Notes to Consolidated Financial Statements

 

Zogenix, Inc. (the Company) is a pharmaceutical company committed to developing and commercializing therapies that address specific clinical needs for people living with pain-related conditions and central nervous system disorders who need innovative treatment alternatives to help them return to normal daily functioning. On October 25, 2013, the Company received marketing approval from the U.S. Food and Drug Administration (FDA) for Zohydro® ER (hydrocodone bitartrate) extended-release capsules, CII, an opioid agonist, extended-release oral formulation of hydrocodone without acetaminophen, for the management of pain severe enough to require daily, around-the-clock, long-term opioid treatment and for which alternative treatment options are inadequate. Zohydro ER is the first extended-release oral formulation of hydrocodone without acetaminophen. The Company launched Zohydro ER in March 2014. On September 30, 2014, the Company submitted a supplemental New Drug Application (sNDA) for a modified formulation of Zohydro ER which was has been designed to have abuse deterrent properties. The new capsule formulation contains additional inactive ingredients that are intended to make the product more difficult to abuse by injection and nasal insufflation. The The FDA assigned a Prescription Drug User Free Act, or PDUFA, target action date on the sNDA of January 30, 2015, and, if approved, we anticipate a transition from the currently marketed product to this new capsule formulation of Zohydro ER in the second quarter of 2015.

The Company’s first commercial product, Sumavel® DosePro® (sumatriptan injection) Needle-free Delivery System, was launched in January 2010. Sumavel DosePro offers fast-acting, easy-to-use, needle-free subcutaneous administration of sumatriptan for the acute treatment of migraine and cluster headache in a pre-filled, single-use delivery system. Sumavel DosePro is the first drug product approved by the FDA that allows for the needle-free, subcutaneous delivery of medication. On April 23, 2014, the Company entered into an asset purchase agreement (Asset Purchase Agreement) with Endo Ventures Bermuda Limited (Endo Ventures Bermuda) and Endo Ventures Limited (Endo Ventures and, together with Endo Ventures Bermuda, Endo), pursuant to which, and on the terms and subject to the conditions thereof, among other things, the Company agreed to sell its Sumavel DosePro business to Endo, including the registered trademarks, certain contracts, the New Drug Application (NDA) and other regulatory approvals, the books and records, marketing materials and product data relating to Sumavel DosePro. The Asset Purchase Agreement closed on May 16, 2014 (the Closing) and in connection with the Closing, the Company and Endo Ventures also entered into a supply agreement (the Supply Agreement), pursuant to which the Company will retain the sole and exclusive right and the obligation to manufacture, have manufactured, supply or have supplied Sumavel DosePro to Endo Ventures, subject to Endo Venture’s right to qualify and maintain a back-up manufacturer. Further, under the Supply Agreement, Endo will support the Company’s Sumavel DosePro manufacturing operations with a working capital advance equivalent to the book value of the inventory of materials and unreleased finished goods held by the Company in connection with the manufacture of Sumavel DosePro minus the accounts payable associated with such materials and unreleased finished goods, capped initially at $7,000,000 and subject to annual adjustment. Upon the Closing, and in addition to the working capital advance, Endo paid the Company $85,000,000 , $8,500,000 of which was deposited into escrow to fund potential indemnification claims for a period of 12 months, and $4,624,000 for finished goods inventory on hand at Closing. In addition to the upfront cash payment, the Company is eligible to receive additional cash payments of up to $20,000,000 based on the achievement of pre-determined sales and gross margin milestones (see Note 4).

On October 24, 2014, Zogenix Europe Limited (Zogenix Europe), a wholly-owned subsidiary of the Company, acquired Brabant Pharma Limited, a privately-held company organized under the laws of England and Wales (Brabant), pursuant to the terms of a Sale and Purchase Agreement (the Sale and Purchase Agreement), dated October 24, 2014. Brabant owns worldwide development and commercialization rights to Brabafen, low-dose fenfluramine, for the treatment of Dravet syndrome (also known as Severe Myoclonic Epilepsy of Infancy). Dravet syndrome is a rare and catastrophic form of pediatric epilepsy with life threatening consequences for patients and current treatment options are very limited. Brabafen has recently received orphan drug designation in Europe and the United States for the treatment of Dravet syndrome. Under the terms of the Sale and Purchase Agreement, Zogenix Europe paid consideration of (i)  $20,000,000 in cash (plus $8,432,000 which represents the net cash position of Brabant at the closing), of which $2,000,000 was deposited into escrow to fund potential indemnification claims for a period of 6 months, and (ii) 11,995,202 shares of the Company’s common stock. Zogenix Europe also committed to paying up to an aggregate amount of $95,000,000 in connection with the achievement of certain milestones for Brabafen, including $50,000,000 in regulatory milestones and $45,000,000 in sales milestones. The Company has agreed to use commercially reasonable efforts (as defined in the Sale and Purchase Agreement) to develop and commercialize Brabafen and to achieve the milestones (see Note 9).

The Company was incorporated in the state of Delaware on May 11, 2006 as SJ2 Therapeutics, Inc. and commenced operations on August 25, 2006. On August 28, 2006, the Company changed its name to Zogenix, Inc.

The Company has incurred significant net losses since inception and has relied on its ability to fund its operations through equity financings, debt financings, revenues from the sale of product and proceeds from business collaborations. As the Company continues to incur losses, successful transition to profitability is dependent upon achieving a level of revenues adequate to support the Company’s cost structure. This may not occur and, unless and until it does, the Company will continue to need to raise additional cash. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern and do not include any adjustments that might result from the outcome of this uncertainty. This basis of accounting contemplates the recovery of the Company’s assets and the satisfaction of liabilities in the normal course of business.

Management expects operating losses and negative cash flows to continue for at least the next year as the Company continues to incur costs related to the commercialization of Zohydro ER, the introduction of Zohydro ER with abuse deterrent properties to the market, if approved, the clinical development of Relday and Brabafen, required post-market testing for Zohydro ER, safe use initiatives for Zohydro ER and additional development activities with respect to Zohydro ER, including the development of multiple formulations of extended-release hydrocodone with abuse deterrent properties. Management may pursue additional opportunities to raise further capital, if required, through public or private equity offerings, including through a controlled equity offering program, debt financings, receivables financings or through collaborations or partnerships with other companies to further support its planned operations. There can be no assurance that the Company will be able to obtain any source of financing on acceptable terms, or at all. If the Company is unsuccessful in raising additional required funds, it may be required to significantly delay, reduce the scope of or eliminate one or more of its development programs or its commercialization efforts, or cease operating as a going concern. The Company also may be required to relinquish, license or otherwise dispose of rights to product candidates or products that it would otherwise seek to develop or commercialize itself on terms that are less favorable than might otherwise be available.

On November 6, 2014, the Company entered into a controlled equity offering sales agreement with Cantor Fitzgerald & Co., or Cantor, as sales agent, under which the Company can issue and sell shares of its common stock having an aggregate offering price of up to  $25,000,000  from time to time through Cantor. Sales of the Company's common stock made pursuant to the controlled equity offering program, if any, will be made on the Nasdaq Global Market under the Company's shelf registration statement on Form S-3 filed on November 6, 2014, following such time as the registration statement is declared effective by the SEC. However, such registration statement cannot be declared effective until such time as the Company has filed certain financial statements from its recent acquisition of Brabant as required by SEC rules, which must be filed within 71 days of the date of the Company's Current Report on Form 8-K filed with the SEC on October 27, 2014. There can be no assurance that Cantor will be successful in consummating sales under the program based on prevailing market conditions or in the quantities or at the prices that the Company deems appropriate.

Financial Statement Preparation and Use of Estimates

The unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q have been prepared by Zogenix, Inc. according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been omitted.

In the opinion of management, the accompanying unaudited consolidated financial statements for the periods presented reflect all adjustments, which are normal and recurring, necessary to fairly state the financial position, results of operations and cash flows. These unaudited consolidated financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 filed with the SEC on March 7, 2014.

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from those estimates.

Principles of Consolidation

The unaudited interim consolidated financial statements include the accounts of Zogenix, Inc. and its wholly owned subsidiary Zogenix Europe Limited, which was incorporated under the laws of England and Wales in June 2010. All intercompany transactions and investments have been eliminated in consolidation. Zogenix Europe Limited’s functional currency is the U.S. dollar, the reporting currency of its parent.

Restricted Cash

In connection with its sale of the Sumavel DosePro business in May 2014, the Company has $8,500,000 of cash in escrow as of September 30, 2014 to fund potential indemnification claims for a period of 12 months (see Note 4). The Company classifies the cash flow from this restricted cash as an investing activity in the consolidated statement of cash flows as the source of the restricted cash is related to the sale of the Sumavel DosePro business.

Further, in December 2009, the Company issued a line of credit for $200,000 in connection with an operating lease which was collateralized by a certificate of deposit in the same amount and recorded as restricted cash within other assets on the consolidated balance sheet as of December 31, 2013. This line of credit and certificate of deposit were terminated in February 2014 in connection with a renegotiation of the operating lease.

Fair Value Measurements

The carrying amount of financial instruments consisting of cash, restricted cash, trade accounts receivable, prepaid expenses and other current assets, accounts payable, accrued expenses and accrued compensation included in the Company’s consolidated financial statements are reasonable estimates of fair value due to their short maturities. Based on the borrowing rates currently available to the Company for loans with similar terms, management believes the fair value of long-term debt approximates its carrying value. The accrued liability for the annual tail payment due to Astellas Pharma US, Inc. (Astellas) (see Note 5) for the termination of the Company’s co-promotion agreement was measured at fair value in December 2011 using a present value technique, which incorporated the Company’s own credit risk as measured by the most recent round of debt financing with Healthcare Royalty Partners (Healthcare Royalty) (formerly Cowen Healthcare Royalty Partners II, L.P.).

Authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

 

The Company classifies its cash equivalents within Level 1 of the fair value hierarchy because it values its cash equivalents using quoted market prices. The Company classifies its common stock warrant liabilities and embedded derivative liabilities within Level 3 of the fair value hierarchy because they are valued using valuation models with significant unobservable inputs. Assets and liabilities measured at fair value on a recurring basis at September 30, 2014 and December 31, 2013 are as follows (in thousands):

 

The following table provides a reconciliation of liabilities measured at fair value using significant unobservable inputs (Level 3) for the nine months ended September 30, 2014 (in thousands):

Changes in fair value of the liabilities shown in the table above are recorded through change in fair value of warrant liabilities and change in fair value of embedded derivatives in other income (expense) in the consolidated statements of

operations and comprehensive income (loss). The derecognition of the embedded derivative liabilities was included in the loss on early extinguishment of debt in non-operating expenses in the consolidated statements of operations and comprehensive income (loss).

Net Income (Loss) per Share

Basic net income (loss) per share is calculated by dividing the net income (loss) by the weighted average number of common shares outstanding for the period, reduced by weighted average shares subject to repurchase, without consideration for common stock equivalents. Diluted net loss per share is computed by dividing the net income (loss) by the weighted average number of common share equivalents outstanding for the period determined using the treasury-stock method and as-if converted method, as applicable. For purposes of this calculation, stock options, restricted stock units and warrants are considered to be common stock equivalents and are only included in the calculation of diluted net loss per share when their effect is dilutive.

The following table presents the computation of basic and diluted net income (loss) per share (in thousands, except per share amounts):  

There were 58,000 and 9,909,000 dilutive securities (in common stock equivalent shares), from common stock options, excluded from the calculation of diluted net loss during the three and nine months ended September 30, 2014 , respectively, because to include them would be anti-dilutive. There were 1,776,000 dilutive securities (in common stock equivalent shares), from common stock options and restricted stock units, excluded from the calculation of diluted net loss during the three and nine months ended September 30, 2013 because to include them would be anti-dilutive. All common stock warrants disclosed in Note 6 were excluded from the calculation of diluted net loss during the three months ended September 30, 2014 and 2013, and during the nine months ended September 30, 2013, as the exercise price of the warrants was greater than the Company's average stock price during these periods.

Impairment of Long-Lived Assets

The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. As a result of the sale of its Sumavel DosePro business in May 2014, the Company recorded an impairment charge of $838,000 in the consolidated statement of operations and comprehensive income (loss) during the nine months ended September 30, 2014 related to the disposal of construction in progress that will no longer be placed into service.

Revenue Recognition

The Company recognizes revenue from the sale of Sumavel DosePro and Zohydro ER, and from contract manufacturing, license fees, milestones and service fees earned on collaborative arrangements. Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and title has passed, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (a) the Company’s price to the buyer is substantially fixed or determinable at the date of sale, (b) the buyer has paid the Company, or the buyer is obligated to pay the Company and the obligation is not contingent on resale of the product, (c) the buyer’s obligation to the Company would not be changed in the event of theft or physical destruction or damage of the product, (d) the buyer acquiring the product for resale has economic substance apart from that provided by the Company, (e) the Company does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (f) the amount of future returns can be reasonably estimated. The Company currently defers recognition of revenue on product shipments of Zohydro ER until the right of return no longer exists, as the Company currently cannot reliably estimate expected returns of the product at the time of shipment given the limited sales history of Zohydro ER.

Revenue arrangements with multiple elements are divided into separate units of accounting if certain criteria are met, including whether the delivered element has stand-alone value to the customer. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. The application of the multiple element guidance requires subjective determinations, and requires the Company to make judgments about the individual deliverables and whether such deliverables are separable from the other aspects of the contractual relationship. Deliverables are considered separate units of accounting provided that: (1) the delivered item(s) has value to the customer on a stand-alone basis and (2) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the Company's control. In determining the units of accounting, the Company evaluates certain criteria, including whether the deliverables have stand-alone value, based on the consideration of the relevant facts and circumstances for each arrangement. In addition, the Company considers whether the buyer can use the other deliverable(s) for their intended purpose without the receipt of the remaining element(s), whether the value of the deliverable is dependent on the undelivered item(s), and whether there are other vendors that can provide the undelivered element(s).

Arrangement consideration that is fixed or determinable is allocated among the separate units of accounting using the relative selling price method, and the applicable revenue recognition criteria, as described above, are applied to each of the separate units of accounting in determining the appropriate period or pattern of recognition. The Company determines the estimated selling price for deliverables within each agreement using vendor-specific objective evidence (VSOE) of selling price, if available, third-party evidence (TPE) of selling price if VSOE is not available, or management's best estimate of selling price (BESP) if neither VSOE nor TPE is available. Determining the BESP for a unit of accounting requires significant judgment. In developing the BESP for a unit of accounting, the Company considers applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the customer and estimated costs.

Product Revenue, Net

The Company sells Zohydro ER, and sold Sumavel DosePro through May 2014, in the United States to wholesale pharmaceutical distributors and retail pharmacies, or collectively the Company's customers, subject to rights of return within a period beginning six months prior to, and ending 12 months following, product expiration. The Company recognized Sumavel DosePro product sales at the time title transferred to its customer, and reduced product sales for estimated future product returns and sales allowances in the same period the related revenue was recognized.

Given the limited sales history of Zohydro ER, the Company cannot reliably estimate expected returns of the product at the time of shipment. Accordingly, the Company defers recognition of revenue on Zohydro ER product shipments until the right of return no longer exists, which occurs at the earlier of the time Zohydro ER is dispensed through patient prescriptions or expiration of the right of return. The Company estimates Zohydro ER patient prescriptions dispensed using an analysis of third-party syndicated data. Zohydro ER was launched in March 2014 and, accordingly, the Company does not have a significant history estimating the number of patient prescriptions dispensed. If the Company underestimates or overestimates patient prescriptions dispensed for a given period, adjustments to revenue may be necessary in future periods. The deferred revenue balance does not have a direct correlation with future revenue recognition as the Company will record sales deductions at the time the prescription unit is dispensed.

The Company will continue to recognize Zohydro ER revenue upon the earlier to occur of prescription units dispensed or expiration of the right of return until it can reliably estimate product returns, at which time the Company will record a one-time

increase in revenue related to the recognition of revenue previously deferred, net of estimated future product returns and sales allowances. In addition, the costs of Zohydro ER associated with the deferred revenue are recorded as deferred costs, which are included in inventory, until such time the related deferred revenue is recognized.

Product sales allowances for Zohydro ER and Sumavel DosePro include wholesaler and retail pharmacy distribution fees, prompt pay discounts, chargebacks, rebates and patient discount programs, and are based on amounts owed or to be claimed on the related sales. These estimates take into consideration the terms of the Company's agreements with its customers and third-party payors and the levels of inventory within the distribution and retail channels that may result in future rebates or discounts taken. In certain cases, such as patient support programs, the Company recognizes the cost of patient discounts as a reduction of revenue based on estimated utilization. If actual future results vary, the Company may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. The Company records product sales deductions in the statement of operations at the time product revenue is recognized.

In connection with the Closing of the Asset Purchase Agreement (APA) in May 2014, whereby Endo acquired the Company's Sumavel DosePro business, Endo purchased the Company's existing finished goods inventory of Sumavel DosePro at standard cost. The Company will be financially responsible for all returns of Sumavel DosePro product distributed by the Company prior to Closing of the APA up to a maximum per unit amount as specified in the agreements. The Company will also be financially responsible for payment of Sumavel DosePro product sales allowances on product distributed by the Company prior to Closing of the APA. Endo will be responsible for payment of all other Sumavel DosePro returns and sales allowances.

Contract Manufacturing Revenue

In connection with the Closing of the APA in May 2014, the Company and Endo Ventures entered into the Supply Agreement, pursuant to which the Company retains the sole and exclusive right and the obligation to manufacture, have manufactured, supply or have supplied Sumavel DosePro to Endo Ventures (see Note 4). The Company recognizes deferred revenue related to its supply of Sumavel DosePro as contract manufacturing revenue when earned on a "proportional performance" basis, as product is delivered. The Company recognizes revenue related to its sale of Sumavel DosePro product, equal to the cost of contract manufacturing plus a 2.5% mark-up, upon the transfer of title to Endo. The Company supplies Sumavel DosePro product based on non-cancellable purchase orders. The Company initially defers revenue for any consideration received in advance of services being performed and product being delivered, and recognizes revenue pursuant to the related pattern of performance, based on total product delivered relative to the total estimated product delivery over the minimum eight year term of the Supply Agreement. The Company continually evaluates the performance period and will adjust the period of revenue recognition if circumstances change.

In addition, the Company follows the authoritative accounting guidance when reporting revenue as gross when the Company acts as a principal versus reporting revenue as net when the Company acts as an agent. For transactions in which the Company acts as a principal, has discretion to choose suppliers, bears credit risk and performs a substantive part of the services, revenue is recorded at the gross amount billed to a customer and costs associated with these reimbursements are reflected as a component of cost of sales for contract manufacturing services.

Segment Reporting

Management has determined that the Company operates in one business segment, which is the development and commercialization of pharmaceutical products for people living with pain-related conditions and central nervous system disorders.

Recent Accounting Pronouncements

In April 2014, the Financial Accounting Standards Board (FASB) issued an accounting update that raises the threshold for disposals to qualify as discontinued operations and allows companies to have significant continuing involvement with and continuing cash flows from or to the discontinued operations. This accounting update also requires additional disclosures for discontinued operations and new disclosures for individually material disposal transactions that do not meet the definition of a discontinued operation. This guidance will be effective for fiscal years beginning after December 15, 2014, with early adoption permitted. The Company does not expect that the adoption of the guidance will have a material impact on the Company's financial statements.

In May 2014, the FASB issued new accounting guidance related to revenue recognition. This new standard will replace all current GAAP guidance on this topic and eliminate all industry-specific guidance. The new revenue recognition standard provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration

for which the entity expects to be entitled in exchange for those goods or services. This guidance will be effective for fiscal years beginning after December 16, 2016, including interim periods within that reporting period, and can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. Early adoption is prohibited. The Company is evaluating the timing and impact of adopting this new accounting standard on its financial statements and related disclosures.

In June 2014, the FASB issued new accounting guidance related to stock compensation. The new standard requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant date fair value of the award. This update further clarifies that compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the periods for which the requisite service has already been rendered. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015 and can be applied either prospectively or retrospectively to all awards outstanding as of the beginning of the earliest annual period presented as an adjustment to opening retained earnings. Early adoption is permitted. The Company does not expect that the adoption of the guidance will have a material impact on the Company's financial statements.

In August 2014, the FASB issued new accounting guidance which requires management to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and provide related footnote disclosures. The guidance is effective for annual and interim reporting periods beginning on or after December 15, 2016. Early adoption is permitted. The Company does not expect that the adoption of the guidance will have a material impact on the Company’s financial statements.

 

Deferred cost of goods sold consists of the costs of Zohydro ER associated with the deferred revenue, which are included in inventory, until such time the related deferred revenue is recognized.

Endo Ventures Bermuda Limited and Endo Ventures Limited Asset Purchase Agreement

On May 16, 2014, the Company closed the APA with Endo Ventures Bermuda and Endo Ventures, pursuant to which the Company sold its Sumavel DosePro business to Endo, including the registered trademarks, certain contracts, the NDA and other regulatory approvals, the books and records, marketing materials and product data relating to Sumavel DosePro. Upon Closing of the APA, Endo paid the Company $85,000,000 in cash, $8,500,000 of which was deposited into escrow to fund potential indemnification claims for a period of 12 months, and $4,624,000 in cash for the purchase of Sumavel DosePro finished goods inventory on hand at the Company's standard cost. In addition to the upfront cash payments, the Company is eligible to receive additional cash payments of up to $20,000,000 based on the achievement of pre-determined sales and gross margin milestones.

Furthermore, Endo Ventures assumed responsibility for the Company’s royalty obligation to Aradigm Corporation on sales of Sumavel DosePro.

At the Closing, the Company and Endo Ventures Bermuda entered into a license agreement (License Agreement), pursuant to which the Company granted Endo an exclusive, perpetual, sublicensable, irrevocable (unless terminated as set forth in the License Agreement), fully paid-up, royalty-free license to make and have made, use and research, develop and commercialize Sumavel DosePro throughout the world under a specified subset of the Company's technology patents. The Company retained all rights to the DosePro technology patents and know-how for use with other products. Either party may terminate the License Agreement in the event of the other party's uncured material breach.

At the Closing, the Company and Endo Ventures entered into the Supply Agreement, pursuant to which the Company will retain the sole and exclusive right and the obligation to manufacture, have manufactured, supply or have supplied Sumavel DosePro to Endo, subject to Endo’s right to qualify and maintain a back-up manufacturer. Endo will exclusively purchase all Sumavel DosePro supplied by the Company at the cost of goods sold plus a 2.5% mark-up. The Company will grant Endo a manufacturing license under certain circumstances outlined in the Supply Agreement, if Endo requires the use of a back-up supplier. Representatives from the Company and Endo will participate on a joint supply committee for general oversight and strategic functions regarding the Supply Agreement. Further, under the Supply Agreement, Endo will support the Company’s Sumavel DosePro manufacturing operations with an interest-free working capital advance equivalent to the book value of the inventory of materials and unreleased finished goods held by the Company in connection with the manufacture of the Sumavel DosePro minus the accounts payable associated with such materials and unreleased finished goods, capped initially at $7,000,000 and subject to annual adjustment. The working capital advance is evidenced by a promissory note (the Note) and is secured by liens on materials and unreleased finished Sumavel DosePro inventory.

The Supply Agreement may be terminated by either party upon three years' prior written notice, provided that the notice cannot be given prior to the fifth anniversary of the Closing date. Either party may also terminate the Supply Agreement in the following circumstances: (i) if the other party breaches any material term of the agreement and fails to cure such breach within a specified time period following written notice; or (ii) upon the occurrence of certain financial difficulties. Endo Ventures also may terminate the Supply Agreement in the following circumstances: (i) if Sumavel DosePro has been deemed ineffective or unsafe by the applicable governmental authorities; or (ii) if the Company fails to supply to Endo Ventures a minimum quantity of Sumavel DosePro over the course of a six month period which results in Endo Ventures being unable to supply Sumavel DosePro to its trade customers.

Further upon Closing, the Company and Endo Ventures entered into other ancillary agreements associated with the APA, pursuant to which the Company will help facilitate the transfer of the Sumavel DosePro business to Endo Ventures, which Endo Ventures assumed responsibility for as of the Closing date. The services to be provided by the Company include assistance with co-pay/voucher programs, continuation of Zogenix Product Express services, regulatory support and processing of all payment claims made under the Company's National Drug Code. Services provided by the Company will be provided over various time periods specified in the agreements.

The Company accounted for the agreement for the sale of the Sumavel DosePro business as a sale of a business and, as such, was required to estimate the fair value of the business, including the product rights under the APA, DosePro technology license and Sumavel DosePro finished goods inventory on hand at Closing. The Company estimated the fair value of the product rights using an income approach valuation technique through a discounted cash flow method. The assumptions used in the discounted cash flow method included estimated Sumavel DosePro units to be sold in the market based on current demand forecasts, net selling price of Sumavel DosePro based on current market price, working capital needs estimated by management and a discount rate based on a market participant weighted average cost of capital.

The Company estimated the fair value of the DosePro technology license using a relief from royalty valuation method, whereby the presumed royalty savings from owning the license was estimated. The valuation considered royalty rates involving other injection technologies in the current pharmaceutical space.

The Company estimated the fair value of the Sumavel DosePro finished goods inventory on hand at Closing (which was sold to Endo at standard cost) using a market approach reflecting the estimated costs incurred by the Company in performing monitoring and quality control services on inventory supplied to Endo.

The agreements entered into concurrently with the sale of the Sumavel DosePro business, including the License Agreement and Supply Agreement, contain various elements and, as such, are deemed to be an arrangement with multiple deliverables as defined under authoritative accounting guidance (see Note 2). Several non-contingent deliverables were identified within the agreements. The Company identified the contract manufacturing services, manufacturing license, transition services and performance on joint supply committee as separate non-contingent deliverables within the arrangement. The transition services and manufacturing license have standalone value and qualify as separate units of accounting. Performance on the joint supply committee does not have standalone value from the contract manufacturing services, and as such, these two deliverables qualify as one unit of accounting. The non-contingent consideration received from the Endo agreements was allocated to these separate units of accounting, including the sale of the Sumavel DosePro business, based on their respective fair values, using the relative selling price method.

The Company developed its BESP for each non-contingent deliverable, as VSOE and TPE was not available, in order to allocate the non-contingent arrangement consideration to the three undelivered units of accounting. The Company used a market valuation approach to develop the BESP for contract manufacturing services through the use of market rates available for comparable contract manufacturing services and consideration of internal costs of performing inventory monitoring and

quality control services. Significant increases in the hours necessary to perform inventory monitoring and quality controls services would result in a significant increase in the fair value of the contract manufacturing services.

The Company developed the BESP for the manufacturing license by estimating the total number of hours required to qualify another manufacturer, the hourly rate of internal regulatory and manufacturing employees that are required to qualify another manufacturer and the market rate for estimated cost of travel required to qualify another manufacturer. The Company developed the BESP for the transition services through use of an estimate of the total number of hours required to complete the services and the hourly rate of an internal employee that performs the services, which was compared to hourly market rates for similar consulting services. The Company developed the BESP for performance on the joint supply committee through use of an estimate of the total number of participation hours required on the committee and the hourly rate of the internal employees that participate on the joint supply committee. Significant increases in the estimated number of hours required to qualify another manufacturer, required to perform transition services, or required for performance on the joint supply committee would significantly increase the fair value of these deliverables.

The Company allocated $9,100,000 of the upfront consideration to contract manufacturing services, which includes a discount valued at $4,748,000 related to the interest free working capital advance, and an immaterial amount of the upfront consideration was allocated to the manufacturing license, transition services and performance on the joint supply committee. Revenue associated with each of the undelivered elements will be recognized when the element is delivered.

As of June 30, 2014, the Company determined that the Sumavel DosePro business, which is comprised of the product rights under the APA, DosePro technology license and Sumavel DosePro finished goods inventory purchased at Closing, had been fully delivered, and, therefore representing control of the business obtained by Endo. As such, a gain on sale of business of $79,980,000 , net of $660,000 in related transaction costs, was recognized for the sale of the Sumavel DosePro business in the consolidated statement of operations and comprehensive income (loss) for the three and nine months ended September 30, 2014 .

Based on the Sumavel DosePro finished goods inventory delivered and the contract manufacturing services performed, as measured using a proportional performance method, during the three and nine months ended September 30, 2014 a total of $4,225,000 and $6,463,000 , respectively, was recognized as contract manufacturing revenue in the statement of operations and comprehensive income (loss). An immaterial amount of revenue was recognized for performance of transition services and performance on the joint supply committee during the three and nine months ended September 30, 2014 .

As of September 30, 2014 , the Company had $8,863,000 remaining in deferred revenue attributed to the Endo arrangement.

The $79,980,000 gain on sale of Sumavel DosePro business was calculated as the difference between the allocated non-contingent consideration amount for the business and the net carrying amount of the assets transferred to Endo. The following sets forth the net assets and calculation of the gain on sale as of Closing (in thousands):

The net gain on sale of business may be adjusted in future periods by the contingent consideration, of up to $20,000,000 , based upon the achievement of pre-determined sales and gross margin milestones. Any future adjustment of the net gain on sale of business will be determined through use of the relative selling price method.

Further, as noted above, Endo Ventures provided the Company with an interest-free working capital advance upon Closing. The working capital advance of $7,000,000 , which is evidenced by the Note, was recorded as a note payable on the consolidated balance sheet at Closing, net of a $4,748,000 debt discount. The fair value of the debt discount was established using a market approach, including an interest rate reflecting recent term sheets provided to the Company for offerings of debt instruments, interest rates on the Company's most recent debt instruments, and market interest rates on similar debt instruments. The debt discount will be amortized as interest expense using the effective interest method over the minimum eight year term of the Supply Agreement, as the working capital advance must be repaid upon termination of the Supply Agreement. The Company recognized $83,000 and $123,000 of interest expense during the three and nine months ended September 30, 2014 , respectively, related to the working capital advance from Endo.

The sale of the Sumavel DosePro business does not qualify as discontinued operations as the Company will have significant continuing involvement in the business as the exclusive supplier of Sumavel DosePro over the term of the Supply Agreement.

Daravita Ltd License Agreement

In 2007, the Company entered into a license agreement (the Daravita License Agreement) with Daravita Limited (Daravita), formerly Alkermes Pharma Ireland Limited, which was amended in 2009 and then again on September 12, 2014. Under the terms of the Daravita License Agreement, Daravita granted the Company an exclusive license in the United States and its possessions and territories, with defined sub-license rights to third parties other than certain technological competitors of Daravita, to certain Daravita intellectual property rights related to Zohydro ER. The Daravita License Agreement grants the Company the exclusive right under certain Daravita patents and patent applications to import, use, offer for sale and sell oral controlled-release capsule or tablet formulations of hydrocodone, where hydrocodone is the sole active ingredient, for oral prescriptions in the treatment or relief of pain, pain syndromes or pain associated with medical conditions or procedures in the United States. This right enables the Company to exclusively develop and sell Zohydro ER in the United States. Daravita has retained the exclusive right to take action in the event of infringement or threatened infringement by a third party of Daravita's intellectual property rights under the Daravita License Agreement. The Company has the right to pursue an infringement claim against the alleged infringer should Daravita decline to take or continue an action.

Under the Daravita License Agreement, the Company paid an upfront fee of $500,000 to Daravita, which was recorded as research and development expense. The Company paid additional milestone payments in the amount of $750,000 to Daravita in August 2011 in connection with the completion of the treatment phase of the Company’s pivotal efficacy Phase 3 clinical trial, Study 801, and $1,000,000 upon submission of the first Zohydro ER NDA to the FDA in May 2012, which were recorded as research and development expense. Lastly, the Company paid a milestone payment of $2,750,000 upon the first NDA approval of Zohydro ER in October 2013, which was recorded as other assets in the consolidated balance sheet and is being amortized over the estimated life of the technology, through November 2019.

In addition, the Company is required to pay a mid single-digit percentage royalty on net sales of the product for an initial royalty term equal to the longer of the expiration of Daravita’s patents covering the product in the United States, or 15 years after commercial launch, if Daravita does not have patents covering the product in the United States. After the initial royalty term, the Daravita License Agreement will continue automatically for three -year rolling periods during which the Company will continue to pay royalties to Daravita on net sales of the product at a reduced low single-digit percentage rate in accordance with the terms of the Daravita License Agreement.

Under the terms of the Daravita License Agreement, the Company and Daravita agreed that, subject to a separate commercial manufacturing and supply agreement entered into by the Company and Daravita in November 2012, Daravita is the exclusive manufacturer and supplier to the Company of Zohydro ER, subject to certain exceptions. Daravita also granted to the Company, in the event that Daravita is unwilling or unable to manufacture or supply commercial product to the Company, a non-exclusive license to make product under Daravita's intellectual property rights. This non-exclusive license also includes the right to sublicense product manufacturing to a third party, other than certain technological competitors of Daravita.

On September 12, 2014, the Company and Daravita entered into a third amendment (Third Amendment) to the Daravita License Agreement. Pursuant to the Third Amendment, the Company may exercise its option to obtain an exclusive license to certain abuse-deterrent technology and know-how from Altus Formulation Inc. (Altus) (pursuant to that certain Development and Option Agreement, dated November 1, 2013, by and between the Company and Altus). Following such exercise and the first commercial sale by the Company, its affiliates or any of its permitted sublicensees of any extended-release formulations of hydrocodone using Altus’ abuse-deterrent technology (Altus Product), Daravita will be entitled to receive from the Company a royalty on net sales of Altus Product through the date that is 15 years following the first commercial sale of the Altus Product in the United States and its possessions and territories. Prior to December 31, 2019, such royalty will be (i) in the mid single-digits if Daravita or an affiliate is the manufacturer of the Altus Product or (ii) in the low twenty-percent-range if Daravita or an affiliate is not the manufacturer of the Altus Product. After December 31, 2019, such royalty will be in the high single digits, regardless of whether Daravita or an affiliate is the manufacturer. Neither the Company nor Daravita shall be obligated to have Daravita or an affiliate manufacture commercial supplies of Altus Product for the Company. No monetary value was exchanged in connection with the Third Amendment during the three and nine months ended September 30, 2014.

Either party may terminate the Daravita License Agreement upon a material, uncured default or certain insolvency events of the other party or upon 12 months written notice prior to the end of the initial royalty term or any additional three -year

rolling period. The Company may also terminate the Daravita License Agreement, with or without cause, at any point in time upon 12 months' prior written notice, or if the sale of Zohydro ER is prohibited by regulatory authorities.

Mallinckrodt LLC Co-Promotion Agreement

On June 6, 2012, the Company and Mallinckrodt LLC (Mallinckrodt) entered into a co-promotion agreement (the Co-Promotion Agreement), which was originally scheduled to terminate on June 30, 2014. Under the terms of the Co-Promotion Agreement, Mallinckrodt was granted a co-exclusive right (with the Company) to promote Sumavel DosePro to a mutually agreed prescriber audience in the United States. Mallinckrodt’s sales team began selling Sumavel DosePro to its customer base of prescribers in August 2012.

In partial consideration of Mallinckrodt’s sales efforts, the Company paid Mallinckrodt a service fee on a quarterly basis through January 31, 2014 that represented a specified fixed percentage of net sales of prescriptions generated from Mallinckrodt’s prescriber audience over a baseline amount of net sales to the same prescriber audience. Amounts payable to Mallinckrodt for service fees are reflected as selling, general and administrative expenses. For the three and nine months ended September 30, 2014 , the Company incurred $0 and $100,000 , respectively, in service fee expenses under the Co-Promotion Agreement, excluding the tail-payment expense discussed below. For the three and nine months ended September 30, 2013 , the Company incurred $249,000 and $618,000 , respectively, in service fee expenses under the Co-Promotion Agreement.

In January 2014, the Company entered into an amendment to the Co-Promotion Agreement, whereby the Co-Promotion Agreement terminated on January 31, 2014. The Company assumed full responsibility for the commercialization of Sumavel DosePro in February 2014. In connection with the termination of the Co-Promotion Agreement, the Company is required to make a one-time tail payment to Mallinckrodt, calculated as a fixed percentage of net sales from the Mallinckrodt targeted prescriber audience during the 12 month period ending on January 31, 2015. An initial liability of $491,000 for this estimated tail payment was recorded as service fee expense in selling, general and administrative expenses in the statement of operations upon the Co-Promotion Agreement termination in January 2014. This estimated tail payment liability was adjusted based on actual year-to-date net sales through September 30, 2014, which resulted in a credit of $321,000 to service fee expense in selling, general and administrative expenses in the statement of operations during the three and nine months ended September 30, 2014 .

Valeant Pharmaceuticals North America LLC Co-Promotion Agreement

On June 27, 2013, the Company entered into a co-promotion agreement (the Valeant Agreement) with Valeant Pharmaceuticals North America LLC (Valeant). Under the terms of the Valeant Agreement, the Company was granted the exclusive right (with Valeant or any of its affiliates) to promote Migranal® (dihydroergotamine mesylate) Nasal Spray (Migranal) to a prescriber audience of physicians and other health care practitioners in the United States. The Company's sales team began promoting Migranal to prescribers in August 2013. The term of the Valeant Agreement will run through December 31, 2015 (unless otherwise terminated), and can be extended by mutual agreement of the parties in additional 12 month increments. Valeant remains responsible for the manufacture, supply and distribution of Migranal for sale in the United States. In addition, Valeant supplies the Company with a specified amount of product samples every six months, and the Company will reimburse Valeant for the cost of additional samples and any promotional materials ordered by the Company. The cost of any additional samples and any promotional materials ordered by the Company will be recognized as selling, general and administrative expenses.

In partial consideration of the Company's sales efforts, Valeant pays the Company a co-promotion fee on a quarterly basis that represents specified percentages of net sales generated by the Company over defined baseline amounts of net sales (Baseline Forecast or Adjusted Baseline Forecast). In addition, upon completion of the co-promotion term, and only if the Valeant Agreement is not terminated by Valeant due to a bankruptcy event (as defined in the Valeant Agreement) or the inability of the Company to comply with its material obligations under the Valeant Agreement, Valeant will be required to pay the Company an additional tail payment calculated as a fixed percentage of the Company's net sales over the Baseline Forecast (or Adjusted Baseline Forecast) during the first full six months following the last day of the term.

The Company may terminate the Valeant Agreement in the event of a Valeant supply failure (as defined in the Valeant Agreement) or material product recall, or if the net sales price in a fiscal quarter is less than a specified percentage of the net sales price in the immediately preceding quarter, if the reduction in such net sales price would have a material adverse effect on the Company's financial return as a result of performance of its obligation under the Valeant Agreement.

Either party may terminate the Valeant Agreement with six months notice. Either party may terminate the Valeant Agreement with 30 days prior notice if the Company's net sales within a fiscal quarter fall below the Baseline Forecast (or Adjusted Baseline Forecast) for one or more fiscal quarters, or following the commercial introduction of a generic product to

Migranal promoted or otherwise commercialized by a third party in the United States. In addition, either party may terminate the Valeant Agreement in the event of a change of control of itself or the other party (upon 90 days prior written notice), upon any action taken or objection raised by governmental authority that prevents either party from performing its obligations under the Valeant Agreement, upon the filing of an action alleging patent infringement, in connection with the material breach of the other party's material obligations, or if a bankruptcy event of the other party occurs.

The Company recognizes co-promotion fees received under the Valeant Agreement as service revenue in the period in which its promotional activities generate net sales over the Baseline Forecast or Adjusted Baseline Forecast. For the three and nine months ended September 30, 2014 , the Company recognized service revenue of $446,000 and $2,427,000 , respectively, under the Valeant Agreement. For the three and nine months ended September 30, 2013, the Company recognized service revenue of $232,000 under the Valeant Agreement.

Astellas Pharma US, Inc. Co-Promotion Agreement

In July 2009, the Company entered into the co-promotion agreement with Astellas (Astellas Co-Promotion Agreement). Under the terms of the agreement, the Company granted Astellas the co-exclusive right (with the Company) to market and sell Sumavel DosePro in the United States until June 30, 2013. Under the Astellas Co-Promotion Agreement, both Astellas and the Company were obligated to collaborate and fund the marketing of Sumavel DosePro and to provide annual minimum levels of sales effort directed at Sumavel DosePro during the term. In December 2011, the Company entered into an amendment to the Astellas Co-Promotion Agreement, or the amended Astellas Co-Promotion Agreement, whereby the agreement terminated on March 31, 2012.

Following completion of the co-promotion term in March 2012, the Company was required to pay Astellas one tail payment in July 2013 and another tail payment in July 2014, calculated as decreasing fixed percentages (ranging from mid-twenties down to a mid-teen percentage) of net sales in the Astellas Segment during the 12 months ended March 31, 2012. The fair value of the tail payments is being accreted through interest expense through the dates of payment in July 2013 and July 2014. The first tail payment of $2,032,000 was made in July 2013 and the second tail payment of $1,218,000 was made in July 2014. The Company recognized $0 and $40,000 of related interest expense during the three months ended September 30, 2014 and 2013, respectively, and recognized $87,000 and $327,000 of related interest expense during the nine months ended September 30, 2014 and 2013, respectively.

Healthcare Royalty Financing Agreement

On July 18, 2011, the Company closed the royalty financing agreement (the Financing Agreement) with Healthcare Royalty. Under the terms of the Financing Agreement, the Company borrowed $30,000,000 from Healthcare Royalty (the Borrowed Amount) and the Company agreed to repay such Borrowed Amount together with a return to Healthcare Royalty, as described below, out of the Company’s direct product sales, co-promotion revenues and out-license revenues (collectively, Revenue Interest) that the Company may record or receive as a result of worldwide commercialization of the Company’s products including Sumavel DosePro, Zohydro ER and other future products. The Financing Agreement was originally scheduled to terminate on March 31, 2018 , but Healthcare Royalty exercised its right to early terminate the Financing Agreement on May 16, 2014, as discussed below.

Upon the closing of and in connection with the Financing Agreement, the Company issued and sold to Healthcare Royalty $1,500,000 of the Company’s common stock, or 388,601 shares, at a price of $3.86 per share. The Company also issued to Healthcare Royalty a warrant exercisable for up to 225,000 shares of the Company’s common stock. The warrant is exercisable at $9.00 per share and has a term of 10 years. As the warrant contains covenants where compliance with such covenants may be outside the control of the Company, the warrant was recorded as a current liability and marked to market at each reporting date using the Black-Scholes option pricing valuation model (see Note 2).

Under the Financing Agreement, the Company was obligated to pay to Healthcare Royalty:

Net sales of Sumavel DosePro outside the United States were only included in the Revenue Interest if such net sales exceeded $10,000,000 . The Company was also obligated to make three fixed payments of $10,000,000 on (or before, at the option of the Company) each of January 31, 2015, January 31, 2016 and January 31, 2017 .

As security for the payment of the Company's obligations under the Financing Agreement, the Company also entered into a security agreement whereby the Company granted to Healthcare Royalty a security interest in all assets of the Company, including intellectual property and other rights of the Company to the extent necessary or used to commercialize the Company products. Healthcare Royalty’s security interest was extinguished upon early termination of the Financing Agreement on May 16, 2014.

The Company had the option to terminate the Financing Agreement at the Company’s election in connection with a change of control of the Company, upon the payment of a base amount of $52,500,000 , or, if higher, an amount that generated a 19% internal rate of return on the Borrowed Amount as of the date of prepayment, in each case reduced by the Revenue Interest and principal payments received by Healthcare Royalty up to the date of prepayment.

Healthcare Royalty had the option to terminate the Financing Agreement at its election in connection with a change of control of the Company (which includes the sale, transfer, assignment or licensing of the Company’s rights in the United States to either Sumavel DosePro or Zohydro ER), or an event of default (which includes the occurrence of a bankruptcy event or other material adverse change in the Company’s business), as defined in the Financing Agreement. Healthcare Royalty exercised its option to terminate the Financing Agreement in connection with the Company's sale of the Sumavel DosePro business to Endo on May 16, 2014. Upon termination of the Financing Agreement by Healthcare Royalty, the Company was obligated to make a final payment (Final Payment) of $40,041,000 to Healthcare Royalty, which was an amount that generated a 17% internal rate of return on the Borrowed Amount as of the date of prepayment, reduced by the Revenue Interest and principal payments received by Healthcare Royalty up to the date of Final Payment. The Company no longer has any further payment obligations under the Financing Agreement after the Final Payment was made.

The rights of the Company and Healthcare Royalty to terminate the Financing Agreement early, as well as the change in the Revenue Interest rate from 5% to 5.75% in connection with the early termination of the Astellas Co-Promotion Agreement, met the definition of an embedded derivative. As a result, the Company carved out these embedded derivatives from the Financing Agreement and determined the fair value of each derivative using various discounted cash flow valuation models taking into account the probability of these events occurring and various scenarios surrounding the potential Revenue Interest payments that would be made if these events occurred (see Note 2). The aggregate fair value of the embedded derivatives as of December 31, 2013 was $233,000 and is included in other long-term liabilities. The fair value of the embedded derivatives of $247,000 was derecognized upon termination of the Financing Agreement on May 16, 2014 and is included in the loss on early extinguishment of debt in the statement of operations and comprehensive income (loss) for the nine months ended September 30, 2014 .

The Company received aggregate net proceeds of $29,485,000 from the Financing Agreement (including the purchase of common stock). The discounts, which were being amortized using the effective interest method over the term of the arrangement within interest expense, include the fair value of the common stock warrants issued to Healthcare Royalty of $790,000 upon the closing of the Financing Agreement, fees payable to Healthcare Royalty in connection with the execution of the arrangement of $476,000 and the fair value of embedded derivatives of $605,000 upon the closing of the Financing Agreement. The Company has recognized other income (expense) in relation to the change in the fair value of the Healthcare Royalty common stock warrant of $125,000 and $397,000 for the three and nine months ended September 30, 2014 , respectively, and $(8,000) and $(43,000) for the three and nine months ended September 30, 2013 , respectively, in the statement of operations and comprehensive income (loss). The Company has recognized other income in relation to the change in the fair value of the embedded derivatives of $0 and $14,000 for the three and nine months ended September 30, 2014 , respectively, and $1,474,000 and $912,000 for the three and nine months ended September 30, 2013 , respectively, in the statement of operations and comprehensive income (loss).

Upon early termination of the Financing Agreement on May 16, 2014, and the Company's Final Payment to Healthcare Royalty, the Company determined that the early termination resulted in an extinguishment of the outstanding debt and recognized a loss on early extinguishment of debt of $1,254,000 which was recorded as non-operating expenses in the statement of operations and comprehensive income (loss). The loss on early extinguishment of debt is related to the write-off of the unamortized balances of the debt discounts (which includes derecognition of the embedded derivative liabilities, as discussed above), debt acquisition costs, and accrued interest expenses related to the Financing Agreement.

In July 2012, in connection with a public offering of common stock and warrants, the Company sold warrants to purchase 15,784,200 shares of common stock (including over-allotment purchase). The warrants are exercisable at an exercise price of $2.50 per share and will expire on July 27, 2017 , which is five years from the date of issuance. As the warrants contain a cash settlement feature upon the occurrence of certain events that may be outside of the Company’s control, the warrants are recorded as a current liability and are marked to market at each reporting period (see Note 2). During the nine months ended September 30, 2014 , warrants to purchase 465,250 shares of common stock were exercised, and during the year ended December 31, 2013, warrants to purchase 103,500 shares of common stock were exercised. The Company recognized $1,163,000 and $259,000 in proceeds from the exercise of warrants during the nine months ended September 30, 2014 and during the year ended December 31, 2013, respectively. There were no warrants exercised during the three months ended September 30, 2014 . The fair value of the warrants outstanding was approximately $3,912,000 and $30,849,000 as of September 30, 2014 and December 31, 2013, respectively.

In July 2011, upon the closing of and in connection with the Financing Agreement (see Note 5), the Company issued to Healthcare Royalty a warrant exercisable into 225,000 shares of common stock. The warrant is exercisable at $9.00 per share of common stock and has a term of ten years. As the warrant contains covenants where compliance with such covenants may be outside of the Company’s control, the warrant was recorded as a current liability and is marked to market at each reporting date (see Note 2). The fair value of the warrant was approximately $95,000 and $492,000 as of September 30, 2014 and December 31, 2013, respectively.

On August 5, 2014, the Company entered into a new operating lease (the Lease) for approximately 17,361 rentable square feet of office space located in San Diego, California. The Company intends to use the leased premises as its corporate headquarters, and the new lease is expected to commence on December 1, 2014 upon expiration of the Company’s current San Diego office sublease of approximately 13,124 rentable square feet in the same location.

The Lease term will expire 64 months after the Lease commencement date with an option to renew the Lease for an additional five years . The initial base rent will be $73,784 per month, with 100% of rent being abated for the second, third, fourth and fifth months of the Lease term and 50% of rent being abated for the sixth month of the Lease term. The base rent will increase approximately 3.25% on a yearly basis throughout the Lease term. The Lease also requires the Company to pay additional rent consisting of a portion of common area and pass-through expenses in excess of base year amounts. The Company will begin to amortize rent expense related to this operating lease using a straight-line method when it gains access to the new leased space, which had not occurred as of September 30, 2014. Further, under the Lease, the landlord will provide up to $382,000 in a tenant improvements allowance to support interior improvements for the rented space. The tenant improvements will be capitalized by the Company as the improvements are made.

The Company uses the Black-Scholes option-pricing model for determining the estimated fair value of stock-based compensation for stock-based awards to employees and the board of directors. The assumptions used in the Black-Scholes option-pricing model for the three and nine months ended September 30, 2014 and 2013 are as follows:

 

The risk-free interest rate assumption was based on the rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the expected term of the award being valued. The assumed dividend yield was based on the Company’s expectation of not paying dividends in the foreseeable future. The weighted average expected term of options was calculated using the simplified method as prescribed by accounting guidance for stock-based compensation. This decision was based on the lack of relevant historical data due to the Company’s limited historical experience. In addition, due to the Company’s limited historical data, the estimated volatility was calculated based upon the Company's historical volatility, supplemented with historical volatility of comparable companies whose share prices are publicly available for a sufficient period of time.

The Company recognized stock-based compensation expense as follows (in thousands):

 

As of September 30, 2014 , there was approximately $15,079,000 of total unrecognized compensation costs related to outstanding employee and board of director stock options and restricted stock units, which is expected to be recognized over a weighted average period of 2.6 years.

As of September 30, 2014 , there were 181,000 unvested stock options outstanding to consultants, with approximately $151,000 of related unrecognized compensation expense based on a September 30, 2014 measurement date. These unvested stock options outstanding to consultants are expected to vest over a weighted average period of 2.2 years . In accordance with accounting guidance for stock-based compensation, the Company re-measures the fair value of stock option grants to non-employees at each reporting date and recognizes the related income or expense during their vesting period. The income recognized from the valuation of stock options and restricted stock units to consultants was $80,000 and $230,000 for the three and nine months ended September 30, 2014 , respectively, and was immaterial for the three and nine months ended September 30, 2013 . Stock option expense for awards issued to consultants is included in the consolidated statement of operations and comprehensive income (loss) within selling, general and administrative expense.

 

Brabant Pharma Limited Sales and Purchase Agreement

On October 24, 2014, Zogenix Europe acquired Brabant, pursuant to the terms of the Sale and Purchase Agreement dated October 24, 2014, by and among Zogenix Europe, the Company, Brabant and Anthony Clarke, Richard Stewart, Ann Soenen-Darcis, Jennifer Watson, Reyker Nominees Limited and Aquarius Life Science Limited (collectively, the Sellers). In connection with the consummation of the transactions on October 24, 2014 (the closing) contemplated by the Sale and Purchase Agreement, Zogenix Europe purchased the issued share capital of Brabant from the Sellers (the Acquisition) and the Company agreed to guarantee the obligations, commitments, undertakings and warranties of Zogenix Europe. Brabant owns worldwide development and commercialization rights to Brabafen, low-dose fenfluramine, for the treatment of Dravet syndrome (also known as Severe Myoclonic Epilepsy of Infancy). Dravet syndrome is a rare and catastrophic form of pediatric epilepsy with life threatening consequences for patients and current treatment options are very limited. Brabafen has recently received orphan drug designation in Europe and the United States for the treatment of Dravet syndrome.

Under the terms of the Sale and Purchase Agreement, at the closing Zogenix Europe paid to the Sellers consideration of (i)  $20,000,000 in cash (plus $8,432,000 which represents the net cash position of Brabant at the closing), of which $2,000,000 (the escrow amount) will be deposited into escrow to fund potential indemnification claims for a period of 6 months, and (ii)  11,995,202 shares (the Shares) of the Company’s common stock. Zogenix Europe also committed to paying up to an aggregate amount of $95,000,000 in connection with the achievement of certain milestones for Brabafen, including $50,000,000 in regulatory milestones and $45,000,000 in sales milestones. The Company has agreed to use commercially reasonable efforts (as defined in the Sale and Purchase Agreement) to develop and commercialize Brabafen and to achieve the milestones.

In September 2012, Brabant entered into a collaboration and license agreement with the Universities of Antwerp and Leuven in Belgium (the Universities), which was amended and restated in October 2014. Under the terms of the agreement, the Universities granted Brabant an exclusive worldwide license to use the data obtained from the study, as well as certain intellectual property related to fenfluramine for the treatment of Dravet syndrome. Brabant is required to pay a mid single-digit percentage royalty on net sales of fenfluramine for the treatment of Dravet syndrome or, in the case of a sublicense of fenfluramine for the treatment of Dravet syndrome, a percentage in the mid-twenties of the sub-licensing revenues. The agreement terminates in September 2020; however, upon the commencement of Phase 3 clinical trials of fenfluramine or marketing approval by a regulatory authority, the agreement will be extended until September 2045. The agreement may be

terminated by the Universities if Brabant: (a) does not use commercially reasonable efforts to (i) develop and commercialize fenfluramine for the treatment of Dravet syndrome or related conditions stemming from infantile epilepsy, or (ii) seek approval of fenfluramine for the treatment of Dravet syndrome in the United States; or (b) if Brabant becomes insolvent, shall make an assignment for the benefit of creditors, or shall have a petition in bankruptcy filed for or against it or for any similar relief has been filed against it. Brabant can terminate the agreement upon specified prior written notice to the Universities.

Both Zogenix Europe and the Sellers agreed to customary warranties and covenants in the Sale and Purchase Agreement. The Sellers agreed to indemnify Zogenix Europe for certain matters, including breaches of warranties and covenants included in the Sale and Purchase Agreement, up to the escrow amount, subject to limited exceptions.

Pursuant to the Sale and Purchase Agreement, the Company has agreed to prepare and file a registration statement on Form S-3 covering the resale of the Shares issued to the Sellers within 90 days of the closing and to use commercially reasonable efforts to cause such registration statement to be declared effective as promptly as practicable following the filing.

The Company will complete its accounting for this business combination during the fourth quarter of 2014.

Purdue Pharma L.P. Waiver Agreement

On October 29, 2014, the Company entered into a waiver agreement (the Waiver Agreement) with Purdue Pharma L.P. (Purdue) pursuant to which the Company granted a waiver to Purdue of the three -year Hatch-Waxman regulatory exclusivity period with respect to NDA 202880 for Zohydro ER in support of Purdue’s single-entity, extended-release hydrocodone product which is the subject of pending NDA 206627 and any single-entity, once-daily hydrocodone successor products or NDAs filed by Purdue (the Purdue Products). In addition, Purdue granted the Company a waiver of the Hatch-Waxman regulatory exclusivity period with respect to Purdue Products in support of our single-entity, twice-a-day hydrocodone product, including Zohydro ER and any successor products with any abuse deterrent properties or labeling claims. Under the terms of the Waiver Agreement, Purdue will pay to the Company (i) $5,000,000 within fifteen ( 15 ) days of the date of the Waiver Agreement, (ii)  $5,000,000 on July 1, 2015, and (iii) a percentage royalty in the low single-digits on Purdue’s net sales of Purdue Product commencing on October 1, 2015 and ending on October 25, 2016, only to the extent such royalty payment by Purdue in the aggregate would exceed $5,000,000 and then only with respect to royalties in excess of such amount.

Teva Letter Agreement

On November 5, 2014, the Company entered into a letter agreement (the Letter Agreement) with Teva Pharmaceuticals USA, Inc. (Teva), under which the Comapny granted Teva a right of reference to certain carcinogenicity data generated by the Company for hydrocodone bitrate for use in connection with Teva’s NDA for its extended-release hydrocodone product candidate. Teva is obligated to pay the Company a one -time fee of $3,500,000 within 30 days of the date of the Letter Agreement.