$CNAT Form 10-K

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Form 10-K for CONATUS PHARMACEUTICALS INC.


13-Mar-2015

Annual Report

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOverview

We are a biotechnology company focused on the development and commercialization of novel medicines to treat liver disease. Our lead compound, emricasan, is a first-in-class, orally active pan-caspase protease inhibitor designed to reduce the activity of human caspases, which are enzymes that mediate inflammation and apoptosis. We believe that by reducing the activity of these enzymes, emricasan has the potential to interrupt the progression of liver disease and potentially provide treatment options in multiple areas of liver disease. We have observed compelling preclinical and clinical trial results that suggest emricasan may have clinical utility in slowing progression of liver disease regardless of the original cause of the disease. To date, emricasan has been studied in over 550 subjects in thirteen clinical trials. In a randomized Phase 2b clinical trial in patients with liver disease, emricasan demonstrated a statistically significant, consistent, rapid and sustained reduction in elevated levels of key biomarkers of inflammation and apoptosis implicated in the severity and progression of liver disease.

We are conducting a comprehensive clinical program to demonstrate the therapeutic benefit of emricasan in patients with chronic liver disease across the spectrum of liver disease, including: liver cirrhosis, or LC; liver cirrhosis with portal hypertension, or PH; post-orthotopic liver transplant, or POLT, recipients with reestablished liver fibrosis post-transplant as a result of recurrent hepatitis C virus, or HCV, infection who have successfully achieved a sustained viral response, or SVR, following HCV antiviral therapy, or POLT-HCV-SVR; and nonalcoholic fatty liver disease, or NAFLD, including patients with inflammatory and/or fibrotic nonalcoholic steatohepatitis, or NASH. Our development strategy is to generate sufficient pharmacokinetic, or PK, and pharmacodynamic, or PD, data, as well as relevant biomarker and functional endpoint data, related to emricasan in patient populations across the spectrum of liver disease and assess which indications and patient populations present viable pathways to potential marketing approval and attractive commercial opportunities. With the results from three PK/PD clinical trials we recently completed, we intend to meet with the U.S. Food and Drug Administration, or FDA, and EU regulatory authorities to discuss the further development of emricasan. Potential regulatory authority feedback and the results from our ongoing clinical trials will help guide our clinical development plans and initial regulatory pathway.


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The following table summarizes our current development programs for emricasan.

                          Description of Patient
Target Therapeutic Area   Population                    Development Program
Liver Cirrhosis (LC)      In LC patients, healthy       � In September 2014, we
                          liver tissue is replaced      initiated a Phase 2
                          with scar tissue resulting    clinical trial in LC
                          in abnormal structure and     patients. Initial results
                          function of the liver.        from this clinical trial
                                                        are expected to be
                                                        available in the fourth
                                                        quarter of 2015.

Portal Hypertension       These cirrhosis patients      � In September 2014, we
(PH)                      have an increase in the       initiated an exploratory,
                          pressure within the portal    open-label Phase 2 clinical
                          vein, which is caused by a    trial in PH patients.
                          blockage in the blood flow    Results from this clinical
                          through the liver.            trial are expected to be
                                                        available in the third
                                                        quarter of 2015.

Post Liver Transplant     Liver transplant patients     � In May 2014, we initiated
Clearance of Hepatitis    with fibrosis from            a placebo-controlled Phase
C Virus Infection with    recurrent HCV and             2b clinical trial tracking
Sustained Viral           subsequent SVR.               biomarkers and histology in
Response (POLT-HCV-SVR)                                 POLT patients who respond
                                                        to antiviral therapy but
                                                        still have underlying liver
                                                        fibrosis. We expect to have
                                                        initial baseline data from
                                                        this clinical trial in the
                                                        second quarter of 2015.

Non-alcoholic             NASH patients suffer from     � In March 2014, we
Steatohepatitis (NASH)    inflammation due to fat       initiated a Phase 2
                          buildup in the liver, which   clinical trial for NAFLD,
                          can progress to cirrhosis,    including NASH. Our goal is
                          liver cancer and liver        to accumulate sufficient
                          failure.                      and relevant clinical data
                                                        to allow rapid advancement
                                                        of emricasan as appropriate
                                                        regulatory pathways are
                                                        defined. We expect to have
                                                        results from this clinical
                                                        trial in the first quarter
                                                        of 2015.

Pharmacokinetic, or PK,   In the later stages of        � We recently completed and
and Pharmacodynamic, or   liver disease, the level of   reported data from three
PD, Clinical Trials in    organ impairment increases,   PK/PD studies (subjects
Subjects with Varying     potentially leading to        with acute-on-chronic liver
Degrees of Organ          changes in PK and PD          failure, or ACLF, subjects
Impairment                properties of drug            with severe renal
                          candidates.                   impairment and subjects
                                                        with mild, moderate or
                                                        severe hepatic impairment).

Since our inception, our primary activities have been organizational activities, including recruiting personnel, conducting research and development, including clinical trials, and raising capital. We have funded our operations since inception primarily through sales of equity securities and convertible promissory notes.

We have no products approved for sale. We have not generated any revenues to date, and we have incurred significant operating losses since our inception. We have never been profitable and have incurred consolidated net losses of approximately $22.3 million, $15.6 million and $8.7 million in the years ended December 31, 2014, 2013 and 2012, respectively. As of December 31, 2014, we had an accumulated deficit of $96.8 million.


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We expect to continue to incur significant operating losses and negative cash flows from operating activities for the foreseeable future as we continue the clinical development of emricasan and seek regulatory approval for and, if approved, pursue commercialization of emricasan. As of December 31, 2014, we had cash, cash equivalents and marketable securities of approximately $37.1 million. To fund further operations, we will need to raise additional capital. In August 2014, we entered into an At Market Issuance Sales Agreement, or the Sales Agreement, with MLV & Co. LLC, or MLV, pursuant to which we may sell from time to time, at our option, up to an aggregate of $50.0 million of shares of our common stock in “at-the-market” offerings. We may obtain additional financing in the future through the issuance of our common stock in future public offerings, including under the Sales Agreement, through other equity or debt financings or through collaborations or partnerships with other companies. Although it is difficult to predict future liquidity requirements, we believe that our existing cash, cash equivalents and marketable securities will be sufficient to fund our operations for at least the next 12 months. We will need to raise additional funds to complete additional clinical trials of emricasan, to fund regulatory filings for emricasan in the United States and the European Union and for potential commercialization of emricasan.

However, successful transition to profitability is dependent upon achieving a level of revenues adequate to support our cost structure. We cannot assure you that we will ever be profitable or generate positive cash flow from operating activities and, unless and until we do, we will need to raise substantial additional capital through equity or debt financings or through collaborations or partnerships with other companies. We may not be able to raise additional capital on terms acceptable to us, or at all, and any failure to raise capital as and when needed could have a material adverse effect on our results of operations, financial condition and our ability to execute on our business plan.

JOBS Act

In April 2012, the Jumpstart Our Business Startups Act of 2012, or JOBS Act, was signed into law. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for an “emerging growth company.” As an “emerging growth company,” we are electing not to take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision not to take advantage of the extended transition period is irrevocable. In addition, we are in the process of evaluating the benefits of relying on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if as an “emerging growth company” we choose to rely on such exemptions, we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to
Section 404 of the Sarbanes-Oxley Act of 2002, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act,
(iii) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and
(iv) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the Chief Executive Officer’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering, or IPO, or until we no longer meet the requirements of being an “emerging growth company,” whichever is earlier.

Financial Overview

Revenues

We currently have no products approved for sale, and we have not generated any revenues to date. We have not submitted any drug candidate for regulatory approval. In the future, we may generate revenues from a combination of milestone payments, reimbursements and royalties in connection with any future collaboration


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we may enter into with respect to emricasan, as well as product sales from emricasan. However, we do not expect to receive revenues unless and until we receive approval for emricasan or potentially enter into collaboration agreements for emricasan. If we fail to achieve clinical success in the development of emricasan in a timely manner and/or obtain regulatory approval for this drug candidate, our ability to generate future revenues would be materially adversely affected.

Research and Development Expenses

The majority of our operating expenses to date have been incurred in research and development activities. Starting in late 2011, research and development expenses have been focused on the development of emricasan. Since acquiring emricasan in 2010, we have incurred approximately $30.8 million in the development of emricasan through December 31, 2014. Our business model is currently focused on the development of emricasan in various liver diseases and is dependent upon our continuing to conduct research and a significant amount of clinical development. Our research and development expenses consist primarily of:

� expenses incurred under agreements with contract research organizations, or CROs, investigative sites and consultants that conduct our clinical trials and our preclinical studies;

� employee-related expenses, which include salaries and benefits;

� the cost of finalizing our chemistry, manufacturing and controls, or CMC, capabilities and providing clinical trial materials; and

� costs associated with other research activities and regulatory approvals.

Research and development costs are expensed as incurred.

At this time, due to the inherently unpredictable nature of preclinical and clinical development, we are unable to estimate with any certainty the costs we will incur in the continued development of emricasan. Clinical development timelines, the probability of success and development costs can differ materially from expectations.

We are currently focused on advancing emricasan in multiple indications, and our future research and development expenses will depend on its clinical success. In addition, we cannot forecast with any degree of certainty whether emricasan will be the subject of future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements.

Research and development expenditures will continue to be significant and will increase as we continue clinical development of emricasan over at least the next several years. We expect to incur significant development costs as we conduct our planned Phase 2 and Phase 3 clinical trials of emricasan, subject to receiving input from regulatory authorities.

The costs of clinical trials may vary significantly over the life of a project owing to factors that include but are not limited to the following:

� per patient trial costs;

� the number of patients that participate in the clinical trials;

� the number of sites included in the clinical trials;

� the countries in which the clinical trials are conducted;

� the length of time required to enroll eligible patients;

� the number of doses that patients receive;

� the drop-out or discontinuation rates of patients;

� potential additional safety monitoring or other studies requested by regulatory agencies;


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� the duration of patient follow-up; and� the efficacy and safety profile of the drug candidate.

We do not expect emricasan to be commercially available, if at all, for at least the next several years.

General and Administrative Expenses

General and administrative expenses consist principally of salaries and related costs for personnel in executive, finance, business development and administrative functions. Other general and administrative expenses include costs related to being a public company, as well as insurance, facilities, travel, patent filing and maintenance, legal and consulting expenses.

If emricasan receives regulatory approval, we expect to incur increased expenses associated with building a sales and marketing team. Some expenses may be incurred prior to receiving regulatory approval of emricasan. We do not expect to receive any such regulatory approval for at least the next several years.

Interest Income

Interest income consists primarily of interest income earned on our cash, cash equivalents and marketable securities.

Interest Expense

Interest expense consists of coupon interest on our $1.0 million promissory note payable to Pfizer Inc., interest accrued on the convertible promissory notes payable to certain existing investors issued in May 2013, which automatically converted into common stock in connection with the completion of our IPO, and interest accrued pursuant to the loan and security agreement, or the Credit Facility, with Oxford Finance LLC, as collateral agent and a lender, and certain other lenders party thereto from time to time, including Silicon Valley Bank, through our prepayment of the outstanding advances under the Credit Facility in September 2013.

Other Income (Expense)

Other income (expense) includes non-operating transactions such as those caused by currency fluctuations in the conversion of account balances held in foreign currencies to U.S. dollars.

Other Financing Expense

Other financing expense consists of the revaluation of our convertible preferred stock warrants issued in conjunction with our 2010 and 2013 bridge note financings, as well as the write off of the debt discount associated with our 2013 bridge note financing.

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not


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readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in the notes to our audited consolidated financial statements appearing elsewhere in this annual report, we believe that the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our financial statements and understanding and evaluating our reported financial results.

Accrued Research and Development Expenses

As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing contracts and purchase orders, reviewing the terms of our vendor agreements, communicating with our applicable personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual cost. The majority of our service providers invoice us monthly in arrears for services performed. We make estimates of our accrued expenses as of each balance sheet date in our consolidated financial statements based on facts and circumstances known to us at that time.

Examples of estimated accrued research and development expenses include:

� fees paid to CROs in connection with clinical trials;

� fees paid to investigative sites in connection with clinical trials;

� fees paid to vendors in connection with preclinical development activities; and

� fees paid to vendors related to product manufacturing, development and distribution of clinical supplies.

We base our expenses related to clinical trials on our estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and CROs that conduct and manage clinical trials on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows and expense recognition. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual accordingly. Our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in our reporting changes in estimates in any particular period. We have not experienced any significant adjustments to our estimates to date. In the years ended December 31, 2014 and 2013, we increased our clinical trial activities, and we expect our clinical trial activities to continue to increase as we initiate additional future clinical trials. Clinical trial activities were minimal for the year ended December 31, 2012.

Share-Based Compensation

We account for share-based compensation by measuring and recognizing compensation expense for all share-based payments made to employees and directors based on estimated grant date fair values. We use the straight-line method to allocate compensation cost to reporting periods over each optionee’s requisite service period, which is generally the vesting period. We estimate the fair value of our share-based awards to employees and directors using the Black-Scholes option pricing model. The Black-Scholes model requires the input of subjective assumptions, including the risk-free interest rate, expected dividend yield, expected volatility, expected term and the fair value of the underlying common stock on the date of grant, among other inputs. We


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account for stock options granted to non-employees, which primarily consists of members of our board of directors, using the fair value approach. Stock options granted to non-employees are subject to periodic revaluation over their vesting terms.

Convertible Preferred Stock Warrant Liability

We have issued freestanding warrants exercisable for shares of our Series A and Series B convertible preferred stock. These warrants were classified as a liability in the accompanying consolidated balance sheets prior to the completion of our IPO in July 2013, as the terms for redemption of the underlying security were outside our control. The Series A warrants were recorded at fair value using the Black-Scholes option pricing model. The Series B warrants were recorded at fair value using a Monte Carlo model. The fair value of all warrants, except as noted below, was remeasured at each financial reporting date using the Black-Scholes option pricing method with any changes in fair value being recognized in other financing income (expense), a component of other income (expense), in the accompanying consolidated statements of operations. We ceased the remeasure of the fair value of the convertible warrant liability upon the exercise of the Series A warrants and conversion of the Series B warrants to common stock warrants, which occurred immediately prior to the completion of our IPO on July 30, 2013. Subsequent to such exercise and conversion, the warrants are classified as a component of stockholders’ equity and are no longer subject to remeasurement.

Net Operating Loss and Research and Development Tax Credit Carryforwards

At December 31, 2014, we had federal and state net operating loss carryforwards of approximately $64.0 million and $63.3 million, respectively. The federal and state loss carryforwards begin to expire in 2025 and 2015, respectively, unless previously utilized. At December 31, 2014, we also had federal and state research credit carryforwards of approximately $1.8 million and $1.0 million, respectively. The federal research credit carryforwards will begin expiring in 2026 unless previously utilized. The state research credit will carry forward indefinitely.

Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to ownership change limitations provided by the Internal Revenue Code of 1986, as amended. The annual limitation may result in the expiration of our net operating losses and credits before we can use them. We have recorded a valuation allowance on all of our deferred tax assets, including our deferred tax assets related to our net operating loss and research and development tax credit carryforwards.

Results of Operations

Comparison of the Years Ended December 31, 2014, 2013 and 2012

Research and Development Expenses

Research and development expenses were $14.9 million in the year ended December 31, 2014, as compared to $6.9 million for the same period in 2013. The increase of $8.0 million was primarily due to an increase in external costs related to emricasan and higher personnel costs. In 2014, external research and development expenses for emricasan were $9.9 million, compared to $3.8 million in 2013. The increase of $6.1 million was primarily due to the initiation of new clinical trials and increased patient activity on existing clinical trials. Research and development related personnel expenses were $4.7 million in 2014 and $2.8 million in 2013. The increase of $1.9 million was primarily due to higher stock-based compensation expense and headcount.

Research and development expenses were $6.9 million in the year ended December 31, 2013, as compared to $5.5 million for the same period in 2012. The increase of $1.4 million was primarily due to an increase in personnel costs and external costs related to emricasan. Research and development related personnel expenses were $2.8 million in 2013 and $2.0 million in 2012. The increase of $0.8 million was primarily due to higher compensation expense and increased headcount. In 2013, external research and development expenses for


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emricasan were $3.8 million, compared to $3.5 million in 2012. In 2013, costs for emricasan consisted primarily of clinical trial and manufacturing costs. In . . .

 

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