Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by words such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential” and similar expressions intended to identify forward-looking statements. Examples of these statements include, but are not limited to, statements related to the process and timing of anticipated future development of AcelRx's product candidates, ARX-04 ( sufentanil sublingual tablet, 30 mcg) and Zalviso ^® (sufentanil sublingual tablet system), including the ARX-04 clinical trial results; anticipated submission of the New Drug Application, or NDA, for ARX-04 to the U.S. Food and Drug Administration, or FDA; AcelRx’s pathway forward towards gaining approval of Zalviso in the U.S. , including the successful completion of the IAP312 clinical study for Zalviso; anticipated resubmission of the Zalviso NDA to the FDA, including the scope and timing of the resubmission, and FDA review time; the status of the Collaboration and License Agreement with Grünenthal GmbH, a company organized under the laws of Germany, or Grünenthal, or any other future potential collaborations, including potential milestones and royalty payments under the Grünenthal agreement; and the therapeutic and commercial potential of AcelRx’s product candidates, including potential market opportunities for ARX-04 and Zalviso. These forward -looking statements are based on AcelRx Pharmaceuticals’ current expectations and inherently involve significant risks and uncertainties. AcelRx Pharmaceuticals’ actual results and timing of events could differ materially from those anticipated in such forward-looking statements, and as a result of these risks and uncertainties, which include, without limitation, risks related to AcelRx Pharmaceuticals’ ARX-04 development program, including anticipated submission of the ARX-04 NDA and the possibility that the FDA may dispute or interpret differently clinical results obtained from the Phase 3 ARX-04 studies; AcelRx’s ability to successfully execute the pathway towards a resubmission of the Zalviso NDA to the FDA, including successful completion of the IAP312 clinical study for Zalviso; any delays or inability to obtain and maintain regulatory approval of its product candidates, including ARX-04 in the United States and Europe, and Zalviso in the United States; AcelRx’s ability to receive any milestones or royalty payments under the Grünenthal agreement and the timing thereof; ability to manufacture and supply sufficient quantities of Zalviso to Grünenthal on a timely basis; the commercial success of Grünenthal ’s launch of Zalviso in the European Union, or EU; the uncertain clinical development process, including adverse events; the risk that planned clinical trials may not have an effective clinical design, enroll a sufficient number of patients, or be completed on schedule, if at all; the success, cost and timing of all development activities and clinical trials, including the additional clinical trial for Zalviso, IAP312; the market potential for AcelRx’s product candidates; the accuracy of AcelRx’s estimates regarding expenses, capital requirements and the need for financing. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A of this Quarterly Report on Form 10-Q and our other filings with the SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from those we expect. Except as required by law, we assume no obligation to update these forward-looking statements, whether as a result of new information, future events or otherwise.

The following discussion and analysis should be read in conjunction with the unaudited financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q and with the audited consolidated financial statements and related notes thereto included as part of our Annual Report on Form 10-K for the year ended December 31, 2015.

About AcelRx Pharmaceuticals  

We are a specialty pharmaceutical company focused on the development and commercialization of innovative therapies for the treatment of acute pain. Our lead product candidates, ARX-04 and Zalviso ^® , utilize sublingual sufentanil, delivered via a non-invasive route of administration. We intend to commercialize our product candidates in the United States and license the development and commercialization rights to our product candidates for sale outside of the United States through strategic partnerships and collaborations. We may also consider the option to enter into strategic partnerships for our product candidates in the United States.

ARX-04 (sufentanil sublingual tablet, 30 mcg)

ARX-04 is an investigational product candidate consisting of a single tablet delivered via a disposable, pre-filled, single-dose applicator, or SDA. We are developing ARX-04 for the treatment of moderate-to-severe acute pain to be administered by a healthcare professional to a patient in medically-supervised settings of acute pain. If approved, examples of potential patient populations and settings in which ARX-04 could be used include: emergency room patients; patients who are recovering from short-stay or ambulatory surgery and do not require more long-term patient-controlled analgesia; post-operative patients who are transitioning from the operating room to the recovery floor; patients being treated and transported by paramedics; and for battlefield casualties.

In September 2015, we reported that SAP301, a pivotal Phase 3 multi-center, double-blind, placebo-controlled study of ARX-04 that evaluated the efficacy and safety of ARX-04 vs. placebo for the treatment of moderate-to-severe acute pain following ambulatory abdominal surgery, met its primary and secondary endpoints. Results demonstrated that patients receiving ARX-04 administered via a disposable, pre-filled SDA experienced significantly greater pain reduction compared to placebo, as measured by the SPID-12 (p<0.001). Adverse events reported in the study were typical of opioid therapy and were similar for patients treated with ARX-04 and placebo, the most common of which were nausea, headache and vomiting.

We held a pre-NDA meeting with the FDA in December 2015 to review plans for an NDA for ARX-04. Based on discussions with the FDA, we expanded the clinical program for ARX-04 by 176 additional patients to include individuals from specific populations and settings, in order to increase the ARX-04 safety database. We enrolled 76 patients in the SAP302 open-label study in the emergency room, and we enrolled 140 post-operative patients, 40 years of age and older, with moderate-to-severe acute pain in a new open-label study, known as SAP303.

Overall, the 76 adults treated with ARX-04 in the SAP302 study experienced a mean PID-1 of 2.9 from a baseline of 8.1, or a decrease in pain intensity of 35%. In addition, ARX-04 demonstrated a predicted onset of activity in patients enrolled in SAP302. Patients reported a mean pain intensity decrease of 1.1 compared to baseline 15 minutes following first administration of ARX-04, and a decrease of 1.9 after 30 minutes. 

ARX-04 was well tolerated in the SAP302 study, with 79% of patients reporting no adverse events. The most common adverse events reported in the study occurred with single-digit rates - the most common being nausea (9%), somnolence (5%) and vomiting (4%). All these events were rated as mild with the exception of one event of moderate nausea. Drug-induced cognitive impairment was not seen with ARX-04 in this study as assessed using the validated Six-Item Screener, an instrument used to identify patients with cognitive impairment.  

Results from the SAP303 clinical trial, which allowed for administration of ARX-04 for up to 12 hours in 140 patients 40 years of age and older who had moderate-to-severe acute pain following a surgical procedure with general anesthesia or spinal anesthesia (except those who received intrathecal opioids), were reported in September 2016. In this study, ARX-04 was well tolerated in the management of moderate-to-severe acute pain in post-operative study patients, including elderly patients and those with organ impairment. Regardless of age and organ function, approximately 2 in 3 patients had no adverse events during the study (63% of all patients, 63% of those aged ≥65 years, 62% of those with hepatic impairment, 70% of those with renal impairment). The most common adverse events were nausea and headache. On a global assessment of ARX-04 as a method of pain control, 90% of healthcare professionals and 87% of patients responded "good" or "excellent."

The primary efficacy variable for SAP303 was the time-weighted summed pain intensity difference over the 12-hour study period (SPID12), and secondary efficacy variables included pain intensity by evaluation time point. In this study, ARX-04 showed a reduction in pain intensity starting at 30 minutes after the first dose, followed by 27%, 49%, and 57% reductions in mean pain intensity from a baseline mean pain score of 6.2 at 1 hour, 2 hours, and 12 hours, respectively.

With the completion of the Phase 3 clinical program for ARX-04, and the positive data obtained from all three studies, we anticipate submitting the NDA to the FDA for ARX-04 for the treatment of moderate-to-severe acute pain in medically-supervised settings by the end of 2016.

On May 11, 2015, we entered into an award contract supported by the Clinical and Rehabilitative Medicine Research Program, or CRMRP, of the United States Army Medical Research and Materiel Command, or USAMRMC, within the U.S. Department of Defense, or the DoD, in which the DoD agreed to provide up to $17.0 million to support the development of ARX-04, referred to as the DoD Contract. Under the terms of the contract, the DoD has and will reimburse us for costs incurred for development, manufacturing, regulatory and clinical costs outlined in the contract in order to submit an NDA to the FDA, including reimbursement for certain personnel and overhead expenses. The period of performance under the DoD Contract began on May 11, 2015. The contract gives the DoD the option to extend the term of the contract and provide additional funding. On March 2, 2016, the DoD Contract was amended to approve enrollment of additional patients in the SAP302 study, approve the addition of the SAP303 study, and extend the contract period of performance by four months from November 10, 2016 to March 9, 2017, to accommodate the increased SAP302 patient enrollment and the SAP303 study. The costs for these changes will be absorbed within the current contract value. If ARX-04 is approved by the FDA, the DoD has the option to purchase a certain number of units of commercial product pursuant to the terms of the contract.

We have also held various meetings with Health Authorities in Europe to discuss the submission of a Marketing Authorization Application, or MAA, for ARX-04. Based on feedback from these discussions, we intend to submit a hybrid application for a label indication for ARX-04 in the EU for acute moderate-to-severe pain following surgery, or as a result of trauma. At the time of the anticipated submission of the MAA, we will have only completed one study in the emergency room for acute pain patients, in addition to three Phase 3 post-operative pain studies. We may need an additional controlled study in the emergency department with ARX-04 to obtain a label that includes trauma-related pain in addition to post-operative pain. We also anticipate we may need comparator studies in the EU to ensure premium reimbursement in certain countries. We anticipate submitting the MAA for ARX-04 in the first half of 2017.

Zalviso (sufentanil sublingual tablet system)

Our product candidate, Zalviso, is intended for the management of moderate-to-severe acute pain in hospitalized adult patients. Zalviso consists of sufentanil sublingual tablets, 15 mcg, delivered by the Zalviso System, a needle-free, handheld, patient-administered, pain management system, or together, Zalviso.

Zalviso is a pre-programmed, non-invasive, system to allow hospital patients with moderate-to-severe acute pain to self-dose with sufentanil sublingual tablets, 15 mcg, to manage their pain. Zalviso is designed to help address certain problems associated with post-operative intravenous patient-controlled analgesia. Zalviso allows patients to self-administer sufentanil sublingual tablets via a pre-programmed, secure system designed to eliminate the risk of programming errors.  

On December 16, 2013, AcelRx and Grünenthal GmbH, a company organized under the laws of Germany, or Grünenthal, entered into a Collaboration and License Agreement, or the License Agreement, and related Manufacture and Supply Agreement, or the MSA, and together with the License Agreement, the Agreements. The License Agreement grants Grünenthal rights to commercialize Zalviso, our novel sublingual patient-controlled analgesia, or PCA, system, or the Product, in the countries of the European Union, or EU, Switzerland, Liechtenstein, Iceland, Norway and Australia, or the Territory, for human use in pain treatment within, or dispensed by, hospitals, hospices, nursing homes and other medically-supervised settings, or the Field. We retain rights with respect to the Product in countries outside the Territory, including the United States, Asia and Latin America. Under the MSA, we will exclusively manufacture and supply the Product to Grünenthal for the Field in the Territory. We entered into amendments to the License Agreement, effective July 17, 2015 and September 20, 2016, or the License Amendments, and together with the License Agreement, the Amended License Agreement, and entered into an amendment to the MSA, or the MSA Amendment, and together with the MSA, the Amended MSA, effective as of July 17, 2015, and together, the Amended Agreements. For additional information on the Amended Agreements, see Note 5 “Collaboration Agreement” in the accompanying notes to the condensed consolidated financial statements.

Grünenthal is responsible for all commercial activities for Zalviso, including obtaining and maintaining pharmaceutical product regulatory approval in the Territory. We are responsible for obtaining and maintaining device regulatory approval in the Territory and the manufacturing and supply of Zalviso to Grünenthal for commercial sales.

Zalviso is currently commercially available for sale in Germany, France and the UK. Grünenthal currently has pilot programs in Belgium, Italy, the Netherlands and Ireland. Pilot programs are expected to last several months after which Zalviso may be available for commercial sale. Royalty revenues and non-cash royalty revenues from the commercial sales of Zalviso in the EU are expected to be minimal for 2016.

On September 18, 2015, we sold a portion of the expected royalty stream and commercial milestones from the sales of Zalviso in the EU by Grünenthal to PDL, or the Royalty Monetization. AcelRx received gross proceeds of $65.0 million in the Royalty Monetization. PDL will receive 75% of the European royalties under the Amended License Agreement with Grünenthal, as well as 80% of the first four commercial milestones worth $35.6 million (or 80% of $44.5 million), subject to the capped amount of $195.0 million. For additional information on the Royalty Monetization with PDL, see Note 7 “Liability Related to Sale of Future Royalties” in the accompanying notes to the condensed consolidated financial statements.

We submitted an NDA for Zalviso in September 2013, which the FDA accepted for filing in December 2013. On July 25, 2014, the FDA issued a Complete Response Letter, or CRL, for the Zalviso NDA. The CRL contains requests for additional information on the Zalviso System to ensure proper use of the device. The requests include submission of data demonstrating a reduction in the incidence of optical system errors, changes to address inadvertent dosing, among other items, and submission of additional data to support the shelf life of the product. Although there were no requests for additional clinical studies in the CRL, in March 2015, we received correspondence from the FDA stating that, in addition to the work we had performed to address the items in the CRL, a clinical study would be required to test modifications to the Zalviso device.

The IAP312 study was initiated in September 2016. We anticipate the enrollment and treatment period for IAP312 will continue through mid-2017. The IAP312 study will enroll approximately 315 hospitalized, post-operative patients and collect information requested by the Division of Anesthesia, Analgesia, and Addiction Products, or the Division, of the FDA to supplement the three positive Phase 3 trials already completed. In this study, patients will use Zalviso to self-administer sublingually tablets containing 15 micrograms of sufentanil as often as once every 20 minutes for 24‑ to-72 hours to manage their moderate-to-severe acute pain. In addition to safety and efficacy measures, IAP312 will collect information on device usability, including any incidence of Zalviso's failure to dispense medication as well as the incidence of misplaced or dropped tablets.  

Three Phase 3 studies for Zalviso in a total of 768 patients have been completed to date: IAP309, IAP310 and IAP311. In brief, IAP309 was a Phase 3 open-label, active comparator study, in which Zalviso was shown to be non-inferior (p<0.001), as well as superior (p=0.007), to intravenous, or IV, patient-controlled analgesia, or PCA, morphine based on the primary endpoint of Patient Global Assessment method of pain control comparison over the 48-hour trial period, or PGA48. IAP310 and IAP311 were Phase 3 double-blind, placebo-controlled studies in which patients treated with Zalviso to manage their post-operative pain reported a greater summed pain intensity difference to baseline over 48 hours, or SPID48, the primary endpoint, compared to placebo-treated patients (p=0.001 and p<0.001, respectively). The most common adverse events experienced by patients using Zalviso in these clinical studies were nausea, pyrexia (fever) and vomiting.

For Zalviso, we estimate there are 7.8 million inpatient surgery patients and, lastly, we estimate there are 1.8 million hospital inpatient floor (non-surgical) patients who could be eligible for treatment with either ARX-04 or Zalviso, if approved in the United States.

Europe

According to recent EU5 (France, Germany, Italy, Spain, and the United Kingdom) national health statistics, 142 million patients are represented across the ARX-04 target segments annually. Each year, there are an estimated 110 million emergency attendances and 32 million surgical procedures performed each year. It is anticipated that there are 51 million patients in emergency medicine with moderate-to-severe acute pain and 16 million with moderate-to-severe acute pain following surgery each year. Using the published priced benchmarks of Penthrox (methoxyflurane) and branded fentanyl products, £17.89 (UK) and €8.04 (Germany), respectively, we believe that ARX-04 could achieve a €15 price per unit. A recently published micro-costing literature review has determined the total cost of drug and labor per patient necessary to administer IV opioids in the emergency department in the EU5 countries ranges from €18.31 to €26.09. Based on this information, we believe peak year sales in emergency medicine and post-operative pain across Europe are expected to be approximately €700 million, assuming ARX-04 achieves a €15 price point; however, there can be no assurance that ARX-04 will be able to achieve a €15 price per unit.

Financial Overview

We have incurred net losses and generated negative cash flows from operations since inception and expect to incur losses in the future as we continue our research and development activities and pre-commercialization activities. As a result, we expect to continue to incur negative cash flows. Although Zalviso has been approved for sale in the EU, we sold the majority of the royalty rights and certain commercial sales milestones we are entitled to receive under the Grünenthal Agreements to PDL in September 2015. As we pursue development of our product candidates, including regulatory review and potential commercial development, subject to FDA approval, of our product candidates, we expect the business aspects of our company to become more complex. In the future, we plan to add personnel and incur additional costs related to the maturation of our business and the potential commercialization of ARX-04 and Zalviso in the United States. In addition, we believe that continued investment in research and development is critical to attaining our strategic objectives. In order to develop our product candidates as commercially viable therapeutics, we expect to expend significant resources for expertise in manufacturing, regulatory affairs, clinical research and other aspects of pharmaceutical development.

To date, we have funded our operations primarily through the issuance of equity securities, borrowings, payments from our commercial partner, Grünenthal, monetization of certain future royalties and commercial sales milestones from the sales of Zalviso by Grünenthal, and funding from the DoD.  

Our revenues since inception have consisted primarily of revenues from our Amended License Agreement with Grünenthal and our research contracts with the DoD. As mentioned above, in May 2015, the DoD agreed to provide us up to $17.0 million to support the development of ARX-04. Under the terms of the contract, the DoD has and will reimburse us for costs incurred for development, manufacturing, regulatory and clinical costs outlined in the contract in order to submit an NDA to the FDA, including reimbursement for certain personnel and overhead expenses.

There can be no assurance that we will enter into other collaborative agreements or receive research-related contract awards in the future. We expect revenues to continue to fluctuate from period-to-period. There can be no assurance that our relationship with our existing commercial partner, Grünenthal, will continue beyond the initial term, or that we will be able to meet the milestones specified in the Amended License Agreement, or that we will obtain marketing approval for any of our product candidates, outside of Zalviso in the EU and EEA, and subsequently generate revenue from those product candidates in excess of our operating expenses.

Our net loss for the three months and nine months ended September 30, 2016 was $11.4 million and $33.5 million, respectively, compared to net income of $5.1 million and net loss of $13.9 million for the three and nine months ended September 30, 2015, respectively. As of September 30, 2016, we had an accumulated deficit of $236.7 million. As of September 30, 2016, we had cash, cash equivalents and investments totaling $92.5 million compared to $113.5 million as of December 31, 2015.

Critical Accounting Estimates

The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements and the related disclosures, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts in our financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. Our critical accounting policies and estimates are detailed in our Annual Report on Form 10-K for the year ended December 31, 2015. There have been no significant changes in our critical accounting policies and estimates during the three and nine months ended September 30, 2016 from those previously disclosed in our Annual Report on Form 10-K.

Recently Issued Accounting Standards

In August 2016, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2016-15,  Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments,  addressing eight specific cash flow issues in an effort to reduce diversity in practice. The amended guidance is effective for fiscal years beginning after December 31, 2017, and for interim periods within those years. Early adoption is permitted. We do not expect the amended guidance to have a material impact on our statements of cash flows.

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718) , which is part of the FASB's Simplification Initiative. The updated guidance simplifies the accounting for share-based payment transactions. The amended guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, with early adoption permitted. We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) , which establishes a new lease accounting model for lessees. The updated guidance requires an entity to recognize assets and liabilities arising from a lease for both financing and operating leases, along with additional qualitative and quantitative disclosures. The amended guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers , to provide guidance on revenue recognition. ASU No. 2014-09 requires a company to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under today’s guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date , which provided for the adoption of the new standard for fiscal years beginning after December 15, 2017. Accordingly, ASU No. 2014-09 is effective for the Company in the first quarter of 2018. Early adoption up to the first quarter of 2017 is permitted. Upon adoption, ASU No. 2014-09 can be applied retrospectively to all periods presented or only to the most current period presented with the cumulative effect of changes reflected in the opening balance of retained earnings in the most current period presented. The FASB has also issued the following standards which clarify ASU No. 2014-09 and have the same effective date as the original standard:

We are currently evaluating the method of adoption and the impact of adopting ASU No. 2014-09 on our consolidated financial statements. 

Results of Operations

Three and Nine Months Ended September 30, 2016 and 2015

Revenue   

In September 2015, the European Commission, or EC, granted marketing approval for Zalviso in the EU to our commercial partner, Grünenthal. Zalviso is currently commercially available for sale in Germany, France and the UK. Grünenthal currently has pilot programs in Belgium, Italy, the Netherlands and Ireland. Pilot programs are expected to last several months after which Zalviso may be available for commercial sale. We anticipate that royalty revenues and non-cash royalty revenues from the commercial sale of Zalviso in 2016 will be minimal. Revenue during the three months ended September 30, 2016, was $3.4 million, including $1.6 million in collaboration agreement revenue recognized under our Amended Agreements with Grünenthal, plus $1.8 million in revenue for services performed under the DoD Contract.

Revenue for the three and nine months ended September 30, 2015, was $15.4 million and $17.5 million, respectively, the majority of which was generated under our collaboration agreement with Grünenthal.

In support of the launch of Zalviso in Europe by our licensee, Grünenthal, we recognized $1.4 million and $4.3 million in product sales in the three and nine months ended September 30, 2016, respectively, consisting of Zalviso devices, drug product and accessories. Delivery of the Zalviso cartridges ordered by Grünenthal is behind schedule at Patheon. The inability to deliver cartridges to the schedule ordered by Grünenthal may have a negative impact on their future sales including the timing of their launch in certain countries. We are working with Patheon to resolve these issues; however, there can be no assurance that the issues will be resolved in a timely fashion, or that we will be able to meet Grünenthal’s needs in such a way as to not impact their future sales.

The first commercial sale of Zalviso occurred in April 2016. As mentioned above, under the Royalty Monetization, we sold a portion of the expected royalty stream and commercial milestones from the sales of Zalviso in the EU by Grünenthal to PDL. As the royalty amounts are not currently reasonably estimable without the royalty reports, we recognize royalty revenue and non-cash royalty revenue on a quarterly basis in arrears.

As of September 30, 2016, we had current and non-current portions of the deferred revenue balance under the Amended Agreements of $0.4 million and $3.9 million, respectively. Our long-term deferred revenue balance increased during the nine months ended September 30, 2016 from $0.6 million to $3.9 million. The estimated margin we expect to receive on transfer prices under the Amended Agreements was deemed to be a significant and incremental discount on manufacturing services, as compared to market rates for contract manufacturing margin. The value assigned to this portion of the total allocated consideration was $4.4 million. We anticipate that the long-term deferred revenue balance will decline on a straight-line basis through 2029, as we recognize collaboration revenue under the Amended Agreements.   

Contract and Other Revenue  

During the three and nine months ended September 30, 2016, AcelRx recognized revenue of $1.8 million and $6.2 million, respectively, for services performed under the DoD contract for ARX-04. Revenue for the three and nine months ended September 30, 2015, was $1.5 million and $3.0 million, respectively, for services performed under the DoD contract.

Cost of goods sold  

Total cost of goods sold was $2.6 million and $9.2 million for the three and nine months ended September 30, 2016, respectively. As mentioned above, the EC approved Zalviso in late September 2015. Under the Amended Agreements with Grünenthal, we will sell Zalviso at a predetermined transfer price that approximates the direct cost of manufacture at our contract manufacturers. We will not recover internal indirect costs as part of the transfer price. In addition, the Amended Agreements include declining maximum transfer prices over the term of the contract with Grünenthal. These transfer prices were agreed to assuming economies of scale that would occur with increasing production volumes and corresponding decreases in manufacturing costs. We do not have long-term supply agreements with our contract manufacturers and prices are subject to periodic changes. To date, we have not received U.S. approval of Zalviso and the Grünenthal launch is in the very early stages. If we do not receive timely approval of Zalviso in the U.S., are unable to successfully launch Zalviso in the U.S., or the volume of Grünenthal sales does not increase significantly, we are not likely to achieve the manufacturing cost reductions required in order to accommodate these declining transfer prices without a corresponding decrease in our gross margin. Cost of goods sold for Zalviso delivered to Grünenthal includes the inventory costs of the active pharmaceutical ingredient, or API, third-party contract manufacturing costs, estimated warranty costs, packaging and distribution costs, shipping, handling and storage costs. The indirect costs to manufacture include internal personnel and related costs for purchasing, supply chain, quality assurance, depreciation and related expenses. Prior to the initiation of commercial production in October 2015, these costs were included in research and development expenses as period costs.  

Research and Development Expenses

Conducting research and development is central to our business model. The majority of our operating expenses to date have been for research and development activities related to Zalviso; however, in 2016 we anticipate that research and development expenses for ARX-04 will be greater than those for Zalviso. Research and development expenses included the following:

Product candidates in late stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of late stage clinical trials. We will incur substantial future research and development expenditures as we seek to continue development of ARX-04 and Zalviso, including the expenses associated with the anticipated submission of the NDA for ARX-04, in addition to conducting IAP312, the additional clinical trial for Zalviso.

We track external development expenses on a program-by-program basis. Our development resources are shared among all of our programs. Compensation and benefits, facilities, depreciation, stock-based compensation, and development support services are not allocated specifically to projects and are considered research and development overhead. Below is a summary of our research and development expenses during the three and nine months ended September 30, 2016 and 2015:

Due to the inherently unpredictable nature of product development, development timelines and the probability of success, development costs can differ materially from expectations. While we are currently focused on advancing ARX-04 and the continued development of Zalviso, our future research and development expenses will depend on the clinical success of each product candidate as well as ongoing assessments of the commercial potential of our product candidates. In addition, we cannot predict which product candidates may be subject to future collaborations, when these arrangements will be secured, if at all, and to what degree these arrangements would affect our development plans and capital requirements.  

Research and development expenses during the three months ended September 30, 2016, as compared to the three months ended September 30, 2015, decreased by $0.8 million primarily due to a $1.0 million reduction in overhead costs, predominantly as a result of the allocation of certain research and development personnel and related expenses to cost of goods sold. In addition, Zalviso-related expenses decreased by $0.2 million due to the completion of certain development activities as we finalized the development path forward with the FDA, while ARX-04-related spending increased incrementally by $0.4 million due to increased spending as we completed the SAP302 and SAP303 studies and increased activity related to the preparation of the NDA submission, partially offset by the completion of the SAP301 study in 2015.

The $3.9 million decrease in research and development expenses during the nine months ended September 30, 2016, as compared to the nine months ended September 30, 2015, was primarily attributable to a $3.5 million reduction in overhead costs, predominantly as a result of the allocation of certain research and development personnel and related expenses to cost of goods sold. In addition, during the first nine months of 2016, Zalviso-related expenses decreased by $1.2 million while ARX-04-related spending increased by a $0.8 million, as compared to the first nine months of 2015.

General and Administrative Expenses

General and administrative expenses consisted primarily of salaries, benefits and stock-based compensation for personnel in administration, finance, pre-commercialization and business development activities. Other significant expenses included legal expenses related to litigation and patent protection of our intellectual property, allocated facility costs and professional fees for general legal, audit and consulting services. We expect general and administrative expenses for the remainder of 2016 to continue to increase as compared to 2015 expenses, as we focus our efforts on seeking marketing approval for ARX-04, and the continued development of Zalviso. In addition, we anticipate our general and administrative expenses will increase in 2017 as we prepare for the potential commercialization of ARX-04.

Total general and administrative expenses for the three and nine months ended September 30, 2016 and 2015 were as follows:

The $1.2 million increase in general and administrative expenses during the three months ended September 30, 2016, as compared to the three months ended September 30, 2015, was primarily due to $1.0 million in ARX-04-related market research activities, and an incremental increase of $0.2 million in other general and administrative expenses.

The $1.3 million increase in general and administrative expenses during the nine months ended September 30, 2016, as compared to the nine months ended September 30, 2015, was primarily due to $1.9 million in ARX-04-related market research activities, partially offset by decreases of $0.6 million in headcount-related expenses, including a $0.4 million decrease in stock-based compensation expense, and net decreases in other general and administrative expenses of $0.2 million.

Restructuring C osts  

In March 2015, we received correspondence from the FDA stating that in addition to the bench testing and two Human Factors studies we had performed in response to the issues identified in the CRL, a clinical trial would be needed to assess the risk of inadvertent dispensing and overall risk of dispensing failures. On March 19, 2015, our Board of Directors, in connection with our efforts to reduce operating costs, conserve capital, focus our financial and development resources on working with the FDA to seek marketing approval for Zalviso, and continuing development of ARX-04, implemented a cost reduction plan. The cost reduction plan reduced our workforce by 19 employees, approximately 36% of total headcount, in the first quarter of 2015.

Restructuring costs in the nine months ended September 30, 2015 consisted of employee termination benefit costs of $0.8 million which has been fully disbursed.

Interest expense consisted primarily of interest accrued or paid on our debt obligation agreements and amortization of debt discounts. Interest expense for all periods pertains to interest on our Loan and Security Agreement with Hercules Technology II, L.P. and Hercules Capital, Inc., formerly known as Hercules Technology Growth Capital, Inc., together, the Lenders or Hercules. In December 2013, we entered into the Amended Loan Agreement with Hercules, which amends and restates the Loan and Security Agreement. The overall debt facility was increased to $40.0 million, and the maturity was extended to October 1, 2017. On June 16, 2014, we borrowed the second tranche of $10.0 million. We did not have access to the third tranche, of up to $15.0 million, as we did not receive FDA approval of Zalviso by August 1, 2015. Interest expense in the three months ended September 30, 2016 was comparable to the prior year period as the principal balance was consistent during these periods; however, as a result of the lower average principal balance in the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015, the amount of interest expense incurred decreased in the year-to-date period. As of September 30, 2016, the balance due to Hercules was $21.3 million.

On September 18, 2015, concurrently with the closing of the Royalty Monetization, we entered into a Consent and Amendment No. 2, to the Amended Loan Agreement which, among other things, provided for an interest only period from October 1, 2015 through March 31, 2016, with further extension to September 30, 2016 upon satisfaction of certain conditions, which have since been satisfied. On September 30, 2016, we entered in Amendment No. 3 to the Amended Loan Agreement which, among other things, extends the interest only period from October 1, 2016 to April 1, 2017. Principal payments will then be payable through October 1, 2017. However, contingent upon FDA acceptance of the NDA for ARX-04 prior to April 1, 2017, we can elect to cause the Lenders to further amend and restate the Amended Loan Agreement in its entirety into a 36-month term note with an additional six month interest only period. In addition, subject to the achievement of certain milestones, we may be able extend the repayment period up to 48 months and extend the interest only period up to a total of 18 months. Among other things, the further amendment and restatement would reflect changes to the interest rate, the maturity date, certain covenants, and prepayment penalties, and would include up to $10 million of additional loans to be made available to us on the same terms, which would be subject to approval by Hercules Technology II, L.P.’s, or the Agent’s, investment committee (at the Lenders’ sole discretion).

Interest income and other income (expense), net, during the three and nine months ended September 30, 2016 and 2015, consisted primarily of the change in the fair value of our warrants, or PIPE warrants, issued in connection with our private placement of our common stock, which was completed in June 2012.

The change in interest income and other income (expense), net, during the three and nine months ended September 30, 2016 as compared to the three and nine months ended September 30, 2015, was primarily attributable to the change in the fair value of our warrants, or PIPE warrants, issued in connection with our private placement of our common stock, which was completed in June 2012. During the three months ended September 30, 2016, our stock price increased resulting in other expense for the revaluation of the PIPE warrants, while during the three months ended September 30, 2015, our stock price decreased, resulting in other income during the third quarter of 2015; however, this other income was more than offset by $0.5 million in impairment charges related to leasehold improvements in our corporate offices, also recognized in the third quarter of 2015. In the nine months ended September 30, 2016, we recorded other income related to the revaluation of the PIPE warrants due to our declining stock price, while in the nine months ended September 30, 2015, there was a much greater decline in our stock price, resulting in greater other income in the prior year period.

The increase in non-cash interest expense on liability related to the Royalty Monetization during the three and nine months ended September 30, 2016 as compared to the three and nine months ended September 30, 2015, is attributable to the royalty sale transaction that we completed in September 2015. As described above, the Royalty Monetization has been recorded as debt under the applicable accounting guidance. We impute interest on the liability and record interest expense based on the amount and timing of royalty and milestone payments expected to be received by PDL over the life of the arrangement. There are a number of factors that could materially affect the estimated interest rate and we will assess this estimate on a periodic basis. As a result, future interest rates could differ significantly and any such change in interest rate will be adjusted prospectively. We anticipate that we will incur an additional $2.5 million in non-cash interest expense related to the Royalty Monetization in the year ended December 31, 2016, for a total of $9.4 million in 2016.

The Royalty Monetization resulted in a taxable gain of more than $60.0 million, in the three and nine months ended September 30, 2015, the majority of which was offset with net operating loss carryforwards; however, we were subject to U.S. federal alternative minimum taxes in 2015, as reflected in our provision for income taxes in 2015.

Liquidity and Capital Resources

Liquidity

We have incurred losses and generated negative cash flows from operations since inception. We expect to continue to incur significant losses in 2016 and may incur significant losses and negative cash flows from operations for the foreseeable future. We have funded our operations primarily through issuance of equity securities, borrowings, payments from our commercial partner, Grünenthal, monetization of certain future royalties and commercial sales milestones from the sales of Zalviso by Grünenthal, and our contracts with the DoD.

On June 21, 2016, we entered into a Controlled Equity Offering ^SM Sales Agreement, or the Sales Agreement, with Cantor Fitzgerald & Co., or Cantor, as agent, pursuant to which AcelRx may offer and sell, from time to time through Cantor, shares of the Company’s common stock, or the Common Stock, having an aggregate offering price of up to $40.0 million, or the Shares. For a detailed description, see Note 9 “Stockholders’ Equity.”

As of September 30, 2016, we had cash, cash equivalents and investments totaling $92.5 million compared to $113.5 million as of December 31, 2015. The decrease was primarily due to cash required to fund our continuing operations, as we continue our research and development activities. We anticipate that our existing capital resources will permit us to meet our capital and operational requirements through at least the end of 2017. While we believe we have sufficient capital to meet our operational requirements through at least the end of 2017, our expectations may change depending on a number of factors. For example, although the FDA has reviewed the protocol we submitted for the requested clinical trial for Zalviso, IAP312, they may in the future require a scope or design change that is beyond what our current and estimated future capital resources can support. We believe that together with the support from the DoD Contract, we have sufficient resources to submit the NDA to the FDA. However, our existing capital resources will not be sufficient to fund our operations until such time as we may be able to generate sufficient revenues to sustain our operations.   

On September 18, 2015, we sold a portion of the expected royalty stream and commercial milestone payments from the sales of Zalviso in the EU by Grünenthal to PDL. As mentioned above, we received net proceeds of $61.2 million in the Royalty Monetization. PDL will receive 75% of the European royalties under the Amended License Agreement with Grünenthal, as well as 80% of the first four commercial milestones worth $35.6 million (or 80% of $44.5 million), subject to the capped amount of $195.0 million. We are entitled to receive all remaining amounts under the Amended License Agreement which include 25% of the European royalties, 20% of the first four commercial milestones, 100% of the remaining commercial milestones and all development milestones of $43.5 million, including the $15.0 million payment for the EC approval of the MAA for Zalviso, which we received in the fourth quarter of 2015. The total liability related to sale of future royalties to PDL as of September 30, 2016 was $70.5 million.

On December 16, 2013, AcelRx and Grünenthal entered into the License Agreement, and related Manufacture and Supply Agreement, or the MSA, and together with the License Agreement, the Agreements. The License Agreement grants Grünenthal rights to commercialize Zalviso, or the Product, in the Territory for human use in the Field. We retain rights with respect to the Product in countries outside the Territory, including the United States, Asia and Latin America. We entered into amendments to the License Agreement effective as of July 17, 2015 and September 20, 2016, or the License Amendments, and together with the License Agreement, the Amended License Agreement, and an amendment to the MSA effective as of July 17, 2015, or the MSA Amendment, and together with the MSA, the Amended MSA, and together, the Amended Agreements.

Under the terms of the Amended Agreements, we received an upfront cash payment of $30.0 million, a milestone payment of $5.0 million related to the MAA submission in the third quarter of 2014 and an additional $15.0 million milestone payment related to the EC approval of the MAA for Zalviso in September 2015. In addition, under the terms of the Amended Agreements, we are eligible to receive approximately $194.5 million in additional milestone payments, based upon successful regulatory and product development efforts ($28.5 million) and net sales target achievements ($166.0 million).  Grünenthal will also make tiered royalty, supply and trademark fee payments in the mid-teens up to the mid-twenties percent range, depending on the level of sales achieved, on net sales of Zalviso in the Territory. A portion of the tiered royalty payment, exclusive of the supply and trademark fee payments, will be paid to PDL in connection with the Royalty Monetization, as discussed above.

On December 16, 2013, AcelRx entered into the Amended Loan Agreement with Hercules, under which AcelRx may borrow up to $40.0 million in three tranches. The loans are represented by secured convertible term promissory notes, collectively, the Notes. The Amended Loan Agreement amends and restates the Loan and Security Agreement between AcelRx and the Lenders dated as of June 29, 2011. We borrowed the first tranche of $15.0 million upon closing of the transaction on December 16, 2013, and the second tranche of $10.0 million on June 16, 2014. We used approximately $8.6 million of the proceeds from the first tranche to repay our obligations under the Loan and Security Agreement with the Lenders. We recorded the new debt at an estimated fair value of $24.9 million as of December 31, 2014.

On September 24, 2014, we entered into Amendment No. 1 to the Amended Loan Agreement with Hercules which extended the time period under which we could draw down the third tranche, of up to $15.0 million, from March 15, 2015 to August 1, 2015, subject to AcelRx obtaining FDA approval for Zalviso. We did not receive FDA approval of Zalviso by August 1, 2015 and as such, did not have access to the third tranche.

On September 18, 2015, concurrently with the closing of the Royalty Monetization, we entered into a Consent and Amendment No. 2 to the Amended Loan Agreement with Hercules which includes an interest only period from October 1, 2015 through March 31, 2016, with further extension to September 30, 2016 upon satisfaction of certain conditions, which have since been satisfied. On September 30, 2016, we entered in Amendment No. 3 to the Amended Loan Agreement which extends the interest only period from October 1, 2016 to April 1, 2017.

Loans under the Amended Loan Agreement mature on October 31, 2017. As of September 30, 2016, the balance due to Hercules was $21.3 million.

Our cash and investment balances are held in a variety of interest bearing instruments, including obligations of U.S. government agencies, money market funds and time deposits. Cash in excess of immediate requirements is invested with a view toward capital preservation and liquidity.

Cash Flows from Operating Activities

The primary use of cash for our operating activities during these periods was to fund the development of our product candidates, including commercial readiness activities for our product candidates, ARX-04 and Zalviso. Our cash used for operating activities also reflected changes in our working capital, net of adjustments for non-cash charges, such as depreciation and amortization of our fixed assets, stock-based compensation, non-cash interest expense related to the sale of future royalties, interest expense related to our debt financings and the revaluation of our PIPE warrant liability and the contingent put option liability. 

Cash used in operating activities of $19.1 million during the nine months ended September 30, 2016, reflected a net loss of $33.5 million, partially offset by aggregate non-cash charges of $12.4 million, and a net change of $2.0 million in our net operating assets and liabilities. Non-cash charges included $6.9 million in non-cash interest expense on the liability related to the royalty monetization, $3.4 million for stock-based compensation, $1.5 million in depreciation expense, and $0.7 million in interest expense related to the Amended Loan Agreement, partially offset by $0.2 million for the change in fair value of our PIPE warrant liability and contingent put liability. The net change in our operating assets and liabilities included a decrease in accounts receivable of $1.3 million, an increase in deferred revenue of $1.1 million, a decrease in prepaid expenses and other assets of $0.7 million, and an increase in inventories of $1.0 million.

Cash used in operating activities of $26.9 million during the nine months ended September 30, 2015, reflected a net loss of $13.9 million, partially offset by aggregate non-cash charges of $4.5 million, and a net change of $17.6 million in our net operating assets and liabilities. Non-cash charges included $3.8 million for stock-based compensation, and $1.5 million for depreciation and amortization of our fixed assets, partially offset by a $2.4 million for the change in fair value of our PIPE warrant liability and contingent put liability and a $1.3 million decrease in accrued liabilities, primarily due to payment of compensation-related expenses. The net change in our operating assets and liabilities included a $17.4 million increase in accounts receivable, primarily due to the $15.0 million milestone receivable from Grünenthal.

Cash Flows from Investing Activities

Our investing activities have consisted primarily of our capital expenditures and purchases and sales and maturities of our available-for-sale investments.

During the nine months ended September 30, 2016, cash provided by investing activities of $3.6 million was primarily a result of $6.5 million in proceeds from maturity of investments, offset by $1.0 million for purchases of investments and $1.9 million for purchases of property and equipment.

During the nine months ended September 30, 2015, cash provided by investing activities of $4.8 million was primarily as a result of $7.3 million for purchases of investments and $1.1 million for purchases of property and equipment, partially offset by $13.2 million in proceeds from maturity of investments.

Cash Flows from Financing Activities

During the nine months ended September 30, 2016, cash used in financing activities of $26,000 was a result of the payment of debt modification transaction costs offset by stock purchases made under our 2011 Employee Stock Purchase Plan.

During the nine months ended September 30, 2015, cash provided by financing activities of $57.1 million was primarily due $61.2 million in net proceeds from the Royalty Monetization, partially offset by $4.5 million in payments on the Amended Loan Agreement with Hercules.

Operating Capital and Capital Expenditure Requirements

We expect our rate of cash usage to increase in the future, in particular to support our product development activities, including continued development of ARX-04, Zalviso and the potential commercialization of our product candidates, if approved outside of the Grünenthal Territory. Our future cash needs anticipate the receipt of reimbursement for qualified expenses under the DoD Contract. We anticipate that our existing capital resources will permit us to meet our capital and operational requirements through at least the end of 2017. Our current operating plan includes the continued development of ARX-04, specifically the filing of the NDA by the end of 2016. These assumptions may change as a result of many factors. For example, based on feedback from the FDA, we expanded the planned clinical program for ARX-04 by 176 additional patients to include individuals from specific populations and settings. As a result, the completion of the Phase 3 clinical program for ARX-04 was extended and our clinical trial expenses have increased. In addition, although the FDA has provided feedback on both the ARX-04 clinical program and reviewed the protocol for IAP312, the additional clinical trial for Zalviso, the FDA may in the future require us to complete additional work to submit the NDA for ARX-04 and/or to resubmit the NDA for Zalviso. We will continue to evaluate the work necessary to gain approval of ARX-04 and Zalviso in the U.S. and intend to update our cash forecasts accordingly. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. Additional capital may not be available on terms acceptable to us, or at all. If adequate funds are not available, or if the terms underlying potential funding sources are unfavorable, our business and our ability to develop our product candidates would be harmed.

Our future capital requirements may vary materially from our expectations based on numerous forward looking factors, including but not limited to the following:

We will need substantial funds to:

Our existing capital resources may not be sufficient to fund our operations until such time as we may be able to generate sufficient revenues to sustain our operations. To the extent that our capital resources are insufficient to meet our future capital requirements, we will have to raise additional funds through the sale of our equity securities, monetization of current and future assets, issuance of debt or debt-like securities or from development and licensing arrangements to continue our development programs. We may be unable to raise such additional capital on favorable terms, or at all. If we raise additional capital by selling our equity or convertible debt securities, the issuance of such securities could result in dilution of our shareholders’ equity positions. If adequate funds are not available we may have to:

Contractual Obligations  

During the nine months ended September 30, 2016, there were no material changes to our contractual obligations, other than the fulfillment of existing obligations in the ordinary course of business, described under Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended December 31, 2015.

Off-Balance Sheet Arrangements

Through September 30, 2016, we have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. 

  Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our cash, cash equivalents and short-term investments as of September 30, 2016, consisted primarily of money market funds and U.S. government agency securities. We do not have any auction rate securities on our condensed consolidated balance sheet, as they are not permitted by our investment policy. Our cash is invested in accordance with an investment policy approved by our Board of Directors which specifies the categories, allocations, and ratings of securities we may consider for investment. We do not believe our cash, cash equivalents and short-term investments have significant risk of default or illiquidity.

Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates, particularly because the majority of our investments are in short-term marketable debt securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. In an attempt to limit interest rate risk, we follow guidelines to limit the average and longest single maturity dates, place our investments with high quality issuers and follow internally developed guidelines to limit the amount of credit exposure to any one issuer. Some of the securities that we invest in may be subject to market risk. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we purchase a security that was issued with a fixed interest rate and the prevailing interest rate later rises, the value of our investment may decline. If a 10 percent change in interest rates were to have occurred on September 30, 2016, this change would not have had a material effect on the fair value of our investment portfolio as of that date. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate.

In addition, domestic and international equity markets have experienced and may continue to experience heightened volatility and turmoil based on domestic and international economic conditions and concerns. In the event these economic conditions and concerns continue and the markets continue to remain volatile, our results of operations could be adversely affected by those factors in many ways, including making it more difficult for us to raise funds if necessary and our stock price may further decline. In addition, we maintain significant amounts of cash and cash equivalents that are not federally insured. If economic instability continues, we cannot provide assurance that we will not experience losses on these investments.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and the rules and regulations thereunder, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Evaluation of disclosure controls and procedures. As required by Rule 13a-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in internal control over financial reporting. There have been no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II. Other Information

Item 1. Legal Proceedings

From time to time we may be involved in legal proceedings arising in the ordinary course of business.

Item 1A. Risk Factors

This Quarterly Report on Form 10-Q contains forward-looking information based on our current expectations. Because our actual results may differ materially from any forward-looking statements made by or on behalf of us, this section includes a discussion of important factors that could affect our actual future results, including, but not limited to, our revenues, expenses, net loss and loss per share. You should carefully consider these risk factors, together with all of the other information included in this Quarterly Report on Form 10-Q as well as our other publicly available filings with the U.S. Securities and Exchange Commission, or SEC.

We have marked with an asterisk (*) those risks described below that reflect substantive changes from, or additions to, the risks described in our Annual Report on Form 10-K for the year ended December 31, 2015.

Risks Related to Clinical Development and Regulatory Approval

We depend substantially on the success of ARX-04, which may not receive regulatory approval in the United States or in Europe . *

Since our inception in 2005, we have focused primarily on development of our product candidate, Zalviso ^® ; however, given the delay in the potential approval of Zalviso in the United States, we believe the importance of ARX-04 (sufentanil sublingual tablet, 30 mcg) to our future success has increased. ARX-04 is a non-invasive investigational product candidate consisting of a single tablet delivered sublingually via a disposable, pre-filled, single-dose applicator, or SDA.

As part of our development program, we met with the United States Food and Drug Administration, or FDA, in December 2015 to review plans for a New Drug Application, or NDA, for ARX-04. We have also held various meetings with Health Authorities in Europe to discuss the submission of a Marketing Authorization Application, or MAA, for ARX-04. Based on feedback from the FDA, we expanded the clinical program for ARX-04 by 176 additional patients to include individuals from specific populations and settings, in order to increase the ARX-04 safety database. As a result, the completion of the Phase 3 clinical program for ARX-04 has been extended and our clinical trial expenses have increased. Based on feedback from discussions with the Health Authorities in Europe, we intend to submit for a label indication for acute moderate-to-severe pain following surgery, or as a result of trauma. At the time of submission of the MAA we will have only completed one open-label study in the emergency room for acute pain patients, in addition to three Phase 3 post-operative pain studies. We may need an additional controlled study in the emergency department setting with ARX-04 to obtain a label that includes trauma-related pain in addition to post-operative. We also anticipate we may need comparator studies in the European Union, or EU, to ensure premium reimbursement in certain countries. We anticipate submitting the NDA for ARX-04 by the end of 2016 and, assuming successful completion of any additional studies required in the EU, we anticipate submitting a hybrid MAA in the first half of 2017. However, while we have announced positive top-line results from SAP301, SAP302 and SAP303 and we believe these results support an NDA submission for ARX-04, and even if we believe the results from SAP301, SAP302 and SAP303 plus any additional studies required in the EU support MAA submission for ARX-04, the FDA and European Medicines Agency, or EMA, may not agree, or may interpret the study results differently, which would delay the timing of our commercialization of ARX-04 and adversely affect our business operations. If ARX-04 is not approved for sale in the United States or Europe, it could have a significant impact on our ability to generate cash flows from product sales or to enter into a collaboration agreement. If we are not able to receive approval to commercialize ARX-04 in the United States, we would be required to find alternative sources of capital to continue operations. If ARX-04 is not approved for sale in the United States, and we are unsuccessful in finding alternative sources of capital, it will be difficult for us to continue under our current operating plan.

Any disagreement with the FDA or EMA as to the results from SAP301, SAP302, and SAP303, and therefore any additional requirements imposed by the FDA or EMA prior to our ability to submit an NDA or MAA, as well as any delay in approval by the FDA or EMA of the ARX-04 NDA or MAA, if and when it is submitted, may negatively impact our stock price and harm our business operations. If and when the ARX-04 NDA is submitted, the FDA may hold an Advisory Committee meeting to obtain committee input on the safety and efficacy of ARX-04. Typically, Advisory Committees will provide responses to specific questions asked by the FDA, including the Committee’s view on the approvability of the drug under review. Advisory Committee decisions are not binding but an adverse decision at the Advisory Committee may have a negative impact on the regulatory review of ARX-04. Any delay in obtaining, or inability to obtain, regulatory approval would prevent us from commercializing ARX-04 in the United States or Europe, generating revenues and potentially achieving profitability. If any of these events occur, we may be forced to delay or abandon our development efforts for ARX-04, which would have a material adverse effect on our business and could potentially cause us to cease operations.

We depend substantially on the success of Zalviso, which may not receive regulatory approval in the United States. *

While ARX-04’s importance has increased for our future success, Zalviso remains an important product candidate for us. Zalviso consists of sufentanil sublingual tablets, 15 mcg, delivered by the Zalviso System, a needle-free, handheld, patient-administered, pain management system, or together, Zalviso. The success of our business depends, in part, upon our ability to develop, receive regulatory approval in the United States for, and commercialize Zalviso for the management of moderate-to-severe acute pain in adult patients in the hospital setting. To date, our Phase 3 program for Zalviso has consisted of three Phase 3 clinical trials. We reported positive top-line data from each of these trials and submitted an NDA for Zalviso to the FDA in September 2013, which the FDA then accepted for filing in December 2013. On July 25, 2014, the FDA issued a Complete Response Letter, or CRL, for our NDA for Zalviso. The CRL contains requests for additional information on the Zalviso System to ensure proper use of the device. The requests include submission of data demonstrating a reduction in the incidence of optical system errors, changes to address inadvertent dosing, among other items, and submission of additional data to support the shelf life of the product. Furthermore, in March 2015, we received correspondence from the FDA stating that in addition to the bench testing and two Human Factors studies we had performed in response to the issues identified in the CRL, a clinical trial is needed to assess the risk of inadvertent dispensing and overall risk of dispensing failures. Based on the results of the Type C meeting with FDA, which took place in September 2015, we submitted a protocol to the FDA for a clinical study in post-operative patients designed to evaluate the effectiveness of changes made to enhance Zalviso device performance. We completed the protocol review with the FDA and initiated IAP312 in September 2016. Timing of the completion of the IAP312 study will be dependent on the rate of patient enrollment in the study, among other things.

There is no guarantee that the additional work we perform related to Zalviso, including the IAP312 trial, will be supportive of, or guarantee, an NDA resubmission, or result in our successfully obtaining FDA approval of Zalviso in a timely fashion, if at all. For example, the trial might not meet its objectives or the FDA could still have concerns regarding the performance of the device, inadvertent dosing (dropped tablets), or other issues. At any future point in time, the FDA could require us to complete further clinical, Human Factors, pharmaceutical, reprocessing or other studies, which could delay or preclude any NDA submission or approval of the NDA and could require us to obtain significant additional funding. There is no guarantee such funding would be available to us on favorable terms, if at all. If the Zalviso NDA is resubmitted, the FDA may hold an Advisory Committee meeting to obtain committee input on the safety and efficacy of Zalviso. Typically, Advisory Committees will provide responses to specific questions asked by the FDA, including the Committee’s view on the approvability of the drug under review. Advisory Committee decisions are not binding but an adverse decision at the Advisory Committee may have a negative impact on the regulatory review of Zalviso. Additionally, we may choose to engage in the dispute resolution process with the FDA.

Our proposed trade name of Zalviso has been approved by the EMA and is currently being used in the EU. It has also been conditionally approved by the FDA, which must approve all drug trade names to avoid medication errors and misbranding. However, the FDA may withdraw this approval in which case any brand recognition or goodwill that we establish with the name Zalviso prior to commercialization may be worthless.

Any delay in approval by the FDA of the Zalviso NDA, if, and when, it is resubmitted, may negatively impact our stock price and harm our business operations. Any delay in obtaining, or inability to obtain, regulatory approval would prevent us from commercializing Zalviso in the United States, generating revenues and potentially achieving profitability. If any of these events occur, we may be forced to delay or abandon our development efforts for Zalviso, which would have a material adverse effect on our business and could potentially cause us to cease operations.

Positive clinical results obtained to date for our product candidates may be disputed in FDA review, do not guarantee regulatory approval and may not be obtained from future clinical trials. *

We have reported positive top-line data from our three Phase 3 clinical trials for ARX-04, or SAP301, SAP302, and SAP303, as well as each of our three Zalviso Phase 3 clinical trials completed to date, in addition to all of our Phase 2 clinical trials for ARX-04 and Zalviso. However, even if we believe that the data from clinical trials is positive, the FDA has and in the future could determine that the data from our trials was negative or inconclusive or could reach a different conclusion than we did on that same data. Negative or inconclusive results of a clinical trial or difference of opinion could cause the FDA to require us to repeat the trial or conduct additional clinical trials prior to obtaining approval for commercialization, and there is no guarantee that additional trials would achieve positive results or that the FDA will agree with our interpretation of the results. Any such determination by the FDA would delay the timing of our commercialization plan for ARX-04 and Zalviso, or further development of our other product candidates, and adversely affect our business operations. For example, although we had achieved the primary endpoints in each of our three Phase 3 clinical trials for Zalviso which were included in our NDA filed in 2013, in March 2015, we received correspondence from the FDA stating that in addition to the bench testing and two Human Factors studies we had performed in response to the issues identified in the CRL, a clinical trial is needed to assess the risk of inadvertent dispensing and overall risk of dispensing failures.

Delays in clinical trials are common and have many causes, and any delay could result in increased costs to us and jeopardize or delay our ability to obtain regulatory approval and commence product sales. *

We have experienced and may in the future experience delays in clinical trials of our product candidates. While we have completed three Phase 3 clinical trials for ARX-04, three Phase 3 clinical trials for Zalviso, and several Phase 2 clinical trials both for ARX-04 and Zalviso, future clinical trials may not begin on time, have an effective design, enroll a sufficient number of patients or be completed on schedule, if at all. For example, in June 2014, we completed a pharmacokinetic study in support of the ARX-04 development program. In this study of healthy volunteers, it was shown that two sublingual administrations of a Zalviso sufentanil sublingual tablet, 15 mcg, dosed 20 minutes apart were equivalent to one sublingual administration of a sufentanil sublingual tablet, 30 mcg. Based on the pharmacokinetic equivalency of two Zalviso tablets to one ARX-04 tablet, the FDA has agreed to accept 323 Zalviso patients into the ARX-04 safety database; however, the FDA also required that the ARX-04 safety database comprise 350 patients dosed with at least one dose of ARX-04. Based on this feedback from the FDA, we expanded the clinical program for ARX-04 by 176 additional patients to include individuals from specific populations and settings, in order to increase the ARX-04 safety database. As a result, the completion of the Phase 3 clinical program for ARX-04 was extended and our clinical trial expenses increased. Finally, we postponed the start of IAP312, originally planned for the first quarter of 2016, to September 2016. The postponement was due to a delay in the receipt and testing of final clinical supplies for this trial. As a result, the development timeline for Zalviso was further extended. We anticipate the enrollment and treatment period for IAP312 will continue through mid-2017; however, timing of the completion of the IAP312 study will be dependent on the rate of patient enrollment in the study, among other things. 

Our clinical trials for any of our product candidates could be delayed for a variety of reasons, including: