Note 9 – Subsequent Event

We evaluated all events or transactions that occurred after September 30, 2014 up through the date we issued these financial statements.  During this period, we noted one non-recognized subsequent events as described below:

On October 10, 2014, we entered into the Collaboration Agreement with Battelle providing for the further development of our CAG for potential use in our planned phase 3 clinical program for AEROSURF for the treatment of RDS in premature infants and, if AEROSURF is approved for commercial sale by the FDA or other regulatory authority, initial commercial supply.

Pursuant to the Collaboration Agreement, we and Battelle will work together to (i) define the requirements of the phase 3 CAG and disposable dose packs (together, AEROSURF System) and a detailed project plan for the project (Stage 1), (ii) develop the AEROSURF System in accordance with the project plan (Stage 2), and (iii) complete all required testing, verification and documentation to be in a position to manufacture AEROSURF Systems (Stage 3).  Upon completion of the three-stage project plan, we and Battelle intend to negotiate in good faith to enter into an agreement for the manufacture of AEROSURF Systems for the AEROSURF phase 3 clinical program, and, if AEROSURF is approved, to negotiate in good faith to enter into a supply agreement providing for an initial commercial supply of AEROSURF Systems.

A Steering Committee, comprised of an equal number of members appointed by each party, will oversee the work of the project and attempt to reach consensus on the handling of all matters referred to it.  The foregoing notwithstanding, we will retain final decision-making authority on all matters related to the design, registration, manufacture, packaging, marketing, distribution and sale of the AEROSURF Systems.  We and Battelle will share equally in the costs of Stage 1 activities.  Following completion of Stage 1, we and Battelle will agree on the details and projected costs for Stages 2 and 3.  The parties will share equally in the costs of the project plan for Stages 2 and 3 as set forth in the project plan.  Battelle will bear the entire cost of any cost overruns associated with execution of the project plan and we will bear the entire cost of any increase in the agreed upon project plan costs resulting from changes in the scope of the product requirements as agreed in Stage 1 and set forth in the project plan.

In connection with the Collaboration Agreement, on October 10, 2014, we issued to Battelle two warrants to purchase shares of our common stock, each having an exercise price of $5.00 per share and a term of 10 years, subject to earlier termination under certain circumstances set forth therein, including (i) a warrant to purchase up to 1.0 million shares of our common stock, exercisable upon successful completion by Battelle of the Stage 3 activities (Initial Warrant), and (ii) a warrant to purchase up to 0.5 million shares of our common stock (Additional Warrant; and together with the Initial Warrant, the Battelle Warrants), exercisable if and only if Battelle successfully completes the Stage 3 activities no later than May 31, 2016, which date may be adjusted as provided in the Collaboration Agreement.  We and Battelle have agreed to execute a registration rights agreement providing for the registration of the resale of shares underlying the Battelle Warrants.  The Battelle Warrants may be exercised for cash only, except that, in the event a registration statement is not effective at the time of exercise and if an exemption from registration is otherwise available at that time, the Battelle Warrants may be exercised on a cashless basis.  The Battelle Warrants were issued pursuant to an exemption from registration contained in Regulation D, Rule 506.

In addition to the Battelle Warrants, if Battelle successfully completes the Stage 3 activities, we have agreed to pay Battelle royalties equal to a low single-digit percentage of the worldwide net sales and license royalties on sales of AEROSURF for the treatment of RDS in premature infants, up to an aggregate limit of $25 million.

The term of the Collaboration Agreement will end at the time we fulfill our payment obligations to Battelle, except that the Collaboration Agreement may be terminated by a party under certain circumstances, including (i) a declaration of bankruptcy by either party, (ii) a "failure of purpose" as defined in the Collaboration Agreement, including without limitation, a good faith determination by the parties that the objectives of the AEROSURF clinical program, the FDA registration of AEROSURF, or the expected outcomes of the project plan cannot be achieved, or (iii) a material breach by either party.

 

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ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Some of the information contained in this discussion and analysis or set forth elsewhere in this Quarterly Report on Form 10‑Q, including information with respect to our plans and strategy for our business and related financing activities, includes forward-looking statements that involve risks and uncertainties.  You should review the “Forward-Looking Statements” section, and the risk factors discussed in the “Risk Factors” section and elsewhere in this Quarterly Report on Form 10-Q, as well as in our Annual Report on Form 10-K for the year ended December 31, 2013 that we filed with the Securities and Exchange Commission (SEC) on March 17, 2014 (2013 Form 10-K ) and our other filings with the SEC, and any amendments thereto, 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 or elsewhere in this Quarterly Report on Form 10-Q.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is provided as a supplement to the accompanying interim unaudited consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and our results of operations.  This item should be read in connection with our accompanying interim unaudited consolidated financial statements (including the notes thereto).

OVERVIEW

Discovery Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a specialty biotechnology company focused on creating life-saving products for critical-care patients with respiratory disease and improving the standard of care in pulmonary medicine.  Our proprietary drug technology produces a synthetic, peptide-containing surfactant (KL 4 surfactant) that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for normal respiratory function and survival.  We are developing our KL 4 surfactant in liquid, lyophilized and aerosolized dosage forms.  We are also developing novel drug delivery technologies and devices potentially to enable efficient delivery of our aerosolized KL 4 surfactant.  We believe that our proprietary technologies may make it possible, for the first time, to develop a significant pipeline of products to address a variety of respiratory diseases for which there frequently are few or no approved therapies.

We are initially focused on improving the management of respiratory distress syndrome (RDS) in premature infants.  RDS is a serious respiratory condition caused by insufficient surfactant production in underdeveloped lungs of premature infants.  RDS is the most prevalent respiratory disease in the Neonatal Intensive Care Unit (NICU) and can result in long-term respiratory problems, developmental delay and death.  Our first KL 4 surfactant drug product, SURFAXIN ® (lucinactant) Intratracheal Suspension for the prevention of RDS in premature infants at high risk for RDS, was approved by the United States Food and Drug Administration (FDA) and has been commercially available in the U.S. since November 2013.  SURFAXIN is our KL 4 surfactant in liquid form, and is the first synthetic, peptide-containing surfactant approved by the FDA and the only alternative to animal-derived surfactants currently available in the United States (U.S.).

Premature infants with severe RDS currently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may result in serious respiratory conditions and other complications.  To avoid such complications, many neonatologists initially treat infants with less severe RDS by less invasive means, typically nasal continuous positive airway pressure (nCPAP).  Unfortunately, a significant number of premature infants on nCPAP will not respond well (an outcome referred to as nCPAP failure) and thereafter may require endotracheal intubation, mechanical ventilation, and delayed surfactant therapy.  Since neonatologists currently cannot predict which infants will experience nCPAP failure, neonatologists are faced with difficult choices in treating infants with less severe RDS.  This is because the medical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for infants who receive surfactant therapy in the first hours of life.

AEROSURF ® is our investigational combination drug/device product that combines our KL 4 surfactant with our proprietary capillary aerosol generator (CAG).  AEROSURF potentially will enable administration of aerosolized KL 4 surfactant to premature infants supported with nCPAP, without invasive intubation and mechanical ventilation.  By enabling delivery of our KL 4 surfactant using less invasive procedures, we believe that AEROSURF may address a serious unmet medical need and potentially enable the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but are currently not treated.

We are also developing a lyophilized (freeze-dried) dosage form of our KL 4 surfactant that is stored as a powder and reconstituted to liquid form prior to use with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are initially developing this dosage form for use in our AEROSURF development program.  We are also engaged in discussions with the FDA to determine if we could gain marketing authorization for a lyophilized dosage form of our KL 4 surfactant under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS™, in the U.S. and potentially in other markets.

 

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To support the commercial introduction of SURFAXIN in the U.S. and our other KL 4 surfactant pipeline products, if approved, we have our own specialty respiratory critical care commercial and medical affairs team.  This team includes medical professionals with experience in neonatal/pediatric respiratory critical care, and is focused on products that address neonatal indications, beginning with SURFAXIN.  We believe that this team will be able to efficiently introduce our other KL 4 surfactant products under development, if approved, including AEROSURF and potentially SURFAXIN LS and future applications of our aerosolized KL 4 surfactant.  In addition, we recognize that our commercial and medical affairs team could potentially support introductions of other synergistic pipeline products, including products owned or developed by third parties for the NICU/PICU.  To that end, in appropriate circumstances, we may consider potential transactions focused on securing commercial rights to such synergistic products, including in the form of product acquisitions, in-licensing agreements or distribution, marketing or co-marketing arrangements.

We expect in the future that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to develop a product pipeline to address serious critical care respiratory conditions in children and adults in pediatric and adult intensive care units (PICUs and ICUs), including potentially acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  At the present time, we are concentrating our efforts primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have advanced these objectives, we expect to be in a better position to assess the potential of other development programs to address the critical care needs of patients in the PICU and ICU.

Business and Pipeline Programs Update

The reader is referred to, and encouraged to read in its entirety “Item 1 – Business,” in our 2013 Form 10-K, which contains a discussion of our Business and Business Strategy, as well as information concerning our proprietary technologies and our current and planned KL 4 pipeline programs.

Following are updates to our products and pipeline programs since the filing of our 2013 Form 10-K:

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SURFAXIN is the first synthetic, peptide-containing surfactant approved by the FDA and the first such alternative to animal-derived surfactants.  We initiated the commercial introduction of SURFAXIN in late 2013.  Our commercial and medical teams are working to secure formulary acceptance with hospitals that we believe to be recognized centers of excellence with strong reputations and regional and national influence in the neonatal community, as well as affiliated and regional hospitals.  Although not an indicator or predictor of revenue, in most cases, formulary acceptance is a necessary prerequisite to be able to sell SURFAXIN drug product to a hospital.  We believe that gaining acceptance with such centers of excellence could enhance our ability to gain acceptance at other regional and national medical centers.  We also are focused on providing in-service training to hospitals to assure that SURFAXIN is administered in a safe and consistent manner.

Our experience has suggested that the introduction of our hospital-based products, through the formulary acceptance process, pharmacy intake, delivery to NICUs, in-servicing and training, and actual use, is and will continue to be a lengthy process, and subject to a variety of potential delays and other factors not within our control.  For that reason, we anticipate that revenues from sales of SURFAXIN will be modest in the next several years.  In addition, to better inform the formulary committee review process and properly explain the method of administration and the potential benefits of SURFAXIN, including both potential medical and pharmacoeconomic benefits, we adjusted our approach to emphasize primarily medical education and scientific discussions in our formulary process.  To accomplish this shift, as previously reported, in the second quarter of 2014, we resized and realigned our commercial and medical affairs teams.

We plan to continue to monitor and learn from our progress, and routinely will reassess and adjust our tactical plan and make appropriate additional investments, if needed, to maximize formulary acceptance and SURFAXIN sales revenue.  There can be no assurance, however, that we will succeed in these efforts.

AEROSURF:  We are conducting a phase 2a clinical trial for AEROSURF at four sites and currently are in the second half of our planned enrollments.  This initial trial is an open label, single-dose study with the primary goal of evaluating the safety and tolerability of aerosolized KL 4 surfactant drug product administered in escalating inhaled doses in 42 premature infants 29 to 34 weeks gestational age (GA) who are receiving nasal continuous positive airway pressure (nCPAP) for respiratory distress syndrome (RDS), compared to infants receiving nCPAP alone.  In addition, we hope to demonstrate that drug is being effectively delivered into the lungs.  Overall, the rates of enrollment have been slower than expected.  We also have implemented preparatory activities for the planned phase 2b clinical trial and, through this process, have identified four new clinical sites that will begin enrolling patients in the phase 2a clinical trial beginning in November 2014.  We expect that these eight sites, based on their experience and knowledge of AEROSURF from the phase 2a program, will be positioned to be transitioned to the next phase of the clinical program.  Based upon our most recent assessment of the clinical trial plan, we now anticipate completion of the phase 2a clinical trial in the first quarter of 2015, and completion of the phase 2b clinical trial in the first half of 2016.

 

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Manufacturing:  We continue to focus on implementing a long-term manufacturing strategy to assure continuity of our KL 4 surfactant drug and medical device supply and are pursuing several alternatives.

For SURFAXIN, our approved KL 4 surfactant in liquid form, we are actively engaged in discussions with the landlord of our manufacturing facility in Totowa, NJ (Totowa Facility) potentially to secure an extension of our lease, which currently is scheduled to expire on June 30, 2015.  At the present time, our Totowa Facility is the only approved manufacturing facility for SURFAXIN commercial product.  We understand that the landlord is pursuing strategic options for the entire facility.  We are also pursuing potentially manufacturing SURFAXIN using third-party contract manufacturing organizations (CMOs).  At this time, however, we are unable to complete a technology transfer of our SURFAXIN liquid KL 4 surfactant manufacturing process in time to secure FDA approval for a new manufacturer of SURFAXIN prior to the scheduled expiration date of our lease.  Accordingly, our primary goal is to secure longer-term utilization of our Totowa Facility.  We cannot provide any assurance that we will be successful.  If we do not succeed, we most likely will experience an interruption in supply of SURFAXIN drug product. See, Item 1A “–Risk Factors.”

 

We are working with Patheon Manufacturing Services LLC (Patheon, formerly DSM Pharmaceuticals, Inc.) to complete a technology transfer of our lyophilized KL 4 surfactant manufacturing process and complete early manufacturing development activities for our lyophilized KL 4 surfactant.  Patheon successfully manufactured a sufficient supply of lyophilized KL 4 surfactant drug product to support our preclinical drug development activities, development activities for our phase 2 clinic-ready CAG, as well as our ongoing phase 2a clinical trial.  We are working with Patheon to manufacture additional clinical supply to support our phase 2b clinical trial and have entered into a development agreement for the potential further development and manufacture of lyophilized KL 4 surfactant for our potential AEROSURF phase 3 clinical program, as well as other potential pipeline development programs.  In addition, we are advised that Patheon intends to close the building in which our development activities have occurred.  As a result, we are implementing a technology transfer of our lyophilized KL 4 surfactant manufacturing process to a new location in the Patheon campus in anticipation of manufacturing our lyophilized KL 4 surfactant for use in our planned phase 3 clinical trial.

 

 

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In the second quarter of 2014, we secured three additional patents in the U.S., including two patents containing composition of matter and method of making claims for our lyophilized KL 4 surfactant, which extend to March 2033, and one related to our novel AFECTAIR ® aerosol-conducting airway connector for infants that extends to April 2029.  In the third quarter of 2014, we have begun the process to prosecute these patents in various other countries.  We believe that these patents are indicative of our efforts to protect the long-term commercial potential of our KL 4 surfactant and aerosol delivery technologies.  Our lyophilized KL 4 surfactant is being developed initially for our AEROSURF development program.  Our longer-term goal is to develop our technologies to address other potential indications that could benefit from our proprietary KL 4 surfactant.

CRITICAL ACCOUNTING POLICIES

There have been no changes to our critical accounting policies since December 31, 2013.  For a discussion of our accounting policies, see , Note 3, “Accounting Policies and Recent Accounting Pronouncements,” to the consolidated financial statements in our 2013 Form 10-K.  Readers are encouraged to review those disclosures in conjunction with this Quarterly Report on Form 10-Q.

Recent accounting pronouncements

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09,   Revenue from Contracts with Customers , which requires an entity to recognize revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for transferring goods or services to customers.  The ASU will replace most existing revenue recognition guidance in U.S. generally accepted accounting principles (GAAP) when it becomes effective.  The new standard is effective for us in the annual period ending December 31, 2017 , including interim periods within that annual period .  Early application is not permitted.  We are evaluating the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures.  The standard permits the use of either the retrospective or cumulative effect transition method.  We have not yet selected a transition method nor determined the effect of the standard on our financial reporting.

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements – Going Concern , which requires management to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern and, if so, disclose that fact.  Management will also be required to evaluate and disclose whether its plans alleviate that doubt.  The standard defines substantial doubt as when it is probable (i.e., likely) that the entity will be unable to meet its obligations as they become due within one year of the date the financial statements are issued (or available to be issued, when applicable).  The ASU is effective for the annual period ending December 31, 2016 and interim periods thereafter .  Early application is permitted.  We are evaluating the effect that ASU 2014-15 will have on our consolidated financial statements and related disclosures.  The standard permits the use of either the retrospective or cumulative effect transition method.  We have not yet selected a transition method nor determined the effect of the standard on our financial reporting.

RESULTS OF OPERATIONS

Net Loss and Operating Loss

The net loss for the three months ended September 30, 2014 and 2013 was $11.3 million (or $0.13 basic net loss per share) and $12.2 million (or $0.22 basic net loss per share), respectively.  Included in the net loss is (i) the change in fair value of certain common stock warrants classified as derivative liabilities, resulting in non-cash income of $0.2 million and non-cash expense of $1.1 million for 2014 and 2013, respectively, and (ii) interest expense of $1.2 million and $0.4 million for 2014 and 2013, respectively, associated with the Deerfield Loan.

The net loss for the nine months ended September 30, 2014 and 2013 was $33.4 million (or $0.39 basic net loss per share) and $33.5 million (or $0.68 basic net loss per share), respectively.  Included in the net loss is (i) the change in fair value of certain common stock warrants classified as derivative liabilities, resulting in non-cash income of $2.0 million and $1.6 million for 2014 and 2013, respectively, and (ii) interest expense of $3.4 million and $0.9 million for 2014 and 2013, respectively, associated with the Deerfield Loan .

The operating loss for the three months ended September 30, 2014 and 2013 was $10.3 million and $10.8 million, respectively.  The decrease in operating loss from 2013 to 2014 was due to a $0.4 million increase in grant revenues.

 

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The operating loss for the nine months ended September 30, 2014 and 2013 was $32.0 million and $34.2 million, respectively.  The decrease in operating loss from 2013 to 2014 was due to a $1.2 million increase in grant revenues and a $0.9 million decrease in operating expenses .

Product Sales

In accordance with our revenue recognition policy, we recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.  For the three and nine months ended September 30, 2014, we recognized revenue in the amount of $106,000 and $176,000, respectively.  No product sales revenue was recognized for the three and nine months ended September 30, 2013.

Grant Revenue

We recognized grant revenue of $0.4 million and $1.5 million, respectively, for the three and nine months ended September 30, 2014.  During the second quarter of 2014, we were awarded the final $1.9 million of a $2.4 million Fast Track Small Business Innovation Research (SBIR) Grant from the National Heart, Lung, and Blood Institute (NHLBI) of the National Institutes of Health (NIH).  This award provides support for the ongoing phase 2a clinical trial for AEROSURF.  Our eligibility to be considered under this grant program was originally confirmed in 2010, and we previously received $0.6 million to support development activities related to our capillary aerosol generator technology.  We expect to utilize the balance of the grant in the fourth quarter of 2014.

We recognized grant revenue of $0.1 million and $0.3 million for the three and nine months ended September 30, 2013, respectively.  The grant funds were received and expended under a $0.6 million SBIR Phase I award from NIH’s National Institute of Allergy and Infectious Diseases (NIAID) Center for Medical Counter Measures Against Radiation and Nuclear Threats to assess the ability of KL 4 surfactant to mitigate the effects of acute radiation exposure to the lung, including acute pneumonitis and delayed lung injury.

During the third quarter of 2014, we were awarded a Phase II SBIR grant of $1.0 million from the National Institute of Allergy and Infectious Diseases (NIAID) of the NIH to support the development of our aerosolized KL 4 surfactant as a medical countermeasure to mitigate acute and chronic/late-phase radiation-induced lung injury.  Over the next three years, we may be awarded up to an additional $2.0 million as part of this grant.  We did not recognize any revenue from this grant during the quarter ended September 30, 2014.  We expect to utilize the $1.0 million grant beginning in the fourth quarter of 2014 through the first half of 2015.

Cost of product sales

Cost of product sales for the three and nine months ended September 30, 2014 was $0.3 million and $1.8 million, respectively, and primarily represents reserves for SURFAXIN finished goods inventories that are not anticipated to be recoverable through the commercial sale of the product during the initial launch period due to product expiration.

Research and Development Expenses

Our research and development expenses are charged to operations as incurred and are tracked by category rather than by development project.  As many of our research and development activities form a foundation for the development of our KL 4 surfactant and drug delivery technologies, they are expected to benefit more than a single project.  For that reason, we cannot reasonably estimate the costs of our research and development activities on a project-by-project basis.  We believe that tracking our expenses by category is a more accurate method of accounting for these activities.  Our research and development costs consist of expenses associated with (a) product development and manufacturing, (b) medical and regulatory operations, (c) direct preclinical and clinical programs, and (d) other related expenses.

 

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The table below summarizes research and development expenses for the periods presented:

Research and development expenses include non-cash charges associated with stock-based compensation and depreciation of $0.5 million and $0.4 million for the three months ended September 30, 2014 and 2013, respectively; and $1.4 million and $1.1 million for the nine months ended September 30, 2014 and 2013, respectively.

Product Development and Manufacturing

Product development and manufacturing includes (i)  manufacturing operations, both in-house and with CMOs, validation activities and quality assurance and analytical chemistry capabilities to support production of drug supply for our KL 4  surfactant products used in research and development activities, and of medical devices, including CAG and AFECTAIR devices, (ii) design and development activities related to our CAG device for use in our AEROSURF clinical program; and (iii) pharmaceutical and manufacturing development activities, including development of a lyophilized dosage form of our KL 4 surfactant.  These costs include employee expenses, facility-related costs, depreciation, costs of drug substances (including raw materials), supplies, quality control and assurance activities, analytical services, and expert consultants and outside services to support pharmaceutical and device development activities.

 

 

Medical and Regulatory Operations

Medical and regulatory operations includes (i) medical, scientific, clinical, regulatory, data management and biostatistics activities in support of our research and development programs , and (ii) medical affairs activities to provide scientific and medical education support related to SURFAXIN, as well as our other KL 4 surfactant and aerosol delivery products under development.  These costs include personnel, expert consultants, outside services to support regulatory and data management, symposiums at key medical meetings, facilities-related costs, and other costs for the management of clinical trials.

Medical and regulatory operations expenses for the three months ended September 30, 2014 increased $0.5 million compared to the same period in 2013 due to a $0.4 million increase in employee-related costs as we strengthen our clinical leadership team and regulatory capabilities to support our AEROSURF development program.

Medical and regulatory operations expenses for the nine months ended September 30, 2014 increased $1.4 million compared to the same period in 2013 due to (i) a $0.8 million increase in employee-related costs as we strengthen our clinical leadership team and regulatory capabilities to support our AEROSURF development program, and (ii) a $0.3 million increase related to our medical affairs capabilities to execute the commercial introduction of SURFAXIN .

 

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Direct Preclinical and Clinical Programs

Direct preclinical and clinical programs include: (i) development activities, toxicology studies and other preclinical studies to obtain data to support our investigational new drug (IND) applications and, potentially, New Drug Application (NDA) filings; and (ii) activities associated with conducting clinical trials, including patient enrollment costs, external site costs, clinical device and drug supply, and related external costs, such as research consultant fees and expenses.

Direct preclinical and clinical programs expenses for the three months ended September 30, 2014 increased $0.4 million compared to the same period in 2013 due to a $0.3 million increase in AEROSURF clinical trial activities, including ongoing enrollment of the Phase 2a study and initiating the manufacture of clinic-ready CAG devices for the planned AEROSURF Phase 2b clinical study.

Direct preclinical and clinical programs expenses for the nine months ended September 30, 2014 increased $1.4 million compared to the same period in 2013 due to (i) a $1.1 million increase in AEROSURF clinical trial activities, including ongoing enrollment of the Phase 2a study and initial manufacturing of clinic-ready CAG devices for the planned AEROSURF Phase 2b clinical study, and (ii) $0.5 million of preclinical activities in 2014 related to our lyophilized dosage form of our KL 4 surfactant .

We anticipate that our expected direct clinical program costs will increase over the next few years as we refine our plans following review of the results and learnings of our phase 2a program and execute the later stages of the planned AEROSURF clinical development program.

Research and Development Projects – Updates

Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, the nature, timing and costs of the efforts necessary to complete individual projects in development are not reasonably estimable.  With every phase of a development project, there are unknowns that may significantly affect cost projections and timelines.  In view of the number and nature of these factors, many of which are outside our control, the success, timing of completion and ultimate cost of development of any of our product candidates is highly uncertain and cannot be estimated with any degree of certainty.  Certain of the risks and uncertainties affecting our ability to estimate projections and timelines are discussed in the Risk Factors Section and elsewhere in this Quarterly Report on Form 10-Q and in “Item 1 – Business – Government Regulation,” “Item 1A – Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Research and Development Expenses” in our 2013 Form 10-K.

Our research and development projects have been focused initially on the management of RDS in premature infants, and include (i) SURFAXIN liquid instillate, which was approved by the FDA in 2012 and introduced commercially in 2013, (ii) our lyophilized KL 4 surfactant, which we are developing initially for use in our AEROSURF development program and, if we are able to gain FDA agreement for a development program that would be both capital efficient and capable of implementation within a reasonable time, potentially, SURFAXIN LS; (iii) our aerosol delivery technology, in particular the development of a CAG device to support our AEROSURF phase 2 clinical program; and (iv) AEROSURF phase 2 clinical trial activities and preparatory work for the planned AEROSURF phase 3 clinical program.  These and our other development programs are described “Item 1 – Business – Proprietary Platform – Surfactant and Aerosol Technologies,” and “‑ Surfactant Replacement Therapy for Respiratory Medicine” in our 2013 Form 10-K, and in our other periodic filings with the SEC.

To prepare for initiation of our planned AEROSURF phase 2b clinical trial and the phase 3 clinical program, we plan to make additional investments in our development capabilities, including for manufacturing development of our lyophilized KL 4 surfactant, further development of a CAG device under our collaboration with Battelle, and the conduct of the planned clinical trials.   In particular, we anticipate that direct clinical program costs for AEROSURF will increase significantly over the next few years as we refine our plans following review of the results and learnings of our phase 2a program and execute the later stages of the planned AEROSURF clinical development program .

At the present time, we are focusing our efforts primarily on the commercial introduction of SURFAXIN and the development of AEROSURF through the phase 2 clinical trials to the planned phase 3 clinical program.  We believe, however, that in the future we may be able to leverage the information, data and know-how that we gain from our work with SURFAXIN and AEROSURF to support development of a robust product pipeline that could address serious critical care respiratory conditions in larger children and adults in PICUs and ICUs, including potentially ALI, COPD and CF.

The reader is referred to and encouraged to review updates to the Pipeline Programs in “– Overview,” and “– Business and Pipeline Programs Update” at the beginning of this MD&A, which are incorporated herein and contain important updates and information necessary and important to this discussion.  See also, “– Liquidity and Capital Resources.”

 

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Selling, general and administrative expenses consist of the costs of sales and marketing activities, executive management, business development, intellectual property, finance and accounting, legal, human resources, information technology, facilities and other administrative costs.

We account for common stock warrants in accordance with applicable accounting guidance provided in Accounting Standards Codification ( ASC) Topic 815 “Derivatives and Hedging – Contracts in Entity’s Own Equity” (ASC 815) , either as derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.  Derivative warrant liabilities are valued at the date of initial issuance and as of each subsequent balance sheet date using the Black-Scholes or trinomial pricing models, depending on the terms of the applicable warrant agreement.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in the fair value of common stock warrant liability.”  See, Note 6, “– Common Stock Warrant Liability,” in the Notes to Consolidated Financial Statements (unaudited) in this Quarterly Report on Form 10-Q, and “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Change in Fair Value of Common Stock Warrant Liability” our 2013 Form 10-K.

Changes in the fair value of common stock warrant liability generally are due to changes in our common stock share price during the periods.

Interest income consists of interest earned on our cash and cash equivalents.  To ensure preservation of capital, we invest our cash in an interest bearing operating cash account and a U.S. treasury-based money market fund.

Interest expense consists of interest expense associated with the Deerfield Loan ( s ee,   Note 7, “– Deerfield Loan,”   in the Notes to Consolidated Financial Statements (unaudited) in this Quarterly Report on Form 10-Q ) and interest expense incurred under our equipment financing facilities.  Amounts outstanding under the Deerfield Loan as of September 30, 2014 and 2013 were $30.0 million and $10.0 million, respectively.

 

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The following amounts comprise the Deerfield Loan interest expense for the periods presented:

Cash interest expense represents interest at an annual rate of 8.75% calculated on the outstanding principal amount for the period, paid in cash on a quarterly basis.  Non-cash amortization of debt discount represents the amortization of transaction fees and the fair value of the Deerfield Warrants.  The amortization of debt costs represents professional fees incurred in connection with the Deerfield Loan.

LIQUIDITY AND CAPITAL RESOURCES

Overview

We have incurred substantial losses since inception, due to investments in research and development, manufacturing, and, more recently, commercialization and medical affairs activities, and we expect to continue to incur substantial losses over the next several years.  Historically, we have funded our business operations through various sources, including public and private securities offerings, debt facilities, strategic alliances, the use of committed equity financing facilities (CEFFs) and at-the-market (ATM) equity programs, and capital equipment financings.

As of September 30, 2014, we had cash and cash equivalents of $ 54.9 million and long-term debt of $30 million ($ 19.8 million net of discount) under our loan with affiliates of Deerfield Management Company, L.P. (Deerfield) ( see, Note 7, “– Deerfield Loan,” in the Notes to Consolidated Financial Statements (unaudited) in this Quarterly Report on Form 10-Q).  Before any additional financings, including under our ATM Program ( see , Note 11 - “At-the-Market Program (ATM Program),” to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2013 (2013 Form 10‑K)) , we anticipate that we will have sufficient cash available to fund our operations and debt service obligations through the third quarter of 2015.

For the next several years, we expect that our cash outflows for marketing, commercial and medical activities, development programs, operations and debt service will outpace the rate at which we may generate revenues.  To execute our business strategy, pay debt obligations and fund our operations over the next several years, we will require significant additional infusions of capital until such time as the net revenues from the sale of approved products and from other sources are sufficient to offset our cash flow requirements.  While we currently intend to retain all rights and commercialize our approved products in the U.S. by ourselves, an important priority for us is to identify strategic transactions that could provide additional capital and strategic resources to support the continued development and commercial introduction of our RDS products in markets outside the U.S .  For our AEROSURF development program, we seek a significant strategic alliance that potentially could provide development, regulatory and commercial market expertise, and, if approved, support the commercial introduction of AEROSURF in the EU and other selected markets outside the U.S.  Such alliances typically also provide financial resources, in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses.  To advance SURFAXIN in markets outside the U.S. where regulatory marketing authorization is facilitated by the information contained in our new drug application (NDA) approved by the FDA, we would consider various financing or collaboration arrangements that could potentially provide regulatory expertise, support the commercial introduction of SURFAXIN in markets outside the U.S., and a sharing of revenues.  Such countries could potentially include those in Latin America, North Africa and the Middle East.  To secure the necessary capital, we also plan to consider other public and private equity offerings, including under our ATM Program, which currently may allow for the sale of up to approximately $23 million of our commons stock, as well as other financing transactions, such as secured equipment financing facilities or other similar transactions.

Our future capital requirements will depend upon many factors, primarily our efforts to (i) execute the commercial introduction of SURFAXIN in the U.S.; (ii) assure long-term continuity of supply for our commercial liquid, lyophilized and aerosolized KL 4 surfactant drug product, at our manufacturing facility in Totowa, NJ (Totowa Facility) and with CMOs, (iii) advance the AEROSURF development program to completion of the phase 2 clinical trials as planned; (iv) further the development of our CAG for use in a planned phase 3 clinical program and, if approved, early commercial activities, (v) prepare for and conduct an AEROSURF phase 3 clinical program; and (vi) secure one or more strategic alliances or other collaboration arrangements to support our development programs and commercialization of our approved products, if any, in markets outside the U.S.  We believe that we will be better positioned to enter into a significant strategic alliance if we are successful in advancing the commercial introduction of SURFAXIN, and completing and obtaining encouraging results from the AEROSURF phase 2 clinical program within our anticipated time.

 

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Although we currently believe that we will be able to successfully execute our business strategy as planned, there can be no assurance that (i) any of our approved products, including SURFAXIN, will be commercially viable, (ii) that we will be able to execute our long-term manufacturing plan to secure continuity of supply of our SURFAXIN commercial product and our lyophilized and aerosolized KL 4 surfactant product candidates, (iii) that our AEROSURF development program will be successful within our anticipated time frame, if at all, (iv) that we will be able to secure regulatory marketing authorization for AEROSURF and our other KL 4 surfactant product candidates, in the U.S. and other markets, or (v) that the ATM Program will be available when needed, if at all, or that we will be able to obtain additional capital when needed and on acceptable terms. We will require significant additional capital to sustain operations, satisfy debt obligations, and complete product development and execute the commercial introduction of our KL 4 surfactant product candidates, if approved.  Failure to secure the necessary additional capital when needed would have a material adverse effect on our business, financial condition and results of operations.  Even if we succeed in raising additional capital and developing and subsequently commercializing our product candidates, we may never achieve sufficient sales revenue to achieve or maintain profitability.

As of September 30, 2014, we had outstanding warrants to purchase approximately 14 million shares of our common stock at various prices, exercisable on different dates into 2019.  Of these warrants, warrants to purchase 7 million shares were issued to Deerfield in connection with the Deerfield Loan at an exercise price of $2.81 per share (Deerfield Warrants).  The Deerfield Warrants may be exercised for cash or on a cashless basis.  In lieu of paying cash upon exercise, the holders also may elect to reduce the principal amount of the Deerfield Loan in an amount sufficient to satisfy the exercise price of the Deerfield Warrants.  In addition to the Deerfield Warrants, we have outstanding warrants issued in February 2011 to purchase approximately 4.6  million shares of common stock that contain anti-dilution provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price of the warrants.  These warrants currently have an exercise price of $1.50 per share and expire in February 2016.  In addition, in October 2014, we issued to Battelle Memorial Institute (Battelle) warrants to purchase 1.5 million shares of our common stock at an exercise price of $5.00, with a 10-year term, exercisable upon achievement of a development milestone defined in the related Collaboration Agreement with Battelle of the same date, provided that the purchase of .5 million shares is subject to the further condition that the milestone be achieved on or before May 31, 2016.  See, Note 9, “– Subsequent Event,” in the Notes to Consolidated Financial Statements (unaudited) in this Quarterly Report on Form 10-Q.  Although we could receive additional capital from the exercise of any of our outstanding warrants for cash, there can be no assurance that the market price of our common stock will equal or exceed price levels that would make exercise of outstanding warrants likely, that holders of the Deerfield Warrants would choose to exercise their warrants for cash, or that holders of any of our outstanding warrants would choose to exercise any or all of their warrants prior to the applicable warrant expiration dates.  Moreover, if our outstanding warrants are exercised, such exercises likely will be at a discount to the then-market value of our common stock and have a dilutive effect on the value of our shares of common stock at the time of exercise.

As of September 30, 2014, 250 million shares of common stock were authorized under our Amended and Restated Certificate of Incorporation, as amended, and approximately 137.2 million shares of common stock were available for issuance and not otherwise reserved.

Cash Flows

As of September 30, 2014, we had cash and cash equivalents of $54.9 million compared to $86.3 million as of December 31, 2013.  Cash outflows before financing activities for the nine months ended September 30, 2014 consisted of $31.1 million used for ongoing operating activities and $0.7 million for purchases of property and equipment.  Cash provided by financing activities were $0.4 million of proceeds from the exercise of warrants and stock options.

Operating Activities

Net cash used in operating activities for the nine months ended September 30, 2014 and 2013 was $31.1 million and $30.4 million, respectively.  Net cash used in operating activities is a result of our net losses for the period, adjusted for non-cash items and changes in working capital.

 

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Investing Activities

Net cash used in investing activities for the nine months ended September 30, 2014 and 2013 represents capital expenditures of $ 0.7 million and $0.2 million, respectively.  The increase in capital expenditures is due to timing of routine equipment purchases.

Financing Activities

Net cash provided by financing activities for the nine months ended September 30, 2014 and 2013 was $ 0.4 million and $24.9 million, respectively.  Net cash provided by financing activities for the nine months ended September 30, 2014 represents proceeds from the exercise of warrants and stock options.  Net cash provided by financing activities for the nine months ended September 30, 2013 includes proceeds of $15.1 million pursuant to a common stock offering and the first advance in February 2013 of $10.0 million ($9.9 million, net) under the Deerfield Loan.

The following sections provide a more detailed discussion of our available financing facilities.

Common Stock Offerings

Historically, we have funded, and expect that we will continue to fund, our business operations through various sources, including financings in the form of common stock offerings.  In May 2014, we filed with the SEC a universal shelf registration statement on Form S-3 (No. 333-196420) (2014 Universal Shelf) that was declared effective on June 13, 2014 for the proposed offering from time to time of up to $250 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing, on terms and conditions that will be determined at the time of an offering.  The 2014 Universal Shelf replaces an expired 2011 Universal Shelf.   As of September 30, 2014, after reserves for outstanding unexercised warrants and amounts remaining under our ATM Program, approximately $199.0 million remained available under the 2014 Universal Shelf.  The 2014 Universal Shelf will expire in June 2017.

At-the-Market Program (ATM Program)

We have an ATM Program with Stifel, Nicolaus & Company, Incorporated (Stifel), under which Stifel, as our exclusive agent, at our discretion and at such times that we may determine from time to time, may sell up to a maximum of $25 million of our common stock over a three-year period ending February 11, 2016.  We are not required to sell any shares at any time during the term of the ATM Program.  We have agreed to pay Stifel a commission of 3% of gross proceeds of any sales of shares.  See, “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – At-the-Market Program (ATM Program) – Stifel ATM Program,” in our 2013 Form 10-K.  As of September 30, 2014, approximately $23 million shares of common stock remained available under the ATM Program.