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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x                             QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2014

or

o                                TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 001-34973

Anacor Pharmaceuticals, Inc.

(Exact Name of Registrant as Specified in Its Charter)

1020 East Meadow Circle

Palo Alto, California 94303-4230

(Address of Principal Executive Offices) (Zip Code)

(650) 543-7500

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

As of August 4, 2014, there were 41,995,593 shares of the registrant’s common stock outstanding.

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Anacor Pharmaceuticals, Inc.

Form 10-Q

Index

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Anacor Pharmaceuticals, Inc.

Condensed Consolidated Balance Sheets

(In Thousands)

(1) Derived from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Condensed Consolidated Statements of Operations

(In Thousands, Except Share and Per Share Data)

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Condensed Consolidated Statements of Comprehensive Loss

(In Thousands)

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Condensed Consolidated Statements of Cash Flows

(In Thousands)

See accompanying notes.

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Anacor Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. The Company

Nature of Operation

Anacor Pharmaceuticals, Inc. (the Company) is a biopharmaceutical company focused on discovering, developing and commercializing novel small-molecule therapeutics derived from its boron chemistry platform. The Company’s first approved drug, KERYDINTM (tavaborole) topical solution, 5% (formerly known as AN2690), is an oxaborole antifungal approved by the U.S. Food and Drug Administration (FDA) in July 2014 for the topical treatment of onychomycosis of the toenails. The Company’s lead product candidate is AN2728, an investigational anti-inflammatory PDE-4 inhibitor in development for the potential treatment of mild-to-moderate atopic dermatitis and psoriasis. The Company initiated Phase 3 studies of AN2728 for the treatment of mild-to-moderate atopic dermatitis in the first quarter of 2014. In addition to KERYDIN and AN2728, the Company has discovered, synthesized and is developing six molecules. These include three wholly-owned investigational product candidates. AN2718 is an investigational topical antifungal, AN2898 is a backup compound to AN2728 and AN3365 (formerly referred to as GSK2251052, or GSK ‘052) is an investigational antibiotic for the potential treatment of infections caused by Gram-negative bacteria, which previously was licensed to GlaxoSmithKline LLC (GSK). In October 2012, GSK advised the Company that it had discontinued further development of AN3365 and substantially all rights to this compound reverted to the Company. The Company is currently considering its options for further development, if any, of AN3365. The Company has also discovered three other investigational compounds that it has out-licensed for further development. The first compound is licensed to Eli Lilly and Company (Lilly) for the potential treatment of an animal health indication.  The second compound, AN5568, also referred to as SCYX-7158, is licensed to Drugs for Neglected Diseases initiative (DNDi) for the potential treatment of human African trypanosomiasis (HAT, or sleeping sickness) and the third compound is licensed to GSK for development in tuberculosis (TB). The Company also has a pipeline of other internally discovered topical and systemic boron-based compounds in earlier stages of research and pre-clinical development.

Since inception, the Company has not generated revenue from product sales and, as of June 30, 2014, has an accumulated deficit of $176.1 million. The Company may require additional capital to fund research and development activities, including clinical trials for its development programs and preclinical activities for its product candidates. While management believes that the Company’s existing capital resources, together with the payments it is expected to receive based on sales of KERYDIN under the Sandoz Agreement (as defined below), will be sufficient to meet its anticipated operating requirements for at least the next twelve months, the Company may also elect to finance its future cash needs through public or private equity offerings, debt financings or licensing, collaboration or other similar arrangements, or a combination of these sources.

2. Summary of Significant Accounting Policies

Interim Financial Information

The accompanying condensed consolidated financial statements as of June 30, 2014 and for the three and six months ended June 30, 2014 and 2013 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to state fairly the results included in the condensed consolidated financial statements for the interim periods presented. The December 31, 2013 balance sheet is derived from the audited financial statements for the year ended December 31, 2013 but does not include all the disclosures necessary for audited financial statements. The financial data and other information disclosed in these notes to the condensed consolidated financial statements related to the three and six month periods are unaudited. The results for the three and six months ended June 30, 2014 are not necessarily indicative of results to be expected for the year ending December 31, 2014 or for any other interim period or for any future year.

These condensed consolidated financial statements follow the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. generally accepted accounting principles (GAAP) for annual periods can be condensed or omitted. For more complete financial information, these condensed consolidated financial statements, and the notes hereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2013 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 17, 2014.

The Company’s significant accounting policies are more fully described in Note 2 of the notes to the financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

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Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Anacor IP Holdings, Ltd., which was incorporated in the Cayman Islands on October 1, 2013. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of the condensed consolidated financial statements in accordance with U.S. GAAP requires the Company to make estimates and judgments in certain circumstances that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. In preparing these condensed consolidated financial statements, management has made its best estimates and judgments of certain amounts included in the condensed consolidated financial statements, giving due consideration to materiality. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, fair values of financial instruments in which it invests, income taxes, preclinical study and clinical trial accruals, accrued compensation, stock compensation and other contingencies. Management bases its estimates on historical experience or on various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from these estimates.

Cash and Cash Equivalents, Short-Term Investments, Long-Term Investments and Restricted Investments

The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash and cash equivalents. Unless restricted, investments with a maturity date of more than three months, but less than twelve months, from the date of purchase are considered short-term investments and are classified as current assets. Long-term investments have contractual maturities at the date of purchase of over one but less than two years and are classified as noncurrent assets until such time as the time to maturity becomes one year or less, at which time they are reclassified to short-term investments. The Company’s investments in marketable securities are classified as available for sale (see Note 3). Securities available for sale are carried at estimated fair value, with unrealized gains and losses reported as part of accumulated other comprehensive income or loss, a separate component of stockholders’ equity. The Company has estimated the fair value amounts by using available market information. The cost of available for sale securities sold is based on the specific-identification method. Restricted investments are classified as a current or noncurrent asset based upon the terms of the relevant contract and, in some cases, management’s estimate of when the restrictions will be eliminated.

Under its facility lease agreements, the Company is required to deliver letters of credit securing the performance of its obligations thereunder. As of both June 30, 2014 and December 31, 2013, these letters of credit were secured by approximately $0.2 million of long-term restricted investments.

Fair Value of Financial Instruments

The carrying amounts of certain of the Company’s financial instruments, including cash and cash equivalents, short-term investments, restricted investments, contract receivables and accounts payable, approximate their fair value due to their short maturities.  Based on the borrowing rates available to the Company for loans with similar terms and average maturities, the carrying value of the Company’s long-term notes payable approximate their fair values at June 30, 2014 and December 31, 2013.

Fair value is considered to be the price at which an asset could be exchanged or a liability transferred (an exit price) in an orderly transaction between knowledgeable, willing parties in the principal or most advantageous market for the asset or liability. Where available, fair value is based on or derived from observable market prices or other observable inputs. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash and cash equivalents, short-term investments, long-term investments and restricted investments. Substantially all the Company’s cash and cash equivalents, short-term investments, long-term investments and restricted investments are held by two financial institutions that management believes are of high credit quality. Such deposits may, at times, exceed federally insured limits. At June 30, 2014 and December 31, 2013, approximately 60% and 93%, respectively, of the cash and cash equivalents were held in a money market fund invested in U.S. Treasuries, securities guaranteed as to principal and interest by the U.S. government and repurchase agreements in respect of such securities. At June 30, 2014 and December 31, 2013, approximately 90% and 100%, respectively, of the Company’s short-term investments, long-term investments and restricted investments were held in securities guaranteed as to principal and interest by the U.S. government. The Company has not experienced any losses on its deposits of cash and cash equivalents, short-term investments, long-term investments and restricted investments and management believes that its guidelines for investment of its excess cash maintain safety and liquidity through diversification and investment maturity.

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Customer Concentration

For the three and six month periods ended June 30, 2014, the Company’s revenues consisted primarily of contract revenues from a research agreement with The Bill and Melinda Gates Foundation (Gates Foundation), a contract with the United States Department of Defense, Defense Threat Reduction Agency (DTRA) and a collaboration agreement with Lilly. For the three and six month periods ended June 30, 2013, the Company also recognized contract revenues from its collaboration with GSK and from a subcontract with a research institution, each of which accounted for 10% or more of its total revenues during one of those periods. Collaborators, including GSK and Lilly, have accounted for significant revenues in the past and may not provide contract revenues in the future under existing agreements and/or new collaboration agreements, which may have a material effect on the Company’s operating results.

The following table shows the percentage of revenues attributable to contracts that accounted for 10% or more of total revenues in the specified periods:

*    less than 10% of total revenue

Contract Receivables

At June 30, 2014 and December 31, 2013, the Company’s contract receivables included $0.6 million and $0.5 million, respectively, due from DTRA (see Note 7), less than $0.1 million and $0.7 million, respectively, due from GSK (see Note 7) and $0.3 million and $0.1 million, respectively, due from other contracts.

The Company’s contract receivables are primarily composed of amounts due under research agreements and government contracts and the Company believes that the credit risks associated with these parties are not significant. During the three and six months ended June 30, 2014, the Company has not written-off any contract receivables and, accordingly, does not have an allowance for doubtful accounts as of June 30, 2014.

Revenue Recognition

For the three and six month periods ended June 30, 2014, the Company’s contract revenues were generated primarily through research and development collaboration agreements, which typically may include non-refundable, non-creditable upfront fees, funding for research and development efforts, payments for achievement of specified development, regulatory and sales goals and royalties on product sales of licensed products.

The Company recognizes revenue when persuasive evidence of an arrangement exists; transfer of technology has been completed, services are performed or products have been delivered; the fee is fixed or determinable; and collection is reasonably assured.

For arrangements with multiple deliverables, the Company evaluates each deliverable to determine whether it qualifies as a separate unit of accounting. This determination is generally based on whether the deliverable has stand-alone value to the customer. The selling price used for each unit of accounting will be based on vendor-specific objective evidence, if available, third party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific nor third party evidence is available. Management may be required to exercise considerable judgment in determining whether a deliverable is a separate unit of accounting and in estimating the selling prices of identified units of accounting for new agreements. Where multiple deliverables are combined as a single unit of accounting, revenues are recognized based on the performance requirements of the related agreement.

Upfront payments for licensing the Company’s intellectual property are evaluated to determine if the licensee can obtain stand-alone value from the license separate from the value of the research and development services to be provided by the Company. Typically, the Company has determined that the licenses it has granted to collaborators do not have stand-alone value separate from the value of the research and development services provided. As such, upfront payments are recorded as deferred revenue in the

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condensed consolidated balance sheets and are recognized as contract revenue ratably over the contractual or estimated performance period that is consistent with the term of the research and development obligations contained in the research and development collaboration agreement. When stand-alone value is identified, the related consideration is recorded as revenue in the period in which the license or other intellectual property rights are issued.

Some arrangements involving the licensing of the Company’s intellectual property, the provision of research and development services or both may also include exclusivity clauses whereby the Company agrees that, for a specified period of time, it will not conduct further research on licensed compounds or on compounds that would compete with licensed compounds or that it will do so only on a limited basis. Such provisions may also restrict the future development or commercialization of such compounds. The Company does not treat such exclusivity clauses as a separate element within an arrangement and any upfront payments received related to the exclusivity clause would be allocated to the identified elements in the arrangement and recognized as described in the preceding paragraph.

Payments resulting from the Company’s efforts under research and development agreements or government grants are recognized as the activities are performed and are presented on a gross basis. Revenue is recorded gross because the Company acts as a principal, with discretion to choose suppliers, bears credit risk and performs part of the services. The costs associated with these activities are reflected as a component of research and development expense in the condensed consolidated statements of operations and the revenues recognized from such activities approximate these costs.

For certain contingent payments under research or development arrangements, the Company recognizes revenue using the milestone method. Under the milestone method, a payment that is contingent upon the achievement of a substantive milestone is recognized in its entirety in the period in which the milestone is achieved. A milestone is an event (i) that can be achieved based in whole or in part on either the Company’s performance or on the occurrence of a specific outcome resulting from the Company’s performance, (ii) for which there is substantive uncertainty at the date the arrangement is entered into that the event will be achieved and (iii) that would result in additional payments being due to the Company. The determination that a milestone is substantive requires estimation and judgment and is made at the inception of the arrangement. Milestones are considered substantive when the consideration earned from the achievement of the milestone is (i) commensurate with either the Company’s performance to achieve the milestone or the enhancement of value of the item delivered as a result of a specific outcome resulting from the Company’s performance to achieve the milestone, (ii) relates solely to past performance and (iii) is reasonable relative to all deliverables and payment terms in the arrangement. In making the determination as to whether a milestone is substantive or not, management of the Company considers all facts and circumstances relevant to the arrangement, including factors such as the scientific, regulatory, commercial and other risks that must be overcome to achieve the respective milestone, the level of effort and investment required to achieve the respective milestone and whether any portion of the milestone consideration is related to future performance or deliverables.

Other contingent payments received for which payment is either contingent solely upon the passage of time or the results of a collaborative partner’s performance (bonus payments) are not accounted for using the milestone method. Such bonus payments will be recognized as revenue when earned and when collectibility is reasonably assured.

Royalties based on reported sales of licensed products will be recognized based on contract terms when reported sales are reliably measurable and collectibility is reasonably assured. As of June 30, 2014, none of the Company’s products had been approved and therefore the Company had not earned any royalty revenue from product sales as of such date.

Preclinical Study and Clinical Trial Accruals and Deferred Advance Payments

The Company estimates preclinical study and clinical trial expenses based on the services performed pursuant to contracts with research institutions and clinical research organizations that conduct these activities on its behalf. In recording service fees, the Company estimates the time period over which the related services will be performed and compares the level of effort expended through the end of each period to the cumulative expenses recorded and payments made for such services and, as appropriate, accrues additional service fees or defers any non-refundable advance payments until the related services are performed. If the actual timing of the performance of services or the level of effort varies from the estimate, the Company will adjust its accrual or deferred advance payment accordingly. If the Company later determines that it no longer expects the services associated with a deferred non-refundable advance payment to be rendered, the deferred advance payment will be charged to expense in the period that such determination is made.

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Stock-Based Compensation

Employee stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period). Stock option awards granted to the Company’s nonemployee directors for their board-related services are included in employee stock-based compensation in accordance with current accounting standards. The Company uses the Black-Scholes option-pricing model to estimate the fair value of its time-based vesting stock option awards and uses the straight-line (single-option) method for expense attribution. The Company uses a Monte Carlo valuation method to estimate the fair value of its market-based vesting performance stock option and restricted stock unit awards. The Company estimates forfeitures and recognizes expense only for those shares expected to vest.

The Company accounts for equity instruments issued to nonemployees based on their fair values on the measurement dates using the Black-Scholes option-pricing model. The fair values of the options granted to nonemployees are remeasured as they vest. As a result, the noncash charge to operations for nonemployee options that vest in any given reporting period is affected by changes in the fair value of the Company’s common stock during that period.

Net Loss per Share

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of shares outstanding during the period, without consideration for potentially dilutive shares. Diluted net loss per share includes the effect of all potential shares, consisting of stock options (including performance stock options), restricted stock units (including performance restricted stock units) and warrants outstanding for the period, determined using the treasury-stock method. For purposes of this calculation, potentially dilutive securities consisting of stock options, restricted stock units and warrants are considered to be potential shares and, for each period presented in these financial statements, are excluded in the calculation of diluted net loss per share because their effect would be antidilutive. The following table presents the calculation of basic and diluted net loss per share (in thousands, except share and per share data):

Recent Accounting Pronouncements

In June 2014, the Financial Accounting Standards Board (FASB) issued a new accounting standard on accounting for share-based payments for performance-based stock awards, which will require that a performance target that affects vesting and that could be achieved after the required service period be treated as a performance condition. The Company does not currently have any performance-based stock awards that meet these conditions. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2015. The Company is currently evaluating the effect that the updated standard will have on the Company’s consolidated financial statements.

In May 2014, the FASB issued a new accounting standard on revenue from contracts with customers, which will require the Company to recognize revenue when it transfers promised goods or services to a customer in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The updated standard will replace most existing revenue recognition guidance under U.S. GAAP when it becomes effective and will permit the use of either the retrospective or cumulative effect transition method. Early adoption is not permitted. The standard also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. The Company has not yet selected a transition method and is currently evaluating the effect that the updated standard will have on the Company’s consolidated financial statements and related disclosures.

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In July 2013, a new accounting standard was issued that requires the netting of unrecognized tax benefits against a deferred tax asset for a net operating loss carryforward or other carryforward that would apply in the settlement of uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction net operating loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the unrecognized tax benefits. The new standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company adopted this guidance as of January 1, 2014 and its adoption did not have an effect on the Company’s financial statements.

3. Marketable Securities and Fair Value Measurements

The following tables summarize the estimated fair values of the Company’s financial assets measured on a recurring basis as of the dates indicated below. Such financial assets are comprised solely of available for sale securities with remaining contractual maturities of less than two years.

The input levels used in the fair value measurements, the amortized cost and fair value of marketable securities, with gross unrealized gains and losses, were as follows (in thousands and unaudited):

All cash equivalents, short-term investments and short-term restricted investments held at June 30, 2014 and December 31, 2013 had maturities as of these dates of less than one year. Long-term investments and long-term restricted investments had maturities as of these dates of more than one but less than two years.

None of the available for sale securities held as of June 30, 2014 have been in a continuous unrealized loss position for more than one year. As of June 30, 2014, unrealized losses on available for sale investments are not attributed to credit risk and are considered to be temporary. The Company believes that it is more-likely-than-not that investments in an unrealized loss position will be held until maturity or the recovery of the cost basis of the investment. To date, the Company has not recorded any impairment charges on marketable securities related to other-than-temporary declines in market value.

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Management of the Company does not intend to sell these securities and believes that it will be able to hold these securities to maturity and recover their amortized cost bases. There were no realized gains or losses recognized from the sale of marketable securities for the three and six months ended June 30, 2014 and 2013.

In measuring fair value, the Company evaluates valuation techniques such as the market approach, the income approach and the cost approach. A three-level valuation hierarchy, which prioritizes the inputs to valuation techniques that are used to measure fair value, is based upon whether such inputs are observable or unobservable.

Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity. The three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:

·                  Level 1—Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets at the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis;

·                  Level 2—Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are either directly or indirectly observable; and

·                  Level 3—Unobservable inputs that reflect management’s assumptions and best estimates of inputs that market participants would use in pricing the asset or liability at the reporting date.

During the three and six months ended June 30, 2014 and June 30, 2013, there were no transfers between Level 1 and Level 2 financial assets. At June 30, 2014 and December 31, 2013, the Company utilized the market approach to measure fair value for its marketable securities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable instruments. The fair values of the money market fund (Level 1) were based on quoted market prices in an active market. Federal agency securities, commercial paper and corporate debt securities (Level 2) are valued using third party pricing sources that apply applicable inputs and other relevant data, such as quoted prices, interest rates and yield curves, into their models to estimate fair value.

4. Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

5. Commitments and Contingencies

Indemnifications

The Company, as permitted under Delaware law and in accordance with its bylaws, indemnifies its officers and directors for certain events or occurrences, subject to certain limits, while the officer or director is or was serving at the Company’s request in such capacity. The term of the indemnification period is equal to the officer’s or director’s lifetime.

The maximum amount of potential future indemnification is unlimited; however, the Company currently holds director and officer liability insurance. This insurance limits the Company’s exposure and may enable it to recover a portion of any future amounts paid. The Company believes that the fair value of these indemnification obligations is minimal. Accordingly, the Company has not recognized any liabilities relating to these obligations for any period presented.

The Company has certain agreements with contract research organizations and other parties with which it does business that contain indemnification provisions pursuant to which the Company typically agrees to indemnify the party against certain types of third party claims. The Company accrues for known indemnification claims when a loss is probable and can be reasonably estimated. The Company would also accrue for estimated incurred but unidentified indemnification claims based on historical activity. There were no accruals for or expenses related to indemnification claims for any period presented.

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Legal Proceedings

The Company is not a party to any material legal proceedings at this time. From time to time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business.

6. Notes Payable

On June 7, 2013, the Company entered into a loan and security agreement (the Loan Agreement) with Hercules Technology Growth Capital, Inc. as collateral agent and a lender and Hercules Technology III, L.P. as a lender (the lenders, or together Hercules), providing for loans to the Company of up to $45.0 million in three tranches of $30.0 million, $10.0 million and $5.0 million.

The first $30.0 million tranche was drawn at the closing of the transaction, at which time the Company repaid $22.6 million in remaining obligations associated with its previous loan. The Company elected not to draw the second tranche of $10.0 million, which was available to the Company from the closing date of the Loan Agreement until December 5, 2013. The Company also elected not to draw the third tranche of $5.0 million, which was available to the Company from the date of FDA approval of KERYDIN until August 6, 2014. The interest rate applicable to the loans outstanding under the Loan Agreement is a variable rate based upon the greater of either (i) 11.65% and (ii) the sum of (a) the Prime Rate (as defined in the Loan Agreement) as reported in The Wall Street Journal minus 5.25%, plus (b) 11.65%; with a maximum interest rate of 14.90%. As a result of the FDA’s approval of KERYDIN in July 2014 (see Note 10), the end of the interest only period for payments under the Loan Agreement was automatically extended from January 1, 2015 to July 1, 2015. Equal monthly payments of principal and interest will begin at that time and continue through the scheduled maturity date of July 1, 2017.

The Company has paid Hercules financing and amendment fees of $0.6 million and incurred other debt issuance costs, including legal fees, of $0.5 million in connection with the Loan Agreement. These fees are being accounted for as a debt discount and deferred debt issuance costs, respectively. In addition, if the Company repays all or a portion of the loan prior to maturity, it will pay Hercules a prepayment penalty fee, based on a percentage of the then outstanding principal balance, equal to 2% if the prepayment occurs prior to June 7, 2015 or 1% if the prepayment occurs after such date but prior to July 1, 2017.

The Loan Agreement includes customary affirmative and restrictive covenants, and was amended in December 2013 to include a liquidity covenant requiring the Company to maintain certain minimum balances in its United States bank and investment accounts while at the same time increasing the amount of investments the Company is permitted to make in its foreign subsidiaries. The Loan Agreement also includes standard events of default, including payment defaults, breaches of covenants following any applicable cure period, a material impairment in the perfection or priority of Hercules’ security interest in or the value of the collateral and a material impairment of the prospect of repayment of the Company’s obligations under the Loan Agreement.

Upon the occurrence and during the continuance of an event of default, a default interest rate of an additional 5% applies to the outstanding loan balances, and Hercules may declare all outstanding obligations immediately due and payable and take such other actions as are set forth in the Loan Agreement.

The Company’s obligations under the Loan Agreement are secured by substantially all of the assets of the Company except intellectual property. The Company’s intellectual and other property is subject to certain negative pledge and other restrictions set forth in the Loan Agreement, subject to certain exceptions.

In connection with the Loan Agreement, the Company issued warrants to Hercules to purchase 528,375 shares of the Company’s common stock at an exercise price of $5.11 per share (the Warrants).

The fair value of the warrants issued was approximately $1.8 million and was calculated using a Black-Scholes valuation model with assumptions based upon observed risk-free interest rates appropriate for the expected term of the warrants; expected volatility based on the average historical volatilities of a peer group of publicly-traded companies within the Company’s industry; expected term equal to the contractual life of the warrants; and a dividend yield of 0%. The Company recorded a debt discount of $1.8 million in connection with the issuance of the Warrants.

The Warrants were net exercised on a cashless basis in December 2013, resulting in the issuance of 361,995 shares of the Company’s common stock to Hercules. The par value of the shares issued was reclassified from additional paid-in capital to common stock.

The interest on the loans outstanding under the Loan Agreement is calculated using the interest method with the debt issuance costs paid directly to Hercules (financing, amendment and legal fees) and the fair value of the warrants issued to Hercules treated as a discount on the debt. The Company’s debt issuance costs for legal fees and other debt-related expenses are included as prepaid expenses and other current assets and as other assets in the condensed consolidated balance sheet. The amortization of the debt discount is recorded as a noncash interest expense and the amortization of the debt issuance costs is recorded as other expense in the condensed consolidated statements of operations.

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In June 2013, the Company recorded a loss of approximately $1.4 million on the early extinguishment of its previous loan facility. This loss was recorded as a loss on early extinguishment of debt in the condensed consolidated statements of operations for the three and six months ended June 30, 2013.

Future payments as of June 30, 2014, prior to the extension of the interest only period, are as follows (in thousands):

The Company recorded interest expense related to all borrowings of $1.1 million and $0.9 million for the three months ended June 30, 2014 and 2013, respectively, and $2.2 million and $1.8 million for the six months ended June 30, 2014 and 2013,  respectively. Included in interest expense for these periods was $0.2 million and $0.2 million, respectively, for the three months ended June 30, 2014 and 2013, and $0.4 million and $0.3 million, respectively, for the six months ended June 30, 2014 and 2013, for the amortization of the financing fees and debt discounts. The annual effective interest rate on amounts borrowed under the Loan Agreement, including the amortization of the debt discounts, is 16.56%.

7. License, Research, Development and Commercialization Agreements

DTRA

On October 16, 2013, the Company entered into a research agreement with DTRA to design and discover new classes of systemic antibiotics. A drug discovery consortium formed by the Company, Colorado State University and the University of California at Berkeley is conducting the research over a period of up to three and a half years. The work is funded by an award of up to $13.5 million from DTRA’s R&D Innovation and Systems Engineering Office, which was established to search for and execute strategic investments in innovative technologies for combating weapons of mass destruction. Under this award, the Company will apply its boron chemistry to discover rationally designed novel antibiotics that target DTRA-priority pathogens known to exhibit resistance to existing antibiotics. The award is available to the consortium to fund $2.7 million of research reimbursements for the eleven month period through September 15, 2014, with an additional $5.0 million and $5.7 million becoming available subject to the exercise by DTRA of options to fund the research for subsequent twelve and nineteen month periods, respectively. In August 2014, DTRA exercised the first option to fund the twelve month research extension.

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Revenues recognized under the research agreement were as follows (in thousands):

Gates Foundation

On April 5, 2013, the Company entered into a research agreement with the Gates Foundation to discover drug candidates intended to treat two filarial worm diseases (onchocerciasis, or river blindness, and lymphatic filariasis, commonly known as elephantiasis) and tuberculosis (TB) (the Gates Research Agreement). Under the Gates Research Agreement, the Gates Foundation will pay the Company up to $17.7 million over a three-year research term (the Research Funding) to conduct research activities directed at discovering potential neglected disease drug candidates in accordance with an agreed upon research plan. As part of the funded research activities, the Company is also responsible for creating, during the first 18 months following execution of the Gates Research Agreement, an expanded library of boron compounds to screen for additional potential drug candidates to treat neglected diseases (the Library). Once the Library is completed, the Company is responsible for storing the Library compounds and making them accessible to the Gates Foundation and other parties to which the Gates Foundation grants access (the Library Access Services) for the subsequent five-year period.

Upon signing the Gates Research Agreement, the Company received an advance payment of $1.75 million of Research Funding (the Advance Funds). These Advance Funds are replenished by the Gates Foundation each quarter following the Company’s submission of a quarterly report of the expenses incurred for the research activities conducted in the prior quarter. In addition, the Gates Foundation paid the Company a total of $0.8 million as reimbursement for the costs of filarial worm research that was included in the agreed upon research plan, which the Company conducted prior to the April 5, 2013 effective date of the Gates Research Agreement (the Pre-Contract Reimbursements). These Pre-Contract Reimbursements are non-refundable, non-creditable payments and were included in the $17.7 million of Research Funding.

Under the terms of the agreement, the Gates Foundation will have the exclusive right to commercialize selected drug candidates in specified neglected diseases in specified developing countries. The Company retains the exclusive right to commercialize any selected drug candidate outside of the specified neglected diseases as well as with respect to the specified neglected diseases in specified developed countries and would be obligated to pay the Gates Foundation royalties on specified license revenue received. The Gates Research Agreement will continue in effect until the later of five years from the effective date or the expiration of the Company’s specified obligation to provide access to the Library. Either party may terminate the Gates Research Agreement for the other party’s uncured material breach of the Gates Research Agreement.

In connection with the Gates Research Agreement, the Company entered into a Common Stock Purchase Agreement (the Purchase Agreement) pursuant to which the Company issued 809,061 shares of potentially redeemable common stock to the Gates Foundation for net proceeds of approximately $5.0 million (the Stock Proceeds)  (see Note 8). In addition, in connection with both the Gates Research Agreement and the Purchase Agreement, the Company and the Gates Foundation entered into a letter agreement (the Letter Agreement) that, among other things, restricts the Company’s use of both the Research Funding and the Stock Proceeds to expenditures, including an allocation of overhead and administrative expenses, that are reasonably attributable to the activities that are required to support the research projects funded by the Gates Foundation. As a result of such restrictions, in its June 30, 2014 condensed consolidated balance sheet, the Company classified $2.4 million of the Stock Proceeds as long-term restricted investments and $1.1 million of the Stock Proceeds plus the unspent portion of the Advance Funds, approximately $0.2 million, as short-term restricted investments.

The Company evaluated the Gates Research Agreement under the accounting guidance for multiple-element arrangements and identified three deliverables: the research activities, the 5-year Library Access Services and the obligation to participate in the joint steering committee. Although participation in the joint steering committee has stand alone value, it will be delivered as the research activities are performed and has a similar pattern of performance. Accordingly, the Company has combined this deliverable with the research activities deliverable as a single unit of accounting. The Company developed its best estimates of selling prices (BESP) for each deliverable in order to allocate the arrangement consideration to the two units of accounting. The Company determined the BESP for the research activities based on factors such as estimated direct expenses and other costs involved in providing these services, the contractually agreed reimbursement rates for the services and the rates it has charged and the margins it has realized under its other contracts involving the provision of and reimbursement for research services. The Company determined

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the BESP for the Library Access Services based on the projected costs that would be incurred to have a third party store and distribute the library compounds and the estimated costs that would be incurred to provide the Library Access Services for the required 5-year period, plus a reasonable margin, and concluded that the BESP of such services is insignificant. As a result, the entire arrangement consideration was allocated to the research activities and joint steering committee combined unit of accounting. The Company will recognize revenue related to this unit of accounting on a proportional performance basis and the revenue that is recognized as future research services are performed will reduce the Advance Funds. The unspent portion of the Advance Funds will be recorded as deferred revenue in the Company’s condensed consolidated balance sheets.

The Company also evaluated the accounting treatment for the $0.8 million of Pre-Contract Reimbursements, noting that the research activities that gave rise to such reimbursements were conducted prior to the signing of the Gates Research Agreement. The Company concluded that activities performed prior to commencing delivery of the contracted services should not be considered in effort-expended measures of performance when revenue is recognized for services using a proportional performance method and, accordingly, the Company will recognize revenue from the Pre-Contract Reimbursements over the three-year research term on a proportional performance basis. As of June 30, 2014, the Company has deferred revenue of $0.2 million related to the unspent Advance Funds and $0.4 million related to the Pre-Contract Reimbursements.

Revenues recognized under the Gates Research Agreement were as follows (in thousands):

GSK

In September 2011, the Company amended and expanded its 2007 research and development collaboration with GSK (the Master Amendment) to, among other things, give effect to certain rights in AN3365 that would be acquired by the U.S. government in connection with GSK’s contract for government funding to support GSK’s further development of AN3365, provide GSK the option to extend its rights around the bacterial enzyme target leucyl-tRNA synthetase (LeuRS), as well as to add new programs for tuberculosis (TB) and malaria using the Company’s boron chemistry platform. As a result of the Master Amendment, the Company received a $5.0 million upfront payment in September 2011 and was eligible to receive additional milestone payments, bonus payments and research funding as described below, all of which, if earned, will be non-refundable and non-creditable. The Company is also eligible to receive royalties on future sales of resulting products. The Master Amendment also terminated any research and development obligations that the Company had with respect to the original agreement.

Under the terms of the Master Amendment, GSK retained sole responsibility for the further development and commercialization of AN3365. In October 2012, GSK advised the Company that it had discontinued further development of AN3365; accordingly, all rights to the compound have reverted to the Company.

The Master Amendment added a new program for TB, pursuant to which GSK funded the Company’s TB research activities up until candidate selection. Once TB compounds met specified candidate selection criteria, GSK had the option to license such compounds and, upon exercise of such option, would become responsible for all further development and commercialization of such compounds.

In September 2013, GSK selected a compound that resulted from the TB program for further development. GSK will be responsible for all further development and commercialization of the TB compound, and the Company may receive contingent payments, if certain regulatory events occur and/or if certain sales levels are achieved for resulting TB products, and may also receive royalties on sales of such resulting products.

On October 5, 2013, the research period under the collaboration agreement with GSK expired, except with respect to the TB program for which the research period has been extended to October 2014. The Company continues to work with GSK on the TB program. As of June 30, 2014, the Company has no deferred revenue associated with the GSK collaboration agreement.

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Revenues recognized under this agreement were as follows (in thousands):

Lilly

In August 2010, the Company entered into a research, license and commercialization agreement with Lilly to collaborate on the discovery of products for a variety of animal health applications. Lilly will be responsible for worldwide development and commercialization of compounds advancing from these efforts. The Company received an upfront payment of $3.5 million in September 2010, which it had been recognizing over the expected four-year research term on a straight-line basis. The agreement allowed for termination by Lilly upon written notice, with certain additional payments to the Company and a notice period that had a duration dependent on whether the notice was delivered prior to or after the first regulatory approval of a product under the agreement.

In January 2014, Lilly notified the Company of the termination of the research term of the agreement. As a result, the Company revised the expected research term to end in April 2014, approximately five months earlier than estimated under the agreement. The remainder of the agreement remains in effect and Lilly retained its exclusive rights to the development of one of the two compounds it licensed from the Company (as described further below).

From August 2010 through June 30, 2014, the Company received $11.5 million in research funding under the agreement. The termination of the funding for the agreement became effective 90 days after the Company’s receipt of the termination notice discussed above, and ended Lilly’s obligation to make quarterly research payments.

In 2011 and 2012, Lilly licensed two development compounds from the Company and the Company was eligible to receive additional payments upon the occurrence of specified development and regulatory events for these compounds. The Company has determined that none of these contingent payments are substantive milestones. To date, no products have been approved and therefore no royalties have been earned under this agreement. In September 2013, Lilly notified the Company that it was ceasing further development of one of the two previously licensed compounds; Lilly granted the Company a fully paid, sublicenseable, perpetual, irrevocable, exclusive license to the related technology and patents.

As of June 30, 2014, the Company has no deferred revenue related to the upfront fee and no deferred revenue related to the research term funding.

Revenues recognized under the agreement and for other research services were as follows (in thousands):

Medicines for Malaria Venture

In March 2011, the Company entered into a three-year development agreement with Medicines for Malaria Venture (MMV) to collaborate on the development of compounds for the treatment of malaria through human proof-of-concept studies. This development agreement was preceded by a 2010 research agreement between the two parties. In August 2011, the Company and MMV amended the development agreement to, among other things, specify that any advance payments in excess of the actual costs incurred by the Company for the research and development activities under the agreement are either refundable or creditable against future payments, at MMV’s option. In January 2014, the research agreement was amended and extended through December 31, 2014. Under the amended agreement, MMV will no longer make advance payments to the Company and will now reimburse the Company quarterly in arrears for expenses incurred. As of June 30, 2014, the Company had no deferred revenue associated with its agreements with MMV.

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Revenues recognized under the MMV research and development agreement were as follows (in thousands):

8. Potentially Redeemable Common Stock and Stockholders’ Equity

Potentially Redeemable Common Stock

In connection with the Gates Research Agreement (see Note 7), the Company entered into the Purchase Agreement with the Gates Foundation pursuant to which the Company issued 809,061 shares of its common stock at a purchase price of $6.18 per share on April 5, 2013. Net proceeds to the Company from this offering were approximately $5.0 million, after deducting offering expenses of $48,000. On June 28, 2013, the Company filed a registration statement on Form S-3 with the SEC, which became effective on July 11, 2013, to register the resale of the 809,061 shares of common stock. In the event of termination of the Gates Research Agreement by the Gates Foundation for certain specified uncured material breaches by the Company (the Triggering Events), the Company will be obligated, among other remedies, to redeem for cash the Company’s common stock purchased in connection with the Gates Research Agreement, facilitate the purchase of such common stock by a third party or elect to register the resale of such common stock into the public markets unless certain specified conditions are satisfied. The redemption price per share would be the fair value per share of the Company’s common stock on the redemption date or, under certain circumstances, the greater of (i) the fair value per share and (ii) the purchase price of $6.18 per share plus interest at 5% compounded annually from April 5, 2013, the stock purchase date. In connection with both the Gates Research Agreement and the Purchase Agreement, the Company and the Gates Foundation also entered into the Letter Agreement that, among other things, places certain restrictions on the use of both the Research Funding and the Stock Proceeds (see Note 7).

The Company concluded that certain of these Triggering Events are not solely within the control of the Company; and, accordingly, has classified the potentially redeemable securities outside of permanent equity in temporary equity. The 809,061 shares of common stock issued were recorded as potentially redeemable common stock at an initial carrying amount equal to the net proceeds of approximately $5.0 million, which approximates their issuance date fair value.

The Company has determined that the 809,061 shares of potentially redeemable common stock are not currently redeemable and that none of the Triggering Events are currently probable. Accordingly, the carrying amount of the potentially redeemable common stock remains at approximately $5.0 million as of June 30, 2014. Only if, and when, a Triggering Event becomes probable will the Company record a change in the carrying amount to adjust it to the redemption value of the potentially redeemable common stock. At the time of such an occurrence, the potentially redeemable common stock will be immediately adjusted, by a credit or charge to other income or expense, to equal the redemption value and will continue to be adjusted to reflect any change in the redemption value as of the end of each reporting period.

Shelf Registration

In August 2013, the Company filed a shelf registration statement on Form S-3 with the SEC (the Shelf Registration). The Shelf Registration was declared effective by the SEC and permits the Company to sell, from time to time, up to $50.0 million of common stock, preferred stock, debt securities and warrants.

Preferred Stock

In November 2010, the Company amended and restated its certificate of incorporation to authorize 10,000,000 shares of preferred stock upon the completion of its Initial Public Offering (IPO). As of June 30, 2014 and December 31, 2013, there was no preferred stock outstanding.

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9. Stock-Based Compensation

The Company recorded stock-based compensation expense for the three and six months ended June 30, 2014 and 2013 as follows (in thousands):

(1) Includes $3.0 million of expense relating to the modification of options held by the Company’s prior chief executive officer upon his resignation. See discussion of Stock Option Modification below.

For the three and six months ended June 30, 2014, the Company issued 40,022  and 183,846 shares of the Company’s common stock and received approximately $0.3 million and $0.8 million, respectively, in cash from the exercise of stock options. Total stock options (including Performance Stock Options (PSOs) as described below) granted for the three and six months ended June 30, 2014 were 356,000 options, which included no stock option grants to nonemployee advisors, and 1,786,628 options, which included stock option grants of 12,828 options to nonemployee advisors, respectively. Grants to nonemployee advisors do not include grants made to the Company’s nonemployee directors for their board-related services. The weighted-average fair value per share of options, other than PSOs, granted to employees and the Company’s nonemployee directors was $11.80 and $13.58 for the three and six months ended June 30, 2014, respectively.

At June 30, 2014, there were outstanding stock options to purchase 5,826,923 shares of the Company’s common stock. At June 30, 2014, the Company had $29.4 million and $0.1 million of unrecognized compensation expense, net of estimated forfeitures, related to outstanding stock option and restricted stock unit awards and Employee Stock Purchase Program (ESPP) stock purchase rights, respectively, that will be recognized over a weighted-average period of 3.1 years and 0.5 years, respectively. For the six months ended June 30, 2014, there were 43,063 shares of the Company’s common stock purchased under the ESPP. No shares were purchased under the ESPP during the three months ended June 30, 2014.

Stock Option Modification

In connection with the resignation of the Company’s former chief executive officer in March 2014, the Company’s board of directors approved an additional 18 months of vesting for his unvested stock options, or 223,542 stock options. These stock options would have otherwise expired upon termination. The Company’s board of directors also approved the extension of the post-termination period for the exercise of his vested stock options from three months to six months. As a result of these modifications, during the three months ended March 31, 2014, the Company recorded a one-time stock-based compensation expense of $3.0 million for the incremental value of the stock options vested and the extension of the post-termination exercise period.

Restricted Stock Units (RSUs), Performance Restricted Stock Units (PRSUs) and Performance Stock Options (PSOs)

During the six months ended June 30, 2014, the Company began issuing time-based vesting RSUs and market-based vesting PRSUs and PSOs. RSU and PRSU grants cannot be transferred, and until they vest, the underlying shares are subject to forfeiture if the grantee’s service with the Company terminates prior to the release of the applicable vesting restrictions. The Company uses a Monte Carlo valuation method to estimate the fair value of market-based vesting PRSU and PSO grants. Time-based vesting RSUs are valued at the closing price of the Company’s common stock on the date of grant. The vesting conditions applicable to the Company’s outstanding RSUs, PRSUs and PSOs are as follows:

·                  One-fourth of the RSU grants will vest on each of the first four anniversaries of the applicable vesting commencement date, subject to the grantee’s continued service with the Company. Upon vesting of RSUs, the Company will issue to the grantee thereof one share of the Company’s common stock for each such RSU.

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·                  Grants of PRSUs and PSOs made during the three months ended March 31, 2014 will vest in full, subject to the grantee’s continued service with the Company, if at any time during the four-year period beginning March 21, 2014, the volume-weighted average price for the Company’s common stock exceeds $30 per share (using the VAP function on Bloomberg for the Company “ANAC US EQUITY VAP”, or successor thereof) for 30 consecutive trading days. If such vesting condition is not met within such four-year period, such PRSU and PSO grants will expire. Once vested, each PSO provides the grantee with the right to purchase one share of the Company’s common stock at the applicable option exercise price. Upon vesting of PRSUs, the Company will issue to the grantee thereof one share of the Company’s common stock for each such PRSU.

The weighted-average fair values for these PSOs and PRSUs granted during the six months ended June 30, 2014 were determined using Monte Carlo simulation models incorporating the following weighted-average assumptions:

The Company will recognize the estimated expense of these PSOs and PRSUs, as determined under the simulation models, over the expected life of the award, with no adjustment in future periods based upon the Company’s actual stock price over the performance period.

For the three and six months ended June 30, 2014, the Company granted 25,000 and 397,000 RSUs, respectively. The Company granted 50,000 PRSUs and 100,000 PSOs in the six months ended June 30, 2014. There were no PRSU or PSO grants made during the three months ended June 30, 2014.

10. Subsequent Events

On July 7, 2014, the FDA approved the New Drug Application for KERYDINTM (tavaborole) topical solution, 5% for the topical treatment of onychomycosis of the toenails.

On July 18, 2014, the Company entered into a Distribution and Commercialization Agreement (the Sandoz Agreement) with Sandoz Inc. (together with its affiliates, Sandoz), a Novartis company, pursuant to which Sandoz will distribute and commercialize KERYDIN in the United States on an exclusive basis. PharmaDerm, the branded dermatology business of Sandoz, will be responsible for the sales and marketing of KERYDIN.

Under the Sandoz Agreement, the Company is entitled to (i) upfront payments totaling $40 million (of which $15 million was payable upon entry into the Sandoz Agreement and $25 million is payable within 30 days thereof), (ii) a milestone payment of $25 million payable upon the later of (a) the 90th day following the successful fulfillment, as determined pursuant to the Sandoz Agreement, by the Company of Sandoz’s initial purchase order for KERYDIN and (b) January 5, 2015 and (iii) 50% of the gross profits (defined as net sales less cost of goods sold) accrued by Sandoz on sales of KERYDIN, except that in 2015 the Company will start receiving gross profit sharing payments after the first $50 million of gross profits have been accrued by Sandoz. The gross profit sharing arrangement entitles the Company to cumulative minimum gross profit sharing payments totaling $45 million for 2016. The Company is not entitled to cumulative minimum gross profit sharing payments in any other fiscal period under the Sandoz Agreement. Under the terms of the Sandoz Agreement, the Company will continue to hold the New Drug Application for, and be responsible for any further development of, KERYDIN and will supply KERYDIN to Sandoz at cost through the Company’s contract manufacturers, and Sandoz will be responsible for setting the price for KERYDIN and for all of its selling, marketing, distribution, general and administrative costs related to the commercialization of KERYDIN. The Sandoz Agreement also grants the Company an option to repurchase all rights in KERYDIN from Sandoz on the later of three years from the first commercial sale of KERYDIN or December 31, 2017, at a price to be determined pursuant to the Sandoz Agreement. The Sandoz Agreement will continue for an initial term of 5 years and is subject to automatic 5-year renewal terms, unless terminated for specified events under the Sandoz Agreement.

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

You should read the following discussion and analysis together with our condensed consolidated financial statements and the notes to those statements included elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission (SEC) filings, including our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 17, 2014. This discussion contains forward-looking statements that involve risks and uncertainties. We use words such as “may,” “will,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “predict,” “potential,” “believe,” “should” and similar expressions to identify forward-looking statements. These statements appearing throughout this Quarterly Report on Form 10-Q are statements regarding our intent, belief, or current expectations, primarily regarding our operations. 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. As a result of many factors, such as those set forth under “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q, our actual results may differ materially from those anticipated in these forward-looking statements. Unless otherwise noted or the context otherwise requires, references in this Quarterly Report on Form 10-Q to “we,” “us” or “our” refer to Anacor Pharmaceuticals, Inc. and its subsidiary.

Overview

We are a biopharmaceutical company focused on discovering, developing and commercializing novel small-molecule therapeutics derived from our boron chemistry platform. Our first approved drug, KERYDINTM (tavaborole) topical solution, 5% (formerly known as AN2690), is an oxaborole antifungal approved by the U.S. Food and Drug Administration (FDA) in July 2014 for the topical treatment of onychomycosis of the toenails. In July 2014, we entered into an exclusive agreement with Sandoz Inc. (together with its affiliates, Sandoz), a Novartis company, pursuant to which Sandoz will distribute and commercialize KERYDIN in the United States. Our lead product candidate is AN2728, an investigational anti-inflammatory PDE-4 inhibitor in development for the potential treatment of mild-to-moderate atopic dermatitis and psoriasis.  We initiated Phase 3 studies of AN2728 for the treatment of mild-to-moderate atopic dermatitis in the first quarter of 2014.

Beyond KERYDIN and AN2728, we have discovered, synthesized and are developing six molecules. These include three wholly-owned investigational product candidates. AN2718 is an investigational topical antifungal, AN2898 is a backup compound to AN2728 and AN3365 is an investigational antibiotic for the potential treatment of infections caused by Gram-negative bacteria. We have also discovered three other investigational compounds that we have out-licensed for further development. The first compound is licensed to Eli Lilly and Company (Lilly) for the potential treatment of an animal health indication. The second compound, AN5568, is licensed to Drugs for Neglected Diseases initiative (DNDi) for the potential treatment of human African trypanosomiasis (HAT, or sleeping sickness) and the third compound is licensed to GlaxoSmithKline LLC (GSK) for development in tuberculosis (TB). We also have a pipeline of other internally discovered topical and systemic boron-based compounds in earlier stages of research and pre-clinical development.

Recent Developments

On July 18, 2014, we entered into a Distribution and Commercialization Agreement (the Sandoz Agreement) with Sandoz Inc., a Novartis company, pursuant to which Sandoz will distribute and commercialize KERYDIN in the United States on an exclusive basis. PharmaDerm, the branded dermatology business of Sandoz, will be responsible for the sales and marketing of the drug. The Sandoz Agreement entitles us to (i) upfront payments totaling $40 million (of which $15 million was payable upon entry into the Sandoz Agreement  and $25 million is payable within 30 days thereof), (ii)  a milestone payment of $25 million payable upon the later of (a) the 90th day following the successful fulfillment, as determined pursuant to the Sandoz Agreement, by us of Sandoz’s initial purchase order for KERYDIN and (b) January 5, 2015 and (iii) 50% of the  gross profits (defined as net sales less cost of goods sold) accrued by Sandoz on sales of KERYDIN, except that in 2015 we will start receiving gross profit sharing payments after the first $50 million of gross profits have been accrued by Sandoz. The gross profit sharing arrangement entitles us to cumulative minimum gross profit sharing payments totaling $45 million for 2016.  We are not entitled to cumulative minimum gross profit sharing payments in any other fiscal period under the Sandoz Agreement. Under the terms of the Sandoz Agreement, we will continue to hold the New Drug Application (NDA) for, and be responsible for any further development of, KERYDIN and will supply KERYDIN to Sandoz at cost through our contract manufacturers, and Sandoz will be responsible for setting the price for KERYDIN and for all of its selling, marketing, distribution, general and administrative costs related to the commercialization of KERYDIN.  The Sandoz Agreement also grants us an option to repurchase all rights in KERYDIN from Sandoz on the later of three years from launch or December 31, 2017, at a price to be determined pursuant to the Sandoz Agreement. The Sandoz Agreement will continue for an initial term of five years and is subject to automatic five-year renewal terms, unless terminated for specified events under the Sandoz Agreement.

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On July 7, 2014, the FDA approved the NDA for KERYDINTM (tavaborole) topical solution, 5% for the topical treatment of onychomycosis of the toenails.

In October 2013, we entered into a research agreement with the United States Department of Defense, Defense Threat Reduction Agency (DTRA) to design and discover new classes of systemic antibiotics. A drug discovery consortium formed by Colorado State University, the University of California at Berkeley and us is conducting the research over a period of up to three and a half years. The work is funded by an award of up to $13.5 million from DTRA’s R&D Innovation and Systems Engineering Office, which was established to search for and execute strategic investments in innovative technologies for combating weapons of mass destruction. Under this award, we will apply our boron chemistry to discover rationally designed novel antibiotics that target DTRA-priority pathogens known to exhibit resistance to existing antibiotics. The award is available to the consortium to fund $2.7 million of research reimbursements for the eleven month period through September 15, 2014, with an additional $5.0 million and $5.7 million becoming available subject to the exercise by DTRA of options to fund the research for subsequent twelve and nineteen month periods, respectively. In August 2014, DTRA exercised the first option to fund the twelve month research extension.

In April 2013, we entered into a research agreement with The Bill & Melinda Gates Foundation (the Gates Foundation) to discover drug candidates intended to treat two filarial worm diseases (onchocerciasis, or river blindness, and lymphatic filariasis, commonly known as elephantiasis) and TB. Under the research agreement, the Gates Foundation will pay us up to $17.7 million over a three-year research term to conduct research activities directed at discovering potential neglected disease drug candidates in accordance with an agreed upon research plan. As part of the funded research activities, we are responsible for creating an expanded library of boron compounds to screen for additional potential drug candidates to treat neglected diseases, which will be accessible to the Gates Foundation and other third parties. Under the terms of the agreement, the Gates Foundation will have the exclusive right to commercialize selected drug candidates in specified neglected diseases in specified developing countries. We retain the exclusive right to commercialize any selected drug candidate outside of the specified neglected diseases as well as with respect to the specified neglected diseases in specified developed countries and would be obligated to pay the Gates Foundation royalties on specified license revenue received. The agreement will continue in effect until the later of five years from the effective date or the expiration of our specified obligation to provide access to the expanded library of boron compounds. In connection with the research agreement, we issued 809,061 shares of potentially redeemable common stock to the Gates Foundation for net proceeds of approximately $5.0 million. In the event of termination of the research agreement by the Gates Foundation for certain specified uncured material breaches by us, we will be obligated, among other remedies, to redeem for cash our common stock purchased in connection with the research agreement, facilitate the purchase of such common stock by a third party or elect to register the resale of such common stock into the public markets unless certain specified conditions are satisfied. In addition, we are subject to certain restrictions on our use of the potentially redeemable common stock proceeds and the research funding we receive from the Gates Foundation.

In September 2011, the Company amended and expanded its 2007 research and development collaboration with GSK to, among other things, add a new research program using our boron chemistry platform for TB. In September 2013, GSK selected a compound for further development in TB and will be responsible for all further development and commercialization of this compound. In October 2013, the research period under the agreement with GSK expired, except with respect to the TB program for which the research period has been extended to October 2014.

In August 2010, we entered into a research, license and commercialization agreement with Lilly to collaborate on the discovery of products for a variety of animal health applications. Pursuant to this agreement, Lilly licensed a development compound from us in December 2012 and will be responsible for all further development and commercialization of this compound. In January 2014, Lilly notified us of the termination of the research term of the agreement, effective April 2014, which was approximately five months earlier than the research period was originally expected to end. The remainder of the agreement, including provisions related to potential future payments and royalties, remains in effect and Lilly retains its exclusive rights to the development of the licensed compound.

We also have several collaborations with organizations that fund research leveraging our boron chemistry to discover new treatments for neglected diseases. In addition to potentially developing new therapies for such diseases, these collaborations provide us the potential benefits of expanding the chemical diversity of our boron compounds, understanding new properties of our boron compounds, receiving future incentives, such as the potential grant of a priority review voucher by the FDA, and ultimately, if a drug is approved, potential revenue in some regions. Our collaboration partners include DNDi to develop new therapeutics for sleeping sickness, visceral leishmaniasis and Chagas disease, Medicines for Malaria Venture (MMV) to develop compounds for the treatment of malaria, the Global Alliance for Livestock Veterinary Medicines (GALVMed) for the treatment of animal trypanosomiasis and the Liverpool School of Tropical Medicine for the treatment of river blindness and lymphatic filariasis. In 2011, DNDi completed pre-clinical studies of AN5568 for sleeping sickness and, in March 2012, AN5568 became the first compound from our neglected diseases initiatives to enter human clinical trials. The AN5568 Phase 1 clinical trial is currently in its final stages and, depending upon the results of that trial, a Phase 2/3 registration trial could be initiated as early as the first half of 2015.

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Recent Litigation Settlement and Capital Markets and Financing Activities

In October 2013, we entered into a settlement agreement with Valeant Pharmaceuticals International, Inc. (Valeant) and Dow Pharmaceutical Sciences, Inc. (DPS), which was acquired by Valeant in December 2008, pursuant to which Valeant agreed to pay us $142.5 million to settle all existing and future claims and all other disputes between Valeant, DPS and us related to our intellectual property, confidential information and contractual rights, including the breach of contract dispute that we initiated under a master services agreement that we entered into with DPS in March 2004. In addition, we and Valeant, which acquired Medicis Pharmaceutical Corporation (Medicis) in December 2012, agreed to withdraw all claims and complaints relating to arbitration or litigation in connection with a research and development option and license agreement that we entered into with Medicis in February 2011 (the Medicis Agreement), to terminate the Medicis Agreement effective immediately and to cause all rights and intellectual property under the Medicis Agreement to revert to us.

In June 2013, we entered into a loan and security agreement (Loan Agreement) with Hercules Technology Growth Capital, Inc. as collateral agent and a lender and Hercules Technology III, L.P. as a lender (together, Hercules), providing for loans to us of up to $45.0 million. The first $30.0 million tranche was drawn at the closing of the transaction, at which time we repaid $22.6 million in remaining obligations associated with our previous loan facility. We elected not to draw the second tranche of $10.0 million, which was available to us from the closing date of the Loan Agreement until December 5, 2013. We also elected not to draw the third tranche of $5.0 million, which was available to us from the date of FDA approval of KERYDIN until August 6, 2014.

In May 2013, we issued and sold 3,599,373 shares of our common stock, including 469,483 shares issuable pursuant to the exercise of an overallotment option, in a registered public offering. Our net proceeds from this offering were approximately $21.3 million, after deducting underwriting discounts and other offering costs.

In January 2013, we entered into an equity distribution agreement with Wedbush Securities Inc. (Wedbush) under which we may, from time to time, offer and sell common stock having aggregate sales proceeds of up to $25.0 million. Through June 30, 2014, we have sold shares of our common stock under this agreement generating net proceeds of approximately $1.3 million, after deducting underwriting discounts and other offering costs. No shares were sold under this agreement during the six months ended June 30, 2014.

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments in certain circumstances that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, fair values of financial instruments in which we invest, income taxes, preclinical study and clinical trial accruals, accrued compensation, other contingencies and stock-based compensation. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances and review our estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.

There have been no significant changes during the six months ended June 30, 2014 to our critical accounting policies and significant judgments and estimates as disclosed in our management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2013, with the exception of stock-based compensation, which is discussed in greater detail below.

Stock-Based Compensation

Employee stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period). Stock option awards granted to our nonemployee directors for their board-related services are included in employee stock-based compensation in accordance with current accounting standards. We use the Black-Scholes option-pricing model to estimate the fair value of our time-based vesting stock option awards and use the straight-line (single-option) method for expense attribution. We estimate forfeitures and recognize expense only for those shares expected to vest.

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During the three and six months ended June 30, 2014, we began to issue time-based vesting restricted stock units (RSUs), market-based vesting performance restricted stock units (PRSUs) and market-based vesting performance stock options (PSOs). RSU and PRSU grants cannot be transferred and, until they vest, the underlying shares are subject to forfeiture if the grantee’s service with us terminates prior to the release of the applicable vesting restrictions. The RSUs granted during the three and six months ended June 30, 2014 will vest in equal tranches on the first four anniversaries of the applicable vesting commencement dates, subject to the grantee’s continued service with us. Upon vesting of RSUs, we will issue to the grantee thereof one share of common stock for each such RSU. The PSOs and PRSUs granted in the three months ended March 31, 2014 will vest in full, subject to the grantee’s continued service with us, if at any time during the four-year period beginning March 21, 2014, the volume-weighted average price for our common stock exceeds $30 per share (using the VAP function on Bloomberg for the Company “ANAC US EQUITY VAP”, or successor thereof) for 30 consecutive trading days. If such vesting condition is not met within such four-year period, such PRSU and PSO grants will expire.  We use a Monte Carlo valuation method to estimate the fair value of our market-based vesting PSO and PRSU grants. We will recognize the estimated expense of PSOs and PRSUs, as determined under the simulation models, over the expected life of the award, with no adjustment in future periods based upon our actual stock price over the performance period. Time-based vesting RSUs are valued at the closing price of our common stock on the date of grant.

We account for stock options issued to nonemployees based on their fair values on the measurement dates using the Black-Scholes option-pricing model. The fair values of the options granted to nonemployees are remeasured as they vest. As a result, the noncash charge to operations for nonemployee options that vest in any given reporting period is affected by changes in the fair value of our common stock during that period.

We recorded noncash stock-based compensation for employee and nonemployee stock option grants, employee restricted stock units and employee stock purchase program (ESPP) stock purchase rights of $3.2 million and $1.3 million for the three months ended June 30, 2014 and 2013, respectively and $7.9 million and $2.0 million for the six months ended June 30, 2014 and 2013, respectively. Included in the amounts for the six months ended June 30, 2014 was $3.0 million of stock based compensation relating to the modification of options held by the Company’s former chief executive officer upon his resignation. As of June 30, 2014, we had outstanding options (including PSOs) to purchase 5,826,923 shares of our common stock and 447,000 RSUs and PRSUs and had $29.4 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to outstanding stock options and $0.1 million related to ESPP stock purchase rights that will be recognized over weighted-average periods of 3.1 and 0.5 years, respectively. There were 43,063 common shares purchased under the ESPP for the six months ended June 30, 2014. No shares were purchased under the ESPP during the three months ended June 30, 2014. We expect to continue to grant stock options, restricted stock units and ESPP stock purchase rights in the future, which will increase our stock-based compensation expense in future periods. If any of the assumptions used in the Black-Scholes option pricing model or Monte Carlo valuation method change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

Recent Accounting Pronouncements

In June 2014, the Financial Accounting Standards Board (FASB) issued a new accounting standard on accounting for share-based payments for performance-based stock awards, which will require that a performance target that affects vesting and that could be achieved after the required service period be treated as a performance condition. We do not currently have any performance-based stock awards that meet these conditions. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2015. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements.

In May 2014, the FASB issued a new accounting standard on revenue from contracts with customers, which will require us to recognize revenue when we transfer promised goods or services to a customer in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. The updated standard will replace most existing revenue recognition guidance under U.S. GAAP when it becomes effective and will permit the use of either the retrospective or cumulative effect transition method. Early adoption is not permitted. The standard also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. We have not yet selected a transition method and are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

In July 2013, a new accounting standard was issued that requires the netting of unrecognized tax benefits against a deferred tax asset for a net operating loss carryforward or other carryforward that would apply in the settlement of uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction net operating loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the unrecognized tax benefits. The new standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. We adopted this guidance as of January 1, 2014 and its adoption did not have an effect on our financial statements.

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Results of Operations

Comparison of Three and Six Months Ended June 30, 2014 and 2013