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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 September 30, 2015

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 October 30, 2015, there were 44,123,977 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, 2014.

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, KERYDIN® (tavaborole) topical solution, 5%, 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, the Company entered into an exclusive Distribution and Commercialization Agreement with Sandoz Inc. (together with its affiliates, “Sandoz”), a Novartis company, pursuant to which PharmaDerm, the branded dermatology division of Sandoz, distributes and commercializes KERYDIN in the United States. In September 2014, PharmaDerm launched KERYDIN in the United States. The Company’s lead product development candidate is crisaborole topical ointment, 2% (formerly known as AN2728), a novel non-steroidal topical anti-inflammatory phosphodiesterase-4 (PDE-4) inhibitor in development for the potential treatment of mild-to-moderate atopic dermatitis and psoriasis. Beyond KERYDIN and crisaborole, the Company has discovered three 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 for the potential treatment of human African trypanosomiasis. The third compound is licensed to GlaxoSmithKline LLC for development in tuberculosis (“TB”). The Company also has a pipeline of other internally discovered topical and systemic boron-based compounds in early stages of research and development. These include AN3365, an investigational Gram-negative antibiotic, and certain other wholly-owned investigational product candidates.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements as of September 30, 2015 and for the three and nine months ended September 30, 2015 and 2014 have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. 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, 2014 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 16, 2015.

The accompanying December 31, 2014 condensed consolidated balance sheet is derived from the audited financial statements for the year ended December 31, 2014, but does not include all the disclosures necessary for audited financial statements required by GAAP. The accompanying condensed consolidated financial statements reflect all normal recurring adjustments necessary, in the opinion of management, to present fairly the financial position, results of operations and cash flows for the interim periods presented. The results for the three and nine months ended September 30, 2015 are not necessarily indicative of results to be expected for the year ending December 31, 2015 or for any other future period.

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

Use of Estimates

The preparation of the accompanying condensed consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments in certain circumstances that affect the reported amounts of assets, liabilities, revenues and expenses, and the 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 and judgments, including those related to revenue recognition, fair values of financial instruments in which it invests, inventory, income taxes, preclinical study and clinical trial accruals and deferred advance payments, valuation of liability and equity components of the Company’s convertible debt, accrued compensation, stock-based 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.

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Significant Accounting Policies

The Company’s significant accounting policies are more fully described in Note 2 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014. There have been no changes for the three and nine months ended September 30, 2015 to the significant accounting policies discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 that have had a material impact on the Company’s condensed consolidated financial statements and related notes.

Customer Concentration

For the three and nine months ended September 30, 2015, the Company’s revenues consisted primarily of distribution and commercialization agreement revenues under the Sandoz Agreement (as defined in Note 8) (including revenues from gross profit sharing payments, upfront and product launch payments and product sales of KERYDIN to Sandoz) (see Note 8). For the three and nine months ended September 30, 2014, the Company’s revenues consisted primarily of research contracts revenue from a research agreement with The Bill & Melinda Gates Foundation (the “Gates Foundation”), distribution and commercialization agreement revenues under the Sandoz Agreement (including revenues from upfront payments and product sales of KERYDIN to Sandoz) and research contracts revenue from a contract with the United States Department of Defense, Defense Threat Reduction Agency (“DTRA”) and a collaboration agreement with Lilly.

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

*    less than 10% of total revenue

Contract Receivables

As of September 30, 2015, the Company’s contract receivables included $20.7 million due from Sandoz, $1.6 million due from DTRA (see Note 8) and $0.7 million due under other contracts. As of December 31, 2014, the Company’s contract receivables included $4.0 million due from Sandoz, $1.0 million due from DTRA (see Note 8) and $0.7 million due under other contracts.

The Company does not believe that the credit risks associated with the counterparties to such agreements are significant. Based on historical experience, the Company did not record an allowance for doubtful accounts as of September 30, 2015 and December 31, 2014.

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Net Loss per Share

The following table presents the calculation for the three and nine months ended September 30, 2015 and 2014 of basic and diluted net loss per share (in thousands, except share and per share data):

Recent Accounting Pronouncements

In July 2015, the FASB issued an accounting standard update to simplify the subsequent measurement of inventory, which will require an entity using an inventory method other than last-in, first out or the retail inventory method to measure inventory at the lower of cost and net realizable value. The accounting standard update becomes effective for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect that the accounting standard update will have on its consolidated financial statements and related footnote disclosures.

In April 2015, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update that requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The accounting standard update requires retrospective adoption and is effective for financial statements issued for fiscal years beginning after December 15, 2015 and interim periods within those fiscal years. Early adoption is permitted. At the time of adoption, the Company will reclassify debt issuance costs as a direct deduction from the carrying value of the debt liability, consistent with the presentation of a debt discount. The Company does not expect that the adoption of this accounting standard update will have a material impact on its 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 new standard will replace most existing revenue recognition guidance under GAAP when it becomes effective and will permit the use of either the retrospective or cumulative effect transition method. The new 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. In August 2015, the FASB deferred the effective date of the new standard by one year. Following such deferral, the new standard becomes effective for annual reporting periods beginning after December 15, 2017 (including interim reporting periods within those periods). Early adoption is permitted for annual reporting periods beginning after the original effective date of December 15, 2016 (including interim reporting periods within those periods). The new standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. The Company has not yet selected a transition method and is currently evaluating the effect that the new standard will have on its consolidated financial statements and related footnote disclosures.

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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 the fair value of marketable securities, with gross unrealized gains and losses, were as follows (in thousands):

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;

·                  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 observable for substantially the full term of the assets or liabilities; and

·                  Level 3—Unobservable inputs that reflect the reporting entity’s estimate of assumptions that market participants would use in pricing the asset or liability.

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Investments with original maturities of three months or less at the time of purchase are classified as cash and cash equivalents. Classification of short-term investments, short-term restricted investments, long-term investments and long-term restricted investments is initially based on the contractual maturity at the date of purchase and is reevaluated at each balance sheet date. Long-term investments and long-term restricted investments held as of September 30, 2015 and December 31, 2014 had contractual maturities at the date of purchase of more than one year but equal to or less than two years. The Company does not currently intend to sell any of the securities it holds before maturity 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 available for sale securities for the three and nine months ended September 30, 2015 and 2014.

As of September 30, 2015, no unrealized losses on available for sale investments were attributed to credit risk and all unrealized losses on available for sale investments were considered to be temporary. The Company believes that it is more-likely-than-not that investments in an unrealized loss position as of September 30, 2015 will be held until maturity and that the Company will recover the cost basis of such  investments. For the three and nine months ended September 30, 2015 and 2014, the Company did not record any impairment charges on marketable securities related to other-than-temporary declines in market value.

During the three and nine months ended September 30, 2015 and 2014, there were no transfers between Level 1 and Level 2 financial assets.

Convertible Senior Notes

The fair value of the Company’s 2.00% Convertible Senior Notes due 2021 (the “Convertible Senior Notes”) (see Note 6) was determined using Level 2 inputs based on the quoted market value thereof.

The following table summarizes the carrying amount and fair value of the Convertible Senior Notes (in thousands):

4. Inventory

The Company obtained FDA approval of KERYDIN in July 2014 and began to capitalize inventory costs on the balance sheet during that month. As of September 30, 2015 and December 31, 2014, all inventories were related to KERYDIN drug product.

Inventories consist of the following (in thousands):

The Company has a concentration of risk with respect to the manufacture of KERYDIN. As of September 30, 2015, the Company relied on Hovione FarmaCiencia SA (“Hovione”) and DPT Laboratories, Ltd. (“DPT”) for its requirements of active pharmaceutical ingredient (“API”) and finished drug product for KERYDIN, respectively. While the Company actively monitors and manages its third party manufacturers, any inability by Hovione or DPT to supply sufficient quantities of KERYDIN API or finished drug product, as applicable, could adversely affect product commercialization and delay certain payments to the Company under the Sandoz Agreement.

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5. Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

6. Convertible Senior Notes

On October 16, 2014, the Company issued and sold $90.5 million aggregate principal amount of Convertible Senior Notes, comprised of (i) $82.5 million aggregate principal amount of Convertible Senior Notes sold to certain initial purchasers for resale to qualified institutional buyers in a private offering exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance upon Rule 144A under the Securities Act (including $7.5 million aggregate principal amount of Convertible Senior Notes issued upon the exercise in full of the over-allotment option granted to such initial purchasers) and (ii) $8.0 million aggregate principal amount of Convertible Senior Notes (the “Venrock Notes”) sold in a concurrent private placement under the Securities Act to certain funds affiliated with Venrock Associates (the “Venrock Funds”), an affiliate of the Company.

The Company received total net proceeds from the sale of the Convertible Senior Notes of approximately $87.1 million, after deducting the initial purchasers’ fees of $2.9 million and other issuance costs of $0.5 million. During the fourth quarter of 2014, the Company used approximately $30.8 million of the net proceeds from the sale of the Convertible Senior Notes to repay in full its outstanding indebtedness under, and terminate, its loan and security agreement (the “Hercules 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”).

The Convertible Senior Notes were issued pursuant to an indenture, dated as of October 16, 2014 (the “Indenture”), by and between the Company and Wells Fargo Bank, National Association, as trustee. The Convertible Senior Notes are general unsecured obligations of the Company, bear interest at a fixed rate of 2.00% per year (payable semiannually in arrears on April 15 and October 15 of each year, with the first interest payment made on April 15, 2015) and will mature on October 15, 2021, unless earlier purchased, redeemed or converted. Holders may convert their Convertible Senior Notes at their option prior to the close of business on the business day immediately preceding July 15, 2021 only under the following circumstances: (i) during any fiscal quarter commencing after December 31, 2014 (and only during such fiscal quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the applicable conversion price on each applicable trading day; (ii) during the five consecutive business day period after any ten consecutive trading day period in which the trading price (as defined in the Indenture) per $1,000 principal amount of Convertible Senior Notes for each trading day of such ten consecutive trading day period was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on each such trading day; (iii) upon the occurrence of specified corporate events described in the Indenture; or (iv) if the Company calls the Convertible Senior Notes for redemption, until the close of business on the business day immediately preceding the redemption date. As described in clause (i) above, holders may convert their Convertible Senior Notes during the quarter ending December 31, 2015. On or after July 15, 2021 until the close of business on the business day immediately preceding the maturity date, holders may convert their Convertible Senior Notes at any time, regardless of the foregoing circumstances. Upon conversion of the Convertible Senior Notes, the Company will pay or deliver, as the case may be, cash, shares of the Company’s common stock or a combination thereof (with the form of consideration at the Company’s election). The conversion rate is initially 32.2061 shares of common stock per $1,000 principal amount of Convertible Senior Notes (equivalent to an initial conversion price of approximately $31.05 per share of the Company’s common stock), which represents approximately 2,903,413 shares of common stock, based on the $90.2 million aggregate principal amount of Convertible Senior Notes outstanding as of September 30, 2015. The conversion rate and the corresponding conversion price will be subject to adjustment upon the occurrence of certain events, but will not be adjusted for any accrued and unpaid interest. If the Company undergoes a fundamental change (as defined in the Indenture), holders may require the Company to purchase for cash all or part of their Convertible Senior Notes at a purchase price equal to 100% of the principal amount of the Convertible Senior Notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the fundamental change purchase date. In addition, if certain make-whole fundamental changes occur or if the Company issues a notice of redemption for the Convertible Senior Notes, the Company will, in certain circumstances, increase the conversion rate for any Convertible Senior Notes converted in connection with such make-whole fundamental change or notice of redemption. The conversion rate will not be increased on account of a make-whole fundamental change or a notice of redemption to exceed 43.4782 shares of common stock per $1,000 principal amount of Convertible Senior Notes and, as of September 30, 2015, the Company had an aggregate of 3,919,604 shares of common stock reserved for issuance upon conversion of the Convertible Senior Notes. The Convertible Senior Notes will not be redeemable at the Company’s option prior to October 15, 2018. On or after October 15, 2018, the Convertible Senior Notes will be redeemable at the Company’s option if the last reported sale price of the Company’s common stock for at least 20 trading days in any 30 trading day period exceeds 130% of the conversion price for the Convertible Senior Notes. The Indenture provides for customary events of default. The if-converted value of the Convertible Senior Notes exceeded their principal amount by $251.6 million as of September 30, 2015 because the closing market price of the Company’s common stock on such date of $117.71 per share exceeded the implicit conversion price of $31.05 per share.

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During the three months ended September 30, 2015, $0.3 million aggregate principal amount of Convertible Senior Notes was converted at the election of the holders thereof. The Company elected to settle such conversions by delivery of shares of the Company’s common stock and issued an aggregate of 11,239 shares with an estimated fair value of $1.3 million, based on the closing market price of the Company’s common stock on the conversion date. The Company allocated $1.1 million of the fair value of the issued shares to the reacquisition of the equity component of such converted notes and recorded a gain of approximately $20,000 on the extinguishment of the debt component of such converted notes, which is included in other income in the condensed consolidated statements of operations.

In connection with the sale of the Venrock Notes, the Company entered into a registration rights agreement with the Venrock Funds. Pursuant to such registration rights agreement, the Venrock Funds may require the Company, from and after the one-year anniversary of the last date of original issuance of the Venrock Notes, to register the resale by the Venrock Funds of the Venrock Notes, any shares of the Company’s common stock issuable to the Venrock Funds upon conversion of the Venrock Notes or any other securities that may be issued or distributed in respect of such Venrock Notes or shares by way of conversion, dividend, stock split or other distribution or specified corporate transactions.

The Convertible Senior Notes are accounted for in accordance with FASB Accounting Standards Codification (“ASC”) Subtopic 470-20, Debt with Conversion and Other Options. Pursuant to ASC Subtopic 470-20, issuers of certain convertible debt instruments, such as the Convertible Senior Notes, that have a net settlement feature and may be settled wholly or partially in cash upon conversion are required to separately account for the liability (debt) and equity (conversion option) components of the instrument. The carrying amount of the liability component of the instrument is computed by estimating the fair value of a similar liability without the conversion option. The amount of the equity component is then calculated by deducting the fair value of the liability component from the principal amount of the instrument. The fair value of the liability component of the Convertible Senior Notes was estimated to be $59.3 million as of the date of issuance. This fair value was estimated using a binomial lattice to model future changes in the Company’s stock price and a convertible instrument lattice to determine the potential future values for the equity component and the liability component of the Convertible Senior Notes. Inputs to these models included volatility of 45%, an implied credit spread of 6.88%, a risk-free interest rate of 1.99% and a discount rate of 8.87%. The annual effective interest rate on the liability component of the Convertible Senior Notes was 8.57% as of September 30, 2015.

Under current accounting guidance, the Company bifurcated the conversion option of the Convertible Senior Notes from the debt instrument, classified the conversion option in equity and will accrete the resulting debt discount as interest expense over the contractual term of the Convertible Senior Notes. Total issuance costs of $3.4 million related to the Convertible Senior Notes were allocated between debt and equity in the same proportion as the allocation of the total proceeds to the liability and equity components. The Company’s debt issuance costs for legal fees and other debt-related expenses related to the liability component are recorded as prepaid expenses and other current assets and as other assets in the condensed consolidated balance sheets. At the date of issuance, the carrying value of the equity component was $30.0 million, net of $1.2 million of debt issuance costs allocated to the equity component of the Convertible Senior Notes.

Upon issuance of the Convertible Senior Notes, the Company recognized a deferred tax liability of $10.3 million as a result of the temporary difference between the carrying value and the tax basis of the Convertible Senior Notes. This liability is netted with current and long-term deferred tax assets and the resulting net long-term asset is included in other assets and the resulting net current liability is included in other current liabilities in the condensed consolidated balance sheets. An offsetting amount was recorded as a charge to additional paid-in capital, in accordance with the applicable accounting guidance. As the debt discount is accreted over the term of the Convertible Senior Notes, the deferred tax liability will reverse and result in deferred income tax expenses in the Company’s future provisions for income taxes.

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The following table summarizes information about the equity and liability components of the Convertible Senior Notes as of September 30, 2015 and December 31, 2014 (in thousands):

(1)                                 Net of the equity component of debt issuance costs and deferred income taxes.

The following table presents the components of interest expense for the three and nine months ended September 30, 2015 and 2014 (in thousands):

(1)                                 Amounts for the three and nine months ended September 30, 2015 represent contractual coupon interest related to the Convertible Senior Notes.

Interest expense for the three and nine months ended September 30, 2015 was related entirely to the Convertible Senior Notes and interest expense for the three and nine months ended September 30, 2014 was related entirely to the Company’s indebtedness under the Hercules Loan Agreement. The remaining unamortized debt discount related to the Convertible Senior Notes of $27.9 million as of September 30, 2015 will be accreted over the remaining term of the Convertible Senior Notes, which is approximately 6.0 years.

Future payments on the Convertible Senior Notes as of September 30, 2015 are as follows (in thousands):

In accordance with ASC 260, Earnings Per Share, the issuance of the Convertible Senior Notes requires the use of the “if-converted” basis when calculating the Company’s diluted net income (loss) per share. Net income (loss) is adjusted to exclude, or add-back, all Convertible Senior Notes-related earnings effects including interest charges, changes in value of the embedded conversion derivative, accretion of the debt discount and amortization of debt issuance costs. Weighted average shares are adjusted using the conversion rate as if the Convertible Senior Notes had been converted at the date of issuance. The conversion rate is initially 32.2061 shares of common stock per $1,000 principal amount of Convertible Senior Notes (equivalent to an initial conversion price of approximately $31.05 per share of the Company’s common stock), which represents approximately 2,903,413 shares of common stock, based on the $90.2 million aggregate principal of Convertible Senior Notes outstanding as of September 30, 2015. Such adjustments to net income (loss) and weighted average shares were not included in the computation of diluted net loss per share for all periods presented as the effect was anti-dilutive. See Note 2 for a computation of diluted net loss per share.

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7. Commitments and Contingencies

Indemnification Obligations

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, if the officer or director is or was serving in such capacity at the Company’s request at the time of the event or occurrence. 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 collaboration partners, contract research organizations and other counterparties with which it does business that contain indemnification provisions pursuant to which the Company may agree 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.

Legal Proceedings

In August 2015, a hedge fund (acting with affiliated parties and proceeding under the name of the Coalition for Affordable Drugs X LLC (“CFAD”)) filed a total of three petitions with the Patent Trial and Appeal Board (the “PTAB”) of the U.S. Patent and Trademark Office seeking to institute Inter Partes Review (“IPR”) proceedings to invalidate the Company’s Orange Book-listed U.S. Patents Nos. 7,582,621 (the “‘621 Patent”) and 7,767,657 (the “‘657 Patent” and, together with the ‘621 Patent, the “KERYDIN Orange Book Patents”) covering KERYDIN.

CFAD’s petitions seeking to institute IPR proceedings were accepted for filing by the PTAB in August 2015, and the Company has until November 27, 2015 to file its preliminary responses with respect to the petitions. Upon receipt of the Company’s preliminary responses, the PTAB will have three months in which to institute or deny the IPR proceedings. If the IPR proceedings are instituted by the PTAB, CFAD will have an opportunity to challenge the validity of some or all of the claims in the KERYDIN Orange Book Patents before the PTAB.

The Company intends to vigorously oppose the institution of the IPR proceedings and, if the IPR proceedings are instituted, to vigorously defend the KERYDIN Orange Book Patents. However, it is impossible to predict with certainty the outcome of such matters, and the Company can offer no assurance as to whether the IPR proceedings will be instituted and, if so, whether the Company will be successful in its defense of some or all of the claims of the KERYDIN Orange Book Patents. If CFAD is successful in the IPR proceedings, the Company’s business, financial condition, results of operation and cash flows could be materially adversely affected in future periods following the expiration of the expected U.S. regulatory exclusivity for KERYDIN. These matters are in their early stages, and an estimate of the potential loss, or range of loss, if any, to the Company relating to these matters is not possible at this time.

From time to time, the Company may also be involved in litigation relating to claims arising in the ordinary course of its business.

8. License, Research, Development, Distribution and Commercialization Agreements

Sandoz Agreement

In July 2014, the FDA approved the New Drug Application (“NDA”) for KERYDIN. In July 2014, the Company entered into the Sandoz Agreement with Sandoz, a Novartis company, pursuant to which PharmaDerm, the branded dermatology division of Sandoz, distributes and commercializes KERYDIN in the United States on an exclusive basis and is responsible for the selling and marketing of KERYDIN. In September 2014, PharmaDerm launched KERYDIN in the United States.

Pursuant to the Sandoz Agreement, the Company received two upfront payments totaling $40.0 million in the three months ended September 30, 2014 and a product launch payment of $25.0 million in January 2015 (the “Launch Payment”).

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Under the Sandoz Agreement, the Company is entitled to 50% of the gross profits (defined as net sales less cost of goods sold) accrued by Sandoz on sales of KERYDIN during the term of the agreement, except that, in 2015, the Company was entitled to start receiving gross profit sharing payments only after the first $50.0 million of gross profits had been accrued by Sandoz, as the Company effectively received its 50% share of the first $50.0 million of gross profits as a result of the Launch Payment received in January 2015.

In June 2015, the Company entered into an Amendment (the “Sandoz Amendment”) to the Company’s Distribution and Commercialization Agreement with Sandoz (together, the “Sandoz Agreement”). Pursuant to the Sandoz Amendment, (i) Sandoz agreed to increase its commercial investment in KERYDIN in 2015 and (ii) the Company agreed to contribute a total of $20.0 million to Sandoz (the “Anacor Contribution”) to pay for certain specified expenses, primarily focused on consumer-directed commercialization activities. The Company agreed to make the Anacor Contribution in three installments, with $5.0 million, $7.5 million and $7.5 million thereof payable on or prior to June 30, 2015, September 30, 2015 and December 31, 2015, respectively. The Company paid the first two installments of the Anacor Contribution, in the amounts of $5.0 million and $7.5 million, during June 2015 and September 2015, respectively.

The Sandoz Amendment also (i) increased the amount of cumulative minimum gross profit sharing payments to which the Company is entitled under the Sandoz Agreement for 2016 to $65.0 million from $45.0 million, (ii) established new cumulative minimum gross profit sharing payments to the Company for 2017 of $65.0 million and (iii) reduced the price associated with the Company’s option to repurchase all rights in KERYDIN from Sandoz on December 31, 2017, as determined pursuant to the Sandoz Agreement. The Company is not entitled to cumulative minimum gross profit sharing payments under the Sandoz Agreement for any years other than 2016 and 2017.

Under the terms of the Sandoz Agreement, the Company holds the NDA for, and is responsible for any further development of, KERYDIN. In addition, the Company is responsible for maintaining regulatory approvals, reporting safety-related information to the FDA and conducting any additional clinical trials required by the FDA with respect to KERYDIN. Sandoz is responsible for selling, marketing and setting the price for KERYDIN and, except for the Anacor Contribution, for all of its selling, marketing, distribution, general and administrative costs related to the commercialization of KERYDIN. The Sandoz Agreement will continue for an initial term of 5 years and is subject to automatic 5-year renewal terms, unless terminated for certain events specified in the Sandoz Agreement. Either party may terminate the Sandoz Agreement for uncured material breaches by the other party, bankruptcy, force majeure events that remain unabated, withdrawal of KERYDIN from the market or mass tort liability actions. In addition, Sandoz may terminate the Sandoz Agreement for convenience upon 180 days’ prior written notice, subject to the payment to the Company (to the extent then unpaid) of the minimum gross profit sharing amounts, and in the event the Company settles, or an injunction is entered in, a third-party infringement action that prevents the Company from supplying KERYDIN to Sandoz. The Company also has the right to terminate the Sandoz Agreement upon the expiration of all patents covering KERYDIN.

The upfront payments received in 2014 totaling $40.0 million are being recognized on a straight-line basis over the life of the last-expiring patent covering KERYDIN, a period of about 13 years. Under the Sandoz Agreement, the Company is responsible for supplying KERYDIN to Sandoz at a price equal to the Company’s manufacturing costs (as calculated pursuant to the Sandoz Agreement). The Company is currently supplying Sandoz with KERYDIN finished product manufactured by the Company’s contract manufacturers. Revenues from such product sales are being recognized at the price specified by the Sandoz Agreement when the product is released to Sandoz at the Company’s contract manufacturer’s facility since title passes to Sandoz and Sandoz bears the risk of loss at that time. The Company’s gross profit sharing payments under the Sandoz Agreement have been, and are expected to continue to be, recorded in the same period as the related end-market sales. The Company recognizes gross profit sharing revenue under the Sandoz Agreement when the underlying gross profits are reliably measurable and reported to the Company by Sandoz. Sandoz has provided, and is expected to continue to provide, the gross profit reporting in the same quarter as the related end-market sales. The Launch Payment of $25.0 million was recorded as deferred revenue when received and was recognized in full, as gross profit sharing revenue, in the six months ended June 30, 2015. As KERYDIN gross profits for 2015 have exceeded the first $50.0 million to be retained by Sandoz, the Company began recognizing its 50% share of the excess over the first $50.0 million during the three months ended June 30, 2015 based upon gross profits on sales of KERYDIN for the same period, as reported to the Company by Sandoz. The Company recognized gross profit sharing revenue of $19.1 million for the three months ended September 30, 2015 and $45.0 million for the nine months ended September 30, 2015, the latter of which includes $25.0 million related to the Launch Payment as described above. The $65.0 million of cumulative minimum gross profit sharing payments for each of 2016 and 2017 will be recognized as Sandoz reports quarterly gross profits to the Company for each quarter in the applicable year, with any remaining amount to be recognized at the end of the applicable year. Should the Company’s 50% share of KERYDIN gross profits for 2016 or 2017 exceed $65.0 million, the Company’s 50% share of any excess gross profits for the applicable year will be recognized when reliably measurable and reported to the Company by Sandoz. As of September 30, 2015, the Company had current and long-term deferred revenue related to the upfront payments of $3.1 million and $33.2 million, respectively. The Company accounts for the expenses incurred in connection with the Sandoz Agreement, including the Anacor Contribution, based on the nature of those expenses. The Company will record the Anacor Contribution when the associated expenses are incurred by Sandoz, as reported to the Company by Sandoz. If at any balance sheet date the cumulative amount paid to Sandoz in respect of the Anacor Contribution exceeds the amount of such associated expenses incurred and reported by Sandoz, the Company will record the excess amount as prepaid expenses and other current assets in its condensed consolidated balance sheets until the associated expenses are incurred by Sandoz. As of September 30, 2015, there were no prepaid expenses related to the Company’s payment of the first two installments of the Anacor Contribution, and the Company recorded the full amounts of such first two installments as selling, general and administrative expenses in its condensed consolidated statements of operations.

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

Gates Foundation

In April 2013, the Company entered into a research agreement with the Gates Foundation to expand the Company’s boron chemistry library and to discover drug candidates intended to treat two filarial worm diseases (onchocerciasis, or river blindness, and lymphatic filariasis, commonly known as elephantiasis) and TB. Effective October 2014, the research agreement was amended to add an additional parasitic disease target, cryptosporidiosis (as amended, the “Gates Research Agreement”). Under the Gates Research Agreement, the Gates Foundation will pay the Company up to $18.3 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 created an expanded library of boron compounds to screen for additional potential drug candidates to treat neglected diseases (the “Library”). Now that 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 five-year period following the Library completion date (as determined under the Gates Research Agreement), unless earlier terminated pursuant to the terms of the Gates Research Agreement.

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. As of September 30, 2015, the Company had no contract receivables related to the reimbursement of such research costs. In addition, in 2013 the Gates Foundation also 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 are included in the $18.3 million of Research Funding.

Under the terms of the Gates Research 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. In addition, the Company 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 its 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”). The potential redemption amount of such potentially redeemable common stock is disclosed in the accompanying condensed consolidated balance sheets (see Note 9). 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 September 30, 2015 condensed consolidated balance sheet, the Company classified $1.8 million of the Stock Proceeds as long-term restricted investments and $0.5 million of the Stock Proceeds, together with the unspent portion of the Advance Funds as of September 30, 2015, which was approximately $0.4 million, as short-term restricted investments.

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Through September 30, 2015, the Company has recognized total revenue of $14.6 million under the Gates Research Agreement. As of September 30, 2015, the Company has deferred revenue of $0.4 million related to the unspent Advance Funds and  $0.1 million related to the Pre-Contract Reimbursements.

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

United States Department of Defense, Defense Threat Reduction Agency

In October 2013, the Company entered into a research agreement with DTRA to design and discover new classes of systemic antibiotics. A drug discovery consortium led by the Company is conducting the research over a period of up to three and two-thirds years. The work is funded by an award of up to $13.6 million from DTRA’s R&D Innovation and Systems Engineering Office, consisting of (i) $2.9 million of research funding for the eleven month period through September 15, 2014, (ii) $5.0 million of research funding for the current research extension period, which was originally scheduled to end on September 15, 2015 but has been extended to November 30, 2015 and (iii) an additional $5.7 million that may become available subject to the exercise by DTRA of its remaining option to fund the research for a subsequent nineteen-month period.

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

Eli Lilly and Company

Revenues recognized under the research, license and commercialization agreement with Lilly were as follows (in thousands):

9. Redeemable Common Stock

Potentially Redeemable Common Stock

In the event of certain uncured material breaches by the Company under the Gates Research Agreement (the “Triggering Events”), the Company may be obligated, among other remedies, to redeem for cash the Company’s common stock purchased by the Gates Foundation in connection with the Gates Research Agreement or facilitate the purchase of such common stock by a third party. The Company concluded that certain of the Triggering Events are not solely within the control of the Company and, accordingly, has classified the potentially redeemable common stock issued to the Gates Foundation outside of permanent equity in temporary equity. The 809,061 shares of common stock issued to the Gates Foundation 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.

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The Company has determined that the 809,061 shares of potentially redeemable common stock held by the Gates Foundation as of September 30, 2015 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 September 30, 2015. 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. 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. The potential redemption amounts as of September 30, 2015 and December 31, 2014 were $95.2 million and $26.1 million, respectively, based on the closing price of the Company’s common stock on such dates.

10. Common Stock Warrants

During the nine months ended September 30, 2015, 40,623 warrants with an exercise price of $16.936 per share were net exercised, resulting in the issuance of 30,368 shares of the Company’s common stock. As of September 30, 2015, there were no outstanding warrants to purchase the Company’s common stock.

11. Stock-Based Compensation

The Company recorded stock-based compensation expense for the three and nine months ended September 30, 2015 and 2014 as follows (in thousands):

(1)         Includes $3.0 million of expense for the nine months ended September 30, 2014 related to stock options held by the Company’s prior chief executive officer, which were modified upon his resignation, including $2.9 million related to such modifications.

The Company grants time-based stock options, time-based restricted stock units (“RSUs”) and market-based performance restricted stock units (“PRSUs”). In addition, the Company made a grant of market-based performance stock options (“PSOs”) in the nine months ended September 30, 2014. Stock option, RSU, PRSU and PSO grants are subject to (i) limitations on transferability, (ii) accelerated vesting in the event of certain terminations in connection with a change of control and (iii) until they vest, forfeiture if the grantee’s service with the Company terminates prior to the release of the applicable vesting restrictions. Upon vesting of RSUs and PRSUs, the Company issues to the grantee one share of common stock for each such RSU or PRSU. The Company uses the Black-Scholes option-pricing model to estimate the fair value of its time-based stock option awards. The Company uses a Monte Carlo valuation method to estimate the fair value of market-based PRSU and PSO grants. Time-based RSUs are valued at the closing price of the Company’s common stock on the date of grant.

For the three and nine months ended September 30, 2015, the Company issued 104,602 shares and 621,689 shares, respectively, of the Company’s common stock and received approximately $0.7 million and $4.7 million, respectively, in cash as a result of the exercise of stock options. Total stock options granted during the three and nine months ended September 30, 2015 were 5,700 and 662,711, respectively. For the three and nine months ended September 30, 2015, the weighted-average fair value per share of options granted was $71.87 and $27.19, respectively. For the nine months ended September 30, 2015, the Company issued 99,250 shares of the Company’s common stock as a result of the vesting of RSUs. The Company granted 139,839 RSUs and 59,662 PRSUs for the nine months ended September 30, 2015. For the nine months ended September 30, 2015, the weighted-average fair value per share of RSUs and PRSUs granted was $40.25 and $18.45, respectively. During the three months ended September 30, 2015, the Company did not issue any shares of the Company’s common stock as a result of the vesting of RSUs or grant any RSUs or PRSUs. During the three and nine months ended September 30, 2015, the Company did not grant any options, RSUs or PRSUs to nonemployee advisors or grant any PSOs.

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The stock options granted to employees during the three and nine months ended September 30, 2015 will vest over four years, with 25% of the shares subject to the award vesting in an initial annual installment following the applicable vesting commencement date and 1/48th of the shares subject to the award vesting each month thereafter. The stock options granted to nonemployee directors during the nine months ended September 30, 2015 will vest over one year, with 1/12th of the shares subject to the award vesting each month following the grant date thereof. The RSUs granted to employees during the nine months ended September 30, 2015 will vest over four years, with the shares subject to the award vesting in four equal annual installments following the applicable vesting commencement date. The RSUs granted to nonemployee directors during the nine months ended September 30, 2015 will vest in full on the date preceding the date of the Company’s 2016 Annual Meeting of Stockholders. 55,658 of the PRSUs granted during the nine months ended September 30, 2015 have the following vesting terms: in the event that the volume-weighted average price of the Company’s common stock equals or exceeds (i) $80.00 per share for 30 consecutive trading days prior to January 1, 2016 or (ii) $100.00 per share for 30 consecutive trading days prior to January 1, 2017, the shares subject to the award shall vest in two equal annual installments following the date on which the condition specified in clause (i) or (ii) is met. 4,004 of the PRSUs granted during the nine months ended September 30, 2015 have the following vesting terms: in the event that the volume-weighted average price of the Company’s common stock equals or exceeds (i) $80.00 per share for 30 consecutive trading days prior to January 1, 2017, 50% of the shares subject to the award shall vest in two equal annual installments following the date on which the condition specified in this clause (i) is met, and (ii) $100.00 per share for 30 consecutive trading days prior to January 1, 2017, the remaining 50% of the shares subject to the award shall vest in two equal annual installments following the date on which the condition specified in this clause (ii) is met. During August 2015, all of the volume-weighted average price conditions applicable to the PRSUs granted during the nine months ended September 30, 2015 were met.

As of September 30, 2015, there were outstanding stock options to purchase 4,656,354 shares of the Company’s common stock, 437,169 outstanding RSUs and 59,662 outstanding PRSUs. As of September 30, 2015, the Company had $35.8 million and $0.9 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to outstanding stock option, RSU and PRSU awards and Employee Stock Purchase Program (“ESPP”) stock purchase rights, respectively, that will be recognized over a weighted-average period of 2.6 years and 0.9 years, respectively. For the three and nine months ended September 30, 2015, 27,597 and 78,645 shares, respectively, of the Company’s common stock were purchased under the ESPP.

The weighted-average fair values for PSOs and PRSUs granted during the nine months ended September 30, 2015 and 2014 were determined using Monte Carlo simulation models incorporating the following weighted-average assumptions: