NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Note 1: Organization and Significant Accounting Policies

Business Description and Basis of Presentation

Novan, Inc. (“Novan” and together with its subsidiary, the “Company”), is a North Carolina-based clinical-stage biotechnology company focused on leveraging nitric oxide’s natural antiviral and immunomodulatory mechanisms of action to treat dermatological and oncovirus-mediated diseases. Novan was incorporated in January 2006 under the state laws of Delaware and its wholly owned subsidiary, Novan Therapeutics, LLC was organized in 2015 under the state laws of North Carolina.

The accompanying condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). The December 31, 2017 year-end condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by U.S. GAAP. Additionally, the Company’s independent registered public accounting firm report for the December 31, 2017 financial statements included an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern.

Certain prior period amounts have been condensed to conform to current period presentation. As a result, deferred offering costs were condensed with prepaid expenses and other current assets. Additionally, intangible assets and restricted cash were condensed with other assets. These changes had no effect on total current assets or total assets as previously reported as of December 31, 2017. Restricted cash of $539 as of June 30, 2018 and December 31, 2017, consisted of funds maintained in a separate deposit account to secure a letter of credit for the benefit of the lessor of facility space leased by the Company.

Basis of Consolidation

The accompanying condensed consolidated financial statements reflect the operations of the Company and its wholly owned subsidiary. All intercompany accounts and transactions have been eliminated in consolidation.

On December 30, 2015, the Company completed the distribution of 100% of the outstanding member interests of KNOW Bio, LLC (“KNOW Bio”), a former wholly owned subsidiary of the Company, to Novan’s stockholders (the “Distribution”), pursuant to which KNOW Bio became an independent privately held company. The Company does not own an equity interest in KNOW Bio, but does have variable interests in KNOW Bio through the following contractual arrangements:

Through its portfolio of operating subsidiary companies, KNOW Bio is advancing work in nitric oxide-based therapies in fields where they have exclusive intellectual property rights. The Company determined that KNOW Bio continues to be a variable interest entity based on variable interest entity characteristics, pursuant to FASB ASC 810-10, Consolidation. The Company concluded that it is not the primary beneficiary of KNOW Bio and, therefore, does not consolidate KNOW Bio in its condensed consolidated financial statements herein. This conclusion is based on the fact that the Company has no significant power or decision-making authority over KNOW Bio’s drug and medical device development activities, which are the activities most significantly impacting KNOW Bio’s economic performance. Under the KNOW Bio Services Agreement, the Company agreed to provide certain development and

6

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

manufacturing services to KNOW Bio on commercial terms. In exchange for these services, KNOW Bio agreed to pay service fees for actual ti me and materials incurred by the Company on a cost-plus basis. The terms of the amendments to the exclusive sublicense agreements with KNOW Bio were evaluated by the Company, with the support of a third-party expert, and were determined to be at fair value and arms-length. As a result, the amendments did not create any ability for Novan to influence KNOW Bio’s decision-making.

The Company has no exposure to loss as a result of its involvement with KNOW Bio. The Company’s sublicense arrangement with KNOW Bio does expose the Company to potential future risk of loss, whereby the Company is obligated to pay future milestones or royalties to UNC or other licensors in the event of KNOW Bio non-performance under the sublicense arrangement; however, if KNOW Bio failed to pay these obligations, KNOW Bio would be in breach of its agreements with the Company and intellectual property rights would revert back to the Company. See Note 2—Research and Development Licenses for detailed information regarding potential future milestone and royalty payments due to UNC and other licensors.  The contractual terms of the KNOW Bio Services Agreement, including upfront payment requirements, cost-plus pricing and timely payment terms, mitigate the current or potential future risk of loss to the Company for services performed under the KNOW Bio Services Agreement.

Liquidity and Ability to Continue as a Going Concern

The Company’s condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. The accompanying condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from uncertainty related to the Company’s ability to continue as a going concern.

The Company has evaluated principal conditions and events that may raise substantial doubt about its ability to continue as a going concern within one year from the date that these financial statements are issued. The Company identified the following conditions:

The Company has concluded that the prevailing conditions and ongoing liquidity risks faced by the Company raise substantial doubt about its ability to continue as a going concern. To mitigate these prevailing conditions and ongoing liquidity risks, the Company needs and intends to raise additional capital from non-dilutive sources, including partnerships, collaborations, licensing, grants or other strategic relationships, or through equity or debt financings.  There can be no assurance that the Company will be able to obtain additional capital on terms acceptable to the Company, on a timely basis or at all. The failure of the Company to obtain sufficient funds on acceptable terms when needed could cause the Company to alter or reduce its planned operating activities, including but not limited to delaying, reducing, terminating or eliminating planned product candidate development activities, to conserve its cash and cash equivalents. Such actions could delay development timelines and have a material adverse effect on the Company’s results of operations, financial condition and market valuation. Additionally, there is no assurance that the Company can achieve its development milestones or that its intellectual property rights will not be challenged.

7

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

January 2018 Offering

On January 9, 2018, the Company completed a public offering of its common stock and warrants pursuant to the Company’s effective shelf registration statement (the “January 2018 Offering”). The Company sold an aggregate of 10,000,000 shares of common stock and warrants to purchase up to 10,000,000 shares of the Company’s common stock at a public offering price of $3.80 per share of common stock and accompanying warrant. The warrant exercise price is $4.66 per share and will expire four years from the date of issuance. Net proceeds from the offering were approximately $35,194 after deducting underwriting discounts and commissions and offering expenses of approximately $2,806. The shares issued as part of the January 2018 Offering increased the number of shares outstanding, which impacts the comparability of the Company’s reported net loss per share calculations between the 2018 and 2017 periods presented in the accompanying condensed consolidated financial statements.   

The Company incurred costs directly related to (i) the shelf registration statement filing totaling $110 and (ii) the January 2018 Offering completed in January 2018 totaling $370, all of which were initially capitalized and included in prepaid expenses and other current assets. A pro-rata portion of the shelf registration offering costs and all of the January 2018 Offering costs were reclassified to additional paid-in capital upon completion of the January 2018 Offering.   

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Unaudited Interim Condensed Consolidated Financial Statements

The accompanying interim condensed consolidated financial statements and the related footnote disclosures are unaudited. These unaudited condensed consolidated financial statements have been prepared in accordance with U.S. GAAP and applicable rules and regulations of the Securities and Exchange Commission’s (“SEC”) Rule 10-01 of Regulation S-X for interim financial information. The condensed consolidated financial statements were prepared on the same basis as the audited consolidated financial statements and in the opinion of management, reflect all adjustments of a normal, recurring nature that are necessary for the fair statement of the Company’s financial position and its results of operations and cash flows.  The results of operations for interim periods are not necessarily indicative of the results expected for the full fiscal year or any future period. These interim financial statements should be read in conjunction with the financial statements and notes for the year ended December 31, 2017 set forth in the Company’s Annual Report on Form 10-K filed with the SEC on March 27, 2018.

Leases

The Company leases office space and certain equipment under non-cancelable lease agreements. The leases are reviewed for classification as operating or capital leases. For operating leases, rent is recognized on a straight-line basis over the lease period. For capital leases, the Company records the leased asset with a corresponding liability and amortizes the asset over the lease term. Payments are recorded as reductions to the liability with an appropriate interest charge recorded based on the then-outstanding remaining liability.

The Company considers the nature of the renovations and the Company’s involvement during the construction period of newly leased office space to determine if it is considered to be the owner of the construction project during the construction period. If the Company determines that it is the owner of the construction project, it is required to capitalize the fair value of the building as well as the construction costs incurred, including capitalized interest, on its consolidated balance sheet along with a corresponding financing liability (“build-to-suit accounting”). Upon completion of the construction of the facility under a build-to-suit lease, the Company assesses whether the circumstances qualify for sales recognition under the sale-leaseback accounting guidance. If the lease meets the sale-leaseback criteria, the Company will remove the asset and related financial obligation from the balance sheet and evaluate the lease for treatment as a capital or operating lease. If upon completion of construction, the project does not meet the sale-leaseback criteria, the leased property will be treated as an asset financing for financial reporting purposes. The portion of the facility financing obligation representing the principal that will be repaid in the next 12 months will be classified as a current liability in the consolidated balance sheets, with the remaining portion of the obligation classified as a noncurrent liability. See Note 6—Commitments and Contingencies for further discussion of the Company’s application of this guidance related to the Company’s primary facility lease.

8

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Deferred Offering Costs

Deferred offering costs are included in prepaid expense and other current assets on the accompanying condensed consolidated balance sheets and consist of legal, accounting, filing and other fees directly related to offerings or the Company’s shelf registration. These costs are offset against proceeds from each offering as applicable. Offering costs incurred prior to the completion of an offering are initially capitalized as assets, evaluated each period for likelihood of completion and subsequently reclassified to additional paid-in capital upon completion of the offering.  Deferred costs associated with the shelf registration will be reclassified to additional paid-in capital on a pro-rata basis in the event the Company completes an offering under the shelf registration, with any remaining deferred offering costs charged to general and administrative expense at the end of the three-year life of the shelf registration.  

Revenue Recognition

Effective January 1, 2018, the Company adopted ASC Topic 606, Revenue from Contracts with Customers , using the full retrospective transition method. To determine revenue recognition for arrangements that the Company determines are within the scope of Topic 606, the Company performs the following five steps: (i) identify the contracts with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. The Company only applies the five-step model to contracts when it is probable that the entity will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer.

At contract inception, once the contract is determined to be within the scope of Topic 606, the Company assesses the goods or services promised within each contract and determines those that are performance obligations and assesses whether each promised good or service is distinct. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.

The Company’s agreements may contain some or all the following types of provisions or payments:

Licenses of Intellectual Property :  If the license of the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company recognizes revenues from non-refundable, upfront fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. For licenses that are bundled with other promises, the Company utilizes judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the estimated performance period and the appropriate method of measuring progress during the performance period for purposes of recognizing revenue. The Company re-evaluates the estimated performance period and measure of progress each reporting period and, if necessary, adjusts related revenue recognition accordingly.

Milestone Payments :  At the inception of each arrangement that includes development milestone payments, the Company evaluates whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. The transaction price is then allocated to each performance obligation on a relative stand-alone selling price basis, for which the Company recognizes revenue as or when the performance obligations under the contract are satisfied. At the end of each subsequent reporting period, the Company re-evaluates the probability of achievement of such development milestones and any related constraint, and if necessary, adjusts its estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect license and collaboration revenue and earnings in the period of adjustment.

Manufacturing Supply Services : Arrangements that include a promise for future supply of drug substance or drug product for either clinical development or commercial supply at the customer’s discretion are generally considered as options.  The Company assesses if these options provide a material right to the licensee and if so, they are accounted for as separate performance obligations.  If the Company is entitled to additional payments when the customer exercises these options, any additional payments are recorded in license and collaboration revenue when the customer obtains control of the goods, which is upon delivery.

Royalties :  For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, the Company recognizes revenue at the later of (i) when the

9

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). To date, the Company has not recognized any royalty revenue resulting from any of its licensing arrangements.

See Note 4 —Revenue Recognition for further information and accounting considerations related to revenue recognition, including revenue recognition pertaining to licensing arrangements.

Research and Development Expenses

Research and development expenses include all direct and indirect development costs incurred for the development of the Company’s drug candidates. These expenses include salaries and related costs, including share-based compensation and travel costs, for research and development personnel, allocated facility costs, laboratory and manufacturing materials and supplies, consulting fees, product development, preclinical studies, clinical trial costs, licensing fees and milestone payments under license agreements and other fees and costs related to the development of drug candidates. The cost of tangible and intangible assets that are acquired for use on a particular research and development project, have no alternative future uses, and are not required to be capitalized in accordance with the Company’s capitalization policy, are expensed as research and development costs as incurred.

Accrued Outside Research and Development Services

The Company is required to estimate its expenses resulting from its obligations under contracts with clinical research organizations, clinical site agreements, vendors, and consultants in connection with conducting clinical trials and preclinical development. The financial terms of these contracts are subject to negotiations which vary from contract to contract and may result in payment flows that do not match the periods over which materials or services are provided to the Company under such contracts. The Company’s objective is to reflect the appropriate development and clinical trial expenses in its financial statements by matching those expenses with the period in which the services and efforts are expended.

For clinical trials, the Company accounts for these expenses according to the progress of the trial as measured by actual hours expended by contract research organization personnel, investigator performance or completion of specific tasks, patient progression, or timing of various aspects of the trial. During the course of a clinical trial, the Company adjusts its rate of clinical trial expense recognition if actual results differ from its estimates. The Company utilizes judgment and experience to estimate its accrued expenses as of each balance sheet date in its financial statements based on facts and circumstances known at that time. Although the Company does not expect its estimates to be materially different from amounts actually incurred, its understanding of status and timing of services performed relative to the actual status and timing of services performed may vary and may result in increases or decreases in research and development expenses in future periods when the actual results become known.

For preclinical development services performed by outside service providers, the Company determines accrual estimates through financial models, considering development progress data received from outside service providers and discussions with applicable Company and service provider personnel.

Fair Value of Financial Instruments

The carrying values of cash equivalents, accounts payable and accrued liabilities as of June 30, 2018 and December 31, 2017 approximated their fair values due to the short-term nature of these items.

For warrants that are issued or modified and there is a deemed possibility that the Company may have to settle them in cash, it records the fair value of the warrants at the initial measurement date, or date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the condensed consolidated statements of operations and comprehensive loss.

10

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

The Company has categorized its financial instruments, based on the priority of the inputs used to value the investments, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted price s in active markets for identical assets or liabilities (Level 1) and lowest priority to unobservable inputs (Level 3). If the inputs used to measure the investments fall within different levels of the hierarchy, the categorization is based on the lowest l evel input that is significant to the fair value measurement of the investment. Financial instruments recorded in the accompanying condensed consolidated balance sheets are categorized based on the inputs to valuation techniques as follows:

Level 1 – Observable inputs that reflect unadjusted quoted market prices for identical assets or liabilities in active markets.

Level 2 – Observable inputs other than Level 1 that are observable, either directly or indirectly, in the marketplace for identical or similar assets and liabilities.

Level 3 – Unobservable inputs that are supported by little or no market data, where values are derived from techniques in which one or more significant inputs are unobservable.

Share-Based Compensation

The Company applies the fair value method of accounting for share-based compensation, which requires all such compensation to employees, including the grant of employee stock options, to be recognized in the condensed consolidated statements of operations and comprehensive loss based on its fair value at the measurement date (generally the grant date). The expense associated with share-based compensation is recognized over the requisite service period of each award. For awards with only service conditions and graded-vesting features, the Company recognizes compensation cost on a straight-line basis over the requisite service period. For awards with performance conditions, once achievement of the performance condition becomes probable, compensation cost is recognized over the expected period from the date the performance condition becomes probable to the date the performance condition is expected to be achieved. The Company will reassess the probability of vesting at each reporting period for performance awards and adjust compensation cost based on its probability assessment. Share-based awards granted to non-employee directors as compensation for serving on the Company’s board of directors are accounted for in the same manner as employee share-based compensation awards.

The fair value of each option grant is estimated using a Black-Scholes option-pricing model on the grant date using expected volatility, risk-free interest rate, expected life of options and fair value per share assumptions.  Due to limited historical data, the Company estimates stock price volatility based on the actual volatility of comparable publicly traded companies over the expected life of the option. In evaluating similarity, the Company considered factors such as industry, stage of life cycle, financial leverage, size and risk profile.

The Company does not have sufficient stock option exercise history to estimate the expected term of employee stock options and thus continues to calculate expected life based on the mid-point between the vesting date and the contractual term, which is in accordance with the simplified method. The expected term for share-based compensation granted to non-employees is the contractual life. The risk-free rate is based on the U.S. Treasury yield curve during the expected life of the option.

For option grants occurring subsequent to the Company’s IPO in September 2016, the fair value of common stock is based upon the closing stock price as of the grant date. For option grants occurring prior to the Company’s IPO, the fair value of common stock was estimated by a third-party valuation specialist and approved by the board of directors as of the grant date. For options granted to non-employee directors on September 20, 2016 in conjunction with the pricing of the IPO, pursuant to the non-employee director compensation policy then in effect, the fair value of common stock was equal to the public offering price of $11.00 per share.

Income Taxes

Deferred tax assets and liabilities are determined based on the temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. In estimating future tax consequences, all expected future events are considered, other than enactment of changes in the tax law or rates.

The Company did not record a federal or state income tax benefit for the three and six months ended June 30, 2018 and 2017 due to its conclusion that a full valuation allowance is required against the Company’s deferred tax assets .

11

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

The determination of recording or releasing a tax valuation allowance is made, in part, pursuant to an assessment performed by management regarding the likelihood that the Company will generate future taxable income a gainst which benefits of its deferred tax assets may or may not be realized. This assessment requires management to exercise judgment and make estimates with respect to its ability to generate taxable income in future periods.

The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position.

The Company’s policy for recording interest and penalties is to record them as a component of general and administrative expenses. As of June 30, 2018 and December 31, 2017, the Company accrued no interest or penalties related to uncertain tax positions.

Tax years that remain subject to examination by federal and state tax jurisdictions date back to the year ended December 31, 2008. The Company has not been informed by any tax authorities for any jurisdiction that any of its tax years are under examination.

In accordance with Section 382 of the Internal Revenue Code of 1986, as amended, a change in equity ownership of greater than 50% within a three-year period results in an annual limitation on the Company’s ability to utilize its net operating loss carryforwards created during the tax periods prior to the change in ownership. The Company has not determined whether ownership changes exceeding this threshold, including the Company’s IPO, have occurred. If a change in equity ownership has occurred which exceeds the Section 382 threshold, a portion of the Company’s net operating loss carryforwards may be limited.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss by the weighted average shares outstanding during the period, without consideration of common stock equivalents. Diluted net loss per share is calculated by adjusting weighted average shares outstanding for the dilutive effect of common stock equivalents outstanding for the period. Diluted net loss per share is the same as basic net loss per share, since the effects of potentially dilutive securities are anti-dilutive for all periods presented.

The following securities, presented on a common stock equivalent basis, have been excluded from the calculation of weighted average common shares outstanding for the three and six months ended June 30, 2018 and 2017 because the effect is anti-dilutive due to the net loss reported in each of those periods. All share amounts presented in the table below represent the total number outstanding as of the end of each period.

Segment and Geographic Information

The Company has determined that it operates in one segment. The Company uses its nitric oxide-based technology to develop product candidates. The Chief Executive Officer, who is the Company’s chief operating decision maker, reviews financial information on an aggregate basis for purposes of allocating resources and evaluating financial performance. The Company has only had limited revenue since its inception, but all revenue was derived in the United States. All of the Company’s long-lived assets are maintained in the United States.

Although all operations are based in the United States, the Company generated revenue from its licensing partner in Japan of $649 and $1,298 during the three and six months ended June 30, 2018, respectively, and $649 and $973 during the three and six months ended June 30, 2017, respectively. During the three and six months ended June 30, 2018, substantially all revenue was generated from the Company’s licensing partner in Japan. During the three and six months ended June 30, 2017, approximately 91% and 93% of total revenue was generated from its licensing partner, respectively.

12

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Recently Issued Accounting Standards

Accounting Pronouncements Adopted

The Company adopted ASC Topic 606,  Revenue from Contracts with Customers  as of January 1, 2018 and used the full retrospective adoption method, which required the Company to recast each prior reporting period presented. The Company’s material revenues are derived from its license agreement with Sato Pharmaceutical Co., Ltd. (“Sato”), which provides for consideration in the form of an upfront payment, milestone payments and royalties. As the Company adopted Topic 606, it elected to utilize two transition practical expedients provided for in Topic 606: the Company (i) has not restated completed contracts that begin and end in the same annual reporting period and (ii) has not disclosed the amount of the transaction price allocated to the remaining performance obligations and an explanation of when the entity expects to recognize that amount as revenue for the reporting periods presented prior to the initial date of application.

Adoption of the revenue recognition standard impacted previously reported results as follows:

In August 2016, the FASB issued Accounting Standards Update (“ASU”) No. 2016-15,  Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.  The FASB issued ASU 2016-15 to improve U.S. GAAP by providing guidance on the cash flow statement classification of eight specific areas where there is existing diversity in practice. The FASB expects that the guidance in this ASU will reduce the current and potential future diversity in practice in such areas. This ASU was effective for the Company as of January 1, 2018. The adoption of this new accounting guidance did not have a material impact on the Company’s condensed consolidated financial statements.

In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, to improve U.S. GAAP by providing guidance on how to classify and present changes in restricted cash or restricted cash equivalents occurring due to transfers between cash, cash equivalents and restricted cash.  This ASU was effective for the Company as of January 1, 2018. The Company’s condensed consolidated statements of cash flows have been presented in conformance with the requirements in the ASU; however, this presentation did not have a material effect on the Company’s condensed consolidated financial statements.

13

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

In January 2017, the FASB issued ASU No. 2017-01, Business Combi nations (Topic 805): Clarifying the Definition of a Business , which clarifies the definition of a business to provide additional guidance with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. T his ASU is effective for annual periods beginning after December 15, 2017, including interim periods within those periods. This ASU was effective for the Company as of January 1, 2018. The adoption of this new accounting guidance did not have a material ef fect on the Company’s condensed consolidated financial statements.

In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting, to clarify and reduce diversity in practice and cost and complexity of applying guidance for modifications in Topic 718.  Specifically, this ASU further defines which changes to terms or conditions of share-based awards require application of modification accounting in Topic 718.  This ASU is effective for annual periods beginning after December 15, 2017, including interim periods within those periods, with early adoption permitted.  This ASU was effective for the Company as of January 1, 2018. The adoption of this new accounting guidance did not have a material effect on the Company’s condensed consolidated financial statements.   

Accounting Pronouncements Being Evaluated

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) . This guidance revises the accounting related to leases by requiring lessees to recognize a lease liability and a right-of-use asset for all leases. The new lease guidance also simplifies the accounting for sale and leaseback transactions. In July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases and ASU 2018-11, Leases (Topic 842): Targeted Improvements, to provide expanded or clarifying guidance associated with the application of certain principles . These ASUs are effective for annual reporting periods beginning after December 15, 2018 and early adoption is permitted. The Company is currently evaluating the impact of the adoption of these ASUs on its condensed consolidated financial statements.

In June 2018, the FASB issued ASU No. 2018-07 Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting . This guidance simplifies the accounting for non-employee share-based payment transactions by expanding the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from non-employees. Under the new standard, most of the guidance on stock compensation payments to non-employees would be aligned with the requirements for share-based payments granted to employees. This standard is effective for annual reporting periods beginning after December 15, 2018, including interim reporting periods within those annual reporting periods, with early adoption permitted. The Company is currently evaluating the impact of adoption of this ASU on its condensed consolidated financial statements.

Note 2: Research and Development Licenses

The Company has entered into various licensing agreements with universities and other research institutions under which the Company receives the rights, and in some cases substantially all of the rights, of the inventors, assignees or co-assignees to produce and market technology protected by certain patents and patent applications. The Company’s primary license agreement is with UNC and has been described in further detail within the subsection below. The counterparties to the Company’s various other licensing agreements are the University of Akron Research Foundation, Hospital for Special Surgery, Strakan International S.a.r.l., which is a licensee of the University of Aberdeen, KIPAX AB and KNOW Bio. The Company is generally required to make milestone payments based on development milestones and will be required to make royalty payments based on a percentage of future sales of covered products or a percentage of sublicensing revenue. As future royalty payments are directly related to future revenues (either sales or sublicensing), future commitments cannot be determined. No accrual for future payments under these agreements has been recorded, as the Company cannot estimate if, when or in what amount payments may become due.

UNC License Agreement

The Amended, Restated and Consolidated License Agreement dated June 27, 2012, as amended, (the “UNC Agreement”) provides the Company with an exclusive license to issued patents and pending applications directed to the Company’s library of Nitricil compounds, including patents issued in the U.S., Japan and Australia, with claims intended to cover NVN1000, the new chemical entity (“NCE”) for the Company’s current product candidates. The UNC Agreement requires the Company to pay UNC up to $425 in regulatory and commercial milestones on a licensed product by licensed product basis and a running royalty percentage in the low single digits on net sales of licensed products. Licensed products include any products being developed by the Company or by its sublicensees, KNOW Bio and Sato, as described further in Note 3—Collaboration Arrangements. Additionally, the Company made a payment to UNC in February 2017 representing the portion of the upfront payment under the Sato Agreement that was estimated to be

14

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

directly attributable to the UNC intellectual property rights included in the license to Sato. See Note 3—Collaboration Arrangements for the Company’s accounting for this February 2017 payment.

Unless earlier terminated by the Company at its election, or if the Company materially breaches the agreement or becomes bankrupt, the UNC Agreement remains in effect on a country by country and licensed product by licensed product basis until the expiration of the last to expire issued patent covering such licensed product in the applicable country.

Note 3: Collaboration Arrangements

KNOW Bio Technology Agreements

In connection with the Distribution, the Company entered into exclusive license agreements and sublicense agreements with KNOW Bio, as described below. The agreements will continue for so long as there is a valid patent claim under the respective agreement, unless earlier terminated, and upon expiration, will continue as perpetual non-exclusive licenses. KNOW Bio has the right to terminate each such agreement, for any reason upon 90 days advance written notice to the Company.

License of existing and potential future intellectual property to KNOW Bio.   The Company granted to KNOW Bio exclusive licenses, with the right to sublicense, to certain U.S. and foreign patents and patent applications controlled by the Company as of December 29, 2015 (the “KNOW Bio License Agreement”). The Company also granted to KNOW Bio a non-exclusive license, with the right to sublicense, to any patents and patent applications that may become controlled by the Company during the three years immediately following the agreement’s effective date related to nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds and other nitric oxide-based therapeutics.

Sublicense of UNC and other third-party intellectual property to KNOW Bio.   The Company also granted to KNOW Bio exclusive sublicenses, with the ability to further sublicense, under certain of the U.S. and foreign patents and patent applications exclusively licensed to the Company from UNC and another third party directed towards nitric oxide-releasing compositions, to develop and commercialize products utilizing the licensed technology (the “KNOW Bio Sublicense Agreements”). Under the exclusive sublicense to the UNC patents and applications, KNOW Bio is subject to the terms and conditions under the UNC License Agreement, including milestone and diligence payment obligations. However, the Company is obligated to pay UNC any future milestones or royalties in the event of KNOW Bio non-performance under the sublicense arrangement. In such an event, KNOW Bio would be in breach of its agreements with the Company and intellectual property rights would revert back to the Company. There were no milestone or royalty payments required during the three and six months ended June 30, 2018 and 2017.

Amendments to License and Sublicense Agreements with KNOW Bio

The Company and KNOW Bio entered into certain amendments dated October 13, 2017 (the “KNOW Bio Amendments”) to the KNOW Bio License Agreement and KNOW Bio Sublicense Agreements (the “Original KNOW Bio Agreements”) described above. Pursuant to the terms of the KNOW Bio Amendments, t he Company re-acquired from KNOW Bio exclusive, worldwide rights under certain U.S. and foreign patents and patent applications controlled by the Company as of the execution date of the Original KNOW Bio Agreements , and patents and patent applications which may become controlled by the Company during the three years immediately following the execution date of the Original KNOW Bio Agreements , directed towards nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds, and other nitric oxide-based therapeutics, to develop and commercialize products for all diagnostic, therapeutic, prophylactic and palliative uses for any disease, condition or disorder caused by certain oncoviruses (the “Oncovirus Field”). KNOW Bio also granted to the Company an exclusive license, with the right to sublicense, under any patents and patent applications which may become controlled by KNOW Bio during the three years immediately following the execution date of the Original KNOW Bio Agreements and directed towards nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds, and other nitric oxide-based therapeutics, but not towards medical devices, to develop and commercialize products for use in the Oncovirus Field. Additionally, KNOW Bio agreed that KNOW Bio will not commercialize any products in the Oncovirus Field during the first three years following the execution date of the Original KNOW Bio Agreements .

15

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

The Company is obligated to make the following fixed and contingent payments in exchange for the rights granted to the Company in the Oncovirus Field:

Nitricil is not the nitric oxide-releasing composition specified in the KNOW Bio Amendments as the subject of the foregoing payments. As such, products based on Nitricil are not subject to the foregoing milestone, royalty and sublicensing payment obligations.  

The rights granted to the Company in the Oncovirus Field in the KNOW Bio Amendments continue for so long as there is a valid patent claim under the Original KNOW Bio Agreements, and upon expiration continue on a perpetual non-exclusive basis, and are subject to the termination rights of KNOW Bio and the Company that are set forth in the Original KNOW Bio Agreements. In addition, under the KNOW Bio Amendments, KNOW Bio may terminate the rights granted to the Company in the Oncovirus Field if: (i) the Company does not file a first investigational new drug (“IND”) application with the FDA for a product in the Oncovirus Field by October 2020; or (ii) the Company does not file a first new drug application (“NDA”) with the FDA by October 2025 for a product in the Oncovirus Field and does not otherwise have any active clinical programs related to the Oncovirus Field at such time.

The Company also obtained a three-year exclusive option to include within the Company’s rights described above in the Oncovirus Field, the development and commercialization of products for all diagnostic, therapeutic, prophylactic and palliative uses for any disease, condition or disorder caused by up to four other specified oncoviruses (the “Option Field”). If the Company elects to exercise its option, it will pay an exercise fee for each oncovirus for which the option is exercised, and the additional rights included in the Oncovirus Field as a result of the option exercise will be subject to the same payment obligations for Covered Products, conditions, and termination rights as described above for the Oncovirus Field.

The KNOW Bio Amendments also provide a mechanism whereby either party can cause an NCE covered by the Original KNOW Bio Agreements to become exclusive to such party by filing an IND on the NCE. An NCE that becomes exclusive to a party under this provision may not be commercialized by the other party until the later of expiration of patents covering the NCE or regulatory exclusivity covering the NCE. A party who obtains exclusivity for an NCE must advance development of the NCE pursuant to terms of the KNOW Bio Amendments in order to maintain such exclusivity; otherwise, such exclusivity will expire.

The terms of the KNOW Bio Amendments were negotiated at arms-length and do not provide the Company with an ability to significantly influence KNOW Bio or its operations.

Sato License Agreement

On January 12, 2017, the Company entered into a license agreement, and related amendment, with Sato, relating to SB204, its drug candidate for the treatment of acne vulgaris in Japan (the “Sato Agreement”). Pursuant to the Sato Agreement, the Company granted to Sato an exclusive, royalty-bearing, non-tr ansferable right and license under certain of the Company’s intellectual property rights,

16

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

with the right to sublicense with the Company’s prior written consent, to develop, use and sell products in Japan that incorporate SB204 in certain topical dosage for ms for the treatment of acne vulgaris , and to make the finished form of such products . The Company or its designated contract manufacturer will also supply finished product to Sato for use in the development of SB204 in the licensed territory . The rights g ranted to Sato do not include the right to manufacture the active pharmaceutical ingredient (“API”) of SB204; rather, the parties agreed to negotiate a commercial supply agreement pursuant to which the Company or a third-party contract manufacturer would b e the exclusive supplier to Sato of the API for the commercial manufacture of licensed products in the licensed territory. Under the terms of the Sato Agreement, the Company also has exclusive rights to certain intellectual property that may be developed b y Sato in the future, which the Company could choose to use for its own development and commercialization of SB204 outside of Japan.  

In exchange for the licenses granted to Sato under the Sato Agreement, Sato agreed to pay the Company an upfront payment, as well as additional milestone payments upon achievement of various future development, regulatory and commercial milestones. Pursuant to the terms of the Sato Agreement, Sato was required to pay the Company an upfront payment of 1.25 billion Japanese Yen (“JPY”), which the Company received in January 2017 in the amount of $10,813 when converted to U.S. Dollars (“USD”). Sato is also required to pay the Company an aggregate of 2.75 billion JPY upon the achievement of various development and regulatory milestones, including a milestone payment of 0.25 billion JPY (approximately $2,162 USD) upon Sato’s initiation of a Phase I trial in Japan. Sato also agreed to pay the Company up to an aggregate of 0.9 billion JPY in milestone payments upon the achievement of various commercial milestones. Sato must also pay the Company a royalty equal to a mid-single digit percentage of net sales of licensed products in the licensed territory, subject to a reduction in the royalty payments in certain circumstances.

The term of the Sato Agreement and the period during which Sato must pay royalties under the Sato Agreement expires, on a licensed product-by-licensed product basis, on the tenth anniversary of the first commercial sale of a licensed product in the licensed field i n the licensed territory. The term of the Sato Agreement may be renewed with respect to a licensed product by mutual written agreement of the parties for additional two year periods following expiration of the initial term.

Sato is responsible for funding the development and commercial costs for the program that are specific to Japan. The Company is obligated to perform certain oversight, review and supporting activities for Sato, including: (i) using commercially reasonable efforts to obtain marketing approval of SB204 in the U.S., (ii) sharing all future scientific information the Company may obtain during the term of the Sato Agreement pertaining to SB204, (iii) performing certain additional preclinical studies if such studies are deemed necessary by the Japanese regulatory authority, up to and not to exceed a total cost of $1,000 and (iv) participating in a joint committee that oversees, reviews and approves Sato’s development and commercialization activities under the Sato Agreement. Additionally, the Company has granted Sato the option to use the Company’s trademarks in connection with the commercialization of licensed products in the licensed territory for no additional consideration, subject to the Company’s approval of such use.

The Sato Agreement may be terminated by (i) Sato without cause upon 120 days’ advance written notice to the Company, (ii) either party in the event of the other party’s uncured material breach upon 60 days’ advance written notice, (iii) force majeure, (iv) either party in the event of the other party’s dissolution, liquidation, bankruptcy or insolvency and (v) the Company immediately upon written notice if Sato challenges the validity, patentability, or enforceability of any of the Company’s patents or patent applications licens ed to Sato under the Sato Agreement. In the event of a termination, no portion of the upfront fee received from Sato in January 2017 is refundable. 

Note 4: Revenue Recognition

Revenue Recognition—Sato Agreement

The Company assessed the Sato Agreement in accordance with Topic 606 and concluded that the contract counterparty, Sato, is a customer within the scope of Topic 606. The Company identified the following promises under the Sato Agreement: (i) the grant of the intellectual property license to Sato , (ii) the obligation to participate in a joint committee that oversees, reviews, and approves Sato’s research and development activities and provides advisory support during Sato’s development process, (iii) the obligation to manufacture and supply Sato with all quantities of licensed product required for development activities in Japan, and (iv) the stand-ready obligation to perform any necessary repeat preclinical studies, up to $1,000 in cost. The Company determined that these promises were not individually distinct because Sato can only benefit from these licensed intellectual property rights and services when bundled together; they do not have individual benefit or utility to Sato. As a result, all promises have been combined into a single performance obligation.

17

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

The Sato Agreement also provides that the two parties agree to negotiate in good faith the terms of a commercial supply agreement pursuant to which the Company or a third-party manufacturer would be the exclusive supplier to Sato of the API for the commercial manufacture of licensed products in the licensed territory. The Company concluded this obligation to negotiate the terms of a commercial supply agreement does not create (i ) a legally enforceable obligation under which the Company may have to perform and supply Sato with API for commercial manufacturing or (ii) a material right because the incremental commercial supply fee consideration agreed upon between the parties in the Sato Agreement is representative of a stand-alone selling price for the supply of API and does not represent a discount . Therefore, this contract provision is not considered to be a promise to deliver goods or services and is not a performance obligation or part of the combined single performance obligation described above.

The Company concluded that the non-refundable upfront payment of 1.25 billion JPY ($10,813 USD) is the only fixed consideration component of the agreement. The only portion of the variable consideration that is currently probable of not resulting in a significant revenue reversal is the milestone related to initiation of a Phase I trial in Japan, which is expected to occur in the second half of 2018 and requires a milestone payment of 0.25 billion JPY (approximately $2,162 USD). These two consideration amounts are allocated to the single performance obligation. No other variable consideration under the Sato Agreement is currently probable of not resulting in a significant revenue reversal and, therefore, is currently fully constrained and excluded from the transaction price.

The Company evaluated the timing of delivery for each of the obligations and concluded that a time-based input method is most appropriate because Sato is accessing and benefitting from the intellectual property and technology (the predominant items of the combined performance obligation) ratably over the duration of Sato’s estimated development period in Japan. Although the Company concluded that the intellectual property is functional rather than symbolic, the services provided under the performance obligation are provided over time. Therefore, the allocated transaction price will be recognized using a time-based input method that results in straight-line recognition over the Company’s performance period, currently estimated to be approximately five years, starting in February 2017 and completing in the first quarter of 2022. Pursuant to the terms of the Sato Agreement, the Company and Sato are advancing SB204 development for the Japan territory and the parties are working collaboratively to reach agreement with respect to the Japan territory development plan, including a corresponding timeline and estimated duration for the development program in whole. The Company notes that it monitors and reassesses the estimated performance period for purposes of revenue recognition during each reporting period. Therefore, if the duration of the development program timeline is affected by the establishment or subsequent adjustments to a mutually agreed upon SB204 development plan in the Japan territory, the Company will adjust its estimated performance period for revenue recognition purposes accordingly, as needed.

The Company has recorded the transaction price, including the upfront payment received and the unconstrained variable consideration, as deferred revenue that initially totaled $10,813 (comprised of (i) an initial contract liability of $12,975 and net of (ii) a contract asset associated with the Phase I trial initiation milestone payment of $2,162) and is amortizing this deferred revenue over the estimated performance period.

In future periods, the Company will lift the variable consideration constraint from each contingent payment when there is no longer a probable likelihood of significant revenue reversal. When the constraint is lifted from a milestone payment, the Company will recognize the incremental transaction price using the same time-based input method that is being used to recognize the revenue, which results in straight-line recognition over the performance period. If the Company’s performance is not yet completed at the time that the constraint is lifted, a cumulative catch-up adjustment will be recognized in the period. If no other performance is required by the Company at the time the constraint is lifted, the Company expects to recognize all revenue associated with such milestone payments at the time that the constraint is lifted.

During the three and six months ended June 30, 2018, the Company recognized $649 and $1,298, respectively, in license and collaboration revenue under this agreement, all of which was previously included in deferred revenue at the beginning of the respective period. During the three and six months ended June 30, 2017, the Company recognized license and collaboration revenue of $649 and $973, respectively. The deferred revenue balance under the Sato Agreement as of June 30, 2018 was $7,243, including $2,595 and $4,648 in current and non-current deferred revenue, respectively. The deferred revenue balance under the Sato Agreement as of December 31, 2017, as adjusted, was $8,541, including $2,595 and $5,946 in current and non-current deferred revenue, respectively. The change in the deferred revenue balances during the six months ended June 30, 2018 was associated with the continued amortization of deferred revenue and recognition of license and collaboration revenue associated with the Company’s performance during the period.

18

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Contract costs — Sato Agreement

The Company incurred certain fees and costs in the process of obtaining the Sato Agreement that were payable upon contract execution and, therefore, have been recognized as other assets and amortized as general and administrative expense on a straight-line basis over the same estimated performance period being used to recognize the associated revenue. These fees are associated with the following two arrangements and are described as follows:

Performance Obligations under the Sato Agreement

The amount of existing performance obligations under long-term contracts unsatisfied as of June 30, 2018 was $7,243. The Company expects to recognize approximately 36% of the remaining performance obligations as revenue over the next 12 months, and the balance thereafter. The Company applied the practical expedient and does not disclose information about variable consideration related to sales-based or usage-based royalties promised in exchange for a license of intellectual property. This expedient specifically applied to the sales-based milestone payments that are present in the Sato Agreement (0.9 billion JPY), as well as percentage-based royalty payments in the Sato Agreement that are contingent upon future sales.  

No revenue was recognized during the six months ended June 30, 2018 associated with adjustments to the estimated performance period or the measure of progress.

Revenue Recognition—Research and Development Services to KNOW Bio

As described in Note 1—Organization and Significant Accounting Policies, the Company entered the KNOW Bio Services Agreement during 2017 and provided research and development services on a fee-for-service basis. After assessing revenue according to the five-step model of ASC 606, the Company determined that contract research and development services revenue should be recognized in the period in which the services are performed. During the six months ended June 30, 2018, the Company recognized $9 in research and development services revenue for services performed under the KNOW Bio Services Agreement. There was no research and development services revenue recognized during the three months ended June 30, 2018.

19

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Depreciation and amortization expense was $408 and $809 for the three and six months ended June 30, 2018, respectively, and $340 and $639 for the three and six months ended June 30, 2017, respectively. 

Note 6: Commitments and Contingencies

Lease Obligations

Primary Facility Lease

In August 2015, the Company entered into a lease agreement for approximately 51,000 rentable square feet of facility space in Morrisville, North Carolina, commencing in April 2016 (the “Primary Facility Lease”). The initial term of the Primary Facility Lease extends through June 30, 2026. The Company has an option to extend the Primary Facility Lease by five years upon completion of the initial lease term. Current contractual base rent payments are $95 per month, subject to a three percent increase annually over the term of the Primary Facility Lease.

Pursuant to the Company’s accounting policy and applicable guidance in ASC 840, Leases, the facility is being accounted for as an asset financing, with the building asset and related facility financing obligation remaining on the Company’s balance sheet. The building asset is being depreciated over a 25 year period and the facility financing obligation is being amortized so that the net carrying value of the building asset and the facility financing obligation are equivalent at the end of the initial term of the lease agreement. Monthly rental payments will be allocated between principal and interest expense associated with the facility financing obligation, as well as grounds rent expense of $8 per month.

The Company has recorded an asset related to the building and construction costs within property and equipment of $10,557 as of June 30, 2018. The non-current facility lease obligation on the Company’s condensed consolidated balance sheet was $7,998 as of June 30, 2018 and December 31, 2017. During the three and six months ended June 30, 2018, the Company recognized interest expense of $261 and $522, respectively, including $42 of accrued interest included in other accrued expenses as of June 30, 2018. 

Rent expense associated with the primary facility lease, comprised of monthly grounds rent and common area maintenance costs, was $89 and $131 for the three and six months ended June 30, 2018, respectively, and $71 and $166 for the three and six months ended June 30, 2017, respectively.

In May 2018, the Company entered into a sublease agreement under the Primary Facility Lease whereby the Company is the lessor and is subleasing approximately 6,400 square feet of office space to a third party at its leased headquarters facility in Morrisville, North Carolina. The sublease will expire in July 2021, unless sooner terminated in accordance with the provisions of the sublease. If for any reason, the lease between the Company and its landlord is terminated, the sublease will simultaneously terminate. The annual rent payments due to the Company, beginning in the third quarter of 2018, are approximately $141 per year, subject to a three percent increase annually over the term of the sublease agreement.   

20

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of business activities. The Company accrues a liability for such matters when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. See Legal Proceedings below for further discussion of pending legal claims.

The Company has entered into, and expects to continue to enter into, contracts in the normal course of business with various third parties who support its clinical trials, preclinical research studies and other services related to its development activities.  The scope of the services under these agreements can generally be modified at any time, and these agreements can generally be terminated by either party after a period of notice and receipt of written notice. There have been no material contract terminations as of June 30, 2018.

See Note 11—Subsequent Events regarding the Performance Plan adopted in August 2018.

Legal Proceedings

The Company is subject to putative stockholder class action lawsuits that were filed in November 2017 in the United States District Court for the Middle District of North Carolina against the Company and certain of its current and former directors and officers, which have been consolidated under the case name In re Novan, Inc. Securities Litigation . A lead plaintiff has been designated, and on April 30, 2018, the lead plaintiff filed a consolidated amended complaint. The consolidated amended complaint asserts claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to the Company’s Phase 3 clinical trials of SB204. The consolidated amended complaint seeks, among other things, an unspecified amount of compensatory damages and attorneys’ fees and costs on behalf of the putative class. On June 14, 2018, the Company filed a motion to dismiss the consolidated amended complaint. The Company believes that the claims lack merit and intends to defend the lawsuits vigorously. However, there can be no assurance that a favorable resolution will be obtained in such lawsuits, and the actual costs may be significant. The Company is unable to estimate the amount of a potential loss or range of potential loss, if any.

Other than as described above, the Company is not currently a party to any material legal proceedings and is not aware of any claims or actions pending or threatened against the Company that the Company believes could have a material adverse effect on the Company’s business, operating results, cash flows or financial statements. In the future, the Company might from time to time become involved in litigation relating to claims arising from its ordinary course of business.

Compensatory Obligations

In conjunction with the departures of three former Company officers in 2018 and 2017, the Company entered into separation and general release agreements that included separation benefits consistent with the Company’s obligations under their previously existing employment agreements for “separation from service” for “good reason.” The Company recognized combined severance expense of $332 during the six months ended June 30, 2018 and $397 and $793 during the three and six months ended June 30, 2017, respectively. The accrued severance obligation in respect of the three former officers was fully paid as of June 30, 2018. The Company also recognized non-cash stock compensation expense of approximately $212 during the six months ended June 30, 2018, and $124 and $374 during the three and six months ended June 30, 2017, respectively, related to the accelerated vesting of the former officers’ stock options. There was no severance expense or non-cash stock compensation expense in relation to these departures during the three months ended June 30, 2018.

Note 7: Stockholders’ Equity

Capital Structure

Authorized Shares . In conjunction with the completion of the IPO in September 2016, the Company further amended its amended and restated certificate of incorporation and amended and restated its bylaws. The amendment provides for 210,000,000 authorized shares of capital stock, of which 200,000,000 shares have been designated as $0.0001 par value common stock and 10,000,000 shares have been designated as $0.0001 par value preferred stock.

21

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

P referred Stock

The Company’s amended and restated certificate of incorporation provides the Company’s board of directors with the authority to issue $0.0001 par value preferred stock from time to time in one or more series by adopting a resolution and filing a certificate of designations. Voting powers, designations, preferences, dividend rights, conversion rights and liquidation preferences shall be stated and expressed in such resolutions. There were 10,000,000 shares designated as preferred stock and no shares outstanding as of June 30, 2018 and December 31, 2017.  

The Company had reserved shares of common stock for future issuance as follows:

Note 8: Warrants

The Company evaluates its financial assets and liabilities subject to fair value measurements on a recurring basis to determine the appropriate level in which to classify them for each reporting period, pursuant to the fair value measurements policy described in Note 1—Organization and Significant Accounting Policies. This determination requires significant judgments to be made.

On January 9, 2018, the Company sold an aggregate of 10,000,000 shares of common stock and issued warrants to purchase up to 10,000,000 shares of common stock at a public offering price of $3.80 per share of common stock and accompanying warrant. Pursuant to the warrant agreement and form of warrant dated January 9, 2018 (the “Warrant Agreement”), the warrant exercise price is $4.66 per share and the warrants will expire four years from the date of issuance.

22

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

The Warrant Agreement includes a provision whereby t he exercisability of the warrants may be limited if, upon exercise, the warrant holder or any of its affiliates would beneficially own more than 4.99% (or an amount up to 9.99% if the holde r so elects) of the Company’s common stock. The Warrant Agreement also provides that the aforementioned exercise limitation provision is not applicable to any warrant holder that beneficially owns 10.0% or more of the Company’s outstanding common stock imm ediately following the closing of the January 2018 Offering and the issuance of the accompanying warrants.

If, at any time the warrants are outstanding, any fundamental transaction occurs, as described in the Warrant Agreement and generally including any consolidation or merger whereby another entity acquires more than 50% of the Company’s outstanding common stock, or the sale of all or substantially all of its assets, the successor entity must assume in writing all of the obligations to the warrant holders. Additionally, in the event of a fundamental transaction, the Warrant Agreement provides that each warrant holder will have the right to require the Company, or its successor, to repurchase the warrants for an amount of cash equal to the Black-Scholes value of the remaining unexercised portion of the warrants. Further, the Warrant Agreement states that the volatility input used to derive such Black-Scholes value is the greater of the Company’s historical volatility or 100%. Due to the provision that the warrant holder has the option to receive a cash settlement, equal to the Black-Scholes fair value of the remaining unexercised portion of the warrant, in the event that there is a fundamental transaction, the Company has classified the warrants as liabilities in accordance with ASC 480, Distinguishing Liabilities from Equity .

There were no exercises of warrants during the six months ended June 30, 2018. The following table presents the Company’s warrant liability measured at fair value on a recurring basis as of June 30, 2018:

The fair value of the common stock warrants is estimated using a valuation model that approximates a Monte Carlo simulation model, which takes into consideration the probability of a fundamental transaction occurring during the contractual term of the warrants. This valuation model, which includes inputs classified as Level 3 in the fair value hierarchy, estimated a fair value of $1.35 and $1.78 per common stock warrant as of June 30, 2018 and January 9, 2018 (the date of issuance), respectively. The inputs to the valuation model that approximates a Monte Carlo simulation model are presented below.  

Due to the Company’s limited historical stock price data, the Company estimates stock price volatility based on the actual historical volatility of a group of comparable publicly traded companies observed over a historical period equal to the expected life of the warrant.

The change in fair value of the warrants for the three and six months ended June 30, 2018 of $711 and $4,269, respectively, was included as a component of other income and expense in the Company’s condensed consolidated statements of operations and comprehensive loss. The decrease in the warrant liability and the corresponding unrealized gain recognized during the three and six months ended June 30, 2018 is primarily due to the decrease in the market price of the Company’s underlying common stock from the date of issuance to June 30, 2018, in addition to fluctuations in the valuation model inputs.

23

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

The following table summarizes the change in the fair value of the warrant liability, which is valued using significant unobservable Level 3 inputs, for the six months ended June 30, 2018:

Note 9: Stock Option Plan and Inducement Grants

2016 Stock Plan

During the six months ended June 30, 2018, the Company continued to administer and grant awards under the 2016 Incentive Award Plan (the “2016 Plan”), the Company’s only active equity incentive plan. Certain of the Company’s outstanding and exercisable stock options remain subject to the terms of the Company’s 2008 Stock Plan (the “2008 Plan”), which is the predecessor to the 2016 Plan and became inactive upon adoption of the 2016 Plan effective September 20, 2016.

Inducement Grants

In May 2018, the Company awarded nonstatutory stock options to purchase an aggregate of 100,500 shares of common stock to newly-hired employees, not previously employees or directors of the Company, as inducements material to the individuals’ entering into employment with the Company within the meaning of Nasdaq Listing Rule 5635(c)(4) (the “Inducement Grants”). The Inducement Grants have a grant date of May 31, 2018 and an exercise price of $3.15 per share. The Inducement Grants were awarded outside of the Company’s 2016 Plan, pursuant to Nasdaq Listing Rule 5635(c)(4), but have terms and conditions generally consistent with the Company’s 2016 Plan and vest over three years, with one-third of the award vesting on each annual anniversary of the employee’s employment commencement date, subject to the employee’s continued service as an employee through the vesting period.

Stock Compensation Expense

During the three and six months ended June 30, 2018, the Company recorded employee share-based compensation expense of $546 and $1,433, respectively. During the three and six months ended June 30, 2017, the Company recorded employee share-based compensation expense of $883 and $2,135, respectively. Total share-based compensation expense included in the condensed consolidated statements of operations and comprehensive loss is as follows:

Stock option activity for the six months ended June 30, 2018 is as follows:

24

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

As of June 30, 2018, there were a total of 1,786,642 stock options outstanding, including 100,500 inducement grants awarded in May 2018. In addition, there were 651,269 shares available for future issuance under the 2016 Plan as of June 30, 2018.

Note 10: Related Party Transactions

Members of the Company’s board of directors held 1,585,916 shares of the Company’s common stock as of June 30, 2018 and December 31, 2017, respectively.  

In June 2017, G. Kelly Martin was appointed as the Company’s Interim Chief Executive Officer before being named as the Company’s Chief Executive Officer in April 2018. Mr. Martin continues to serve as a member of the Company’s board of directors and previously served as chief executive officer of Malin Corporation plc, the parent company of Malin Life Sciences Holdings Limited (“Malin”), a greater than 10% stockholder of the Company, until October 1, 2017. Mr. Martin did not receive any additional compensation for his service as the Company’s Chief Executive Officer during the six months ended June 30, 2018. Subsequent to June 30, 2018, the Company and Mr. Martin entered into an employment agreement. See Note 11—Subsequent Events for further details.

Two of the Company’s directors are also affiliated with Malin, including Sean Murphy, who is an executive officer and director of Malin and is an executive vice president of Malin Corporation plc, and Robert A. Ingram, who was a director of Malin Corporation plc until July 2018.

During the three and six months ended June 30, 2018, the Company incurred costs of $172 and $370, respectively, in relation to a development and manufacturing consulting agreement with Cilatus BioPharma AG, which is majority-owned by Malin Corporation plc, a related party of the Company. These costs are expensed as incurred and are classified as research and development expenses in the accompanying condensed consolidated statements of operations and comprehensive loss. Aggregate estimated fees under the current statements of work are $418, which are expected to be incurred throughout 2018.