,000 shares of common stock at a public offering price of $15.00 per share, which included 900,000 shares sold upon full exercise of the underwriters’ option to purchase additional shares of common stock resulting in net proceeds of $93.3 million after deducting underwriting discounts and commissions and offering expenses. Since inception, our operations have focused on organizing and staffing our company, business planning, raising capital, establishing our intellectual property portfolio, and performing research to discover and develop oral small-molecule integrin therapeutics. Revenue generation activities have been limited to the following. In October 2018, pursuant to our collaboration and option agreement with AbbVie, or the AbbVie Agreement, we received an upfront payment of $100.0 million for research and development activities, and provided to AbbVie exclusive license options on product candidates directed at multiple targets. In March 2019, pursuant to the Janssen Agreement, we received an upfront payment of $10.0 million and provided Janssen with exclusive license options on product candidates directed at multiple targets. In addition, Janssen will reimburse us for research services at market rates. We do not have any products approved for sale and have not generated any revenue from product sales. Through December 31, 2019 in addition to the foregoing sources of revenue, we have funded our operations primarily through the sale and issuance of our convertible preferred equity securities, borrowings under a loan and security agreement, or the credit facility, with Silicon Valley Bank, or SVB, and an IPO. From inception through December 31, 2019 we raised an aggregate of approximately $242.6 million of gross proceeds through the issuance of equity and debt. Since inception, we have incurred significant operating losses. Our net losses were $43.3 million and $23.8 million for the years ended December 31, 2019 and 2018 respectively. As of December 31, 2019, we had an accumulated deficit of $97.5 million. We expect to continue to incur significant and increasing expenses and operating losses for the foreseeable future, as we advance our current and future product candidates through preclinical and clinical development, seek regulatory approval for them, maintain and expand our intellectual property portfolio, hire additional research and development and business personnel, and operate 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 our product candidates. In addition, if we obtain regulatory approval for our product candidates and do not enter into a third-party commercialization partnership, we expect to incur significant expenses related to developing our commercialization capability to support product sales, marketing, manufacturing, and distribution activities. As a result, we will need substantial additional funding to support our continuing operations and pursue our growth strategy. Until we can generate significant revenue from product sales, if ever, we expect to finance our operations through a combination of public or private equity offerings and debt financings or other sources, such as potential collaboration agreements. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on acceptable terms, or at all. Our failure to raise capital or enter into such agreements as, and when, needed, could have a material adverse effect on our business, results of operations, and financial condition. As of December 31, 2019, we had cash, cash equivalents, and marketable securities of $237.0 million. We believe that our existing cash and cash equivalents, marketable securities will enable us to fund our operating expenses and capital expenditure requirements through at least the end of 2022. Financial Operations Overview Collaboration Revenue We do not have any products approved for sale, and as a result, we have not generated any revenue from product sales and do not expect to generate any revenue from the sale of products in the foreseeable future. To date, all of our collaboration revenue has been derived from our agreements with AbbVie and Janssen. We expect that until we have a marketed product, our revenue, if any, will be derived primarily from payments under our collaboration and option agreements with AbbVie and Janssen or other collaboration and license agreements that we may enter into in the future, if any. Collaboration Revenue - AbbVie In October 2018, we entered into a collaboration with AbbVie, an investor that held approximately 5% of our common stock common stock at the time of the agreement, designed to advance a number of our oral integrin therapeutics for fibrosis-related indications. Under the terms of the agreement, AbbVie paid us an upfront payment of $100.0 million for research and development activities, and we provided to AbbVie exclusive license options on product candidates directed at multiple targets. For each compound, we will conduct research and development activities through the completion of IND-enabling studies, at which point AbbVie may pay a license fee of $20.0 million, on a target-by-target basis, to exercise its exclusive license option and assume responsibility for global development and commercialization. Under the terms of the arrangement, we are responsible for generating at least one research product and one backup. We are also eligible for clinical and commercial milestone payments and tiered royalties from high single digit to low teens on worldwide net sales for each licensed product. In addition, for certain compounds for which we have completed IND-enabling studies and which meet certain advancement criteria for a liver indication, we have the option to commit to share development costs in exchange for an increased fixed royalty rate. We may exercise this option following completion of the first phase IIb clinical trial for the relevant product. Collaboration Revenue - Janssen In February 2019, we entered into the Janssen Agreement to discover and develop novel integrin therapeutics for patients with conditions not adequately addressed by current therapies. The Janssen Agreement focuses on three integrin targets, each target the subject of a research program, with the ability to substitute up to two integrin targets not explored by us. Upon completing IND-enabling studies, on a research program-by-research program basis, Janssen may exercise an exclusive option to obtain an exclusive license with respect to the target that is the subject of the research program, including all licensed compounds that are the subject of the applicable research program, and then Janssen will be responsible for global clinical development and commercialization. In consideration of the rights granted, Janssen paid us an upfront fee of $10.0 million for each of the first two research programs, will pay us an additional $5.0 million fee upon commencement of the third research program, and will fund research activities. Pursuant to the terms of the agreement, we are also eligible to receive additional milestone and royalty payments. Expenses Research and Development Research and development expenses consist primarily of costs incurred for our research and development activities, including our product candidate discovery efforts and preclinical studies under our research programs, which include: § employee-related expenses, including salaries, benefits, and equity-based compensation expense for our research and development personnel; § costs of funding research performed by third parties that conduct research and development and preclinical activities on our behalf; § costs of manufacturing clinical supply related to any of our current or future product candidates; § costs of conducting preclinical studies of any of our current or future product candidates; § consulting and professional fees related to research and development activities, including equity-based compensation to non-employees; § costs of purchasing laboratory supplies and non-capital equipment used in our preclinical studies; § costs related to compliance with clinical regulatory requirements; § facility costs and other allocated expenses, which include expenses for rent and maintenance of facilities, insurance, depreciation and other supplies; and § fees for maintaining licenses and other amounts due under our third-party licensing agreements. Research and development costs are expensed as incurred. Costs for certain activities are recognized based on an evaluation of the progress to completion of specific tasks using data such as information provided to us by our vendors and analyzing the progress of our preclinical studies or other services performed. Significant judgment and estimates are made in determining the accrued expense balances at the end of any reporting period. Non-refundable advance payments for research and development goods or services to be received in the future from third parties are deferred and capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed. The successful development of our product candidates is highly uncertain. As such, at this time, we cannot reasonably estimate or know the nature, timing, and estimated costs of the efforts that will be necessary to complete our future product candidates. We are also unable to predict when, if ever, material net cash inflows will commence from the sale of our product candidates, if approved. This is due to the numerous risks and uncertainties associated with developing product candidates, including the uncertainty of: § the scope, rate of progress, and expenses of our ongoing research activities as well as any additional preclinical studies and clinical trials and other research and development activities; § establishing an appropriate safety profile; § successful enrollment in and completion of clinical trials; § whether our product candidates show safety and efficacy in our clinical trials; § receipt of marketing approvals from applicable regulatory authorities, if any; § establishing commercial manufacturing capabilities or making arrangements with third-party manufacturers; § obtaining and maintaining patent and trade secret protection and regulatory exclusivity for our product candidates; § commercializing the product candidates, if and when approved, whether alone or in collaboration with others; and § continued acceptable safety profile of the products following any regulatory approval. A change in the outcome of any of these variables with respect to the development of our current and future product candidates would significantly change the costs and timing associated with the development of those 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 research and development costs to increase significantly for the foreseeable future as we continue the development of our product candidates. However, we do not believe that it is possible at this time to accurately project total program-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 General and administrative expenses consist primarily of employee-related expenses, including salaries, benefits, and equity-based compensation expenses for personnel in executive, finance, accounting, business development, legal, and human resources functions. Other significant general and administrative expenses include facility costs not otherwise included in research and development expenses, legal fees relating to patent and corporate matters, and fees for accounting and consulting services. We anticipate that our general and administrative expenses will increase in the future as our business expands to support expected growth in research and development activities, including our future clinical programs. These increases will likely include increased costs related to the hiring of additional personnel and fees to outside consultants, among other expenses. We also anticipate increased expenses associated with being a public company, including costs for audit, legal, regulatory, and tax-related services related to compliance with the rules and regulations of the Securities and Exchange Commission, or SEC, and listing standards applicable to companies listed on Nasdaq, director and officer compensation and insurance premiums, and investor relations costs. In addition, if we obtain regulatory approval for any of our product candidates and do not enter into a third-party commercialization collaboration, we expect to incur significant expenses related to building a sales and marketing team to support product sales, marketing and distribution activities. Interest Income, Net Interest income, net consists primarily of interest income earned on our cash and cash equivalents and marketable securities, partially offset by interest expense incurred on our credit facility, including amortization of debt discount and debt issuance costs. Provision for Income Tax Expense We recorded $0.9 million in income tax expense during the year ended December 31, 2019 primarily due to the current tax liability associated with the tax recognition of the upfront AbbVie collaboration payment received in 2018. A significant portion of the taxable income related to the collaboration payment was offset by the current year operating expenses as well as prior year accumulated losses and research and development credits. For additional details about the current year tax provision, refer to Note 9 in the Notes to the Consolidated Financial Statements appearing elsewhere in this Annual Report on Form 10-K. Results of Operations Comparison of the years ended December 31, 2019 and 2018 The following table summarizes our results of operations for years ended December 31, 2019 and 2018: * Percentage not meaningful Collaboration Revenue Collaboration revenue increased to $17.0 million for the year ended December 31, 2019 from $3.4 million for the year ended December 31, 2018. The overall increase in revenue is attributable to $7.4 million increase in revenue recognized under our collaboration with AbbVie that we executed in October 2018 to advance several oral integrin therapeutics for fibrosis-related indications. Revenue we recognize from satisfaction of performance obligations under the AbbVie agreement is impacted by our estimates of the remaining costs to complete our obligations, which require significant judgment, and may cause fluctuation in the revenue recognized from period to period. Additionally, we recorded $6.2 million in revenue from our collaboration with Janssen that we executed in February 2019. Research and Development Expenses Research and development expense increased by $31.1 million, or 137%, from $22.6 million for the year ended December 31, 2018 to $53.7 million for the year ended December 31, 2019. A significant portion of our research and development costs have been external pre-clinical contract research organization (CRO) costs, which we track on a program-by-program basis related to a clinical product candidate that has been identified. Our internal research and development costs are primarily personnel-related costs, depreciation, and other indirect costs. The following table summarizes our research and development expense for the years ended December 31, 2019 and 2018: * Percentage not meaningful The increase in research and development expense was primarily attributable to the following: § The $24.0 million increase in external costs primarily related to increased research and preclinical development and manufacturing costs associated with product candidates MORF-720 and MORF-057 targeting αvβ6 and α4β7, respectively, and other external research costs associated with our other early development candidates. § The $7.1 million increase in internal costs was primarily attributable to a $4.4 million increase in employee compensation and benefits costs related to increased headcount to support increased activities in our research and development function, and a $1.6 million increase in stock-based compensation expenses. General and Administrative Expenses General and administrative expense increased by $4.9 million, or 91%, from $5.4 million for the year ended December 31, 2018 to $10.2 million for the year ended December 31, 2019. The increase in general and administrative expense was primarily attributable to an increase of $1.5 million in employee compensation and benefits due to increased headcount, a $0.8 million increase in stock-based compensation expenses, an increase of $0.9 million in professional services and consulting fees primarily due to increases in legal fees related to business development, regulatory and patent costs, and expenses related to public company administrative costs, and a $1.7 million increase in other expenses. Interest Income, Net Interest income increased by $3.8 million from $0.9 million for the year ended December 31, 2018 to $4.7 million for the year ended December 31, 2019. The increase in interest income, net was attributable to increased income earned on our investment portfolio, which increased significantly year-over-year due to the Series B financing, up-front payments pursuant to the AbbVie and the Janssen agreements, and receipt of the IPO proceeds in July 2019. Provision for Income Tax We recorded $0.9 million in income tax expense during the year ended December 31, 2019 primarily due to the current tax liability associated with the tax recognition of the upfront AbbVie collaboration payment received in 2018. No income tax expense was recorded during the year ended December 31, 2018 due to the net loss recorded during the period. Liquidity and Capital Resources Sources of Liquidity From inception through December 31, 2019, we have funded our operations primarily with net proceeds of $93.3 million from the sale of common stock in our IPO, the gross proceeds of $138.1 million from sales of our convertible preferred equity securities and borrowings of $1.0 million under our credit facility with SVB, $100.0 million we received as an up-front, non-refundable payment from our collaboration with AbbVie, $10.0 million we received as an up-front, non-refundable payment from the Janssen Agreement, as well as on-going research funding from the Janssen Agreement. The following table provides information regarding our total cash, cash equivalents, and marketable securities, each of which are stated at their respective fair values as of December 31, 2019 and of December 31, 2018: In March 2016, we entered into a credit facility with SVB for an equipment line of credit of up to $1.5 million to finance the purchase of eligible equipment. Principal and interest payments commenced on January 1, 2017 for a period of 36 months. The loan and security agreement also included a final payment fee equal to 5.0% of the aggregate advances and a pre-payment fee of 0.5% to 1.0%, depending on when the prepayment occurs. In December 2018, we paid the entire balance back to SVB, including a prepayment penalty of 0.5% and terminated the credit facility. We had no balances outstanding due to SVB or any other lender as of December 31, 2019 or December 31, 2018. In connection with the credit facility, we issued warrants to SVB to purchase 6,825 Series Seed convertible preferred units at a purchase price of $4.39 per unit, which became exercisable for 6,825 shares of common stock at a purchase price of $4.39 per share in connection with the IPO. In August 2019, SVB exercised warrants via a cashless exercise which resulted in the issuance of 5,766 common shares. Cash Flows The following table provides information regarding our cash flows for the years ended December 31, 2019 and 2018: Net Cash Used in Operating Activities Net cash used in operating activities was $41.7 million for year ended December 31, 2019 compared to $76.3 million in net cash provided by operating activities for the year ended December 31, 2018. The $118.0 million decrease in cash provided by operating activities was primarily due to the receipt of an upfront payment of $100 million from AbbVie in 2018, as well as the $19.5 million increase to net loss. Net Cash Used in Investing Activities Net cash used in investing activities was $136.0 million for year ended December 31, 2019 compared to net cash used in investing activities of $0.7 million for year ended December 31, 2018, an increase of $135.3 million. This increase was primarily due to the net purchases of $296.3 million in marketable securities, and a net increase of $1.5 million in capital expenditures, offset by $162.5 million in proceeds from maturities of marketable securities. Net Cash Provided by Financing Activities Net cash provided by financing activities was $93.3 million for year ended December 31, 2019 compared to $89.5 million in the comparable prior year period. The increase of $3.8 million was due to increase in funds raised from the Company’s IPO. Funding Requirements We expect our expenses to increase in connection with our ongoing activities, particularly as we continue research and development, initiate clinical trials, and seek marketing approval for our current and any of our future product candidates. In addition, if we obtain marketing approval for any of our current or our future product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution, which costs we might offset through entry into collaboration agreements with third parties. Furthermore, as a result of the IPO, we expect to incur additional costs associated with operating as a newly public company. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on acceptable terms, we would be forced to delay, reduce, or eliminate our research and development programs or future commercialization efforts. We expect our existing cash and cash equivalents and marketable securities will enable us to fund our operating expenses and capital expenditure requirements through at least the end of 2022. We have based this estimate on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. Our future capital requirements will depend on many factors, including: § the costs of conducting preclinical studies and future clinical trials; § the costs of future manufacturing; § the scope, progress, results and costs of discovery, preclinical development, laboratory testing, and clinical trials for other potential product candidates we may develop, if any; § the costs, timing, and outcome of regulatory review of our product candidates; § our ability to establish and maintain collaborations on favorable terms, if at all; § the achievement of milestones or occurrence of other developments that trigger payments under any collaboration agreements we might have at such time; § the costs and timing of future commercialization activities, including product sales, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval; § 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, obtaining, maintaining 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 research and development activities; and § the cost 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. Critical Accounting Policies and Estimates This management’s discussion and analysis is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires us to make judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events, and various other factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. On an ongoing basis, we evaluate our judgments and estimates in light of changes in circumstances, facts, and experience. The effects of material revisions in estimates, if any, will be reflected in the consolidated financial statements prospectively from the date of change in estimates. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements included in this Annual Report on Form 10-K, we believe the following accounting policies used in the preparation of our consolidated financial statements require the most significant judgments and estimates. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf, and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments, if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. In certain instances, we prepay for services to be provided in the future. These amounts are expensed as the services are performed. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid balance accordingly. Non-refundable advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts incurred. Equity-Based Compensation Prior to the Reorganization, we granted incentive units, which we accounted for as equity-classified awards. As part of the Reorganization, the incentive units were exchanged for shares of our common stock and restricted common stock, which we account for as equity-classified awards. In December 2018 and during year ended December 31, 2019, we granted stock options, which we account for as equity-classified awards. We measure employee and nonemployee equity-based compensation based on the grant date fair value of the equity-based awards and recognize equity-based compensation expense on a straight-line basis over the requisite service period of the awards, which is generally the vesting period of the respective award. We recognize forfeitures as they occur. We classify equity-based compensation expense in our consolidated statements of operations in the same manner in which the award recipient’s salary and related costs are classified or in which the award recipient’s service payments are classified. In future periods, we expect equity-based compensation expense to increase, due in part to our existing unrecognized stock-based compensation expense and as we grant additional stock-based awards to continue to attract and retain our employees. We determine the fair value of restricted common stock awards granted based on the fair value of our common stock. We estimate the fair value of stock option awards and restricted stock granted using the Black-Scholes option-pricing model, which uses as inputs, the fair value of our common stock or unit and subjective assumptions we make, including the expected stock price volatility, the expected term of the award, the risk-free interest rate, and expected dividends. Due to insufficient company-specific historical data, we base the estimate of expected volatility on the historical volatility of a representative group of publicly traded companies for which historical information is available. The historical volatility is generally calculated based on a period of time commensurate with the expected term assumption. We use the simplified method to calculate the expected term for options granted to employees and directors. We utilize this method as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For options granted to non-employees, we utilize the expected term. The risk-free interest rate is based on a U.S. 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 do not have current plans to pay any dividends on our common stock. Revenue from Contracts with Customers As of December 31, 2019, all of our revenue to date has been generated from the AbbVie Agreement and Janssen Agreement. Effective January 1, 2018, we adopted the provisions of ASC Topic 606, Revenue from Contracts with Customers, or ASC 606, using the full retrospective transition method. Under ASC 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect 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 contract(s) with the customer, (ii) identification of the promised goods or services in the contract and determination of whether the promised goods or services are performance obligations, (iii) measurement of the transaction price, (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 the consideration we are entitled to in exchange for the goods or services we transfer to our customer. Identification of the Contracts with the Customers We evaluate every contract to determine whether it in its entirety or in part represent a contract with a customer, or a collaboration agreement and, based on this determination, apply appropriate accounting guidance. We account for a contract with a customer that is within the scope of ASC 606 when all of the following criteria are met: (i) the arrangement has been approved by the parties and the parties are committed to perform their respective obligations, (ii) each party’s rights regarding the goods or services to be transferred can be identified, (iii) the payment terms for the goods or services to be transferred can be identified, (iv) the arrangement has commercial substance and (v) collection of 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 is probable. Identification of the Performance Obligations The promised goods or services in our collaboration and option arrangements consist of research and development services. The arrangements also have options for additional items (i.e., license rights). Options are considered to be marketing offers and are to be accounted for as separate contracts when the customer elects such options, unless we determine the option provides a material right which would not be provided without entering into the contract. The determination as to whether such options are material rights requires significant management judgment, and management considers factors such as other similar arrangements, market data and the terms of the contractual arrangement to make such conclusion. Performance obligations are promised goods or services in a contract to transfer a distinct good or service to the customer. Promised goods or services are considered distinct when: (i) the customer can benefit from the good or service on its own or together with other readily available resources and (ii) the promised good or service is separately identifiable from other promises in the contract. In assessing whether promised goods or services are distinct, we consider factors such as the stage of development of the underlying intellectual property, the capabilities of our customer to develop the intellectual property on their own and whether the required expertise is readily available. Determination of the Transaction Price We estimate the transaction price based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. The consideration may include both fixed consideration and variable consideration. At the inception of each arrangement that includes variable consideration, we evaluate the amount of the potential payments and the likelihood that the payments will be received. We utilize either the most likely amount method or expected value method to estimate the transaction price based on which method better predicts the amount of consideration expected to be received. If it is probable that a significant revenue reversal would not occur, the variable consideration is included in the transaction price. All contingent future payments, which include research, development, regulatory, and sales-based royalty payments, have not been considered in the initial analysis, as they are contingent upon option(s) being exercised or are subject to significant risk of achievement. Allocation of Transaction Price We allocate the transaction price based on the estimated standalone selling price. We must develop assumptions that require judgment to determine the standalone selling price for each performance obligation identified in the contract. We utilize key assumptions to determine the standalone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction, and the estimated costs. Certain variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated to each performance obligation are consistent with the amounts we would expect to receive for satisfying each performance obligation. Recognition of Revenue We recognize revenue as we perform the research and development services based on the costs incurred to date, as such costs have a direct relationship between our effort and the progress made towards satisfying its performance obligations to AbbVie and Janssen. Consideration allocated to material rights is recognized upon exercise or expiration of the related option. As the Company progresses towards satisfaction of performance obligations under the AbbVie and Janssen agreements, the estimated costs associated with the remaining effort required to complete the performance obligations may change, which may materially impact revenue recognition. Factors that impact this estimate include but are not limted to inherhent uncertainty of early stage research, interactions with regulatory authorities and results of pre-clinical studies all of which may materially impact our estimates of the remaining costs to complete. The Company regularly evaluates and, when necessary, updates the costs associated with the remaining effort associated with each performance obligation under the AbbVie and Janssen agreements. For example, during fiscal year 2019 we made certain changes to our estimated costs, including in November 2019 upon receiving feedback from the FDA which required us to conduct one additional toxicology study before submitting an IND for MORF-720. Additionally, we are pursuing a backup molecule for idiopathic pulmonary fibrosis, or IPF. As a result of these changes during fiscal year 2019, we reduced revenue by $2.0 million during fiscal year 2019. Income Taxes We record income taxes under the liability method. Deferred tax assets and liabilities reflect our estimation of the future tax consequences of temporary differences between the carrying amounts of assets and liabilities for book and tax purposes. We determine deferred income taxes based on the differences in accounting methods and timing between financial statement and income tax reporting. Accordingly, we determine the deferred tax asset or liability for each temporary difference based on the enacted tax rates expected to be in effect when we realize the underlying items of income and expense. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent earnings experience, expectations of future taxable income, and the carryforward periods available to us for tax reporting purposes, as well as other relevant factors. We establish a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. Due to inherent complexities arising from the nature of our business, future changes in income tax law, or variances between our actual and anticipated operating results, we make certain judgments and estimates, including our ability to realize our deferred tax assets and our ability to use our operating loss carryforwards and tax credits to offset taxable income. Therefore, actual income taxes could materially vary from these estimates. Despite the collaboration revenue, we continue to maintain a valuation allowance against all deferred tax assets. We believe that it is more likely than not that we will not realize a future tax benefit of these attributes, as the research programs continue to require significant investment and future revenue is subject to uncertainties. Ultimate realization of any deferred tax asset is dependent on our ability to generate sufficient future taxable income in the appropriate tax jurisdiction before the expiration of carryforward periods, if any. As the company’s research spending has increased in scope and complexity during fiscal year 2019, a detailed review of the current year R&D credit computation was undertaken to support the company’s methodology and conclusions. We have not yet conducted a study of its research and development credit carryforwards for fiscal years prior to 2019. Such a study may result in an adjustment to our research and development credit carryforwards; however, until a study is completed and any adjustment is known, no amount is being presented as an uncertain tax position. A full valuation allowance has been provided against our research and development credits, and, if an adjustment is required, this adjustment would be offset by an adjustment to the valuation allowance. Thus, there would be no impact to the balance sheet or statement of operations and comprehensive loss if an adjustment were required. Off-Balance Sheet Arrangements We did not have, during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under applicable SEC rules. Contractual Obligations The following table summarizes our significant contractual obligations by period presented according to the payment due date at December 31, 2019 (in thousands): (1) Represents future minimum repayments under our non-cancellable operating leases as of December 31, 2019. We entered into contracts with a number of third parties, including external CROs, that require us to make upfront payments, some of which may be non-refundable. Under various licensing and related agreements with third parties, we have agreed to make milestone payments and pay royalties to third parties. Pursuant to an exclusive license agreement with Children’s Medical Center Corporation, or CMCC, a holder of our common stock, we paid CMCC an annual license maintenance fee of $10,000 in each of 2015-2018. In 2018, we amended the agreement and this obligation increased to $80,000 per year, and continues until the agreement is terminated. We will also be responsible for up to $1.3 million of development milestone payments through the first regulatory approval of a licensed product, tiered royalty payments of low single-digit percentages on net sales of licensed products in the event that we realize sales from products covered by the license agreement, and between 10% and 20% of non-royalty income attributable to a sublicense of the CMCC rights. Amounts paid to CMCC are recorded as research and development expense in the statements of operations. Pursuant to a collaboration agreement with Schrödinger, we may be required to pay Schrödinger certain development milestones, not to exceed in the aggregate, on a target-by-target basis, a low six-figure payment upon initiation of lead optimization and $3.1 million on a compound-by-compound basis, as well as royalties in the low single digits on sales of products containing such compounds. In addition, we have agreed to pay Schrödinger a percentage, in the mid-single digits, of certain payments we receive from third parties in connection with the licensing or transfer of the rights to exploit such compounds to such third parties, including a one-time fee of $1.0 million paid in 2019. We enter into agreements in the normal course of business with vendors for preclinical studies, preclinical and clinical supply and manufacturing services, professional consultants for expert advice, and other vendors for other services for operating purposes. We have not included these payments in the table of contractual obligations above since the contracts do not contain any minimum purchase commitments and are cancelable at any time by us, generally upon 30 days prior written notice, and therefore we believe that our non-cancelable obligations under these agreements are not material. Emerging Growth Company and Smaller Reporting Status We are an “emerging growth company,” or EGC, under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Section 107 of the JOBS Act provides that an EGC 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 EGC can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to avail ourselves of delayed adoption of new or revised accounting standards and, therefore, we will be subject to the same requirements to adopt new or revised accounting standards as private entities. As an EGC, we may take advantage of certain exemptions and reduced reporting requirements under the JOBS Act. Subject to certain conditions, as an EGC: § we will avail ourselves of the exemption from 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; § we will avail ourselves of the exemption from complying with any requirement that may be adopted by the Public Company Accounting Oversight Board, or PCAOB, regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis; § we will provide reduced disclosure about our executive compensation arrangements; and § we will not require nonbinding advisory votes on executive compensation or stockholder approval of any golden parachute payments. We will remain an EGC until the earliest of (i) December 31, 2025 (the last day of the fiscal year following the fifth anniversary of the completion of our IPO), (ii) the last day of the 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 in non-convertible debt during the previous rolling three-year period, or (iv) the date on which we are deemed to be a large accelerated filer under the Securities Exchange Act of 1934, as amended, or the Exchange Act. We are also a “smaller reporting company,” meaning that the market value of our stock held by non-affiliates is less than $700.0 million and our annual revenue is less than $100.0 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 $250.0 million or (ii) our annual revenue is less than $100.0 million during the most recently completed fiscal year and the market value of our stock held by non-affiliates is less than $700.0 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. Recent Accounting Pronouncements We have reviewed all recently issued standards and have determined that, other than as disclosed in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report, such standards will not have a material impact on our financial statements or do not otherwise apply to our operations.

<s>[INST] Overview We are a biopharmaceutical company applying our proprietary insights into integrins to discover and develop a pipeline of potentially firstinclass oral smallmolecule integrin therapeutics. Integrins are a target class with multiple approved injectable blockbuster drugs for the treatment of serious chronic diseases, including autoimmune, cardiovascular and metabolic diseases, fibrosis and cancer. To date, no oral smallmolecule integrin therapies have been approved by the FDA. Despite significant unsuccessful efforts, we believe tremendous untapped potential remains for us to develop oral integrin therapies. We created the Morphic integrin technology platform, or MInT Platform, by leveraging our unique understanding of integrin structure and biology to develop novel product candidates designed to achieve the potency, high selectivity, and pharmaceutical properties required for oral administration. We are advancing our preclinical pipeline, including our whollyowned program MORF057, a α4β7 specific integrin inhibitor affecting inflammation, into clinical development for the treatment of inflammatory bowel disease, or IBD. We are also developing MORF720, our selective oral αvβ6 specific integrin inhibitor affecting fibrosis, toward an Investigational New Drug application, or IND. We intend to advance MORF057 and MORF720 toward IND submissions by the middle of 2020 and the end of 2020, respectively. Beyond our current targets, we are using our MInT Platform to create a broad pipeline of programs across a variety of therapeutic areas, all of which aim to harness the potential of inhibition or activation. We were formed as a limited liability company under the laws of the State of Delaware in August 2014 under the name Integrin Rock, LLC. We subsequently changed our name to Morphic Rock Holding, LLC in October 2014 and then to Morphic Holding, LLC in June 2016, and we subsequently converted to a corporation under the name Morphic Holding, Inc. in December 2018. In connection with the conversion to a Delaware corporation, or the Reorganization, each of the outstanding units of the members of the limited liability company were converted into shares of capital stock. Upon consummation of the Reorganization, the historical consolidated financial statements of Morphic Holding, LLC became the historical consolidated financial statements of Morphic Holding, Inc. All information included in this Annual Report is presented after giving effect to the Reorganization. On July 1, 2019, we completed the initial public offering, or IPO, of our common stock and issued and sold 6,900,000 shares of common stock at a public offering price of $15.00 per share, which included 900,000 shares sold upon full exercise of the underwriters’ option to purchase additional shares of common stock resulting in net proceeds of $93.3 million after deducting underwriting discounts and commissions and offering expenses. Since inception, our operations have focused on organizing and staffing our company, business planning, raising capital, establishing our intellectual property portfolio, and performing research to discover and develop oral smallmolecule integrin therapeutics. Revenue generation activities have been limited to the following. In October 2018, pursuant to our collaboration and option agreement with AbbVie, or the AbbVie Agreement, we received an upfront payment of $100.0 million for research and development activities, and provided to AbbVie exclusive license options on product candidates directed at multiple targets. In March 2019, pursuant to the Janssen Agreement, we received an upfront payment of $10.0 million and provided Janssen with exclusive license options on product candidates directed at multiple targets. In addition, Janssen will reimburse us for research services at market rates. We do not have any products approved for sale and have not generated any revenue from product sales. Through December 31, 2019 in addition to the foregoing sources of revenue, we have funded our operations primarily through the sale and issuance of our convertible preferred equity securities, borrowings under a loan and security [/INST] Positive. </s>

PROFICIENT ALPHA ACQUISITION CORP

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 our results of operations and financial condition should be read together with our audited financial statements and the notes thereto, which are included elsewhere in this report. Our financial statements have been prepared in accordance with U.S. GAAP. In addition, our financial statements and the financial information included in this report reflect our organizational transactions and have been prepared as if our current corporate structure had been in place throughout the relevant periods. We are a newly organized blank check company formed as a Nevada corporation for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. Our initial business combination and value creation strategy is to identify, acquire and, after our initial business combination, assist in the growth of a business which provide financial services in Asia, primarily China. We intend to utilize cash derived from the proceeds of our initial public offering and a private placement of private warrants that occurred simultaneously with the completion of our initial public offering, our securities, debt or a combination of cash, securities and debt, in effecting a business combination. The issuance of additional shares of common stock or preferred stock: • may significantly reduce the equity interest of our stockholders; • may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; • will likely cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and most likely will also result in the resignation or removal of our present officers and directors; and • may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities or incur other indebtedness to finance our initial business combination, it could result in: • default and foreclosure on our assets if our operating revenues after a business combination are insufficient to pay our debt obligations; • acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if the debt security contains covenants that required the maintenance of certain financial ratios or reserves and we breach any such covenant 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; and • our inability to obtain additional financing, if necessary, if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our proposed fundraising through an offering of our equity securities and to seek business combination targets for our initial business combination. We are an emerging growth company as defined in the JOBS Act. As an emerging growth company, we have elected 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 such, our financial statements may not be comparable to companies that comply with public company effective dates. (38) Operating Expenses We had operating expenses of $716,008 and $113,016 for the year ended September 30, 2019 and the period from July 27, 2018 (inception) through September 30, 2018, respectively. During the year ended September 30, 2019, operating expenses were primarily due to audit fees of $38,545, legal fees of $95,000, general and administrative expenses of $316,278, and officers’ compensation of $266,185, of which $13,333 were in connection with stock issuances to our Chief Executive Officer and Chief Financial Officer. During the period from July 27, 2018 (inception) through September 30, 2018, we had legal fees of $25,000, general and administrative expenses of $40,238, and officers’ compensation of $47,778, of which $2,222 were in connection with stock issuances to our Chief Executive Officer and Chief Financial Officer. Pursuant to the executed Offer Letters, the Company agreed to pay the Company’s Chief Executive Officer $2,000 in cash per month and 50,000 founder shares, and pay the Company’s Chief Financial Officer $5,000 in cash per month and 50,000 founder shares. The total 100,000 founder shares were issued in September of 2018. Accordingly, we recognized stock-based compensation of $13,333 during the year ended September 30, 2019, and recognized stock-based compensation of $2,222 during the period from July 27, 2018 (inception) through September 30, 2018, to the statement of operations. The unrecognized stock-based compensation was $4,444 as of September 30, 2019. Our operating expenses increased significantly in 2019 due to fees associated with our initial public offering, including fees paid to Nasdaq, and professional and consulting fees and travel expenses associated with evaluating various initial business combination candidates. Our operating expenses are difficult to predict due to the uncertainty of the business combination, and it may be necessary to continuously raise additional capital to sustain operations. On July 24, 2019, we issued an unsecured promissory note to the sponsor for a principal amount of up to $800,000 for working capital purposes. Pursuant to the note, the sponsor agreed to loan to us up to a total of $800,000 in the event our cash held outside of the trust account is less than $150,000. Liquidity and Capital Resources For year ended September 30, 2019, cash provided by operating activities amounted to $134,610, mainly due to interest earned on government securities held in the trust account of $925,644, plus non-cash expenses of $13,333 as the stock based compensation to our Chief Executive Officer and Chief Financial Officer, offset by operating loss of $716,008. Comparatively, cash of $70,138 used in operating activities during the period from July 27, 2018 (inception) through September 30, 2018 was due to the net loss of $113,016, partially offset by the increase in accrued expenses and accrued expenses to related parties amounted to $19,333 and $21,323, respectively. On June 3, 2019, we consummated our initial public offering of 10,000,000 units, plus 1,500,000 additional units pursuant to the full exercise of the over-allotment option by the underwriters, at a price of $10.00 per unit, generating an aggregate amount of gross proceeds of $115,000,000. Simultaneously with the closing of our initial public offering, we consummated a sale of 5,375,000 warrants in a private placement to our sponsor at a price of $1.00 per warrant, generating gross proceeds of $5,375,000. Following our initial public offering and the exercise of the over-allotment option in full, a total of $115,000,000 was placed in the trust account. Offering costs consist of legal, accounting, underwriting fees and other costs incurred through the balance sheet date that are directly related to our initial public offering. Offering costs of $6,625,439 include underwriting fees of $2,875,000 in cash, initial public offering costs of $315,120, and the fair value of 92,000 shares issued and 920,000 warrants granted to the underwriters in total amount of $3,435,319, pursuant to the underwriting agreement, which were charged to stockholders’ equity upon the completion of our initial public offering. During the period from July 27, 2018 (inception) through September 30, 2018, we had cash of $372,500 provided by financing activities primarily due to the proceeds from sales of founder shares. As of September 30, 2019, we had cash and government securities held in the trust account of $115,925,644 (including approximately unrealized gain of $925,644), substantially all of which has been 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 any interest income from 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 to complete our initial Business Combination. We may withdraw interest from 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 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 September 30, 2019, we had cash of $1,078,708 held outside the trust account and $800,000 was in an escrow account setup for a non-binding Letter of Intent with a potential target company for an initial business combination between the Company and such potential target company. The deal was not closed as of September 30, 2019 and $800,000 was released by the escrow agent and returned to the Company on October 2, 2019. We intend to use the funds held outside the trust account to identify and evaluate target candidates, perform business and legal 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, and structure, negotiate and complete a business combination. In order to finance transaction costs in connection with an intended initial business combination, our sponsor, initial stockholders, officers, directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we consummate an initial business combination, we would repay such loaned amounts. In the event that the 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 of the post business combination entity at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the private warrants. On July 24, 2019, we issued an unsecured promissory note to the sponsor for a principal amount of up to $800,000 for working capital purposes. Pursuant to the note, the sponsor agreed to loan to us up to a total of $800,000 in the event our cash held outside of the trust account is less than $150,000. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if the actual costs to identify a target business, undertake in-depth due diligence and negotiate a business combination exceed our estimated amount, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing by issuance of additional securities or incurrence of debt to consummate our initial business combination or to fulfill our obligations to redeem a significant number of our public shares upon consummation of our initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the consummation of our initial business combination, in which case we may issue additional securities or incur debt in connection with such initial business combination. We cannot provide any assurance that financing will be available to us on commercially acceptable terms, if at all. If we are unable to complete our initial business combination due to insufficient funds, 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. (39) Controls and Procedures We are not currently required to maintain an effective system of internal controls as defined by Section 404 of the Sarbanes-Oxley Act. We may be required to comply with the internal control requirements of the Sarbanes-Oxley Act for the fiscal year ending September 30, 2020. As of the date of this report, we have not completed an assessment, nor have our auditors tested our systems, of internal controls. We expect to assess the internal controls of our target business or businesses prior to the completion of our initial business combination and, if necessary, to implement and test additional controls as we may determine are necessary in order to state that we maintain an effective system of internal controls. A target business may not be in compliance with the provisions of the Sarbanes-Oxley Act regarding the adequacy of internal controls. Target businesses we may consider for a business combination may have internal controls that need improvement in areas such as: • staffing for financial, accounting and external reporting areas, including segregation of duties; • reconciliation of accounts; • proper recording of expenses and liabilities in the period to which they relate; • evidence of internal review and approval of accounting transactions; • documentation of processes, assumptions and conclusions underlying significant estimates; and • documentation of accounting policies and procedures. Because it will take time, management involvement and perhaps outside resources to determine what internal control improvements are necessary for us to meet regulatory requirements and market expectations for our operation of a target business, we may incur significant expense in meeting our public reporting responsibilities, particularly in the areas of designing, enhancing, or remediating internal and disclosure controls. Doing so effectively may also take longer than we expect, thus increasing our exposure to financial fraud or erroneous financing reporting. Once our management’s report on internal controls is complete, we will retain our independent auditors to audit and render an opinion on such report when required by Section 404. The independent auditors may identify additional issues concerning a target business’s internal controls while performing their audit of internal control over financial reporting. Quantitative and Qualitative Disclosures about Market Risk The net proceeds of our initial public offering, including amounts in the trust account, will be invested in United States “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act having a maturity of 180 days or less, or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk. Off-Balance Sheet Arrangements; Commitments and Contractual Obligations; Quarterly Results As of the date of this report, 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. No unaudited quarterly operating data is included in this report as we have conducted no operations to date.

<s>[INST] The following discussion and analysis of our results of operations and financial condition should be read together with our audited financial statements and the notes thereto, which are included elsewhere in this report. Our financial statements have been prepared in accordance with U.S. GAAP. In addition, our financial statements and the financial information included in this report reflect our organizational transactions and have been prepared as if our current corporate structure had been in place throughout the relevant periods. We are a newly organized blank check company formed as a Nevada corporation for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. Our initial business combination and value creation strategy is to identify, acquire and, after our initial business combination, assist in the growth of a business which provide financial services in Asia, primarily China. We intend to utilize cash derived from the proceeds of our initial public offering and a private placement of private warrants that occurred simultaneously with the completion of our initial public offering, our securities, debt or a combination of cash, securities and debt, in effecting a business combination. The issuance of additional shares of common stock or preferred stock: may significantly reduce the equity interest of our stockholders; may subordinate the rights of holders of shares of common stock if we issue shares of preferred stock with rights senior to those afforded to our shares of common stock; will likely cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and most likely will also result in the resignation or removal of our present officers and directors; and may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities or incur other indebtedness to finance our initial business combination, it could result in: default and foreclosure on our assets if our operating revenues after a business combination are insufficient to pay our debt obligations; acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if the debt security contains covenants that required the maintenance of certain financial ratios or reserves and we breach any such covenant 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; and our inability to obtain additional financing, if necessary, if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our proposed fundraising through an offering of our equity securities and to seek business combination targets for our initial business combination. We are an emerging growth company as defined in the JOBS Act. As an emerging growth company, we have elected 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 such, our financial statements may not be comparable to companies that comply with public company effective dates. (38) Operating Expenses We had operating expenses of $716,008 and $113,016 for the year ended September 30, 2019 and the period from July 27, 2018 (inception) through September 30, 2018, respectively. During the year ended September 30, 2019, operating expenses were primarily due to audit fees of $38,545, legal fees of $95,000, general and administrative expenses of $316,278, and officers’ compensation of $266,185, of which $13,333 were in connection with stock issuances to our Chief Executive Officer and Chief Financial Officer. During the period from July 27, 2018 (inception) through September 30, 2018, we had legal fees of $25,000, general and administrative expenses of $40,238, and officers’ compensation of $47,778, of which $2,222 were in connection with stock issuances to our Chief Executive [/INST] Positive. </s>

VIEMED HEALTHCARE, INC.

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 of our financial condition and results of operations should be read in conjunction with our financial statements and the accompanying notes included elsewhere in this report. The forward-looking statements include statements that reflect management’s beliefs, plans, objectives, goals, expectations, anticipations and intentions with respect to our future development plans, capital resources and requirements, results of operations, and future business performance. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in the section entitled “Special Note Regarding Forward-Looking Statements” immediately preceding Part I of this report. Prior Period Corrections We have corrected our previously issued consolidated financial statements contained in this Annual Report on Form 10-K with respect to the fiscal year ended December 31, 2018. Refer to the "Explanatory Note" for background on the correction and other information. Overview We provide an array of home medical equipment, services and supplies, specializing in post-acute respiratory care services in the United States. Our primary objective is to focus on the organic growth of the business and thereby solidify our position as one of the United States’ largest providers of in home therapy for patients suffering from respiratory diseases. Our respiratory care programs are designed specifically for payors to have the ability to treat patients in the home for less total cost and with a superior quality of care. Our services include respiratory disease management (through the rental of various durable medical equipment devices), in-home sleep testing and sleep apnea treatment, oxygen therapy, and the sale of associated supplies. We derive the majority of our revenue through the rental of non-invasive and invasive ventilators which represented 86.0% and 89.8% of our revenue for the years ended December 31, 2019 and December 31, 2018, respectively. We combine the benefits of home ventilation support with licensed Respiratory Therapists ("RTs") to drive improved patient outcomes and reduce costly hospital readmissions. We expect to use an organic growth model whereby expansion is accomplished through existing service areas as well as in new regions through a cost efficient launch that reduces location expenses. Our licensed RTs currently serve patients in 31 states. We expect to continue to employ more RTs in order to assure our high service model is accomplished in the home. As of December 31, 2019, we employed 228 licensed RTs, representing 55% of our company-wide employee count. By focusing overhead costs to clinical personnel that service the patient rather than physical location costs, we aim to efficiently scale our business in regions that are currently not being effectively serviced. The continued trend of servicing patients in the home rather than in hospitals is aligned with our business objective and we anticipate that this trend will continue to offer growth opportunities for us. We expect to continue to be a solution to the rising health costs in the United States by offering more cost effective, home based solutions while increasing the quality of life for patients fighting serious respiratory diseases. As a result of this trend, we continue to experience significant organic growth. For the year ended December 31, 2019, we generated revenues of $80.3 million and had net income of $8.5 million, compared to revenues of $64.5 million and net income of $9.5 million for the year ended December 31, 2018. Our primary sources of capital to date have been from operating income and the leverage of our manufacturer credit lines and to a lesser extent access to bank term loans. In addition, our line of credit availability of $10.0 million remains undrawn. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 The below table highlights summary financial and operational metrics for the last eight quarters.The information in the table below has been updated to reflect the reclassification described in Note 2 to the Notes to Consolidated Financial Statements and the correction to prior period financial statements described in Note 3 and Note 13 to the Notes to Consolidated Financial Statements. (1) Refer to "Non-GAAP Financial Measures" section below for definition of Adjusted EBITDA. (2) Vent Patients represents the number of active ventilator patients on recurring billing service at the end of each calendar quarter. (3) Revenue, gross profit, gross profit percentage, net income, total assets, and Adjusted EBITDA have been updated to reflect the correction as discussed in Note 3 and Note 13 to the Notes to the Consolidated Financial Statements. (4) Revenue has been updated to reflect the reclassification as discussed in Note 2 to the Notes to the Consolidated Financial Statements. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affected the reported amounts of assets and liabilities, and related disclosure of contingent assets and liabilities, revenues and expenses at the date of the financial statements. Generally, we base our estimates on historical experience and on various other assumptions in accordance with U.S. GAAP that we believe to be reasonable under the circumstances. Actual results may differ from these estimates and such differences could be material to our financial position and results of operations. While our significant accounting policies are more fully described in Note 2 to our consolidated financial statements included elsewhere in this report, we believe 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 our most difficult, subjective and complex judgments. Reporting Currency All values are in U.S. dollars ($ or "USD") unless specifically indicated otherwise. Canadian dollars are indicated as CAD$. Functional Currency Management has exercised judgment in selecting the functional currency of each of the entities that it combines based on the primary economic environment in which the entity operates and in reference to the various indicators including the currency that primarily influences or determines the selling prices of goods and services and the cost of those services, including labor, material and other costs and the currency whose competitive forces and regulations mainly determine selling prices. The Company's functional currency was determined to be the U.S. dollar, which was determined using management’s assumption that the primary economic environment which it will derive its revenue and expenses incurred to generate those revenues is the United States. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Revenue Recognition Revenue from a customer consists of any combination of the sale and rental of DME and/or patient medical services. Revenues are billed to and collections received from Medicare, Medicaid, third-party insurers, co-insurance and patient-pay. Revenue is recognized net of contractual adjustments and bad debt based on contractual arrangements with third-party payors, an evaluation of expected collections resulting from the analysis of current and past due accounts, past collection experience in relation to amounts billed and other relevant information. Contractual adjustments result from the differences between the rates charged for services and reimbursements by government-sponsored healthcare programs and insurance companies for such services. The Company's contracts with customers often include multiple products and services, and the Company evaluates these arrangements to determine the unit of accounting for revenue recognition purposes based on whether the product or service is distinct from other products or services in the arrangement and should be accounted for as separate performance obligation. A product or service is distinct if the customer can benefit from it on its own or together with other readily available resources and the Company's ability to transfer the goods or services is separately identifiable from other promises in the contractual arrangement with the customer (e.g. patient). Revenue is then allocated to each separately identifiable good or service based on their relative standalone selling price of the items underlying the performance obligations. Most of the Company’s products fall in the Medicare Fee-for-Service (“FFS”) program which is a payment model where services are unbundled and paid for separately. These services are paid based on a Medicare determined price that is publicly available on the website for CMS. For commercial payors, DME companies must negotiate in-network pricing separately, though in general, the Company’s payors tend to benchmark their contract rates and coverage policies closely to those of Medicare. The Company considers performance obligations for sales and rentals to be met when the customer receives the equipment, and revenue for rentals is recognized straight line, over the respective rental period. For revenue associated with DME rentals, the Company recognizes revenue in accordance with FASB ASU 2016-02 “Leases,” (Topic 842). For any DME sales and services, the Company recognizes revenue under FASB ASU 2014-09, “Revenue from Contracts with Customers,” (Topic 606) and related amendments. The Company recognizes equipment rental revenue over the non-cancelable lease term, which is one month, less estimated adjustments, in accordance with Topic 842, "Leases". The Company has separate contracts with each patient that are not subject to a master lease agreement with any third-party payor. The Company would first consider the lease classification issue (sales-type lease or operating lease) and then appropriately recognize or defer rental revenue over the lease term. Revenue Accounting under Topic 842 The Company leases DME such as non-invasive and invasive ventilators, PAP machines, percussion vests, oxygen concentrator units and other small respiratory equipment to customers for a fixed monthly amount on a month-to-month basis. The customer generally has the right to cancel the lease at any time during the rental period. The Company considers these rentals to be operating leases. Under FASB Accounting Standards Codification Topic 842, “Leases”, the Company recognizes rental revenue on operating leases on a straight-line basis over the contractual lease term. The lease term begins on the date products are delivered to patients, and revenues are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors, including Medicare, private commercial payors, and Medicaid. Certain customer co-payments are included in revenue when considered probable of payment, which is generally when paid. Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenue and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application or claim denial. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Revenue Accounting under Topic 606 The Company sells DME, replacement parts and supplies to customers and recognizes revenue based on contractual payment rates as determined by the payors at the point in time where control of the good or service is transferred through delivery to the customer. The customer and, if applicable, the payors are generally charged at the time that the product is sold. The Company also provides sleep study services to customers and recognizes revenue when the results of the sleep study are complete as that is when the performance obligation is met. The transaction price on both equipment sales and sleep studies is the amount that the Company expects to receive in exchange for the goods and services provided. Due to the nature of the durable medical equipment business, gross charges are retail charges and generally do not reflect what the Company is ultimately paid. As such, the transaction price is constrained for the difference between the gross charge and what is estimated to be collected from payors and from patients. The transaction price therefore is predominantly based on contractual payment rates as determined by the payors. The Company does not generally contract with uninsured customers. The payment terms and conditions of customer contracts vary by customer type and the products and services offered. The Company determines its estimates of contractual allowances and discounts based upon contractual agreements, its policies and historical experience. While the rates are fixed for the product or service with the customer and the payors, such amounts typically include co-payments, co-insurance and deductibles, which vary in amounts, and are due from the patient. The Company includes in the transaction price only the amount that the Company expects to be entitled, which is substantially all of the payor billings at contractual rates. Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenue and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application or claim denial. Returns and refunds are not accepted on either equipment sales or sleep study services. The Company does not offer warranties to customers in excess of the manufacturer’s warranty. Any taxes due upon sale of the products or services are not recognized as revenue. The Company does not have any partially or unfilled performance obligations related to contracts with customers and as such, the Company has no contract liabilities as of December 31, 2019. Allowance for Doubtful Accounts The Company estimates that a certain portion of receivables from customers may not be collected and maintains an allowance for doubtful accounts. The Company evaluates the net realizable value of accounts receivable as of the date of the consolidated balance sheets. Specifically, we consider historical realization data including current and historical cash collections, accounts receivable aging trends, other operating trends and relevant business conditions. Because of continuing changes in the health care industry and third-party reimbursement, it is possible that the estimates could change, which could have a material impact on the operations and cash flows. If circumstances related to certain customers change or actual results differ from expectations, our estimate of the recoverability of receivables could fluctuate from that provided for in our consolidated financial statements. A change in estimate could impact bad debt expense and accounts receivable. Our allowance for doubtful accounts was $7.8 million and $4.3 million as of December 31, 2019 and 2018, respectively, and based on our analysis, we believe the reserve is adequate for any exposure to credit losses. Stock-Based Compensation The Company accounts for its stock-based compensation in accordance with ASC 718-Compensation-Stock Compensation, which establishes accounting for share-based awards exchanged for employee services and requires companies to expense the estimated fair value of these awards over the requisite employee service period. Stock-based compensation cost for stock options are determined at the grant date using the Black-Scholes option pricing model. Stock-based compensation costs for restricted stock units are determined at the grant date based on the closing stock price. The expense of such stock-based compensation awards is recognized using the graded vesting attribution method over the vesting period and the offsetting credit is recorded as an increase in additional paid-in capital. Forfeitures are recorded as incurred. Any excess tax benefit or deficiency is recognized as a component of income taxes and within operating cash flows upon vesting of the share-based award. For the Company’s phantom share units settled in cash, the Company computes the fair value of the phantom share units using the closing price of the Company's stock at the end of each period and records a liability based on the percentage of requisite service. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Income Taxes The Company is subject to income taxes in numerous jurisdictions. Significant judgment is required in determining the provision for income taxes. The Company’s income tax provisions reflect management’s interpretation of country and state tax laws. There are many transactions and calculations for which the ultimate tax determination is uncertain during the ordinary course of business and may remain uncertain for several years after their occurrence. The Company recognizes assets and liabilities for taxation when it is probable that the Company will receive refunds or pay taxes to the relevant tax authority. Where the final determination of tax assets and liabilities is different from the amounts that were initially recorded, such differences will impact the current and deferred income taxes provision in the period in which such determination is made. Changes in tax law or changes in the way tax law is interpreted may also impact the Company’s effective tax rate as well as its business and operations. Income tax expense consists of current and deferred tax expense. Current and deferred tax are recognized in profit or loss except to the extent that it relates to items recognized directly in equity or other comprehensive income. Current tax is recognized and measured at the amount expected to be recovered from or payable to the taxation authorities based on the income tax rates enacted at the end of the reporting period and includes any adjustment to taxes payable in respect of previous years. Deferred income tax assets and liabilities are recognized for the future income tax consequences attributable to temporary differences between the financial statement carrying value of assets and liabilities and their respective income tax bases. Deferred income tax assets or liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be settled. The calculation of current and deferred income taxes requires management to make estimates and assumptions and to exercise a certain amount of judgment concerning the carrying value of assets and liabilities. The current and deferred income tax assets and liabilities are also impacted by expectations about future operating results and the timing of reversal of temporary differences as well as possible audits of tax filings by regulatory agencies. Changes or differences in these estimates or assumptions may result in changes to the current and deferred tax assets and liabilities on the consolidated statements of financial position and a charge to or recovery of income tax expense. Deferred tax is recognized on any temporary differences between the carrying amounts of assets and liabilities in the consolidated financial statements and the corresponding tax bases used in the computation of taxable earnings. The effect of a change in the enacted tax rates is recognized in net earnings and comprehensive income or in equity depending on the item to which the adjustment relates. Deferred tax assets are recognized to the extent future recovery is probable. At each reporting period end, deferred tax assets are evaluated for recoverability based on whether it is more likely than not that sufficient taxable earnings will be available to allow all or part of the asset to be recovered. See Note 10 to the audited financial statements for the fiscal years ended December 31, 2019 and 2018 included in this Annual Report on Form 10-K for details on income taxes recognized. Impairment of Long-Lived Assets The Company follows ASC Topic 360, which requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the asset group’s carrying amounts may not be recoverable. In performing the review for recoverability, if future undiscounted cash flows (excluding interest charges) from the use and ultimate disposition of the assets are less than their carrying values, an impairment loss represented by the difference between its fair value and carrying value, is recognized. When properties are classified as held for sale they are recorded at the lower of the carrying amount or the expected sales price less costs to sell. There were no impairment charges recognized during the periods ended December 31, 2019 and 2018. Net Income per Share Attributable to Common Stockholders The Company uses the two-class method to compute net income per common share attributable to common stockholders because the Company issued securities, other than common stock, that contractually entitled the holders to participate in the dividends and earnings prior to the initial listing after the Arrangement. The two-class method requires earnings for the period to be allocated between common stock and participating securities based upon their respective rights to receive distributed and undistributed earnings. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Under the two-class method, for periods with net income, basic net income per share attributable to common stockholders is computed by dividing the net income attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share attributable to common stockholders is computed by dividing the net income attributable to common stockholders by the weighted-average number of shares of common stock and dilutive potential shares of common stock outstanding during the period. Net income attributable to common stockholders is computed by subtracting from net income the portion of the current period's earnings that the participating securities would have been entitled to receive pursuant to their dividend rights had all of the period’s earnings been distributed. No such adjustment to earnings is made during periods with a net loss, as the holders of the participating securities have no obligation to fund losses. See Note 11 to the audited financial statements for the fiscal years ended December 31, 2019 and 2018 included in this Annual Report on Form 10-K for earnings per share computations. Results of Operations The following financial information includes certain prior period corrections relating to daily revenue recognition of the Company’s home medical equipment rentals. The Company concluded that the cumulative effect of such corrections in fiscal year 2019 would materially misstate the Company’s consolidated statement of income for the year ended December 31, 2019. The financial results for the prior year have been restated. 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: Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Revenue The following table summarizes our revenue for the years ended December 31, 2019 and 2018: For the year ended December 31, 2019, net revenue totaled $80.3 million, an increase of $15.8 million (or 24.5%) from the comparable period in 2018. The revenue growth was primarily driven by an $11.1 million (or 19.2%) increase in ventilator rental revenue. This increase is attributable to our organic growth in active ventilator patient base. Our active ventilator patient base grew from 5,905 as of December 31, 2018 to 7,759 as of December 31, 2019, an increase of 31%. In addition to the ventilator rental revenue growth, rental revenue from other DME grew $2.6 million (or 96.5%). As a result of the current year adoption of ASC 842, bad debt is required to be presented within net revenue, instead of within selling, general administrative expenses as presented in the prior year. Current year net revenue has been reduced by $9.8 million as a result of this change in presentation. Cost of revenue and gross profit For the year ended December 31, 2019, cost of revenue totaled $24.3 million, an increase of $7.6 million (or 45.3%) from the comparable period in 2018. For the years ended December 31, 2019 and 2018, gross profit percentage decreased from 74.1% to 69.8%. The primary driver for the decreased gross profit percentage is the result of the current year adoption of ASC 842, which requires bad debt to be presented within net revenue reducing current year net revenue by $9.8 million. Selling, general & administrative expense For the year ended December 31, 2019, selling, general and administrative expenses totaled $41.4 million, an increase of $7.1 million (or 20.6%) from the comparable period in 2018. The increase was primarily the result of an increase in employee costs which includes the impact of our phantom stock plan. Our phantom stock plan is measured at fair value as of the reporting period and is driven primarily by our stock price. During the year ended December 31, 2019, our stock price increased 55%, resulting in higher expenses related to these awards. Offsetting these increases is the current year change in bad debt presentation required as a result of the current year adoption of ASC 842. Current year selling, general and administrative expenses are $9.8 million lower as a result of this change in presentation. Selling, general, and administrative expenses as a percentage of revenue increased to 51.6% for the year ended December 31, 2019 compared to 53.2% and for the year ended December 31, 2018. As noted, the primary driver of our selling, general and administrative expenses is employee associated cost. As we continue to grow into new markets and increase our employee count, we expect overall selling, general and administrative expenses will increase accordingly. However, we expect that selling, general and administrative expenses as a percentage of revenue will remain relatively consistent with 2019 levels. Research and development costs For the year ended December 31, 2019, research and development costs totaled $0.8 million, an increase of $0.8 million (or 100%) from the comparable period in 2018. As we continue to invest in research and development related projects to support our technology initiatives, we expect that associated costs will increase in 2020 relative to 2019 costs. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Stock-based compensation For the year ended December 31, 2019, stock-based compensation totaled $3.9 million, an increase of $1.2 million (or 43.8%) from the comparable period in 2018. This increase is attributed to the expense of additional stock-based awards during 2019. We expect that as we continue to increase our employee count and utilize stock-based awards as an aspect of employee compensation, stock-based compensation expense will increase accordingly. Stock-based compensation as a percentage of net revenue has historically remained at or below 5%. Interest expense, net For the year ended December 31, 2019, net interest expense totaled $314,000, an increase of $133,000 (or 73.5%) from the comparable period in 2018. We expect net interest expense to increase as a result of the Building Term Note and Term Note described below. Provision for income taxes For the year ended December 31, 2019, the provision for income taxes was $271,000, compared to $162,000 during 2018. The current period provision is related to state income tax liabilities. We expect to continue to benefit from the federal tax environment in the United States. Recent tax changes allow for accelerated deductions for capital expenditures and lower corporate tax rates. As we continue to incur substantial capital expenditures to acquire medical equipment to accommodate our rapid patient base growth, combined with the deferred tax assets, we expect most near-term tax payments will continue to result from state tax liabilities. Net income For the year ended December 31, 2019, net income was $8.5 million,a decrease of $1.0 million (or 10.3%) from the comparable period in 2018. Net income as a percentage of net revenue decreased from 14.7% for the year ended December 31, 2018 to 10.6% for the year ended December 31, 2019, primarily driven by increased selling, general and administrative expenses, research and development costs, and stock-based compensation, as described above. 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 one of the most important measures for our company is Adjusted EBITDA. Adjusted EBITDA is a non-GAAP financial measure. We believe Adjusted 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 the impact of our capitalization structure and items that are not part of our day-to-day operations. Management uses Adjusted EBITDA (i) to compare our operating performance on a consistent basis, (ii) to calculate incentive compensation for our employees, (iii) for planning purposes including the preparation of our internal annual operating budget, and (iv) to evaluate the performance and effectiveness of our operational strategies. Accordingly, we believe that Adjusted EBITDA provides useful information in understanding and evaluating our operating performance in the same manner as management. In calculating Adjusted EBITDA, certain items (mostly non-cash) are excluded from net income including interest, taxes and depreciation of property and equipment. Set forth below are descriptions of the financial items that have been excluded from net income to calculate Adjusted EBITDA and the material limitations associated with using this non-GAAP financial measure as compared to net income. • Depreciation may be useful for investors to consider because it generally represents the wear and tear on the property and equipment used in our operations. However, we do not believe these charges necessarily reflect the current and ongoing cash charges related to our operating costs. • The amount of interest expense we incur or interest income we generate may be useful for investors to consider and may result in current cash inflows or outflows. However, we do not consider the amount of interest expense or interest income to be a representative component of the day-to-day operating performance of our business. • Unrealized loss on warrant conversion liability may be useful for investors to consider as it represents changes in the fair value of warrants and exchangeable shares of subsidiaries, driven predominantly by changes in our share price and exchange rates. These changes are non-cash, as is the settlement of the underlying derivative liability, which occurs upon the conversion of the derivative instrument into common shares of the Company. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 • Stock-based compensation may be useful for investors to consider because it is an estimate of the non-cash component of compensation received by the Company’s directors, officers, employees and consultants. However, stock-based compensation is being excluded from our operating expenses because the decisions which gave rise to these expenses were not made to increase revenue in a particular period, but were made for the Company’s long-term benefit over multiple periods. While strategic decisions, such as those to issue stock-based awards are made to further our long-term strategic objectives and do impact the our earnings under U.S. GAAP, these items affect multiple periods and management is not able to change or affect these items within any period. • Income tax expense may be useful for investors to consider because it generally represents the taxes which may be payable for the period and the change in deferred income taxes and may reduce or increase the amount of funds otherwise available for use. However, we do not consider the amount of income tax expense to be a representative component of the day-to-day operating performance of our business. The following table is a reconciliation of Net income, the most directly comparable U.S. GAAP measure, to Adjusted EBITDA, on a historical basis for the periods indicated: Use of Non-GAAP Financial Measures Adjusted EBITDA should be considered in addition to, not as a substitute for, or superior to, financial measures calculated in accordance with U.S. GAAP. It is not a measurement of our financial performance under U.S. GAAP and should not be considered as alternatives to revenue or net income (loss), as applicable, or any other performance measures derived in accordance with U.S. GAAP and may not be comparable to other similarly titled measures of other businesses. Adjusted 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 U.S. GAAP. Adjusted 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 Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. Liquidity and Capital Resources Cash and cash equivalents at December 31, 2019 was $13.4 million, compared to $10.4 million at December 31, 2018. Based on our current plan of operations, including potential acquisitions, we believe this amount, when combined with expected cash flows from operations and amounts available under our $10.0 million line of credit will be sufficient to fund our growth strategy and to meet our anticipated operating expenses, capital expenditures, and debt service obligations for at least the next 12 months. The Company utilizes short term leases with a major supplier that could be extended over a longer term if there was a need for additional liquidity. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Cash Flows The following table summarizes our cash flows for the periods indicated: Net Cash Provided by Operating Activities Net cash provided by operating activities during the year ended December 31, 2019 was $19.1 million, resulting from net income of $8.5 million and non-cash net income adjustments of $20.1 million, which was partially offset by an increase in net operating assets of $9.5 million. The non-cash net income adjustments primarily consisted of $9.8 million of change in allowance for doubtful accounts, $6.4 million of depreciation and $3.9 million of stock-based compensation. The uses of cash related to changes in operating assets primarily consisted of an increase in accounts receivable of $12.5 million and an increase in inventory of $0.3 million. Our increase in gross accounts receivable is driven by the impact of our current year billing conversion. Net accounts receivable increased $2.7 million during the period. The changes in operating liabilities primarily consisted of a decrease in accounts payable of $0.8 million, an increase in accrued liabilities of $2.5 million, and an increase in deferred revenue of $0.7 million. The increase in our operating assets and liabilities were primarily driven by our increased business volume period-over-period and higher compensation and personnel-related costs. Net cash provided by operating activities during the year ended December 31, 2018 was $22.4 million, resulting from net income of $9.5 million, non-cash net income adjustments of $12.9 million, and an increase in net operating liabilities of $6.9 million, which were partially offset by an increase in net operating assets of $7.0 million. The non-cash net income adjustments primarily consisted of $6.2 million of bad debt expense, $3.8 million of depreciation and $2.7 million of stock-based compensation. The uses of cash related to changes in operating assets primarily consisted of an increase in gross accounts receivable of $5.3 million as a result of increased revenue growth and an increase in inventory of $1.3 million. The changes in operating liabilities primarily consisted of increases in accounts payable of $2.5 million, accrued liabilities of $3.6 million, and deferred revenue of $0.8 million. The increase in operating liabilities was primarily attributed to higher expense incurred as a result of phantom stock and bonus awards. Net Cash Used in Investing Activities Net cash used in investing activities during the year ended December 31, 2019 was $12.8 million, consisting of $13.4 million of purchases of property and equipment, partially offset by $0.6 million of proceeds from the disposal of property and equipment. Purchases of property and equipment were primarily related to the purchase of our new corporate headquarters, in addition to medical equipment rented to our patients. Combining cash purchases of property and equipment of $13.4 million and equipment financed through leases and long term debt of $12.0 million, our total capital expenditures for the year ended December 31, 2019 were $25.4 million. This represents a $10.9 million, or 74.9%, increase year over year, which was driven by our revenue growth of 24.5% during the same periods combined with the purchase of our new corporate headquarters. Net cash used in investing activities during the year ended December 31, 2018 was $5.3 million, consisting of $6.1 million of purchases of property and equipment, partially offset by $0.8 million of proceeds from the disposal of property and equipment. Purchases of property and equipment were primarily related to the medical equipment we rent to patients. Combining cash purchases of property and equipment of $6.1 million and equipment financed through finance leases and long term debt of $8.4 million, our total capital expenditures for the year ended December 31, 2018 were $14.5 million. Net Cash Used in Financing Activities Net cash used in financing activities during the year ended December 31, 2019 was $3.3 million, consisting of $4.8 million in proceeds to finance the purchase of our corporate headquarters, $5.0 million in proceeds from the Term Note described below, partially offset by $11.6 million in repayments of finance lease liabilities and $1.5 million of shares repurchased and canceled under our normal course issuer bid described below. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 Net cash used in financing activities during the year ended December 31, 2018 was $11.8 million, consisting of $10.2 million in repayments of finance lease liabilities and $1.6 million of shares repurchased and canceled under our normal course issuer bid described below. Credit Agreement On February 20, 2018, the Company entered into a two year commercial business loan agreement with Hancock Whitney Bank. Any amounts advanced will be secured by substantially all our assets and carry an interest rate of one month ICE libor plus 3.00%, with a 4.00% interest rate floor. Advances on the line of credit initially were subject to a borrowing base as determined in accordance with the loan agreement, which was based on the value of our accounts receivable balance. On March 19, 2019, the Company entered into an amendment to the loan agreement increasing the available line of credit from $5.0 million to $10.0 million and extending the expiration date to March 19, 2021. In addition, the borrowing base restriction was removed from the loan agreement. On September 19, 2019, in conjunction with the Term Note described below, the Company entered into a third amendment to the loan agreement, which, among other things, replaced the financial covenants in the loan agreement with the following: The Company was in compliance with all covenants in effect at December 31, 2019. There were no borrowings against this line of credit at December 31, 2019 and December 31, 2018. Commercial Term Notes On May 30, 2019, the Company entered into an amendment to the loan agreement providing for a term note (the “Building Term Note”) with Hancock Whitney Bank in the principal amount of $4.8 million. The proceeds of the Building Term Note were used to purchase a building to utilize as a corporate headquarters. Beginning July 1, 2019, the Company makes monthly payments towards the outstanding balance. The Building Term Note matures on May 30, 2026 and is secured by substantially all of the assets of the borrowers, including the real property acquired with the proceeds of the Building Term Note. The Building Term Note bears interest at a variable rate equal to the one month ICE libor index plus a margin of 2.45% per annum. The Company is required to maintain a loan to value ratio of 85% with respect to the appraised value of the real property. In connection with the Building Term Note, the Company entered into an interest rate swap transaction (the "Interest Rate Swap Transaction") with Hancock Whitney Bank effectively fixing the interest rate for the Building Term Note at 4.68%. On September 19, 2019, the Company entered into a third amendment to the loan agreement providing for a term note (the “Term Note") with Hancock Whitney Bank in the principal amount of $5,000,000. The proceeds of the Term Note will be used for general corporate purposes. Beginning October 19, 2019, the Company makes monthly payments towards the outstanding balance. The Term Note matures on September 19, 2022 and is secured by substantially all of the assets of the borrowers. The Term Note bears interest at the rate of 4.60% per annum. Sources of funds Our cash provided by operating activities for the year ended December 31, 2019 was $19.1 million compared to $22.4 million for the year ended December 31, 2018. As of December 31, 2019, we had cash and cash equivalents of $13.4 million. Use of funds Our principal uses of cash are funding our new rental assets and other capital purchases, operations, and other working capital requirements. Over the past two years, our revenue has increased significantly from year-to-year and, as a result, our cash provided by operating activities has increased over time and now is a significant source of capital to the business, which we expect to continue in the future. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 We may need to raise additional funds to support our investing operations, and such funding may not be available to us on acceptable terms, or at all. If we are unable to raise additional funds when needed, our operations and ability to execute our business strategy could be adversely affected. We may seek to raise additional funds through equity, equity-linked or debt financings. If we raise additional funds through the incurrence of indebtedness, such indebtedness would have rights that are senior to holders of our equity securities and could contain covenants that restrict our operations. Any additional equity financing may be dilutive to our stockholders. For the year ended December 31, 2019, the Company re-purchased and canceled 365,100 common shares pursuant to our Normal Course Issuer Bid (the "NCIB") at a cost of $1,522,000. For the year ended December 31, 2018, the Company repurchased and canceled 410,703 common shares pursuant to our NCIB at a cost of $1,594,000. Total shares repurchased under the NCIB were 775,803 as of December 31, 2019. Under the NCIB, we were authorized to repurchase up to a maximum of 1,875,575 common shares through November 28, 2019. Leases Leases under which we assume substantially all the risks and rewards of ownership are classified as finance leases. Upon initial recognition, the leased asset is measured at an amount equal to the lesser of its fair value and the present value of the minimum lease payments. Subsequent to initial recognition, the asset is accounted for in accordance with the accounting policy applicable to the asset. The associated lease liability is drawn down over the life of the lease by allocating a portion of each lease payment to the liability with the remainder being recognized as finance charges. Leases that do not transfer the risks and rewards of ownership to the Company are treated as operating leases and are expensed as incurred. Retirement Plan The Company maintains a 401(k) retirement plan for employees to which eligible employees can contribute a percentage of their pre-tax compensation. Matching employer contributions to the 401(k) plan totaled $615,000 and $440,000 for the years ended December 31, 2019 and 2018, respectively. Off-Balance Sheet Arrangements The Company has no material undisclosed off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its results of operations or financial condition. Recent Accounting Pronouncements In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230) - Classification of Certain Cash Receipts and Cash Payments,” to provide clarity on how certain cash receipt and cash payment transactions are presented and classified within the statement of cash flows. The ASU is effective for annual periods beginning December 31, 2018, and its adoption did not impact our condensed consolidated financial statements. In July 2018, the FASB issued ASU No. 2018-07 “Improvements to Non-employee Share-Based Payment Accounting,” which expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from non-employees. The ASU is effective for interim periods as of January 1, 2019, and its adoption did not have any material impact on our consolidated financial statements. In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, “Leases” (Topic 842) (“ASC 842”), which supersedes the existing guidance for lease accounting, “Leases” (Topic 840) (“ASC 840”). ASC 842 requires lessees to recognize a lease liability and a right of use asset for all leases that extend beyond one year. This standard was adopted using the modified retrospective transition approach at the adoption date of January 1, 2019. This approach does not require the restatement of previous periods. The Company completed a qualitative and quantitative assessment of its leases from both a lessee and lessor perspective. As part of this process, the Company elected to utilize certain practical expedients that provided transition relief. Accordingly, the Company did not reassess expired or existing contracts, lease classifications or related initial direct costs as part of the assessment process for either lessee or lessor leases. From a lessor perspective, the Company recognizes revenue on rentals in accordance with Topic 842 on a straight line basis over the term of the lease. The adoption of this standard, from a lessee perspective, resulted in the recording of Right of Use (“ROU”) operating lease assets as a component of property and equipment, net and liabilities as a component of current and non-current liabilities of approximately $1.5 million on the Condensed Consolidated Balance Sheet as of January 1, 2019, with no impact to retained earnings. In addition, the Company elected as an accounting policy, not to record leases with an initial term of less than 12 months. (See Note 6 - “Debt and lease liabilities” for additional information and required disclosures.) Adoption of this standard had no change on finance leases previously subject to capital lease treatment under Topic 840. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 In August 2017, the FASB issued ASU No. 2017-12, "Derivatives and Hedging", which changes both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results, in order to better align an entity’s risk management activities and financial reporting for hedging relationships. The amendments expand and refine hedge accounting for both nonfinancial and financial risk components and align the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. The Company adopted this standard on June 1, 2019 and adoption of this standard did not have a material impact on the Company’s consolidated financial statement presentation or results.

<s>[INST] Prior Period Corrections We have corrected our previously issued consolidated financial statements contained in this Annual Report on Form 10K with respect to the fiscal year ended December 31, 2018. Refer to the "Explanatory Note" for background on the correction and other information. Overview We provide an array of home medical equipment, services and supplies, specializing in postacute respiratory care services in the United States. Our primary objective is to focus on the organic growth of the business and thereby solidify our position as one of the United States’ largest providers of in home therapy for patients suffering from respiratory diseases. Our respiratory care programs are designed specifically for payors to have the ability to treat patients in the home for less total cost and with a superior quality of care. Our services include respiratory disease management (through the rental of various durable medical equipment devices), inhome sleep testing and sleep apnea treatment, oxygen therapy, and the sale of associated supplies. We derive the majority of our revenue through the rental of noninvasive and invasive ventilators which represented 86.0% and 89.8% of our revenue for the years ended December 31, 2019 and December 31, 2018, respectively. We combine the benefits of home ventilation support with licensed Respiratory Therapists ("RTs") to drive improved patient outcomes and reduce costly hospital readmissions. We expect to use an organic growth model whereby expansion is accomplished through existing service areas as well as in new regions through a cost efficient launch that reduces location expenses. Our licensed RTs currently serve patients in 31 states. We expect to continue to employ more RTs in order to assure our high service model is accomplished in the home. As of December 31, 2019, we employed 228 licensed RTs, representing 55% of our companywide employee count. By focusing overhead costs to clinical personnel that service the patient rather than physical location costs, we aim to efficiently scale our business in regions that are currently not being effectively serviced. The continued trend of servicing patients in the home rather than in hospitals is aligned with our business objective and we anticipate that this trend will continue to offer growth opportunities for us. We expect to continue to be a solution to the rising health costs in the United States by offering more cost effective, home based solutions while increasing the quality of life for patients fighting serious respiratory diseases. As a result of this trend, we continue to experience significant organic growth. For the year ended December 31, 2019, we generated revenues of $80.3 million and had net income of $8.5 million, compared to revenues of $64.5 million and net income of $9.5 million for the year ended December 31, 2018. Our primary sources of capital to date have been from operating income and the leverage of our manufacturer credit lines and to a lesser extent access to bank term loans. In addition, our line of credit availability of $10.0 million remains undrawn. Page VIEMED HEALTHCARE, INC. (Tabular amounts expressed in thousands of US Dollars, except per share amounts) December 31, 2019 and 2018 The below table highlights summary financial and operational metrics for the last eight quarters.The information in the table below has been updated to reflect the reclassification described in Note 2 to the Notes to Consolidated Financial Statements and the correction to prior period financial statements described in Note 3 and Note 13 to the Notes to Consolidated Financial Statements. (1) Refer to "NonGAAP Financial Measures" section below for definition of Adjusted EBITDA. (2) Vent Patients represents the number of active ventilator patients on recurring billing service at the end of each calendar quarter. (3) Revenue, gross profit, gross profit percentage, net income, total assets, and Adjusted EBITDA have been updated to reflect the correction as discussed in Note 3 and Note 13 to the Notes to the Consolidated Financial Statements. (4) Revenue has been updated to reflect the reclassification as discussed in Note 2 to the Notes to the Consolidated Financial Statements. Critical Accounting Policies [/INST] Positive. </s>

RAPT 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 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 immunology-based biopharmaceutical company focused on discovering, developing and commercializing oral small molecule therapies for patients with significant unmet needs in oncology and inflammatory diseases. Utilizing our proprietary drug discovery and development engine, we are developing highly selective small molecules designed to modulate the critical immune responses underlying these diseases. We have discovered and advanced into clinical development two unique drug candidates each targeting C-C motif chemokine receptor 4 (“CCR4”): FLX475 for the treatment of a range of tumors, and RPT193 for the treatment of allergic inflammatory diseases. We are also pursuing a range of targets, including general control nonderepressible 2 (“GCN2”) and hematopoietic progenitor kinase 1 (“HPK1”), that are in the discovery stage of development. Financial Overview Since commencing operations in 2015, we have devoted substantially all of our efforts and financial resources to building our research and development capabilities and establishing our corporate infrastructure. As a result, we have incurred net losses since inception. As of December 31, 2019, we had an accumulated deficit of $162.0 million. We have incurred net losses of $43.0 million and $36.1 million for the years ended December 31, 2019 and 2018, respectively. We do not expect to generate product revenue unless and until we obtain approval for the commercialization of a drug candidate, and we cannot assure you that we will ever generate significant revenue or profits. Since inception, we have financed our operations primarily through the private placements of convertible preferred stock with net proceeds of $175.5 million and sale of equity securities. As of December 31, 2019, we had cash and cash equivalents of $77.4 million and working capital of $71.3 million. We believe our current cash and cash equivalents, including the net proceeds of approximately $69.7 million from our follow-on offering (the “Follow-on Offering”) in February 2020, will be sufficient to fund our planned operations for a period of at least twelve months following the filing date of this report. We expect to incur substantial expenditures in the foreseeable future as we expand our pipeline and advance our drug candidates through clinical development, undergo the regulatory approval process and, if approved, launch commercial 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 our drug candidates, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, including potential collaborations with other companies or other strategic transactions. Adequate funding may not be available to us on acceptable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of our drug candidates or delay our efforts to expand our product pipeline. We may also be required to sell or license to other parties rights to develop or commercialize our drug candidates that we would prefer to retain. Components of Operating Results Research and Development Expenses We expense both internal and external research and development costs as such expenses are incurred. We track the external research and development costs incurred for each of our drug candidates. However, we do not track our internal research and development costs by drug candidate, as the related efforts and their costs are typically spread across multiple drug candidates. We account for non-refundable advance payments for goods or services that will be used in future research and development activities as expenses when the goods have been received or when the service have been performed rather than when the payment is made. Clinical trial costs are a component of research and development expenses. We expense costs for our clinical trial activities performed by third parties, including clinical research organizations (“CROs”) and other service providers, as they are incurred, based upon estimates of the work completed over the life of the individual study in accordance with the associated agreements. We use information received from internal personnel and outside service providers to estimate the clinical trial costs incurred. External research and development expenses consist primarily of costs incurred for the development of our drug candidates and include: • expenses incurred under agreements with CROs, investigative sites and consultants to conduct our clinical trials and preclinical and non-clinical studies; • costs to acquire, develop and manufacture supplies for clinical trials and other studies, including fees paid to contract manufacturing organizations (“CMOs”); and • costs related to compliance with drug development regulatory requirements. Internal research and development costs include: • salaries and related costs, including stock-based compensation and travel expenses, for personnel in our research and development functions; and • depreciation and other allocated facility-related and overhead expenses. 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 FLX475 and RPT193 and advance other programs into 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 and accounting services; 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 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 professional fees for legal, consulting and accounting services, investor relations costs, higher insurance premiums and other compliance costs. Other Income, Net Our cash and cash equivalents are invested in money market funds. Other income, net, consists primarily of interest earned on our cash and cash equivalents and also includes interest earned on promissory notes we executed with our president and chief executive officer and our former chief operating officer. The promissory note with our former chief operating officer was extinguished in May 2019, and the promissory note with our president and chief executive officer was forgiven in June 2019. Critical Accounting Policies, Significant Judgments and Use of Estimates Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“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. While our significant accounting policies are described in the notes to our consolidated financial statements, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Revenue Our license and collaborative agreements consist of license, milestone and royalty payments generated through agreements with strategic partners for the development and commercialization of certain product candidates. The terms of an agreement may include a non-refundable upfront fee, payments based upon achievement of milestones and royalties on net product sales. If a portion of the nonrefundable upfront fee or other payments received is allocated to continuing performance obligations under the terms of an agreement, such portion is recorded as deferred revenue and recognized as revenue when (or as) the underlying performance obligation is satisfied. We recognize revenue when we transfer promised goods or services to customers or counterparties in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. In determining the appropriate amount of revenue to be recognized, we perform the following steps: (i) identification of the promised goods or services in the agreement; (ii) determination of whether the promised goods or services are performance obligations, including whether they are distinct in the context of the agreement; (iii) measurement of the transaction price, including any constraint on variable consideration; (iv) allocation of the transaction price to performance obligations based on estimated selling prices; and (v) recognition of revenue when (or as) we satisfy each performance obligation. Licenses: If a license to our intellectual property is determined to be distinct from the other performance obligations identified in an agreement, we will recognize revenue from the nonrefundable, upfront fee allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. If a license is bundled with other performance obligations, we utilize judgment to assess the nature of the combined performance obligations to determine whether the combined performance obligations are satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Milestone payments: If an agreement includes event-based or milestone payments, we evaluate whether the events or milestones are considered likely to be achieved and estimate the amount to be included in the transaction price using the most likely amount method. If it is unlikely that a significant revenue reversal would occur, the value of the associated event-based or milestone payments is included in the transaction price. Event-based or milestone payments that are not within our control are not included in the transaction price until they become likely to be achieved. Royalties: If an agreement includes sales-based royalties and the license is deemed to be the predominant item to which the royalties relate, we will recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). As of December 31, 2019, we recorded deferred revenue of $4.0 million on the consolidated balance sheet related to our license and collaborative agreement with Hanmi. Research and Development Expenses Research and development costs are expensed as incurred. Research and development costs consist primarily of salaries and benefits of research and development personnel, costs related to research activities, preclinical studies, clinical trials, drug manufacturing and allocated overhead and facility-related costs. We account for non-refundable advance payments for goods or services that will be used in future research and development activities as expenses when the related goods have been received or when the service has been performed rather than when the payment is made. Clinical trial costs are a component of research and development expenses. We expense costs for our clinical trial activities performed by third parties, including CROs and other service providers, as they are incurred, based upon estimates of the work completed over the life of the individual study in accordance with associated agreements. We use information we receive from internal personnel and outside service providers to estimate the progress of services performed and the associated clinical trial costs incurred. Stock-Based Compensation Expense We account for stock-based compensation arrangements with employees in accordance with ASC 718, Stock Compensation. Stock-based awards issued by us have been primarily stock options with time-based vesting or performance-based vesting. ASC 718 requires the recognition of compensation expense, using a fair value-based method, for costs related to all stock-based awards. To determine the grant-date fair value of stock-based awards with time-based vesting, we utilize the Black-Scholes option pricing model, which is impacted by the fair value of our common stock as well as other variables including, but not limited to, expected term that stock-based awards will remain outstanding, expected common stock price volatility over the term of the stock-based awards, risk-free interest rates and expected dividends. Prior to our IPO, there had been no public market for our common stock. As such, the estimated fair values of our common stock underlying our stock-based awards were determined at each grant date by our board of directors, with input from management, based on the information known to us on the grant date, including a review of any recent events and their potential impact on the estimated per share fair value of our common stock. Valuations of our common stock were prepared by a third-party valuation firm in accordance with the guidance outlined in the American Institute of Certified Public Accountants Technical Practice Aid, Valuation of Privately Held Company Equity Securities Issued as Compensation (the “Practice Aid”). For stock-based awards with time-based vesting, stock-based compensation is recognized over the period during which an awardee is required to provide services in exchange for the stock-based award, known as the requisite service period (usually the vesting period), on a straight-line basis. For stock-based awards with performance-based vesting, the fair value of the award is recognized as expense when the achievement of the associated performance criteria becomes probable, using an accelerated attribution method. For both time-based and performance-based stock-based awards, stock-based compensation expense is recognized based on the fair value determined on the date of grant. Equity instruments issued to non-employees are accounted for in accordance with ASC 505-50, Equity Based Payments to Non-Employees, and are recorded at their fair value on the measurement date and are subject to periodic adjustments as the equity instruments vest. The fair value of stock-based awards granted to non-employees is expensed when vested. Estimates of the fair value of stock-based awards as of the grant date using the Black-Scholes option pricing model are 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. These inputs are: Expected term - The expected term represents the period that our stock-based awards granted is expected to be outstanding and is determined using the simplified method (based on the mid-point between the vesting date and the end of the contractual term). We have very limited historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior for our stock-based awards. Expected volatility - Prior to our IPO, we did not have any trading history for our common stock, so the expected volatility was estimated based on the average volatility for comparable publicly traded biopharmaceutical companies over a period, where available, equal to the expected term of the stock-based awards. The comparable companies were chosen based on their similar size, life cycle stage or area of specialty. Risk-Free Interest Rate - The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of the stock-based awards. Expected Dividend - We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. We will continue to use judgment in evaluating the expected volatility, expected terms and interest rates utilized for our stock-based compensation expense calculations on a prospective basis. Stock-based compensation expense for employees and non-employees is reflected in the consolidated statements of operations and comprehensive loss as follows (in thousands): Common Stock Valuations Prior to our initial public offering (“IPO”), the grant date fair value of our common stock was determined by our board of directors with the assistance of management and an independent third-party valuation specialist. The grant date fair value of our common stock was determined using valuation methodologies that utilize certain assumptions, including probability weighting of events, volatility, time to liquidation, a risk-free interest rate and a discount for lack of marketability (Level 3 inputs). In determining the fair value of our common stock, the methodologies used to estimate our enterprise value were performed using methodologies, approaches and assumptions consistent with the 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 our fair value by including an estimation of the value of the business based on guideline public companies under a number of different scenarios. The assumptions used to determine the estimated fair value of our common stock are based on numerous objective and subjective factors, combined with management 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 convertible preferred stock relative to those of our common stock; the prices at which we sold shares of our 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. 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: • Option Pricing Method. Under the option pricing method (“OPM”), shares are valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these options. • Probability-Weighted Expected Return Method. The probability-weighted expected return method (“PWERM”) is a scenario-based analysis that estimates value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. Based on our early stage of development and other relevant factors, we determined that the OPM was the most appropriate method for allocating our enterprise value to determine the estimated fair value of our common stock for valuations during 2018. In 2019 until our IPO in November 2019, we used the PWERM to determine the estimated fair value of our common stock. The PWERM is appropriate for a company expecting a near term liquidity event. In determining the estimated fair value of our common stock, we 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. Following our IPO, our board of directors determines the fair value of our common stock based on the closing price of our common stock on the date of grant. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities are determined based on differences between the financial statement reporting and tax bases of assets and liabilities and net operating loss and credit carryforwards, and are measured using the enacted tax rates and laws that will be in effect when such items are expected to reverse. Deferred income tax assets are reduced, as necessary, by a valuation allowance when management determines it is more likely than not that some or all of the tax benefits will not be realized. We 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 $34.6 million. Due to our lack of earnings history and uncertainties surrounding our ability to generate future taxable income, 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 (“NOLs”). Utilization of NOLs may be limited by the “ownership change” rules, as defined in Section 382 of the Internal Revenue 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 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 (in thousands): *: Percentage not meaningful Research and Development Expenses Research and development expenses increased $3.1 million, or 10%, to $34.9 million for the year ended December 31, 2019 from $31.8 million for the year ended December 31, 2018. The increase in research and development expenses was primarily due to an increase of $3.6 million in clinical costs relating to RPT193, an increase of $0.5 million in clinical costs relating to FLX475, an increase of $1.3 million in personnel and other costs, $1.0 million of facilities related expenses and an increase of $0.8 million in consulting, offset by a decrease of $2.3 million of outsourced research and development costs, a decrease of $1.6 million in laboratory supplies to support our preclinical programs and a decrease of $0.2 million in depreciation expense. 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 FLX475 and RPT193 and advance other programs into the clinic. The following is a comparison of research and development expenses for the years ended December 31, 2019 and 2018 (in thousands): As previously noted, we do not track our own internal research and development costs by drug candidate, as the related efforts and their costs are typically spread across multiple drug candidates. General and Administrative Expenses General and administrative expenses increased $3.5 million, or 68%, to $8.7 million for the year ended December 31, 2019 from $5.2 million for the year ended December 31, 2018. The increase was primarily due to an increase of $0.9 million in consultant costs, an increase of $0.7 million in accounting and audit related costs, an increase of $0.8 million in legal fees, an increase of $0.6 million in personnel costs, an increase of $0.3 million in insurance and corporate fees as a public company, an increase in $0.1 million of facilities related expenses and an increase of $0.1 million in travel costs. We expect our general and administrative expenses to increase substantially during the next few years as a result of staff expansion, costs associated with being a public company, including higher insurance premiums, legal and accounting fees and other compliance costs associated with operating a public company. Other Income, Net Other income, net increased $0.5 million to $1.3 million for the year ended December 31, 2019 from $0.8 million for the year ended December 31, 2018. The increase was primarily due to an increase in interest income as a result of a higher average cash and cash equivalents balances in 2019. Liquidity and Capital Resources We had cash and cash equivalents of $77.4 million and working capital of $71.3 million as of December 31, 2019. Our cash and cash equivalents are held in money market funds. Since inception, we have incurred net losses and negative cash flows from operations. At December 31, 2019, we had an accumulated deficit of $162.0 million. In addition, we expect to incur substantial costs in order to conduct research and development activities necessary to develop and commercialize a product. Additional capital will be needed to undertake these activities and we intend to raise such capital through the issuance of additional equity, borrowings and strategic alliances with other companies. However, if such capital is not available at adequate levels or on acceptable terms, we could be required to significantly reduce operating expenses and delay or reduce the scope of or eliminate some of our development programs. We believe our current cash and cash equivalents, including the net proceeds of approximately $69.7 million from the Follow-on Offering in February 2020, will be sufficient to fund our anticipated level of operations through at least the next 12 months following the filing date of this report. 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 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 scope, rate of progress and costs of our drug discovery, preclinical development activities, laboratory testing and clinical trials for our drug candidates; • the number and scope of clinical programs we decide to pursue; • the scope and costs of manufacturing development and commercial manufacturing activities; • the extent to which we acquire or in-license other drug candidates and technologies; • the cost, timing and outcome of regulatory review of our drug candidates; • the cost and timing of establishing sales and marketing capabilities, if any of our drug candidates receive marketing approval; • the costs of preparing, filing and prosecuting patent applications, obtaining, maintaining and enforcing our intellectual property rights and defending intellectual property-related claims; • our ability to establish and maintain collaborations on favorable terms, if at all; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the development of our drug candidates; • the costs associated with being a public company; and • the cost associated with commercializing our drug candidates, if they receive marketing approval. See “Risk Factors” for additional risks associated with our substantial capital requirements. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing 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 equity or debt financing 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 other parties’ rights to develop or commercialize our drug candidates that we would prefer to retain. Summary Consolidated Statements 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): Operating Activities Net cash used in operating activities was $35.5 million for the year ended December 31, 2019, reflecting a net loss of $43.0 million, partially offset by non-cash charges for depreciation, amortization and stock-based compensation expense of $3.4 million and net cash provided by changes in operating assets and liabilities of $4.1 million. Net cash used in operating activities was $33.0 million for the year ended December 31, 2018, reflecting a net loss of $36.1 million, partially offset by non-cash charges for depreciation, amortization and stock-based compensation expense of $2.4 million, and net cash provided by changes in operating assets and liabilities of $0.7 million. Investing Activities Cash used in investing activities was $0.8 million and $3.5 million for years ended December 31, 2019 and 2018, respectively, and primarily resulted from the purchase of laboratory equipment and leasehold improvements. Financing Activities Net cash provided by financing activities was $49.9 million for the year ended December 31, 2019, primarily from the receipt of net proceeds of $34.7 million from our IPO and $14.4 million from the issuance of our convertible preferred stock. Net cash provided by financing activities was $52.7 million for the year ended December 31, 2018, primarily from the issuance of our convertible preferred stock. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): As of December 31, 2019, our commitments consisted of operating leases for our facilities of approximately 36,754 square feet. Under the terms of the agreements, we will have lease obligations, net of sublease income, of $14.3 million from 2020 through 2026. We enter into contracts in the normal course of business with third-party contract organizations for clinical trials, non-clinical studies and testing, 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 and are not included in the table above. 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. 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 pursuant to indemnification agreements. 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 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 are choosing to elect the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (1) the last day of our first fiscal year (a) following the fifth anniversary of the completion of the IPO, (b) in which we have total annual gross revenue of at least $1.07 billion, or (c) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700.0 million of the prior June 30th and (2) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period.

<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 immunologybased biopharmaceutical company focused on discovering, developing and commercializing oral small molecule therapies for patients with significant unmet needs in oncology and inflammatory diseases. Utilizing our proprietary drug discovery and development engine, we are developing highly selective small molecules designed to modulate the critical immune responses underlying these diseases. We have discovered and advanced into clinical development two unique drug candidates each targeting CC motif chemokine receptor 4 (“CCR4”): FLX475 for the treatment of a range of tumors, and RPT193 for the treatment of allergic inflammatory diseases. We are also pursuing a range of targets, including general control nonderepressible 2 (“GCN2”) and hematopoietic progenitor kinase 1 (“HPK1”), that are in the discovery stage of development. Financial Overview Since commencing operations in 2015, we have devoted substantially all of our efforts and financial resources to building our research and development capabilities and establishing our corporate infrastructure. As a result, we have incurred net losses since inception. As of December 31, 2019, we had an accumulated deficit of $162.0 million. We have incurred net losses of $43.0 million and $36.1 million for the years ended December 31, 2019 and 2018, respectively. We do not expect to generate product revenue unless and until we obtain approval for the commercialization of a drug candidate, and we cannot assure you that we will ever generate significant revenue or profits. Since inception, we have financed our operations primarily through the private placements of convertible preferred stock with net proceeds of $175.5 million and sale of equity securities. As of December 31, 2019, we had cash and cash equivalents of $77.4 million and working capital of $71.3 million. We believe our current cash and cash equivalents, including the net proceeds of approximately $69.7 million from our followon offering (the “Followon Offering”) in February 2020, will be sufficient to fund our planned operations for a period of at least twelve months following the filing date of this report. We expect to incur substantial expenditures in the foreseeable future as we expand our pipeline and advance our drug candidates through clinical development, undergo the regulatory approval process and, if approved, launch commercial 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 our drug candidates, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources, including potential collaborations with other companies or other strategic transactions. Adequate funding may not be available to us on acceptable terms, or at all. If we fail to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the development and commercialization of our drug candidates or delay our efforts to expand our product pipeline. We may also be required to sell or license to other parties rights to develop or commercialize our drug candidates that we would prefer to retain. Components of Operating Results Research and Development Expenses We expense both internal and external research and development costs as such expenses are incurred. We track the external research and development costs incurred for each of our drug [/INST] Positive. </s>

Phathom Pharmaceuticals, 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 our financial statements and related notes included elsewhere in this annual report. This discussion and analysis contains forward-looking statements based upon our current beliefs, plans and expectations that involve risks, uncertainties and assumptions. 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” or in other parts of this annual report. Overview We are a late clinical-stage biopharmaceutical company focused on developing and commercializing novel treatments for GI diseases. Our initial product candidate, vonoprazan, is an oral small molecule P-CAB. P-CABs are a novel class of medicines that block acid secretion in the stomach. Vonoprazan has shown rapid, potent, and durable anti-secretory effects and has demonstrated clinical benefits over the current standard of care as a single agent in the treatment of GERD, and in combination with antibiotics for the treatment of H. pylori infection. Takeda developed vonoprazan and has received marketing approval in thirteen countries in Asia and Latin America. Vonoprazan generated over $500 million in net sales in its fourth full year on the market since its approval in Japan in late 2014. In May 2019, we in-licensed the U.S., European, and Canadian rights to vonoprazan from Takeda. We initiated two pivotal Phase 3 clinical trials in the fourth quarter of 2019 for vonoprazan: one for the treatment of erosive GERD, also known as erosive esophagitis, and a second for the treatment of H. pylori infection. We believe that the successful completion of our Phase 3 clinical trials, together with the existing clinical data, will support regulatory submissions in 2021 and 2022 for marketing approval for the treatment of H. pylori infection and erosive esophagitis, respectively. We have received QIDP and Fast Track designations from the FDA, for vonoprazan in combination with certain antibiotics for the treatment of H. pylori infection. QIDP designation also provides potential eligibility for priority review and extension of any regulatory exclusivity awarded if approved. If approved, we plan to independently commercialize vonoprazan in the United States. We also plan to seek commercial partnerships for vonoprazan in Europe and Canada, expand development of vonoprazan across indications, dosing regimens and alternative formulations and packaging, and in-license or acquire additional clinical or commercial stage product candidates for the treatment of GI diseases in a capital efficient manner. We commenced our operations in 2018 and have devoted substantially all of our resources to date to organizing and staffing our company, business planning, raising capital, in-licensing our initial product candidate, vonoprazan, meeting with regulatory authorities, preparing for our planned Phase 3 clinical trials of vonoprazan, and providing other general and administrative support for these operations. Our operations to date have been funded primarily through the issuance of convertible promissory notes, commercial bank debt and the proceeds from our initial public offering. From our inception through December 31, 2019, we have raised aggregate gross proceeds of $90.3 million from the issuance of convertible promissory notes, $25.0 million of commercial bank debt and net proceeds from our initial public offering of $191.5 million from the sale of 10,997,630 shares of common stock, which included the exercise in full by the underwriters of their option to purchase 1,434,473 additional shares at a public offering price of $19.00 per share, after deducting underwriting discounts, commissions and offering costs. As of December 31, 2019, we had cash and cash equivalents of $243.8 million. Based on our current operating plan, we believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash requirements through at least the next 24 months. US-DOCS\113023198.3 We do not have any products approved for sale and have incurred net losses since our inception. Our net losses for the years ended December 31, 2019 and 2018 were $255.1 million and $1.3 million, respectively. Our net losses for the year ended December 31, 2019 included non-cash charges related to the change in fair value of warrant liabilities of $96.3 million, the change in fair value of convertible promissory notes of $49.5 million, the issuance to Takeda of 1,084,000 shares of our common stock at a fair value of $5.9 million and the issuance of the Takeda Warrant at an initial fair value of $47.9 million. As of December 31, 2019, we had an accumulated deficit of $256.4 million. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical development activities, other research and development activities and pre-commercialization activities. We expect our expenses and operating losses will increase substantially as we advance vonoprazan through clinical trials, seek regulatory approval for vonoprazan, expand our clinical, regulatory, quality, manufacturing and commercialization capabilities, incur significant commercialization expenses for marketing, sales, manufacturing and distribution if we obtain marketing approval for vonoprazan, protect our intellectual property, expand our general and administrative support functions, including hiring additional personnel, and incur additional costs associated with operating as a public company. We have never generated any revenue and do not expect to generate any revenues from product sales unless and until we successfully complete development and obtain regulatory approval for vonoprazan, which will not be for several years, if ever. Accordingly, until such time as we can generate significant revenue from sales of vonoprazan, if ever, we expect to finance our cash needs through equity offerings, our Loan Agreement, debt financings, or other capital sources, including potential collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements when needed would have a negative impact on our financial condition and could force us to delay, 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. Financial Operations Overview Our combined financial statements include the accounts of Phathom (the receiving entity) and YamadaCo IIA prior to being merged into a single entity effective March 13, 2019. Phathom and YamadaCo IIA were entities under common control of Frazier Life Sciences IX, L.P., or Frazier, as a result of, among other things, Frazier’s: (i) ownership of a majority of the outstanding capital stock of both companies; (ii) financing of both companies; (iii) control of the board of directors of both companies; and (iv) management of both companies. Both Phathom and YamadaCo IIA were formed for the purpose of identifying potential assets around which to form an operating company. As the merged entities were under common control, the combined financial statements report the financial position, results of operations and cash flows of Phathom and YamadaCo IIA as though the transfer of net assets and equity interests had occurred at the beginning of 2018. All intercompany accounts and transactions have been eliminated in combination. License Agreement with Takeda On May 7, 2019, we and Takeda entered into the Takeda License, pursuant to which we in-licensed the U.S., European, and Canadian rights to vonoprazan. During the term of the Takeda License, we and our affiliates are not permitted to commercialize any pharmaceutical product, other than vonoprazan, that treats acid-related disorders, except for certain generic and OTC competing products in specified circumstances. We will be responsible at our cost for the development, manufacture and commercialization of vonoprazan products. We are required to use commercially reasonable efforts to develop and commercialize the vonoprazan products in our licensed territory. Under the Takeda License, Takeda has the sole right and authority, with our input, to prepare, file, prosecute, and maintain all Takeda and joint patents on a worldwide basis at its own cost. We are responsible, at our cost, for preparing, filing, prosecuting, and maintaining patents on inventions made solely by us in connection with vonoprazan, subject to input from Takeda. US-DOCS\113023198.3 We paid Takeda upfront consideration consisting of a cash fee of $25.0 million, 1,084,000 shares of our common stock, the Takeda Warrant to purchase 7,588,000 shares of our common stock at an exercise price of $0.00004613 per share, and issued Takeda a right to receive an additional common stock warrant, or the Takeda Warrant Right, if Takeda’s fully-diluted ownership of the Company represented less than a certain specified percentage of the fully-diluted capitalization, including shares issuable upon conversion of then outstanding convertible promissory notes, calculated immediately prior to the closing of our IPO. The Takeda Warrant Right expired upon completion of our IPO, and no additional warrant was issued. We agreed to make milestone payments to Takeda upon achieving certain tiered aggregate annual net sales of licensed products in the United States, Europe and Canada up to a total maximum milestone amount of $250.0 million. We also agreed to make tiered royalty payments at percentages in the very low to mid double digits on net sales of licensed products, subject to specified offsets and reductions. Royalties will be payable, on a product-by-product and country-by-country basis from the first commercial sale of such product in such country, until the latest of expiration of the licensed patents covering the applicable product, expiration of regulatory exclusivity in such country, or 15 years following first commercial sale in such country. Components of Results of Operations Operating Expenses Research and Development To date, our research and development expenses have related to the development of vonoprazan. Research and development expenses are recognized as incurred and payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. Research and development expenses include: • salaries, payroll taxes, employee benefits, and stock-based compensation charges for those individuals involved in research and development efforts; • external research and development expenses incurred under agreements with CROs, and consultants to conduct and support our ongoing clinical trials of vonoprazan; and • costs related to the manufacturing of vonoprazan for our clinical trials. We plan to substantially increase our research and development expenses for the foreseeable future as we continue the development of vonoprazan. We cannot determine with certainty the timing of initiation, the duration or the completion costs of current or future clinical trials and nonclinical studies of vonoprazan or any future product candidates due to the inherently unpredictable nature of clinical and preclinical development. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. In addition, we cannot forecast which product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. Our future 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; US-DOCS\113023198.3 • the number of patients that participate in the trials; • the number of doses evaluated in the trials; • the drop-out or discontinuation rates of patients; • potential additional safety monitoring requested by regulatory agencies; • the duration of patient participation in the trials and follow-up; • the phase of development of the product candidate; and • the efficacy and safety profile of the product candidate. In-Process Research and Development In-process research and development expenses relate to the Takeda License, and include the $78.9 million purchase price of the acquired research and development assets. The purchase price of the Takeda License consisted of the following: (i) $25.0 million in cash; (ii) issuance to Takeda of 1,084,000 shares of our common stock at a fair value of $5.9 million; (iii) issuance of the Takeda Warrant at an initial fair value of $47.9 million; (iv) issuance of the Takeda Warrant Right, with a nominal initial fair value due to the low probability of issuance; and (v) $0.1 million of transaction costs incurred by us. The fair value of the Takeda Warrant and Takeda Warrant Right were determined using the methodologies described below under “Change in Fair Value of Warrant Liabilities.” General and Administrative General and administrative expenses consist of salaries and employee-related costs, including stock-based compensation, for personnel in executive, finance and other administrative functions, legal fees relating to intellectual property and corporate matters, and professional fees for accounting and consulting services. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities, pre-commercial preparation activities for vonoprazan and, if any future product candidate receives marketing approval, commercialization activities. We also anticipate increased expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with operating as a public company. Interest Income Interest income consists of interest on our money market fund. Interest Expense Interest expense consists of (i) interest on our convertible promissory notes at per annum interest rates ranging from 1.68% to 6.00% and (ii) interest on our outstanding commercial bank debt at a floating per annum interest rate which was 7.25% as of December 31, 2019, and amortization of the commercial bank debt discount recorded in connection with the fair value of warrants issued to the lenders, the debt issuance costs incurred and the obligation to make a final payment fee. US-DOCS\113023198.3 Change in Fair Value of Warrant Liabilities In connection with the Takeda License, we issued the Takeda Warrant and Takeda Warrant Right, or together the Takeda Warrants. Prior to increasing the number of authorized shares of our common stock in October 2019, the Takeda Warrants are accounted for as liabilities as they did not meet all the conditions for equity classification due to (i) insufficient authorized shares for the Takeda Warrant and (ii) the Takeda Warrant Right not being indexed to our own stock. We adjusted the carrying value of the Takeda Warrants to their estimated fair value at each reporting date, with any change in fair value of the warrant liabilities recorded as an increase or decrease to change in fair value of warrant liabilities in the combined statements of operations. The fair value of the Takeda Warrants was derived from the model used to estimate the fair value of our common stock prior to our IPO. On October 11, 2019, we increased our authorized shares of common stock to 50,000,000, and as a result, there were sufficient authorized shares of common stock for us to settle the Takeda Warrant. As such, we recorded an adjustment to the fair value of the Takeda Warrant as of October 11, 2019, and reclassified the balance from warrant liabilities to additional paid-in capital. Additionally, upon closing of the IPO, the Takeda Warrant Right expired without effect since no fair value had been allocated to it. In connection with the entry into the Loan Agreement, we issued the lenders warrants to purchase our capital stock, or the Lender Warrants. The Lender Warrants are accounted for as liabilities as they contain a holder put right under which the lenders could require us to pay cash in exchange for the warrants. We adjust the carrying value of the Lender Warrants to their estimated fair value at each reporting date, with any change in fair value of the warrant liabilities recorded as an increase or decrease to change in fair value of warrant liabilities in the combined statements of operations. Prior to our IPO, the fair value of the Lender Warrants was estimated using a probability-weighted model considering IPO and non-IPO scenarios. The IPO scenarios utilized a binomial lattice model to estimate a distribution of total equity values as of a projected IPO date. The non-IPO scenario utilized the repurchase price associated with the warrant put right discounted to present value based on venture capital rates of return and the term associated with the put right. Subsequent to our IPO, the Lender Warrants are accounted for at fair value using the Black-Scholes option-pricing model with an expected term equal to the remaining contractual term of the warrants. The Lender Warrants will continue to be accounted for as liabilities adjusted to fair value at each reporting date, until the lender put right expires. Change in Fair Value of Convertible Promissory Notes We issued convertible promissory notes in 2018 and 2019 for which we elected the fair value option. We adjust the carrying value of our convertible promissory notes to their estimated fair value at each reporting date, with any change in fair value of the convertible promissory notes recorded as an increase or decrease to change in fair value of convertible promissory notes in our combined statements of operations. Prior to their exchange into convertible promissory notes issued in May 2019, the fair value of convertible promissory notes issued from inception through April 2019 was estimated using a scenario-based analysis that estimated the fair value of the convertible promissory notes based on the probability-weighted present value of expected future investment returns, considering possible outcomes available to the noteholders, including conversions in subsequent equity financings, change of control transactions, settlement and dissolution. The fair value of the convertible promissory notes issued in May 2019 is estimated using a scenario-based analysis that estimates the fair value of the convertible promissory notes based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to the noteholders, including various IPO, settlement, equity financing, corporate transaction and dissolution scenarios. The notes issued in May 2019 and related accrued interest thereon were converted into 6,107,918 shares immediately prior to the completion of the IPO. US-DOCS\113023198.3 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. The $20.4 million of research and development expenses for the year ended December 31, 2019 consisted of $16.0 million of expenses for the clinical development of vonoprazan, $2.3 million of personnel-related expenses, $1.7 million of consulting expenses, and $0.4 million of expenses related to regulatory requirements. We had minimal research and development expenses for the year ended December 31, 2018 as we had not yet entered into the Takeda License. In-Process Research and Development Expenses. The $78.9 million of in-process research and development expenses for the year ended December 31, 2019 consisted of the purchase price for the research and development assets we acquired as part of the Takeda License. The purchase price of the Takeda License consisted of the following: (i) $25.0 million in cash; (ii) issuance to Takeda of 1,084,000 shares of our common stock at a fair value of $5.9 million as of the date of issuance; (iii) issuance of the Takeda Warrant at an initial fair value of $47.9 million; (iv) issuance of the Takeda Warrant Right, with a nominal initial fair value due to the low probability of issuance; and (v) $0.1 million of transaction costs incurred by us. We had no in-process research and development expenses for the year ended December 31, 2018. General and Administrative Expenses. General and administrative expenses were $6.9 million and $1.2 million for the years ended December 31, 2019 and 2018, respectively. The increase of $5.7 million was due to increases of $1.8 million in personnel-related expenses, $1.3 million in professional services expenses for accounting, audit, tax, valuation and other services, $0.9 million in legal fees related to corporate and intellectual property matters, $0.8 million of insurance premiums related to general operating matters, $0.2 million of consulting expenses, and $0.7 million of other operating expenses. Other Income (Expense). Other expense of $148.9 million for the year ended December 31, 2019 consisted of $96.3 million of other expense related to the increase in the fair value of warrant liabilities, $49.5 million of other expense related to the increase in the fair value of our convertible promissory notes, $2.6 million of interest expense on our then outstanding convertible promissory notes, $1.6 million of interest expense on outstanding commercial bank debt, partially offset by $1.1 million of interest income. Other expense of $63,000 for the year ended December 31, 2018 consisted of $13,000 of interest expense on our outstanding convertible promissory notes and $50,000 of other expense related to the increase in fair value of those convertible promissory notes. US-DOCS\113023198.3 Liquidity and Capital Resources We have incurred 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 cash and cash equivalents of $243.8 million. Commercial Bank Debt On May 14, 2019, we entered into the Loan Agreement with SVB, as administrative and collateral agent, and lenders SVB and WestRiver Innovation Lending Fund VIII, L.P.. We borrowed $25.0 million, or Term Loan A, at the inception of the Loan Agreement and had the right to borrow an additional $25.0 million, or Term Loan B, which we collectively refer to as the Term Loans. Term Loan B was available through March 31, 2020, provided that (i) we have received at least $150.0 million of net cash proceeds in connection with the issuance and sale, subsequent to April 1, 2019, of our equity securities and subordinated debt, (ii) we had initiated Phase 3 clinical trials for vonoprazan, and (iii) no event of default has occurred. As of December 31, 2019, we had outstanding principal on the Term Loans of $25.0 million and accrued interest of $0.2 million. In March 2020, we borrowed the additional $25.0 million available under Term Loan B. The Term Loans bear interest at a floating rate of the higher of the Wall Street Journal Prime rate plus 1.75% (6.5% at December 31, 2019) or 7.25%. The monthly payments consist of interest-only through May 31, 2021 or, in the event of positive data with respect to our Phase 3 clinical trials in both indications for vonoprazan sufficient to file a NDA, with the FDA, through May 31, 2022. On March 11, 2020, we amended the Loan Agreement to potentially extend the interest-only payment period. Pursuant to the amendment to the Loan Agreement, the interest-only payment period, which ends on May 31, 2021, will be extended either (i) until December 31, 2021, if we receive positive data from our Phase 3 clinical trial in H. pylori infection sufficient to file an NDA with the FDA; or (ii) until November 30, 2022, if we receive positive data from our Phase 3 clinical trials in both indications for vonoprazan sufficient to file an NDA with the FDA; provided, in each case, that we had drawn down Term Loan B. Subsequent to the interest-only period, the Term Loans will be payable in equal monthly installments of principal, plus accrued and unpaid interest through the maturity date of May 1, 2024. In addition, we are obligated to pay a final payment fee of 8.25% of the original principal amount of the Term Loans. We may elect to prepay all or a portion of the Term Loans prior to maturity, subject to a prepayment fee of up to 2.0% of the then outstanding principal balance and payment of a pro rata portion of the final payment fee. After repayment, no Term Loan amounts may be borrowed again. The borrowings under the Loan Agreement are collateralized by substantially all of our assets, excluding intellectual property and certain other assets. We have agreed not to encumber our intellectual property assets without SVB’s prior written consent unless a security interest in the underlying intellectual property is necessary to have a security interest in the accounts and proceeds that are part of the assets securing the Term Loans, in which case our intellectual property will automatically be included within the assets securing the Term Loans. The Loan Agreement contains certain customary affirmative and negative covenants and events of default. The affirmative covenants include, among others, covenants requiring us to maintain our legal existence and governmental approvals, deliver certain financial reports, maintain insurance coverage and satisfy certain requirements regarding our operating accounts. The negative covenants include, among others, limitations on our ability to incur additional indebtedness and liens, merge with other companies or consummate certain changes of control, acquire other companies, engage in new lines of business, make certain investments, pay dividends, transfer or dispose of assets, amend certain material agreements or enter into various specified transactions. Upon the occurrence of an event of default, subject to any specified cure periods, all amounts owed by us would begin to bear interest at a rate that is 4.00% above the rate effective immediately before the event of default and may be declared immediately due and payable by SVB, as collateral agent. As of December 31, 2019, we were in compliance with all applicable covenants under the Loan Agreement. In connection with the Loan Agreement, we issued the Lender Warrants, which became exercisable when we borrowed Term Loan B in March 2020. The Lender Warrants are exercisable for 16,446 shares of common stock. The Lender Warrants expire ten years from the date of issuance. The Lender Warrants included a put option pursuant to which, in the event that we did not draw down Term Loan B on or before March 31, 2020, the warrant holders could have required us to repurchase the warrants for a total aggregate repurchase price of $0.5 million. The put right expired when we drew down Term Loan B in March 2020. US-DOCS\113023198.3 Convertible Note Financings From January 2018 to April 2019, we issued an aggregate of $2.4 million of convertible promissory notes to Frazier, or the Frazier Notes, bearing interest at per annum rates ranging from 1.68% to 2.55%. In May 2019, these notes and related accrued interest were exchanged, at their then fair value of $2.4 million, for the May 2019 convertible promissory notes described below. On May 7, 2019, we entered into a note purchase agreement under which we issued an aggregate of $90.3 million of unsecured convertible promissory notes, or the May 2019 Notes, resulting in gross proceeds to us of $87.8 million in cash and $2.4 million related to the exchange of the Frazier Notes. Including the conversion of the Frazier Notes, Frazier purchased $20.0 million of the May 2019 Notes. The May 2019 Notes bear interest at a rate of 6% per annum and are subordinated to borrowings under our Loan Agreement. The May 2019 Notes were payable upon demand of the holders of at least 60% of the outstanding principal amount of the May 2019 Notes, including Frazier, on May 7, 2020, or the Maturity Date, and were due and payable on May 7, 2022, subject to earlier conversion or repayment in the event we completed certain equity financings or a change of control. The note purchase agreement included certain customary covenants and events of default. Immediately prior to the completion of our IPO on October 29, 2019, the May 2019 Notes automatically converted into 6,107,918 shares of common stock, representing the outstanding principal and interest of the May 2019 notes at the date of automatic conversion. Funding Requirements Based on our current operating plan, we believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash requirements through at least the next 24 months. We expect our current cash and cash equivalents will allow us to complete our ongoing Phase 3 clinical trials of vonoprazan in the treatment of erosive esophagitis and H. pylori infection. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could deplete our capital resources sooner than we expect. Additionally, the process of testing product candidates in clinical trials is costly, and the timing of progress and expenses in these trials is uncertain. Our future capital requirements will depend on many factors, including: • the initiation, type, number, scope, results, costs and timing of, our clinical trials of vonoprazan, and preclinical studies or clinical trials of other potential product candidates we may choose to pursue in the future, including feedback received from regulatory authorities; • delays and cost increases as a result of the COVID-19 outbreak; • the costs and timing of manufacturing for vonoprazan or any future product candidates, including commercial scale manufacturing if any product candidate is approved; • the costs, timing and outcome of regulatory review of vonoprazan or any future product candidates; • the costs of obtaining, maintaining and enforcing our patents and other intellectual property rights; • our efforts to enhance operational systems and hire additional personnel to satisfy our obligations as a public company, including enhanced internal controls over financial reporting; • the costs associated with hiring additional personnel and consultants as our business grows, including additional executive officers and clinical development personnel; • the timing and amount of the milestone or other payments we must make to Takeda and any future licensors; • the costs and timing of establishing or securing sales and marketing capabilities for vonoprazan or any future product candidate; US-DOCS\113023198.3 • our ability to achieve sufficient market acceptance, coverage and adequate reimbursement from third-party payors and adequate market share and revenue for any approved products; • patients’ willingness to pay out-of-pocket for any approved products in the absence of coverage and/or adequate reimbursement from third-party payors; • the terms and timing of establishing and maintaining collaborations, licenses and other similar arrangements; and • costs associated with any products or technologies that we may in-license or acquire. Until such time, if ever, as we can generate substantial product revenues to support our cost structure, we expect to finance our cash needs through equity offerings, the Loan Agreement, debt financings, or other capital sources, including potential collaborations, licenses and other similar arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, or other similar arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. Including our existing cash and cash equivalents we believe that we have sufficient working capital on hand to fund operations such that there is no substantial doubt as to our ability to continue as a going concern at the date the combined financial statements were issued. There can be no assurance that we will be successful in acquiring additional funding, that our projections of its future working capital needs will prove accurate, or that any additional funding would be sufficient to continue operations in future years. Cash Flows The following table sets forth a summary of the net cash flow activity for each of the periods indicated (in thousands): Operating Activities Net cash used in operating activities was approximately $36.5 million and $1.0 million for the years ended December 31, 2019 and 2018, respectively. The net cash used in operating activities for the year ended December 31, 2019 was due to approximately $27.0 million spent on recently commenced research and development activities and ongoing general and administrative activities as well as a $9.5 million net change in operating assets and liabilities. The net change in operating assets and liabilities related to a $0.2 million increase in accrued interest on our commercial bank debt, $0.1 million increase for changes related to our operating right-of-use asset and lease liabilities and a $2.2 million increase in accounts payable and accrued expenses in support of the growth in our operating activities, partially offset by a $11.8 million increase in prepaid clinical activities and $0.2 million increase in other long-term assets. The net cash used in operating activities the year ended December 31, 2018 was primarily due to approximately $1.2 million spent on general and administrative activities. US-DOCS\113023198.3 Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was primarily due to the cash we paid, including transaction costs, to acquire the Takeda License. We had no investing activities for the year ended December 31, 2018. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $304.6 million, due to $191.5 million of net proceeds from our IPO, $88.3 million of net proceeds from our issuance of convertible promissory notes, and $24.8 million of net proceeds from our commercial bank debt. Net cash provided by financing activities for the year ended December 31, 2018 was due to proceeds from our issuance of convertible promissory notes. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): Under the Takeda License, we have milestone payment obligations that are contingent upon the achievement of specified levels of product sales and are required to make certain royalty payments in connection with the sale of products developed under the agreement. As of December 31, 2019, we are unable to estimate the timing or likelihood of achieving the milestones or making future product sales and, therefore, any related payments are not included in the table above. We enter into contracts in the normal course of business for contract research services, contract manufacturing services, professional services and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our combined financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of our combined financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities and expenses and the disclosure of contingent assets and liabilities in our combined financial statements and accompanying notes. 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 from these estimates under different assumptions or conditions. While our significant accounting policies are more fully described in Note 1 to our combined financial statements, we believe that the following accounting policies are the most critical for fully understanding and evaluating our financial condition and results of operations. US-DOCS\113023198.3 Accrued Research and Development Expenses As part of the process of preparing our combined financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments, if necessary. The significant estimates in our accrued research and development expenses include the costs incurred for services performed by our vendors in connection with research and development activities for which we have not yet been invoiced. We base our expenses related to research and development activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct research and development on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. In-Process Research and Development We evaluate whether acquired intangible assets are a business under applicable accounting standards. Additionally, we evaluate whether the acquired assets have a future alternative use. Intangible assets that do not have future alternative use, such as the Takeda License, are considered acquired in-process research and development. When the acquired in-process research and development assets are not part of a business combination, the value of the consideration paid is expensed on the acquisition date. Future costs to develop these assets are recorded to research and development expense as they are incurred. Fair Value of Warrant Liabilities and Convertible Promissory Notes As described above, our warrant liabilities and convertible promissory notes are revalued at each reporting period with changes in the fair value of the liabilities recorded as a component of other income (expense) in the combined statements of operations. There are significant judgments and estimates inherent in the determination of the fair value of these liabilities. If we had made different assumptions including, among others, those related to the timing and probability of various corporate scenarios, discount rates, volatilities and exit valuations, the carrying values of our warrant liabilities and convertible promissory notes, and our net loss and net loss per common share could have been significantly different. Leases At the inception of any contractual arrangements we may enter into, we determine whether the contract contains a lease by assessing whether there is an identified asset and whether the contract conveys the right to control the use of the identified asset in exchange for consideration over a period of time. If both criteria are met, we record the associated lease liability and corresponding right-of-use asset upon commencement of the lease using either the implicit rate or a discount rate based on our credit-adjusted secured borrowing rate commensurate with the term of the lease. Additionally, we evaluate leases at their inception to determine if they are to be accounted for as an operating lease or a finance lease. We assess if a lease is accounted for as a finance lease if it meets one of the following five criteria: the lease has a purchase option that is reasonably certain of being exercised, the present value of the future cash flows is substantially all of the fair market value of the underlying asset, the lease term is for a significant portion of the remaining economic life of the underlying asset, the title to the underlying asset transfers at US-DOCS\113023198.3 the end of the lease term, or if the underlying asset is of such a specialized nature that it is expected to have no alternative uses to the lessor at the end of the term. We account for leases that do not meet the finance lease criteria as operating leases, representing our right to use an underlying asset for the lease term. We also recognize operating lease liabilities as our obligation to make lease payments arising from the lease. We recognize operating lease liabilities with a term greater than one year and their corresponding right-of-use assets on the balance sheet at the commencement date of the lease based on the present value of lease payments over the expected lease term. As needed, we make certain adjustments to the right-of-use asset for items such as initial direct costs paid or incentives received. Because our leases do not typically provide an implicit rate, we utilize the rate of interest that we would have to pay to borrow on a collateralized basis over a similar term and in a similar economic environment. We recognize lease costs on a straight-line basis over the lease term and variable lease payments as operating expenses in the period in which the obligation for those payments is incurred. Variable lease payments primarily include common area maintenance, utilities, real estate taxes, insurance, and other operating costs that are passed on from the lessor in proportion to the space we lease. Stock-Based Compensation Expense Stock-based compensation expense represents the cost of the grant date fair value of equity awards recognized over the requisite service period of the awards (generally the vesting period) on a straight-line basis with forfeitures recognized as they occur. Through December 31, 2019, our stock-based compensation expense consisted of our issuance of restricted stock awards, for which the fair value is determined based on the fair value of the underlying common stock and stock options. As of December 31, 2019, unrecognized stock-based compensation expense was $6.8 million, which is expected to be recognized over a weighted-average period of approximately 3.75 years. Other Company Information JOBS Act As an emerging growth company under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, we 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 irrevocably elected not to avail ourselves of this exemption and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. We intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of Sarbanes-Oxley. We will remain an emerging growth company until the earliest of (i) the last day of the fiscal year following the fifth anniversary of the consummation of our IPO, (ii) the last day of the fiscal year in which we have total annual gross revenue of at least $1.07 billion, (iii) the last day of the fiscal year in which we are deemed to be a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock held by non-affiliates exceeded $700.0 million as of the last business day of the second fiscal quarter of such year, or (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 The information required by this item is included in Note 1, Organization, Basis of Presentation and Summary of Significant Accounting Policies included in Item 15 of this annual report. Off-Balance Sheet Arrangements During the periods presented we did not have, nor do we currently have, any off-balance sheet arrangements as defined under SEC rules. US-DOCS\113023198.3

<s>[INST] Overview We are a late clinicalstage biopharmaceutical company focused on developing and commercializing novel treatments for GI diseases. Our initial product candidate, vonoprazan, is an oral small molecule PCAB. PCABs are a novel class of medicines that block acid secretion in the stomach. Vonoprazan has shown rapid, potent, and durable antisecretory effects and has demonstrated clinical benefits over the current standard of care as a single agent in the treatment of GERD, and in combination with antibiotics for the treatment of H. pylori infection. Takeda developed vonoprazan and has received marketing approval in thirteen countries in Asia and Latin America. Vonoprazan generated over $500 million in net sales in its fourth full year on the market since its approval in Japan in late 2014. In May 2019, we inlicensed the U.S., European, and Canadian rights to vonoprazan from Takeda. We initiated two pivotal Phase 3 clinical trials in the fourth quarter of 2019 for vonoprazan: one for the treatment of erosive GERD, also known as erosive esophagitis, and a second for the treatment of H. pylori infection. We believe that the successful completion of our Phase 3 clinical trials, together with the existing clinical data, will support regulatory submissions in 2021 and 2022 for marketing approval for the treatment of H. pylori infection and erosive esophagitis, respectively. We have received QIDP and Fast Track designations from the FDA, for vonoprazan in combination with certain antibiotics for the treatment of H. pylori infection. QIDP designation also provides potential eligibility for priority review and extension of any regulatory exclusivity awarded if approved. If approved, we plan to independently commercialize vonoprazan in the United States. We also plan to seek commercial partnerships for vonoprazan in Europe and Canada, expand development of vonoprazan across indications, dosing regimens and alternative formulations and packaging, and inlicense or acquire additional clinical or commercial stage product candidates for the treatment of GI diseases in a capital efficient manner. We commenced our operations in 2018 and have devoted substantially all of our resources to date to organizing and staffing our company, business planning, raising capital, inlicensing our initial product candidate, vonoprazan, meeting with regulatory authorities, preparing for our planned Phase 3 clinical trials of vonoprazan, and providing other general and administrative support for these operations. Our operations to date have been funded primarily through the issuance of convertible promissory notes, commercial bank debt and the proceeds from our initial public offering. From our inception through December 31, 2019, we have raised aggregate gross proceeds of $90.3 million from the issuance of convertible promissory notes, $25.0 million of commercial bank debt and net proceeds from our initial public offering of $191.5 million from the sale of 10,997,630 shares of common stock, which included the exercise in full by the underwriters of their option to purchase 1,434,473 additional shares at a public offering price of $19.00 per share, after deducting underwriting discounts, commissions and offering costs. As of December 31, 2019, we had cash and cash equivalents of $243.8 million. Based on our current operating plan, we believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash requirements through at least the next 24 months. USDOCS\113023198.3 We do not have any products approved for sale and have incurred net losses since our inception. Our net losses for the years ended December 31, 2019 and 2018 were $255.1 million and $1.3 million, respectively. Our net losses for the year ended December 31, 2019 included noncash charges related to the change in fair value of warrant liabilities of $96.3 million, the change in fair value of convertible promissory notes of $49.5 million, the [/INST] Negative. </s>

BRP Group, 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 Item 6. Selected Financial Data and our consolidated financial statements and the related notes and other financial information 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 may differ materially from those discussed in the forward-looking statements as a result of various factors, including those set forth in Item 1A. Risk Factors and included elsewhere in this Annual Report on Form 10-K. The following discussion contains references to periods prior to the Initial Public Offering, including the period from January 1, 2019 through October 27, 2019 and calendar year 2018. The financial information of BRP Group has been combined with that of BRP as of the earliest period presented. EXECUTIVE SUMMARY OF 2019 FINANCIAL RESULTS We are a rapidly growing independent insurance distribution firm delivering solutions that give our clients the peace of mind to pursue their purpose, passion and dreams. The following is a summary of our 2019 financial results: Revenues for the year ended December 31, 2019 were $137.8 million, an increase of $58.0 million, or 73%, as compared to the same period of 2018. Our revenue growth was primarily attributable to our 2019 Partnerships, which comprised $43.0 million in revenues, in addition to organic growth of $7.8 million and a full year of contribution from Partners acquired in 2018. Operating expenses for the year ended December 31, 2019 were $142.9 million, an increase of $72.6 million, or 103%, as compared to the same period of 2018. The increase in operating expenses was primarily attributable to our 2019 Partnerships, which comprised $52.7 million of operating expenses (including an increase in the fair value of contingent consideration of $14.0 million), $4.7 million of expenses related to the Initial Public Offering, increased compensation for sales and support related to our growth and continued investments in Growth Services to support our growth. Interest expense, net for the year ended December 31, 2019 was $10.6 million, an increase of $4.0 million, or 61%, as compared to the same period of 2018. Interest expense, net increased as a result of higher total debt balances during the second and third quarters of 2019 resulting from draws on our Credit Agreements to fund cash consideration for Partnerships, a higher interest rate on the Villages Credit Agreement that went into effect in March 2019 until this facility was closed in October 2019, and higher amortization of deferred financing costs related to refinancing our Credit Agreements on several occasions during 2019. Loss on extinguishment of debt was $6.7 million for the year ended December 31, 2019, of which $6.2 million related to our repayment in full of the outstanding indebtedness under the Villages Credit Agreement in connection with the Initial Public Offering. The remaining loss related to refinancing the JPMorgan Credit Agreement on several occasions during 2019. Net loss for the year ended December 31, 2019 was $22.5 million, an increase of $25.1 million as compared to net income of $2.7 million in the same period of 2018. Adjusted EBITDA for the year ended December 31, 2019 was $28.5 million, an increase of $12.5 million as compared to the same period of 2018. Adjusted EBITDA margin was 21% for 2019 and 20% for 2018. Organic Revenue for the year ended December 31, 2019 was $87.7 million as compared to $56.8 million for the same period of 2018. Organic Revenue Growth was $7.8 million, or 10%, for 2019 and $8.8 million, or 18%, for 2018. Refer to the Non-GAAP Financial Measures section below for reconciliations of Adjusted EBITDA, Adjusted EBITDA Margin, Organic Revenue and Organic Revenue Growth to the most directly comparable GAAP financial measures. PARTNERSHIPS We utilize strategic acquisitions, which we refer to as Partnerships, to complement and expand our business. The financial impact of Partnerships may affect the comparability of our results from period to period. Our acquisition strategy also entails certain risks, including the risks that we may not be able to successfully source, close, integrate and effectively manage businesses that we acquire. To mitigate that risk, we have a professional team focused on finding new Partners and integrating new Partnerships. We plan to execute on numerous Partnerships annually as it is a key pillar in our long-term growth strategy over the next ten years. We completed six Partnerships for an aggregate purchase price of $174.1 million during 2019 and twelve Partnerships for an aggregate purchase price of $66.4 million during 2018. The most significant Partnerships that we have completed during 2019 are discussed in greater detail below. Refer to Note 4 to BRP’s consolidated financial statements included in Item 8. Financial Statements and Supplementary Data of this Annual Report on Form 10-K for additional information on the Partnerships that we have completed during 2019. Effective March 1, 2019, we entered into an asset purchase agreement to purchase certain assets and intellectual and intangible rights and assume certain liabilities of Lykes Insurance, Inc., a Middle Market Partnership for cash consideration of $36.0 million and fair value of noncontrolling interest of $1.0 million. The acquisition was made to expand our Middle Market business presence in Florida. We recognized total revenues and net income from the Lykes Partnership of $8.8 million and $1.4 million, respectively, during 2019. As a result of the Lykes Partnership, we recognized goodwill in the amount of $25.9 million. The factors contributing to the recognition of the amount of goodwill are based on strategic benefits that are expected to be realized from acquiring Lykes’ assembled workforce in addition to other synergies gained from integrating Lykes’ operations into our consolidated structure. We incurred approximately $152,000 in acquisition-related costs for Lykes during 2019. Effective April 1, 2019, we entered into a securities purchase agreement to purchase the membership interests of Millennial Specialty Insurance LLC, a Specialty Partnership, for cash consideration of $45.5 million, fair value of contingent earnout consideration of $25.6 million, fair value of noncontrolling interest of $31.0 million and a trust balance adjustment of $1.1 million. The Partnership was made to obtain access to certain technology and invest in executive talent for building and growing MGA of the Future and to apply its functionality to other insurance placement products, as well as to expand our market share in specialty renter’s insurance. MGA of the Future is a national renter’s insurance product distributed via sub-agent partners and property management software providers, which has expanded distribution capabilities for new products through our wholesale and retail networks. We recognized total revenues and net loss from the MSI Partnership of $31.2 million and $12.3 million, respectively, during 2019. As a result of the MSI Partnership, we recognized goodwill in the amount of $50.2 million. The factors contributing to the recognition of the amount of goodwill are based on strategic benefits that are expected to be realized from acquiring MSI’s MGA platform. We incurred approximately $233,000 in acquisition-related costs for MSI during 2019. The maximum potential contingent earnout consideration available to be earned by MSI is $61.5 million. Effective August 1, 2019, we entered into an asset purchase agreement with an unrelated third party to purchase certain assets and intellectual and intangible rights and assume certain liabilities of Foundation Insurance of Florida, LLC for cash consideration of $20.8 million, fair value of noncontrolling interest of $6.0 million and fair value of contingent earnout consideration of $3.3 million. The Partnership was made to expand our MainStreet business presence in Florida. We recognized total revenues and net income from the Foundation Insurance Partnership of $2.1 million and $1.4 million, respectively, during 2019. As a result of the Foundation Insurance Partnership, we recognized goodwill in the amount of $21.5 million. The factors contributing to the recognition of the amount of goodwill are based on strategic benefits that are expected to be realized from acquiring Foundation Insurance’s assembled workforce in addition to other synergies gained from integrating Foundation Insurance’s operations into our consolidated structure. We incurred approximately $51,000 in acquisition-related costs for Foundation Insurance during 2019. The maximum potential contingent earnout consideration available to be earned by Foundation Insurance is $21.8 million. As of the date of this Annual Report on Form 10-K, we have completed four Partnerships during 2020 for consideration consisting of $44.3 million of cash, 487,534 shares of Class A common stock, 286,624 units of membership interests of BRP (and a corresponding number of shares of Class B common stock issued pursuant to the terms of the Amended LLC Agreement) and a maximum potential contingent earnout consideration of $16.8 million. NOVEL CORONAVIRUS (COVID-19) An outbreak of a novel strain of the coronavirus, COVID-19, was recently identified in China and has subsequently been recognized as a pandemic by the World Health Organization. This COVID-19 outbreak has severely restricted the level of economic activity around the world. In response to this outbreak, the governments of many countries, states, cities and other geographic regions, including in the United States, have taken preventative or protective actions, such as imposing restrictions on travel and business operations and advising or requiring individuals to limit or forego their time outside of their homes. In the United States, temporary closures of businesses have been ordered and numerous other businesses have temporarily closed voluntarily. These actions have expanded significantly in the past several weeks and are expected to continue to expand. Given the uncertainty regarding the spread and severity of COVID-19 and the adverse effects on the national and global economy, the related financial impact on our business cannot be accurately predicted at this time. We intend to continue to execute on our strategic plans and operational initiatives during the outbreak. However, the uncertainties associated with the protective and preventative measures being put in place or recommended by both governmental entities and other businesses, among other uncertainties, may result in delays or modifications to these plans and initiatives. See Item 1A. “Risk Factors - Risks Relating to our Business - The occurrence of natural or man-made disasters, including the recent novel coronavirus (COVID-19) outbreak, could result in declines in business and increases in claims that could adversely affect our business, financial condition and results of operations.” RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2019 AND 2018 The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements for the years ended December 31, 2019 and 2018 and the related notes and other financial information 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. 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 those discussed under Item 1A. Risk Factors. The following is a discussion of our consolidated results of operations for each of the years ended December 31, 2019 and 2018. Seasonality The insurance brokerage market is seasonal and our results of operations are somewhat affected by seasonal trends. Our Adjusted EBITDA and Adjusted EBITDA Margins are typically highest in the first quarter and lowest in the fourth quarter. This variation is primarily due to fluctuations in our revenue, while overhead remains consistent throughout the year. Our revenues are generally highest in the first quarter due to the impact of contingent payments received in the first quarter from Insurance Company Partners that we cannot readily estimate before receipt without the risk of significant reversal and a higher degree of first quarter policy commencements and renewals in Medicare and certain Middle Market lines of business such as employee benefits and commercial. In addition, a higher proportion of our first quarter revenue is derived from our highest margin businesses. Partnerships can significantly impact Adjusted EBITDA and Adjusted EBITDA Margins in a given year and may increase the amount of seasonality within the business, especially results attributable to Partnerships that have not been fully integrated into our business or owned by us for a full year. Commissions and Fees We earn commissions and fees by facilitating the arrangement between Insurance Company Partners and individuals or businesses for the carrier to provide insurance to the insured party. Our commissions and fees are usually a percentage of the premium paid by the insured and generally depends on the type of insurance, the particular Insurance Company Partner and the nature of the services provided. Under certain arrangements with clients, we earn pre-negotiated service fees in lieu of commissions. Additionally, we may also receive from Insurance Company Partners a profit-sharing commission, or straight override, which represent forms of variable consideration associated with the placement of coverage and are based primarily on underwriting results, but may also contain considerations for volume, growth or retention. Commissions and fees increased by $58.0 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was primarily attributable to 2019 Partnerships, which comprised $43.0 million in commissions and fees, in addition to organic growth of $7.8 million and a full year of contribution from Partners acquired in 2018. Major Sources of Commissions and Fees The following table sets forth our commissions and fees by major source by amount for the years ended December 31, 2019 and 2018: Direct bill revenue represents commission revenue earned by providing insurance placement services to clients, primarily for private risk management, commercial risk management, employee benefits and Medicare insurance types. Direct bill revenue increased by $18.6 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was primarily attributable to organic growth and a full year of contribution from Partners acquired in 2018. In addition, 2019 Partnerships accounted for $8.0 million of this increase. Agency bill revenue primarily represents commission revenue earned by providing insurance placement services to clients wherein we act as an agent on behalf of the Client. Agency bill revenue increased by $25.7 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was primarily attributable to $23.4 million related to our 2019 Partnerships and the remainder was primarily attributable to organic growth. Profit-sharing revenue represents bonus-type revenue that is earned by us as a sales incentive provided by certain Insurance Company Partners. Profit-sharing revenue increased by $3.6 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was partially attributable to $2.2 million related to our MSI Partner. Policy fee and installment fee revenue represents revenue earned for acting in the capacity of an MGA and providing payment processing and services and other administrative functions on behalf of Insurance Company Partners. We earned $8.2 million of policy fee and installment fee revenue during 2019 from our Specialty Operating Group. Commissions, Employee Compensation and Benefits Commissions, employee compensation and benefits is our largest expense. It consists of (a) base compensation comprising salary, bonuses and benefits paid and payable to Colleagues, commissions paid to Colleagues and outside commissions paid to others; and (b) equity-based compensation associated with the grants of restricted interest awards to senior management, Risk Advisors and executives. We expect to continue to experience a general rise in commissions, employee compensation and benefits expense commensurate with expected growth in our sales and headcount and as a result of increasing employee compensation related to ongoing public company costs. We operate in competitive markets for human capital and need to maintain competitive compensation levels as we expand geographically and create new products and services. Our compensation arrangements with our employees contain significant bonus or commission components driven by the results of our operations. Therefore, as we grow commissions and fees, we expect compensation costs to rise. Commissions, employee compensation and benefits expenses increased by $45.3 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was primarily attributable to $28.7 million related to 2019 Partnerships, an additional $4.9 million attributable to Partners acquired in 2018, $1.9 million in bonuses and $1.3 million in share-based compensation related to the Initial Public Offering, increased compensation as a result of hiring new executive roles necessary as a public company, including a chief operating officer, chief accounting officer and general counsel, increased compensation for sales and support related to our growth and continued investments in Growth Services to support our growth. Other Operating Expenses Other operating expenses include travel, accounting, legal and other professional fees, placement fees, rent, office expenses, depreciation and other costs associated with our operations. We expect our other operating expenses to continue to increase in absolute terms as a result of ongoing public company costs, including those associated with compliance with the Sarbanes-Oxley Act and other regulations governing public companies, increased costs of directors’ and officers’ liability insurance, and increased professional services expenses, particularly associated with the adoption of new accounting standards and integration of acquired businesses. Our occupancy-related costs and professional services expenses, in particular, generally increase or decrease in relative proportion to the number of our employees and the overall size and scale of our business operations. In addition, we are investing in the expansion of our Tampa offices to accommodate our growth plans, which will result in an increase to rent expense beginning in April 2020. Certain corporate expenses are allocated to the Operating Groups. Other operating expenses increased by $10.2 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was primarily attributable to $2.8 million of expenses related to the Initial Public Offering and $3.4 million of additional operating expenses from 2019 Partners such as additional rent and increased software costs, increased professional fees, travel, and other expenses related to those new Partners. Amortization Expense Amortization expense increased by $7.4 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was driven by amortization related to $72.7 million of intangible assets capitalized in connection with our 2019 Partnerships. Change in Fair Value of Contingent Consideration Change in fair value of contingent consideration was $10.8 million for the year ended December 31, 2019 as compared to $1.2 million for the year ended December 31, 2018. The change in fair value of contingent consideration results from fluctuations in the value of the relevant measurement basis, normally revenue or EBITDA, of our Partners. We had a significantly higher estimate for the contingent earnout liability of the MSI Partnership at the end of 2019 related to growth of their business during the period under consolidation. Interest Expense, Net Interest expense, net increased by $4.0 million for the year ended December 31, 2019 as compared to the same period of 2018. This increase was attributable to higher total debt balances during the second and third quarters of 2019 resulting from draws on our Credit Agreements to fund cash consideration for Partnerships, a higher interest rate on the Villages Credit Agreement that went into effect in March 2019 until this facility was closed in October 2019, and higher amortization of deferred financing costs related to refinancing our Credit Agreements on several occasions during 2019. Loss on Extinguishment of Debt Loss on extinguishment of debt was $6.7 million for the year ended December 31, 2019, of which $6.2 million related to our repayment in full of the outstanding indebtedness under the Villages Credit Agreement in connection with the Initial Public Offering. The remaining loss related to refinancing the JPMorgan Credit Agreement on several occasions during 2019. FINANCIAL CONDITION - COMPARISON OF CONSOLIDATED FINANCIAL CONDITION AT DECEMBER 31, 2019 TO DECEMBER 31, 2018. Our total assets and total liabilities increased $258.9 million and $44.5 million, respectively, at December 31, 2019 as compared to December 31, 2018. The most significant changes in assets and liabilities are described below. Cash and cash equivalents increased $59.7 million as a result of $241.4 million of net proceeds received from the Initial Public Offering, offset in part by $89.0 million in cash used to repay in full and concurrently terminate the Villages Credit Agreement and $65.0 million of cash used to repay a portion of the JPMorgan Credit Agreement. Restricted cash increased $3.4 million as a result of restricted trust accounts we hold in connection with the MSI Partnership. Premiums, commissions and fees receivable, net increased $29.4 million as a result of our revenue growth. Intangible assets, net increased $62.7 million primarily as a result of the MSI, Lykes and Foundation Insurance Partnerships, which contributed $52.7 million, $8.7 million and $8.7 million, respectively, to gross intangible assets during 2019.These additions were offset in part by $10.0 million of amortization during 2019. Goodwill increased $98.7 million primarily as a result of the MSI, Lykes and Foundation Insurance Partnerships, which contributed $50.2 million, $25.9 million and $21.5 million, respectively, to goodwill during 2019. Premiums payable to insurance companies increased $27.3 million as a result of our revenue growth. Accrued expenses and other current liabilities increased $7.1 million as a result of higher contract liabilities relating to our revenue growth, higher accrued expenses relating to costs associated with being a public company and new Partnerships, and higher accrued compensation and benefits from 2019 bonus accruals relating to an increase in the number of executives and other Colleagues in 2019. Revolving lines of credit increased $6.5 million due to draws used for closing Partnerships during 2019. Related party debt decreased $36.9 million due to the payoff and termination of the Villages Credit Agreement in 2019. Contingent earnout liabilities increased $39.5 million primarily as a result of an increase in the fair value of the liability recorded in connection with the MSI Partnership. Equity accounts were all reset in connection with the Reorganization Transactions. Refer to Item 1. Business for a discussion of these transactions. NON-GAAP FINANCIAL MEASURES Adjusted EBITDA, Adjusted EBITDA Margin, Organic Revenue, Organic Revenue Growth, Adjusted Net Income and Adjusted Diluted Earnings Per Share (“EPS”), are not measures of financial performance under GAAP and should not be considered substitutes for GAAP measures, including commissions and fees (for Organic Revenue and Organic Revenue Growth), net income (loss) (for Adjusted EBITDA and Adjusted EBITDA Margin) net income (loss) attributable to BRP Group, Inc. (for Adjusted Net Income) or diluted EPS (for Adjusted Diluted EPS), which we consider to be the most directly comparable GAAP measures. These non-GAAP financial measures have limitations as analytical tools, and when assessing our operating performance, you should not consider these non-GAAP financial measures in isolation or as substitutes for commissions and fees, net income (loss) or other consolidated income statement data prepared in accordance with GAAP. Other companies in our industry may define or calculate these non-GAAP financial measures differently than we do, and accordingly these measures may not be comparable to similarly titled measures used by other companies. Adjusted EBITDA eliminates the effects of financing, depreciation and amortization. We define Adjusted EBITDA as net income (loss) before interest, taxes, depreciation, amortization and certain items of income and expense, including share-based compensation expense, transaction-related expenses related to Partnerships including severance, and certain non-recurring costs, including those related to the Initial Public Offering and loss on modification and extinguishment of debt. We believe that Adjusted EBITDA is an appropriate measure of operating performance because it eliminates the impact of expenses that do not relate to business performance, and that the presentation of this measure enhances an investor’s understanding of our financial performance. Adjusted EBITDA Margin is Adjusted EBITDA divided by commissions and fees. Adjusted EBITDA is a key metric used by management and our board of directors to assess our financial performance. We believe that Adjusted EBITDA is an appropriate measure of operating performance because it eliminates the impact of expenses that do not relate to business performance, and that the presentation of this measure enhances an investor’s understanding of our financial performance. We believe that Adjusted EBITDA Margin is helpful in measuring profitability of operations on a consolidated level. Adjusted EBITDA and Adjusted EBITDA Margin have important limitations as analytical tools. For example, Adjusted EBITDA and Adjusted EBITDA Margin: • do not reflect any cash capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future; • do not reflect changes in, or cash requirements for, our working capital needs; • do not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; • do not reflect the interest expense or the cash requirements necessary to service interest or principal payments on our debt; • do not reflect stock-based compensation expense and other non-cash charges; and • exclude certain tax payments that may represent a reduction in cash available to us. We calculate Organic Revenue Growth based on commissions and fees for the relevant period by excluding (i) the first twelve months of commissions and fees generated from new Partners and (ii) the impact of the change in our method of accounting for commissions and fees from contracts with customers as a result of the adoption of Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, effective January 1, 2018, under the New Revenue Standard on our 2018 commissions and fees when the impact is measured across periods that are not comparable. Organic Revenue Growth is the change in Organic Revenue period-to-period, with prior period results adjusted for Organic Revenues that were excluded in the prior period because the relevant Partners had not yet reached the twelve-month owned mark, but which have reached the twelve-month owned mark in the current period. For example, revenues from a Partner acquired on June 1, 2018 are excluded from Organic Revenue for 2018. However, after June 1, 2019, results from June 1, 2018 to December 31, 2018 for such Partners are compared to results from June 1, 2019 to December 31, 2019 for purposes of calculating Organic Revenue Growth in 2019. Organic Revenue Growth is a key metric used by management and our board of directors to assess our financial performance. We believe that Organic Revenue and Organic Revenue Growth are appropriate measures of operating performance as they allow investors to measure, analyze and compare growth in a meaningful and consistent manner. Adjusted Net Income is presented for the purpose of calculating Adjusted Diluted EPS. We define Adjusted Net Income as net income (loss) adjusted for amortization, and certain items of income and expense, including costs related to our Initial Public Offering, share-based compensation expense, transaction-related expenses related to Partnerships including severance, and certain non-recurring costs that, in the opinion of management, significantly affect the period-over-period assessment of operating results, and the related tax effect of those adjustments. Adjusted Diluted EPS measures our per share earnings excluding certain expenses as discussed above and assuming all shares of Class B common stock were exchanged for Class A common stock. Adjusted Diluted EPS is calculated as Adjusted Net Income divided by adjusted dilutive weighted-average shares outstanding. We believe Adjusted Diluted EPS is useful to investors because it enables them to better evaluate per share operating performance across reporting periods. Adjusted EBITDA and Adjusted EBITDA Margin The following table reconciles Adjusted EBITDA and Adjusted EBITDA Margin to net income (loss), which we consider to be the most directly comparable GAAP financial measure to Adjusted EBITDA and Adjusted EBITDA Margin: Organic Revenue and Organic Revenue Growth The following table reconciles Organic Revenue to commissions and fees, which we consider to be the most directly comparable GAAP financial measure to Organic Revenue: __________ (1) As discussed in Note 2 to our audited consolidated financial statements for the year ended December 31, 2019 included under Item 8 of this 10-K, the Company changed its method of accounting for commissions and fees from contracts with customers as a result of the adoption of ASC Topic 606, Revenue from Contracts with Customers, effective January 1, 2018, under the modified retrospective method. Under the modified retrospective method, the Company was not required to restate comparative financial information prior to the adoption of these standards and therefore such information presented prior to January 1, 2018 continues to be reported under the Company’s previous accounting policies. As such, an adjustment is made to remove the impact of the adoption from the calculation of organic growth when the impact is measured across periods that are not comparable. (2) Excludes the first twelve months of such commissions and fees generated from newly acquired Partners. (3) Organic Revenue for the year ended December 31, 2018 used to calculate Organic Revenue Growth for the year ended December 31, 2019 was $79.9 million, which is adjusted to reflect revenues from Partnerships that reached the twelve-month owned mark during the year ended December 31, 2019. Adjusted Net Income and Adjusted Diluted EPS The following table reconciles Adjusted Net Income to net loss attributable to BRP Group, Inc. and reconciles Adjusted Diluted EPS to diluted net loss per share attributable to BRP Group, Inc. Class A common stock: ___________ (1) Represents corporate income taxes at assumed effective tax rate of 9.9% applied to adjusted pre-tax income. (2) Assumes the full exchange of Class B shares for Class A common stock pursuant to the Amended LLC Agreement. RESULTS OF OPERATIONS BY OPERATING GROUP Commissions and Fees In the Middle Market, MainStreet and Specialty Operating Groups, the Company generates commissions and fees from insurance placement under both agency bill and direct bill arrangements. In addition, BRP generates profit sharing income in each of those segments based on either the underlying book of business or performance, such as loss ratios. In the Middle Market Operating Group only, the Company generates fees from service fee and consulting arrangements. Service fee arrangements are in place with certain customers in lieu of commission arrangements. In the Medicare Operating Group, BRP generates commissions and fees in the form of direct bill insurance placement and marketing income. Marketing income is earned through co-branded marketing campaigns with the Company’s Insurance Company Partners. The following table sets forth our commissions and fees by Operating Group by amount and as a percentage of our commissions and fees: Commissions and fees increased across all Operating Groups for the year ended December 31, 2019 as compared to the same period of 2018. These increases were primarily attributable to our 2019 Partners, which contributed $9.6 million, $31.2 million and $2.2 million to the Middle Market, Specialty and MainStreet Operating Groups, respectively, during 2019, in addition to organic growth and a full year of contribution from our 2018 Partners, which accounted for $6.8 million, $1.1 million and $1.0 million to the Middle Market, Specialty and MainStreet Operating Groups, respectively. The Middle Market Operating Group also had $1.4 million of higher contingent revenue during 2019. We expect higher loss ratios in our Middle Market and MainStreet Operating Groups to reduce contingent revenue during the first half of 2020 and increase base commissions and fees towards the end of 2020 and into 2021 for those Operating Groups. Policies in force for the MSI Partnership grew by 99,393, or 36%, to 374,591 at December 31, 2019 from 275,198 at December 31, 2018. Since the MSI Partnership was not completed until April 2019, the 36% policies in force growth was calculated including periods during which MSI was not owned by the Company. Commissions, Employee Compensation and Benefits The following table sets forth our commissions, employee compensation and benefits by Operating Group by amount and as a percentage of our commissions, employee compensation and benefits: __________ n/m not meaningful Commissions, employee compensation and benefits expenses increased across all Operating Groups for the year ended December 31, 2019 as compared to the same period of 2018. These increases were primarily attributable to our 2019 Partners, which contributed $6.0 million, $21.5 million and $1.2 million to the Middle Market, Specialty and MainStreet Operating Groups, respectively, during 2019. During 2019, we also had full year of contribution from our 2018 Partners, which accounted for $2.9 million, $1.1 million and $0.7 million of the Middle Market, Specialty and MainStreet Operating Groups, respectively. Corporate and Other incurred $1.9 million in bonuses and $1.3 million in share-based compensation related to the Initial Public Offering during 2019. Commissions, employee compensation and benefits expenses also increased as a result of hiring new roles necessary as a public company, including a chief operating officer, chief accounting officer and general counsel, in addition to continued investments in Growth Services to support our growth, which costs are allocated among the Operating Groups. Other Operating Expenses The following table sets forth our other operating expenses by Operating Group by amount and as a percentage of our operating expenses: Other operating expenses increased across all Operating Groups for the year ended December 31, 2019 as compared to the same period of 2018. These increases were attributable in part to our 2019 Partners, which contributed $1.3 million and $2.0 million to the Middle Market and Specialty Operating Groups, respectively. The remainder of the increases in the four Operating Groups were driven by organic growth. The increase in Corporate and Other is primarily related to costs related to our Initial Public Offering in 2019. We expect our other operating expenses to continue to increase in 2020 in relation to 2019 as a result of ongoing public company costs. Amortization Expense The following table sets forth our amortization by Operating Group by amount and as a percentage of our amortization: __________ n/m not meaningful Amortization expense increased across all Operating Groups for the year ended December 31, 2019 as compared to the same period of 2018. These increases were driven by amortization related to $10.6 million, $52.7 million and $8.7 million of intangible assets capitalized in connection with Middle Market, Specialty and MainStreet Partnerships, respectively, during 2019. Change in Fair Value of Contingent Consideration The following table sets forth our change in fair value of contingent consideration by Operating Group by amount and as a percentage of our change in fair value of contingent consideration: __________ n/m not meaningful The change in fair value of contingent consideration results from fluctuations in the value of the relevant measurement basis, normally revenue or EBITDA of our Partners. The Specialty Operating Group recorded a loss of $13.5 million during 2019 as a result of a higher estimate for the contingent consideration liability of the MSI Partnership related to growth of business. LIQUIDITY AND CAPITAL RESOURCES Our primary liquidity needs for the foreseeable future will include cash to (i) provide capital to facilitate the organic growth of our business and to fund future Partnerships, (ii) pay operating expenses, including cash compensation to our employees and expenses related to being a public company, (iii) make payments under the Tax Receivable Agreement, (iv) pay interest and principal due on borrowings under the JPMorgan Credit Agreement, (v) pay contingent earnout liabilities, and (vi) pay income taxes. We have historically financed our operations, funded our debt service and distributions to our owners through the sale of our insurance products and services. In addition, we financed significant cash needs to fund growth through the acquisition of Partners through debt financing. On October 28, 2019, BRP Group sold an aggregate of 18,859,300 shares of Class A common stock including 2,459,300 shares pursuant to the underwriters’ over-allotment option, which subsequently settled on November 26, 2019. The shares were sold at an initial offering price of $14.00 per share for net proceeds of $241.4 million after deducting underwriting discounts and commissions of $17.8 million and net offering expenses of $4.8 million payable by BRP. As of December 31, 2019, our cash and cash equivalents were $67.7 million. We believe that our cash and cash equivalents, proceeds from the Initial Public Offering, cash flow from operations and available borrowings under the JPMorgan Credit Agreement will be sufficient to fund our working capital and meet our commitments for the foreseeable future. However, we expect that we will require additional funding to continue to execute on our Partnership strategy. Such funding could include the incurrence of additional debt or the issuance of equity. Additional funds may not be available on a timely basis, on favorable terms, or at all, and such funds, if raised, may not be sufficient to enable us to continue to implement our long-term Partnership strategy. If we are not able to raise funds when needed, we could be forced to delay or reduce the number of Partnerships that we complete. See Item 1A. “Risk Factors - Risks Relating to our Business - We may not be able to successfully identify and acquire Partners or integrate Partners into our company, and we may become subject to certain liabilities assumed or incurred in connection with our Partnerships that could harm our business, results of operations and financial condition.” Credit Agreements As of December 31, 2019, we had an aggregate borrowing capacity of $225.0 million under the revolving credit commitment (the “Revolving Credit Commitment”) of the JPMorgan Credit Agreement, which matures on September 23, 2024 and of which no more than $65.0 million is available for working capital purposes and the entirety of which is available to fund acquisitions permitted under the JPMorgan Credit Agreement. The facility also had an accordion feature that allows us to increase the aggregate borrowing capacity from $225.0 million to $300.0 million, which we utilized by entering into the Incremental Facility Amendment No. 1 to the JPMorgan Credit Agreement on March 12, 2020. The outstanding balance of the Revolving Credit Commitment was $40.4 million at December 31, 2019. The Revolving Credit Commitment is collateralized by a first priority lien on substantially all the assets of the Company, including a pledge of all equity securities of each of its subsidiaries. The interest rate of the Revolving Credit Commitment is based on, depending on the type of loan, the Eurodollar rate or the Alternative Base Rate, plus, in each case, a margin based on Total Leverage Ratio (as defined in the JPMorgan Credit Agreement), as set forth in the pricing grid below, provided that under no circumstances will the LIBO Rate (as defined in the JPMorgan Credit Agreement) used in the determination of the Eurodollar rate be less than 0.00% or the Alternate Base Rate be less than 1.00%: At December 31, 2019, the variable rate in effect for the JPMorgan Credit Agreement was the London Interbank Offered Rate (“LIBOR”) due to a pricing option and the applicable interest rate on the Revolving Credit Commitment was 3.81%. The JPMorgan Credit Agreement contains covenants that, among other things, restrict our ability to make certain restricted payments, incur additional debt, engage in certain asset sales, mergers, acquisitions or similar transactions, create liens on assets, engage in certain transactions with affiliates, change our business or make certain investments. Following the Initial Public Offering, the JPMorgan Credit Agreement continues to contain these covenants, including a covenant that restricts BRP’s ability to make dividends or other distributions to BRP Group. In addition, the JPMorgan Credit Agreement contains financial covenants requiring us to maintain our Total Leverage Ratio (as defined in the JPMorgan Credit Agreement) at or below 5.00 to 1.00 up to but excluding September 21, 2022 (with scheduled annual step downs to 4.75 to 1.00 and 4.50 to 1.00 beginning in 2022 and with step ups of 0.50 to 1.00 and 0.25 to 1.00 for the first and second quarters, respectively, after any Material Acquisition (as defined in the JPMorgan Credit Agreement)), Debt Service Coverage Ratio (as defined in the JPMorgan Credit Agreement) at or above 2.00 to 1.00 up to but excluding September 21, 2022 (with scheduled annual step ups to 2.25 to 1.00 and 2.50 to 1.00 beginning in 2022) and Senior Leverage Ratio (as defined in the JPMorgan Credit Agreement) at or below 4.50 to 1.00 up to but excluding September 21, 2022 (with scheduled annual step downs to 4.25 to 1.00 and 4.00 to 1.00 beginning in 2022 and with step ups of 0.50 to 1.00 and 0.25 to 1.00 for the first and second quarters, respectively, after any Material Acquisition). As of September 30, 2019, we had borrowings under the Villages Credit Agreement consisting of a non-revolving line of credit up to $125.0 million. The line of credit under the Villages Credit Agreement bore interest at a fixed rate of 8.75% per annum and matured in September 2024, or such later date as the parties may agree. On October 28, 2019, BRP used a portion of the proceeds it received from the sale of newly-issued LLC Units to BRP Group in connection with the Initial Public Offering to repay in full the outstanding indebtedness and accrued interest under the Villages Credit Agreement in the amount of $89.0 million and concurrently terminated the Villages Credit Agreement. Source and Uses of Cash The following table summarizes our cash flows from operating, investing and financing activities for the periods indicated: Operating Activities The primary sources and uses of cash for operating activities are net income adjusted for non-cash items and changes in assets and liabilities, or operating working capital. Net cash provided by operating activities remained relatively consistent for the year ended December 31, 2019 as compared to the same period of 2018. Significant changes in operating cash resulted from increases in commissions and fees receivable net and accounts payable, accrued expenses and other current liabilities, which can be attributed to growth in our business resulting from Partnerships and organic growth. Investing Activities The primary sources and uses of cash for investing activities relate to cash consideration paid for business combinations and asset acquisitions, as well as capital expenditures. Net cash used in investing activities increased $58.5 million for the year ended December 31, 2019 as compared to the same period of 2018. Cash consideration paid for business combinations and asset acquisitions increased $57.1 million primarily as a result of the MSI, Lykes and Foundation Insurance Partnerships during 2019. Financing Activities The primary sources and uses of cash for financing activities relate to the issuance of our Class A common stock, borrowings from and repayment to our Credit Agreements, payment of debt issuance costs, payment of contingent and guaranteed earnout consideration, distributions and contributions, and other equity transactions. Net cash provided by financing activities increased $116.5 million for the year ended December 31, 2019 as compared to the same period of 2018. Proceeds from our initial public offering netted us $246.2 million during 2019. We used $31.3 million of these proceeds to purchase LLC Units from our Chairman and Villages Invesco. Net cash paid in relation to our Credit Agreements increased $17.7 million primarily as a result of the repayment of $154.6 million to the Credit Agreements, offset in part by additional borrowings to fund our Partnerships during 2019. In addition, we had cash payments of $12.5 million related to the repurchase of membership interests from members. Contractual Obligations The following table represents our contractual obligations, aggregated by type, at December 31, 2019: __________ (1) The Company leases facilities and equipment under noncancelable operating leases. Rent expense was $4.2 million and $3.0 million for the years ended December 31, 2019 and 2018, respectively. (2) Represents scheduled debt obligation and interest payments. (3) Includes $48.8 million of current and noncurrent estimated contingent earnout liabilities at December 31, 2019. Off-Balance Sheet Arrangements We do not invest in any off-balance sheet vehicles that provide liquidity, capital resources, market or credit risk support, or engage in any activities that expose us to any liability that is not reflected in our consolidated financial statements except for those described under the Contractual Obligations section above. Dividend Policy Assuming Baldwin Risk Partners, LLC makes distributions to its members in any given year, the determination to pay dividends, if any, to our Class A common stockholders out of the portion, if any, of such distributions remaining after our payment of taxes, Tax Receivable Agreement payments and expenses (any such portion, an “excess distribution”) will be made at the sole discretion of our board of directors. Our board of directors may change our dividend policy at any time. See Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Dividend Policy.” Tax Receivable Agreement On October 28, 2019, BRP Group entered into the Tax Receivable Agreement with BRP’s LLC Members that provides for the payment by BRP Group to BRP’s LLC Members of 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax or franchise tax that BRP Group actually realizes as a result of (i) any increase in tax basis in BRP assets resulting from (a) acquisitions by BRP Group of BRP’s LLC Units from BRP’s LLC Members in connection with the Initial Public Offering, (b) the acquisition of LLC Units from BRP’s LLC Members using the net proceeds from any future offering, (c) redemptions or exchanges by BRP’s LLC Members of LLC Units and the corresponding number of shares of Class B common stock for shares of Class A common stock or cash or (d) payments under the Tax Receivable Agreement, and (ii) tax benefits related to imputed interest resulting from payments made under the Tax Receivable Agreement. Holders of BRP’s LLC Units (other than BRP Group) may, subject to certain conditions and transfer restrictions described above, redeem or exchange their LLC Units for shares of Class A common stock of BRP Group on a one-for-one basis. BRP intends to make an election under Section 754 of the Internal Revenue Code of 1986, as amended, and the regulations thereunder (the “Code”) effective for each taxable year in which a redemption or exchange of LLC Units for shares of Class A common stock occurs, which is expected to result in increases to the tax basis of the assets of BRP at the time of a redemption or exchange of LLC Units. The redemptions or exchanges are expected to result in increases in the tax basis of the tangible and intangible assets of BRP. These increases in tax basis may reduce the amount of tax that BRP Group would otherwise be required to pay in the future. We have entered into a Tax Receivable Agreement with the BRP’s LLC Members that provides for the payment by us to the BRP’s LLC Members of 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax or franchise tax that we actually realize as a result of (i) any increase in tax basis in BRP Group’s assets resulting from (a) the purchase of LLC Units from any of the BRP’s LLC Members using the net proceeds from any future offering, (b) redemptions or exchanges by the BRP’s LLC Members of LLC Units for shares of our Class A common stock or (c) payments under the Tax Receivable Agreement and (ii) tax benefits related to imputed interest deemed arising as a result of payments made under the Tax Receivable Agreement. This payment obligation is an obligation of BRP Group and not of BRP. For purposes of the Tax Receivable Agreement, the cash tax savings in income tax will be computed by comparing the actual income tax liability of BRP Group (calculated with certain assumptions) to the amount of such taxes that BRP Group would have been required to pay had there been no increase to the tax basis of the assets of BRP as a result of the redemptions or exchanges and had BRP Group not entered into the Tax Receivable Agreement. Estimating the amount of payments that may be made under the Tax Receivable Agreement is by its nature imprecise, insofar as the calculation of amounts payable depends on a variety of factors. While the actual increase in tax basis, as well as the amount and timing of any payments under the Tax Receivable Agreement, will vary depending upon a number of factors, including the timing of redemptions or exchanges, the price of shares of our Class A common stock at the time of the redemption or exchange, the extent to which such redemptions or exchanges are taxable, the amount and timing of our income, the tax rates then applicable and the portion of our payments under the Tax Receivable Agreement constituting imputed interest. We anticipate that we will account for the effects of these increases in tax basis and associated payments under the Tax Receivable Agreement arising from future redemptions or exchanges as follows: • we will record an increase in deferred tax assets for the estimated income tax effects of the increases in tax basis based on enacted federal and state tax rates at the date of the redemption or exchange; • to the extent we estimate that we will not realize the full benefit represented by the deferred tax asset, based on an analysis that will consider, among other things, our expectation of future earnings, we will reduce the deferred tax asset with a valuation allowance; and • we will record 85% of the estimated realizable tax benefit (which is the recorded deferred tax asset less any recorded valuation allowance) as an increase to the liability due under the Tax Receivable Agreement and the remaining 15% of the estimated realizable tax benefit as an increase to additional paid-in capital. All of the effects of changes in any of our estimates after the date of the redemption or exchange will be included in net income. Similarly, the effect of subsequent changes in the enacted tax rates will be included in net income. CRITICAL ACCOUNTING ESTIMATES Our consolidated financial statements are prepared in accordance with GAAP, which requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of commissions and fees and expenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on historical experience and factors we believe to be reasonable under the circumstances. The results involve judgments about the carrying value of assets and liabilities not readily apparent from other sources and actual results could differ from those estimates. The areas that we believe are critical accounting estimates, as discussed below, affect the more significant estimates, judgments and assumptions used to prepare our consolidated financial statements. Different assumptions in the application of these policies could result in material changes in our consolidated financial position or consolidated results of operations. Commissions and Fees Recognition We earn commission revenue by acting as an agent or broker on behalf of our clients and Insurance Company Partners to provide insurance placement services to clients. Commission revenue is usually a percentage of the premium paid by clients and generally depend upon the type of insurance, the particular insurance company and the nature of the services provided. Commission revenue is earned at a point in time upon the effective date of bound insurance coverage, as no performance obligation exists after coverage is bound. The Company makes its best estimate of direct bill commissions at the policy effective date, particularly in employee benefits within the Middle Market Operating Group, which is subject to change based on enrollment and other factors over the policy period. Commissions revenue is recorded net of an allowance for estimated policy cancellations, which is determined based on an evaluation of historical and current cancellation data. Given a hypothetical 1% increase in our policy cancellation rate, our annual allowance for estimated policy cancellations would have increased by $1.2 million for the year ended December 31, 2019. We earn consulting and service fee revenues by negotiating fees in lieu of a commission by providing specialty insurance consulting. Consulting and service fee revenue from certain agreements are recognized over time depending on when the services within the contract are satisfied and when the Company has transferred control of the related services to the customer. We earn policy fee revenue for acting in the capacity of a managing general agent on behalf of the Insurance Company Partner and fulfilling certain services and administrative functions during the term of the insurance policy. Policy fee revenue is deferred and recognized over the life of the policy. We earn installment fee revenue related to policy premiums paid on an installment basis for payment processing services performed on behalf of the Insurance Company Partner. The Company recognizes installment fee revenue in the period the services are performed. Profit-sharing commissions represent a form of variable consideration, which includes additional commissions over base commissions received from Insurance Company Partners. Profit-sharing commissions associated with relatively predictable measures are estimated with a constraint applied and recognized at a point in time. The profit-sharing commissions are recorded as the underlying policies that contribute to the achievement of the metric are placed with any adjustments recognized when payments are received or as additional information that affects the estimate becomes available. A constraint of variable consideration is necessary when commissions and fees are subject to significant reversal. Profit-sharing commissions associated with loss performance are uncertain, and therefore, are subject to significant reversal through catastrophic loss season and as loss data remains subject to material change. The constraint is relieved when management estimates commissions and fees that are not subject to significant reversal, which often coincides with the earlier of written notification from the Insurance Company Partner that the target has been achieved or cash collection. Year-end amounts incorporate estimates based on confirmation from Insurance Company Partners after calculation of potential loss ratios that are impacted by catastrophic losses. The consolidated financial statements include estimates that are not subject to significant reversal and incorporates information received from Insurance Company Partners, and where still subject to significant changes in estimates due to loss ratios and external factors that are outside of the Company’s control, a full constraint is applied. We are entitled to commissions each year for multi-year Medicare contracts. We have applied a constraint to renewal commission that limits commissions and fees recognized on new policies to the policy year in effect, and revenue recognized on renewal policies to the receipt of periodic cash, when a risk of significant reversal exists based on (1) insufficient history; and (2) the influence of external factors outside of our control including policyholder discretion over plans and Insurance Company Partner relationships, political influence, and a contractual provision, which limits our right to receive renewal commissions to ongoing compliance and regulatory approval of the relevant Insurance Company Partner. Costs to obtain contracts includes compensation in the form of producer commissions paid on new business. These incremental costs are capitalized as deferred commission expense and amortized over five years, which represents management’s estimate of the average period over which a Client maintains its initial coverage relationship with the original Insurance Company Partner. Given a hypothetical one-year increase in the amortization period for deferred commission expense, our annual expense related to deferred commissions would have decreased by $173,000 for the year ended December 31, 2019. Business Combinations and Purchase Price Allocation We continue to acquire significant intangible assets through multiple business combinations. The determination of estimated useful lives of intangible assets, the allocation of purchase price to intangible assets and the determination of the fair value of contingent earnout liabilities require significant judgment and affects the amount of future amortization, potential impairment charges and net fair value gain or loss. Business combination purchase prices are typically based upon a multiple of average adjusted EBITDA or commission and fees earned over a one to three-year period within a minimum and maximum price range. We perform a purchase price allocation in connection with our business combinations, in connection with which we record the fair value of the identifiable tangible and intangible assets acquired and liabilities assumed, including contingent consideration relating to potential earnout provisions. The excess of the purchase price of the business combination over the fair value of the net assets acquired is recorded as goodwill. Intangible assets generally consist of purchased customer accounts, carrier relationships, software and trade names. Purchased customer accounts include the records and files obtained from acquired businesses that contain information about insurance policies and the related insured parties that are essential to policy renewals. We assess the fair value of purchased customer accounts by comparison of a reasonable multiple applied to either the corresponding commissions and fees or EBITDA in addition to considering the estimated future cash flows expected to be received over the estimated future renewal periods of the insurance policies comprising those purchased customer accounts. The valuation of purchased customer accounts involves significant estimates and assumptions concerning matters such as cancellation frequency, expenses and discount rates. Any change in these assumptions could affect the carrying value of purchased customer accounts. Carrier relationships consist of relationships with Insurance Company Partners that were not previously established. Trade names consist of acquired business names with potential customer base recognition. Purchased customer accounts, carrier relationships and trade names are amortized on a basis consistent with the underlying cash flows over the related estimated lives of between five and twenty years. Software is amortized on the straight-line basis over an estimated useful life of three to five years. The fair value of contingent earnout liabilities and contingently returnable consideration is based upon estimated payments expected to be or paid to, or clawed back from, the sellers of the acquired businesses as measured by expected future cash flow projections under various scenarios. We use a probability weighted value analysis as a valuation technique to convert future estimated cash flows under various scenarios to a single present value amount. We assess the fair value of these liabilities and assets at each balance sheet date based on the expected performance of the associated business and any changes in fair value are recorded through change in fair value of contingent consideration in the consolidated statements of comprehensive income (loss). Impairment of Long-lived Assets Including Goodwill In applying the acquisition method of accounting for business combinations, the excess of the purchase price of an acquisition over the fair value of the identifiable tangible and intangible assets and liabilities acquired is assigned to goodwill. Intangible assets are initially valued at fair value using generally accepted valuation methods appropriate for the type of intangible asset. Definite-lived intangible assets are amortized over their estimated useful lives and evaluated for impairment whenever an event occurs that indicates the asset may be impaired. Goodwill is not amortized but rather is evaluated for impairment at least annually or more frequently if indicators of impairment are present. Indicators of impairment include a reduction of expected future cash flows of our reporting units, a significant negative trend in the economy or insurance industry, and a sustained significant decrease in our market capitalization. We test for goodwill impairment at the reporting unit level, which is an Operating Group or one level below an Operating Group. We have four reporting units, which are also our Operating Groups. We have the option of performing a qualitative assessment to determine whether a quantitative impairment test is necessary. If, after assessing qualitative factors, we determine it is more likely than not that the fair value of a reporting unit is less than the carrying amount, then we proceed to the quantitative assessment. The quantitative goodwill impairment test requires the fair value of each reporting unit to be compared to its book or carrying value. If the carrying value of a reporting unit is determined to be less than the fair value of the reporting unit, goodwill is deemed not to be impaired. If the carrying value of a reporting unit is greater than the fair value, an impairment charge is recorded for the amount that the carrying amount of the reporting unit, including goodwill, exceeds its fair value, limited to amount of goodwill of the reporting unit. During 2019, we performed an impairment evaluation for each of our reporting units beginning with a qualitative assessment. The qualitative factors we considered included general economic conditions, limitations on accessing capital, industry and market considerations, cost factors such as commissions expense that could have a negative effect on future cash flows, overall financial performance including declining cash flows and a decline in actual or anticipated commissions and fees, earnings or key statistics, and other entity-specific events such as changes in management and loss of key personnel or customers. We determined that based on the overall results and outlook of our reporting units, company and industry, including consideration of the effect of our new Partnerships, there was no indication of goodwill impairment at December 31, 2019. As such, no further testing was required. We review our definite-lived intangible assets and other long-lived assets for impairment whenever an event occurs that indicates the carrying amount of an asset may not be recoverable. There were no indications that the carrying values of our definite-lived intangible assets or other long-lived assets were impaired at December 31, 2019. Any impairment charges that we may record in the future could materially impact our results of operations. Tax Receivable Agreement Liability On October 28, 2019, BRP Group entered into the Tax Receivable Agreement with BRP’s LLC Members that provides for the payment by BRP Group to BRP’s LLC Members of 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax or franchise tax that BRP Group actually realizes as a result of (i) any increase in tax basis in BRP assets resulting from (a) acquisitions by BRP Group of BRP’s LLC Units from BRP’s LLC Members in connection with the Initial Public Offering, (b) the acquisition of LLC Units from BRP’s LLC Members using the net proceeds from any future offering, (c) redemptions or exchanges by BRP’s LLC Members of LLC Units and the corresponding number of shares of Class B common stock for shares of Class A common stock or cash or (d) payments under the Tax Receivable Agreement, and (ii) tax benefits related to imputed interest resulting from payments made under the Tax Receivable Agreement. The actual increase in tax basis, as well as the amount and timing of any payments under the Tax Receivable Agreement, will vary depending on a number of factors, including, but not limited to, the timing of any future redemptions, exchanges or purchases of the LLC Units held by BRP’s LLC Members, the price of our Class A common stock at the time of the purchase, redemption or exchange, the extent to which redemptions or exchanges are taxable, the amount and timing of the taxable income that we generate in the future, the tax rates then applicable and the portion of our payments under the Tax Receivable Agreement constituting imputed interest. Advisor Incentive Liabilities We have granted Advisor incentive rights to certain advisors to incentivize them to stay with us and grow their Book of Business. The Advisor incentive rights grant the Advisor the right to equity shares after the achievement of certain milestones. We account for the advisor incentive awards as liability-classified share-based payment awards under ASC Topic 718, Compensation - Stock Compensation. Once a milestone is deemed probable of occurring, we record an advisor incentive liability and compensation expense based on the fair value of the grants which are remeasured each reporting period through the settlement date .The fair value of the award is determined by projecting the future value of the Advisor’s Book of Business and multiplying it by the Advisor’s proceeds sharing right. Significant increases or decreases in the fair value of the award would result in a significantly higher or lower liability. Ultimately, the liability will be equivalent to the amount settled, and the difference between the fair value estimate and the amount settled will be recorded in earnings. Share-Based Compensation Share-based compensation for periods subsequent to the Initial Public Offering includes restricted stock awards to Colleagues and Class A common stock awards to our board of directors. We measure share-based compensation expense at the grant date based on the fair value of the award and recognize compensation expense over the requisite service period, which is generally the vesting period. We use the straight-line method from the date of grant to recognize compensation expense for equity awards with service conditions and the ratable method for equity awards with performance conditions. Share-based compensation for periods prior to the Initial Public Offering includes Management Incentive Units awards. These awards vest according to time-based benchmarks or performance-based benchmarks that vary between issuance. The fair value of each time-based and performance-based Management Incentive Unit was estimated on the grant date using a Black Scholes model, which requires the input of highly complex and subjective variables, and includes assumptions for expected volatility, expected dividend yield, expected term and the risk-free interest rate. Expected volatility was based on the historical volatility of industry peers. The expected term was calculated by analyzing historical exercise data and obtaining the weighted average of the holding period for similar awards. The risk-free interest rate was based on the U.S. Treasury yield curve in effect at the time of the grant. Income Taxes We record a tax provision for the anticipated tax consequences of the reported results of operations. We compute the provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. We measure deferred tax assets and liabilities using the currently enacted tax rates in each jurisdiction that applies to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We are required to establish a valuation allowance for deferred tax assets and record a charge to income if it is determined, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred taxes in 2019 have been reduced by a full valuation allowance due to a determination that it is more likely than not that all of the deferred tax assets will not be realized based on the weight of all available evidence. Our evaluation of the realizability of the deferred tax assets focuses on identifying significant, objective evidence that we will more likely than not be able to realize our deferred tax assets in the future. We consider both positive and negative evidence when evaluating the need for a valuation allowance, which is highly judgmental and requires subjective weighting of such evidence. EMERGING GROWTH COMPANY STATUS We are an emerging growth company, as defined in the Jumpstart Our Business Startups (“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. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period 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 have also elected to take advantage of some of the reduced regulatory and reporting requirements of emerging growth companies pursuant to the JOBS Act, including not being required to comply with the auditor attestation requirements of Section 404(b) 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 golden parachute payments, if applicable. We may take advantage of these exemptions up until the last day of the fiscal year following the fifth anniversary of our Initial Public Offering 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. RECENT ACCOUNTING PRONOUNCEMENTS Please refer to Note 1 to our consolidated financial statements included in Item 8. Financial Statements of this Annual Report on Form 10-K for a discussion of recent accounting pronouncements that may impact us.

<s>[INST] The following discussion contains references to periods prior to the Initial Public Offering, including the period from January 1, 2019 through October 27, 2019 and calendar year 2018. The financial information of BRP Group has been combined with that of BRP as of the earliest period presented. EXECUTIVE SUMMARY OF 2019 FINANCIAL RESULTS We are a rapidly growing independent insurance distribution firm delivering solutions that give our clients the peace of mind to pursue their purpose, passion and dreams. The following is a summary of our 2019 financial results: Revenues for the year ended December 31, 2019 were $137.8 million, an increase of $58.0 million, or 73%, as compared to the same period of 2018. Our revenue growth was primarily attributable to our 2019 Partnerships, which comprised $43.0 million in revenues, in addition to organic growth of $7.8 million and a full year of contribution from Partners acquired in 2018. Operating expenses for the year ended December 31, 2019 were $142.9 million, an increase of $72.6 million, or 103%, as compared to the same period of 2018. The increase in operating expenses was primarily attributable to our 2019 Partnerships, which comprised $52.7 million of operating expenses (including an increase in the fair value of contingent consideration of $14.0 million), $4.7 million of expenses related to the Initial Public Offering, increased compensation for sales and support related to our growth and continued investments in Growth Services to support our growth. Interest expense, net for the year ended December 31, 2019 was $10.6 million, an increase of $4.0 million, or 61%, as compared to the same period of 2018. Interest expense, net increased as a result of higher total debt balances during the second and third quarters of 2019 resulting from draws on our Credit Agreements to fund cash consideration for Partnerships, a higher interest rate on the Villages Credit Agreement that went into effect in March 2019 until this facility was closed in October 2019, and higher amortization of deferred financing costs related to refinancing our Credit Agreements on several occasions during 2019. Loss on extinguishment of debt was $6.7 million for the year ended December 31, 2019, of which $6.2 million related to our repayment in full of the outstanding indebtedness under the Villages Credit Agreement in connection with the Initial Public Offering. The remaining loss related to refinancing the JPMorgan Credit Agreement on several occasions during 2019. Net loss for the year ended December 31, 2019 was $22.5 million, an increase of $25.1 million as compared to net income of $2.7 million in the same period of 2018. Adjusted EBITDA for the year ended December 31, 2019 was $28.5 million, an increase of $12.5 million as compared to the same period of 2018. Adjusted EBITDA margin was 21% for 2019 and 20% for 2018. Organic Revenue for the year ended December 31, 2019 was $87.7 million as compared to $56.8 million for the same period of 2018. Organic Revenue Growth was $7.8 million, or 10%, for 2019 and $8.8 million, or 18%, for 2018. Refer to the NonGAAP Financial Measures section below for reconciliations of Adjusted EBITDA, Adjusted EBITDA Margin, Organic Revenue and Organic Revenue Growth to the most directly comparable GAAP financial measures. PARTNERSHIPS We utilize strategic acquisitions, which we refer to as Partnerships, to complement and expand our business. [/INST] Positive. </s>

Mirum Pharmaceuticals, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included in Item 8 “Financial Statements and Supplementary Data” and included elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements based upon our current beliefs, estimates, plans and expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those contained in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” or in other parts of this Annual Report. Overview We are a biopharmaceutical company focused on the development and commercialization of a late-stage pipeline of novel therapies for debilitating liver diseases. We focus on diseases for which the unmet medical need is high and the biology for treatment is clear. Our pipeline consists of two clinical-stage product candidates with mechanisms of action that have potential utility across a wide range of orphan cholestatic liver diseases. We are initially developing maralixibat for the treatment of pediatric patients with Alagille syndrome (“ALGS”) and progressive familial intrahepatic cholestasis (“PFIC”). Based on improvements in pruritus, or itching, and other outcomes and disease markers observed in Phase 2 clinical trials, we are planning to initiate a rolling submission of a New Drug Application (“NDA”), for the treatment of cholestatic pruritus associated with ALGS in the third quarter of 2020. We expect to complete the rolling submission of our NDA in the first quarter of 2021, and pending a successful submission, we will plan for a potential launch in ALGS in the second half of 2021. We are also conducting the Phase 3 MARCH clinical trial in PFIC, from which we expect to complete enrollment in the second quarter of 2020 and announce topline Phase 3 data in late-2020. Further, we are also conducting an analysis of our long-term treatment data in PFIC against a natural history control group in conjunction with the NAtural course and Prognosis of PFIC and Effect of biliary Diversion Consortium and plan to share these results with regulators in 2020. We are developing volixibat for the treatment of adult patients with cholestatic liver diseases and expect to initiate our first clinical trial in these indications in late 2020. We were incorporated in May 2018 and commenced operations in November 2018. To date, we have focused primarily on acquiring and in-licensing our product candidates, maralixibat and volixibat, organizing and staffing our company, business planning, raising capital, and preparing for advancement of our product candidates into clinical development. We have a limited operating history and incurred significant operating losses since our inception and expect to continue to incur significant operating losses for the foreseeable future. We have no products approved for commercial sale and have never generated any revenues from product sales. We have funded our operations to date primarily through equity financings. In November 2018, we completed the initial closing of our Series A redeemable convertible preferred stock (“Series A convertible preferred stock”) financing and sold an aggregate of 59,908,284 shares at a purchase price of $1.00259507 per share. In addition, at the request of our board of directors, in April 2019, certain purchasers in the initial closing purchased an aggregate of 59,844,699 additional shares of our Series A convertible preferred stock at the same purchase price per share in a subsequent closing. On July 22, 2019, we completed our initial public offering (“IPO”) pursuant to which we sold an aggregate of 5,000,000 shares of our common stock at a price of $15.00 per share, resulting in net proceeds of $67.2 million after deducting underwriting discounts, commissions and offering expenses payable by us. Upon the closing of our IPO, all outstanding shares of our Series A convertible preferred stock automatically converted into 14,969,118 shares of our common stock. Subsequent to December 31, 2019, on January 13, 2020, we completed a follow-on public offering of our common stock pursuant to which we sold an aggregate of 2,400,000 shares of common stock at a price of $20.00 per share, resulting in net proceeds of approximately $44.7 million after deducting underwriting discounts, commissions and offering expenses payable by us. Our net loss was $52.6 million and $17.3 million for the year ended December 31, 2019 and for the period from May 2, 2018 to December 31, 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $69.9 million and cash, cash equivalents and investments of $140.0 million. We expect our expenses and operating losses will increase substantially as we conduct our planned clinical trials, continue our research and development activities, initiate commercial preparation activities, and seek regulatory approvals for our product candidates, as well as hire additional personnel, protect our intellectual property and incur additional costs associated with being a public company. In addition, as our product candidates progress through development and toward commercialization, we will need to make milestone payments to the licensors and other third parties from whom we have in-licensed or acquired our product candidates. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending in particular on the timing of our clinical trials and non-clinical studies and our expenditures on other research and development activities. We do not expect to generate any revenue from product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which could take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. Accordingly, until such time as we can generate substantial product revenues to support our cost structure, if ever, we expect to finance our cash needs through equity offerings, debt financings or other capital sources, including potential collaborations, licenses and other similar arrangements. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies. If we are unable to raise additional capital when needed, we could be forced to delay, limit, reduce or terminate our product candidate development or future commercialization efforts or grant rights to develop and market our product candidates even if we would otherwise prefer to develop and market such product candidates ourselves. Assignment and License Agreement with Shire In November 2018, we entered into an assignment and license agreement (“Shire License Agreement”) with Shire International GmbH (“Shire”), in which we were granted an exclusive, royalty bearing worldwide license to develop and commercialize our two product candidates, maralixibat and volixibat. As part of the Shire License Agreement, we were assigned license agreements held by Shire with Satiogen Pharmaceuticals, Inc. (“Satiogen” and altogether, the “Satiogen License”), Pfizer Inc. (“Pfizer”), and Sanofi-Aventis Deutschland GmbH (“Sanofi”). In partial consideration for the rights granted to us under the Shire License Agreement, we made an upfront payment to Shire of $7.5 million and issued Shire 1,859,151 shares of our common stock with an estimated fair value of $7.0 million. In January 2019, we entered into a Transition Services Agreement with Shire (“TSA”), which covered services to be provided by Shire to transfer certain research and development activities and the related know-how from Shire to us, including continuation of work on any existing trials and manufacturing activities until fully transferred to us. We completed the activities under the TSA and finalized amounts due to Shire for services and pass-through expenses on existing trials and manufacturing activities in the second quarter of 2019. In July 2019, we achieved a development milestone under the Shire License Agreement related to the initiation of the Phase 3 MARCH clinical trial, and made a $2.5 million payment to Shire and a $0.5 million payment to Satiogen accordingly. See Note 6 to our consolidated financial statements included elsewhere in this Annual Report. Components of Results of Operations Operating Expenses Research and Development Expenses Research and development expenses primarily relate to non-clinical and clinical development of our product candidates. Our research and development expenses include or could include: • salaries and related expenses for employee personnel, including benefits, travel and expenses related to stock-based compensation granted to personnel in development functions; • external expenses paid to clinical trial sites, contract research organizations and consultants that conduct our clinical trials; • expenses related to drug formulation development and the production of non-clinical and clinical trial supplies, including fees paid to contract manufacturers; • licensing milestone payments related to development, regulatory or commercialization events; • expenses related to non-clinical studies; • expenses related to compliance with drug development regulatory requirements; and • other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation of equipment, and other supplies. We expense research and development costs 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 expenses. The prepaid amounts are expensed as the related goods are delivered or the services are performed. We expect to continue to incur substantial expenses related to our development activities for the foreseeable future as we continue to further our clinical development pipeline. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We expect our research and development expenses to be significant over the next several years as we increase personnel and compensation costs, further our development programs and prepare to seek regulatory approval for our product candidates. It is difficult to determine with certainty the duration and completion costs of any clinical trial we may conduct. Because our product candidates are still in clinical and non-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 product candidates or whether, or when, we may achieve profitability. Due to the early stage nature of our programs, we do not track costs on a project by project basis. As our programs become more advanced, we intend to track the external and internal cost of each program. In Process Research and Development In process research and development (“IPR&D”) expenses include in-process research and development acquired as part of an asset acquisition or in-license for which there is no alternative future use, and are expensed as incurred. IPR&D expenses consist of our upfront cash payment and issuance of our common stock made to Shire in connection with the acquisition to the rights of maralixibat and volixibat. General and Administrative Expense General and administrative expenses consist primarily of salaries and employee-related costs, including stock-based compensation, for personnel in executive, finance and other administrative functions. Other significant costs include facility-related costs, legal fees relating to intellectual property and corporate matters, professional fees for accounting and consulting services and insurance costs. We expect that our general and administrative expenses will increase in the future as we expand our operating activities, including commercial preparation activities, increase headcount, as well as incur additional costs associated with being a publicly traded company, such as increased personnel expenses, legal fees, accounting fees and directors’ and officers’ liability insurance premiums and maintaining compliance with exchange listing and SEC requirements. Interest Income Interest income consists of interest earned on our cash equivalents and investments. Other Income (Expense), Net Other income (expense), net consists of (i) transactional currency exchange gain or loss and (ii) interest expense related to a convertible promissory note issued in August 2018 which converted into shares of our Series A convertible preferred stock in November 2018. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements 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 at the date of the consolidated financial statements. We base our estimates on historical experience, known trends and events, and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying 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. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements appearing elsewhere in this Annual Report, we believe the following accounting policies are the most critical for fully understanding and evaluating our financial condition and results of operations. Accrued Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. We accrue and expense clinical trial activities performed by third parties based upon estimates of the proportion of work completed over the life of the individual study and patient enrollment rates in accordance with agreements established with clinical research organizations and clinical trial sites. We determine the estimates by reviewing contracts, vendor agreements and purchase orders and through discussions with internal clinical personnel and external service providers as to the progress or stage of completion of trials or services and the agreed-upon fee to be paid for such services. We make estimates of accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments, if necessary. If the actual timing of the performance of services or the level of effort varies from the estimate, we will adjust the accrual accordingly. Nonrefundable advance payments for goods and services, including fees for process development or manufacturing and distribution of clinical supplies that will be used in future research and development activities, are deferred and recognized as expense in the period that the related goods are consumed or services are performed. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Stock-Based Compensation We recognize compensation costs related to stock-based awards granted to employees and directors, including stock options, based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of subjective assumptions to determine the fair value of stock-based awards. These assumptions include: • Fair value of common stock-For grants prior to our IPO in July 2019, the fair value of our common stock underlying 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, 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 all grants subsequent to our IPO in July 2019, the fair value of common stock was determined by using the closing price per share of common stock as reported on the Nasdaq Global Market. • 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- We use an average historical stock price volatility of comparable public companies within the biotechnology and pharmaceutical industry that were deemed to be representative of future stock price trends as we do not have sufficient trading history for our common stock. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. • Risk-free interest rate-The risk-free interest rate is based on the U.S. Treasury 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. The assumptions used in our Black-Scholes option-pricing model represent management’s best estimates at the time of measurement. These estimates are complex, involve a number of variables, uncertainties and assumptions and the application of management’s judgment, as they are inherently subjective. If any assumptions change, our stock-based compensation could be materially different in the future. For the year ended December 31, 2019 and for the period from May 2, 2018 to December 31, 2018, stock-based compensation was $6.1 million and $34,000, respectively. As of December 31, 2019, we had $22.2 million of total unrecognized stock-based compensation which we expect to recognize over a weighted-average period of 3.1 years. 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 2 to our consolidated financial statements included elsewhere in this Annual Report. Results of Operations for the Year Ended December 31, 2019 and from May 2, 2018 to December 31, 2018 The following table summarizes our results of operations for the year ended December 31, 2019 and the period from May 2, 2018 to December 31, 2018 (in thousands): Research and Development Expenses Research and development expenses were $43.0 million for the year ended December 31, 2019, an increase of $40.7 million compared to the period from May 2, 2018 to December 31, 2018. The increase was driven by $18.4 million in clinical trial expenses primarily associated with the PFIC and ALGS programs, $8.3 million of personnel and other compensation related expenses reflecting an increase in our number of employees, including stock-based compensation of $2.4 million, $4.6 million for manufacturing activities supporting clinical trial supplies and NDA registration activities, $3.4 million of consulting expenses associated with our clinical, manufacturing and regulatory activities, $3.0 million for development milestone expenses related to initiation of the Phase 3 MARCH clinical trial, $1.9 million of non-clinical expenses and $1.0 million related to other general expenses. IPR&D IPR&D expenses were approximately $14.5 million for the period from May 2, 2018 to December 31, 2018 relating to the acquisition of the rights to maralixibat and volixibat from Shire consisting of a $7.5 million upfront cash payment and $7.0 million for the fair value of the redeemable common stock issued to Shire. There were no IPR&D expenses incurred for the year ended December 31, 2019. General and Administrative Expenses General and administrative expenses were $11.8 million for the year ended December 31, 2019, an increase of $11.2 million compared to the period from May 2, 2018 to December 31, 2018. The increase was primarily due to $7.3 million of personnel and other compensation related expenses reflecting an increase in our number of employees, including stock-based compensation of $3.7 million, $1.1 million of professional and consulting services, $1.1 million of expenses associated with being a public company primarily related to costs for insurance, $0.8 million of general legal and patent expenses, $0.7 million of expenses related to other general expenses and $0.2 million of expenses associated with commercial preparation activities. Interest Income Interest income was $2.2 million for the year ended December 31, 2019, an increase of $2.2 million compared to the period from May 2, 2018 to December 31, 2018. The increase was primarily due to interest earned on investments following an increase in our cash, cash equivalents and investment balances in 2019 due to the proceeds related to completion of our IPO in July 2019 and the sale of our Series A convertible preferred stock in April 2019. Liquidity and Capital Resources Overview We had $140.0 million of cash, cash equivalents and investments as of December 31, 2019 compared to $52.0 million as of December 31, 2018. To date, we have incurred operating losses and negative cash flows from operations. As of December 31, 2019, we had an accumulated deficit of $69.9 million. In November 2018, we completed the initial closing of our Series A convertible preferred stock financing and sold an aggregate of 59,908,284 shares at a purchase price of $1.00259507 per share. In addition, at the request of our board of directors, in April 2019, certain purchasers in the initial closing purchased an aggregate of 59,844,699 additional shares of our Series A convertible preferred stock at the same purchase price per share in a subsequent closing, resulting in net proceeds of $60.0 million net of issuance costs. Upon the closing of our IPO in July 2019, all shares of our Series A convertible preferred stock automatically converted into 14,969,118 shares of our common stock. On July 22, 2019, we completed our IPO, pursuant to which we sold an aggregate of 5,000,000 shares of our common stock at a price of $15.00 per share, resulting in net proceeds of $67.2 million after deducting underwriting discounts, commissions and offering expenses payable by us. Subsequent to December 31, 2019, on January 13, 2020, we completed a follow-on public offering of our common stock pursuant to which we sold an aggregate of 2,400,000 shares of common stock at a price of $20.00 per share, resulting in net proceeds of approximately $44.7 million after deducting underwriting discounts, commissions and offering expenses payable by us. Based on our current and anticipated level of operations, we believe our cash, cash equivalents and investments, together with the proceeds from our follow-on public offering on January 13, 2020, will be sufficient to fund current operations through at least the next 12 months. Our cash, cash equivalents and investments 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. We anticipate that we will continue to incur net losses for the foreseeable future as we continue research efforts and the development of our product candidates, initiate commercial preparation activities, hire additional staff, including clinical, scientific, operational, financial and management personnel, and incur additional costs associated with being a public company. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures, and to a lesser extent, general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. Until such time, if ever, as we can generate substantial product revenue from sales of maralixibat, volixibat or any future product candidates, we expect to finance our cash needs through a combination of equity offerings, debt financings and potential collaboration, license or development agreements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect rights as a stockholder. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may be required to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our drug development or future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. 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, which consist of cash, cash equivalents and investments, sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of our 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 cost of commercialization activities if our product candidates or any future product candidates are approved or cleared for sale, including marketing, sales and distribution costs; • the cost of establishing sales and marketing activities; • the number and characteristics of any future product candidates we develop or acquire; • the timing of any cash milestone payments pursuant to the Shire License Agreement as well as our other license and acquisition agreements if we successfully achieve certain predetermined milestones; • our ability to forecast demand for our products, scale our supply to meet that demand and manage working capital effectively • the cost of manufacturing our product or any future product candidates and any products we successfully commercialize, including costs associated with building our supply chain; • 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; • 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, including litigation costs related to maralixibat and volixibat, 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 or cleared products, if any. Cash Flows The following table provides a summary of the net cash flow activity for the periods indicated (in thousands): Cash Used in Operating Activities Net cash used in operating activities was $39.4 million for the year ended December 31, 2019, reflecting our net loss of $52.6 partially offset by non-cash items of $6.1 million. Non-cash items consisted primarily of $6.1 million in stock-based compensation, $0.3 million in depreciation and amortization of our operating lease right-of-use assets and fixed assets and $0.3 million of discount accretion on our investments. Additionally, cash used in operating activities reflected changes in net operating assets of $7.1 million, consisting primarily of an $10.1 million increase in accounts payable, accrued expenses and other liabilities primarily due to clinical and manufacturing activities, a $2.7 million increase in prepaid expenses and other current assets consisting primarily of $1.4 million in prepayments for directors and officers insurance, $0.8 million in prepaid research and development expenses representing increased operating activities over 2018 and $0.4 million in interest receivable, and a $0.2 million increase in other assets. Net cash used in operating activities was $0.4 million for the period from May 2, 2018 to December 31, 2018 which consisted primarily of our net loss of $17.3 million, reduced by in process research and development expense of $14.5 million and a $2.4 million decrease in the net assets due to the increase in accounts payable. Cash Used in Investing Activities Net cash used in investing activities was $127.8 million for the year ended December 31, 2019 due to the purchases of $152.0 million of investments and the purchases of $0.3 million of property and equipment, partially offset by proceeds from maturities of investments of $24.5 million. Net cash used in investing activities was $7.5 million for the period from May 2, 2018 to December 31, 2018 consisting of a $7.5 million upfront cash payment to Shire, as partial consideration for the rights granted to us under the Shire License Agreement. Cash Provided by Financing Activities Net cash provided by financing activities was $127.2 million for the year ended December 31, 2019, primarily due to $67.2 million in net proceeds received from our IPO and $60.0 million in net proceeds from the issuance of 59,844,699 shares of Series A convertible preferred stock. Net cash provided by financing activities was $59.8 million for the period from May 2, 2018 to December 31, 2018 primarily consisted of net proceeds from issuance of 59,844,699 shares of Series A convertible preferred stock. Contractual Obligations and Commitments The following table summarizes our principal contractual obligations and commitments as of December 31, 2019 that will affect our future liquidity (in thousands): (1) Consists of leases for our corporate headquarters encompassing approximately 11,200 square feet of office space that expires in March 2025, and the lease for our office space in Basel, Switzerland encompassing approximately 1,400 square feet that expires in May 2024. From time to time we enter into certain types of contracts that contingently require us to indemnify parties against third-party claims, including the Shire License Agreement, and certain real estate leases, supply purchase agreements, and agreements with directors and officers. The terms of such obligations vary by contract and in most instances a maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted, thus no liabilities have been recorded for these obligations on our consolidated balance sheet for the periods presented. We enter into contracts in the normal course of business with clinical research organizations and clinical sites for the conduct of clinical trials, non-clinical research studies, professional consultants for expert advice and other vendors for clinical supply manufacturing or other services. These contracts generally provide for termination on notice, and therefore are cancelable contracts. Contractual Arrangements Under the Shire License Agreement, as well as our other license and acquisition agreements, we have payment obligations that are contingent upon future events such as our achievement of specified development, regulatory and commercial milestones and are required to make royalty payments in connection with the sale of products developed under those agreements. In July 2019, we achieved the first development milestone under the Shire License Agreement and Satiogen License and made an aggregate payment of $3.0 million. As for the remaining milestones, as of December 31, 2019, we were unable to estimate the timing or likelihood of achieving future milestones or making future product sales and, therefore, any related payments are not included herein. For additional information regarding these license agreements, including our payment obligations thereunder, see Note 6 to our consolidated financial statements. 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. JOBS Act As an emerging growth company under the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), we 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 irrevocably elected not to avail ourselves of this exemption and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. We intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”). We will remain an emerging growth company until the earliest of (i) December 31, 2024, (ii) the last day of the fiscal year in which we have total annual gross revenue of at least $1.07 billion, (iii) the last day of the fiscal year in which we are deemed to be a “large accelerated filer” as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended (“Exchange Act”) which would occur if the market value of our common stock held by non-affiliates exceeded $700.0 million as of the last business day of the second fiscal quarter of such year, or (iv) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period.

<s>[INST] Overview We are a biopharmaceutical company focused on the development and commercialization of a latestage pipeline of novel therapies for debilitating liver diseases. We focus on diseases for which the unmet medical need is high and the biology for treatment is clear. Our pipeline consists of two clinicalstage product candidates with mechanisms of action that have potential utility across a wide range of orphan cholestatic liver diseases. We are initially developing maralixibat for the treatment of pediatric patients with Alagille syndrome (“ALGS”) and progressive familial intrahepatic cholestasis (“PFIC”). Based on improvements in pruritus, or itching, and other outcomes and disease markers observed in Phase 2 clinical trials, we are planning to initiate a rolling submission of a New Drug Application (“NDA”), for the treatment of cholestatic pruritus associated with ALGS in the third quarter of 2020. We expect to complete the rolling submission of our NDA in the first quarter of 2021, and pending a successful submission, we will plan for a potential launch in ALGS in the second half of 2021. We are also conducting the Phase 3 MARCH clinical trial in PFIC, from which we expect to complete enrollment in the second quarter of 2020 and announce topline Phase 3 data in late2020. Further, we are also conducting an analysis of our longterm treatment data in PFIC against a natural history control group in conjunction with the NAtural course and Prognosis of PFIC and Effect of biliary Diversion Consortium and plan to share these results with regulators in 2020. We are developing volixibat for the treatment of adult patients with cholestatic liver diseases and expect to initiate our first clinical trial in these indications in late 2020. We were incorporated in May 2018 and commenced operations in November 2018. To date, we have focused primarily on acquiring and inlicensing our product candidates, maralixibat and volixibat, organizing and staffing our company, business planning, raising capital, and preparing for advancement of our product candidates into clinical development. We have a limited operating history and incurred significant operating losses since our inception and expect to continue to incur significant operating losses for the foreseeable future. We have no products approved for commercial sale and have never generated any revenues from product sales. We have funded our operations to date primarily through equity financings. In November 2018, we completed the initial closing of our Series A redeemable convertible preferred stock (“Series A convertible preferred stock”) financing and sold an aggregate of 59,908,284 shares at a purchase price of $1.00259507 per share. In addition, at the request of our board of directors, in April 2019, certain purchasers in the initial closing purchased an aggregate of 59,844,699 additional shares of our Series A convertible preferred stock at the same purchase price per share in a subsequent closing. On July 22, 2019, we completed our initial public offering (“IPO”) pursuant to which we sold an aggregate of 5,000,000 shares of our common stock at a price of $15.00 per share, resulting in net proceeds of $67.2 million after deducting underwriting discounts, commissions and offering expenses payable by us. Upon the closing of our IPO, all outstanding shares of our Series A convertible preferred stock automatically converted into 14,969,118 shares of our common stock. Subsequent to December 31, 2019, on January 13, 2020, we completed a followon public offering of our common stock pursuant to which we sold an aggregate of 2,400,000 shares of common stock at a price of $20.00 per share, resulting in net proceeds of approximately $44.7 million after deducting underwriting discounts, commissions and offering expenses payable by us. Our net loss was $52.6 million and $17.3 million for the year [/INST] Positive. </s>

Schrodinger, 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 consolidated financial statements and related notes appearing 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 “Item 1A. Risk Factors” 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. Overview We are transforming the way therapeutics and materials are discovered. Our differentiated, physics-based software platform enables discovery of high-quality, novel molecules for drug development and materials applications more rapidly, at lower cost, and with, we believe, a higher likelihood of success compared to traditional methods. Our software is used by biopharmaceutical and industrial companies, academic institutions, and government laboratories around the world, and we are the leading provider of computational software solutions for drug discovery. We also apply our computational platform to a broad pipeline of drug discovery programs in collaboration with biopharmaceutical companies, some of which we co-founded. In addition, we are using our platform to advance a pipeline of internal, wholly-owned drug discovery programs. Since our founding, we have been primarily focused on developing our computational platform, which is capable of predicting critical properties of molecules with a high degree of accuracy. We have devoted substantially all of our resources to introducing new capabilities and refining our software, conducting research and development activities, recruiting skilled personnel, and providing general and administrative support for these operations. We are using our computational platform in both collaborative and wholly-owned drug discovery programs. Over the last decade, we have entered into a number of collaborations with biopharmaceutical companies that have provided us with significant income and have the potential to produce additional milestone payments, option fees, and future royalties. Furthermore, since mid-2018, we have launched five internal, wholly-owned programs. We generate revenues from sales of our software solutions and from research funding and milestone payments from our drug discovery collaborations, which we have used to support our research and development and other operating expenses. In addition, since inception we have raised gross proceeds of $192.6 million from sales of our convertible preferred stock as well as amounts received from our equity investment in Nimbus Therapeutics, LLC, or Nimbus, which we co-founded in 2009. In late 2018 and early 2019, we issued and sold an aggregate of 73,795,777 shares of Series E convertible preferred stock at $1.4906 per share, for $110.0 million in gross proceeds. In 2016, Nimbus sold its Acetyl-CoA carboxylase, or ACC, inhibitor, firsocostat, to Gilead Sciences, Inc., or Gilead Sciences, in a transaction valued at approximately $1.2 billion, comprised of an upfront payment and earn outs that are tied to the achievement of specified development and regulatory milestones. Of this amount, $601.3 million has been paid to Nimbus to date, and we received a total of $46.0 million in cash distributions in 2016 and 2017. We are eligible to receive up to $46 million in future cash distributions on the remaining approximately $600 million of earn outs, if and when such earn outs are achieved. However, the likelihood and timing of such payments, if any, are not possible for us to predict as the achievement of the development and regulatory milestones under the transaction agreement is uncertain and outside of our control. In December 2019, Gilead Sciences announced topline results from its Phase 2 clinical trial which included firsocostat, both as a monotherapy and in combination with other investigational therapies, in which the primary endpoint was not met. Gilead Sciences announced that it was continuing to analyze the data from the trial and determine next steps. We do not know how this development will affect Nimbus’ right to receive future earnout payments from Gilead Sciences or our right to receive cash distributions from Nimbus. However, if Gilead Sciences determined not to continue to advance the development of firsocostat, then we would not expect to receive any additional distributions from Nimbus on account of this program. Additionally, even if Nimbus were to receive any further earnout payments from Gilead Sciences, any distribution to us as an investor in Nimbus would need to be approved by the board of directors of Nimbus. On February 10, 2020, we closed our initial public offering of our common stock, in which we sold 13,664,704 shares of common stock at a public offering price of $17.00 per share, resulting in net proceeds to us of $209.9 million, after deducting underwriting discounts and commissions and offering expenses borne by us. We currently conduct our operations through two reportable segments: software and drug discovery. The software segment is focused on selling our software to transform drug discovery across the life sciences industry, as well as to customers in materials science industries. The drug discovery segment is focused on generating revenue from a diverse portfolio of preclinical and clinical programs, internally and through collaborations, that have advanced to various stages of discovery and development. Our software segment generates revenue from software product licenses, hosted software subscriptions, software maintenance, and professional services. The revenue we generate through our software solutions from each of our customers varies largely depending on the number of software licenses our customers purchase from us. The licenses that our customers purchase from us provide them the ability to perform a certain number of calculations used in the design of molecules for drug discovery or materials science. We deliver our software through either (i) a product license that permits our customers to install the software solution directly on their own in-house hardware and use it for a specified term, or (ii) a subscription that allows our customers to access the cloud-based software solution for a specified term. We currently generate drug discovery revenue from our collaborations, including research funding payments and discovery and development milestones. In the future, we may also derive drug discovery revenue from our collaborations from option fees, the achievement of commercial milestones, and royalties on commercial drug sales. In addition to revenue from our collaborations, in the future we may also derive drug discovery revenue from out-licensing our internal drug discovery programs when we believe it will help maximize the commercial potential of the program. We generated revenue of $66.6 million and $85.5 million in 2018 and 2019, respectively, representing year-over-year growth of 28%. Our net loss was $28.4 million and $24.6 million for the years ended December 31, 2018 and 2019, respectively. Key Factors Affecting Our Performance Ability to drive additional revenue from our software solutions from existing customers Our large existing base of customers represents a significant opportunity for us to expand our revenue through increased utilization of our software. The revenue that we generate through our software solutions from each of our customers varies depending on the number of licenses for each software solution that each customer purchases from us. Accordingly, we work with our customers to improve their experience and increase the utility of our platform in order to expand the scale at which they deploy our platform in their business. Biopharmaceutical companies are increasingly adopting our software at a larger scale, and we anticipate that this scaling-up will drive future revenue growth. Our ability to expand within our customer base is best demonstrated by the increasing number of our customers with an annual contract value, or ACV, of over $100,000. We had 103, 122, and 131 of these customers for the years ended December 31, 2017, 2018, and 2019, respectively. This subset of customers represented approximately 75%, 77%, and 78% of our total ACV for the years ended December 31, 2017, 2018, and 2019, respectively. In addition, we had nine, 11, and 10 customers with an ACV of over $1.0 million for the years ended December 31, 2017, 2018, and 2019, respectively. With respect to contracts that have a duration of one year or less, or contracts of more than one year in duration that are billed annually, we define ACV as the contract value billed during the applicable period. For contracts with a duration of more than one year that are billed upfront, ACV in each period represents the total billed contract value divided by the term. ACV should be viewed independently of revenue and does not represent revenue calculated in accordance with generally accepted accounting principles in the United States, or U.S. GAAP, on an annualized basis, as it is an operating metric that can be impacted by contract execution start and end dates and renewal rates. ACV is not intended to be a replacement for, or forecast of, revenue. Furthermore, another important driver of our ability to expand our customer relationships is the retention of our customers with an ACV over $100,000. For the year ended December 31, 2019 and for each of the previous six fiscal years, our year-over-year customer retention for such customers was 96% or higher. We calculate year-over-year customer retention for our customers with an ACV over $100,000 by starting with the number of such customers we had in the previous fiscal year. We then calculate how many of these customers were active customers in the current fiscal year. We then divide this number by the number of customers with an ACV over $100,000 we had in the previous fiscal year to arrive at the year-over-year customer retention rate for such customers. We intend to leverage our existing relationships with our customers to drive larger-scale adoption of our software solutions. If we are unable to continue to increase revenue from existing customers, our financial performance will be adversely impacted. Ability to increase our customer base for our software solutions We believe that we have significant opportunity to continue to increase the number of customers who use our solutions. We had 1,042, 1,150, and 1,266 active customers for the years ended December 31, 2017, 2018, and 2019, respectively. We define the number of active customers as the number of customers who had an ACV of at least $1,000 in the fiscal year. We use $1,000 as a threshold for defining our active customers as this amount will generally exclude customers who only license our PyMOL software, which is our open-source molecular visualization system broadly available at low cost. While we have significantly penetrated the pharmaceutical industry, with all of the top 20 pharmaceutical companies, measured by 2018 revenue, licensing our software in 2019, our strategy is to grow our customer base. We believe there remains a large opportunity for growth as there are thousands of biopharmaceutical companies that could benefit from our solutions. Additionally, since the physics underlying the properties of drug molecules and materials is the same, we have been able to extend our computational platform to materials science applications in fields such as aerospace, energy, semiconductors, and electronic displays. We sell our software solutions to a growing number of materials science customers, and we believe the materials science industry is only beginning to recognize the potential of computational methods. We continue to promote the education and recognition of our computational platform across industries. As part of our strategy, we have driven the adoption of our software by researchers, and we had more than 1,350 academic institutions across the world using our software in 2019. We believe that by introducing the benefits of our computational software at the academic stage, we will drive brand awareness and expand the use of our platform to industries that have historically relied on traditional methods for discovery of molecules. Our ability to continue to grow our customer base is dependent upon our ability to educate the market and support the business through investment in our sales and marketing efforts and the ongoing enhancement of our software solutions. Advancement of our collaborations We have entered into a number of collaborations with various biopharmaceutical companies, some of which we have co-founded, to advance drug discovery. We will seek to enter into additional collaboration agreements, driven by the synergies we expect to achieve between our platform and the capabilities and expertise of our potential collaborators. We believe that our collaborations will be a significant driver of value for us in the form of equity stakes, research fees, pre-clinical, clinical, and commercial milestone payments, and option fees, as well as royalties on any potential future sales of products, if approved. We continue to work with our current collaborators to advance existing programs through discovery research stages and initiate additional programs. However, we do not generally exercise control over the development programs of our collaborators and often rely on decisions of the management of such companies with respect to clinical development and commercialization. Our ability to continue to derive value from our collaborations will be driven by both our capability to make progress in these programs as well as whether our collaborators successfully advance such programs beyond the discovery stage. Ability to develop and expand our internal proprietary drug discovery pipeline We are advancing our pipeline of internal drug discovery programs through extensive application of our software platform. Since launching our first program in mid-2018, we have built a pipeline of five programs. We intend to progress our wholly-owned programs through the development candidate stage and potentially into investigational new drug-enabling studies and clinical development. As we progress these programs, we will strategically evaluate on a program-by-program basis entering into clinical development ourselves or out-licensing programs to maximize commercial opportunities. However, we will need to devote substantial resources to develop and expand our internal pipeline. Our ability to advance and build value in our internal drug discovery programs will impact our financial performance, especially as we increasingly shift our focus to these programs. Components of Results of Operations Software Products and Services Revenue Our software business generates revenue from four sources: (i) on-premise software license fees, (ii) hosted software subscription fees, (iii) software maintenance fees, and (iv) professional services fees. On-premise software. Our on-premise software license arrangements grant customers the right to use our software on their own in-house servers for a specified term, typically for one year. We recognize revenue for on-premise software license fees upfront, either upon delivery of the license or the effective date of the agreement, whichever is later Hosted software. Hosted software revenue consists primarily of fees to provide our customers with access to our hosted software platform and is recognized ratably over the term of the arrangement, which is typically one year. When a customer enters into a hosted arrangement for which revenue is recognized over time, the amount paid upfront that is not recognized in the current period is included in deferred revenue in our statement of financial position until the period in which it is recognized. Software maintenance. Software maintenance includes technical support, updates, and upgrades related to our on-premise software licenses. Software maintenance revenue is recognized ratably over the term of the arrangement. Software maintenance activities are performed in connection with the use of our on-premise software, and may fluctuate from period to period. Professional services. Professional services, such as technical setup or installation or modeling services, where we use our software to perform tasks such as virtual screening and homology modeling on behalf of our customers, generally are not related to the functionality of our software and are recognized as revenue when resources are consumed. Since each professional services agreement represents a unique, ad hoc engagement, professional services revenue may fluctuate from period to period. Drug Discovery Revenue We currently generate drug discovery revenue from discovery collaboration arrangements, including research funding payments and discovery and development milestones. We expect our drug discovery revenue to trend higher over time as these collaboration arrangements advance and we receive additional revenue from research funding payments, the achievement of discovery, development, and commercial milestones, option fees, and royalties on commercial drug sales. The majority of our current collaborations are in the discovery stage. Milestone payments typically increase in magnitude as a program advances. In addition to revenue from our collaborations, in the future we may also derive drug discovery revenue from out-licensing our internal drug discovery programs when we believe it will help maximize the commercial potential of the program. However, we expect that our revenue will fluctuate from period to period due to the inherently uncertain nature of the timing of milestone achievement and our dependence on the program decisions of our collaborators. Cost of Revenues Software products and services. Cost of revenues for software includes personnel-related expenses (comprised of salaries, benefits, and stock-based compensation) for employees directly involved in the delivery of software solutions, maintenance and professional services, royalties paid for products sold and services performed using third-party licensed software functionality, and allocated overhead (facilities and information technology support) costs. Pursuant to various third party arrangements, we license technology that is used in our software. These arrangements require us to pay royalties based on sales volume, and such royalty payments represented 7.6% and 6.4% of software revenues in the years ended December 31, 2018 and 2019, respectively. Drug discovery. Costs of revenue for drug discovery includes personnel-related expenses and costs of third-party contract research organizations, or CROs, that support discovery activities in our collaborations, royalties paid for services performed using third-party licensed software functionality, and allocated compute capacity and overhead costs. Currently, we have only one collaboration that involves payment of CRO costs. While we have incurred costs associated with discovery efforts for this collaboration since late 2017, we have recognized and expect to continue to recognize revenues in the future if and when milestones are achieved. Generally, drug discovery costs of revenue for collaborations are incurred in advance of the revenue milestone achievement. Royalty payments to third parties represented 5.1% and 6.7% of drug discovery revenues in the years ended December 31, 2018 and 2019, respectively. We expect our drug discovery costs of revenue to trend higher over time as our discovery collaborations advance. Personnel-related expenses for our internal discovery programs are classified within research and development expense. Gross Profit and Gross Margin Gross profit represents revenue less cost of revenues. Gross margin is gross profit expressed as a percentage of revenue. Our software products and services gross margin may fluctuate from period to period as our revenue fluctuates, and as a result of changes in sales mix between on-premise and hosted software solutions. For example, the cost of royalties due for sales of our hosted software arrangements are recognized upfront, whereas the associated revenue is recognized over the term of the underlying agreement. Currently, gross margin is not meaningful for measuring the operating results of our drug discovery business. Research and Development Expense Research and development expense accounts for a significant portion of our operating expenses. We recognize research and development expenses as incurred. Research and development expenses consist of internal drug discovery program costs and costs incurred for continuous development of the technology and science that supports our computational platform, primarily: • personnel-related expenses, including salaries, benefits, bonuses, and stock-based compensation for employees engaged in research and development functions; • expenses incurred under agreements with third-party CROs and consultants involved in our internal discovery programs; and • allocated compute capacity and overhead (facilities and information technology support) costs. We expect our research and development expense to increase substantially in absolute dollars for the foreseeable future as we continue to invest in activities related to discovery and development of our internal target candidates, in advancing our platform, and as we incur expenses associated with hiring additional personnel directly involved in such efforts. At this time, we do not know, nor can we reasonably estimate, the nature, timing, or costs of the efforts that will be necessary to complete the development of any of our internal drug discovery programs. Since our internal drug discovery efforts are at a very early stage, currently we do not track research and development expense on a program-by-program basis. Sales and Marketing Expense Sales and marketing expense consists primarily of personnel-related costs for our sales and marketing staff and application scientists supporting our sales efforts, including salaries, benefits, bonuses, and stock-based compensation. Other sales and marketing costs include promotional events that promote and expand knowledge of our company and platform, including industry conferences and events and our annual user group meetings in the United States and Europe, advertising, and allocated overhead costs. Most operating costs of our sales offices in Europe and Japan are included in sales and marketing expense. Due to the inherent scientific complexity of our software solutions, a high level of scientific expertise is needed to support our sales and marketing efforts. We plan to increase our investment in sales and marketing over the foreseeable future to foster the growth of our business as we aim to expand software sales to existing customers and increase our customer base. General and Administrative Expense General and administrative expense consists of personnel-related expenses associated with our executive, legal, finance, human resources, information technology, and other administrative functions, including salaries, benefits, bonuses, and stock-based compensation. General and administrative expense also includes professional fees for external legal, accounting and other consulting services, allocated overhead costs, and other general operating expenses. We expect to increase the size of our general and administrative staff to support the anticipated growth of our business. We expect to incur 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 U.S. securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. In addition, as a public company, we expect to incur increased expenses such as insurance and professional services. As a result, we expect the dollar amount of our general and administrative expense to increase for the foreseeable future. Gain on Equity Investments Gain on equity investments consists of realized gains in the form of cash distributions received from our equity investments. Change in Fair Value Fair value gains and losses consist of adjustments to the fair values of our equity investments, including Nimbus and Morphic Holding, Inc., or Morphic. In June 2019, Morphic became a publicly traded company and, as such, fair value is determined as the current market value of Morphic common stock as of the reporting date. We remeasure our holding in Morphic at each period end. Prior to Morphic’s initial public offering, fair value changes for our Morphic investment were determined under the hypothetical liquidation book value, or HLBV, method. For further information regarding the HLBV method, see “-Critical Accounting Policies and Significant Judgments and Estimates-Valuation of Equity Investments.” We expect that fair value gains and losses may fluctuate significantly in future periods. Interest Income Interest income consists of interest earned on our cash equivalents and marketable securities. Income Tax Expense (Benefit) Income tax expense (benefit) 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 Comparison of the years ended December 31, 2018 and 2019 The following table summarizes our unaudited results of operations data for the years ended December 31, 2018 and 2019: Revenues On-premise software. The increase in revenues for on-premise software was primarily attributable to new customer and existing customer growth during 2019 as compared to 2018. This was partially offset by a shift in sales mix from customers purchasing our software product licenses for use on their own in-house servers, which is recognized upfront at a single point in time, to accessing our software as a hosted solution, which is classified within hosted software revenue and recognized ratably over the term of the arrangement. Hosted software. The increase in revenues for hosted software was primarily due to existing customers shifting from on-premise software product licenses to hosted software subscriptions, for which revenue is recognized ratably over time. Software maintenance. The increase in revenues for software maintenance was primarily due to growing product sales in previous years. Maintenance revenue is recognized over time. Professional services. The decrease in revenues from professional services was primarily due to lower modeling services fees and non-renewing technology service projects. Drug discovery. The increase in revenues for drug discovery was primarily due to an increase in the number of collaboration milestones achieved during 2019 as compared to 2018. Cost of Revenues Software products and services. The increase in cost of revenues for software products and services was attributable to increases of $2.3 million in personnel-related expenses, $0.5 million in compute capacity costs, and $0.2 million in other costs of revenue. The decrease in gross margin was primarily attributable to an increase in personnel-related expenses. Drug discovery. The increase in cost of revenues for drug discovery was attributable to increases of $4.5 million in third-party CRO costs to support a collaboration, $1.9 million in compute capacity costs, $1.9 million in personnel-related expenses, $0.9 million in royalties paid to third parties for use of licensed software functionality, and $0.6 million in other costs of revenue. Research and Development Expense The increase in research and development expense was primarily due to additional CRO costs associated with the expansion and progression of internal drug discovery programs. Sales and Marketing Expense The increase in sales and marketing expense was primarily attributable to an increase in personnel-related expenses due to additional employee headcount to support the expansion of our business. General and Administrative Expense In the year ended December 31, 2019, we recognized a total of $3.3 million in non-comparable costs, which consisted of $1.8 million of costs related to a cash distribution we received from Nimbus and a $1.5 million unconditional gift to Columbia University intended to fund a research laboratory. The increase in general and administrative expense was also attributable to an increase of $3.8 million in personnel-related expenses due to additional employee headcount and a $1.4 million increase in other expenses. Gain on Equity Investment In the year ended December 31, 2019, we received a $0.9 million cash distribution from our Nimbus investment in 2019. There was no such distribution in 2018. Change in Fair Value The increase in fair value was due to a $14.1 million gain on our equity investment in Morphic, partially offset by a $4.2 million loss on our equity investment in Nimbus. Morphic became a publicly traded company in June 2019 and, as such, we revalued our investment as of December 31, 2019 to equal the current fair market value of Morphic’s common stock. The Nimbus fair value loss was determined under the HLBV method. Interest Income The increase in interest income was attributable to increased earnings on our investment portfolio balance, which increased significantly year-over-year due to the investment of proceeds from our Series E preferred stock issuance. Income Tax Expense (Benefit) Due to the full valuation allowance on our U.S. federal and state deferred tax assets, income tax expense (benefit) represents our income tax obligations in certain foreign jurisdictions in which we conduct business. Quarterly Results of Operations The following tables summarize our selected unaudited quarterly results 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 elsewhere in this Annual Report. 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 as indicated in the table located further below. Revenues: Deferred Revenue: Gross Margin: Stock-Based Compensation: Depreciation: Quarterly Revenue Trends On-premise software revenue is subject to seasonality that favors the first quarter of each year, primarily due to the calendar year timing of customer renewals for on-premise software arrangements, for which revenue is recognized at a single point in time. Hosted software revenue grew steadily in the periods presented, as existing customers migrated from on-premise licenses to hosted solutions, for which revenue is recognized over time. As a result, a substantial portion of the software products and services revenue we reported in each period was attributable to sales we made in prior periods. Software maintenance revenue is related to on-premise software sales and also is recognized ratably over the term of the underlying agreement. Therefore, increases or decreases in customer sales, customer expansion, or renewals in a period may not be immediately reflected in revenue for the period. Our professional services arrangements are typically project-based and, therefore, fluctuated based on individual customer needs and ongoing project support. Drug discovery revenue fluctuated from period to period based on the achievement of specific collaboration milestones, but has grown in recent periods as our collaborations have advanced. The majority of our current collaborations are in the discovery stage. Milestone payments typically increase in magnitude as a program advances. Quarterly Deferred Revenue Trends Deferred revenue consists of the unearned portion of customer billings, which is recognized as revenue in accordance with our revenue recognition policy, as well as the unearned portion of unbilled collaboration milestones that are deemed probable in advance of actual achievement. Deferred revenue balances have generally increased over the periods presented, but have fluctuated based on the timing of sales, the shift of product mix as customers transitioned from on-premise software to hosted software that is recognized over time, and the increase in the number of milestones that were deemed probable in advance of actual achievement. Quarterly Gross Margin Trends Our software products and services gross margin experienced declines over the periods presented due to increased headcount and the timing effect of a shift in software sales from on-premise to hosted solutions. The cost of royalties due on sales of our hosted software is recognized upfront, while the associated revenue is recognized over the term of the related agreement, which created fluctuation in gross margin from quarter-to-quarter. Currently, gross margin is not meaningful for measuring the operating results of our drug discovery business. Quarterly Operating Expense Trends Operating expenses generally increased during the periods presented due to increased headcount involved in research and development, sales and marketing, general and administrative activities, and CRO costs related to our internal drug discovery programs. These increases in headcount across our operations have supported the overall growth and management of our business. CRO cost increases were driven by the launch and expansion of our internal drug discovery programs. Included in general and administrative expense for the year ended December 31, 2019 was $3.3 million of non-comparable items. Quarterly Other (Expense) Income Trends Other (expense) income during the periods presented consisted primarily of fair value gains and losses related to our equity investments in Nimbus and Morphic and, to a lesser degree, interest income. Segment Information The following tables summarize segment information for the years ended December 31, 2018 and 2019. See Note 15 in our audited consolidated financial statements for additional information regarding our segments. Segment gross profit is derived by deducting operational expenditures, with the exception of research and development, sales and marketing, and general and administrative activities, from U.S. GAAP revenue. Operational expenditures are expenditures made that are directly attributable to the reportable segment. In many cases, these expenditures are allocated to the segments based on headcount. The reportable segment expenditures include compensation, supplies, and services from contract research organizations. Certain cost items are not allocated to our reportable segments. These cost items primarily consist of compensation and general operational expenses associated with our research and development, sales and marketing, and general and administrative activities. These costs are incurred by both segments and, due to the integrated nature of our software and drug discovery segments, any allocation methodology would be arbitrary and provide no meaningful analysis. Additionally, we report assets on a consolidated basis and do not allocate assets to our reportable segments for purposes of assessing segment performance or allocating resources. Liquidity and Capital Resources Historically we have incurred substantial operating losses and expect to continue to incur significant operating losses for the foreseeable future and may never become profitable. As of December 31, 2019, we had an accumulated deficit of $105.1 million. Our operating cash flows are impacted by the magnitude and timing of our software sales and, to a lesser degree, by the magnitude and timing of our drug discovery milestone achievements and research funding fees. Our primary use of cash is to fund operating expenses, which consist of research and development, sales and marketing, and general and administrative expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay operating expenses to vendors and collect amounts due from customers and collaborators, which is reflected in changes in our operating assets and liabilities, including accounts payable, accrued expenses, prepaid expenses, deferred revenue, and accounts receivable. We generate revenues from sales of our software solutions and from research funding and milestone payments from our drug discovery collaborations, which we have used to support our research and development and other operating expenses. Since inception, we have also financed our operations from sales of our convertible preferred stock, as well as amounts received from our equity investment in Nimbus, which we co-founded in 2009, and the net proceeds of our initial public offering in February 2020. In late 2018 and early 2019, we issued and sold an aggregate of 73,795,777 shares of Series E convertible preferred stock at $1.4906 per share, for $110.0 million in gross proceeds. In 2016, Nimbus sold its ACC inhibitor to Gilead Sciences in a transaction valued at approximately $1.2 billion, comprised of an upfront payment and earn outs. Of this amount, $601.3 million has been paid to Nimbus to date, and we have received a total of $46.0 million in cash distributions to date. We are eligible to receive future cash distributions on the remaining approximately $600 million of earn outs, if and when such earn outs are achieved. However, the likelihood and timing of such payments, if any, are not possible for us to predict as the achievement of the development and regulatory milestones under the transaction agreement is uncertain and outside of our control. In December 2019, Gilead Sciences announced topline results from its Phase 2 clinical trial which included firsocostat, both as a monotherapy and in combination with other investigational therapies, in which the primary endpoint was not met. Gilead Sciences announced that it was continuing to analyze the data from the trial and determine next steps. We do not know how this development will affect Nimbus’ right to receive future earnout payments from Gilead Sciences or our right to receive cash distributions from Nimbus. However, if Gilead Sciences determined not to continue to advance the development of firsocostat, then we would not expect to receive any additional distributions from Nimbus on account of this program. Additionally, even if Nimbus were to receive any further payments from Gilead Sciences, any distribution to us as an investor in Nimbus would need to be approved by the board of directors of Nimbus. As of December 31, 2019, we had cash, cash equivalents, restricted cash, and marketable securities of $86.3 million. In addition, on February 10, 2020, we closed our initial public offering of our common stock, in which we sold 13,664,704 shares of common stock at a public offering price of $17.00 per share, resulting in net proceeds of $209.9 million, after deducting underwriting discounts and commissions and offering expenses borne by us. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view towards capital preservation and liquidity. Cash Flows The following table presents a summary of our cash flows for the periods shown: Operating activities During the year ended December 31, 2018, operating activities used approximately $23.7 million of cash, primarily resulting from net loss of $28.4 million, partially offset by $3.6 million of non-cash operating expenses included in net loss, including depreciation and stock-based compensation costs, and a $0.8 million non-cash loss from changes in fair value. Changes in our operating assets and liabilities provided cash of approximately $0.3 million. During the year ended December 31, 2019, operating activities used approximately $26.1 million of cash, primarily resulting from net loss of $25.7 million, which included a $9.9 million non-cash gain from changes in fair value and a $0.9 million gain on equity investment that is classified as an investing activity, partially offset by $6.2 million of non-cash operating expenses included in net loss, including depreciation and stock-based compensation costs. Changes in our operating assets and liabilities provided cash of approximately $4.2 million. Investing activities During the year ended December 31, 2018, investing activities provided approximately $11.2 million of cash, primarily attributable to $20.1 million of proceeds upon the maturity of marketable securities, partially reduced by $5.3 million used for purchases of property and equipment, $3.3 million for the purchase of additional shares of Nimbus, and $0.3 million for the purchase of additional shares of Morphic. During the year ended December 31, 2019, investing activities used approximately $53.9 million of cash, primarily for purchases of marketable securities. Financing activities During the year ended December 31, 2018, financing activities provided approximately $80.3 million of cash, primarily attributable to proceeds from issuances of our Series E preferred stock. During the year ended December 31, 2019, financing activities provided approximately $28.7 million of cash, primarily attributable to proceeds from issuances of our Series E preferred stock. Funding Requirements We believe that our existing cash, cash equivalents, and marketable securities will be sufficient to fund our operations and capital expenditure requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including the growth of our software revenue, the timing and extent of spending to support research and development efforts, the continued expansion of sales and marketing activities, the timing and receipt of milestone payments from our collaborations, as well as spending to support, advance, and broaden our internal programs. Furthermore, our capital requirements will also change depending on the timing and receipt of any distributions we may receive from our equity stakes in our co-founded companies. The potential for these distributions, and the amounts which we may be entitled to receive, are difficult to predict due to the inherent uncertainty of the events which may trigger such distributions. In addition, with respect to our internal wholly-owned programs, as part of our strategy we may choose to pursue licensing arrangements when we believe it will help maximize the commercial value of any such program. If we are able to successfully enter into any licensing arrangements in the future, the potential amounts we may be entitled to and the likelihood and timing of such payments, including at what stage of discovery or development we may choose to pursue such arrangements, is uncertain. 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 maintain or expand our operations and invest in our platform, we may not be able to compete successfully, which would harm our business, operations and financial condition. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: (1) Operating lease obligations consist of our continuing rent obligations through January 2029, primarily for our principal offices located in New York, New York and Portland, Oregon, which expire in August 2021 and August 2026, respectively. In November 2019, we entered into a three-year agreement with a third-party cloud provider for compute power. The agreement contains a minimum payment obligation which totals $18 million over the three years after the date we entered into the agreement. These amounts are not included in the table above because there is not an annual commitment. We enter into agreements in the normal course of business with CRO vendors for research and preclinical studies, professional consultants for expert advice, and other vendors for various products and services. We have not included these payments in the table of contractual obligations above since the contracts do not contain any minimum purchase commitments and are cancelable at any time by us, generally upon 30 days prior written notice, and therefore we believe that our non-cancelable obligations under these agreements are not material. We have also agreed to pay volume-based royalties to third parties for use of software functionality under various licensing and related agreements. Income Taxes At December 31, 2019, we had federal and state net operating loss carryforwards of approximately $104.3 million and $64.8 million, respectively. These carryforwards will expire between 2020 and 2039, with the exception of 2018 and 2019 federal net operating losses, if not used by us to reduce income taxes payable in future periods. Utilization of post 2017 federal net operating loss carryforwards is limited to 80% of taxable income generated in a given tax year and carry forward indefinitely. At December 31, 2019, we had federal and state research and development tax credit carryforwards of approximately $8.0 million and $0.4 million, respectively. These carryforwards will expire between 2020 and 2039 if not used by us to reduce income taxes payable in future periods. As required by Accounting Standards Codification, or ASC, Topic 740, Income Taxes, our management has evaluated the positive and negative evidence bearing upon the realizability of our deferred tax assets, which are composed principally of NOL carryforwards and research and development credit carryforwards. Management has determined that it is more likely than not that we will not realize the benefits of our federal and state deferred tax assets and, as a result, a valuation allowance of $27.6 million and $35.3 million has been established at December 31, 2018 and 2019, respectively. The change in the valuation allowance was $7.8 million for the year ended December 31, 2018 and $7.7 million for the year ended December 31, 2019. We recorded income tax expense of $0.1 million for the year ended December 31, 2018 and income tax benefit of $0.3 million for the year ended December 31, 2019. Seasonality Historically, the first quarter of each year has been our largest quarter for software products and services revenue, primarily due to the timing of customer renewals of on-premise software arrangements, for which revenue is recognized at a single point in time. Seasonality has been a less significant factor for our hosted software arrangements, for which revenue is recognized ratably over time. Seasonality has not been a factor for our drug discovery revenues. Historical seasonality may not be indicative of future periods. Off-Balance Sheet Arrangements During the periods presented, we did not have, and currently we do not have, any off-balance sheet arrangements, as defined under the rules and regulations of the SEC. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make judgments and estimates that affect the reported amounts of assets, liabilities, revenues, and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements. We base our estimates on historical experience, known trends and events, and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. On an ongoing basis, we evaluate our judgments and estimates in light of changes in circumstances, facts, and experience. The effects of material revisions in estimates, if any, are reflected in the consolidated financial statements prospectively from the date of change in estimates. While our significant accounting policies are described in more detail in the notes to our consolidated financial statements appearing elsewhere in this Annual Report, we believe the following accounting policies used in the preparation of our consolidated financial statements require the most significant judgments and estimates. Revenue We recognize revenue in accordance with ASC 606, Revenue from Contracts with Customers, which we adopted as of January 1, 2017 on a full retrospective basis. In accordance with ASC 606, we recognize revenue when our customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of ASC 606, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when or as we satisfy a performance obligation. Our software revenue may include upfront payments for the performance of services in the future, which have both fixed and variable consideration. At contract inception, we assess the goods or services promised within each contract that falls under the scope of ASC 606 to identify distinct performance obligations. 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. For a collaborative arrangement that falls within the scope of ASC 808, Collaborative Arrangements, we apply the revenue recognition model under ASC 606 to part or all of the arrangement, when deemed appropriate. We have determined that we are the principal in arrangements where we act as a reseller, and therefore recognize revenue on a gross basis. We include the unconstrained amount of estimated variable consideration in the transaction price. The amount included in the transaction price is constrained to the amount for which 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, adjust our estimate of the overall transaction price. Research support payments: Payments by the licensees in exchange for research activities we performed on behalf of the licensee are recognized upon performance of such activities at rates consistent with prevailing market rates. If the expectation at contract inception is such that the period between payment by the licensee and the completion of related performance obligations will be one year or less, we assume that the contract does not have a significant financing component. Milestone payments: Research and development or regulatory milestones in our collaboration agreements may include some, but not necessarily all, of the following types of events: • completion of preclinical research and development work leading to selection of product candidates; • initiation of Phase 1, Phase 2, and Phase 3 clinical trials; • filing of regulatory applications for marketing approval in the United States, Europe or Japan; • marketing approval in major markets, such as the United States, Europe, or Japan; and • achievement of certain other technical, scientific, or development criteria. 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 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 that of the licensee, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. The transaction price is then allocated to each performance obligation on a relative stand-alone selling price basis, for which we recognize revenue as or when the performance obligations under the contract are satisfied. At the end of each subsequent reporting period, we re-evaluate the probability of achievement of such development milestones and any related constraint, and if necessary, adjusts our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which may affect license, collaboration, and other revenues and earnings in the period of adjustment. The process of successfully achieving the criteria for the milestone payments is highly uncertain. Consequently, there is a risk that we may not earn all of the milestone payments from each of our collaborators. Royalties and commercial milestones: For arrangements that include sales-based royalties, including commercial milestone payments based on pre-specified level of sales, 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). Achievement of these royalties and commercial milestones may solely depend upon performance of the licensee. The process of successfully achieving the criteria for the commercial milestone payments and sales-based royalties under our arrangements is highly uncertain. As a result, we cannot predict when we might achieve any commercial milestone or royalty payments or estimate the amount of such payments. Since inception to date, we have not recognized any royalty revenue or commercial milestone payments from any of our collaborations. We may never receive any such payments. Stock-Based Compensation We estimate the fair value of stock option awards granted using the Black-Scholes option-pricing model, which uses as inputs the fair value of our common stock and subjective assumptions we make as follows: Fair Value of Common Stock. As our stock was not publicly traded prior to our initial public offering in February 2020, we historically estimated the fair value of common stock as discussed below. Expected Term. The expected term of employee stock options represents the weighted average period that the stock options are expected to remain outstanding. The expected terms were calculated using an average of historical exercises. Expected Volatility. As we did not have a trading history for our common stock prior to our initial public offering in February 2020, 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 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 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 option grant at the date nearest the option 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. Prior to our initial public offering in February 2020, our board of directors, with input from management, estimated the price of our common stock based upon several factors, including third-party valuations and our operating results and financial performance. The valuations took into consideration several factors, including, but not limited to, prices for our preferred stock that was sold to outside investors in arms-length transactions, and the rights, preferences, and privileges of our preferred stock and common stock; the fact that the option grants involved illiquid securities in a private company; our stage of development and revenue growth; the state of the biopharmaceutical industry and the economy; the marketplace and major competitors; and the likelihood of achieving a liquidity event for shares of common stock underlying the options, such as an initial public offering or sale of our company, given prevailing market conditions. These valuations were performed in accordance with the American Institute of Certified Public Accountants’ Audit and Accounting Practice Aid, Valuation of Privately Held Company Equity Securities Issued as Compensation. The assumptions underlying these valuations represented management’s best estimates, which involved inherent uncertainties and the application of management judgment. As a result, if factors or expected outcomes changed and we had used significantly different assumptions or estimates, our stock-based compensation expense could have been materially different. Subsequent to the completion of our initial public offering in February 2020, our board of directors determines the fair value of our common stock based on the closing price of our common stock as reported on the Nasdaq Global Select Market. Valuation of Equity Investments We have investments in a number of early stage biotechnology companies. If we determine that, for accounting purposes, we have significant influence over the company, we value the investment using the HLBV method. The HLBV method is a balance sheet-oriented approach to equity method accounting. Under the HLBV method, we determine our share of earnings or losses by comparing our claim on the book value at the beginning and end of each reporting period. This claim is calculated as the amount that we would receive if the investee were to liquidate all of its assets at recorded amounts, determined as of the balance sheet date in accordance with generally accepted accounting principles, and distribute the resulting cash to creditors and investors in accordance with their respective priorities. Significant unobservable inputs used under the HLBV method include annual financial statements of investment companies and our respective liquidation priority. 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 fair value gains and losses could be materially different. A 10% increase in the net assets of our HLBV equity investments and a 10% increase in the fair value of common stock of our other equity investment holdings would result in a $1.5 million increase in the valuation of our equity investments as of December 31, 2019. A 10% decrease in the net assets of our HLBV investments and a 10% decrease in the fair value of common stock of our other equity investment holdings would result in a $1.4 million decrease in the valuation of our equity investments as of December 31, 2019. JOBS Act Election We qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act. An emerging growth company may take advantage of reduced reporting requirements that are not otherwise applicable to public companies. These provisions include, but are not limited to: • not being required to comply with the auditor attestation requirements on the effectiveness of our internal control over financial reporting; • not being required to 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); • reduced disclosure obligations regarding executive compensation arrangements; and • exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We may use these provisions until December 31, 2025. However, if certain events occur prior to such date, 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. We have elected to take advantage of certain of the reduced disclosure obligations in this Annual Report and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our stockholders may be different than the information you receive from other public companies in which you hold stock. 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, until those standards apply to private companies. We have elected to take advantage of the benefits of this extended transition period and, therefore, we will not be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. Our financial statements may therefore not be comparable to those of companies that comply with such new or revised accounting standards. Until the date that we are no longer an emerging growth company or affirmatively and irrevocably opt out of the exemption provided by Section 7(a)(2)(B) of the Securities Act of 1933, as amended, upon issuance of a new or revised accounting standard that applies to our financial statements and that has a different effective date for public and private companies, we will disclose the date on which we will adopt the recently issued accounting standard. Recent Accounting Pronouncements See Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report for a discussion of recent accounting pronouncements.

<s>[INST] Overview We are transforming the way therapeutics and materials are discovered. Our differentiated, physicsbased software platform enables discovery of highquality, novel molecules for drug development and materials applications more rapidly, at lower cost, and with, we believe, a higher likelihood of success compared to traditional methods. Our software is used by biopharmaceutical and industrial companies, academic institutions, and government laboratories around the world, and we are the leading provider of computational software solutions for drug discovery. We also apply our computational platform to a broad pipeline of drug discovery programs in collaboration with biopharmaceutical companies, some of which we cofounded. In addition, we are using our platform to advance a pipeline of internal, whollyowned drug discovery programs. Since our founding, we have been primarily focused on developing our computational platform, which is capable of predicting critical properties of molecules with a high degree of accuracy. We have devoted substantially all of our resources to introducing new capabilities and refining our software, conducting research and development activities, recruiting skilled personnel, and providing general and administrative support for these operations. We are using our computational platform in both collaborative and whollyowned drug discovery programs. Over the last decade, we have entered into a number of collaborations with biopharmaceutical companies that have provided us with significant income and have the potential to produce additional milestone payments, option fees, and future royalties. Furthermore, since mid2018, we have launched five internal, whollyowned programs. We generate revenues from sales of our software solutions and from research funding and milestone payments from our drug discovery collaborations, which we have used to support our research and development and other operating expenses. In addition, since inception we have raised gross proceeds of $192.6 million from sales of our convertible preferred stock as well as amounts received from our equity investment in Nimbus Therapeutics, LLC, or Nimbus, which we cofounded in 2009. In late 2018 and early 2019, we issued and sold an aggregate of 73,795,777 shares of Series E convertible preferred stock at $1.4906 per share, for $110.0 million in gross proceeds. In 2016, Nimbus sold its AcetylCoA carboxylase, or ACC, inhibitor, firsocostat, to Gilead Sciences, Inc., or Gilead Sciences, in a transaction valued at approximately $1.2 billion, comprised of an upfront payment and earn outs that are tied to the achievement of specified development and regulatory milestones. Of this amount, $601.3 million has been paid to Nimbus to date, and we received a total of $46.0 million in cash distributions in 2016 and 2017. We are eligible to receive up to $46 million in future cash distributions on the remaining approximately $600 million of earn outs, if and when such earn outs are achieved. However, the likelihood and timing of such payments, if any, are not possible for us to predict as the achievement of the development and regulatory milestones under the transaction agreement is uncertain and outside of our control. In December 2019, Gilead Sciences announced topline results from its Phase 2 clinical trial which included firsocostat, both as a monotherapy and in combination with other investigational therapies, in which the primary endpoint was not met. Gilead Sciences announced that it was continuing to analyze the data from the trial and determine next steps. We do not know how this development will affect Nimbus’ right to receive future earnout payments from Gilead Sciences or our right to receive cash distributions from Nimbus. However, if Gilead Sciences determined not to continue to advance the development of firsocostat, then we would not expect to receive any additional distributions from Nimbus on account of this program. Additionally, even if Nimbus were to receive any further earnout payments from Gilead Sciences, any distribution to us as an investor in Nimbus would need to be approved by the board of directors of Nimbus. On February 10, 2020, we closed our initial public offering of our common stock, in which we sold 13,664,704 shares of common stock at a public offering price of [/INST] Negative. </s>

Cincinnati Bancorp, Inc.

2020-03-30

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION This section is intended to help potential investors understand our financial performance through a discussion of the factors affecting our financial condition at December 31, 2019 and December 31, 2018 and our results of operations for the years ended December 31, 2019 and December 31, 2018. This section should be read in conjunction with the consolidated financial statements and notes thereto that appear elsewhere in this Annual Report on Form 10-K. Overview Cincinnati Federal provides financial services to individuals and businesses from our main office in Cincinnati, Ohio and our full service branch offices in Miami Heights, Anderson and Price Hill and in Covington and Florence in Northern Kentucky. Our primary market area includes Hamilton County, Ohio, and, to a lesser extent, Warren, Butler and Clermont Counties, Ohio. We also conduct business in the northern Kentucky region and make loans secured by properties in Campbell, Kenton and Boone Counties, Kentucky, as well as in Dearborn County, in southeastern Indiana. Our business consists primarily of taking deposits from the general public and investing those deposits, together with borrowings and funds generated from operations, in one- to four-family residential real estate loans, and, to a lesser extent, nonresidential real estate and multi-family loans, home equity loans and lines of credit and construction and land loans. At December 31, 2019, $104.8 million, or 57.7% of our total loan portfolio, was comprised of one- to four-family residential real estate loans; $23.4 million, or 12.9%, consisted of nonresidential real estate loans; $36.6 million, or 20.2%, consisted of multi-family loans; $10.0 million, or 5.5%, consisted of home equity lines of credit; $1.4 million or 0.8% consisted of commercial business loans and consumer loans; and $5.3 million, or 2.9%, consisted of construction and land loans. We also invest in securities, which currently consist primarily of mortgage-backed securities issued by U.S. government sponsored entities and Federal Home Loan Bank stock. Cincinnati Federal also operates an active mortgage banking unit with nine mortgage loan officers. This unit originates loans both for sale in the secondary market and for retention in our portfolio. The revenue from gain on sales of loans was $2.1 million for year ended December 31, 2019 and $1.7 million for year ended December 31, 2018. We offer a variety of deposit accounts, including checking accounts, savings accounts and certificate of deposit accounts. We utilize advances from the FHLB-Cincinnati for liquidity and for asset/liability management purposes. At December 31, 2019, we had $47.2 million in advances (net of deferred prepayment penalties) outstanding with the FHLB-Cincinnati. Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets and the interest we pay on our interest-bearing liabilities. Our results of operations also are affected by our provisions for loan losses, non-interest income and non-interest expense. Non-interest income currently consists primarily of gain (loss) on sale of mortgage loans, checking account service fee income, interchange fees from debit card transactions and income from bank owned life insurance. Non-interest expense currently consists primarily of expenses related to compensation and employee benefits, occupancy and equipment, data processing, franchise taxes, federal deposit insurance premiums, impairment losses on foreclosed real estate and other operating expenses. We invest in bank owned life insurance to provide us with a funding source to offset some costs of our benefit plan obligations. Bank owned life insurance provides us with non-interest income that is nontaxable. Federal regulations generally limit our investment in bank owned life insurance to 25% of our Tier 1 capital plus our allowance for loan losses. At December 31, 2019, this limit was $6.2 million, and we had invested $4.1 million in bank owned life insurance. Cincinnati Federal Investment Services, LLC, a wholly owned subsidiary under Ohio law, was formed in 2015 to offer nondeposit investment and insurance products in partnership with Infinex Investments, Inc. Cincinnati Federal Investment Services, LLC is currently inactive. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities. Business Strategy Our current business strategy is to operate as a well-capitalized and profitable community bank dedicated to serving the needs of our consumer and business customers, and offering personalized and efficient customer service. Our goals are to increase interest income through loan portfolio growth, expand fee income with the mortgage banking unit, lower our cost of deposits by increasing non-maturity based accounts, achieve economies of scale through balance sheet growth and diversify sources of income. Highlights of our current business strategy include: · Increasing our origination of nonresidential real estate and multi-family loans. We began originating a significant amount of nonresidential real estate and multi-family loans in the early 2000s. As of December 31, 2019 and 2018, such loans, together with construction and land loans, totaled $65.3 million and $53.4 million, or 258.8% and 218.9% of capital plus ALLL, respectively. Under our current board approved loan concentration policy, such loans (including construction and land loans) shall not exceed 300% of our capital plus ALLL. We intend to continue to increase our origination of nonresidential real estate and multi-family real estate loans, with a focus on multi-family loans. Most nonresidential real estate and multi-family loans are originated with adjustable rates. Nonresidential real estate and multi-family lending is expected to increase loan yields with shorter repricing terms than fixed-rate loans. Nonresidential real estate and multi-family originations in 2019 increased $8.1 million or 54.9% over 2018 origination levels. See “Business of Cincinnati Federal-Lending Activities-Commercial Real Estate and Multi-Family Lending.” · Continuing to focus on our residential mortgage banking operations. For the year ended December 31, 2019, we originated $113.7 million of one-to four-family residential loans, and we sold $93.8 million of one-to four-family residential loans. For the year ended December 31, 2018, we originated $73.1 million of one-to four family residential loans, and we sold $52.8 million of one- to four-family residential loans. These loans are all sold on a non-recourse basis primarily to the FHLB-Cincinnati, Freddie Mac, and other private sector third-party buyers. Loans are sold on both a servicing-retained and servicing-released basis. Subject to mortgage market conditions, we intend to continue to increase the number of mortgage loan originators in order to increase our volume of sold loans with the potential for increased servicing income. · Continuing to emphasize one- to four-family residential adjustable rate mortgage lending. We will continue to focus on originating one- to four-family adjustable rate mortgages for retention in our portfolio. As of December 31, 2019, $83.0 million, or 46.1%, of our total loans consisted of one- to four-family residential adjustable rate mortgage loans with contractual maturities after December 31, 2020. As of December 31, 2018, $84.6 million, or 49.7%, of our total loans consisted of one- to four-family residential adjustable rate mortgage loans. Adjustable rate loans have shorter repricing terms to mitigate interest rate risk. · Increasing our “core” deposit base. We seek to increase our core deposit base, particularly checking accounts. Core deposits include all deposit account types except certificates of deposit. Core deposits are our least costly source of funds, which improves our interest rate spread, and represent our best opportunity to develop customer relationships that enable us to cross-sell our full complement of products and services. Core deposits also contribute non-interest income from account-related fees and services and are generally less sensitive to withdrawal when interest rates fluctuate. We have continued our marketing efforts for checking accounts through digital, print and outdoor advertising channels. Core deposits as of December 31, 2019 grew $4.3 million or 7.0% over December 31, 2018 balances. In recent years, we have significantly expanded and improved the products and services we offer our retail and business deposit customers who maintain core deposit accounts and have improved our infrastructure for electronic banking services, including business online banking, mobile banking, bill pay, remote deposit capture and e-statements. The deposit infrastructure we have established can accommodate significant increases in retail and business deposit accounts without additional capital expenditure. We will also continue to use non-core deposits, including certificates of deposit from the National CD Rateline Program, as a source of funds, in accordance with our asset/liability policies and funding strategies. · Implementing a managed growth strategy. We intend to pursue a growth strategy for the foreseeable future, with the goal of improving the profitability of our business through increased net interest income and new sources of non-interest income. Subject to market conditions, we intend to grow our one- to four-family residential adjustable rate, nonresidential real estate and multi-family loan portfolios. To a lesser extent we intend to grow our construction and commercial business loan portfolio. Summary of Critical Accounting Policies The discussion and analysis of the financial condition and results of operations are based on our consolidated financial statements, which are prepared in conformity with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. We consider the accounting policies discussed below to be critical accounting policies. The estimates and assumptions that we use are based on historical experience and various other factors and are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions, resulting in a change that could have a material impact on the carrying value of our assets and liabilities and our results of operations. As an “emerging growth company” we may delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. We intend to take advantage of the benefits of this extended transition period. Accordingly, our financial statements may not be comparable to companies that comply with such new or revised accounting standards. The following represent our critical accounting policies: 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 income. Loan losses are charged against the allowance when management believes the uncollectability 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, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of allocated and general components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical charge-off experience and expected loss given default derived from our internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data. A loan is considered impaired when, based on current information and events, it is probable that we may not be able 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 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. Groups of loans with similar risk characteristics are collectively evaluated for impairment based on the group’s historical loss experience adjusted for changes in trends, conditions and other relevant factors that affect repayment of the loans. In the course of working with borrowers, we may choose to restructure the contractual terms of certain loans. In this scenario, we attempt to work-out an alternative payment schedule with the borrower in order to optimize collectability of the loan. Any loans that are modified are reviewed by us to identify if a troubled debt restructuring has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, we grant a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with the borrower’s current financial status, and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms or a combination of the two. If such efforts by us do not result in a satisfactory arrangement, the loan is referred to legal counsel, at which time we commence foreclosure. We may terminate foreclosure proceedings if the borrower is able to work-out a satisfactory payment plan. It is our policy that any restructured loans on nonaccrual, prior to being restructured, remain on nonaccrual status until six months of satisfactory borrower performance, at which time management would consider its return to accrual status. If a loan was accruing at the time of restructuring, we review the loan to determine if it is appropriate to continue the accrual of interest on the restructured loan. With regards to determination of the amount of the allowance for credit losses, troubled debt restructured loans are considered to be impaired. As a result, the determination of the amount of impaired loans for each portfolio segment within troubled debt restructurings is the same as detailed previously. Federal Home Loan Bank of Cincinnati Lender Risk Account Receivable. Certain loan sale transactions with the Federal Home Loan Bank of Cincinnati provide for establishment of a lender risk account receivable, which consists of amounts withheld from loan sale proceeds by the Federal Home Loan Bank of Cincinnati for absorbing inherent losses that are probable on those sold loans. These withheld funds are an asset as they are scheduled to be paid to us in future years, net of any credit losses on those loans sold. The receivables are initially measured at fair value. The fair value is estimated by discounting the cash flows over the life of each master commitment contract. The accretable yield is amortized over the life of the master commitment contract. Expected cash flows are re-evaluated at each measurement date. If there is an adverse change in expected cash flows, the accretable yield would be adjusted on a prospective basis and the asset would be evaluated for impairment. Mortgage Servicing Rights. Mortgage servicing assets are recognized separately when rights are acquired through sale of financial assets. Under the servicing assets and liabilities accounting guidance (ASC 860-50), servicing rights resulting from the sale of loans originated by us are initially measured at fair value at the date of transfer. Cincinnati Federal subsequently measures each class of servicing asset using the fair value method. Under the fair value method, the servicing rights are carried in the balance sheet at fair value and the changes in fair value are reported in earnings in the period in which the changes occur. Fair value is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. These variables change from quarter to quarter as market conditions and projected interest rates change, and may have an adverse impact on the value of the mortgage servicing rights and may result in a reduction or addition to noninterest income. Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. Comparison of Financial Condition at December 31, 2019 and Total Assets. Total assets were $241.8 million at December 31, 2019, an increase of $44.1 million, or 22.3%, from the $197.7 million at December 31, 2018. The increase resulted primarily from increases in cash and cash equivalents of $26.6 million, net loans of $9.0 million, available-for-sale securities of $6.1 million and loans held for sale of $1.8 million. Cash and Cash Equivalents. Cash and cash equivalents increased $26.6 million, or 240.3%, to $37.7 million at December 31, 2019 from $11.1 million at December 31, 2018. This increase was primarily the result of the receipt of stock subscription proceeds of $23.4 million which were held in a segregated account pending the closing of the offering. Available-for-Sale Securities. Investment securities available-for-sale increased $6.1 million to $6.7 million at December 31, 2019 over the $630,000 total at December 31, 2018. Purchases of securities totaled $6.4 million during 2019 and were partially offset by maturities of $278,000. Loans Held for Sale. Loans held for sale increased $1.8 million, or 142.9%, to $3.1 million at December 31, 2019 from $1.3 million at December 31, 2018. The increase was due to higher mortgage activity due to lower interest rates during 2019. Net Loans. Net loans increased $9.0 million, or 5.3%, to $179.3 million at December 31, 2019 from $170.3 million at December 31, 2018. During the year ended December 31, 2019, we originated $145.2 million of loans, $113.7 million of which were one- to four- family residential real estate loans, $7.5 million were nonresidential real estate loans, $15.3 million were multi-family loans, $5.0 million were home equity lines of credit, $2.9 million were construction and land loans and the remaining $644,000 were commercial business loans and consumer loans. In 2019, we sold $95.5 million of loans, of which $93.8 million were one- to four-family residential real estate loans and $1.7 million were multifamily loans. We sell loans on both a servicing-retained and servicing-released basis. Management intends to continue this sales activity in future periods to generate gain on sale revenue and servicing fee income. The largest increases in our loan portfolio were in the multifamily loan portfolio of $9.5 million and $4.4 million in the nonresidential loan portfolio. Loan portfolio growth was partially offset by declines in the residential loan portfolio of $3.1 million, construction and land loans of $2.0 million and home equity lines of credit of $1.3 million. This loan growth reflects our strategy to grow the portfolio through loan originations and purchases primarily with adjustable-rate loans and mitigate interest rate risk on the balance sheet. We currently sell certain fixed-rate, 15- and 30-year term mortgage loans. We have sold loans on both a servicing-released and servicing-retained basis to: the FHLB-Cincinnati, through its mortgage purchase program; Freddie Mac; and other private sector third-party buyers. Other Assets. Other assets increased $725,000, or 141.5%, to $1.2 million at December 31, 2019 from $512,000 at December 31, 2018. The increase was primarily due to increased prepaid expenses related to the stock subscription offering, which totaled $584,000 at December 31, 2019. Deposits. Deposits increased $1.0 million, or 0.7%, to $143.4 million at December 31, 2019 from $142.4 million at December 31, 2018. Our core deposits increased $4.3 million, or 7.0%, to $66.2 million at December 31, 2019 compared to December 31, 2018. Time deposits decreased $3.3 million, or 4.1%, to $77.2 million at December 31, 2019 from $80.5 million at December 31, 2018. The decrease in time deposits was primarily due to a decrease in certificates of deposit obtained through the National CD Rateline Program. At December 31, 2019 National Rateline Program CD’s totaled $6.6 million compared to $13.1 million at December 31, 2018. During the year ended December 31, 2019, management continued its strategy of pursuing growth in lower cost core deposits, and intends to continue its efforts to increase core deposits in 2020. Federal Home Loan Bank Advances. Federal Home Loan Bank advances increased $18.6 million, or 65.1%, to $47.2 million at December 31, 2018 from $28.6 million at December 31, 2018. Proceeds from FHLB advances were used primarily to fund loan originations and reduce the level of National CD Rateline certificates of deposit. Stock Subscription Funds. Stock subscription funds totaled $23.4 million at December 31, 2019, representing segregated funds received pending the closing of the second step stock conversion. The closing occurred effective January 22, 2020. The subscription offering was over-subscribed and $9.8 million was refunded to prospective investors after the closing date. Stockholders’ Equity. Stockholders’ equity increased $876,000, or 3.8%, to $23.8 million at December 31, 2019 from $23.0 million at December 31, 2018. The increase resulted primarily from net income for the year of 798,000. Comparison of Operating Results for the Years Ended December 31, 2019 and December 31, 2018 General. Net income for the year ended December 31, 2019 was $798,000, compared to a net income of $2.3 million for the year ended December 31, 2018, a decrease of $1.5 million or 65.3%. The decrease was primarily due to a $1.9 million decrease in noninterest income, a $419,000 increase in noninterest expense, partially offset by a $720,000 increase in net interest income, a $20,000 decrease in the provision for loan losses and a $104,000 decrease in the provision for income taxes. The decrease was largely attributable to the $2.2 million gain on merger with Kentucky Federal for the year ended December 31, 2018. There was no gain on merger for the year ended December 31, 2019. The merger with Kentucky Federal was completed on October 12, 2018. As a result, the results of operations for year ended December 31, 2019 include the effects of the merger, while the results of operations for the year ended December 31, 2018 include the effects of Kentucky Federal only for the period after the completion date of the merger. Accordingly, the income and expense items in the income statement for the year ended December 31, 2019, can be expected to show overall increases in comparison to the year ended December 31, 2018. See footnote No. 2 to the financial statements for additional information regarding the merger. Interest and Dividend Income. Interest and dividend income increased $1.5 million, or 22.0%, to $8.5 million for the year ended December 31, 2019 from $7.0 million for the year ended December 31, 2018. This increase was primarily attributable to a $1.4 million increase in interest on loans receivable. The average balance of loans increased $23.2 million, or 14.7%, to $180.9 million for the year ended December 31, 2019 from $157.7 million for the year ended December 31, 2018, while the average yield on loans increased 25 basis points to 4.52% for the year ended December 31, 2019 from 4.27% for the year ended December 31, 2018, reflecting the shift in the loan origination mix to higher yielding multifamily and nonresidential loans, as well, as higher market interest rates. Interest income on securities increased $9,000, or 45.6%, as the average balance of investment securities increased $634,000 to $1.4 million for the year ended December 31, 2019, from $763,000 for the year ended December 31, 2018, reflecting higher levels of liquidity. The average yield on investment securities decreased 62 basis points to 2.00% for the year ended December 31, 2019 from 2.62% for the year ended December 31, 2018, attributable to the addition of lower yielding adjustable and floating rate mortgage-backed securities. Dividends on Federal Home Loan Bank stock and other investments increased $93,000 primarily due to increases in interest-bearing demand deposits in banks and federal funds sold. The average balance of other interest-bearing deposits, including certificates of deposit in other financial institutions, and federal funds sold increased $3.3 million to $13.7 million at December 31, 2019 from $10.4 million at December 31, 2018. The average yield for other interest-earning assets increased 11 basis points to 2.45% at December 31, 2019 from 2.34% at December 31, 2018. Interest Expense. Total interest expense increased $820,000, or 39.4%, to $2.9 million for the year ended December 31, 2019. Interest expense on deposit accounts increased $519,000, or 36.3%, to $1.9 million for the year ended December 31, 2019 from $1.4 million for the year ended December 31, 2018. The increase was primarily due to an increase of $8.7 million, or 32.8%, in the average balance of savings accounts to $35.0 million for the year ended December 31, 2019 from $26.4 million for the year ended December 31, 2018. The increase in the average cost of savings accounts was 28 basis points. The average balance of interest-bearing demand accounts increased $10.5 million and the average cost of interest-bearing demand accounts decreased 71 basis points to 0.76% at December 31, 2019. The decrease in the average cost of interest-bearing demand deposits was due to the addition of lower cost Kentucky Federal interest-bearing accounts and the low cost of the stock subscription funds. The average balance of certificates of deposits increased $5.0 million while the average cost of certificates of deposits increased 39 basis points to 2.12% at December 31, 2019. Interest expense on FHLB advances increased $301,000 to $955,000 for the year ended December 31, 2019 from $654,000 for the year ended December 31, 2018. The average balance of advances increased $7.7 million to $42.9 million for the year ended December 31, 2019 compared to $35.2 million for the year ended December 31, 2018, while the average cost of these advances increased 37 basis points to 2.23% from 1.86%. The increase in the average balance of advances was due to management utilizing advances as a funding source for loan originations and to reduce National CD Rateline certificates of deposit and replace these CD’s with longer term and lower rate FHLB advances. Net Interest Income. Net interest income increased $720,000, or 14.7%, to $5.6 million for the year ended December 31, 2019 from $4.9 million for the year ended December 31, 2018. Average net interest-earning assets decreased $4.6 million compared to year end December 31, 2018. The interest rate spread increased to 2.69% for the year ended December 31, 2019 from 2.67% for the year ended December 31, 2018. The net interest margin decreased to 2.87% for the year ended December 31, 2019 from 2.91% for the year ended December 31, 2018. Provision for Loan Losses. Based on management’s analysis of the allowance for loan losses described in Note 1 of our financial statements “Nature of Operations and Summary of Significant Accounting Policies,” we recorded a provision for loan losses of $25,000 for the year ended December 31, 2019 and a provision for loan losses of $45,000 for the year ended December 31, 2018. The allowance for loan losses was $1.4 million, or 0.78% of total loans, at December 31, 2019, compared to $1.4 million or 0.81% of total loans, at December 31, 2018. The decrease in the provision for loan losses in 2019 compared to 2018 was due primarily to the continued low balances of nonperforming loans and delinquent loans during 2019 and decrease in historical charge-offs for the six year look back period. Total nonperforming loans were $111,000 and $744,000 at December 31, 2019 and 2018, respectively. Classified loans declined to $1.4 million at December 31, 2019, from $1.7 million at December 31, 2018, and loans past due greater than 30 days totaled $209,000 and $1.0 million at December 31, 2019 and 2018, respectively. Loan charge-offs totaled $23,000 for the year ended December 31, 2019, and there were no loans charged-off during the year ended December 31, 2018. As a percentage of nonperforming loans, the allowance for loan losses was 1,268% and 189% at December 31, 2019 and 2018, respectively. The allowance for loan losses reflects the estimate we believe to be adequate to cover incurred probable losses which were inherent in the loan portfolio at December 31, 2019 and 2018. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, such estimates and assumptions could be proven incorrect in the future, and the actual amount of future provisions may exceed the amount of past provisions, and the increase in future provisions that may be required may adversely impact our financial condition and results of operations. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Non-Interest Income. Non-interest income decreased $1.9 million, or 39.5%, to $2.9 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily due to a $2.2 million gain related to the Kentucky Federal merger recognized in 2018, a $289,000 decrease in the fair value of mortgage servicing rights, due to an assumption of higher prepayment speeds on mortgages, which were partially offset by a $451,000 increase in the gain on sale of loans. Non-Interest Expense. Non-interest expense increased $419,000, or 5.8%, to $7.7 million for 2019 from $7.2 million for 2018. The overall increase in non-interest expense reflects a full year of operations from the integration of Kentucky Federal which merged into Cincinnati Federal on October 12, 2018. Noninterest expense increases were partially offset by a $559,000 decrease in merger-related expenses, as $577,000 of such expenses were incurred in the year ended December 31, 2018 compared to $18,000 in the year ended December 31, 2019, and a $104,000 increase in gains on sales of foreclosed real estate year-to-year. Federal Income Taxes. The provision for income taxes decreased $104,000 to a tax expense of $88,000 in 2019. The decrease was due primarily to the effects of the nondeductible merger related expenses included in the 2018 results. The effective rates were 9.90% and 7.67% for December 31, 2019 and 2018, respectively. Average Balances and Yields. The following tables set forth average balance sheets, average yields and costs, and certain other information at the dates and for the periods indicated. No tax-equivalent yield adjustments have been made. Any adjustments necessary to present yields on a tax-equivalent basis are insignificant. All average balances are monthly average balances. Management does not believe that the use of month-end balances instead of daily average balances has caused any material differences in the information presented. Non-accrual loans were included in the computation of average balances only. 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) Consists of FHLB-Cincinnati stock, FHLB DDA, Fed Funds sold, certificates of deposit and cash reserves. (2) Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average rate of interest-bearing liabilities. (3) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities. (4) Net interest margin represents net interest income divided by average total interest-earning assets. Rate/Volume Analysis The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. 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 total column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately based on the changes due to rate and the changes due to volume. Management of Market Risk General. Our most significant form of market risk is interest rate risk because, as a financial institution, the majority of our assets and liabilities are monetary in nature and sensitive to changes in interest rates. Therefore, a principal part of our operations is to manage interest rate risk and limit the exposure of our financial condition and results of operations to changes in market interest rates. Our Asset/Liability Committee is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the policy and guidelines approved by our board of directors. Our asset/liability management strategy attempts to manage the impact of changes in interest rates on net interest income, our primary source of earnings. Among the techniques we use to manage interest rate risk are: · originating nonresidential real estate and multi-family loans, and, to a lesser extent, construction, consumer and commercial business loans, all of which tend to have shorter terms and higher interest rates than one- to four-family residential real estate loans, and which generate customer relationships that can result in larger non-interest bearing checking accounts; · selling substantially all of our newly-originated longer-term fixed-rate one- to four-family residential real estate loans and retaining the shorter-term fixed-rate and adjustable-rate one- to four-family residential real estate loans that we originate, subject to market conditions and periodic review of our asset/liability management needs; · reducing our dependence on certificates of deposit to support lending and investment activities and increasing our reliance on core deposits, including checking accounts and savings accounts, which are less interest rate sensitive than certificates of deposit; and Our Board of Directors is responsible for the review and oversight of our Asset/Liability Committee, which is comprised of our executive management team and other essential operational staff. This committee is charged with developing and implementing an asset/liability management plan, and meets at least quarterly to review pricing and liquidity needs and assess our interest rate risk. We currently utilize a third-party modeling program, prepared on a quarterly basis, to evaluate our sensitivity to changing interest rates, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of Directors. Net Portfolio Value. We compute amounts by which the net present value of our cash flow from assets, liabilities and off-balance sheet items (net portfolio value or “NPV”) would change in the event of a range of assumed changes in market interest rates. We measure our interest rate risk and potential change in our NPV through the use of a financial model. This model uses a discounted cash flow analysis and an option-based pricing approach to measure the interest rate sensitivity of net portfolio value. Historically, the model estimated the economic value of each type of asset, liability and off-balance sheet contract under the assumption that the United States Treasury yield curve increases or decreases instantaneously by 100 to 300 basis points in 100 basis point increments. However, given the current level of market interest rates, an NPV calculation for an interest rate decrease of greater than 100 basis points has not been prepared. A basis point equals one-hundredth of one percent, and 100 basis points equals one percent. An increase in interest rates from 3% to 4% would mean, for example, a 100 basis point increase in the “Change in Interest Rates” column below. The table below sets forth, as of December 31, 2019, the calculation of the estimated changes in our net portfolio value that would result from the designated immediate changes in the United States Treasury yield curve. (1) Assumes an immediate uniform change in interest rates at all maturities. (2) NPV is the discounted present value of expected cash flows from assets, liabilities and off-balance sheet contracts. (3) Present value of assets represents the discounted present value of incoming cash flows on interest-earning assets. (4) NPV Ratio represents NPV divided by the present value of assets. The table above indicates that at December 31, 2019, in the event of an instantaneous parallel 100 basis point increase in interest rates, we would experience a 5.65% decrease in net portfolio value. In the event of an instantaneous 100 basis point decrease in interest rates, we would experience an 8.41% decrease in net portfolio value. (1) The calculated changes assume an immediate shock of the static yield curve. Depending on the relationship between long-term and short-term interest rates, market conditions and consumer preference, we may place greater emphasis on maximizing our net interest margin than on strictly matching the interest rate sensitivity of our assets and liabilities. We believe that the increased net income which may result from an acceptable mismatch in the actual maturity or re-pricing of our assets and liabilities can, during periods of declining or stable interest rates, provide sufficient returns to justify an increased exposure to sudden and unexpected increases in interest rates. We do not engage in hedging activities, such as engaging in futures, options or swap transactions, or investing in high-risk mortgage derivatives, such as collateralized mortgage obligation residual interests, real estate mortgage investment conduit residual interests or stripped mortgage backed securities. Liquidity and Capital Resources Liquidity describes our ability to meet the financial obligations that arise in the ordinary course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of our customers and to fund current and planned expenditures. Our primary sources of funds are deposits, principal and interest payments on loans and securities, proceeds from the sale of loans, and proceeds from maturities of securities. We also have the ability to borrow from the FHLB-Cincinnati. At December 31, 2019, we had $47.2 million outstanding in advances from the FHLB-Cincinnati, and had the capacity to borrow approximately an additional $41.5 million from the FHLB-Cincinnati based on our collateral capacity. We had an additional $11.5 million on lines of credit available with three commercial banks. 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. Our most liquid assets are cash and short-term investments including interest-bearing demand deposits. The levels of these assets are dependent on our operating, financing, lending, and investing activities during any given period. Our cash flows are comprised of three primary classifications: cash flows from operating activities, investing activities, and financing activities. Net cash used in operating activities was $1.5 million for the year ended December 31, 2019 and net cash provided by operating activities was $887,000 for the year ended December 31, 2018. Net cash used by investing activities, which consists primarily of disbursements for loan originations and purchase of investment securities, partially offset by proceeds from maturing securities, pay downs on mortgage-backed securities and proceeds from sale of foreclosed assets was $14.9 million for the year ended December 31, 2019. Net cash used in investing activities was $3.7 million for the year ended December 31, 2018. Net cash provided by financing activities, consisting primarily of the proceeds from the stock subscription and proceeds from Federal Home Loan Bank borrowings, was $43.0 million for the year ended December 31, 2019. Net cash used in financing activities, consisting mainly of the repayment of Federal Home Loan Bank borrowings was $3.8 million for the year ended December 31, 2018. We are committed to maintaining a strong liquidity position. We monitor our liquidity position on a daily basis. We anticipate that we will have sufficient funds to meet our current funding commitments. Based on our deposit retention experience and current pricing strategy, we anticipate that a significant portion of maturing time deposits will be retained. We also anticipate continued participation in the National CD Rateline Program as a wholesale source of certificates of deposit, and continued use of FHLB-Cincinnati advances. Cincinnati Bancorp, Inc. is a separate corporate entity from Cincinnati Federal and it must provide for its own liquidity to pay any dividends to its stockholders, to repurchase any shares of its common stock, and for other corporate purposes. Cincinnati Bancorp Inc.’s primary source of liquidity is any dividend payments it may receive from Cincinnati Federal. Cincinnati Federal paid $750,000 in dividends to Old Cincinnati Bancorp in 2019. In 2018, Cincinnati Federal paid no dividends to Old Cincinnati Bancorp. See “Regulation and Supervision - Federal Banking Regulation - Capital Distributions” for a discussion of the regulations applicable to the ability of Cincinnati Federal to pay dividends. At December 31, 2019, Old Cincinnati Bancorp (on an unconsolidated basis) had liquid assets totaling $459,000. At December 31, 2019, Cincinnati Federal exceeded all of its regulatory capital requirements with a Tier 1 leverage capital level of $23.5 million, or 10.2% of adjusted total assets, which is above the well-capitalized required level of $11.5 million, or 5.0%; total risk-based capital of $24.9 million, or 16.3% of risk-weighted assets, which is above the well-capitalized required level of $15.3 million, or 10.0%; and common equity tier 1 risk based capital of $23.5 million, or 15.4%, of risk weighted assets, which is above the well-capitalized required level of $9.9 million, or 6.5%. At December 31, 2018, Cincinnati Federal exceeded all of its regulatory capital requirements with a Tier 1 leverage capital level of $23.1 million, or 11.5% of adjusted total assets, which is above the well-capitalized required level of $10.0 million, or 5.0%; and total risk-based capital of $24.5 million, or 17.5% of risk-weighted assets, which is above the well-capitalized required level of $14.0 million, or 10.0%. Accordingly, Cincinnati Federal was categorized as well capitalized at December 31, 2019 and 2018. Management is not aware of any conditions or events since the most recent notification that would change our category. Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Commitments. As a financial services provider, we routinely are a party to various financial instruments with off-balance-sheet risks, such as commitments to extend credit and unused lines of credit. While these contractual obligations represent our future cash requirements, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans we make. At December 31, 2019, we had outstanding commitments to originate loans of $761,000, unfunded lines of credit of $16.8 million and forward sale commitments of $7.0 million. We anticipate that we will have sufficient funds available to meet our current lending commitments. Time deposits that are scheduled to mature in one year or less from December 31, 2019 totaled $32.9 million. Management expects that a substantial portion of the maturing time deposits will be renewed. However, if a substantial portion of these deposits is not retained, we may utilize Federal Home Loan Bank advances or raise interest rates on deposits to attract new accounts, which may result in higher levels of interest expense. Contractual Obligations. In the ordinary course of our operations, we enter into certain contractual obligations. Such obligations include data processing services, operating leases for premises and equipment, agreements with respect to borrowed funds and deposit liabilities. Recent Accounting Pronouncements Please refer to Note 20 to the Consolidated Financial Statements for the years ended December 31, 2019 and 2018 beginning on page for a description of recent accounting pronouncements that may affect our financial condition and results of operations. Impact of Inflation and Changing Price The consolidated financial statements and related data presented herein 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 changes 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 of 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 does 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] Overview Cincinnati Federal provides financial services to individuals and businesses from our main office in Cincinnati, Ohio and our full service branch offices in Miami Heights, Anderson and Price Hill and in Covington and Florence in Northern Kentucky. Our primary market area includes Hamilton County, Ohio, and, to a lesser extent, Warren, Butler and Clermont Counties, Ohio. We also conduct business in the northern Kentucky region and make loans secured by properties in Campbell, Kenton and Boone Counties, Kentucky, as well as in Dearborn County, in southeastern Indiana. Our business consists primarily of taking deposits from the general public and investing those deposits, together with borrowings and funds generated from operations, in one to fourfamily residential real estate loans, and, to a lesser extent, nonresidential real estate and multifamily loans, home equity loans and lines of credit and construction and land loans. At December 31, 2019, $104.8 million, or 57.7% of our total loan portfolio, was comprised of one to fourfamily residential real estate loans; $23.4 million, or 12.9%, consisted of nonresidential real estate loans; $36.6 million, or 20.2%, consisted of multifamily loans; $10.0 million, or 5.5%, consisted of home equity lines of credit; $1.4 million or 0.8% consisted of commercial business loans and consumer loans; and $5.3 million, or 2.9%, consisted of construction and land loans. We also invest in securities, which currently consist primarily of mortgagebacked securities issued by U.S. government sponsored entities and Federal Home Loan Bank stock. Cincinnati Federal also operates an active mortgage banking unit with nine mortgage loan officers. This unit originates loans both for sale in the secondary market and for retention in our portfolio. The revenue from gain on sales of loans was $2.1 million for year ended December 31, 2019 and $1.7 million for year ended December 31, 2018. We offer a variety of deposit accounts, including checking accounts, savings accounts and certificate of deposit accounts. We utilize advances from the FHLBCincinnati for liquidity and for asset/liability management purposes. At December 31, 2019, we had $47.2 million in advances (net of deferred prepayment penalties) outstanding with the FHLBCincinnati. Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interestearning assets and the interest we pay on our interestbearing liabilities. Our results of operations also are affected by our provisions for loan losses, noninterest income and noninterest expense. Noninterest income currently consists primarily of gain (loss) on sale of mortgage loans, checking account service fee income, interchange fees from debit card transactions and income from bank owned life insurance. Noninterest expense currently consists primarily of expenses related to compensation and employee benefits, occupancy and equipment, data processing, franchise taxes, federal deposit insurance premiums, impairment losses on foreclosed real estate and other operating expenses. We invest in bank owned life insurance to provide us with a funding source to offset some costs of our benefit plan obligations. Bank owned life insurance provides us with noninterest income that is nontaxable. Federal regulations generally limit our investment in bank owned life insurance to 25% of our Tier 1 capital plus our allowance for loan losses. At December 31, 2019, this limit was $6.2 million, and we had invested $4.1 million in bank owned life insurance. Cincinnati Federal Investment Services, LLC, a wholly owned subsidiary under Ohio law, was formed in 2015 to offer nondeposit investment and insurance products in partnership with Infinex Investments, Inc. Cincinnati Federal Investment Services, LLC is currently inactive. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities. Business Strategy [/INST] Negative. </s>

BICYCLE THERAPEUTICS plc

2020-03-10

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. You should read this discussion and analysis of our financial condition and consolidated results of operations together with the consolidated financial statements, related notes and other financial information included 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 statements of our plans, objectives, expectations and intentions, contain forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Please also see the section titled “Forward-Looking Statements.” For the discussion of the financial condition and results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations" and "-Liquidity and Capital Resources" included in the final prospectus forming a part of the registration statement declared effective by the SEC in connection with our initial public offering, or IPO, and filed pursuant to Rule 424(b) under the Securities Act on May 23, 2019. Overview We are a clinical-stage biopharmaceutical company developing a novel and differentiated class of medicines, which we refer to as Bicycles®, for diseases that are underserved by existing therapeutics. Bicycles are fully synthetic short peptides constrained to form two loops which stabilize their structural geometry. This constraint is designed to confer high affinity and selectivity, making Bicycles attractive candidates for drug development. Bicycles are a unique therapeutic modality combining the pharmacology usually associated with a biologic with the manufacturing and pharmacokinetic, or PK, properties of a small molecule. The relatively large surface area presented by Bicycles allow targets to be drugged that have historically been intractable to non-biological approaches. Bicycles are excreted by the kidney rather than the liver and have shown no signs of immunogenicity to date, which we believe together support a favorable toxicological profile. We have a novel and proprietary phage display screening platform which we use to identify Bicycles in an efficient manner. The platform initially displays linear peptides on the surface of engineered bacteriophages, or phages, before “on-phage” cyclization with a range of small molecule scaffolds which can confer differentiated physicochemical and structural properties. Our platform encodes quadrillions of potential Bicycles which can be screened to identify molecules for optimization to potential product candidates. We have used this powerful screening technology to identify our current portfolio of candidates in oncology and intend to use it in conjunction with our collaborators to seek to develop additional future candidates across a range of other disease areas. Our initial internal programs are focused on oncology indications with high unmet medical need. Our lead product candidate, BT1718, is a Bicycle Toxin Conjugate, or BTC. This Bicycle is being developed to target tumors that express Membrane Type 1 matrix metalloprotease, or MT1-MMP. The Bicycle is chemically attached to a toxin that when administered is cleaved from the Bicycle and kills the tumor cells. BT1718 is being investigated for safety, tolerability and efficacy in an ongoing Phase I/IIa clinical trial in collaboration with, and fully funded by, the Centre for Drug Development of Cancer Research UK, or CRUK. We are also evaluating BT5528, a second-generation BTC targeting Ephrin type-A receptor 2, or EphA2, in a Company-sponsored Phase I/II study and conducting Investigational New Drug application, or IND, -enabling activities for BT8009, a BTC targeting Nectin-4. Our discovery pipeline in oncology includes Bicycle-based systemic immune cell agonists and Bicycle tumor-targeted immune cell agonists (TICAs™). Beyond oncology, we are collaborating with biopharmaceutical companies and organizations in therapeutic areas where we believe our proprietary Bicycle screening platform can identify therapies to treat diseases with significant unmet medical need. Our partnered programs outside of oncology include collaborations for anti-bacterial, cardiovascular, ophthalmology and respiratory indications. Financial Overview Since our inception, we have devoted substantially all of our resources to developing our Bicycle platform and our lead product candidates, BT1718, BT5528, BT8009, BT7480 and BT7401, conducting research and development of our product candidates and preclinical programs, 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 ADSs and ordinary shares, convertible preferred shares, as well as proceeds received from upfront payments, research and development payments, and development milestone payments from our collaboration agreements with Oxurion, AstraZeneca and Sanofi. Since our inception in 2009 through December 31, 2019, we have received gross proceeds of $193.1 million from the sale of ADSs, ordinary shares and convertible preferred shares, including the proceeds from our initial public offering, and $30.2 million of cash payments under our collaboration revenue arrangements, including $4.1 million from Oxurion, $9.0 million from AstraZeneca, $15.0 million from Sanofi and $1.1 million from DDF. We do not have any products approved for sale and have not generated any revenue from product sales. 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 $30.6 million, $21.8 million and $16.3 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $100.6 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. 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 and, if any product candidates are approved, pursue the commercialization of such product candidates by building internal sales and marketing capabilities. In addition, we expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. We expect that our expenses and capital requirements will increase substantially if and as we: · continue our development of our product candidates, including conducting future clinical trials of BT1718 and BT5528; · progress the preclinical and clinical development of BT8009, BT7480 and BT7401; · seek to identify and develop additional product candidates; · develop the necessary processes, controls and manufacturing data to obtain marketing approval for our product candidates and to support manufacturing to commercial scale; · develop, maintain, expand and protect our intellectual property portfolio; · seek marketing approvals for our product candidates that successfully complete clinical trials, if any; · hire and retain additional personnel, such as non-clinical, clinical, pharmacovigilance, quality assurance, regulatory affairs, manufacturing, distribution, legal, compliance, medical affairs, commercial and scientific personnel; · acquire or in-license other products and technologies; · expand our infrastructure and facilities to accommodate our growing employee base, including adding equipment and infrastructure to support our research and development; 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 operations as a public company. We do not expect to generate revenue from product sales unless and until we successfully complete development and obtain marketing approval for one or more of our product candidates, which we expect will take many years and is subject to significant uncertainty. We have no commercial-scale manufacturing facilities of our own, and all of our manufacturing activities have been and are planned to be contracted out to third parties. Additionally, we currently utilize third-party contract research organizations, or CROs, to carry out our clinical development activities. If we seek to obtain marketing approval for any of our product candidates from which we obtain promising results in clinical development, we expect to incur significant commercialization expenses as we prepare for 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 equity offerings, debt financings, collaborations, strategic alliances, charitable grants, monetization transactions 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 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 of $92.1 million. We believe that our existing cash will enable us to fund our operating expenses and capital expenditure requirements for at least 12 months from the date of filing of this Annual Report on Form 10-K. We have based this estimate on assumptions that may prove to be wrong, and we could deplete our available capital resources sooner than we expect. See “- Liquidity and Capital Resources.” Components of Our Results of Operations Collaboration Revenues To date, we have not generated any revenue from product sales and we do not expect to generate any revenue from product sales for the foreseeable future. Our revenue consists of collaboration revenue under our arrangements with AstraZeneca, Sanofi, Oxurion, and DDF, including amounts that are recognized related to upfront payments, milestone payments, option exercise payments, and amounts due to us for research and development services. In the future, revenue may include additional milestone payments, option exercise payments, and royalties on any net product sales under our collaborations. We expect that any revenue we generate will fluctuate from period to period as a result of the timing and amount of license, research and development services, and milestone and other payments. Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our research and development activities, including our discovery efforts, and the development of our product candidates, which include: · employee-related expenses including salaries, benefits, and share-based compensation expense; · expenses incurred under agreements with third parties that conduct research and development, preclinical activities, clinical activities and manufacturing on our behalf; · the cost of consultants; · the cost of lab supplies and acquiring, developing and manufacturing preclinical study materials and clinical trial materials; · costs related to compliance with regulatory requirements; and · facilities, depreciation, and other expenses, which include direct and allocated expenses for rent and maintenance of facilities, insurance, and other operating costs. Research and development costs are expensed as incurred. Costs for certain activities are recognized based on an evaluation of the progress to completion of specific tasks. 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 a prepaid expense or 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 capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed. U.K. research and development tax credits and government grant funding are recorded as an offset to research and development expense. See “-Benefit from Income Taxes.” 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 and contract manufacturing organizations, or CMOs, in connection with our preclinical and clinical development activities. Costs incurred after a product candidate has been designated and that are directly related to the product candidate are included in direct research and development expenses for that program. Costs incurred prior to designating a product candidate are included in other discovery and platform related expense. 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. In December, 2016, we entered into a Clinical Trial and License Agreement with the Cancer Research Technology Limited, or CRTL and Cancer Research UK, or CRUK, whereby the CRUK’s Centre for Drug Development is sponsoring and funding a Phase I/IIa clinical trial for our lead product candidate, BT1718, in patients with advanced solid tumors. CRUK has designed and prepared and is carrying out and sponsoring the clinical trial at its own cost. Upon the completion of the Phase I/IIa clinical trial, we have the right to obtain a license to the results of the clinical trial upon the payment of a milestone, in cash and ordinary shares, with a combined value in the mid six digit dollar amount. If such license is not acquired, or if it is acquired and the license is terminated and we decide to abandon development of all products that deliver cytotoxic payloads to the MT1 target antigen, Cancer Research Technology Limited may elect to receive an exclusive license to develop and commercialize the product on a revenue sharing basis (in which case we will receive tiered royalties of 70% to 90% of the net revenue depending on the stage of development when the license is granted is less certain costs, as defined in the agreement). The CRUK agreement contains additional future milestone payments upon the achievement of development, regulatory and commercial milestones, payable in cash and shares, with an aggregate total value of $50.9 million, as well as royalty payments based on a single digit percentage on net sales of products developed. Upon the completion of the Phase IIa part of the clinical trial, we expect research and development expenses to increase significantly as we expect to fund the continued development of BT1718, as well as incur additional development milestone payments. 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 a result of our expanded portfolio of product candidates and as we: (i) continue the clinical development and obtain marketing approval for our product candidates, including BT1718 and BT5528; (ii) initiate clinical trials for our product candidates, including BT8009 and BT7480 and BT7401; and (iii) build our in-house process development and analytical capabilities and continue to discover and develop additional product candidates. The successful development of our product candidates is highly uncertain. As such, at this time, we cannot reasonably estimate or know the nature, timing and estimated costs of the efforts that will be necessary to complete the remainder of the development of these product candidates. We are also unable to predict when, if ever, material net cash inflows will commence from our product candidates. This is due to the numerous risks and uncertainties associated with developing products, including the uncertainty of: · completing research and preclinical development of our product candidates, including conducting future clinical trials of BT1718 and BT5528; · progressing the preclinical and clinical development of BT8009, BT7480 and BT7401; · establishing an appropriate safety profile with IND-enabling studies to advance our preclinical programs into clinical development; · identifying new product candidates to add to our development pipeline; · successful enrollment in, and the initiation and completion of clinical trials; · the timing, receipt and terms of any marketing approvals from applicable regulatory authorities; · commercializing the product candidates, if and when approved, whether alone or in collaboration with others; · establishing commercial manufacturing capabilities or making arrangements with third party manufacturers; · the development and timely delivery of commercial-grade drug formulations that can be used in our clinical trials; · addressing any competing technological and market developments, as well as any changes in governmental regulations; · negotiating favorable terms in any collaboration, licensing or other arrangements into which we may enter and performing our obligations under such arrangements; · maintaining, protecting and expanding our portfolio of intellectual property rights, including patents, trade secrets and know-how, as well as obtaining and maintaining regulatory exclusivity for our product candidates; · continued acceptable safety profile of the drugs following approval; and · attracting, hiring and retaining qualified personnel. 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, the FDA, EMA or another regulatory authority may 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 we may experience significant trial delays due to patient enrollment or other reasons, in which case we would be required to expend significant additional financial resources and time on the completion of clinical development. In addition, we may obtain unexpected results from our clinical trials and we may elect to discontinue, delay or modify clinical trials of some product candidates or focus on others. Identifying potential product candidates and conducting preclinical testing and clinical trials is a time-consuming, expensive and uncertain process that takes years to complete, and we may never generate the necessary data or results required to obtain marketing approval and achieve product sales. In addition, our product candidates, if approved, may not achieve commercial success. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including share-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. Foreign currency transactions in currencies different from the functional currency of our UK entities are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Foreign exchange differences resulting from the settlement of such transactions and from the translation at period-end exchange rates in foreign currencies are recorded in general and administrative expense in the statement of operations and comprehensive loss. As such, our operating expenses may be impacted by future changes in exchange rates. See “Quantitative and Qualitative Disclosures About Market Risks” for further discussion. 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 portfolio of product candidates. We also expect to incur increased expenses associated with being a public company, including costs of accounting, audit, information systems, legal, regulatory and tax compliance services, director and officer insurance costs and investor and public relations costs. Other Income (Expense) Interest and Other Income Interest and other income consists primarily of interest earned on our cash held in operating accounts. Other Expense Prior to our IPO, other expense, net consisted primarily of changes in the fair value associated with the remeasurement of the warrant liability for warrants we issued to subscribe for Series A and Series B1 convertible preferred shares. We remeasured the warrant liability at fair value at each reporting period until completion of our IPO in May 2019. Upon the completion of the IPO, the respective warrants were exercised or converted to warrants to subscribe for ordinary shares, and as such, we will not incur additional expense related to the remeasurement of the warrant liability in future periods. Benefit from Income Taxes We are subject to corporate taxation in the United States and the United Kingdom. We have generated losses since inception and have therefore not paid United Kingdom corporation tax. The benefit from income taxes presented in our consolidated statements of operations and comprehensive loss represents the tax impact from our operating activities in the United States, which generates taxable income based on intercompany service arrangements. The research and development tax credit received in the U.K. is recorded as a reduction to research and development expenses. The U.K. research and development tax credit, as described below, is fully refundable to us after surrendering tax losses and is not dependent on current or future taxable income. As a result, we have recorded the entire benefit from the U.K. research and development tax credit as a reduction to research and development expenses and is not reflected as part of the income tax provision. If, in the future, any U.K. research and development tax credits generated are needed to offset a corporate income tax liability in the U.K., that portion would be recorded as a benefit within the income tax provision and any refundable portion not dependent on taxable income would continue to be recorded as a reduction to research and development expenses. As a company that carries out extensive research and development activities, we seek to benefit from one of two U.K. research and development tax credit cash rebate regimes: The Small and Medium-sized Enterprises R&D Tax Credit Program, or SME Program, and the Research and Development Expenditure program, or RDEC Program. Qualifying expenditures largely comprise employment costs for research staff, consumables expenses incurred under agreements with third parties that conduct research and development, preclinical activities, clinical activities and manufacturing on our behalf and certain internal overhead costs incurred as part of research projects. Based on criteria established by U.K. law, a portion of expenditures being carried out in relation to our pipeline research and development, clinical trials management and manufacturing development activities are to be eligible for the RDEC Program for the year ended December 31, 2019. We will assess whether it is possible to qualify under the more favorable SME regime for future accounting periods, but this will be affected as a result of becoming a large company by reference to our staff headcount and/or our financial results. Unsurrendered U.K. losses may be carried forward indefinitely to be offset against future taxable profits, subject to numerous utilization criteria and restrictions. The amount that can be offset each year is limited to £5.0 million plus an incremental 50% of U.K. taxable profits. After accounting for tax credits receivable, we had accumulated tax losses for carry forward in the U.K. of $41.7 million and $29.1 million as of December 31, 2019 and 2018. Value Added Tax, or VAT, is broadly charged on all taxable supplies of goods and services by VAT-registered businesses. Under current rates, an amount of 20% of the value, as determined for VAT purposes, of the goods or services supplied is added to all sales invoices and is payable to HMRC. Similarly, VAT paid on purchase invoices is generally reclaimable from HMRC and is included as a component of prepaid and other current assets in our consolidated balance sheet. Results of Operations The following table summarizes our results of operations for the years ended December 31, 2019, 2018 and 2017: Comparison of the Years Ended December 31, 2019 and 2018 Collaboration Revenues Collaboration revenues increased by $6.7 million during the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to an increase of $6.7 million of revenue from our collaboration with Sanofi. In March 2019, Sanofi exercised its right to terminate the sickle cell program and in October 2019, Sanofi terminated the hemophilia program, resulting in the recognition of revenue of $5.3 million and $4.7 million, respectively, for amounts allocated to material rights when these options expired. These amounts were offset by a decrease in research services revenue, which services were substantially completed in the second quarter of 2019. Additional increases in collaboration revenue included an increase of $1.0 million of revenue under a material transfer agreement and an increase of $0.4 million of revenue from a collaboration arrangement with DDF, which was entered into in May 2019. These amounts were offset by a decrease of $1.7 million of revenue under our collaboration with Oxurion, primarily due to $1.2 million of revenue recognized for certain development milestones achieved during the year ended December 31, 2018 that did not recur in the year ended December 31, 2019. Research and Development Expenses The following table summarizes our research and development expenses for the years presented: Research and development expense increased by $4.8 million in the year ended December 31, 2019 as compared to year ended December 31, 2018, primarily due to increases of $0.5 million and $1.1 million in the BT8009 and tumor-targeted immune cell agonist program spending, respectively, $2.4 million in other unallocated discovery and platform related expense, $1.9 million in employee and contractor-related expense due to an increase in headcount as we expanded our operations in the United States and the United Kingdom and $0.8 million of share-based compensation expense. These expenses were offset by a decrease of $0.7 million in BT5528 program spending due to the timing of IND-enabling activities in 2018, as well as an increase in research and development tax credit reimbursement of $0.8 million, due to the corresponding increase in research and development spending in the United Kingdom. We begin to separately track program expenses beginning at candidate nomination and accumulate all costs incurred to support each program to date. Through December 31, 2019, we have incurred approximately $12.9 million, $8.4 million, $6.1 million and $1.1 million of direct expenses for the development of the BT1718, BT5528, BT8009 and tumor-targeted immune cell agonist programs, respectively. General and Administrative Expenses The following table summarizes our general and administrative expenses for the years presented: General and administrative expenses increased by $6.4 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018, primarily due to increases of $1.6 million in personnel related costs due to an increase in headcount as we expanded our operations in the United States and the United Kingdom, $1.2 million in share-based compensation expense as a result of an increase in fair value of our ordinary shares and share options following our IPO, as well as $2.5 million in professional fees, including legal, human resources, marketing and consulting costs and $1.6 million in other general and administrative cost, including insurance costs to support our operations as a public company. These amounts were offset by an increase of $0.6 million in gains from the effect of foreign exchange rates during year ended December 31, 2019. Other Expense, net Other expense, net increased by $4.1 million for the year ended December 31, 2019, as compared to the year ended December 31, 2018, primarily due to $4.7 million of additional expense associated with changes in the fair value of the warrant liability and final re-measurement upon completion of the IPO, offset by higher interest income of $0.6 million as a result of a higher cash balance due to proceeds from our IPO. Liquidity and Capital Resources From our inception through December 31, 2019, we have not generated any revenue from product sales and have incurred significant operating losses and negative cash flows from our operations. We do not expect to generate significant revenue from sales of any products for several years, if at all. To date, we have financed our operations primarily with proceeds from the sale of ordinary shares (including in the form of ADSs) and convertible preferred shares, as well as proceeds received from upfront payments, payments for research and development services, and development milestone payments from our collaboration agreements with AstraZeneca, Oxurion, Sanofi, and DDF. From our inception in 2009 through December 31, 2019, we have received gross proceeds of $193.1 million from the sale of ordinary shares (including in the form of ADSs) and convertible preferred shares, including the proceeds from our IPO, as well as $30.2 million of cash payments under our collaboration revenue arrangements including $4.1 million from Oxurion, $9.0 million from AstraZeneca, $15.0 million from Sanofi, and $1.1 million from DDF. Cash Flows The following table summarizes our cash flows for the years ended December 31, 2019, 2018 and 2017: Operating Activities Net cash used in operating activities for the year ended December 31, 2019 included our net loss of $30.6 million, net cash used in our operating assets and liabilities of $7.4 million and non-cash charges of $9.4 million, which included share-based compensation expense of $3.1 million, depreciation and amortization of $1.0 million, and changes in the fair value of the warrant liability of $5.4 million. Net changes in our operating assets and liabilities for the year ended December 31, 2019, consisted primarily of a decrease in accounts receivable of $4.9 million primarily due to a payment received from AstraZeneca for its exercise of the Additional Four Target Option, a decrease in deferred revenue of $9.3 million, primarily due to the recognition of revenue related to the Sanofi collaboration arrangement, and a decrease in accrued expenses and other current liabilities of $0.9 million, an increase in prepaid expenses and other assets of $3.1 million primarily due to prepaid clinical costs, offset by an increase in accounts payable of $0.2 million and an increase in other long-term liabilities of $1.1 million. Net cash used in operating activities for the year ended December 31, 2018 included our net loss of $21.8 million, net cash used in our operating assets and liabilities of $6.6 million and net non-cash charges of $2.4 million, which included share-based compensation expense of $1.0 million and depreciation and amortization of $0.7 million, as well as a changes in the fair value of our warrant liability of $0.7 million. Net changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of an increase of $3.6 million in research and development incentives receivable, an increase in accounts receivable of $0.4 million and an increase in prepaid expenses and other assets of $1.6 million, as well as a decrease in accounts payable of $0.2 million and a decrease deferred revenue of $3.9 million due to the recognition of revenue related to the Sanofi collaboration arrangement. These amounts were offset by an increase in accrued expenses and other current liabilities of $2.6 million. Investing Activities During the years ended December 31, 2019 and 2018, we used $1.6 million and $1.2 million, respectively, of cash in investing activities for purchases of property and equipment consisting primarily of laboratory equipment. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $58.4 million, primarily consisting of net proceeds of $57.0 million from our IPO, and net proceeds of $1.3 million from our Series B2 convertible preferred shares issued in January 2019. During the year ended December 31, 2018, net cash provided by financing activities was $25.4 million, consisting of net proceeds of $26.0 million from the sale of our Series B2 convertible preferred shares issued in December 2018 offset by payments of $0.6 million of costs related to our IPO. 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 and as we: · continue our development of our product candidates, including conducting future clinical trials of BT1718 and BT5528; · progress the preclinical and clinical development of BT8009, BT7480 and BT7401; · seek to identify and develop additional product candidates; · develop the necessary processes, controls and manufacturing data to obtain marketing approval for our product candidates and to support manufacturing of product to commercial scale; · develop, maintain, expand and protect our intellectual property portfolio; · seek marketing approvals for any of our product candidates that successfully complete clinical trials, if any; · hire and retain additional personnel, such as non-clinical, clinical, pharmacovigilance, quality assurance, regulatory affairs, manufacturing, distribution, legal, compliance, medical affairs, finance, commercial and scientific personnel; · acquire or in-license other products and technologies; · expand our infrastructure and facilities to accommodate our growing employee base, including adding equipment and infrastructure to support our research and development; 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 operations as a public company. In addition, if we obtain marketing approval for any product candidate that we identify and develop, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing, and distribution to the extent that such sales, marketing, and distribution are not the responsibility of our collaboration partners. Even if we are able to generate product sales, we may not become profitable. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce, or eliminate our research and development programs or future commercialization efforts. As of December 31, 2019, we had cash of $92.1 million. We believe that our existing cash will enable us to fund our operating expenses and capital expenditure requirements for at least 12 months from the date of filing of this Annual Report on Form 10-K. We have based our estimates on assumptions that may prove to be wrong, and we may use our available capital resources sooner than we currently expect. Because of the numerous risks and uncertainties associated with the development of 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 drug discovery, preclinical development, laboratory testing, and clinical trials for the product candidates we may develop; · our ability to enroll clinical trials in a timely manner and to quickly resolve any delays or clinical holds that may be imposed on our development programs; · the costs associated with our manufacturing process development and evaluation of third-party manufacturers and suppliers; · the costs, timing and outcome of regulatory review of our product candidates; · the costs of preparing and submitting marketing approvals for any of our product candidates that successfully complete clinical trials, and the costs of maintaining marketing authorization and related regulatory compliance for any products for which we obtain marketing approval; · 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 of future activities, including product sales, medical affairs, marketing, manufacturing, and distribution, for any product candidates for which we receive marketing approval; · the terms of our current and any future license agreements and collaborations; and the extent to which we acquire or in-license other product candidates, technologies and intellectual property. · the success of our collaborations with AstraZeneca, Oxurion and DDF; · our ability to establish and maintain additional collaborations on favorable terms, if at all; and · the costs of operating as a public company. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, monetization transactions, government contracts or other strategic transactions. To the extent that we raise additional capital through the sale of equity, the ownership interests of our existing holders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our existing equity holders. If we raise additional funds through collaboration agreements, strategic alliances, licensing arrangements, monetization transactions, 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 or grant rights to develop and market products or product candidates that we would otherwise prefer to develop and market ourselves. 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. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1) Amounts reflect minimum payments due for our office and laboratory space leases. We have one office lease in Cambridge, U.K. under an operating lease that expires in December 2021. We lease laboratory space in Lexington, Massachusetts under an operating lease that expires in December 2022. In the ordinary course of business, we enter into various agreements with contract research organizations to provide clinical trial services, with contract manufacturing organizations to provide clinical trial materials, and with vendors for preclinical research studies, synthetic chemistry and other services for operating purposes. These payments are not included in the table of contractual obligations above since the contracts are generally cancelable at any time upon less than 90 days’ prior written notice. We are not contractually able to terminate for convenience and avoid any and all future obligations to these vendors. Under such agreements, we are contractually obligated to make certain minimum payments to the vendors, with the payments in the event of a termination with less than 90 days’ notice based on the timing of the termination and the exact terms of the agreement. Legal Proceedings For a discussion of legal matters as of December 31, 2019, see Note 12 “Commitments and Contingencies,” within the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K 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 U.S. 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 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. Collaboration Revenues Our revenues are generated primarily through collaborative arrangements and license agreements with pharmaceutical companies. The terms of these arrangements may include (i) performing research and development services using our bicyclic peptide screening platform with the goal of identifying compounds for further development and commercialization, (ii) options to obtain additional research and development services or licenses for additional targets, or to optimize product candidates, upon the payment of option fees, or (iii) the transfer of intellectual property rights (licenses). The terms of these arrangements typically include payment to us of one or more of the following: non-refundable upfront license fees; payments for research and development services; fees upon the exercise of options to obtain additional services or licenses; payments based upon the achievement of defined collaboration objectives; future regulatory and sales-based milestone payments; and royalties on net sales of future products. We recognize revenue in accordance with ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”) and all subsequent amendments. This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. 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 we determine are within the scope of ASC 606, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when, or as, we satisfy the performance obligations. We only apply the five-step model to contracts when it is probable that we will collect substantially all of the consideration we are entitled to in exchange for the goods or services it transfers to the customer. As part of the accounting for these arrangements, we must make significant judgments, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each performance obligation. Once a contract is determined to be within the scope of ASC 606, we assess the goods or services promised within the contract and determine those that are performance obligations. 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, they are considered performance obligations. Performance obligations are promised goods or services in a contract to transfer a distinct good or service to the customer. The promised goods or services in our contracts with customers primarily consist of license rights to our intellectual property for research and development, research and development services, and options to acquire additional research and development services or options to obtain additional licenses, such as a commercialization license for a potential product candidate. Promised goods or services are considered distinct when: (i) the customer can benefit from the good or service on its own or together with other readily available resources, and (ii) the promised good or service is separately identifiable from other promises in the contract. In assessing whether promised goods or services are distinct, we consider factors such as the stage of development of the underlying intellectual property, the capabilities of the customer to develop the intellectual property on their own and whether the required expertise is readily available. In addition, we consider whether the collaboration partner can benefit from a promise for its intended purpose without the receipt of the remaining promises, whether the value of the promise is dependent on the unsatisfied promises, whether there are other vendors that could provide the remaining promises, and whether it is separately identifiable from the remaining promises. We estimate the transaction price based on the amount of consideration we expect to receive for transferring the promised goods or services in the contract. The consideration may include both fixed consideration and variable consideration. At the inception of each arrangement that includes variable consideration, we evaluate the amount of the potential payments and the likelihood that the payments will be received. We utilize either the most likely amount method or expected value method to estimate variable consideration to include in the transaction price based on which method better predicts the amount of consideration expected to be received. The amount included in the transaction price is constrained to the amount for which 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, adjust our estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment. After determining the transaction price, we allocate it to the identified performance obligations based on the estimated standalone selling prices. We must develop assumptions that require judgment to determine the standalone selling price for each performance obligation identified in the contract. We utilize key assumptions to determine the standalone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction, probabilities of technical and regulatory success and the estimated costs. Certain variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated to each performance obligation are consistent with the amounts we would expect to receive for each performance obligation. We then recognize as revenue in 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 based on the use of an output or input method. Licenses of Intellectual Property: If a license to our intellectual property is determined to be distinct from the other promises or performance obligations identified in the arrangement, we recognize revenue from non-refundable, upfront 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 combined with other promises, such as research and development services and a research license, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue. We evaluate the measure of progress each reporting period and, if necessary, adjusts the measure of performance and related revenue recognition. The measure of progress, and thereby periods over which revenue should be recognized, are subject to estimates by management and may change over the course of the research and development and licensing agreement. Research and Development Services: The promises under our collaboration agreements may include research and development services to be performed by us on behalf of the partner. Payments or reimbursements resulting from our research and development efforts are recognized as the services are performed and presented on a gross basis because we are the principal for such efforts. Customer Options: We evaluate customer options to obtain additional items (i.e. additional license rights) for material rights, or options to acquire additional goods or services for free or at a discount. Optional future services that reflect their standalone selling prices do not provide the customer with a material right and, therefore, are not considered performance obligations and are accounted for as separate contracts. If optional future services reflect a significant or incremental discount, they are material rights, and are accounted for as performance obligations. We allocate the transaction price to material rights based on the relative standalone selling price, which is determined based on the identified discount and the probability that the customer will exercise the option. Amounts allocated to a material right are not recognized as revenue until, at the earliest, the option is exercised or expires. Milestone Payments: Our collaboration agreements may include development and regulatory milestones. We evaluate whether the milestones are considered probable of being reached and estimate the amounts to be included in the transaction price using the most likely amount method. We evaluate factors such as the scientific, clinical, regulatory, commercial, and other risks that must be overcome to achieve the particular milestone in making this assessment. 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 marketing approvals, are not considered probable of being achieved until those approvals are received. At the end of each reporting period, we re-evaluate the probability of achievement of such milestones and any related constraint, and if necessary, adjusts the estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenue and net loss in the period of adjustment. Royalties: For sales-based royalties, including milestone payments based on the level of sales, we determine whether the sole or predominant item to which the royalties relate is a license. When the license is the sole or predominant item to which the sales-based royalty relates, 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 sales-based royalty revenue resulting from our collaboration agreements. We receive payments from customers based on billing schedules established in each contract. Up-front payments and fees are recorded as deferred revenue upon receipt or when due until we perform our obligations under these arrangements. Amounts are recorded as accounts receivable when our right to consideration is unconditional, such as when we have a contractual right to payment per the terms of the contract. 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: · vendors in connection with performing research activities on our behalf and conducting preclinical studies and clinical trials on our behalf; · CMOs in connection with the production of preclinical and clinical trial materials; · CROs, 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, research institutions and vendors 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. 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 actual results could differ from our estimates. As of December 31, 2019, there have not been any material adjustments to our prior estimates of accrued research and development expenses. Share-Based Compensation We measure share-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 record the expense for awards with only service-based vesting conditions using the straight-line method and account for forfeitures as they occur. We have granted awards that include both a service condition, that vests over time, and a performance condition, that will accelerate vesting upon the achievement of a specified collaboration revenue threshold. For equity awards that contain both performance and service conditions, we recognize share-based compensation expense using an accelerated attribution model over the requisite service period when the achievement of a performance-based milestone is probable based on the relative satisfaction of the performance condition as of the reporting date. The fair value of each share option is estimated using the Black-Scholes option-pricing model, which requires inputs based on certain subjective assumptions, including the fair value of ordinary shares, the expected share price volatility, the expected term of the award, the risk-free interest rate, and expected dividends. The assumptions used in computing the fair value of stock option awards reflect our best estimates but involve uncertainties related to market and other conditions, many of which are outside of our control. Changes in any of these assumptions may materially affect the fair value of share-based awards granted and the amount of share-based compensation recognized in future periods. 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 on the basis of the differences between the consolidated financial statements 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 in the future 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. Research and Development Incentives and Receivable We receive reimbursements of certain research and development expenditures, through our subsidiaries in the United Kingdom, as part of a United Kingdom government’s research and development tax reliefs program. Under the program, a percentage of qualifying research and development expenses incurred by our subsidiaries in the United Kingdom are reimbursed up to 14.5% of the surrenderable losses. We assess our research and development activities and expenditures to determine which activities and expenditures are likely to be eligible under the research and development incentive program described above. At each period end, we estimate the reimbursement available to the Company based on available information at the time. We recognize income from the research and development incentives when the relevant expenditure has been incurred, the associated conditions have been satisfied and there is reasonable assurance that the reimbursement will be received. We record these research and development incentives as a reduction to research and development expenses in the statements of operations and comprehensive loss, as the research and development tax credits are not dependent on us generating future taxable income, our ongoing tax status, or tax position. The refund is denominated in pounds sterling and, therefore, the receivable is remeasured into U.S. dollars as of each reporting date. The research and development incentives receivable represents an amount due in connection with the above program. We recorded a reduction to research and development expense of $6.7 million, $5.9 million and $2.9 million during the years ended December 31, 2019, 2018 and 2017, respectively. Emerging Growth Company Status We are an “emerging growth company,” or EGC, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, We will remain an EGC until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our initial public offering (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” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our ordinary shares held by non-affiliates exceeded $700.0 million as of the last business day of the second fiscal quarter of such fiscal year or (4) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. The JOBS Act permits an EGC 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. In addition, we intend to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, we are entitled to rely on certain exemptions as an "emerging growth company," we are not 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(b), (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 has or may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor's report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the chief executive officer's compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of this offering or until we no longer meet the requirements of being an emerging growth company, whichever is earlier. 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.

<s>[INST] For the discussion of the financial condition and results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017, refer to "Management's Discussion and Analysis of Financial Condition and Results of OperationsResults of Operations" and "Liquidity and Capital Resources" included in the final prospectus forming a part of the registration statement declared effective by the SEC in connection with our initial public offering, or IPO, and filed pursuant to Rule 424(b) under the Securities Act on May 23, 2019. Overview We are a clinicalstage biopharmaceutical company developing a novel and differentiated class of medicines, which we refer to as Bicycles®, for diseases that are underserved by existing therapeutics. Bicycles are fully synthetic short peptides constrained to form two loops which stabilize their structural geometry. This constraint is designed to confer high affinity and selectivity, making Bicycles attractive candidates for drug development. Bicycles are a unique therapeutic modality combining the pharmacology usually associated with a biologic with the manufacturing and pharmacokinetic, or PK, properties of a small molecule. The relatively large surface area presented by Bicycles allow targets to be drugged that have historically been intractable to nonbiological approaches. Bicycles are excreted by the kidney rather than the liver and have shown no signs of immunogenicity to date, which we believe together support a favorable toxicological profile. We have a novel and proprietary phage display screening platform which we use to identify Bicycles in an efficient manner. The platform initially displays linear peptides on the surface of engineered bacteriophages, or phages, before “onphage” cyclization with a range of small molecule scaffolds which can confer differentiated physicochemical and structural properties. Our platform encodes quadrillions of potential Bicycles which can be screened to identify molecules for optimization to potential product candidates. We have used this powerful screening technology to identify our current portfolio of candidates in oncology and intend to use it in conjunction with our collaborators to seek to develop additional future candidates across a range of other disease areas. Our initial internal programs are focused on oncology indications with high unmet medical need. Our lead product candidate, BT1718, is a Bicycle Toxin Conjugate, or BTC. This Bicycle is being developed to target tumors that express Membrane Type 1 matrix metalloprotease, or MT1MMP. The Bicycle is chemically attached to a toxin that when administered is cleaved from the Bicycle and kills the tumor cells. BT1718 is being investigated for safety, tolerability and efficacy in an ongoing Phase I/IIa clinical trial in collaboration with, and fully funded by, the Centre for Drug Development of Cancer Research UK, or CRUK. We are also evaluating BT5528, a secondgeneration BTC targeting Ephrin typeA receptor 2, or EphA2, in a Companysponsored Phase I/II study and conducting Investigational New Drug application, or IND, enabling activities for BT8009, a BTC targeting Nectin4. Our discovery pipeline in oncology includes Bicyclebased systemic immune cell agonists and Bicycle tumortargeted immune cell agonists (TICAs™). Beyond oncology, we are collaborating with biopharmaceutical companies and organizations in therapeutic areas where we believe our proprietary Bicycle screening platform can identify therapies to treat diseases with significant unmet medical need. Our partnered programs outside of oncology include collaborations for antibacterial, cardiovascular, ophthalmology and respiratory indications. Financial Overview Since our inception, we have devoted substantially all of our resources to developing our Bicycle platform and our lead product candidates, BT1718, BT5528, BT8009, BT7480 and BT7401, conducting research and development of our product candidates and preclinical programs, raising capital and providing general and administrative support [/INST] Positive. </s>

MainStreet Bancshares, Inc.

2020-03-23

2019-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company during the years ended December 31, 2019 and 2018. The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Corporation. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements. Forward-Looking Statements This Annual Report on Form 10-K contains certain forward-looking statements and information relating to the Company within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on the beliefs of management as well as assumptions made by and information currently available to management. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words like “believe,” “expect,” “anticipate,” “estimate,” and “intend” or future or conditional verbs such as “will,” “should,” “could,” or “may” and similar expressions or the negative thereof. Important factors that could cause actual results to differ materially from those in the forward-looking statements included herein include, but are not limited to: • general economic conditions, either nationally or in our market area, that are worse than expected; • competition among depository and other financial institutions, particularly intensified competition for deposits; • inflation and an interest rate environment that may reduce our margins or reduce the fair value of financial instruments; • adverse changes in the securities markets; • changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory structure and in regulatory fees and capital requirements; • our ability to enter new markets successfully and capitalize on growth opportunities; • our ability to successfully integrate acquired entities; • changes in consumer spending, borrowing and savings habits; • changes in accounting policies and practices; • changes in our organization, compensation and benefit plans; • our ability to attract and retain key employees; • changes in our financial condition or results of operations that reduce capital; • changes in the financial condition or future prospects of issuers of securities that we own; • the concentration of our business in the Northern Virginia as well as the greater Washington, DC metropolitan area and the effect of changes in the economic, political and environmental conditions on this market; • adequacy of our allowance for loan losses; • deterioration of our asset quality; • cyber threats, attacks or events • reliance on third parties for key services • future performance of our loan portfolio with respect to recently originated loans; • additional risks related to new lines of business, products, product enhancements or services; • results of examination of us by our regulators, including the possibility that our regulators may require us to increase our allowance for loan losses or to write-down assets or take other supervisory action; • the effectiveness of our internal controls over financial reporting and our ability to remediate any future material weakness in our internal controls over financial reporting; • liquidity, interest rate and operational risks associated with our business; and • implications of our status as a smaller reporting company and as an emerging growth company Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those described herein. We caution readers not to place undue reliance on forward-looking statements. The Company disclaims any obligation to revise or update any forward-looking statements contained in this Form 10-K to reflect future events or developments. The discussion of the critical accounting policies and analysis set forth below is intended to supplement and highlight information contained in the accompanying Consolidated Financial Statements and the selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies The accounting and financial reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Accordingly, the financial statements require certain estimates, judgments, and assumptions, which are believed to be reasonable, based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. Critical accounting policies comprise those that management believes are the most critical to aid in fully understanding and evaluating our reported financial results. These policies require numerous estimates or economic assumptions that may prove inaccurate or may be subject to variations which may significantly affect our reported results and financial condition for the current period or in future periods. The accounting principles followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. The Company’s critical accounting policies relate to (1) the allowance for loan losses, (2) fair value of financial instruments, (3) income taxes, (4) derivative financial instruments, and (5) other real estate owned. These critical accounting policies require the use of estimates, assumptions and judgments which are based on information available as of the date of the financial statements. Accordingly, as this information changes, future financial statements could reflect the use of different estimates, assumptions and judgments. Certain determinations inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Allowance for Loan Losses: Management’s policy is to maintain the allowance for loan losses at a level sufficient to absorb estimated probable incurred losses inherent in the loan portfolio. Management performs periodic and systematic detailed reviews of its loan portfolio to identify trends and to assess the overall collectability of the loan portfolio. Accounting standards require that loan losses be recorded when management determines it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. The allowance consists of a specific component and a general component. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. For impaired collateral dependent loans, an updated appraisal will typically be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when appropriate. The general component covers non-classified or performing loans and those loans classified as substandard or special mention that are not impaired. The general component is based on historical loss experience adjusted for qualitative factors, such as current economic conditions, including current home sales and foreclosures, unemployment rates and retail sales. Non-impaired classified loans are assigned a higher allowance factor based on an internal migration analysis, which increases with the severity of classification, than non-classified loans. Estimates for the allowance for loan losses are determined by analyzing historical losses, historical migration to charge-off experience, current trends in delinquencies and charge-offs, the results of regulatory examinations and changes in the size, composition and risk assessment of the loan portfolio. Also included in management’s estimate for the allowance for loan losses are considerations with respect to the impact of current economic events. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical areas and industries in which the Company conducts business. While management uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses and methodology may be necessary if economic or other conditions differ substantially from the assumptions used in making the estimates. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels vary from previous estimates. A detailed discussion of the methodology used in determining the allowance for loan losses is included in Note 1, Basis of Presentation, in Notes to Consolidated Financial Statements. Fair Value of Financial Instruments: A portion of the Company’s assets and liabilities is carried at fair value, with changes in fair value recorded either in earnings or accumulated other comprehensive income (loss). These include investment securities available for sale and interest rate loan swaps on qualifying commercial loans. Periodically, the estimation of fair value also affects investment securities held to maturity when it is determined that an impairment write-down is other than temporary. Fair value determination is also relevant for certain other assets such as other real estate owned, which is recorded at the lower of the recorded balance or fair value, less estimated costs to sell. The determination of fair value also impacts certain other assets that are periodically evaluated for impairment using fair value estimates, including impaired loans. Fair value is generally based upon quoted market prices, when available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use observable market-based parameters as inputs. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as other unobservable parameters. Any such valuation adjustments are applied consistently over time. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. See Note 19, Fair Value Presentation, in Notes to Consolidated Financial Statements for a detailed discussion of determining fair value, including pricing validation processes. Income Taxes: The Company’s income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated taxes due. The calculation of each component of the Company’s income tax provision is complex and requires the use of estimates and judgments in its determination. As part of the Company’s evaluation and implementation of business strategies, consideration is given to the regulations and tax laws that apply to the specific facts and circumstances for any tax positions under evaluation. Management closely monitors tax developments on both the federal and state level in order to evaluate the effect they may have on the Company’s overall tax position and the estimates and judgments used in determining the income tax provision and records adjustments as necessary. Deferred income taxes arise from temporary differences between the tax and financial statement recognition of revenue and expenses. In evaluating the Company’s ability to recover its deferred tax assets within the jurisdiction from which they arise, the Company must consider all available evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and the results of recent operations. A valuation allowance is recognized for a deferred tax asset if, based on the available evidence, it is more likely than not that some portion or all of a deferred tax asset will not be realized. See Note 10, Income Taxes, in Notes to Consolidated Financial Statements for additional information. Derivative Financial Instruments: The Bank recognizes derivative financial instruments at fair value as either other assets or other liabilities in the consolidated balance sheet. The Bank’s derivative financial instruments include interest rate swaps with certain qualifying commercial loan customers and dealer counterparties. Because the interest rate swaps with loan customers and dealer counterparties are not designated as hedging instruments, adjustments to reflect unrealized gains and losses resulting from changes in fair value of these instruments are reported as noninterest income or noninterest expense, as applicable. The Bank’s interest rate swaps with loan customers and dealer counterparties are described more fully in Note 18 in the December 31, 2019, Consolidated Financial Statements. Other Real Estate Owned: Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less estimated costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of similar properties, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Company may incur additional write-downs of foreclosed assets to fair value less estimated costs to sell if valuations indicate a further deterioration in market conditions. Analysis of Results of Operations for the Years Ended December 31, 2019 and 2018 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 $14.0 million, an increase of $4.7 million, or 51.48% compared to $9.2 million earned during the year ended December 31, 2018. The increase in net income was due to $8.3 million of additional net interest income, primarily driven by increased loan production and an increase in net interest margin of 9 basis points. The increase in non-interest expenses was due to a $3.9 million increase in salaries and employee benefits as a result of additional employee growth during the year ended. Net Interest Income and Net Interest Margin Net interest income is the principal component of the Company’s income stream and represents the difference, or spread, between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds. Net interest margin, stated as a percentage, is the yield obtained by dividing the difference between interest income generated on earning assets and the interest expense paid on all funding sources by average earning assets. Fluctuations in interest rates as well as changes in the volume and mix of earning assets and interest-bearing liabilities can impact net interest income and net interest margin. Net interest income before provision for loan losses totaled $39.4 million for the year ended December 31, 2019, compared to $31.2 million for the year ended December 31, 2018. The increase in net interest income was driven by a significant increase in loan production during the year, in addition to our net interest margin increasing 9 basis points for the year ended December 31, 2019. The net interest margin was 3.50% for the year ended December 31, 2019, compared to 3.41% for the year ended December 31, 2018. The increase in net interest margin primarily resulted from an increase in average rates earned on our loan portfolio and investment in higher yielding securities. This increase was offset by increasing rates on our cost of funds, primarily in wholesale deposits and other borrowings. The yield for the year ended December 31, 2019 for the loan portfolio was 5.61% compared to 5.19% for the year ended December 31, 2018. The increase primarily reflects the maturity of lower yielding loans and higher yields on new loans based on higher interest rates in the first half of the year. However, the Federal Reserve made three separate quarter point rate adjustments decreasing its benchmark interest rate, which offset the higher yields obtained on new loans. For the year ended December 31, 2019, the yield on the total investment securities portfolio was 3.09% compared to 2.66% for the year ended December 31, 2018. The increase of 43 basis points was primarily due to higher yields on investment securities purchased during the period. The rate paid on interest bearing deposits increased to 2.25% during the year ended December 31, 2019, from 1.75% during the year ended December 31, 2018. This increase was a result of higher rates paid on brokered deposits and wholesale funding needed to fund the loan growth experienced during the year. The rate paid on FHLB borrowings for the year ended December 31, 2019 was 2.59% compared to 1.96% for the corresponding period in 2018. This increase was primarily due to rising interest rates for these types of borrowings. The following table sets forth the major components of net interest income and the related yields and rates for the year ended December 31, 2019 compared to the year ended December 31, 2018. Average Balances, Net Interest Income, Yields Earned and Rates Paid The following table shows for the periods indicated the total dollar amount of interest from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. All average balances are based on daily balances. (1) Includes loans classified as non-accrual (2) Interest rate spread represents the difference between the average yield on average interest-earning assets and the average cost of average interest-bearing liabilities. (3) Net interest earning assets represent total average interest-earning assets less total interest-bearing liabilities. (4) Net interest margin represents net interest income divided by total average interest-earning assets. Rate/ Volume Analysis The following table presents the effects of changing rates and volumes on net interest income for the periods indicated. 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 both rate and volume, which cannot be segregated, have been allocated proportionately, based on the changes due to rate and the changes due to volume. Provision for Loan Losses We establish a provision for loan losses, which is charged to operations, in order to maintain the allowance for loan losses at a level we consider necessary to absorb credit losses incurred in the loan portfolio that are both probable and reasonably estimated at the balance sheet date. In determining the level of the allowance for loan losses, we consider past and current loss experience, evaluations of real estate collateral, current economic conditions, volume and type of lending, adverse situations that may affect a borrower’s ability to repay a loan and the levels of non-performing loans. The amount of the allowance is based on estimates, and actual losses may vary from such estimates as more information becomes available or economic conditions change. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as circumstances change as more information becomes available. The allowance for loan losses is assessed on a monthly basis and provisions are made for loan losses as required in order to maintain the allowance. The provision for loan losses decreased to $1.6 million for the year ended December 31, 2019 from $3.1 million for the year ended December 31, 2018. The reduction is primarily due to a reduction in loan originations which totalled $396.2 million for the year ended December 31, 2018 compared to loan originations of $230.8 million for the year ended December 31, 2019. Non-performing loans decreased $1.9 million, or 100% from $1.9 million at December 31, 2018 to $0 as of December 31, 2019, as a result of the Bank foreclosing on its only non-performing loan. The foreclosed loan had a specific reserve of $733,000 that was charged to the allowance for loans losses upon foreclosure. During the year ended December 31, 2019, substandard loans increased $2.9 million for a balance of $3.3 million; however, much of the balance was isolated to one relationship. Management believes there is a very nominal risk of loss on this relationship and the grading is only cautionary due to temporary conditions. The entire relationship did not meet the definition of impaired at December 31, 2019. During the year ended December 31, 2019, there were $929,000 in charge-offs and recoveries of $64,000 were received. During the year ended December 31, 2018, there were charge-offs recorded and recoveries received of $44,000 each. Non-Interest Income Our primary sources of non-interest income are service charges on deposit accounts, such as interchange fees and statement fees, income earned on bank owned life insurance, fees earned from executing interest rate swaps on commercial loans, and gains realized on the sale of the guaranteed portion of Small Business Administration (“SBA”) loans. The following table presents, for the period indicated, the major categories of non-interest income: Non-interest income increased $1.6 million, or 50.1%, to $4.9 million for the year ended December 31, 2019 from $3.2 million for the year ended December 31, 2018. The increase in non-interest income was primarily due to an increase in service fees on our merchant service business accounts, additional processing fees and gains realized on sale of the guaranteed portion of SBA loans for the year ended December 31, 2019. The Bank has focused on expanding these areas and expects similar opportunities throughout 2020. Deposit account service fees increased $565,000 to $1.7 million for the year ended December 31, 2019 from $1.1 million for the year ended December 31, 2018 primarily as a result of an increased customer deposit portfolio and fee structure. Bank owned life insurance income increased $71,000 for the year ended December 31, 2019 compared to the year ended December 31, 2018 due to additional policies purchased during the year. Fees earned on interest rate swaps for commercial loans increased $276,000, or 38.7%, to $989,000 for the year ended December 31, 2019 from $713,000 for the year ended December 31, 2018. Non-Interest Expense Generally, non-interest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of non-interest expense is salaries and employee benefits. Non-interest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, advertising expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage. The following table presents, for the periods indicated, the major categories of non-interest expense: Non-interest expense increased $5.4 million or 27.0% to $25.4 million for the year ended December 31, 2019 from $20.0 million for the year ended December 31, 2018 primarily as a result of increases in salary and employee benefits of $3.9 million, franchise tax of $544,000 and other operating expenses of $322,000. Salaries and employee benefits expense increased by $3.9 million to $15.8 million for the year ended December 31, 2019 from $11.8 million for the year ended December 31, 2018 primarily as a result of adding sixteen employees and the increases in additional health insurance premium expense for these additional employees. Other operating expenses increased $322,000, or 25.1%, to $1.6 million for the year ended December 31, 2019 from $1.2 million for the year ended December 31, 2018 due to increases in professional and consulting fees and fees related to investments in technology infrastructure. Franchise tax increased approximately $544,000 to $1.2 million for the year ended December 31, 2019 from $685,000 for the year ended December 31, 2018 as a result of the increase in the Company’s capital as of December 31, 2019 compared to the balance sheet as of December 31, 2018. Income Tax Expense Income tax expense increased $1.3 million, or 60.2%, to $3.4 million for the year ended December 31, 2019 from $2.1 million for the year ended December 31, 2018. The increase in federal income tax expense for the year ended December 31, 2019 compared to the same period a year ago was driven by the increase in income before income taxes of $6.0 million, or 53.1%, to $17.3 million as of December 31, 2019 compared to $11.3 million for the same period in the prior year. As a result of recent tax regulation, the Company has included assessments in income tax expense for state tax liabilities during 2019. For the year ended December 31, 2019, the Bank had an effective federal tax rate of 19.4%, compared to effective federal tax rate of 18.5% for the year ended December 31, 2018. Comparison of Statements of Financial Condition at December 31, 2019 and at December 31, 2018 Total Assets Total assets increased $176.7 million, or 16.1%, to $1.3 billion at December 31, 2019 from $1.1 billion at December 31, 2018. The increase was primarily the result of increases of $114.1 million in gross loans receivable, $34.5 million in available-for-sale securities, $10.5 million in Bank owned life insurance and $10.0 million in other assets. Investment 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. Our investment policy is established and reviewed annually by the Board of Directors. We are permitted under federal law to invest in various types of liquid assets, including United States Government obligations, securities of various federal agencies and of state and municipal governments, mortgage-backed securities, time deposits of federally insured institutions, certain bankers’ acceptances and federal funds. Our investment objectives are to maintain high asset quality, to provide and maintain liquidity, to establish an acceptable level of interest rate and credit risk, to provide an alternate source of low-risk investments when demand for loans is weak and to generate a favorable return. The Board of Directors has the overall responsibility for the investment portfolio, including approval of our investment policy. The Board of Directors is also responsible for implementation of the investment policy and monitoring investment performance. The Board of Directors reviews the status of the investment portfolio on a quarterly basis, or more frequently if warranted. Generally accepted accounting principles require that, at the time of purchase, we designate a security as held to maturity, available-for-sale, or trading, depending on our ability and intent to hold such security. Securities available for sale are reported at fair value, while securities held to maturity are reported at amortized cost. We do not maintain a trading portfolio. Establishing a trading portfolio would require specific authorization by the Board of Directors. The total investment securities portfolio, including both investment securities available for sale and investment securities held to maturity, was $116.7 million at December 31, 2019, an increase of $34.5 million compared with December 31, 2018. At December 31, 2019, the investment securities portfolio includes $92.8 million of investment securities available for sale and $23.9 million of investment securities held to maturity compared to $56.0 million of investment securities available for sale and $26.2 million of investment securities held to maturity at December 31, 2018. During the year ended December 31, 2019, the Company sold seven securities in the available-for-sale investment portfolio. Of these seven, four were sold at a loss of $18,000 and three were sold at a gain of $23,000 for a net gain of $5,000. The Company did not sell any securities within the investment portfolio for the year ended December 31, 2018. While all securities are reviewed by the Company for other-than-temporary impairments (“OTTI”), the securities that typically are impacted by credit impairment are non-agency collateralized mortgage obligations and asset-backed securities. Refer to Note 3, in Notes to Consolidated Financial Statements for further details. To date, we have had no OTTI. Securities Portfolio Composition. The following table sets forth the amortized cost and estimated fair value of our available for sale and held to maturity securities at the dates indicated. Portfolio Maturities and Yields. The composition and maturities of the investment securities portfolio at December 31, 2019, are summarized in the following table. Maturities are based on the final contractual payment date, and do not reflect the effect of scheduled principal repayments, prepayments, or early redemptions that may occur. Adjustable-rate mortgage-backed securities are included in the period in which interest rates are next scheduled to adjust. 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 and consumer loans, substantially all of which are secured by corresponding deposits at the Bank. 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, 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 Washington, D.C. and Northern Virginia metropolitan areas. Average loans represented 87.3% of average interest-earning assets for the year ended December 31, 2019, compared to 87.0% for the year ended December 31, 2018. The following table presents the Company’s loan portfolio by portfolio segment at December 31, 2019 and December 31, 2018. The consumer loans above include $599,000 and $452,190 of overdrafts reclassified as loans for the years ended December 31, 2019 and 2018, respectively. The Bank held no loans for sale at December 31, 2019 and 2018. Loan Portfolio Maturities and Yields. The following table summarizes the scheduled repayments of our loan portfolio at December 31, 2019. Demand loans, having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. Maturities are based on the final contractual payment date and do not reflect the impact of prepayments and scheduled principal amortization. The following table sets forth our fixed and adjustable-rate loans at December 31, 2019 that are contractually due after December 31, 2019. The following table shows our loan originations, participations, purchases, sales and repayment activities for the periods indicated. Loans, net of unearned income, totaled $1.0 billion at December 31, 2019, an increase of $114.1million from December 31, 2018. The increase in total loans was primarily driven by growth in the overall loan portfolio, with significant increases in the commercial real estate and construction portfolios. Asset Quality The Company’s asset quality remained strong during the year ended December 31, 2019. Nonperforming assets, which includes nonaccrual loans, accruing loans 90 days past due, accruing troubled debt restructured (“TDR”) loans 90 days past due, and other real estate owned totaled $1.2 million at December 31, 2019 compared to $2.0 million at December 31, 2018. The decrease in nonperforming assets was primarily due to foreclosure on a previously identified TDR loan. The loan had a specific reserve of $732,892 that was charged off during the foreclosure process. A loan’s past due status is based on the contractual due date of the most delinquent payment due. All loans which are 30 or more days past due at the end of the month are reported to the Board of Directors. Commercial loans are generally placed on nonaccrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Consumer loans are generally placed on nonaccrual status when the collection of principal or interest is 120 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. For those loans that are carried on nonaccrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. As a percentage of total assets, nonperforming assets were 0.09% at December 31, 2019 compared with 0.18% at December 31, 2018. As of December 31, 2019, the Company did not have any loans placed on nonaccrual status. See Note 1, Organization, Basis of Presentation, and Impact of Recently Issued Accounting Pronouncements and Note 5, Allowance for Loan Losses, in Notes to Consolidated Financial Statements for further information on the Company’s credit grade categories, which are derived from standard regulatory rating definitions. The following table summarizes asset quality information at December 31, 2019 and December 31, 2018. Interest income that would have been recorded for the years ended December 31, 2019 and 2018 had non-accruing loans been current according to their original terms amounted to $0 and $142,962 respectively. We did not recognize any interest income for these loans for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, there were no loans not disclosed in the above table, where known information about possible credit problems of borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms. Delinquent Loans. The following table sets forth our delinquent loans at December 31, 2019 and 2018. Classified Assets. Federal regulations provide for the classification of loans and other assets that are considered to be of lesser quality as substandard, doubtful, or loss assets. Loans not classified as impaired are assigned a higher allowance factor based on an internal migration analysis, which increases with the severity of classification, than pass rated loans. The characteristics of the loan ratings are as follows: • Pass rated loans are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loan, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that this type of payment history will continue. When necessary, acceptable personal guarantors support the loan. • Special mention loans have a specific defined weakness in the borrower’s operations and the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history is characterized by late payments. The Bank’s risk exposure is mitigated by collateral supporting the loan. The collateral is considered to be well-margined, well maintained, accessible and readily marketable. • Substandard loans are considered to have specific and well-defined weaknesses that jeopardize the viability of the Bank’s credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantor(s) to pay the loan may not adequately protect the Bank. There is a distinct possibility that the Bank will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of impaired unless the loan is significantly past due and the borrower’s performance and financial condition provide evidence that it is probable that the Bank will be unable to collect all amounts due. • Doubtful rated loans have all the weaknesses inherent in a loan that is classified substandard but 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. The possibility of loss is extremely high. • Loss rated loans are not considered collectible under normal circumstances and there is no realistic expectation for any future payment on the loan. Loss rated loans are fully charged off. In connection with the filing of our periodic reports with the Federal Reserve Board and in accordance with our classification of assets policy, we regularly review the problem loans in our portfolio to determine whether any loans require classification in accordance with applicable regulations. On the basis of this review of our assets, our classified and special mention assets, at the dates indicated were as follows. Analysis and Determination of the Allowance for Loan Losses. The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. Because of uncertainties associated with regional economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that management’s estimate of probable credit losses inherent in the loan portfolio and the related allowance may change materially in the near-term. The allowance is increased by a provision for loans losses which is charged to expense and reduced by full and partial charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Management’s periodic evaluation of the adequacy of the allowance is based on various factors, including, but not limited to, management’s ongoing review and grading of loans, facts and issues related to specific loans, historical loan loss or loan pools, the fair value of the underlying collateral, current economic conditions and other qualitative and quantitative factors which could affect potential credit losses. An an integral part of their examination process, the Federal Reserve Board will periodically review our allowance for loan losses, and as a result of such reviews, we may have to adjust our allowance for loan losses. The following table sets forth activity in our allowance for loan losses for the periods indicated. At December 31, 2019, our allowance for loan losses represented 0.92% of total loans and had no non-performing loans. The allowance for loan losses increased to $9.6 million at December 31, 2019 from $8.8 million at December 31, 2018 primarily attributable to provision expense on newly originated loans. There were $865,000 and $0 in net loan charge-offs during the years ended December 31, 2019 and December 31, 2018, respectively. Allocation of Allowance for Loan Losses. The following table sets forth the allowance for loan losses allocated by loan category and the percent of the allowance in each category to the total allocated allowance at the dates indicated. 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. Derivative Financial Instruments The Bank uses derivative financial instruments (“derivatives”) primarily to manage risks to the Bank associated with changing interest rates, and to assist customers with their risk management objectives. The Bank classifies these items as free standing derivatives consisting of customer accommodation loan swaps (“loan swaps”). The Bank enters into interest rate swaps with certain qualifying commercial loan customers to meet their interest rate risk management needs. The Bank simultaneously enters into interest rate swaps with dealer counterparties, with identical notional amounts and terms. The net result of these interest rate swaps is that the customer pays a fixed rate of interest and the Bank receives a floating rate. These back-to-back loan swaps qualify as financial derivatives with fair values reported in “Other assets” and “Other liabilities” in the Consolidated Balance Sheet. Changes in fair value are recorded in other noninterest expense and net to zero because of the identical amounts and terms of the swaps. The following tables summarize key elements of the Banks’s derivative instruments as of the dates indicated. Funding Activities Deposits are the primary source of funds for lending and investing activities and their cost is the largest category of interest expense. The Company also utilizes brokered deposits as a funding source in addition to customer deposits. Scheduled payments, as well as prepayments, and maturities from portfolios of loans and investment securities also provide a stable source of funds. FHLB advances, other secured borrowings, federal funds purchased, and other short-term borrowed funds, as well as longer-term debt issued through the capital markets, all provide supplemental liquidity sources. The Company’s funding activities are monitored and governed through the Company’s asset/liability management process Deposits Total deposits increased by $151.5 million from December 31, 2018 to December 31, 2019. Brokered deposits, which are included in the table below, totaled $236.9 million and $140.8 million at December 31, 2019 and December 31, 2018, respectively. The following table presents the Company’s average deposits segregated by major category for the year ended December 31, 2019: The overall increase in total deposits was primarily driven by an increase in non-interest bearing demand deposits and time deposits. The increase was partially offset by a decrease in interest bearing demand deposits. Certificates and other time deposits increased from December 31, 2019 compared to December 31, 2018 primarily as a result of an increase in brokered deposits. At December 31, 2019, the aggregate amount of all our certificates of deposit in amounts greater than or equal to $250,000 was approximately $217.2 million. The following table sets forth the maturity of these certificates as of December 31, 2019. The following table sets forth all of our time deposits classified by interest rate as of the dates indicated. The following table sets forth by interest rate ranges information concerning the maturities of our certificates of deposit as of December 31, 2019. Borrowed Funds We may obtain advances from the Federal Home Loan Bank of Richmond upon the security of the common stock we own in that bank and certain of our residential mortgage loans, provided certain standards related to creditworthiness have been met. These advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities. Federal Home Loan Bank advances are generally available to meet seasonal and other withdrawals of deposit accounts and to permit increased lending. At December 31, 2019 and 2018, we were permitted to borrow up to an aggregate total of $308.4 million and $264.1 million, respectively, from the Federal Home Loan Bank of Richmond. There were Federal Home Loan Bank borrowings of $40.0 million outstanding at December 31, 2019 and 2018. Additionally, we had credit availability of $49.0 million with correspondent banks for short-term liquidity needs, if necessary. There were borrowings outstanding of $5.6 million at December 31, 2018, under this facility. No borrowings were outstanding at December 31, 2019, under this facility. The following table shows certain information regarding Federal Home Loan Bank advances at or for the dates indicated: On December 30, 2016, the Company completed the issuance of $14.3 million in aggregate principal amount of fixed-to-floating rate subordinated notes in a private placement transaction to various accredited investors. During the first quarter 2017, an additional $700,000 of subordinated notes was issued for a total issuance of $15.0 million. The net proceeds of the offering are intended to support growth and be used for other general business purposes. The notes have a maturity date of December 31, 2026 and have an annual fixed interest rate of 6.25% until December 31, 2021. Thereafter, the notes will have a floating interest rate based on three-month London Interbank Offered Rate (“LIBOR”) rate plus 425 basis points (4.25%) (computed on the basis of a 360-day year of twelve 30-day months) from and including January 1, 2022 to the maturity date or any early redemption date. Interest will be paid semi-annually, in arrears, on July 1 and January 1 of each year during the time that the notes remain outstanding through the fixed interest rate period or earlier redemption date. Interest will be paid quarterly, in arrears, on April 1, July 1, October 1 and January 1 throughout the floating interest rate period or earlier redemption date. Stockholders’ Equity Total stockholders’ equity at December 31, 2019 was $137.0 million, an increase of $15.8 million compared to December 31, 2018. Stockholders' equity increased $14.0 million primarily due to net income during the period. In addition, accumulated other comprehensive income increased $790,000, primarily as a result of a decrease in the fair value of investment securities available for sale. Liquidity and Capital Resources Liquidity is the ability of the Company to convert assets into cash or cash equivalents without significant loss and to raise additional funds by increasing liabilities. Liquidity management involves maintaining the Company’s ability to meet the day-to-day cash flow requirements of its customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, the Company would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the needs of the communities it serves. The Company assesses liquidity needs on a daily basis using a sophisticated monitoring system that identifies daily sources and uses for a rolling 30-day period. The Company also assesses liquidity needs under various scenarios of market conditions, asset growth and changes in credit ratings. The assessment includes liquidity stress testing which measures various sources and uses of funds under the different scenarios. The assessment provides regular monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The asset portion of the balance sheet provides liquidity primarily through unencumbered securities available for sale, loan principal and interest payments, maturities and prepayments of investment securities held to maturity and, to a lesser extent, sales of investment securities available for sale. Other short-term investments such as federal funds sold and maturing interest- bearing deposits with other banks, are additional sources of liquidity. The liability portion of the balance sheet provides liquidity through various customers’ interest-bearing and noninterest-bearing deposit accounts and through FHLB and other borrowings. Brokered deposits, federal funds purchased, and other short-term borrowings are additional sources of liquidity and, basically, represent the Company’s incremental borrowing capacity. These sources of liquidity are used as necessary to fund asset growth and meet short-term liquidity needs. In addition to the Company’s financial performance and condition, liquidity may be impacted by the Company’s structure as a bank holding company that is a separate legal entity from the Bank. The Company requires cash for various operating needs that could include payment of dividends to its stockholder, the servicing of debt, and the payment of general corporate expenses. The primary source of liquidity for the Company is dividends paid by the Bank. Applicable federal and state statutes and regulations impose restrictions on the amount of dividends that may be paid by the Bank. In addition to the formal statutes and regulations, regulatory authorities also consider the adequacy of the Bank’s total capital in relation to its assets, deposits and other such items. Any future dividends must be set forth in the Company's capital plans before any dividends can be paid. The Company’s ability to raise funding at competitive prices is affected by the rating agencies’ views of the Company’s credit quality, liquidity, capital and earnings. Management meets with the rating agencies on a routine basis to discuss the current outlook for the Company. The Board of Director and the Asset Liability Committee (ALCO) are responsible for establishing and monitoring our liquidity targets and strategies in order to ensure that sufficient liquidity exists for meeting the borrowing needs and deposit withdrawals of our customers as well as unanticipated contingencies. We believe that we have enough sources of liquidity to satisfy our short and long-term liquidity needs as of December 31, 2019. We monitor and 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. 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. Our most liquid assets are cash and cash equivalents, which include federal funds sold and interest-earning deposits in other banks. 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 $64.8 million. Securities classified as available-for-sale, which provide additional sources of liquidity, totaled $92.8 million at December 31, 2019. Our cash flows are comprised of three primary classifications: cash flows from operating activities, investing activities, and financing activities. Net cash provided by operating activities was $16.7 million and $12.6 million for the twelve months ended December 31, 2019 and December 31, 2018, respectively. Net cash used in investing activities, which consists primarily of disbursements for loan originations and the purchase of securities, offset by principal collections on loans and proceeds from maturing securities, was $161.4 million and $273.4 million for the twelve months ended December 31, 2019 and December 31, 2018, respectively. During the twelve months ended December 31, 2019, the Company realized gains on sale of available-for-sale securities of $5,000. There were no sales of available-for-sale securities in 2018. Net cash provided by financing activities was $151.5 million and $281.4 million for the twelve months ended December 31, 2019 and 2018, respectively, which consisted primarily of increases in interest bearing deposits of $110.5 million and $212.3 million offset by net repayments of $13.8 million from the Federal Home Loan Bank for the twelve months ended December 31, 2018. There were no net repayments from the Federal Home Loan Bank for the same period in 2019. We are committed to maintaining a strong liquidity position. We monitor our liquidity position on a daily basis. We anticipate that we will have sufficient funds to meet our current funding commitments. Certificates of deposit due within one year of December 31, 2019, totaled $279.6 million of total deposits. If these deposits do not remain with us, we will be required to seek other sources of funds in the normal course of business, including other deposits and Federal Home Loan Bank advances. Depending on market conditions, we may be required to pay higher rates on such deposits or borrowings than we currently pay. We believe, however, based on past experience that a significant portion of such deposits will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates offered. Management believes that the current sources of liquidity are adequate to meet the Company’s requirements and plans for continued growth. Off Balance Sheet Arrangements Commitments. As a financial services provider, we routinely are a party to various financial instruments with off-balance-sheet risks, such as commitments to extend credit and unused lines of credit. While these contractual obligations represent our future cash requirements, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans we make. The following table presents information about the Company's commitments at December 31, 2019. Regulatory Capital The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated 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 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. The federal regulatory capital rules apply to all depository institutions as well as to bank holding companies with consolidated assets of $3 billion or more. However, the regulatory capital requirements generally do not apply on a consolidated basis to a bank holding company with total consolidated assets of less than $3 billion unless the holding company: (1) is engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (2) conducts significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; or (3) has a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission. The Federal Reserve may apply the regulatory capital standards at its discretion to any bank holding company, regardless of asset size, if such action is warranted for supervisory purposes. Because the Company has total consolidated assets of less than $3 billion and does not engage in activities that would trigger application of the federal regulatory capital rules, it is not at present subject to consolidated capital requirements under the such rules. The Basel III Capital Rules, a comprehensive capital framework for U.S. banking organizations, became effective for the Company and the Bank on January 1, 2015 (subject to a phase-in period for certain provisions). Under the Basel III rules, the Company must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2019 is 2.50% and 1.875% for 2018. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of Total capital, Common Equity Tier 1 capital, and Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2019, the Company and the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2019 and 2018, the most recent notification from the Federal Reserve Bank of Richmond categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Common Equity Tier 1 risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the Bank’s category. The Bank’s actual regulatory capital amounts and ratios as of December 31, 2019 and 2018 are presented in the table below.

<s>[INST] ForwardLooking Statements This Annual Report on Form 10K contains certain forwardlooking statements and information relating to the Company within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on the beliefs of management as well as assumptions made by and information currently available to management. Forwardlooking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words like “believe,” “expect,” “anticipate,” “estimate,” and “intend” or future or conditional verbs such as “will,” “should,” “could,” or “may” and similar expressions or the negative thereof. Important factors that could cause actual results to differ materially from those in the forwardlooking statements included herein include, but are not limited to: general economic conditions, either nationally or in our market area, that are worse than expected; competition among depository and other financial institutions, particularly intensified competition for deposits; inflation and an interest rate environment that may reduce our margins or reduce the fair value of financial instruments; adverse changes in the securities markets; changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory structure and in regulatory fees and capital requirements; our ability to enter new markets successfully and capitalize on growth opportunities; our ability to successfully integrate acquired entities; changes in consumer spending, borrowing and savings habits; changes in accounting policies and practices; changes in our organization, compensation and benefit plans; our ability to attract and retain key employees; changes in our financial condition or results of operations that reduce capital; changes in the financial condition or future prospects of issuers of securities that we own; the concentration of our business in the Northern Virginia as well as the greater Washington, DC metropolitan area and the effect of changes in the economic, political and environmental conditions on this market; adequacy of our allowance for loan losses; deterioration of our asset quality; cyber threats, attacks or events reliance on third parties for key services future performance of our loan portfolio with respect to recently originated loans; additional risks related to new lines of business, products, product enhancements or services; results of examination of us by our regulators, including the possibility that our regulators may require us to increase our allowance for loan losses or to writedown assets or take other supervisory action; the effectiveness of our internal controls over financial reporting and our ability to remediate any future material weakness in our internal controls over financial reporting; liquidity, interest rate and operational risks associated with our business; and implications of our status as a smaller reporting company and as an emerging growth company Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those described herein. We caution readers not to place undue reliance on forwardlooking statements. The Company disclaims any obligation to revise or update any forwardlooking statements contained in this Form 10K to reflect future events or developments. The discussion of the critical accounting policies and analysis set forth below is intended to supplement and highlight information contained in the accompanying Consolidated Financial Statements and the selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies The accounting and financial reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Accordingly, the financial statements require certain estimates, judgments, and assumptions, which are believed to be reasonable, based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. Critical accounting policies comprise those that management believes are the most critical to aid in fully understanding and evaluating our reported financial results. These policies require numerous estimates or economic assumptions that may prove inaccurate or may be subject to variations which may significantly affect our reported results and financial condition for the current period or in future periods. The accounting principles followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. The Company’s critical accounting policies relate to (1) the allowance for loan losses, (2) fair value of financial instruments, (3) income taxes, (4) derivative [/INST] Negative. </s>

Arconic Rolled Products Corp

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. (dollars in millions; shipments in thousands of metric tons [kmt]) References in this Management's Discussion and Analysis of Financial Condition and Results of Operations to (i) “ParentCo” refer to Arconic Inc., a Delaware corporation, and its consolidated subsidiaries, and (ii) “2016 Separation Transaction” refer to the November 1, 2016 separation of Alcoa Inc., a Pennsylvania corporation, into two standalone, publicly-traded companies, Arconic Inc. and Alcoa Corporation. Overview The Separation The Proposed Separation. On February 8, 2019, ParentCo announced that its Board of Directors approved a plan to separate into two standalone, publicly-traded companies (the “Separation”). The spin-off company, Arconic Rolled Products Corporation (“Arconic Corporation” or the “Company”), will include the rolled aluminum products, aluminum extrusions, and architectural products operations of ParentCo, as well as the Latin America extrusions operations sold in April 2018 (collectively, the “Arconic Corporation Businesses”). The existing publicly-traded company, ParentCo, will continue to own the engine products, engineered structures, fastening systems, and forged wheels operations (collectively, the “Howmet Aerospace Businesses”). The Separation is subject to a number of conditions, including, but not limited to: final approval by ParentCo’s Board of Directors (see below); receipt of an opinion of legal counsel regarding the qualification of the distribution, together with certain related transactions, as a “reorganization” within the meaning of Sections 355 and 368(a)(1)(D) of the U.S. Internal Revenue Code (i.e., a transaction that is generally tax-free for U.S. federal income tax purposes); and the U.S. Securities and Exchange Commission (the “SEC”) declaring effective a Registration Statement on Form 10, as amended, filed with the SEC on February 13, 2020 (effectiveness was declared by the SEC on February 13, 2020). Arconic Corporation and Howmet Aerospace have entered into and will enter into several agreements to implement the legal and structural separation between the two companies; govern the relationship between Arconic Corporation and Howmet Aerospace after the completion of the Separation; and allocate between Arconic Corporation and Howmet Aerospace various assets, liabilities, and obligations, including, among other things, employee benefits, environmental liabilities, intellectual property, and tax-related assets and liabilities. One agreement in particular, the Separation and Distribution agreement, will identify the assets to be transferred, the liabilities to be assumed, and the contracts to be transferred to each of Arconic Corporation and Howmet Aerospace as part of the Separation, and will provide for when and how these transfers and assumptions will occur. ParentCo may, at any time and for any reason until the Separation is complete, abandon the separation plan or modify its terms. ParentCo is incurring costs to evaluate, plan, and execute the Separation, and Arconic Corporation is allocated a pro rata portion of these costs based on segment revenue (see Cost Allocations below). In 2019, ParentCo recognized $78 for such costs, of which $40 was allocated to Arconic Corporation. The allocated amounts were included in Selling, general administrative, and other expenses on Arconic Corporation’s Statement of Combined Operations. On February 5, 2020, ParentCo's Board of Directors approved the completion of the Separation, which is scheduled to become effective on April 1, 2020 (the “Separation Date”) at 12:01 a.m. Eastern Daylight Time. The Separation will occur by means of a pro rata distribution by ParentCo of all of the outstanding shares of common stock of Arconic Corporation to ParentCo common shareholders of record as of the close of business on March 19, 2020 (the “Record Date”). Specifically, ParentCo common shareholders are expected to receive one share of Arconic Corporation common stock for every four shares of ParentCo common stock held as of the Record Date (ParentCo common shareholders will receive cash in lieu of fractional shares). In connection with the consummation of the Separation, ParentCo will change its name to Howmet Aerospace Inc. (“Howmet Aerospace”) and Arconic Rolled Products Corporation will change its name to Arconic Corporation. “When-issued” trading of Arconic Corporation common stock began on March 18, 2020 under the ticker symbol “ARNC WI” and will continue until the distribution date. “Regular-way” trading of Arconic Corporation common stock is expected to begin with the opening of the New York Stock Exchange on April 1, 2020 under the ticker symbol “ARNC.” Basis of Presentation. The Combined Financial Statements of Arconic Corporation are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). In accordance with GAAP, certain situations require management to make estimates based on judgments and assumptions, which may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. They also may affect the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates upon subsequent resolution of identified matters. The Combined Financial Statements of Arconic Corporation are prepared from ParentCo’s historical accounting records and are presented on a standalone basis as if the Arconic Corporation Businesses have been conducted independently from ParentCo. Such Combined Financial Statements include the historical operations that are considered to comprise the Arconic Corporation Businesses, as well as certain assets and liabilities that have been historically held at ParentCo’s corporate level but are specifically identifiable or otherwise attributable to Arconic Corporation. Cost Allocations. The Combined Financial Statements of Arconic Corporation include general corporate expenses of ParentCo that were not historically charged to the Arconic Corporation Businesses for certain support functions that are provided on a centralized basis, such as expenses related to finance, audit, legal, information technology, human resources, communications, compliance, facilities, employee benefits and compensation, and research and development activities. These general corporate expenses are included on Arconic Corporation’s Statement of Combined Operations within Cost of goods sold, Selling, general administrative and other expenses, and Research and development expenses. These expenses have been allocated to Arconic Corporation on the basis of direct usage when identifiable, with the remainder allocated based on the Arconic Corporation Businesses’ segment revenue as a percentage of ParentCo’s total segment revenue, as reported in the respective periods. All external debt not directly attributable to Arconic Corporation has been excluded from the Company’s Combined Balance Sheet. Financing costs related to these debt obligations have been allocated to Arconic Corporation based on the ratio of capital invested by ParentCo in the Arconic Corporation Businesses to the total capital invested by ParentCo in both the Arconic Corporation Businesses and the Howmet Aerospace Businesses, are included on the Company’s Statement of Combined Operations within Interest expense. The following table reflects the allocations described above: __________________ (1) For all periods presented, amount principally relates to an allocation of expenses for ParentCo’s retained pension and other postretirement benefit obligations associated with closed and sold operations. (2) In 2019, amount includes an allocation of $40 for costs incurred by ParentCo associated with the proposed separation transaction (see The Proposed Separation above). In 2017, amount includes an allocation of $30 in costs related to ParentCo’s proxy, advisory, and governance-related matters. (3) In 2018, amount includes an allocation of settlement and curtailment charges and benefits related to several actions taken (lump sum payments and benefit reductions) by ParentCo associated with pension and other postretirement benefit plans. (4) In 2017, amount includes an allocation of two gains related to ParentCo’s investing and financing activities. Specifically, an allocation of $182 associated with the sale of a portion of ParentCo’s investment in Alcoa Corporation common stock and an allocation of $87 related to an exchange of cash and the remaining portion of ParentCo’s investment in Alcoa Corporation common stock to acquire a portion of ParentCo’s outstanding debt. These amounts were allocated to Arconic Corporation in preparing the accompanying Combined Financial Statements as the Company participates in ParentCo’s centralized treasury function, which includes cash and debt management. As a result, Arconic Corporation benefited from the cash received by ParentCo and/or the reduction of ParentCo debt, including the reduction in related interest cost, in the respective transactions. Management believes the assumptions regarding the allocation of ParentCo’s general corporate expenses and financing costs are reasonable. Nevertheless, the Combined Financial Statements of Arconic Corporation may not include all of the actual expenses that would have been incurred and may not reflect Arconic Corporation’s combined results of operations, financial position, and cash flows had it been a standalone company during the periods presented. Actual costs that would have been incurred if Arconic Corporation had been a standalone company would depend on multiple factors, including organizational structure, capital structure, and strategic decisions made in various areas, including information technology and infrastructure. Transactions between Arconic Corporation and ParentCo, including sales to the Howmet Aerospace Businesses, have been presented as related party transactions on Arconic Corporation’s Combined Financial Statements and are considered to be effectively settled for cash at the time the transaction is recorded. The total net effect of the settlement of these transactions is reflected on Arconic Corporation’s Statement of Combined Cash Flows as a financing activity and on the Company’s Combined Balance Sheet as Parent Company net investment. Results of Operations Earnings Summary Net Income. Net income was $225 in 2019 compared to $170 in 2018. The improvement in results of $55 was principally caused by favorable product pricing and mix and a favorable change in LIFO inventory accounting. These negative impacts were mostly offset by the absence of a 2018 gain on the sale of a rolling mill, 2019 asset impairment charges and layoff costs, and an allocation of costs related to the proposed separation. Net income was $170 in 2018 compared with $209 in 2017. The decrease in results of $39 was principally caused by the non-recurring nature of an allocation of two gains related to ParentCo’s 2017 investing and financing activities, an allocation of a net charge associated with several actions taken by ParentCo related to employee retirement benefit plans, and unfavorable pricing and product mix. These negative impacts were mostly offset by a gain on the sale of the Texarkana (Texas) rolling mill, lower allocations of ParentCo’s corporate overhead and financing costs, the absence of charges related to the divestiture of the Fusina (Italy) rolling mill and Latin America extrusions business, and higher volumes in the Rolled Products and Building and Construction Systems segments. Sales. Sales in 2019 were $7,277 compared with $7,442 in 2018, a decrease of $165, or 2%. The decrease was largely attributable to lower aluminum prices, the absence of sales ($169 combined) as a result of both the ramp down of Arconic Corporation’s North American packaging operations (completed in December 2018) and the divestiture of the Latin America Extrusions business (April 2018), and unfavorable foreign currency movements. These negative impacts were mostly offset by favorable product mix and pricing in the Rolled Products segment and volume growth related to the packaging (excluding North America), aerospace, and industrial end markets. Sales in 2018, were $7,442 compared with $6,824 in 2017, an increase of $618, or 9%. The improvement was largely attributable to volume growth in the Rolled Products and Building and Construction Systems segments and both higher aluminum prices and favorable product mix in the Rolled Products segment. These positive impacts were somewhat offset by lower sales of $190 as a result of each of the following: the divestitures of both the Latin America Extrusions business (April 2018) and the rolling mill in Fusina, Italy (March 2017) and the ramp down of the North American packaging operations (completed in December 2018). Cost of Goods Sold. COGS was $6,270, or 86.2% of Sales, in 2019 compared with $6,549, or 88.0% of Sales, in 2018. The percentage was positively impacted by favorable product pricing and mix in the Rolled Products segment, a favorable change in LIFO inventory accounting ($89 - see below), and the absence of a charge for a physical inventory adjustment at an Extrusions plant ($14). These positive impacts were partially offset by costs associated with the transition of Arconic Corporation’s Tennessee plant to industrial products from packaging, a charge to increase an environmental reserve related to a U.S. Extrusions plant ($25), and a charge, primarily for a one-time employee signing bonus, related to a collective bargaining agreement negotiation ($9 - see below). The positive change in LIFO inventory accounting was mostly related to a decrease in the price of aluminum at December 31, 2019 indexed to December 31, 2018 compared to an increase in the price of aluminum at December 31, 2018 indexed to December 31, 2017. In June of 2019, Arconic Corporation and the United Steelworkers (USW) reached a tentative three-year labor agreement covering approximately 3,400 employees at four U.S. locations; the previous labor agreement expired on May 15, 2019. The tentative agreement was ratified on July 11, 2019. COGS was $6,549, or 88.0% of Sales, in 2018 compared with $5,866, or 86.0% of Sales, in 2017. The percentage was negatively impacted by higher aluminum prices, unfavorable aerospace product mix, and higher transportation costs. These negative impacts were partially offset by higher volumes in the Rolled Products and Building and Construction Systems segments and a favorable LIFO inventory adjustment (difference of $59). In preparation for the Separation, effective January 1, 2020, certain U.S. pension and other postretirement defined benefit plans previously sponsored by ParentCo were separated into standalone plans for both Arconic Corporation (the “U.S. Shared Plans”) and Howmet Aerospace (see Obligations for Operating Activities in Contractual Obligations below). Accordingly, in 2020, the Company will recognize the related expense of the U.S. Shared Plans in accordance with defined benefit plan accounting, under which expense is split between operating income (service cost) and nonoperating income (nonservice cost). Total combined net periodic benefit cost of the U.S. Shared Plans in 2020 is estimated to be approximately $100, of which approximately $20 is service cost. The nonservice cost will be recognized in Other expenses (income), net and the service cost will be recognized in COGS. In the Company’s historical Combined Financial Statements prior to January 1, 2020, Arconic Corporation recognized its portion of the expense of these ParentCo-sponsored U.S. benefit plans in accordance with multiemployer plan accounting, under which expense is recorded entirely in operating income. In 2019, the Company’s Statement of Combined Operations reflects the following expense amounts for these ParentCo-sponsored U.S. benefit plans: $95 in Cost of goods sold, $13 in Selling, general administrative, and other expenses, and $2 in Research and development expenses. Selling, General Administrative, and Other Expenses. SG&A expenses were $346, or 4.8% of Sales, in 2019 compared with $288, or 3.9% of Sales, in 2018. The increase of $58, or 20%, was primarily the result of a higher allocation (increase of $59) of ParentCo’s corporate overhead, which was mostly driven by the following: costs incurred for the planned Separation ($78, of which $40 was allocated to Arconic Corporation) and higher expenses for both executive compensation and estimated annual employee incentive compensation, all of which was somewhat offset by reductions in several other overhead costs. SG&A expenses were $288, or 3.9% of Sales, in 2018 compared with $361, or 5.3% of Sales, in 2017. The decrease of $73, or 20%, was primarily the result of a lower allocation (decrease of $64) of ParentCo’s corporate overhead, which was mostly driven by overall cost reductions and the non-recurring nature of certain ParentCo costs in 2017 for proxy, advisory, and governance-related matters. In 2020, the Company expects to recognize no expense in SG&A related to U.S. pension and other postretirement employee defined benefit plans compared to $13 recognized in 2019 (see Cost of Goods Sold above for additional information). Research and Development Expenses. R&D expenses were $45 in 2019 compared with $63 in 2018 and $66 in 2017. The decrease in both periods was principally related to a lower allocation of ParentCo’s expenses, which was driven by decreased spending. In 2020, the Company expects to recognize no expense in R&D related to U.S. pension and other postretirement employee defined benefit plans compared to $2 recognized in 2019 (see Cost of Goods Sold above for additional information). Provision for Depreciation and Amortization. The provision for D&A was $252 in 2019 compared with $272 in 2018. The decrease of $20, or 7%, was primarily due to the divestiture of the Texarkana (Texas) rolling mill and cast house. The provision for D&A was $272 in 2018 compared with $266 in 2017. The increase of $6, or 2%, was primarily due to capital projects placed into service related to Arconic Corporation’s Davenport (Iowa) (very thick plate stretcher related to aerospace expansion) and Tennessee (equipment upgrades and conversions to transition to automotive sheet and industrial applications from can sheet) rolling mills. Restructuring and Other Charges. In 2019, Restructuring and other charges were $87, which were comprised of the following components: a $53 impairment charge for the assets associated with an aluminum rolling mill in Brazil as a result of signing a definitive sale agreement; a $30 charge for layoff costs, including the separation of approximately 480 employees (240 in the Rolled Products segment, 190 in the Building and Construction Systems segment, and 50 in the Extrusions segment); a $20 benefit for contingent consideration received related to the sale of the Texarkana (Texas) cast house; a $10 charge for the impairment of the carrying value of a trade name intangible asset; a $7 charge for an allocation of ParentCo’s corporate restructuring charges (see Cost Allocations in Overview above); and a $7 net charge for other items. In 2018, Restructuring and other charges were a net benefit of $104, which were comprised of the following components: a $154 gain on the sale of the Texarkana (Texas) rolling mill and cast house; a $50 charge for an allocation of ParentCo’s corporate restructuring charges (see Cost Allocations in Overview above); a $2 charge for a post-closing adjustment related to the divestiture of the Latin America extrusions business; an $8 net charge for other items; and a $10 benefit for the reversal of several layoff reserves related to prior periods. In 2017, Restructuring and other charges were $133, which were comprised of the following components: a $60 loss related to the divestiture of the Fusina (Italy) rolling mill; a $41 impairment charge for the assets associated with the Latin America extrusions business as a result of signing a definitive sale agreement (completed sale in April 2018); a $31 charge for layoff costs related to cost reduction initiatives, including the separation of approximately 400 employees (the majority of which related to the Rolled Products and Building and Construction Systems segments); a $6 charge for an allocation of ParentCo’s corporate restructuring charges (see Cost Allocation in Overview above); a $2 net benefit for other items; and a $3 benefit for the reversal of several layoff reserves related to prior periods. See Note E to the Combined Financial Statements in Part II Item 8 Financial Statements and Supplementary Data. Interest Expense. Interest expense was $115 in 2019 compared with $129 in 2018. The decrease of $14, or 11%, was mostly the result of a lower allocation (decrease of $10) of ParentCo’s financing costs due to a lower average amount of ParentCo’s outstanding debt in 2019 compared to 2018 and an increase ($3) in the amount of interest capitalized due to expansion projects at the Company's Davenport (Iowa) and Tennessee facilities (see Investing Activities in Liquidity and Capital Resources below). Interest expense was $129 in 2018 compared with $168 in 2017. The decrease of $39, or 23%, was mostly the result of a lower allocation (decrease of $37) of ParentCo’s financing costs due to a lower average amount of ParentCo’s outstanding debt in 2018 compared to 2017. The Company’s 2020 Combined Financial Statements will continue to be prepared on a “carve-out" basis (see Basis of Presentation in Overview above) for the first three months of 2020. Accordingly, Arconic Corporation’s interest expense for these three months will include an allocation of ParentCo's financing costs consistent with the Company’s historical Combined Financial Statements ($115 in 2019 - see Cost Allocations in Overview above). Additionally, Arconic Corporation’s interest expense for these three months will also include an amount ($12 in 2019) related to indebtedness associated with the Davenport (Iowa) rolling mill, an obligation which will be retained by ParentCo effective on the Separation Date (see Obligations for Financing Activities in Contractual Obligations below). Beginning on the Separation Date, Arconic Corporation’s gross interest expense (i.e. prior to capitalization) is expected to be approximately $80 on an annual run rate basis related to $1,200 of indebtedness incurred in connection with the capital structure to be established at the time of the Separation (see Financing Activities under Liquidity and Capital Resources). Other (Income) Expenses, Net. Other income, net was $15 in 2019 compared with Other expenses, net of $4 in 2018. The change of $19 was largely attributable to net favorable foreign currency movements. Other expenses, net was $4 in 2018 compared with Other income, net of $287 in 2017. The change of $291 was largely attributable to the non-recurring nature of an allocation ($269) of two gains related to ParentCo’s 2017 investing and financing activities. Specifically, an allocation of $182 associated with the sale of a portion of ParentCo’s investment in Alcoa Corporation common stock and an allocation of $87 related to an exchange of cash and the remaining portion of ParentCo’s investment in Alcoa Corporation common stock to acquire a portion of ParentCo’s outstanding debt. See Cost Allocations in Overview above for an explanation of the allocation methodology of ParentCo activities for purposes of Arconic Corporation’s Combined Financial Statements. In 2020, the Company expects to recognize approximately $80 of nonservice cost related to U.S. pension and other postretirement employee defined benefit plans (see Cost of Goods Sold above for additional information). Income Taxes. Arconic Corporation’s effective tax rate was 27.1% (benefit on income) in 2019 compared with the U.S. federal statutory rate of 21%. The effective tax rate differs from the U.S. federal statutory rate by 48.1 percentage points primarily as a result of a $118 benefit related to a worthless stock deduction, a $35 charge related to GILTI inclusion (see Income Taxes in Critical Accounting Policies and Estimates below), a $28 charge related to an increase in valuation allowance attributable to non-U.S. jurisdictions primarily for Brazil and China, and a $22 net benefit related to a U.S. tax election which caused the deemed liquidation of a foreign subsidiary’s assets into its U.S. tax parent. Arconic Corporation’s effective tax rate was 29.5% (provision on income) in 2018 compared with the U.S. federal statutory rate of 21%. The effective tax rate differs from the U.S. federal statutory rate by 8.5 percentage points primarily as a result of a $15 charge related to an increase in valuation allowance attributable to non-U.S. jurisdictions, primarily in Brazil and China, and a $6 charge for U.S. state taxes. Arconic Corporation’s effective tax rate was 16.7% (provision on income) in 2017 compared with the U.S. federal statutory rate of 35%. The effective tax rate differs from the U.S. federal statutory rate by 18.3 percentage points primarily as a result of a $50 benefit related to the remeasurement of U.S. net deferred tax assets as a result of the federal tax rate reduction from 35% to 21% pursuant to the provision of the U.S. Tax Cuts and Jobs Act of 2017 (the “2017 Act”). In addition, the effective tax rate differs from the U.S. federal statutory rate as a result of a $37 tax benefit related to the tax impact of corporate allocations, a $37 charge related to an increase in valuation allowance attributable to non-U.S. jurisdictions, primarily in Brazil and China, an $18 charge for an increase in unrecognized tax benefits recorded in Germany, a $16 benefit for foreign income taxed in lower rate jurisdictions, a $7 charge for U.S. state taxes, and a $7 benefit related to intercompany transactions within Arconic Corporation and between Arconic Corporation and ParentCo. The Company anticipates that the effective tax rate in 2020 will be between 20% and 25%. However, the Separation, changes in the current economic environment, tax legislation or rate changes, currency fluctuations, ability to realize deferred tax assets, and the results of operations in certain taxing jurisdictions may cause this estimated rate to fluctuate. Segment Information Arconic Corporation’s operations consist of three reportable segments: Rolled Products, Extrusions, and Building and Construction Systems. Segment performance under Arconic Corporation’s management reporting system is evaluated based on several factors; however, the primary measure of performance is Segment operating profit. Arconic Corporation calculates Segment operating profit as Total sales (third-party and intersegment) minus the following items: Cost of goods sold; Selling, general administrative, and other expenses; Research and development expenses; and Provision for depreciation and amortization. Segment operating profit may not be comparable to similarly titled measures of other companies. Segment operating profit for all reportable segments totaled $531 in 2019, $420 in 2018, and $500 in 2017. The following information provides Sales and Segment operating profit for each reportable segment for each of the three years in the period ended December 31, 2019. See Note D to the Combined Financial Statements in Part II Item 8 Financial Statements and Supplementary Data. Rolled Products __________________ * In 2019, 2018, and 2017, third-party sales included $131, $145, and $133, respectively, and third-party aluminum shipments included 64 kmt, 60 kmt, and 60 kmt, respectively, related to sales to ParentCo’s Howmet Aerospace Businesses. These sales are deemed to be related-party sales and are presented as such on Arconic Corporation’s Statement of Combined Operations. Overview. The Rolled Products segment produces aluminum sheet and plate for a variety of end markets. Sheet and plate are sold directly to customers and through distributors related to the aerospace, automotive, commercial transportation, packaging, building and construction, and industrial products (mainly used in the production of machinery and equipment and consumer durables) end markets. A small portion of this segment also produces aseptic foil for the packaging end market (see below). While the customer base for flat-rolled products is large, a significant amount of sales of sheet and plate is to a relatively small number of customers. Prices for these products are generally based on the price of metal plus a premium for adding value to the aluminum to produce a semi-finished product, resulting in a business model in which the underlying price of metal is contractually passed-through to customers. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are the U.S. dollar and, to a lesser extent, each of the following: the Russian ruble, Chinese yuan, the euro, the British pound, and the Brazilian real. In August 2019, Arconic Corporation reached an agreement to sell its aluminum rolling mill in Itapissuma, Brazil to Companhia Brasileira de Alumínio (this transaction was completed on February 1, 2020). This rolling mill produces specialty foil and sheet products. The rolling mill generated third-party sales of $143, $179, and $162 in 2019, 2018, and 2017, respectively, and, at the time of divestiture, had approximately 500 employees. See Restructuring and other charges in Earnings Summary above for additional information. In March 2017, Arconic Corporation completed the divestiture of its Fusina, Italy rolling mill. The rolling mill generated third-party sales of $54 in 2017 (through the date of divestiture) and had 312 employees at the time of the divestiture. See Restructuring and Other charges in Earnings Summary above for additional information. On November 1, 2016, Arconic Corporation entered into a toll processing agreement with Alcoa Corporation for the tolling of metal for the Warrick, IN rolling mill which became a part of Alcoa Corporation upon the completion of the 2016 Separation Transaction. As part of this arrangement, Arconic Corporation provided a toll processing service to Alcoa Corporation to produce can sheet products at its facility in Tennessee through the end date of the contract, December 31, 2018. Alcoa Corporation supplied all required raw materials to Arconic Corporation, which processed the raw materials into finished can sheet coils ready for shipment to the end customer. Tolling revenue for 2018 and 2017 was $144 and $190, respectively. Sales. Third-party sales for the Rolled Products segment decreased $122, or 2%, in 2019 compared with 2018, primarily attributable to lower aluminum prices (see below), the absence of sales ($144) as a result of the ramp down of Arconic Corporation’s North American packaging operations (completed in December 2018), and unfavorable foreign currency movements. These negative impacts were partially offset by favorable product pricing and mix and higher volumes in the packaging (excluding North America), aerospace, and industrial products end markets. Third-party sales for this segment increased $606, or 12%, in 2018 compared with 2017, primarily attributable to higher aluminum prices; higher volumes in the automotive, commercial transportation, and industrial end markets; and favorable product mix; partially offset by the absence of sales of $54 from the rolling mill in Fusina, Italy (see above) and the ramp down of the North American packaging operations (completed in December 2018). Segment Operating Profit. Segment operating profit for the Rolled Products segment increased $127, or 39%, in 2019 compared with 2018, primarily driven by favorable pricing adjustments on industrial products and commercial transportation products, favorable aluminum price impacts, net cost savings, and favorable product mix. These positive impacts were somewhat offset by Arconic Corporation’s Tennessee plant’s transition to industrial production from packaging production. Segment operating profit for this segment declined $56, or 15%, in 2018 compared with 2017, primarily driven by unfavorable aerospace wide-body production mix, higher aluminum prices, and higher transportation costs and scrap spreads, partially offset by higher automotive, commercial transportation, and industrial volumes. Changes in aluminum prices in 2019 compared to 2018 negatively impacted Third-party sales by approximately $335 and positively impacted Segment operating profit by approximately $20. Metal price is a pass-through to this segment's customers with limited exception (e.g., fixed-priced contracts, certain regional premiums). On average, the price of aluminum on the London Metal Exchange declined approximately 15% in 2019 compared with 2018. Extrusions __________________ * In 2019, 2018, and 2017, third-party sales included $52, $61, and $49, respectively, and third-party aluminum shipments included 7 kmt, 7 kmt, and 6 kmt, respectively, related to sales to ParentCo’s Howmet Aerospace Businesses. These sales are deemed to be related-party sales and are presented as such on Arconic Corporation’s Statement of Combined Operations. Overview. The Extrusions segment produces a range of extruded and machined parts for the aerospace, automotive, commercial transportation, and industrial products end markets. These products are sold directly to customers and through distributors. Prices for these products are generally based on the price of metal plus a premium for adding value to the aluminum to produce a semi-finished product, resulting in a business model in which the underlying price of metal is contractually passed-through to customers. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are the U.S. dollar and, to a lesser extent, the euro. In October 2019, Arconic Corporation reached an agreement to sell its hard alloy extrusions plant in South Korea (this transaction was completed on March 1, 2020). The extrusions plant generated third-party sales of $51, $53, and $50 in 2019, 2018, and 2017, respectively, and, at the time of divestiture, had approximately 160 employees. Sales. Third-party sales for the Extrusions segment increased $4, or 1%, in 2019 compared with 2018, primarily driven by favorable product mix (mainly related to the automotive end market). Third-party sales for this segment increased $28, or 5%, in 2018 compared with 2017, primarily driven by higher aluminum prices and higher volumes in the automotive end market, partially offset by lower volumes in the aerospace and industrial end markets. Segment Operating Profit. Segment operating profit for the Extrusions segment declined $37 in 2019 compared with 2018, principally driven by higher operating costs, including labor, maintenance, and transportation. These negative impacts were partially offset by the absence of a charge for a physical inventory adjustment at one plant ($14) and a favorable change in LIFO inventory accounting ($13). Segment operating profit for this segment declined $33 in 2018 compared with 2017, principally driven by operational challenges at one plant, higher aluminum prices, and lower volumes for aerospace and industrial products, partially offset by higher volumes for automotive products. Building and Construction Systems Overview. The Building and Construction Systems segment manufactures products that are used in the non-residential building and construction end market. These products include integrated aluminum architectural systems and architectural extrusions, which are sold directly to customers and through distributors. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are the U.S. dollar and, to a lesser extent, each of the following: the euro, the British pound, and Canadian dollar. Sales. Third-party sales for the Building and Construction Systems segment decreased $22, or 2%, in 2019 compared with 2018, primarily driven by unfavorable foreign currency movements, principally driven by a weaker euro, and unfavorable aluminum pricing (see below). These negative impacts were somewhat offset by higher volume. Third-party sales for this segment increased $74, or 7%, in 2018 compared with 2017, primarily driven by higher volume related to the building and construction end market, increased product pricing, and favorable foreign currency movements due to a stronger euro and British pound. Segment Operating Profit. Segment operating profit for the Building and Construction Systems segment increased $21, or 23%, in 2019 compared with 2018, principally driven by net cost savings. Segment operating profit for this segment increased $9, or 11%, in 2018 compared with 2017, principally driven by favorable product pricing and higher volume related to the building and construction end market, mostly offset by higher costs. The improved pricing was mainly the result of price increases partially offset by absorption of a portion of a higher LME aluminum price. Changes in aluminum prices in 2019 compared to 2018 negatively impacted Third-party sales by approximately $15 and positively impacted Segment operating profit by approximately $15. A limited amount of this segment’s product sales is directly impacted by metal pricing, which is a pass-through to the related customers. On average, the price of aluminum on the London Metal Exchange declined approximately 15% in 2019 compared with 2018. Reconciliation of Total Segment Operating Profit to Combined Income before Income Taxes __________________ (1) Cost allocations are composed of an allocation of ParentCo’s general administrative and other expenses related to operating its corporate headquarters and other global administrative facilities, as well as an allocation of ParentCo’s research and development expenses associated with its corporate technical center (see Cost Allocations in Overview above). (2) See same titled sections under Earnings Summary in Results of Operations above for a description of notable changes. Forward-Look As a result of the escalating COVID-19 (coronavirus) pandemic and the uncertainty regarding its duration and impact on the Company's customers, suppliers, and operations, Arconic Corporation is not currently able to estimate the specific future impact on its operations or financial results. Several of the Company's automotive and aerospace customers have temporarily suspended operations, including Arconic Corporation's largest customer, Ford, which suspended its North American operations beginning on March 19, 2020 and have announced they are targeting to restart at least a portion of these operations on April 14, 2020. In addition, Arconic Corporation cannot predict the impact of any governmental regulations that might be imposed in response to the pandemic, including required temporary facility shutdowns. At this time, the Company’s material manufacturing facilities continue to operate. While the situation is fluid, the Company, like many companies around the world, anticipates temporary reductions in operating levels at many of its material manufacturing facilities due to the COVID-19 pandemic, although we do not currently know the extent, duration or impact of such reductions. Arconic Corporation is continuing to evaluate the impact this global event may have on its future results of operations, cash flows, financial position, and availability under the Company's revolving credit facility (see Financing Activities in Liquidity and Capital Resources below). Environmental Matters See the Environmental Matters section of Note T to the Combined Financial Statements in Part II Item 8 Financial Statements and Supplementary Data. Liquidity and Capital Resources Historically, ParentCo has provided capital, cash management, and other treasury services to Arconic Corporation. ParentCo will continue to provide these services to Arconic Corporation until the Separation is consummated. Only cash amounts specifically attributable to Arconic Corporation were reflected in the Company’s Combined Financial Statements. Transfers of cash, both to and from ParentCo’s centralized cash management system, were reflected as a component of Parent Company net investment in the Combined Financial Statements of Arconic Corporation. Arconic Corporation’s primary future cash needs will be centered on operating activities, including working capital, as well as recurring and strategic capital expenditures. Following the Separation, Arconic Corporation’s capital structure and sources of liquidity will change significantly from its historical capital structure. Arconic Corporation will no longer participate in capital management with ParentCo; rather Arconic Corporation’s ability to fund its cash needs will depend on its ongoing ability to generate and raise cash in the future. Although Arconic Corporation believes that its future cash from operations, together with its access to capital markets, will provide adequate resources to fund its operating and investing needs, the Company's access to, and the availability of, financing on acceptable terms in the future will be affected by many factors, including: (i) Arconic Corporation’s credit rating; (ii) the liquidity of the overall capital markets; and (iii) the current state of the economy. There can be no assurances that Arconic Corporation will continue to have access to capital markets on terms acceptable to it. ParentCo has an arrangement with several financial institutions to sell certain customer receivables without recourse on a revolving basis. The sale of such receivables is completed through the use of a bankruptcy-remote special-purpose entity, which is a consolidated subsidiary of ParentCo. In connection with this arrangement, certain of Arconic Corporation’s customer receivables are sold on a revolving basis to this bankruptcy-remote subsidiary of ParentCo; these sales were reflected as a component of Parent Company net investment in Arconic Corporation’s Combined Financial Statements. Effective January 2, 2020, in preparation for the Separation, ParentCo's arrangement was amended to no longer include customer receivables associated with the Arconic Corporation Businesses in this program, as well as to remove previously included customer receivables related to the Arconic Corporation Businesses not yet collected as of January 2, 2020. Accordingly, uncollected customer receivables of $281 related to the Arconic Corporation Businesses were removed from the program and the right to collect and receive the cash from the customer was returned to Arconic Corporation. The Company is evaluating whether to enter into a similar arrangement of its own subsequent to the Separation Date. In addition, ParentCo participates in several account payable settlement arrangements with certain vendors and third-party intermediaries. These arrangements provide that, at the vendor’s request, the third-party intermediary advances the amount of the scheduled payment to the vendor, less an appropriate discount, before the scheduled payment date and ParentCo makes payment to the third-party intermediary on the date stipulated in accordance with the commercial terms negotiated with its vendors. In connection with these arrangements, certain of Arconic Corporation’s accounts payable are settled, at the vendor’s request, before the scheduled payment date; these settlements were reflected as a component of Parent Company net investment in Arconic Corporation’s Combined Financial Statements. Arconic Corporation expects to maintain a similar standalone arrangement subsequent to the Separation. Operating Activities Cash provided from operations was $457 in 2019 compared with $503 in 2018 and $182 in 2017. In 2019, cash provided from operations was comprised primarily of a positive add-back for non-cash transactions in earnings of $327 and net income of $225, slightly offset by an unfavorable change in working capital of $119. In 2018, cash provided from operations was comprised primarily of a positive add-back for non-cash transactions in earnings of $196, net income of $170, and a favorable change in working capital of $159. In 2017, cash provided from operations was comprised principally of net income of $209 and a positive add-back for non-cash transactions in earnings of $194, partially offset by an unfavorable change in working capital of $185. Financing Activities Cash used for financing activities was $295 in 2019 compared with cash used for financing activities of $536 in 2018 and cash provided from financing activities of $136 in 2017. The amount in each period primarily reflects net cash activity between Arconic Corporation and ParentCo. In connection with the capital structure to be established at the time of the Separation, Arconic Corporation secured $1,200 in third-party indebtedness. On February 7, 2020, Arconic Corporation completed a Rule 144A (U.S. Securities Act of 1933, as amended) debt offering for $600 of 6.125% (fixed rate) Senior Secured Second-Lien Notes due 2028 (the “2028 Notes”). Additionally, on March 25, 2020, Arconic Corporation entered into a credit agreement, which provides a $600 Senior Secured First-Lien Term B Loan Facility (variable rate and seven-year term) (the “Term Loan”) and a $1,000 Senior Secured First-Lien Revolving Credit Facility (variable rate and five-year term) (the “Credit Facility”), with a syndicate of lenders and issuers named therein (the “Credit Agreement”). Arconic Corporation intends to use a portion of the net proceeds from the aggregate indebtedness to make a payment to ParentCo to fund the transfer of certain net assets from ParentCo to Arconic Corporation in connection with the completion of the Separation. The payment to ParentCo will be calculated as the difference between (i) the approximately $1,165 of net proceeds from the aggregate indebtedness and (ii) the difference between a beginning cash balance at the Separation Date of $500 and the amount of cash held by Arconic Corporation Businesses at March 31, 2020 ($72 as of December 31, 2019). The net proceeds from the 2028 Notes offering will be held in escrow until the satisfaction of the escrow release conditions, including the substantially concurrent completion of the Separation. Prior to the escrow release, the 2028 Notes will not be guaranteed. Following the escrow release, the 2028 Notes will be guaranteed by certain of Arconic Corporation’s wholly-owned domestic subsidiaries. Each of the 2028 Notes and the related guarantees will be secured on a second-priority basis by liens on certain assets of Arconic Corporation and the guarantors, as defined therein. The variable interest rate with respect to the Term Loan is currently based on LIBOR for the relevant interest period plus an applicable margin of 2.75% and the variable commitment fee for undrawn capacity related to the Credit Facility is 0.35%. The provisions of the Term Loan require a mandatory 1% repayment of the initial $600 borrowing each annual period during the seven-year term. The Term Loan and the Credit Facility are guaranteed by certain of Arconic Corporation’s wholly-owned domestic subsidiaries. Each of the Term Loan, the Credit Facility, and the related guarantees are secured on a first-priority basis by liens on certain assets of Arconic Corporation and the guarantors. The Credit Agreement includes financial covenants requiring the maintenance of a Consolidated Total Leverage Ratio and a Consolidated Interest Coverage Ratio, as defined in the Credit Agreement. The Consolidated Total Leverage Ratio is the ratio of Consolidated Debt to Consolidated EBITDA for the trailing four fiscal quarters, as defined in the Credit Agreement, and may not exceed a ratio of 2.50 to 1.00 for each fiscal quarter commencing with the fiscal quarter ending on June 30, 2020 through and including the fiscal quarter ending on March 31, 2021, and 2.25 to 1.00 for each fiscal quarter thereafter. The Consolidated Interest Coverage Ratio is the ratio of Consolidated EBITDA to Consolidated Interest Expense for the trailing four fiscal quarters, as defined in the Credit Agreement, and may not fall below a ratio of 3.00 to 1.00 for any fiscal quarter during the term of the Credit Agreement, commencing with the fiscal quarter ending on June 30, 2020. In addition, the Credit Agreement requires pro forma compliance with these financial covenants at each instance of borrowing under the Credit Facility, which may limit the Company's ability to draw the full amount. The gross availability of $1,000 under the Credit Facility is subject to compliance with certain financial covenants based on the trailing twelve months of financial performance. For illustrative purposes, assuming the Separation had previously occurred and the capital structure had been in place on December 31, 2019, the availability under the Credit Facility would have been approximately $760 based on fourth quarter actual results and the Company's deemed Consolidated EBITDA set forth in the Credit Agreement. The illustrative availability is based upon a variety of assumptions and, though considered reasonable by the Company, may not be indicative of future availability. Investing Activities Cash used for investing activities was $170 in 2019 compared with $10 in 2018 and $250 in 2017. The use of cash in 2019 reflects capital expenditures of $201, including for an approximately $140 project at the Davenport (Iowa) plant and an approximately $100 project at the Tennessee plant, slightly offset by additional proceeds of $27 (contingent consideration) from the sale of the Texarkana, Texas cast house. At Davenport, Arconic Corporation installed a new horizontal heat treat furnace to capture growth in the aerospace and industrial products markets. This project began near the end of 2017 and was completed in 2019 (furnace was in customer qualification stage as of December 31, 2019). At Tennessee, Arconic Corporation is expanding its hot mill capability and adding downstream equipment capabilities to capture growth in the automotive and industrial products markets. This project began in early 2019 and is expected to be completed by the end of 2020. The use of cash in 2018 reflects capital expenditures of $317, including for a horizontal heat treat furnace at the Davenport, Iowa plant, mostly offset by proceeds of $302 from the sale of the Texarkana, Texas rolling mill and cast house. The use of cash in 2017 reflects capital expenditures of $241, including for the aerospace expansion (very thick plate stretcher and horizontal heat treat furnace) at the Davenport, Iowa plant. Contractual Obligations and Off-Balance Sheet Arrangements Following the Separation, Arconic Corporation’s capital structure and sources of liquidity will differ from its historical capital structure. Also, Arconic Corporation will no longer participate in cash management and intercompany funding arrangements with ParentCo. Arconic Corporation’s ability to fund its operating and capital needs will depend on the Company’s ability to generate cash from operations and access capital markets. Contractual Obligations. Arconic Corporation is required to make future payments under various contracts, including long-term purchase obligations, lease agreements, and financing arrangements. The Company also has commitments to fund its pension plans, provide payments for other postretirement benefit plans, and fund capital projects. As of December 31, 2019, a summary of Arconic Corporation’s outstanding contractual obligations is as follows (these contractual obligations are grouped in the same manner as they are classified in the Statement of Combined Cash Flows in order to provide a better understanding of the nature of the obligations and to provide a basis for comparison to historical information) (see the information below the contractual obligations table that describes the Company’s future employee benefit plan and debt obligations incurred subsequent to December 31, 2019): __________________ (1) Subsequent to December 31, 2019, Arconic Corporation incurred $1,200 in indebtedness. See Obligations for Financing Activities below for scheduled annual repayments and Obligations for Operating Activities below for the related interest obligations. (2) Effective January 1, 2020, Arconic Corporation assumed approximately $1,900 in employee benefit plan obligations. See Obligations for Operating Activities below for estimated annual pension contributions and other postretirement benefit payments. Obligations for Operating Activities Raw material purchase obligations consist mostly of aluminum with expiration dates ranging from less than one year to three years. Energy-related purchase obligations consist primarily of electricity and natural gas contracts with expiration dates ranging from one year to nine years. Many of these purchase obligations contain variable pricing components, and, as a result, actual cash payments may differ from the estimates provided in the preceding table. Operating leases represent multi-year obligations for certain land and buildings, plant equipment, vehicles, and computer equipment. Interest related to debt is based on a stated rate of 4.75% calculated on the principal amount of the financing used to acquire, construct, reconstruct, and renovate certain facilities at Arconic Corporation’s rolling mill plant in Davenport, IA. This debt matures in 2042. At Separation, ParentCo is expected to retain all obligations associated with this debt. Accordingly, this debt will be removed from Arconic Corporation's Combined Balance Sheet in connection with the Separation. The interest obligations of the 2028 Notes and Term Loan (see Financing Activities in Liquidity and Capital Resources above) are not included in the preceding table as these financing arrangements closed subsequent to December 31, 2019. The annual interest rate associated with the 2028 Notes is 6.125% and the Term Loan is 1-month LIBOR plus an applicable margin of 275 basis points. Estimated minimum required pension funding and other postretirement benefit payments are based on actuarial estimates using current assumptions for, among others, discount rates, long-term rate of return on plan assets, rate of compensation increases, and/or health care cost trend rates. It is Arconic Corporation’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Arconic Corporation has determined that it is not practicable to present pension funding and other postretirement benefit payments beyond 2024 and 2029, respectively. In preparation for the Separation, effective January 1, 2020, certain U.S. pension and other postretirement benefit plans previously sponsored by ParentCo were separated into standalone plans for both Arconic Corporation (the “U.S. Shared Plans”) and Howmet Aerospace. Accordingly, on January 1, 2020, Arconic Corporation recognized an aggregate liability of $1,920 reflecting the combined net unfunded status, comprised of a benefit obligation of $4,255 and plan assets of $2,335, of the U.S. Shared Plans, and $1,752 (net of tax impact) in Accumulated other comprehensive loss. During the next five years, estimated minimum required pension funding related to the U.S. Shared Plans is $250 in 2020, $180 in 2021, $180 in 2022, $170 in 2023, and $160 in 2024. Also, during the next ten years, estimated other postretirement benefit payments are $53 in 2020, $54 in 2021, $54 in 2022, $53 in 2023, $53 in 2024, and a combined $171 in 2025 through 2029. Layoff and other restructuring payments to be paid within one year relate virtually all to severance costs. Deferred revenue arrangements require Arconic Corporation to deliver sheet and plate to a certain customer over the specified contract period (through 2020). While this obligation is not expected to result in cash payments, it is included in the preceding table as Arconic Corporation would have such an obligation if the specified product deliveries could not be made. Uncertain tax positions taken or expected to be taken on an income tax return may result in additional payments to tax authorities. As of December 31, 2019, no interest and penalties were accrued related to such positions. The total amount of uncertain tax positions is included in the “Thereafter” column as Arconic Corporation is not able to reasonably estimate the timing of potential future payments. If a tax authority agrees with the tax position taken or expected to be taken or the applicable statute of limitations expires, then additional payments will not be necessary. Obligations for Financing Activities The debt amount in the preceding table matures in 2042 and represents the principal amount of the financing used to acquire, construct, reconstruct, and renovate certain facilities at Arconic Corporation’s rolling mill plant in Davenport, IA. At Separation, ParentCo is expected to retain all obligations associated with this debt. Accordingly, this debt will be removed from Arconic Corporation's Combined Balance Sheet in connection with the Separation. The 2028 Notes and Term Loan (see Financing Activities in Liquidity and Capital Resources above) are not included in the preceding table as these financing arrangements closed subsequent to December 31, 2019. The scheduled repayment of the 2028 Notes and Term Loan is $5 in 2020, $6 in each of 2021, 2022, 2023, and 2024, and a combined $1,171 in 2025 through 2028. Obligations for Investing Activities Capital projects in the preceding table only include amounts approved by management as of December 31, 2019. Funding levels may vary in future years based on anticipated construction schedules of the projects. It is expected that significant expansion projects will be funded through various sources, including cash provided from operations. Total capital expenditures are anticipated to be in the range of $150 to $190 in 2020. Off-Balance Sheet Arrangements. ParentCo has outstanding bank guarantees, on behalf of Arconic Corporation, related to, among others, tax matters and customs duties. The total amount committed under these guarantees, which expire at various dates between 2020 and 2026 was $3 at December 31, 2019. ParentCo has outstanding letters of credit, on behalf of Arconic Corporation, primarily related to environmental and lease obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2020, was $57 at December 31, 2019. ParentCo has outstanding surety bonds, on behalf of Arconic Corporation, primarily related to customs duties and environmental-related matters. The total amount committed under these surety bonds, which expire at various dates, primarily in 2020, was $8 at December 31, 2019. Critical Accounting Policies and Estimates The Combined Financial Statements of Arconic Corporation are prepared from ParentCo’s historical accounting records and are presented on a standalone basis as if the Arconic Corporation Businesses have been conducted independently from ParentCo. Such Combined Financial Statements include the historical operations that are considered to comprise the Arconic Corporation Businesses, as well as certain assets and liabilities that have been historically held at ParentCo’s corporate level but are specifically identifiable or otherwise attributable to Arconic Corporation. The preparation of Arconic Corporation’s Combined Financial Statements in accordance with accounting principles generally accepted in the United States of America requires management to make certain estimates based on judgments and assumptions regarding uncertainties that may affect the amounts reported in the Combined Financial Statements and disclosed in the Notes to the Combined Financial Statements. Areas that require such estimates include cost allocations (see Cost Allocations in Overview above), the review of properties, plants, and equipment and goodwill for impairment, and accounting for each of the following: environmental and litigation matters; pension and other postretirement employee benefit obligations; stock-based compensation; and income taxes. Management uses historical experience and all available information to make these estimates, and actual results may differ from those used to prepare Arconic Corporation’s Combined Financial Statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Combined Financial Statements, including the Notes to the Combined Financial Statements, provide a meaningful and fair perspective of the Company. A summary of Arconic Corporation’s significant accounting policies is included in Note B to the Combined Financial Statements in Part II Item 8 Financial Statements and Supplementary Data. Management believes that the application of these policies on a consistent basis enables Arconic Corporation to provide the users of the Combined Financial Statements with useful and reliable information about Arconic Corporation’s operating results and financial condition. Properties, Plants, and Equipment. Properties, plants, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the related operations (asset group) to the carrying value of the associated assets. An impairment loss would be recognized when the carrying value of the assets exceeds the estimated undiscounted net cash flows of the asset group. The amount of the impairment loss to be recorded is calculated as the excess of the carrying value of the assets over their fair value, with fair value determined using the best information available, which generally is a discounted cash flow (DCF) model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of the assets also require significant judgments. Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell, exit, or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include, among others, deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods. The fair value that could be realized in an actual transaction may differ from that used to evaluate goodwill for impairment. Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Arconic Corporation has three reporting units-the Rolled Products segment, the Extrusions segment, and the Building and Construction Systems segment-all of which contain goodwill. As of December 31, 2019, the carrying value of the goodwill for Rolled Products, Extrusions, and Building and Construction Systems was $246, $71, and $69, respectively. In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (greater than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform a quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. Arconic Corporation determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Arconic Corporation’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three-year period. Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent quantitative impairment test completed for a reporting unit and compares the weighted average cost of capital (WACC) between the current and prior years for each reporting unit. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Arconic Corporation uses a DCF model to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. Several significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. Certain of these assumptions may vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated by management with the assistance of valuation experts. In the event the estimated fair value of a reporting unit per the DCF model is less than the carrying value, Arconic Corporation would recognize an impairment charge equal to the excess of the reporting unit’s carrying value over its fair value without exceeding the total amount of goodwill applicable to that reporting unit. During the 2019 annual review of goodwill, management proceeded directly to the quantitative impairment test for all three of the Company's reporting units. The estimated fair value for each of the three reporting units was substantially in excess of the respective carrying value, resulting in no impairment. The annual review in 2018 and 2017 indicated that goodwill was not impaired for any of Arconic Corporation’s reporting units and there were no triggering events that necessitated an impairment test for any of the reporting units. Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future revenues, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery, which are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Arconic Corporation has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations. Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as, among others, the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine the probability an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss. Pension and Other Postretirement Benefits. Certain employees attributable to Arconic Corporation operations participate in defined benefit pension and other postretirement benefit plans (“Shared Plans”) sponsored by ParentCo, which also includes ParentCo participants. For purposes of the Company's Combined Financial Statements, Arconic Corporation accounts for the portion of the Shared Plans related to its employees as multiemployer benefit plans. Accordingly, Arconic Corporation does not record an asset or liability to recognize the funded status of the Shared Plans. However, the related expense recorded by Arconic Corporation is based primarily on pensionable compensation and estimated interest costs related to participants attributable to Arconic Corporation operations. Certain ParentCo plans that are entirely attributable to employees of Arconic Corporation-related operations (“Direct Plans”) are accounted for as defined benefit pension and other postretirement benefit plans for purposes of the Combined Financial Statements. Accordingly, the funded and unfunded position of each Direct Plan is recorded in the Combined Balance Sheet. Actuarial gains and losses that have not yet been recognized in earnings are recorded in accumulated other comprehensive income net of taxes, until they are amortized as a component of net periodic benefit cost. The determination of benefit obligations and recognition of expenses related to the Direct Plans are dependent on various assumptions, including discount rates, long-term expected rates of return on plan assets, and future compensation increases. ParentCo’s management develops each assumption using relevant company experience in conjunction with market-related data for each individual location in which such plans exist. The following table summarizes the total expenses recognized by Arconic Corporation related to the pension and other postretirement benefits described above: __________________ * In each of 2019, 2018, and 2017, net periodic benefit cost for pension benefits was comprised of service cost of $3 and non-service cost of $2. Stock-Based Compensation. Eligible employees attributable to Arconic Corporation operations participate in ParentCo’s stock-based compensation plans. Until consummation of the Separation, these employees will continue to participate in ParentCo’s stock-based compensation plans and Arconic Corporation will record compensation expense based on the awards granted to relevant employees. ParentCo recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. The compensation expense recorded by Arconic Corporation, in all periods presented, includes the expense associated with employees historically attributable to Arconic Corporation operations, as well as the expense associated with the allocation of stock-based compensation expense for ParentCo’s corporate employees. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance stock units containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. In 2019, 2018, and 2017, Arconic Corporation recognized stock-based compensation expense of $38 ($30 after-tax), $22 ($17 after-tax), and $23 ($15 after-tax), respectively. Income Taxes. Arconic Corporation’s operations have historically been included in the income tax filings of ParentCo. The provision for income taxes in Arconic Corporation’s Statement of Combined Operations is based on a separate return methodology using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year calculated as if Arconic Corporation was a standalone taxpayer filing hypothetical income tax returns where applicable. Any additional accrued tax liability or refund arising as a result of this approach is assumed to be immediately settled with ParentCo as a component of Parent Company net investment. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid and result from differences between the financial and tax bases of Arconic Corporation’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. Deferred tax assets are reflected in the Combined Balance Sheet for net operating losses, credits or other attributes to the extent that such attributes are expected to transfer to Arconic Corporation upon the Separation. Any difference from attributes generated in a hypothetical return on a separate return basis is adjusted as a component of Parent Company net investment. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not (greater than 50%) that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic Corporation’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the grant and lapse of tax holidays. Arconic Corporation applies a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset Global Intangible Low Taxed Income (GILTI) income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed its examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. Related Party Transactions Transactions between the Arconic Corporation Businesses and the Howmet Aerospace Businesses have been presented as related party transactions on Arconic Corporation’s Combined Financial Statements. In 2019, 2018, and 2017, sales to the Howmet Aerospace Businesses from the Arconic Corporation Businesses were $183, $206, and $182, respectively. Recently Adopted Accounting Guidance See the Recently Adopted Accounting Guidance section of Note B to the Combined Financial Statements in Part II Item 8 Financial Statements and Supplementary Data. Recently Issued Accounting Guidance See the Recently Issued Accounting Guidance section of Note B to the Combined Financial Statements in Part II Item 8 Financial Statements and Supplementary Data.

<s>[INST] References in this Management's Discussion and Analysis of Financial Condition and Results of Operations to (i) “ParentCo” refer to Arconic Inc., a Delaware corporation, and its consolidated subsidiaries, and (ii) “2016 Separation Transaction” refer to the November 1, 2016 separation of Alcoa Inc., a Pennsylvania corporation, into two standalone, publiclytraded companies, Arconic Inc. and Alcoa Corporation. Overview The Separation The Proposed Separation. On February 8, 2019, ParentCo announced that its Board of Directors approved a plan to separate into two standalone, publiclytraded companies (the “Separation”). The spinoff company, Arconic Rolled Products Corporation (“Arconic Corporation” or the “Company”), will include the rolled aluminum products, aluminum extrusions, and architectural products operations of ParentCo, as well as the Latin America extrusions operations sold in April 2018 (collectively, the “Arconic Corporation Businesses”). The existing publiclytraded company, ParentCo, will continue to own the engine products, engineered structures, fastening systems, and forged wheels operations (collectively, the “Howmet Aerospace Businesses”). The Separation is subject to a number of conditions, including, but not limited to: final approval by ParentCo’s Board of Directors (see below); receipt of an opinion of legal counsel regarding the qualification of the distribution, together with certain related transactions, as a “reorganization” within the meaning of Sections 355 and 368(a)(1)(D) of the U.S. Internal Revenue Code (i.e., a transaction that is generally taxfree for U.S. federal income tax purposes); and the U.S. Securities and Exchange Commission (the “SEC”) declaring effective a Registration Statement on Form 10, as amended, filed with the SEC on February 13, 2020 (effectiveness was declared by the SEC on February 13, 2020). Arconic Corporation and Howmet Aerospace have entered into and will enter into several agreements to implement the legal and structural separation between the two companies; govern the relationship between Arconic Corporation and Howmet Aerospace after the completion of the Separation; and allocate between Arconic Corporation and Howmet Aerospace various assets, liabilities, and obligations, including, among other things, employee benefits, environmental liabilities, intellectual property, and taxrelated assets and liabilities. One agreement in particular, the Separation and Distribution agreement, will identify the assets to be transferred, the liabilities to be assumed, and the contracts to be transferred to each of Arconic Corporation and Howmet Aerospace as part of the Separation, and will provide for when and how these transfers and assumptions will occur. ParentCo may, at any time and for any reason until the Separation is complete, abandon the separation plan or modify its terms. ParentCo is incurring costs to evaluate, plan, and execute the Separation, and Arconic Corporation is allocated a pro rata portion of these costs based on segment revenue (see Cost Allocations below). In 2019, ParentCo recognized $78 for such costs, of which $40 was allocated to Arconic Corporation. The allocated amounts were included in Selling, general administrative, and other expenses on Arconic Corporation’s Statement of Combined Operations. On February 5, 2020, ParentCo's Board of Directors approved the completion of the Separation, which is scheduled to become effective on April 1, 2020 (the “Separation Date”) at 12:01 a.m. Eastern Daylight Time. The Separation will occur by means of a pro rata distribution by ParentCo of all of the outstanding shares of common stock of Arconic Corporation to ParentCo common shareholders of record as of the close of business on March 19, 2020 (the “Record Date”). Specifically, ParentCo common shareholders are expected to receive one share of Arconic Corporation common stock for every four shares of ParentCo common stock held as of the Record Date (ParentCo common shareholders will receive cash in lieu of fractional shares). In connection with the consummation [/INST] Positive. </s>

Trevi 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 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 statements 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, constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words “anticipate,” “believe,” “continue” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “would,” “could,” “continue” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We have based these forward-looking statements on our current expectations and projections about future events. The following information and any forward-looking statements should be considered in light of factors discussed elsewhere in this Annual Report on Form 10-K, particularly including those risks identified in Part I-Item 1A “Risk Factors” and our other filings with the SEC. Our actual results and timing of certain events may differ materially from the results discussed, projected, anticipated, or indicated in any forward-looking statements. 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 development of the industry in which we operate may differ materially from the forward-looking statements contained in this Annual Report on Form 10-K. Statements made herein are as of the date of the filing of this Annual Report on Form 10-K with the SEC and should not be relied upon as of any subsequent date. Even if our results of operations, financial condition and liquidity, and the development of the industry in which we operate are consistent with the forward-looking statements contained in this Annual Report on Form 10-K, they may not be predictive of results or developments in future periods. 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. 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. Overview We are a clinical-stage biopharmaceutical company focused on the development and commercialization of nalbuphine ER to treat serious neurologically mediated conditions. We are developing nalbuphine ER for the treatment of chronic pruritus, chronic cough in patients with idiopathic pulmonary fibrosis, or IPF, and levodopa-induced dyskinesia, or LID, in patients with Parkinson’s disease. We are conducting a Phase 2b/3 clinical trial of nalbuphine ER, which we refer to as the PRISM trial, in patients with severe pruritus associated with prurigo nodularis. The PRISM trial is a randomized, double-blind, placebo controlled, two-arm treatment study that is designed to evaluate the safety and anti-pruritic efficacy of nalbuphine ER in approximately 240 patients in the United States and Europe. To date, we have enrolled approximately 45% of the target number of patients. The pace of enrollment has been slower than anticipated primarily due to competition from other clinical trials and slower than planned site start-ups in Europe. We expect to report top-line data from the 14-week blinded treatment period of the PRISM trial in the second half of 2020. Additionally, the protocol for the PRISM trial provides for a sample size re-estimation analysis once 50% of the patients in the trial are evaluable for the primary endpoint. We expect to reach 50% patient enrollment during the second quarter of 2020. Once all of these patients complete the primary efficacy endpoint, the sample size re-estimation analysis will occur. We expect this analysis will occur in mid-2020. If we increase the target number of patients in the trial as a result of the re-estimation analysis, the timing of our report of top-line data may be delayed. We are also conducting a Phase 2 clinical trial of nalbuphine ER for chronic cough in patients with IPF. This Phase 2 clinical trial is a randomized, double-blind, placebo controlled, two-treatment, two-period, crossover study designed to evaluate the efficacy, safety, tolerability and dosing of nalbuphine ER for chronic cough in up to 56 patients with IPF in the United Kingdom. We expect to report top-line data from the trial in the second half of 2020. In addition, we are conducting a Phase 1b clinical trial in patients with chronic liver disease to evaluate the safety and pharmacokinetics, or PK, of nalbuphine ER in this population. This trial was designed as an open label, non-randomized, parallel-group, single and multiple ascending dose pharmacokinetic trial in patients with mild, moderate and severe hepatic impairment. We completed the single ascending dosing portion of this trial in patients with mild and moderate hepatic impairment and there were no serious adverse events reported in the trial. After reviewing the safety and PK data generated to date in the single ascending dose portion of the trial, we believe that these data are sufficient to support further investigation of nalbuphine ER in potential future safety and efficacy studies in patients with relevant liver diseases. We intend to start planning for a Phase 2 trial of nalbuphine ER in patients with pruritus associated with primary biliary cholangitis, or PBC. In addition, we intend to use the data from the hepatic impairment study to support a new drug application, or NDA, submission for nalbuphine ER for pruritus in prurigo nodularis. We have written the protocol for a Phase 2 clinical trial for LID in patients with Parkinson’s disease and plan to submit an Investigational New Drug, or IND, application to the FDA in the upcoming months. We are currently focusing our resources on completing the PRISM trial and Phase 2 trial for chronic cough in patients with IPF. We are continuing to prepare to conduct the Phase 2 trials for LID in patients with Parkinson’s disease and pruritus associated with PBC but plan to prioritize our cash and operational resources on our two lead clinical programs. Since commencing operations in 2011, we have devoted substantially all of our efforts and financial resources to the clinical development of nalbuphine ER. We have not generated any revenue from product sales and, as a result, we have never been profitable and have incurred net losses in each year since commencement of our operations. As of December 31, 2019, we had an accumulated deficit of $114.2 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 nalbuphine ER for the treatment of pruritus associated with prurigo nodularis, chronic cough in patients with IPF or LID in patients with Parkinson’s disease, and we can provide no assurance that we will ever generate significant revenue or profits. On May 9, 2019, we issued and sold 5,500,000 shares of common stock in our initial public offering, or IPO, and 1,500,000 shares of common stock in a concurrent private placement, in each case at an offering price of $10.00 per share, for combined net proceeds of $62.1 million after deducting aggregate underwriting discounts and commissions and private placement agent fees of $4.9 million and other offering expenses of $3.0 million. Upon the closing of the IPO, our preferred stock then outstanding converted into an aggregate of 10,381,234 shares of common stock. As of December 31, 2019, we had cash and cash equivalents of $57.3 million. We believe that our existing cash and cash equivalents will enable us to fund our operating expenses and capital expenditure requirements into the third quarter of 2021. Our estimate as to how long we expect our existing cash and cash equivalents to continue to fund our operations is based on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we expect. See “-Liquidity and Capital Resources.” Our future viability beyond that point is dependent on our ability to raise additional capital to finance our operations. We expect to incur substantial expenditures in the foreseeable future as we advance nalbuphine ER 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 Phase 2b/3 PRISM trial in patients with pruritus associated with prurigo nodularis, the additional Phase 3 clinical trial we will be required to conduct to support the submission of an NDA to the United States Food and Drug Administration, or FDA, for nalbuphine ER for the treatment of pruritus associated with prurigo nodularis, our ongoing Phase 2 clinical trial in chronic cough in patients with IPF, the development and validation of our commercial manufacturing process for nalbuphine ER and other development activities, including potentially commencing Phase 2 clinical trials for the treatment of LID in patients with Parkinson’s disease and for pruritus associated with PBC. 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. 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 sales of nalbuphine ER, 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 nalbuphine ER for one or more indications or delay our efforts to expand our product pipeline. 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 nalbuphine ER. These expenses include certain payroll and personnel expenses, including stock-based compensation, consulting costs, contract manufacturing costs and fees paid to clinical research organizations, or CROs, to conduct certain research and development activities on our behalf. We do not allocate our costs by each indication for which we are developing nalbuphine ER, as a significant amount of our development activities broadly support all indications. In addition, several of our departments support our nalbuphine ER drug candidate development program and we do not identify internal costs for each potential indication. We expect our research and development expenses to increase over the next few years as we pursue our development program, pursue regulatory approval of nalbuphine ER in the United States and Europe and prepare for a possible commercial launch of nalbuphine ER. Predicting the timing or the cost to conduct our nalbuphine ER development program and prepare for a possible commercial launch of nalbuphine ER is difficult and delays may occur because of many factors including factors outside of our control such as the sample size re-estimation for our PRISM trial. For example, if the FDA or other regulatory authorities were to require us to conduct clinical trials beyond those that we currently anticipate, or if we experience significant delays in enrollment in any of our clinical trials, we could be required to expend significant additional financial resources and time on our development program. Furthermore, we are unable to predict when or if nalbuphine ER will receive regulatory approval in the United States or elsewhere with any certainty. General and Administrative Expenses General and administrative expenses consist principally of personnel-related costs, including stock-based compensation, for personnel in executive, finance, commercial and other administrative functions, professional fees for legal, consulting and accounting services as well as rent and other general operating expenses not otherwise classified as research and development expenses. We anticipate that our general and administrative expenses will increase as a result of increased personnel costs, including stock-based compensation, expanded infrastructure and higher consulting, legal and accounting services associated with maintaining compliance with stock exchange listing and SEC requirements, investor relations costs and director and officer insurance premiums associated with being a public company. Other Income (Expense), Net Interest Expense on our Term Loan Facility In December 2014, we entered into a loan and security agreement with Solar Capital, Ltd. and Square 1 Bank under which we borrowed $15.0 million under a term loan, or the Term Loan. The Term Loan accrued interest at a floating rate equal to the one-month LIBOR plus 7.75% per annum. The Term Loan required interest-only payments until March 2016, which was extended to November 2016. After November 2016, payments on the Term Loan were made monthly in 20 equal installments of principal plus interest. In June 2018, we paid all amounts owed under the Term Loan. Change in Fair Value of Series C Redeemable Convertible Preferred Stock Liability The stock purchase agreement under which we sold shares of Series C preferred stock provided for the issuance and sale of our Series C preferred stock in three separate tranches. The tranches represented a free-standing financial instrument under Accounting Standards Codification, or ASC, 480 and required fair value accounting until they were settled. We recognized a liability on our consolidated balance sheet for the obligations under this financial instrument. We adjusted this liability to fair value at each reporting date and recognized the changes in fair value in our statements of operations as a component of other income (expense), net. We continued to recognize changes in the fair value of this liability through the closing of the third tranche, which occurred on January 18, 2019. Change in Fair Value of Obligation for Loan Success Fee In connection with the Term Loan, we entered into the Success Fee Agreement under which we agreed to pay the lenders a Success Fee upon the occurrence of an exit event, as defined in the Success Fee Agreement. We classified this contingent obligation for the Success Fee as a liability on our consolidated balance sheet and we adjusted this liability to fair value at each reporting date. We recognized changes in the fair value of this obligation for the Success Fee in our statements of operations as a component of other income (expense), net. We recognized changes in the fair value of the obligation for the Success Fee until the Success Fee payment was triggered and paid upon the closing of our IPO in May 2019. Interest Income Interest income consists of interest earned from money market funds on our cash and cash equivalents. 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): Operating Expenses Research and Development Expenses The following table summarizes our research and development expenses for the periods indicated (in thousands): Research and development expenses increased $5.3 million, or 37.4%, from $14.1 million for the year ended December 31, 2018 to $19.3 million for the year ended December 31, 2019. The increase was primarily due to a $4.8 million increase in clinical development expenses primarily related to increased activities in several clinical trials including our Phase 2b/3 PRISM trial, our Phase 2 trial in chronic cough in patients with IPF and our Phase 1b trial in patients with chronic liver disease. In addition, personnel and related expenses increased by $0.3 million as a result of an increase in our employee headcount, and consulting expenses and professional fees increased by $0.3 million as a result of our increased clinical trial activity. For the years ended December 31, 2019 and 2018, all of our research and development expenses relate to our development activity for nalbuphine ER. General and Administrative Expenses General and administrative expenses increased $3.0 million, or 68.5%, from $4.3 million for the year ended December 31, 2018 to $7.3 million for the year ended December 31, 2019. The increase was primarily due to an increase in personnel and stock-based compensation expenses of $1.4 million, which we incurred from the issuance of new stock option grants upon the IPO and from expanded operations, an increase in expenses related to being a public company of $1.1 million and an increase in consulting expenses and professional fees of $0.5 million. Other Income (Expense), Net Other income (expense), net for the year ended December 31, 2019 increased to other income, net of $0.6 million from other (expense), net of $2.3 million for the year ended December 31, 2018. The increase primarily reflects the change in fair value of our liability during the year ended December 31, 2018 for the shares of Series C preferred stock purchasable in the second and third tranches of our Series C preferred stock financing as well as increased interest income of $0.8 million due to our larger cash balance following our IPO in May 2019. 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. Prior to the completion of our IPO and concurrent private placement in May 2019, we financed our operations primarily through private placements of our preferred stock and convertible notes as well as borrowings under the Term Loan. From inception to our IPO, we raised an aggregate of $102.2 million in gross proceeds from sales of our preferred stock and convertible notes and borrowed $15.0 million under the Term Loan. As of June 30, 2018, all amounts owed under the Term Loan had been paid in full. In May 2019, we issued and sold 5,500,000 shares of common stock in our IPO and 1,500,000 shares of common stock in a concurrent private placement, in each case at an offering price of $10.00 per share, for combined net proceeds of $62.1 million after deducting aggregate underwriting discounts and commissions and private placement agent fees of $4.9 million and other offering expenses of $3.0 million. As of December 31, 2019, we had cash and cash equivalents of $57.3 million. Our cash and cash equivalents are primarily held in money market accounts. Cash Flows The following table summarizes our cash flows for each of the periods presented below (in thousands): Operating Activities During the year ended December 31, 2019, operating activities used $23.1 million of cash, resulting from our net loss of $26.1 million, partially offset by changes in our operating assets and liabilities of $1.6 million and non-cash charges of $1.4 million. Changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $1.4 million increase in accrued expenses, a $0.8 million increase in accounts payable, a $0.4 million increase in receivables, and a $0.2 million increase in prepaid expenses. The increase in accrued expenses was primarily due to increases in accruals related to our Phase 2b/3 PRISM trial in prurigo nodularis and our Phase 2 trial for chronic cough in IPF. The increase in accounts payable was primarily due to timing of vendor invoices. The increase in receivables was primarily due to prepayments made to one of our vendors, which we expect will be paid back to us in the first half of 2020. The increase in prepaid expenses was primarily due to prepayments of our insurance policies. The non-cash charges for the year ended December 31, 2019 consisted primarily of stock-based compensation expense of $1.1 million and changes in fair value of the Success Fee of $0.2 million. During the year ended December 31, 2018, operating activities used $18.3 million of cash, resulting from our net loss of $20.5 million and net cash used in changes in our operating assets and liabilities of $0.6 million, partially offset by non-cash charges of $2.8 million. Net cash used in changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $1.3 million increase in prepaid expenses. The increase in prepaid expenses was primarily due to increases in prepayments under our ongoing research, development and clinical trial work performed by CROs. The non-cash charges for the year ended December 31, 2018 consisted primarily of a $2.1 million expense related to the change in fair value of our Series C redeemable convertible preferred stock liability and stock-based compensation expense of $0.5 million. Investing Activities During the years ended December 31, 2019 and 2018, we used an insignificant amount of cash in investing activities, consisting of purchases of property and equipment. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $73.2 million, primarily consisting of cash proceeds, net of underwriting discounts and commissions and placement agent fees, of $65.1 million from our IPO and concurrent private placement, and $10.0 million from our sales of shares of Series C preferred stock in the third tranche of our Series C preferred stock financing in January 2019, partially offset by costs relating to our IPO of $1.2 million and payment of the $0.7 million Success Fee. During the year ended December 31, 2018, net cash provided by financing activities was $3.6 million, primarily consisting of net cash proceeds of $10.5 million from our sales of shares of Series C preferred stock in the second tranche of our Series C preferred stock financing in August 2018, partially offset by payments of $4.8 million on the Term Loan and $0.5 million of final fees on the Term Loan. Funding Requirements We expect to incur substantial expenditures in the foreseeable future as we advance nalbuphine ER 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 Phase 2b/3 PRISM trial, the additional Phase 3 clinical trial we will need to conduct to support the submission of an NDA to the FDA and a marketing authorization application to the European Medicines Agency for nalbuphine ER for the treatment of pruritus associated with prurigo nodularis, our ongoing Phase 2 clinical trial in chronic cough in patients with IPF, the costs of commercialization activities, including manufacturing capabilities, for nalbuphine ER and other development activities including potentially commencing Phase 2 clinical trials for the treatment of LID in patients with Parkinson’s disease and for pruritus associated with PBC. 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 that we did not incur as a private company. 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 sales of nalbuphine ER, if ever, we expect to finance our operations through public or private equity offerings, debt financings, collaborations and licensing arrangements or other sources to achieve our business objectives. Adequate additional financing may not be available to us on acceptable terms, or at all. Our future funding requirements, both short-term and long-term, will depend on many factors, including: • the scope, progress, timing, costs and results of clinical trials of nalbuphine ER for the treatment of pruritus associated with prurigo nodularis, including the results of the sample size re-estimation for our ongoing Phase 2b/3 PRISM trial that we expect will take place in mid-2020 as well as the scope, progress, timing, costs and results of clinical trials of nalbuphine ER for other serious neurologically mediated conditions, including our ongoing Phase 2 trial for chronic cough in patients with IPF, as well as any future product candidates; • the number and characteristics of indications for which we seek to develop nalbuphine ER or any future product candidates, and their respective development requirements; • the outcome, timing and costs of clinical and nonclinical trials and of seeking regulatory approvals, including the costs of supportive clinical studies such as our planned human abuse liability study and our planned Thorough QT studies; • the costs associated with the manufacture of necessary quantities of nalbuphine ER or any future product candidate for clinical development in connection with regulatory submissions; • the costs of commercialization activities for nalbuphine ER for the treatment of pruritus associated with prurigo nodularis or for any other serious neurologically mediated conditions or for any future product candidates that receive marketing approval, if any, including the costs and timing of establishing product sales, marketing, distribution and manufacturing capabilities; • subject to receipt of marketing approvals, revenue, if any, received from commercial sales of nalbuphine ER for the treatment of pruritus associated with prurigo nodularis or for any other serious neurologically mediated conditions or from any future product candidates; • our ability to identify potential collaborators for nalbuphine ER for the treatment of pruritus associated with prurigo nodularis or for any future product candidates and the terms and timing of any collaboration agreement that we may establish for the development and any commercialization of such product candidates; • the extent to which we acquire or in-license rights to other potential product candidates or technologies, and the terms and timing of any such acquisition or licensing arrangements; • our headcount growth and associated costs as we expand our research and development activities and establish a commercial infrastructure; • the costs of preparing, filing and prosecuting patent applications, maintaining, expanding and protecting our intellectual property rights and defending against intellectual property-related claims; • the effect of competing technological and market developments; • our ability to establish and maintain healthcare coverage and adequate reimbursement for our products; and • the costs of operating as a public company. We believe that our existing cash and cash equivalents will enable us to fund our operating expenses and capital expenditure requirements into the third quarter of 2021. We have based our estimates as to how long we expect we will be able to fund our operations on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we currently expect, in which case we would be required to obtain additional financing, which 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 our business strategy. We do not have any committed external source of funds. Accordingly, we will be required to obtain further funding through public or private equity offerings, debt financings, collaborations and licensing arrangements or other sources to complete the clinical development and commercialization of nalbuphine ER for pruritus associated with prurigo nodularis or any other indication. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing into which we enter would result in fixed payment obligations and may involve agreements that include grants of security interests on our assets and restrictive covenants that limit our ability to take specific actions, such as incurring additional debt, making capital expenditures, granting liens over our assets, redeeming stock or declaring dividends, that could adversely impact our ability to conduct our business. Any debt financing or additional equity that we raise may contain terms that could adversely affect our common stockholders. If we are unable to raise sufficient capital as and when needed, we may be required to delay, reduce or abandon our product development programs or commercialization efforts. If we raise additional funds through collaborations or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to future revenue streams or product candidates or grant licenses on terms that may not be favorable to us. Critical Accounting Policies and Use of Estimates Our financial statements have been prepared in accordance with U.S. 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 expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in the Notes to our financial statements, 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. Nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities are deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. We have entered into agreements with CROs, contract manufacturing organizations and other companies. 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. The estimated costs of research and development provided, but not yet invoiced, are included in accrued expenses on our consolidated 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 CROs, contract manufacturing organizations and other companies under these arrangements in advance of the performance of the related services are recorded as prepaid expenses. Stock-Based Compensation Expense We account for stock-based compensation arrangements with employees in accordance with ASC 718, Stock Compensation, or ASC 718. ASC 718 requires the recognition of compensation expense, using a fair value based method, for costs related to all stock-based payments, including stock options. Our determination of the fair value of stock options on the date of grant utilizes the Black-Scholes option pricing model for stock options with time-based vesting, and is impacted by our common stock price as well as changes in assumptions regarding a number of complex and subjective variables. These variables include expected term that options will remain outstanding, expected common stock price volatility over the term of the option awards, risk-free interest rates and expected dividends. We have awarded stock options to non-employees for consultancy services. We have adopted new guidance, effective as of January 1, 2018, which requires that non-employee share-based payment transactions be measured at the grant-date fair value and no longer remeasured at the then-current fair values at each reporting date until the stock options have vested. The fair value of an option award is recognized over the period during which the 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. 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 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-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. 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. The following assumptions were used to calculate the fair value of awards granted during the periods indicated: We will continue to use judgment in evaluating the expected volatility, expected terms and interest rates utilized for our stock-based compensation expense calculations on a prospective basis. Stock-based compensation expense, is reflected in the statements of operations and comprehensive loss as follows (in thousands): As of December 31, 2019, total unrecognized stock-based compensation was $3.9 million, which is expected to be recognized over the remaining vesting period of 3.0 years. The intrinsic value of all outstanding stock options as of December 31, 2019 was approximately $0.9 million based on a common stock fair value of $3.75 per share, which was the closing price of our common stock on the Nasdaq Global Market on December 31, 2019. Common Stock Valuations Prior to our IPO in May 2019, 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 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. In the absence of a public trading market for our common stock prior to our IPO in May 2019, 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. As is provided for in Section 409A of the Internal Revenue Code of 1986, as amended, or the Code, we generally relied on our valuations for up to twelve months unless we had experienced a material event that would have affected the estimated fair value of our common stock. Our valuations of our common stock prior to our IPO in May 2019 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, or 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. The assumptions used to determine the estimated fair value of our common stock were based on numerous objective and subjective factors, combined with management 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 convertible preferred stock relative to those of our common stock; the prices at which we sold shares of our 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. 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: • Option Pricing Method, or OPM-The OPM treats common stock and convertible 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 exceed the value of the liquidation preferences at the time of a liquidity event, such as a strategic sale or 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 convertible preferred stock liquidation preference is paid. The OPM uses the Black-Scholes option-pricing model to price the call options. This model defines the securities’ fair values as functions of the current fair value of a company and uses assumptions, such as the anticipated timing of a potential liquidity event and the estimated volatility of the equity securities. • Probability Weighted Expected Return Method, or PWERM-Under the PWERM methodology, the fair value of common stock is estimated 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. • Hybrid Method-The hybrid method is a PWERM where the equity value in one of the scenarios is calculated using an OPM. In the hybrid method used by us, we considered an IPO, as the other potential future liquidity event. The equity value for the IPO scenario was determined using the guideline public company, or GPC, method under the market approach. The relative probability of the IPO scenario was determined based on an analysis of market conditions at the time and our expectations as to the timing and likely prospects of the IPO at each valuation date. In our application of the GPC method, we considered publicly traded companies in the biopharmaceutical industry that had a similar profile to ours as well as recently completed IPOs as indicators of our estimated future value in an IPO. We then discounted that future value back to the valuation date at an appropriate discount rate. Based on our early stage of development and other relevant factors, our board of directors determined that the OPM was the most appropriate method for allocating our enterprise value to determine the estimated fair value of our common stock for the valuation performed for December 2017, which resulted in our board of directors determining that the fair value of our common stock was $3.33. Following its determination in early 2018 that we should explore a potential IPO, our board of directors determined that the Hybrid Method was the most appropriate method for allocating our enterprise value to determine the estimated fair value of our common stock for valuations performed for April 2018, September 2018 and December 2018, which resulted in the fair value of our common stock being $6.65, $9.12 and $9.31, respectively. In determining the estimated fair value of our common stock prior to our IPO in May 2019, our board of directors also considered the fact that our stockholders could not freely trade our common stock in the public markets. Accordingly, our board of directors 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. Subsequent to the completion of our IPO in May 2019, the fair value of our common stock has been determined based on the closing price of our common stock as reported on the date of grant on the primary stock exchange on which our common stock is traded. Income Taxes We provide for income taxes under the asset and liability method. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Deferred income tax assets and liabilities are determined based on differences between the financial statement reporting and tax bases of assets and liabilities and net operating loss and credit carryforwards, and are measured using the enacted tax rates and laws that will be in effect when such items are expected to reverse. Deferred income tax assets are reduced, as necessary, by a valuation allowance when management determines it is more likely than not that some or all of the tax benefits will not be realized. We account for uncertain tax positions in accordance with ASC 740, Accounting for Uncertainty in Income Taxes, or ASC 740. 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 $33.3 million. Due to our lack of earnings history and uncertainties surrounding our ability to generate future taxable income, 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 loss, or NOL, carryforwards; which totaled approximately $106.8 million at December 31, 2019. Due to our Series A preferred stock financing in December 2012 and the shares we issued in connection with our IPO in May 2019, we were subject to an “ownership change” under Section 382 of the Code. As a result, our ability to use $91.3 million of these NOL carryforwards is limited. We may experience further ownership changes in the future as a result of subsequent shifts in our stock ownership, some of which may be outside of our control. If a further ownership change occurred, our ability to use our NOL carryforwards might be further limited. Fair Value Measurements Our financial instruments have consisted of cash and cash equivalents, income tax receivable, accounts payable, accrued expenses, term loan payable, Series C redeemable convertible preferred stock liability and obligation for loan success fee. Fair value estimates of these instruments are made at a specific point in time, based on relevant market information. The carrying amounts of cash and cash equivalents, income tax receivable, accounts payable and accrued expenses are generally considered to be representative of their respective fair values because of the short term nature of those instruments. The fair value of the obligation for loan success fee has been estimated utilizing a probability-weighted income approach, including variables for the timing of the success event and other probability estimates. The fair value of Series C redeemable convertible preferred stock liability has been estimated as the excess, if any, of the fair value of our Series C preferred stock over the purchase price of any outstanding tranches that may be sold pursuant to our stock purchase agreement referred to in “-Components of Operating Results-Other Income (Expense), Net-Change in Fair Value of Series C Redeemable Convertible Preferred Stock Liability”. Current accounting guidance defines fair value, establishes a framework for measuring fair value in accordance with ASC 820, Fair Value Measurements and Disclosures, and requires certain disclosures about fair value measurements. The valuation techniques included in the guidance are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect market assumptions and are classified into the following fair value hierarchy: • Level 1-Observable inputs-quoted prices in active markets for identical assets or liabilities. • Level 2-Observable inputs other than the quoted prices in active markets for identical assets and liabilities-such as quoted prices for similar instruments, quoted prices for identical or similar instruments in inactive markets, or other inputs that are observable or can be corroborated by observable market data. • Level 3-Unobservable inputs-includes amounts derived from valuation models where one or more significant inputs are unobservable and require the company to develop relevant assumptions. 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. See Note 14 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for discussion regarding our commitments and contingent commitments. JOBS Act Accounting Election The Jumpstart Our Business Startups Act of 2012, as amended, or JOBS Act, permits emerging growth companies such as us to 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 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. Recently Adopted Accounting Pronouncements In February 2016, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2016-02 titled Leases, or ASU 2016-02, which requires rights and obligations arising from both operating and capital leases to be reported on the Consolidated Balance Sheet, and to disclose quantitative and qualitative information about lease transactions (such as information about variable lease payments and options to renew and terminate leases). ASU 2016-02 was effective for fiscal years beginning after December 15, 2018, with early adoption permitted. We adopted this new guidance as of January 1, 2019, which included an assessment of the impact of the new guidance on the consolidated financial statements. We utilized the transition practical expedient added by the FASB, which eliminated the requirement that entities apply the new lease standard to the comparative periods presented in the year of adoption. We elected to use the package of practical expedients that allowed us to not reassess: (1) whether any expired or existing contracts were or contained leases, (2) lease classification for any expired or existing leases and (3) initial direct costs for any expired or existing leases. We used the practical expedient that allows lessees to treat the lease and non-lease components of leases as a single lease component. The adoption of this standard resulted in the recognition of a right-of-use asset of $379 and related lease liabilities of $424 related to our operating lease commitments on the Consolidated Balance Sheet as of January 1, 2019 (Note 4). The impact of adoption of the new leasing standard did not have a material impact on the Consolidated Statement of Operations during the year ended December 31, 2019. Recently Issued Accounting Pronouncements In December 2019, the FASB issued ASU 2019-12, Simplifying the Accounting for Income Taxes. The list of changes is comprehensive and many will not have a significant effect on our consolidated financial reporting. The changes include removing exceptions to incremental intraperiod tax allocation of losses and gains from different financial statement components, exceptions to the method of recognizing income taxes on interim period losses and exceptions to deferred tax liability recognition related to foreign subsidiary investments. In addition, ASU 2019-12 requires that entities recognize franchise tax based on an incremental method, requires an entity to evaluate the accounting for step-ups in the tax basis of goodwill as inside or outside of a business combination, and removes the requirement to allocate the current and deferred tax provision among entities in stand-alone financial statement reporting. ASU 2019-12 also now requires that an entity reflect enacted changes in tax laws in the annual effective rate, and other codification adjustments have been made to employee stock ownership plans. For public business entities, the amendments in ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption of ASU 2019-12 is permitted, including adoption in any interim period for public business entities for periods for which financial statements have not yet been issued. An entity that elects to early adopt the amendments in an interim period should reflect any adjustments as of the beginning of the annual period that includes that interim period. Additionally, an entity that elects early adoption must adopt all the amendments in the same period. We are currently evaluating whether to early adopt ASU 2019-12 in the first interim period of the year ending December 31, 2020. In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments, which changes the way credit losses on certain financial instruments are estimated. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. We do not expect that the adoption of ASU 2016-13 will have a material effect on our Consolidated Financial Statements.

<s>[INST] Our actual results and timing of certain events may differ materially from the results discussed, projected, anticipated, or indicated in any forwardlooking statements. We caution you that forwardlooking statements are not guarantees of future performance and that our actual results of operations, financial condition and liquidity, and the development of the industry in which we operate may differ materially from the forwardlooking statements contained in this Annual Report on Form 10K. Statements made herein are as of the date of the filing of this Annual Report on Form 10K with the SEC and should not be relied upon as of any subsequent date. Even if our results of operations, financial condition and liquidity, and the development of the industry in which we operate are consistent with the forwardlooking statements contained in this Annual Report on Form 10K, they may not be predictive of results or developments in future periods. 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. 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. Overview We are a clinicalstage biopharmaceutical company focused on the development and commercialization of nalbuphine ER to treat serious neurologically mediated conditions. We are developing nalbuphine ER for the treatment of chronic pruritus, chronic cough in patients with idiopathic pulmonary fibrosis, or IPF, and levodopainduced dyskinesia, or LID, in patients with Parkinson’s disease. We are conducting a Phase 2b/3 clinical trial of nalbuphine ER, which we refer to as the PRISM trial, in patients with severe pruritus associated with prurigo nodularis. The PRISM trial is a randomized, doubleblind, placebo controlled, twoarm treatment study that is designed to evaluate the safety and antipruritic efficacy of nalbuphine ER in approximately 240 patients in the United States and Europe. To date, we have enrolled approximately 45% of the target number of patients. The pace of enrollment has been slower than anticipated primarily due to competition from other clinical trials and slower than planned site startups in Europe. We expect to report topline data from the 14week blinded treatment period of the PRISM trial in the second half of 2020. Additionally, the protocol for the PRISM trial provides for a sample size reestimation analysis once 50% of the patients in the trial are evaluable for the primary endpoint. We expect to reach 50% patient enrollment during the second quarter of 2020. Once all of these patients complete the primary efficacy endpoint, the sample size reestimation analysis will occur. We expect this analysis will occur in mid2020. If we increase the target number of patients in the trial as a result of the reestimation analysis, the timing of our report of topline data may be delayed. We are also conducting a Phase 2 clinical trial of nalbuphine ER for chronic cough in patients with IPF. This Phase 2 clinical trial is a randomized, doubleblind, placebo controlled, twotreatment, twoperiod, crossover study designed to evaluate the efficacy, safety, tolerability and dosing of nalbuphine ER for chronic cough in up to 56 patients with IPF in the United Kingdom. We expect to report topline data from the trial in the second half of 2020. In addition, we are conducting a Phase 1b clinical trial in patients with chronic liver disease to evaluate the safety and pharmacokinetics, or PK, of nalbuphine ER in this population. This trial was designed as an open label, nonrandomized, parallelgroup, single and multiple ascending dose pharmacokinetic trial in patients with mild, moderate and severe hepatic impairment. We completed the single ascending dosing portion of this trial in patients with mild and moderate hepatic impairment and there were no serious adverse events reported in the trial. After reviewing the [/INST] Positive. </s>