Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2020

OR

For the transition period from                              to                             

Commission File Number: 001-33678

NOVABAY PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

2000 Powell Street, Suite 1150, Emeryville, CA 94608

(Address of principal executive offices) (Zip Code)

Registrant’s Telephone Number, Including Area Code: (510) 899-8800

Securities Registered Pursuant to Section 12(b) of the Act:

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 ☒    No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).

Yes ☒    No ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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 ☐ No ☒

As of November 10, 2020, there were 41,782,584 shares of the registrant’s common stock outstanding.  

NOTE 1. ORGANIZATION

NovaBay Pharmaceuticals, Inc. (the “Company”) is a medical device company predominantly focused on eye care. Our main product is Avenova®, an FDA cleared product sold in the United States that has proven in laboratory testing to have broad antimicrobial properties as it removes foreign material including microorganisms and debris from skin around the eye, including the eyelid. Avenova is formulated with our proprietary, stable and pure form of hypochlorous acid and is available direct to consumers through on-line distribution channels and is also often prescribed and dispensed by eyecare professionals for blepharitis and dry-eye disease. During the second quarter of 2020, our primary source of revenue was from third-party manufactured disposable KN95 facial coverings (“KN95 Masks”) which we offered in response to the consumer demand created by the COVID-19 pandemic. Sales of our KN95 Masks continued in the third quarter of 2020 but were not our primary source of revenue during that quarter. We do not anticipate that KN95 Masks will provide a significant future source of revenue.

The Company was incorporated under the laws of the State of California on January 19, 2000, as NovaCal Pharmaceuticals, Inc. It had no operations until July 1, 2002, on which date it acquired all of the operating assets of NovaCal Pharmaceuticals, LLC, a California limited liability company. In February 2007, it changed its name from NovaCal Pharmaceuticals, Inc. to NovaBay Pharmaceuticals, Inc. In June 2010, the Company changed the state in which it was incorporated (the “Reincorporation”) and is now incorporated under the laws of the State of Delaware. All references to “the Company” herein refer to the California corporation prior to the date of the Reincorporation and to the Delaware corporation on and after the date of the Reincorporation. The Company is managed as a single segment focused on commercializing Avenova in the United States.

Liquidity

Based primarily on the funds available at September 30, 2020, management believes that the Company’s existing cash and cash equivalents and cash flows generated from product sales will be sufficient to enable the Company to meet its planned operating expenses at least through November 12, 2021. However, changing circumstances may cause the Company to expend cash significantly faster than currently anticipated, and the Company may need to spend more cash than currently expected because of circumstances beyond its control. Additionally, our future results, cash expenditures and ability to obtain additional external financing could be adversely affected by the COVID-19 pandemic and general adverse economic conditions. 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP") and are expressed in U.S. dollars.

Use of Estimates

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates include useful lives for property and equipment and related depreciation calculations, assumptions for valuing options and warrants, income taxes, and other contingencies. Actual results could differ from those estimates.

Unaudited Interim Financial Information

The accompanying unaudited interim condensed consolidated financial statements and related disclosures have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and note disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosure made are adequate to make the information not misleading. It is suggested that these condensed financial statements be read in conjunction with the Company's financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2019. The year-end condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by U.S. GAAP. The condensed consolidated results of operations for any interim period are not necessarily indicative of the results to be expected for the full year or for any other future year or interim period. 

Cash, Cash Equivalents, and Restricted Cash

The Company considers all highly-liquid instruments with a stated maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents are stated at cost, which approximates fair value. As of September 30, 2020 and December 31, 2019, the Company’s cash and cash equivalents were held in a highly-rated, major financial institution in the United States.

The following table provides a reconciliation of the cash and cash equivalents reported in the condensed consolidated balance sheets to cash, cash equivalents and restricted cash reported in the statement of cash flows: 

The restricted cash amount included in other assets on the condensed consolidated balance sheets represents amounts held as certificates of deposit for long-term financing and lease arrangements as contractually required by our financial institution and landlord.

Concentrations of Credit Risk and Major Partners

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash, cash equivalents and restricted cash. The Company maintains deposits of cash, cash equivalents and restricted cash with a highly-rated, major financial institution in the United States. 

Deposits in this bank may exceed the amount of federal insurance provided on such deposits. The Company does not believe it is exposed to significant credit risk due to the financial position of the financial institution in which the deposits are held. 

During the three and nine months ended September 30, 2020, revenues were derived primarily from sales of Avenova. Avenova is sold directly to consumers through Amazon.com and Avenova.com. Avenova is also sold with a prescription through local pharmacies via three major distribution partners, at eye care specialist offices and through a limited number of partner pharmacies. During the nine months ended September 30, 2020, primarily during the second quarter, the Company also generated revenue from the sale of KN95 Masks through the Company’s webstore and offline bulk orders. The Company does not expect KN95 Masks to provide a significant future source of revenue.

During the three and nine months ended September 30, 2020 and 2019, revenues from each product were as follows:

During the three and nine months ended September 30, 2020 and 2019, Avenova revenues from our major distribution partners greater than 10% were as follows:

*Not greater than 10%

As of September 30, 2020 and December 31, 2019, accounts receivable from our customers and distribution partners greater than 10% were as follows:

The Company relies on two contract manufacturers to produce Avenova. The Company does not own any manufacturing facilities and intends to continue to rely on third parties for the supply of finished goods. Contract manufacturers may or may not be able to meet the Company’s needs with respect to timing, quantity or quality. In particular, it is possible that we may suffer from unexpected supply chain delays in light of the worldwide COVID-19 pandemic.

Fair Value of Financial Assets and Liabilities

The Company’s financial instruments include cash and cash equivalents, restricted cash, accounts receivable, accounts payable, accrued liabilities, related party note payable, and warrants liabilities. The fair value of cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, and related party note payable is carried at cost, which management believes approximates fair value due to the short-term nature of these instruments.

A liability for warrants that are expected to be issued upon the achievement of future milestones by TLF Bio Innovation (See Note 8, “Commitments and Contingencies”) is carried at fair value and included in accrued liabilities in the Company’s condensed consolidated balance sheet.

The Company follows Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures, with respect to assets and liabilities that are measured at fair value on a recurring basis and nonrecurring basis. Under this standard, fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. The standard also establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors market participants would use in valuing the asset or liability developed based upon the best information available in the circumstances. There are three levels of inputs that may be used to measure fair value:

Level 1 – quoted prices in active markets for identical assets or liabilities;

Level 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observable; and

Level 3 – inputs that are unobservable (for example cash flow modeling inputs based on assumptions).

Categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Allowance for Doubtful Accounts

The Company charges bad debt expense and records an allowance for doubtful accounts when management believes it to be unlikely that specific invoices will be collected. Management identifies amounts due that are in dispute and it believes are unlikely to be collected. Management did not record any reserves for accounts receivable at September 30, 2020. At December 31, 2019, management reserved $51 thousand based on specific amounts that were in dispute or were over 120 days past due as of those dates.

Inventory

Inventory is comprised of (1) raw materials and supplies, such as bottles, packaging materials, labels, boxes and pumps; (2) goods in progress, which are normally unlabeled bottles; and (3) finished goods. We utilize contract manufacturers to produce our products and the cost associated with manufacturing is included in inventory. Inventory is stated at the lower of cost or estimated net realizable value determined by the first-in, first-out method. At September 30, 2020 and December 31, 2019, management had recorded an allowance for excess and obsolete inventory and lower of cost or estimated net realizable value adjustments of $194 thousand and $247 thousand, respectively.

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the related assets of five to seven years for office and laboratory equipment, three years for computer equipment and software and seven years for furniture and fixtures. Leasehold improvements are amortized over the shorter of seven years or the lease term.

The costs of normal maintenance, repairs, and minor replacements are expensed as incurred. 

Impairment of Long-Lived Assets and Operating Lease Right-of-Use Assets

The Company accounts for long-lived assets and operating lease right-of-use assets in accordance with ASC 360, Property, Plant and Equipment, which requires that companies consider whether events or changes in facts and circumstances, both internally and externally, may indicate that an impairment of long-lived assets held for use or right-of-use assets is present. Management periodically evaluates the carrying value of long-lived assets and right-of-use assets. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are not expected to be sufficient to recover the carrying amount of the asset, the assets are written down to their estimated fair values and the loss is recognized in the condensed consolidated statements of operations and comprehensive loss. During the first quarter of 2019, in connection with the restructuring of its U.S. sales force, the Company reviewed its fleet leases for impairment and recorded an impairment charge of $125 thousand. There was no such impairment charge during the three and nine months ended September 30, 2020.

Leases

In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2016-02, Leases (Topic 842), to enhance the transparency and comparability of financial reporting related to leasing arrangements. The Company adopted the standard effective January 1, 2019. Using the optional transition method, prior period financial statements have not been recast to reflect the new lease standard.

At the inception of an arrangement, the Company determines whether the arrangement is or contains a lease based on the unique facts and circumstances present. Operating lease liabilities and their corresponding right-of-use assets are recorded based on the present value of lease payments over the expected lease term. The interest rate implicit in lease contracts is typically not readily determinable. As such, the Company utilizes its incremental borrowing rate, which is the rate incurred to borrow, on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. Certain adjustments to the right-of-use assets may be required for items such as initial direct costs paid or incentives received.

The Company has elected to combine lease and non-lease components as a single component for all leases in which it is a lessee or a lessor. The lease expense is recognized over the expected term on a straight-line basis. Operating leases are recognized on the balance sheet as right-of-use assets, operating lease liabilities current and operating lease liabilities non-current. As a result, as of the effective date, the Company no longer recognizes deferred rent on the condensed consolidated balance sheet.

Comprehensive Income (Loss)

ASC 220, Comprehensive Income, requires that an entity’s change in equity or net assets during a period from transactions and other events from non-owner sources be reported.

Revenue Recognition

Revenue generated through the Company’s webstore for Avenova and KN95 Masks is recognized upon receipt by the customer through multiple third-party carriers. Shipping and handling costs are expensed as fulfillment costs are incurred and included in cost of goods sold in the condensed consolidated statements of operations and comprehensive loss. We present revenue net of sales taxes and refunds.

Revenue generated through Amazon.com for Avenova and other products is recognized upon fulfillment, which generally occurs upon delivery of the related products to a third-party carrier or, in the case of an Amazon delivery, to the customer. We present revenue net of commissions and any related fulfillment and shipping fees charged by these partners. Fees paid to partners for promoting our product are expensed as incurred and are included in sales and marketing expenses within the operating expenses in the condensed consolidated statements of operations and comprehensive loss.

The Company also generates Avenova product revenue through product sales to its major distribution partners. Product supply of Avenova is the only performance obligation contained in these arrangements, and the Company recognizes product revenue upon transfer of control to its major distribution partners at the amount of consideration that the Company expects to be entitled to, generally upon shipment to the distributor on a “sell-in” basis. Upon recognition of product sales, contract liabilities are recorded for invoiced amounts that are subject to significant reversal, including product revenue allowances for cash consideration paid to customers for services, discounts, rebate programs, chargebacks, and product returns. Because the Company does not have sufficient historical data to compute its own return rate, the return rate used to estimate the constraint on variable consideration for product returns is based on an average of peer and competitor company historical return rates. The Company updates the return rate assumption quarterly and applies it to the inventory balance that is held at the distributor and has not yet been sold through to the end customer. Payment for product supply is typically due 30 days after control transfers to the distributor. At any point in time there is generally one month of inventory in the sales channel, therefore uncertainty surrounding constraints on variable consideration is generally resolved one month from when control is transferred.

Revenue generated through the Company’s partner pharmacies is recognized when control of the product transfers to the end customer.

Bulk orders of KN95 Masks are shipped directly to the customer from a manufacturer in China. Revenue is recognized when control of the product passes to the customer, which is upon delivery of the KN95 Masks to the customer. As such, customer orders are recorded as deferred revenue prior to product delivery.

Cost of Goods Sold

Cost of goods sold includes third party manufacturing costs, shipping and handling costs, and other costs associated with products sold. Cost of goods sold also includes any necessary allowance for excess and obsolete inventory along with lower of cost and estimated net realizable value.

Research and Development Costs

The Company charges research and development costs to expense as incurred. These costs include all costs associated with research, development and regulatory activities, including Emergency Use Authorization (“EUA”) submissions to the Food and Drug Administration (“FDA”). Research and development costs may vary depending on the type of item or service incurred, location of performance or production, level of availability of the item or service, and specificity required in production for certain compounds.

Patent Costs

Patent costs, including legal expenses, are expensed in the period in which they are incurred. Patent expenses are included in general and administrative expenses in the condensed consolidated statements of operations and comprehensive loss.

Stock-Based Compensation

The Company’s stock-based compensation includes grants of stock options and restricted stock units (“RSUs”) to employees, consultants and non-employee directors. The expense associated with these programs is recognized in the Company’s condensed consolidated statements of stockholders’ equity (deficit) based on their fair values as they are earned under the applicable vesting terms. For stock options granted, the fair value of the stock options is estimated using a Black-Scholes option pricing model. See Note 13, “Equity-Based Compensation” for further information regarding stock-based compensation expense and the assumptions used in estimating that expense. The Company accounts for RSUs issued to employees and non-employees (consultants and advisory board members) based on the fair market value of the Company’s common stock as of the date of issuance.

Income Taxes

The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recognized if it is more likely than not that some portion or the entire deferred tax asset will not be recognized.

Common Stock Warrant Liability

The Company accounts for common stock purchase warrants issued in connection with its equity offerings in accordance with the provisions of ASC 480, Distinguishing Liabilities from Equity, and ASC 815, Derivatives and Hedging.

The Company accounts for common stock purchase warrants issued in connection with share-based compensation agreements in accordance with the provisions of ASC 718, Stock Compensation, which encompasses the provisions of ASC 480, Distinguishing Liabilities from Equity.

The Company classifies as equity any contracts that (i) require physical settlement or net-share settlement or (ii) give the Company a choice of net-cash settlement or settlement in its own shares (physical settlement or net-share settlement). The Company classifies as assets or liabilities any contracts that (i) require net-cash settlement (including a requirement to net-cash settle the contract if an event occurs and if that event is outside the control of the Company) or (ii) give the counterparty a choice of net-cash settlement or settlement in shares (physical settlement or net-share settlement). Additionally, for common stock purchase warrants accounted for in accordance with ASC 718, Stock Compensation, the Company classifies as liabilities any contracts where it believes the warrants are deemed to be probable of issuance.

For warrants that are classified as liabilities, the Company records the fair value of the warrants at each balance sheet date and records changes in the estimated fair value as a non-cash gain or loss in the condensed consolidated statements of operations and comprehensive loss. The fair values of these warrants have been determined using the Black-Scholes option pricing model, the Binomial Lattice (“Lattice”) valuation model, or the Monte Carlo simulation model where deemed appropriate. These values are subject to a significant degree of management’s judgment.

On January 1, 2019, the Company adopted ASU 2017-11, “Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and Derivatives and Hedging (Topic 815): I. Accounting for Certain Financial Instruments with Down Round Features; II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception” on a modified retrospective basis. Upon adoption of ASU 2017-11, the Company changed its method of accounting for warrants by reclassifying warrant liabilities related to outstanding warrants that have a down round feature to additional paid in capital on its March 31, 2019 consolidated balance sheet, which increased additional paid-in capital by $56 thousand and decreased warrant liability by $56 thousand. In addition, because of the modified retrospective adoption, the Company recorded a cumulative-effect adjustment of $356 thousand to the Company’s beginning accumulated deficit as of January 1, 2019, with an offset that increased additional paid-in capital by $356 thousand.

Net Loss per Share

The Company computes net loss per share by presenting both basic and diluted earnings (loss) per share (“EPS”).

Basic EPS is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period, including stock options and warrants, using the treasury stock method. In computing diluted EPS, the average stock price for the period is used to determine the number of shares assumed to be purchased from the exercise of stock options or warrants. Potentially dilutive common share equivalents are excluded from the diluted EPS computation in net loss periods because their effect would be anti-dilutive.

During the three months ended September 30, 2020, both basic and diluted EPS was a net loss of $0.08 per share. The gain on changes in fair value of the October 2015 warrant liability had a nominal impact on the diluted EPS. During the three months ended September 30, 2019, the basic EPS was a net loss of $0.01 per share, and the diluted EPS was a net loss of $0.02 per share, due to the gain on changes in fair value of warrant liability. During the nine months ended September 30, 2020 and 2019, both basic and diluted EPS was a net loss of $0.28 and $0.36, per share, respectively. The gain on changes in fair value of the October 2015 warrant liability had a nominal impact on the diluted EPS.

The following table sets forth the calculation of basic and diluted EPS: 

The following outstanding stock options and stock warrants were excluded from the diluted net loss per share computation, as their effect would have been anti-dilutive: 

Recent Accounting Pronouncements

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. ASU 2018-13 improved the effectiveness of disclosure requirements for recurring and nonrecurring fair value measurements. The standard removes, modifies, and adds certain disclosure requirements. The Company adopted the new standard effective January 1, 2020 and the adoption of this guidance did not have a material impact on our condensed consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in ASU 2016-13 require a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. ASU 2016-13 is effective for the Company for annual and interim reporting periods beginning January 1, 2023. The Company will adopt the new standard effective January 1, 2023. We are currently evaluating the impact of the new guidance on our condensed consolidated financial statements.

In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (ASU 2019-12), which simplifies the accounting for income taxes. This guidance will be effective for us in the first quarter of 2021 on a prospective basis. We are currently evaluating the impact of the new guidance on our condensed consolidated financial statements.

NOTE 3. FAIR VALUE MEASUREMENTS

The Company follows ASC 820, Fair Value Measurements and Disclosures, with respect to assets and liabilities that are measured at fair value on a recurring basis and nonrecurring basis. Under this standard, fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. 

The Company’s cash equivalents are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices in active markets, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of investments that are generally classified within Level 1 of the fair value hierarchy include money market securities and certificates of deposit.

The Company’s warrant liability for outstanding warrants is classified within Level 3 of the fair value hierarchy because the value is calculated using significant judgment based on the Company’s own assumptions using the Black-Scholes valuation method or the Lattice valuation model as appropriate. As of September 30, 2020, the Company’s warrant liability consisted of 38,000 October 2015 Warrants (see Note 11, “Warrant Liability”). The 2019 Domestic Warrants and 2019 Foreign Warrants (see Note 11, “Warrant Liability”) were amended and exercised in July 2020 (see Note 12, “Stockholders’ Equity (Deficit)”), resulting in a decrease of $9.1 million in warrant liability. The 2019 Ladenburg Warrants were also amended in July 2020 (see Note 12, “Stockholders’ Equity (Deficit)”), resulting in a decrease of $197 thousand in warrant liability.

A liability for warrants that are expected to be issued upon the achievement of future milestones by TLF Bio Innovation (See Note 8, “Commitments and Contingencies”) is classified within Level 3 of the fair value hierarchy because the value is calculated using significant judgment based on the Company’s own assumptions in the valuation of this liability. The Company determined the fair value of the liability using the Monte Carlo simulation model. The liability is included in accrued liabilities in the Company’s condensed consolidated balance sheet.

The embedded derivative liability related to the Convertible Note (as defined below) was fully settled in September 2020. See Note 10, “Convertible Note” for further discussion of the settlement of the Convertible Note and embedded derivative liability during the quarter ended September 30, 2020.

The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2020:

The following table presents the Company's assets and liabilities measured at fair value on a recurring basis as of December 31, 2019:

The following is a reconciliation of the beginning and ending balances for the liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and nine months ended September 30, 2020:

NOTE 4. PREPAID EXPENSES AND OTHER CURRENT ASSETS

Prepaid expenses and other current assets consisted of the following:

NOTE 5. INVENTORY   

Inventory consisted of the following:

NOTE 6. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:

Depreciation and amortization expense was $12 thousand and $17 thousand for the three months ended September 30, 2020 and 2019, respectively, and $40 thousand and $50 thousand for the nine months ended September 30, 2020 and 2019, respectively.

There was no impairment charge during the three months ended September 30, 2020. During the three months ended September 30, 2020, the Company disposed of damaged, unusable and fully depreciated property and equipment. As a result, the Company recognized an immaterial loss on the disposal of these assets. During the three and nine months ended September 30, 2019, the Company recorded an impairment charge of $32 thousand related to previously capitalized software. 

NOTE 7. ACCRUED LIABILITIES

Accrued liabilities consisted of the following:

NOTE 8. COMMITMENTS AND CONTINGENCIES 

Directors and Officers Indemnification

As permitted under Delaware law and in accordance with its bylaws, the Company indemnifies its officers and directors for certain events or occurrences while the officer or director is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a director and officer insurance policy that limits its exposure and may enable it to recover a portion of any future payments. The Company believes the fair value of these indemnification agreements is minimal. Accordingly, it has not recorded any liabilities for these agreements as of September 30, 2020. 

In the normal course of business, the Company provides indemnification of varying scope under its agreements with other companies, typically its clinical research organizations, investigators, clinical sites, suppliers and others. Pursuant to these agreements, it generally indemnifies, holds harmless, and agrees to reimburse the indemnified parties for losses suffered or incurred by the indemnified parties in connection with the use or testing of its products or product candidates or with any U.S. patent or any copyright or other intellectual property infringement claims by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The potential future payments the Company could be required to make under these indemnification agreements is unlimited. Historically, costs related to these indemnification provisions have been immaterial. The Company also maintains various liability insurance policies that limit its exposure. As a result, it believes the fair value of these indemnification agreements is minimal. Accordingly, the Company has not recorded any liabilities for these agreements as of September 30, 2020. 

Legal Matters

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

On July 29, 2019, Mr. John McGovern, the Company’s former Interim President & Chief Executive Officer and Chief Financial Officer, submitted a demand for arbitration in connection with his separation from service with the Company. On September 29, 2020, Mr. McGovern was granted severance in the amount of $370 thousand in an interim arbitration award; the arbitration is ongoing as relates to additional damages. As of September 30, 2020, the Company has accrued a liability of $502 thousand related to the matter.

As of September 30, 2020, there are no other matters that, in the opinion of management, would ultimately result in liability that would have a material adverse effect on the Company’s financial position, results of operations or cash flows.

Leases

The Company leases office space for its corporate headquarters located in Emeryville, California. The initial lease term is through February 28, 2022. The Company has the option to extend the term of the lease for one five (5)-year period upon written notice to the landlord. The Company intends to exercise the renewal option for this lease.

The Company also had a lease commitment for laboratory facilities and office space at EmeryStation North in Emeryville, California (“EmeryStation”) under an operating lease. In July 2016, the Company subleased the EmeryStation space (the “Sublease Agreement”). The Sublease Agreement commenced September 8, 2016. The EmeryStation lease and Sublease Agreement were terminated as of August 31, 2020 pursuant to a sublease termination agreement executed on July 31, 2020. In conjunction with the termination, the Company recognized a gain of $54 thousand which is recorded within the operating expenses in the Company’s condensed consolidated statements of operations and comprehensive loss for the three months ending September 30, 2020.

In addition to the facility leases, the Company previously leased 54 vehicles under a master fleet lease agreement. Each lease was for a period of 36 months, which commenced upon the delivery of the vehicles during the first quarter of 2017. During the first quarter of 2019, in connection with the restructuring of its U.S. sales force, the Company reviewed its fleet leases for impairment. The Company estimated fair value based on the lowest level of identifiable estimated future cash flows and recorded an impairment charge of $125 thousand, which is included in sales and marketing expenses within the operating expenses in the consolidated statements of operations and comprehensive loss for the year ended December 31, 2019. During the fourth quarter of 2019, the Company terminated the lease agreement related to the idled vehicles early and had 15 leased vehicles as of December 31, 2019. The lease agreement expired in the first quarter of 2020.

In calculating the present value of the lease payments, the Company has elected to utilize its incremental borrowing rate based on the original lease term and not the remaining lease term. The Company has elected to account for each lease component and its associated non-lease components as a single lease component and has allocated all of the contract consideration across lease components only. This will potentially result in the initial and subsequent measurement of the balances of the right-of-use assets and lease liability for leases being greater than if the policy election was not applied. The leases include variable components (e.g. common area maintenance) that are paid separately from the monthly base payment based on actual costs incurred and therefore were not included in the right-of-use assets and lease liability, but are reflected as an expense in the period incurred.

Total operating lease costs and supplemental cash flow information related to operating leases for the three and nine months ended September 30, 2020 were as follows (in thousands):

The Company has measured its operating lease liabilities at its incremental borrowing rate over the remaining term for each operating lease. The weighted average remaining lease term and the weighted average discount rate are summarized as follows:

Future lease payments under non-cancelable leases as of September 30, 2020 were as follows (in thousands):

Contracts

On May 13, 2020, the Company entered into an agreement with TLF Bio Innovation Lab LLC (“TLF Bio Innovation”), a related party, to manage the relaunch of the Company’s CelleRx product (the “TLF Agreement”) which was further amended on September 4, 2020. Under the agreement, the Company pays TLF Bio Innovation a monthly cash fee. Additionally, upon the successful completion of certain milestones, TLF Bio Innovation is eligible to receive warrants exercisable for up to 2 million shares of the Company’s common stock with an exercise price equal to the average closing price of the Company’s common stock for the last calendar month immediately prior to the date on which an individual milestone was achieved. As of September 30, 2020, the achievement of the first milestone was deemed probable. As a result, during the three months ended September 30, 2020, the Company recorded a $109 thousand consulting expense and related liability for the expected warrant issuance. The expense was included in sales and marketing expenses within operating expenses in the condensed consolidated statements of operations and comprehensive loss. The expense was based on the fair value of the warrants calculated using the Black-Scholes valuation model and  management’s estimates of the probable dates of issuance of the warrants,  the number of warrants probable of being issued, as well as the estimated exercise price calculated using the Monte Carlo valuation model as of September 30, 2020. The key assumptions used in the Monte Carlo valuation model to calculate the estimated exercise price were as follows:

The key assumptions used in the Black-Scholes valuation model to value the TLF Bio Innovation consulting service liability related to potential warrant issuance as of September 30, 2020 were as follows:

On April 16, 2020, the Company entered into an international distribution agreement with Shenzhen Microprofit Biotech Co., LTD, (“Microprofit”) (the “Microprofit Agreement”). The Microprofit Agreement grants the Company exclusive rights to distribute Microprofit’s SARS-CoV-2 IgG and IgM Antibody Combined Test Kit (“Test Kits”) in the United States through December 31, 2021. In accordance with the Microprofit Agreement, the Company is assisting Microprofit to apply for approval of the Test Kits by the U.S. Food & Drug Administration (“FDA”). Under the terms of the Microprofit Agreement, if such approvals are granted, the Company will issue warrants to certain Microprofit officers exercisable for an aggregate number of shares of the Company’s common stock equivalent to 12% of the Company’s outstanding common stock on the date of approval. As of September 30, 2020, the Company has determined that the issuance of warrants under this agreement is not probable.

In connection with the Microprofit Agreement, on April 16, 2020, the Company entered into an intermediary distribution agreement with Chongqing Pioneer Pharma Holdings Limited (“Chongqing Pioneer”), a related party, which was subsequently amended on June 29, 2020. The amended agreement provides that the Company will purchase all Test Kits from Pioneer as an intermediary.

NOTE 9. RELATED PARTY NOTE PAYABLE

On February 27, 2019, the Company issued a $1.0 million promissory note payable to Pioneer Pharma (Hong Kong) Company Ltd. (“Pioneer Pharma”), which was amended on June 25, 2019 and May 14, 2020 (the “Promissory Note”). The Promissory Note provided for an interest payment of $150 thousand which was initially amended to a payment of $300 thousand and subsequently to the delivery of 65,178 units of NeutroPhase (40ml) to Pioneer Pharma, inclusive of 40,644 units previously delivered in the first quarter of 2020. The second amendment to the Promissory Note also provided the Company with the right to repay the note at any time. On May 14, 2020, the Company repaid the $1.0 million principal balance of the Promissory Note using proceeds raised through the ATM program (see Note 12, “Stockholders’ Equity (Deficit)”). As of September 30, 2020, the remaining interest payable was $104 thousand, which was settled through the delivery of 24,534 units of NeutroPhase subsequent to September 30, 2020 in October 2020. Upon full repayment of principal and interest during the fourth quarter of 2020, the Company was released from the Promissory Note with Pioneer Pharma.

In connection with the Promissory Note, the Company paid China Kington a 2% fee for brokering the transaction and entered into a consulting agreement with China Kington for a term of one year, which expired on March 1, 2020. Bob Wu, acting in a dual role as a member of the Company’s Board of Directors and as principal of China Kington, was paid $100 thousand pursuant to such consulting agreement. Upon the expiration of the original consulting agreement, the parties entered into a consulting agreement, in which no cash compensation will be paid. Debt issuance costs associated with the issuance of the Promissory Note of $20 thousand was recognized and recorded as an offset to the related party note payable in the condensed consolidated balance sheet.

The interest expense recognized, including amortization of the issuance costs, was $0 and $75 thousand during the three and nine months ended September 30, 2020, respectively. The interest expense recognized, including amortization of the issuance costs, was $45 thousand and $175 thousand during the three and nine months ended September 30, 2019, respectively.

NOTE 10. CONVERTIBLE NOTE

On March 26, 2019 (the “Closing Date”), the Company entered into a Securities Purchase Agreement (the “Iliad Securities Purchase Agreement) with Iliad Research and Trading, L.P. (the “Lender”), pursuant to which the Company issued a Secured Convertible Promissory Note (the “Convertible Note”) to the Lender dated as of the Closing Date. The Convertible Note had an original principal amount of $2.2 million and an interest rate of 10% per annum. The Company received net proceeds of $2.0 million after deducting an original issue discount of $200 thousand and debt issuance cost of Lender’s transaction fees of $15 thousand. The Company recognized an additional $182 thousand of debt issuance costs associated with the issuance of the Convertible Note. The Convertible Note was repaid in full prior to September 30, 2020. Upon full repayment, the Company was released from the Iliad Securities Purchase Agreement with Lender.

The Convertible Note provided the Lender with the right to convert, at any time, all or any part of the outstanding principal and accrued but unpaid interest into unregistered shares of the Company’s common stock at a conversion price of $1.65 per share. Beginning on September 26, 2019, the Convertible Note also provided the Lender with the right to redeem all or any portion of the Convertible Note (“Redemption Amount”) up to $200 thousand per calendar month. The payments of each Redemption Amount could be made, at the option of the Company, in cash, by converting such Redemption Amount into unregistered shares of Common Stock (“Redemption Conversion Shares”), or a combination thereof. The number of Redemption Conversion Shares equaled the portion of the applicable Redemption Amount being converted divided by the lesser of $1.65 or the Market Price. The Market Price was defined as 85% of the lowest closing bid price during the 20 trading days immediately preceding the applicable measurement date. In addition, the Company could redeem the Convertible Note at its option at any time at a redemption price equal to 115% of the aggregate outstanding balance of principal and interest.

The Convertible Note contained events of default upon the occurrence and during the continuance of which all obligations could be declared immediately due and payable. Under certain events of default, the outstanding balance of principal and interest could be automatically due and payable in cash. Upon other events of default, the Lender, at its option, could elect to increase the outstanding balance by up to 15%, depending on the magnitude of the default, without accelerating the outstanding balance.

The Company’s prepayment terms represented an embedded call option, the Lender’s share redemption terms represent an embedded put option and certain events of default represent embedded derivatives, each of which required bifurcation. A single derivative comprising all bifurcated features was measured at fair value using a Monte Carlo simulation model. The fair value of the embedded derivative at issuance of the Convertible Note on March 26, 2019 was $0.4 million. The key assumptions used to value the combined embedded derivative upon issuance on March 26, 2019 were as follows:

The key assumptions used to value the combined embedded derivative as of December 31, 2019 were as follows: 

A $627 thousand discount, including the original issue discount, and $197 thousand of debt issuance costs, including the Company’s issuance costs and payment for the Lender’s transaction fees, were recorded at issuance and classified as an offset to the Convertible Note on the condensed consolidated balance sheet. The discount and debt issuance costs were amortized to interest expense using the effective interest rate method over the term of the Convertible Note. During the three and nine months ended September 30, 2020, the effective interest rate on the Convertible Note was 22% and 20%, respectively. Interest expense recognized, including amortization of the issuance costs and debt discount, was $16 thousand and $215 thousand during the three and nine months ended September 30, 2020, respectively. During the three and nine months ended September 30, 2019, the effective interest rate on the Convertible Note was 52% and 53%, respectively. Interest expense recognized, including amortization of the issuance costs and debt discount, was $293 thousand and $615 thousand during the three and nine months ended September 30, 2019, respectively.

During the three and nine months ended September 30, 2020, the Company repaid a total of $0.4 million and $1.6 million in cash,  which was applied against the outstanding principal balance of the convertible note, respectively.

NOTE 11. WARRANT LIABILITY  

In July 2011, the Company sold common stock and warrants in a registered direct financing. As part of this transaction, 139,520 warrants were issued with an exercise price of $33.25 and were exercisable from January 1, 2012 to July 5, 2016. The terms of the warrants require registered shares to be delivered upon each warrant’s exercise and also require possible cash payments to the warrant holders (in lieu of the warrant’s exercise) upon specified fundamental transactions involving the Company’s common stock, contractually defined to include various merger, acquisition or stock transfer activities. Under ASC 480, Distinguishing Liabilities from Equity, the Company’s ability to deliver registered shares upon an exercise of the warrants and the Company’s potential obligation to cash-settle the warrants if specified fundamental transactions occur are deemed to be beyond the Company’s control. The warrants contain a provision according to which the warrant holder would have the option to receive cash, equal to the Black-Scholes fair value of the remaining unexercised portion of the warrant, as cash settlement in the event that there is a fundamental transaction. Due to this provision, ASC 480 requires that these warrants be classified as liabilities. The fair values of these warrants have been determined using the Lattice model, and the changes in the fair value are recorded in the condensed consolidated statement of operations and comprehensive loss. The Lattice model provides for assumptions regarding volatility and risk-free interest rates within the total period to maturity. In addition, if the closing bid price per share of the common stock in the principal market equals or exceeds $66.50 for any ten trading days (which do not have to be consecutive) in a period of fifteen consecutive trading days, the Company has the right to require the exercise of one-third of the warrants then held by the warrant holders.

In October 2015, the holders of all warrants issued pursuant to the Company’s securities purchase agreement, dated March 3, 2015 (the “2015 Securities Purchase Agreement”), agreed to reduce the length of notice required to such investors prior to the Company’s issuance of new securities from twenty business days to two business days, for the remainder of such investors’ pre-emptive right period (which expired March 3, 2016). The Company entered into these agreements to enable it to expeditiously raise capital in the October 2015 Offering (as described below) and future offerings. As consideration for these agreements, the Company amended certain provisions of both the warrants with a 15-month term (the “Short-Term Warrants”) and warrants with a five-year term (the “Long-Term Warrants”) issued pursuant to the 2015 Securities Purchase Agreement (together, the “March 2015 Warrants”) and the warrants issued pursuant to the placement agent agreement, dated June 29, 2011 (the “July 2011 Warrants”). Specifically, the amendments decreased the exercise price for both the March 2015 Warrants and the July 2011 Warrants to $5.00 per share. In addition, the amendments extended the exercise expiration date for the Short-Term Warrants and the July 2011 Warrants, which have since expired on March 6, 2020. A price protection provision also was added to both the July 2011 Warrants and March 2015 Warrants, such that if the Company subsequently sold or otherwise disposed of Company common stock at a lower price per share than $5.00 or any securities exchangeable for common stock with a lower exercise price than $5.00, the exercise price of such warrants would be reduced to that lower price.

In October 2015, the Company also entered into an underwriting agreement with Roth Capital Partners, LLC, relating to the public offering and sale of up to (i) 492,000 shares of the Company’s common stock; and (ii) warrants to purchase up to 442,802 shares of the Company’s common stock (the “October 2015 Warrants”) with an exercise price of $5.00 per share (the “October 2015 Offering”). The shares of common stock and warrants were issued separately. Each warrant was exercisable immediately upon issuance and will expire 60 months from the date of issuance. The price to the public in the October 2015 Offering was $5.00 per share of common stock and related warrant. The net proceeds to the Company were approximately $2.1 million after deducting underwriting discounts and commissions and offering expenses.

In February 2016, the strike price of the July 2011, March 2015 and October 2015 Warrants was reduced to $1.81 per share, pursuant to the price protection provisions in such warrants, because the Company sold common stock to Mr. Jian Ping Fu at that price. 

In May 2019, the strike price of the July 2011 Warrants, March 2015 Warrants and October 2015 Warrants was further reduced to $0.2061 per share, pursuant to the price protection provisions in such warrants, because the Company sold common stock to Triton Funds LP at that price.

On March 6, 2020, 35,107 July 2011 Warrants and 7,419 March 2015 Warrants expired without being exercised. As of September 30, 2020, there were no July 2011 Warrants or March 2015 Warrants outstanding.

The key assumptions used to value the July 2011 Warrants as of December 31, 2019 were as follows: 

As noted above, the Company issued warrants in connection with the October 2015 Offering. The Company evaluated the terms of the October 2015 Warrants and noted that under ASC 480, the Company’s potential obligation to cash-settle the warrants if specified fundamental transactions occur are deemed to be beyond the Company’s control. Due to this provision, ASC 480 requires that these warrants be classified as liabilities. The fair values of these warrants have been determined using the Lattice valuation model, and the changes in the fair value are recorded in the condensed consolidated statement of operations and comprehensive loss. The fair value of the warrants at issuance on October 27, 2015 was $1.3 million. 

The key assumptions used to value the October 2015 Warrants as of September 30, 2020 and December 31, 2019 were as follows:

During the second quarter of 2019, a total of 158,400 warrants to purchase 158,400 shares of common stock were exercised related to the July 2011 Warrants and the October 2015 Warrants resulting in gross proceeds of $33 thousand. Upon exercise, the warrant liability associated with these warrants was adjusted to its fair value as of the date of exercise of $0.4 million, with any change in fair value recorded in the condensed consolidated statement of operations and comprehensive loss. The $0.4 million fair value was subsequently transferred to equity as of the date of exercise.

During the third quarter of 2019, a total of 102,602 warrants to purchase 102,602 shares of common stock were exercised related to the October 2015 Warrants resulting in gross proceeds of $21 thousand. Upon exercise, the warrant liability associated with these warrants was adjusted to its fair value as of the date of exercise of $0.2 million, with any change in fair value recorded in the condensed consolidated statement of operations and comprehensive loss. The $0.2 million fair value was subsequently transferred to equity as of the date of exercise.

As further described in Note 12, “Stockholders’ Equity (Deficit)”, in the third quarter of 2019, the Company issued the 2019 Domestic Warrants, the 2019 Foreign Warrants and the 2019 Ladenburg Warrants. Beginning on July 20, 2020, the Company and the holders of the 2019 Domestic Warrants and the 2019 Foreign Warrants entered into Exercise Agreements (as defined below) which resulted in a reduction of the exercise prices underlying the warrants as well as the cash exercise of these warrants at the reduced exercise price. The Company also entered into Reprice Agreement (as defined below) with Ladenburg and amend the 2019 Ladenburg Warrants to reduce the exercise price to $0.99 per share. Each of the 2019 Domestic Warrants, the 2019 Foreign Warrants and the 2019 Ladenburg Warrants were classified as liabilities prior to the Exercise Agreements. The fair value of these liabilities was determined using the Black-Scholes option pricing model with the changes in fair value recorded in the condensed consolidated statement of operations and comprehensive loss.

The fair value of the 2019 Domestic Warrants at issuance on August 13, 2019 was determined to be $3.1 million in accordance with the following key assumptions:

The key assumptions used to value the 2019 Domestic Warrants as of December 31, 2019 were as follows:

The fair value of the 2019 Domestic Warrants was determined to be $4.9 million and was subsequently transferred to equity in the Company’s condensed consolidated balance sheets as of the date of exercise on July 21, 2020 in accordance with the following key assumptions:

The fair value of the 2019 Foreign Warrants at issuance on August 13, 2019 was determined to be $2.0 million in accordance with the following key assumptions: 

The key assumptions used to value the 2019 Foreign Warrants as of December 31, 2019 were as follows: 

The fair value of the 2019 Foreign Warrants was determined to be $4.2 million and was subsequently transferred to equity in the Company’s condensed consolidated balance sheets as of the date of exercise on July 21, 2020 in accordance with the following key assumptions:

The fair value of the 2019 Ladenburg Warrants at issuance on August 13, 2019 was determined to be $124 thousand using the following key assumptions:

The key assumptions used to value the 2019 Ladenburg Warrants as of December 31, 2019 were as follows:

As further discussed below in Note 12, “Stockholders’ Equity (Deficit)”, in connection with the Reprice Agreement, the Company’s potential obligation to cash-settle the warrants if specified fundamental transactions occur was renegotiated to only apply in situations within the Company’s control. Pursuant to this change, the 2019 Ladenburg Warrants were no longer classified as liabilities.

The fair value of the 2019 Ladenburg Warrants was determined to be $0.2 million and was subsequently transferred to equity in the Company’s condensed consolidated balance sheets upon amendment on July 21, 2020 in accordance with the following key assumptions: