The revenue recognition for these collaboration agreements is discussed further in Note 2 below.  

The Company is actively monitoring the ongoing COVID-19 pandemic. The financial results for the three and nine months ended June 30, 2020 were not significantly impacted by COVID-19. The Company temporarily paused enrollment in its two ARO-AAT studies, SEQUOIA and the ARO-AAT 2002 study, but resumed the process of screening and enrolling patients during the three months ended June 30, 2020. During the pause in enrollment, patients already enrolled in these studies continued to be dosed per protocol and continued to come in for their follow up visits. Additional delays have occurred in the Company’s earlier stage programs, but we do not expect a material impact to any program’s anticipated timelines. Several of the Company’s other clinical candidates are in the start-up stage (ARO-HSD, ARO-HIF2 and ARO-ENaC), during which significant clinical costs will continue to be incurred. Additionally, the Company’s operations at its research and development facilities in Madison, Wisconsin and San Diego, California, and its corporate headquarters in Pasadena, California have continued to operate with limited impact, other than for enhanced safety measures, including work from home policies. However, the Company cannot predict the impact of the progression of COVID-19 will have on future financial results due to a variety of factors including the ability of the Company’s clinical sites to continue to enroll subjects, the ability of the Company’s suppliers to continue to operate, the continued good health and safety of the Company’s employees, and ultimately the length of the COVID-19 pandemic.

Liquidity

The Consolidated Financial Statements have been prepared in conformity with the accounting principles generally accepted in the United States of America, which contemplate the continuation of the Company as a going concern.  Historically, the Company’s primary source of financing has been through the sale of its securities. Research and development activities have required significant capital investment since the Company’s inception. The Company expects its operations to continue to require cash investment to pursue its research and development goals, including clinical trials and related drug manufacturing. 

At June 30, 2020 the Company had $219.3 million in cash and cash equivalents (including $1.8 million in restricted cash), $67.7 million in short-term investments, and $177.5 million in long-term investments to fund operations.  During the nine months ended June 30, 2020, the Company’s cash and investments balance increased by $161.7 million, which was primarily the result of the December 2019 securities offering that generated $250.5 million in net cash proceeds for the Company, as discussed further in Note 6 below.  These cash inflows were partially offset by cash outflows primarily related to operating activities.        

Summary of Significant Accounting Policies

There have been no changes to the significant accounting policies disclosed in the Company’s most recent Annual Report on Form 10-K, except as a result of the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Update (“ASU”) No. 2016-02, Leases (ASC 842), as discussed below.

The Company has evaluated these agreements in accordance with the new revenue recognition standard that became effective for the Company on October 1, 2018.  The adoption of the new revenue standard did not have a material impact on the balances reported when evaluated under the superseded revenue standard.  At the inception of these agreements, the Company has identified one distinct performance obligation.  Regarding the Janssen License Agreement, the Company determined that the key deliverables included the license and certain R&D services including the Company’s responsibility to complete the ongoing Phase 1/2 study of JNJ-3989 (ARO-HBV) and the Company’s responsibility to ensure certain manufacturing of JNJ-3989 (ARO-HBV) drug product is completed and delivered to Janssen (the “Janssen R&D Services”).  Due to the specialized and unique nature of these Janssen R&D services, and their direct relationship with the license, the Company determined that these deliverables represent one distinct bundle and thus, one performance obligation.  The Company also determined that Janssen’s option to require the Company to develop up to three new targets is not a material right, and thus, not a performance obligation at the onset of the agreement.  The consideration for this option will be accounted for if and when it is exercised.

The Company determined the transaction price totaled approximately $252.6 million which includes the upfront payment, the premium paid by JJDC for its equity investment in the Company, the two $25 million milestone payments earned and estimated payments for reimbursable Janssen R&D services to be performed.  The Company has allocated the total $252.6 million initial transaction price to its one distinct performance obligation for the JNJ-3989 (ARO-HBV) license and the associated Janssen R&D Services.  This revenue will be recognized using a proportional performance method (based on actual labor hours versus estimated total labor hours) beginning in October 2018 and ending as the Company’s efforts in overseeing the ongoing phase 1/2 clinical trial are completed.  During the three months ended June 30, 2020 and 2019, the Company recognized approximately $6.9 million and $42.3 million of Revenue associated with its agreements with Janssen and JJDC, respectively. During the nine months ended June 30, 2020 and 2019, the Company recognized approximately $57.9 million and $124.8 million of Revenue associated with its agreements with Janssen and JJDC, respectively. As of June 30, 2020, there were $0 in contract assets recorded as accounts receivable, and $26.3 million of contract liabilities recorded as current deferred revenue on the Company’s Consolidated Balance Sheets.  The $26.3 million of current deferred revenue is driven by the upfront payment, the premium paid by JJDC for its equity investment in the Company, and the two $25 million milestone payments earned, net of revenue recognized to date.

Janssen has also selected the first of the three targets under the Janssen Collaboration Agreement, now referred to as ARO-JNJ1, and the Company has begun to conduct its discovery, optimization and preclinical research and development of ARO-JNJ1.  All costs and labor hours spent by the Company will be entirely funded by Janssen.  During the three months ended June 30, 2020 and 2019, the Company recognized approximately $0.4 million and $0.4 million of Revenue associated with its efforts on the ARO-JNJ1 candidate, respectively. During the nine months ended June 30, 2020 and 2019, the Company recognized $2.4 million and $0.4 million of Revenue associated with these efforts on the ARO-JNJ1 candidate, respectively. As of June 30, 2020, there were $1.7 million of contract assets recorded as accounts receivable, and $0 of contract liabilities recorded as current deferred revenue on the Company’s Consolidated Balance Sheets.                               

In December 2019, the Company sold 4,600,000 shares of its Common Stock in a public offering at a price of $58.00 per share.  The aggregate purchase price paid by the investors for the Common Stock was $266.8 million, and the Company received net proceeds of $250.5 million after deducting advisory fees and offering expenses.  

Effective August 5, 2020, the Company entered into an Open Market Sale Agreement (the “ATM Agreement”), pursuant to which the Company may, from time to time, sell up to $250,000,000 in shares of the Company’s common stock through Jefferies LLC, acting as the sales agent and/or principal, in an at-the-market offering (“ATM Offering”). The Company is not required to sell shares under the ATM Agreement. The Company will pay Jefferies LLC a commission of up to 3.0% of the aggregate gross proceeds received from all sales of the common stock under the ATM Agreement. Unless otherwise terminated, the ATM Agreement continues until the earlier of selling all shares available under the ATM Agreement or December 2, 2022. No sales have been made under the ATM Agreement.

In January 2016, the Company entered into a lease for its research facility in Madison, Wisconsin.  The lease was for approximately 60,000 square feet of office and laboratory space and had an expiration date of September 30, 2026. The lease was amended in January 2019 to expand the rentable square feet by an additional 14,000 square feet and to extend the lease expiration date to September 2029. In May 2020, the Company further amended the lease to increase the rentable square feet by an additional 26,000 square feet and extended the lease expiration date to September 30, 2031.  Lease payments are estimated to total approximately $26.2 million for the term. The lease contains two options to renew for two terms of five years. The exercise of these options were not determined to be reasonably certain and thus was not included in lease liabilities on the Company’s Consolidated Balance Sheet at June 30, 2020.    

In March 2020, the Company entered into a sublease agreement (the “Sublease”) with Halozyme, Inc. for additional research and development facility space in San Diego, California.  The Sublease provides additional space needed to accommodate the recent growth of the Company’s personnel and discovery efforts. The lease is for approximately 21,000 rentable square feet.  The term of the Sublease commenced on April 1, 2020 and will end on January 14, 2023.  Lease payments are estimated to total approximately $2.0 million over the term.

Operating lease cost during the three and nine months ended June 30, 2020 was $0.8 million and $1.7 million, respectively.  Variable lease costs during the three and nine months ended June 30, 2020 were $0.2 million and $0.6 million, respectively.  There was no short-term lease cost during the three and nine months ended June 30, 2020.

Cash paid for the amounts included in the measurement of the operating lease liabilities on the Company’s Consolidated Balance Sheet and included in Other changes in operating assets and liabilities within cash flows from operating activities on the Company’s Consolidated Statement of Cash Flow for the three and nine months ended June 30, 2020 was $0.5 million and $1.1 million, respectively. The weighted-average remaining lease term and weighted-average discount rate for all leases as of June 30, 2020 was 9.6 years and 8.4%, respectively.

NOTE 9. STOCK-BASED COMPENSATION

Arrowhead has two plans that provide for equity-based compensation. Under the 2004 Equity Incentive Plan and 2013 Incentive Plan, as of June 30, 2020, 744,250 and 5,652,008 shares, respectively, of Arrowhead’s Common Stock are reserved for the grant of stock options, stock appreciation rights, restricted stock awards and performance unit/share awards to employees, consultants and others. No further grants may be made under the 2004 Equity Incentive Plan.  As of June 30, 2020, there were options granted and outstanding to purchase 744,250 and 2,672,851 shares of Common Stock under the 2004 Equity Incentive Plan and the 2013 Incentive Plan, respectively, and there were 2,583,000 restricted stock units granted and outstanding under the 2013 Incentive Plan. Also, as of June 30, 2020, there were 1,112,463 shares reserved for options and 744,075 shares reserved for restricted stock units issued as inducement grants to new employees outside of equity compensation plans. During the three months ended June 30, 2020, 0 options and 0 restricted stock units were granted under the 2013 Incentive Plan, and 134,000 options and 153,000 restricted stock units were granted as inducement awards to new employees outside of equity incentive plans. During the nine months ended June 30, 2020, 310,500 options and 1,749,071 restricted stock units were granted under the 2013 Incentive Plan, and 477,000 options and 737,575 restricted stock units were granted as inducement awards to new employees outside of the equity incentive plans.

Stock-based compensation expense related to stock options for the three months ended June 30, 2020 and 2019 was $2,659,265 and $1,016,206, respectively. Stock-based compensation expense related to stock options for the nine months ended June 30, 2020 and 2019 was $6,796,175 and $2,823,706, respectively. For non-qualified stock options, the expense creates a timing difference, resulting in a deferred tax asset, which is fully reserved by a valuation allowance.

The grant date fair value of the options granted by the Company for the three months ended June 30, 2020 and 2019 was $3,421,181 and $1,316,220, respectively. The grant date fair value of the options granted by the Company for the nine months ended June 30, 2020 and 2019 was $30,020,524 and $9,453,469, respectively.

The intrinsic value of the options exercised during the three months ended June 30, 2020 and 2019 was $9,529,237 and $9,349,226, respectively. The intrinsic value of the options exercised during the nine months ended June 30, 2020 and 2019 was $39,775,062 and $17,471,520, respectively.

As of June 30, 2020, the pre-tax compensation expense for all outstanding unvested stock options in the amount of $35,021,715 will be recognized in the Company’s results of operations over a weighted average period of 3.3 years.

The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which do not have vesting restrictions and are fully transferable. The determination of the fair value of each stock option is affected by the Company’s stock price on the date of grant, as well as assumptions regarding a number of highly complex and subjective variables. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

The dividend yield is zero as the Company currently does not pay a dividend.

The risk-free interest rate is based on that of the U.S. Treasury bond.

Volatility is estimated based on volatility average of the Company’s Common Stock price.

Restricted Stock Units

Restricted stock units (RSUs), including time-based and performance-based awards, were granted under the Company’s 2013 Incentive Plan and as inducements grants granted outside of the Plan. During the three months ended June 30, 2020, the Company issued 0 RSUs under the 2013 Incentive Plan and 153,000 RSUs as inducement awards. During the nine months ended June 30, 2020, the Company issued 1,749,071 RSUs under the 2013 Incentive Plan and 737,575 RSUs as inducement awards. At vesting, each outstanding RSU will be exchanged for one share of the Company’s Common Stock. RSU recipients may elect to net share settle upon vesting, in which case the Company pays the employee’s income taxes due upon vesting and withholds a number of shares of Common Stock of equal value.  RSU awards generally vest subject to the satisfaction of service requirements or the satisfaction of both service requirements and achievement of certain performance targets.  

During the three months ended June 30, 2020 and 2019, the Company recorded $7,386,943 and $941,788 of expense related to RSUs, respectively. During the nine months ended June 30, 2020 and 2019, the Company recorded $20,713,488 and $4,453,169 of expense related to RSUs, respectively. Such expense is included in stock-based compensation expense in the Company’s Consolidated Statement of Operations and Comprehensive Income (Loss). For RSUs, the expense creates a timing difference, resulting in a deferred tax asset, which is fully reserved by a valuation allowance.  

For RSUs, the grant date fair value of the award is based on the Company’s closing stock price at the grant date, with consideration given to the probability of achieving performance conditions for performance-based awards.

As of June 30, 2020 the pre-tax compensation expense for all unvested RSUs in the amount of $87,634,315 will be recognized in the Company’s results of operations over a weighted average period of 3.3 years.

NOTE 10. FAIR VALUE MEASUREMENTS

The Company measures its financial assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Additionally, the Company is required to provide disclosure and categorize assets and liabilities measured at fair value into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Level 1 provides the most reliable measure of fair value while Level 3 generally requires significant management judgment. Financial assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows:

Level 1—Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2—Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly.

Level 3—Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date.