Arcutis Biotherapeutics, Inc. 10-Q

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with our unaudited condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q, and the audited financial statements and notes thereto as of and for the year ended December 31, 2021 and the related Management's Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K for the year ended December 31, 2021, which has been filed with the Securities and Exchange Commission (SEC). Some of the information contained in this discussion and analysis or set forth elsewhere in this Quarterly Report on Form 10-Q, including information with respect to our plans, objectives, expectations, projections, and strategy for our business, includes forward-looking statements that involve risks and uncertainties. These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “should,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties, and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. As a result of many factors, including those factors identified below and those set forth in the “Risk Factors” section of our Annual Report on Form 10-K, our actual results and the timing of selected events could differ materially from the forward-looking statements contained in the following discussion and analysis. Overview We are an early commercial-stage biopharmaceutical company focused on developing and commercializing treatments for dermatological diseases with high unmet medical needs. Our current portfolio is comprised of highly differentiated topical and systemic treatments with significant potential to treat immune-mediated dermatological diseases and conditions. We believe we have built the industry's leading platform for dermatologic product development. Our strategy is to focus on validated biological targets, and to use our drug development platform and deep dermatology expertise to develop differentiated products that have the potential to address the major shortcomings of existing therapies in our targeted indications. We believe this strategy uniquely positions us to rapidly progress towards our goal of bridging the treatment innovation gap in dermatology, while maximizing our probability of technical success and financial resources. We launched our lead product, ZORYVE ® (roflumilast) cream 0.3%, in August 2022 after obtaining FDA approval for the treatment of plaque psoriasis, including psoriasis in the intertriginous areas (e.g., groin or axillae), in individuals 12 years of age or older. ZORYVE is approved for once-daily treatment of mild, moderate, and severe plaque psoriasis with no limitations on location or duration of use. In addition, we submitted and Health Canada has accepted a New Drug Submission (NDS) for roflumilast cream for plaque psoriasis in Canada with a target action date of April 30, 2023. ZORYVE is a once-daily topical formulation of roflumilast, a highly potent and selective phosphodiesterase-4 (PDE4) inhibitor. PDE4 is an established biological target in dermatology, with multiple PDE4 inhibitors approved by the FDA for the treatment of dermatological conditions. In addition to the recent approval of ZORYVE for plaque psoriasis, we are also developing roflumilast cream for the treatment of atopic dermatitis. In atopic dermatitis, we completed enrollment in two of our pivotal Phase 3 clinical trials: INTEGUMENT-1 and INTEGUMENT-2, in subjects six years of age or older. We continue to enroll subjects in our other pivotal Phase 3 atopic dermatitis trial, INTEGUMENT-PED, in subjects between the ages of two and five years. We expect to provide topline data from each of INTEGUMENT-1 and -2 by the end of 2022. We intend to submit a supplemental New Drug Application (sNDA) for topical roflumilast cream for the treatment of atopic dermatitis patients aged six years or older in 2023 based on the results of INTEGUMENT-1 and -2. We expect to provide topline data from INTEGUMENT-PED in 2023 and submit a subsequent sNDA for the younger age cohort following the potential initial atopic dermatitis approval in patients aged six years or older. We are also developing a topical foam formulation of roflumilast, and have successfully completed pivotal Phase 3 clinical trials in both seborrheic dermatitis and scalp and body psoriasis. In seborrheic dermatitis, we announced positive topline data in June 2022 and we expect the data to be a sufficient basis for an NDA submission in the first quarter of 2023. In scalp and body psoriasis, we announced positive topline data in September 2022, which we expect to be a sufficient basis for an sNDA submission following the potential approval of roflumilast foam for seborrheic dermatitis. 29 Table of Contents Beyond topical roflumilast, we are developing ARQ-252, a cream formulation of a potent and highly selective topical JAK1 inhibitor. We have Investigational New Drug application-enabling efforts continuing for ARQ-255, an alternative deep-penetrating topical formulation of our JAK1 inhibitor designed to reach deeper into the skin and hair follicle in order to potentially treat alopecia areata. We expect to initiate a clinical trial of ARQ-255 in alopecia areata in 2022. In May 2021, we announced that the Phase 2 study of ARQ-252 in chronic hand eczema did not meet its primary endpoint, with further analyses of the study pointing to inadequate local drug delivery to the skin. Given these analyses, we also elected to terminate the Phase 2a clinical trial evaluating ARQ-252 as a potential treatment in vitiligo, as we began reformulation efforts to develop an enhanced formulation of ARQ-252 that delivers more active drug to targets in the skin. The ARQ-255 formulation is separate and distinct from ARQ-252, and thus there are no implications to ARQ-255 from ARQ-252. In September 2022, we acquired Ducentis and its lead asset, DS-234 (now ARQ-234), a fusion protein that is a potent and highly selective checkpoint agonist of the CD200 Receptor (CD200R). We plan to develop ARQ-234 for an atopic dermatitis indication that would potentially be a highly complementary treatment option to roflumilast cream in that indication. We believe the acquisition is a transformative opportunity for Arcutis and, in leveraging our deep dermatology expertise and broad biologics experience, we have the right leadership and operational team to shape the future path of ARQ-234. Under the terms of the Share Purchase Agreement, we acquired the outstanding shares of Ducentis for an upfront payment of $15.9 million, inclusive of liabilities acquired, and Arcutis stock valued at $12.5 million, as well as future contingent payments based on development and commercial success. The transaction was accounted for as an asset acquisition and, as a result, a one-time charge to in-process research and development expense of $29.6 million, which includes certain transaction-related expenses, was recognized during the third quarter of 2022. See Note 6 to the unaudited condensed consolidated financial statements for additional information. Since our inception in 2016, we have invested a significant portion of our efforts and financial resources in clinical development activities. We only recently started generating revenue from product sales and have historically funded our operations primarily with the net proceeds from equity and debt offerings. Prior to our IPO, we received $162.5 million in net cash proceeds from private placements of convertible preferred stock which was converted into shares of common stock in connection with our IPO. On February 4, 2020, we received $167.2 million in net proceeds in connection with our IPO. On October 6, 2020, we closed a public offering and a concurrent private placement of our common stock and received an aggregate of $128.4 million in net proceeds. On February 5, 2021, we closed a public offering of our common stock and received an aggregate of $207.5 million in net proceeds. In December 2021, we received $72.4 million in net proceeds under the Loan Agreement. In March 2022, we received $14.5 million in net proceeds related to shares issued under our ATM. On August 2, 2022, we received $125.0 million in proceeds under the Loan Agreement. On August 5, 2022, we closed a public offering of our common stock and received $161.6 million of aggregate net proceeds. We have incurred net losses in each year since inception, including net losses of $107.7 million and $239.4 million for the three and nine months ended September 30, 2022, respectively, and $57.0 million and $135.0 million for the three and nine months ended September 30, 2021, respectively. As of September 30, 2022, we had an accumulated deficit of $647.7 million and cash, cash equivalents, restricted cash, and marketable securities of $478.2 million. As of September 30, 2022, we had $200.0 million outstanding under our Loan Agreement, with an additional $25.0 million in funding that may become available subject to the satisfaction of specified conditions. We expect to continue to incur losses for the foreseeable future and expect to incur significant expenses as we commercialize ZORYVE in psoriasis and as we advance ZORYVE as well as our product candidates and label extensions through clinical trials, regulatory submissions, and commercialization. We expect to incur significant commercialization expenses related to sales, marketing, manufacturing, and distribution of ZORYVE, and our other product candidates and label extensions, if we obtain regulatory approval for them. If our available cash balances, amounts available under the Loan Agreement, and anticipated future cash flows from operations are insufficient to cover these expenses, we may need to fund our operations through equity or debt financings or other sources, such as future potential collaboration agreements. Adequate funding may not be available to us on acceptable terms, or at all. Any failure to obtain sufficient funds on acceptable terms as and when needed could have a material adverse effect on our business, results of operations, and financial condition. We rely on third parties in the conduct of our nonclinical studies and clinical trials and for manufacturing and supply of our product candidates. We have no internal manufacturing capabilities, and we will continue to rely on third parties, many of whom are single source suppliers, for our nonclinical and clinical trial materials, as well as the commercial supply of our products. In addition, we recently completed the initial build out of our sales organization. Accordingly, we expect to incur significant expenses related to our sales organization and our commercial infrastructure to support ZORYVE commercialization. 30 Table of Contents COVID-19 Update In March 2020, the World Health Organization declared a pandemic related to the COVID-19 outbreak. COVID-19 has placed strains on the providers of healthcare services, including the sites where we conduct our clinical trials. These strains have resulted in some clinical sites slowing or halting enrollment in clinical trials and restricting the on-site monitoring of clinical trials. We follow FDA guidance on clinical trial conduct during the COVID-19 pandemic, including the remote monitoring of clinical data. We are monitoring the impact COVID-19 may have on the clinical development of our product candidates, including potential delays or modifications to ongoing and planned trials. We believe that the rapid spread of the Omicron variant in late 2021 and early 2022 has likely had a minor impact on the enrollment of our clinical trials. Because of this likely impact, along with the inherent challenges of enrolling young children in clinical trials, we have updated our expectation for providing topline data for the INTEGUMENT-PED trial, in atopic dermatitis subjects between two and five years of age, to 2023. We cannot, at this time, predict the specific extent, duration, or full impact that the COVID-19 outbreak will have on our ongoing and planned clinical trials and other business operations, including our commercialization activities. There have been no disruptions in our supply chain of drug manufacturers necessary to conduct our clinical trials and, given our drug inventories, we believe that we will be able to supply the drug needs of our ongoing clinical studies and commercialization efforts. In alignment with public health guidance designed to slow the spread of COVID-19, we implemented a remote work plan for all employees as of mid-March 2020. With COVID-19 moving to an endemic phase, we have formally returned to our previously existing hybrid work environment consisting of both local and remote employees. We may need to undertake additional actions that could impact our operations as required by applicable laws or regulations, or which we determine to be in the best interests of our employees. License Agreements AstraZeneca License Agreement In July 2018, we entered into the AstraZeneca License Agreement with AstraZeneca, granting us a worldwide exclusive license, with the right to sublicense through multiple tiers, under certain AstraZeneca-controlled patent rights, know-how and regulatory documentation, to research, develop, manufacture, commercialize, and otherwise exploit products containing roflumilast in topical forms, as well as delivery systems sold with or for the administration of roflumilast, or collectively, the AZ-Licensed Products, for all diagnostic, prophylactic and therapeutic uses for human dermatological indications, or the Dermatology Field. Under this agreement, we have sole responsibility for development, regulatory, and commercialization activities for the AZ-Licensed Products in the Dermatology Field, at our expense, and we shall use commercially reasonable efforts to develop, obtain, and maintain regulatory approvals for, and commercialize the AZ-Licensed Products in the Dermatology Field in each of the United States, Italy, Spain, Germany, the United Kingdom, France, China, and Japan. We paid AstraZeneca an upfront non-refundable cash payment of $1.0 million and issued 484,388 shares of our Series B convertible preferred stock, valued at $3.0 million on the date of the AstraZeneca License Agreement. We subsequently paid AstraZeneca the first milestone cash payment of $2.0 million upon the completion of a Phase 2b study of roflumilast cream in plaque psoriasis in August 2019 for the achievement of positive Phase 2 data for an AZ-Licensed Product. We also paid AstraZeneca $7.5 million in the third quarter of 2022 in connection with FDA approval of ZORYVE. We have agreed to make additional cash payments to AstraZeneca of up to an aggregate of $5.0 million upon the achievement of specific regulatory approval milestones with respect to the AZ-Licensed Products, and payments up to an additional aggregate amount of $15.0 million upon the achievement of certain aggregate worldwide net sales milestones, of which $5.0 million will become payable when we achieve $100.0 million in worldwide sales. With respect to any AZ-Licensed Products we commercialize under the AstraZeneca License Agreement, we will pay AstraZeneca a low to high single-digit percentage royalty rate on our, our affiliates’ and our sublicensees’ net sales of such AZ-Licensed Products, until, as determined on an AZ-Licensed Product-by-AZ-Licensed Product and country-by-country basis, the later of the date of the expiration of the last-to-expire AstraZeneca-licensed patent right containing a valid claim in such country and ten years from the first commercial sale of such AZ-Licensed Product in such country. Accordingly, in September 2022, we began to accrue royalties payable to AstraZeneca as a result of the commercialization and generation of net sales related to ZORYVE. See Note 6 to the unaudited condensed consolidated financial statements for additional information. 31 Table of Contents Hengrui Exclusive Option and License Agreement In January 2018, we entered into the Hengrui License Agreement, with Hengrui, whereby Hengrui granted us an exclusive option to obtain certain exclusive rights to research, develop, and commercialize products containing the compound designated by Hengrui as SHR0302, a JAK 1 inhibitor, in topical formulations for the treatment of skin diseases, disorders, and conditions in the United States, Canada, Japan, and the European Union (including for clarity the United Kingdom). We made a $0.4 million upfront non-refundable cash payment to Hengrui upon execution of the Hengrui Option and License Agreement. In December 2019, we exercised our exclusive option under the agreement, for which we made a $1.5 million cash payment, and also contemporaneously amended the agreement to expand the territory to additionally include Canada. In addition, we have agreed to make cash payments of up to an aggregate of $20.5 million upon our achievement of specified clinical development and regulatory approval milestones with respect to the licensed products and cash payments of up to an additional aggregate of $200.0 million in sales-based milestones based on achieving certain aggregate annual net sales volumes with respect to a licensed product. With respect to any products we commercialize under the Hengrui License Agreement, we will pay tiered royalties to Hengrui on net sales of each licensed product by us, or our affiliates, or our sublicensees, ranging from mid single-digit to sub-teen percentage rates based on tiered annual net sales bands subject to specified reductions. We are obligated to pay royalties until the later of (1) expiration of the last valid claim of the licensed patent rights covering such licensed product in such country and (2) the expiration of regulatory exclusivity for the relevant licensed product in the relevant country, on a licensed product-by-licensed product and country-by-country basis. Additionally, we are obligated to pay Hengrui a specified percentage, ranging from the low-thirties to the sub-teens, of certain non-royalty sublicensing income we receive from sublicensees of our rights to the licensed products, such percentage decreasing as the development stage of the licensed products advance. The agreement continues in effect until the expiration of our obligation to pay royalties as described above, unless earlier terminated in accordance with the following: (1) by either party upon written notice for the other party’s material breach or insolvency event if such party fails to cure such breach or the insolvency event is not dismissed within specified time periods; and (2) by us for convenience upon 90 days prior written notice to Hengrui and having discussed and consulted any potential cause or concern with Hengrui in good faith. In June 2022, we entered into a side letter agreement with Hengrui and one of its subsidiaries to extend certain rights and obligations under the Hengrui License Agreement to the subsidiary under specified circumstances, including a change of control of such subsidiary. See Note 6 to the unaudited condensed consolidated financial statements for additional information. 32 Table of Contents Components of Our Results of Operations Revenue In August 2022, in conjunction with the launch of our first FDA approved product, ZORYVE, we began to recognize revenue from product sales, net of rebates, chargebacks, discounts, and other adjustments. We will continue to evaluate trends related to revenue momentum for ZORYVE. If our development efforts for our other product candidates and label extensions are successful and result in regulatory approval, we may generate additional revenue in the future from product sales. Cost of Sales Cost of sales includes direct and indirect costs related to the manufacturing and distribution of ZORYVE, including raw materials, third-party manufacturing costs, packaging services, and freight-in, as well as third-party royalties payable on our net product sales and amortization of intangible assets associated with ZORYVE. Operating Expenses Research and Development Expenses Since our inception, we have focused significant resources on our research and development activities, including conducting nonclinical studies and clinical trials, manufacturing development efforts, and activities related to regulatory filings for our product candidates. Research and development costs are expensed as incurred. These costs include direct program expenses, which are payments made to third parties that specifically relate to our research and development, such as payments to clinical research organizations, clinical investigators, manufacturing of clinical material, nonclinical testing, and consultants. In addition, employee costs, including salaries, payroll taxes, benefits, stock-based compensation, and travel for employees contributing to research and development activities are classified as research and development costs. We allocate direct external costs on a program specific basis (topical roflumilast program, topical JAK inhibitor program, and early stage programs). Our internal costs are primarily related to personnel or professional services and apply across programs, and thus are not allocable on a program specific basis. We expect to continue to incur substantial research and development expenses in the future as we develop our product candidates. In particular, we expect to incur substantial research and development expenses for the Phase 3 trials of roflumilast cream for atopic dermatitis, ARQ-252 for chronic hand eczema and vitiligo, and ARQ-255 for alopecia areata. We have entered, and may continue to enter, into license agreements to access and utilize certain molecules for the treatment of dermatological diseases and disorders. We evaluate if the license agreement is an acquisition of an asset or a business. To date, none of our license agreements have been considered to be an acquisition of a business. For asset acquisitions, such as with Ducentis, the upfront payments, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate the nature, timing, or costs required to complete the remaining development of roflumilast cream, roflumilast foam, ARQ-252, and ARQ-255, or any other product candidates. This is due to the numerous risks and uncertainties associated with the development of product candidates. See “Risk Factors” for a discussion of the risks and uncertainties associated with the development of our product candidates. 33 Table of Contents Selling, General, and Administrative Expenses Our selling, general, and administrative expenses consist primarily of salaries and related costs, including payroll taxes, benefits, stock-based compensation, and travel. Other selling, general, and administrative expenses include costs related to sales and marketing of ZORYVE, legal costs of pursuing patent protection of our intellectual property, insurance, and professional services fees for marketing, auditing, tax, and general legal services. We expect our selling, general, and administrative expenses to continue to increase in the future as we expand our operating activities and continue to commercialize ZORYVE, increase our headcount, and support our operations; including increased expenses related to legal, accounting, insurance, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, directors and officers liability insurance premiums, and investor relations activities. Other Income, Net Other income, net primarily consists of interest income earned on our cash, cash equivalents, and marketable securities. Interest Expense Interest expense is related to our long term debt. 34 Table of Contents Results of Operations Comparison of the Three Months Ended September 30, 2022 and 2021 The following table sets forth our results of operations for the periods indicated: Three Months Ended September 30, Change 2022 2021 $ % (unaudited) (in thousands) Revenues: Product revenue, net $ 725 $ — $ 725 * Total revenues 725 — 725 * Operating expenses: Cost of sales 269 — 269 * Research and development 69,731 40,604 29,127 72 % Selling, general, and administrative 35,473 16,474 18,999 115 % Total operating expenses 105,473 57,078 48,395 85 % Loss from operations (104,748) (57,078) (47,670) 84 % Other income (expense): Other income, net 1,938 98 1,840 1878 % Interest expense (4,899) — (4,899) * Total other income (expense) (2,961) 98 (3,059) (3121) % Net loss $ (107,709) $ (56,980) $ (50,729) 89 % ______________ *Not applicable Product revenue, net We began recording product revenues in the third quarter of 2022 following the FDA approval of ZORYVE and our subsequent commercial launch in the U.S. in August 2022. During the three months ended September 30, 2022, we recognized $0.7 million of net product revenues related to sales of ZORYVE. Revenues were driven by end customer demand as well as an initial build up of inventories by our wholesaler customers. Sales discounts consisted primarily of co-pay card discounts and distribution fees. Cost of Sales Cost of sales of $0.3 million for the three months ended September 30, 2022 is related primarily to amortization of intangible assets as a result of the milestone payment to AstraZeneca in connection with the FDA approval of ZORYVE. Cost of sales also included product costs incurred after FDA approval as well as royalties on net sales payable to AstraZeneca under a license agreement. See Note 6. 35 Table of Contents Research and Development Expenses Three Months Ended September 30, Change 2022 2021 $ % (unaudited) (in thousands) Direct external costs: Topical roflumilast program $ 21,901 $ 26,743 $ (4,842) (18) % Topical JAK inhibitor program 1,113 955 158 17 % Other early stage programs 132 178 (46) (26) % In-process research and development 29,630 — 29,630 * Indirect costs: Compensation and personnel-related 11,251 8,436 2,815 33 % Other 5,704 4,292 1,412 33 % Total research and development expense $ 69,731 $ 40,604 $ 29,127 72 % Research and development expenses increased by $29.1 million, or 72%, for the three months ended September 30, 2022 compared to the three months ended September 30, 2021. The increase was primarily due to IPR&D expense as a result of the acquisition of ARQ-234 from Ducentis, an increase in compensation and personnel-related costs of $2.8 million, and an increase in other costs of $1.4 million, partially offset by a decrease in direct costs related to the topical roflumilast program of $4.8 million. The increase in compensation and personnel-related expenses, which includes stock-based compensation, was primarily due to an increase in headcount. The increase in other costs was primarily due to an increase in medical affairs spending. The decrease in topical roflumilast program costs was primarily due to the completion of Phase 3 studies of roflumilast foam in seborrheic dermatitis and scalp and body psoriasis. Selling, General, and Administrative Expenses Selling, general, and administrative expenses increased by $19.0 million, or 115%, for the three months ended September 30, 2022 compared to the three months ended September 30, 2021. The increase was primarily due to higher compensation and personnel-related expenses of $9.7 million, higher sales and marketing expenses of $7.3 million, and higher professional services of $1.2 million. The increase in compensation and personnel-related expenses, which includes stock-based compensation, was primarily due to an increase in headcount related to commercialization efforts for ZORYVE. The increase in sales and marketing expenses was primarily related to commercialization efforts. The increase in professional services was due to an increase in consulting activity. Other Income, Net Other income, net increased by $1.8 million for the three months ended September 30, 2022 compared to the three months ended September 30, 2021, primarily due to the impact of rising interest rates and a larger marketable securities balance for the three months ended September 30, 2022. Interest Expense Interest expense increased by $4.9 million for the three months ended September 30, 2022 compared to the three months ended September 30, 2021, due to interest expense related to our long-term debt. See Note 8. 36 Table of Contents Comparison of the Nine Months Ended September 30, 2022 and 2021 The following table sets forth our results of operations for the periods indicated: Nine Months Ended September 30, Change 2022 2021 $ % (unaudited) (in thousands) Revenues: Product revenue, net $ 725 $ — $ 725 * Total revenues 725 — 725 * Operating expenses: Cost of sales 269 — 269 * Research and development 148,558 93,000 55,558 60 % Selling, general, and administrative 85,101 42,243 42,858 101 % Total operating expenses 233,928 135,243 98,685 73 % Loss from operations (233,203) (135,243) (97,960) 72 % Other income (expense): Other income, net 2,501 213 2,288 1074 % Interest expense (8,737) — (8,737) * Total other income (expense) (6,236) 213 $ (6,449) (3028) % Net loss $ (239,439) $ (135,030) $ (104,409) 77 % ______________ *Not applicable Product revenue, net We began recording product revenues in the third quarter of 2022 following the approval of ZORYVE by the FDA and our subsequent commercial launch in the U.S. on August 10, 2022. During the nine months ended September 30, 2022, we recognized $0.7 million of net product revenues related to sales of ZORYVE. Revenues were driven by end customer demand as well as an initial build up of inventories by our wholesaler customers. Sales discounts consisted primarily of co-pay card discounts and distribution fees. Cost of Sales Cost of sales of $0.3 million for the nine months ended September 30, 2022 is related primarily to amortization of intangible assets as a result of the milestone payment to AstraZeneca in connection with the FDA approval of ZORYVE. It also included product costs incurred after FDA approval as well as royalties on net sales payable to AstraZeneca under a license agreement. See Note 6. 37 Table of Contents Research and Development Expenses Nine Months Ended September 30, Change 2022 2021 $ % (unaudited) (in thousands) Direct external costs: Topical roflumilast program $ 68,214 $ 53,416 $ 14,798 28 % Topical JAK inhibitor program 2,505 8,470 (5,965) (70) % Other early stage programs 625 434 191 44 % In-process research and development 29,630 — 29,630 * Indirect costs: Compensation and personnel-related 30,880 19,874 11,006 55 % Other 16,704 10,806 5,898 55 % Total research and development expense $ 148,558 $ 93,000 $ 55,558 60 % Research and development expenses increased by $55.6 million, or 60%, for the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021. The increase was primarily due to IPR&D expense as a result of the acquisition of ARQ-234 from Ducentis, an increase in direct costs related to the topical roflumilast program of $14.8 million, compensation and personnel-related costs of $11.0 million, and an increase in other costs of $5.9 million. These increases were partially offset by a decrease in direct costs related to the topical JAK inhibitor program of $6.0 million. The increase in topical roflumilast program costs relate primarily to increased clinical trial costs due to the ongoing Phase 3 studies of roflumilast cream in atopic dermatitis and higher manufacturing costs. The increase in compensation and personnel-related expenses, which includes stock-based compensation, was primarily due to an increase in headcount. The increase in other costs were primarily due to an increase in medical affairs spending and consulting activity. The decrease in topical JAK inhibitor program costs were primarily due to the completion of our Phase 2 studies of ARQ-252 in chronic hand eczema and vitiligo. Selling, General, and Administrative Expenses Selling, general, and administrative expenses increased by $42.9 million, or 101%, for the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021. The increase was primarily due to an increase in compensation and personnel-related expenses of $20.9 million, an increase in sales and marketing expenses of $14.9 million, and an increase in professional services of $4.8 million. The increase in compensation and personnel-related expenses, which includes stock-based compensation, was due to an increase in headcount related to commercialization efforts for ZORYVE. The increase in sales and marketing expenses was primarily related to commercialization efforts for ZORYVE. The increase in professional services was mainly due to an increase in consulting activity. Other Income, Net Other income, net increased by $2.3 million for the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021, primarily due to the impact of rising interest rates and a larger marketable securities balance for the nine months ended September 30, 2022. Interest Expense Interest expense increased by 8.7 million for the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021, due to interest expense related to our long-term debt. See Note 8. 38 Table of Contents Liquidity, Capital Resources, and Requirements Sources of Liquidity We have incurred operating losses since our inception and have an accumulated deficit as a result of ongoing efforts to commercialize ZORYVE, develop our product candidates, including conducting nonclinical and clinical trials and providing selling, general, and administrative support for these operations. As of September 30, 2022, we had cash, cash equivalents, restricted cash, and marketable securities of $478.2 million, and an accumulated deficit of $647.7 million. Upon FDA approval of ZORYVE, we drew down an additional $125.0 million under the Loan Agreement and, as of September 30, 2022, had $200.0 million outstanding, with an additional $25.0 million in funding that may become available subject to the satisfaction of specified conditions. We also received $161.6 million in aggregate net proceeds from the closing of the public offering of our common stock in August 2022. See Notes 1 and 8 to the unaudited condensed consolidated financial statements for additional information. We have historically financed our operations primarily through private placements of preferred stock, our IPO completed in January 2020, our follow-on financings in October 2020, February 2021, and August 2022, our Loan Agreement, and our ATM. Cash Flows The following table sets forth our cash flows for the periods indicated: Nine Months Ended September 30, 2022 2021 (unaudited) (in thousands) Cash used in operating activities $ (186,650) $ (122,918) Cash used in investing activities (129,400) (99,452) Cash provided by financing activities 300,836 209,066 Net decrease in cash, cash equivalents, and restricted cash $ (15,214) $ (13,304) Net Cash Used in Operating Activities During the nine months ended September 30, 2022, net cash used in operating activities was $186.7 million, which consisted of a net loss of $239.4 million and a change in net operating assets and liabilities of $2.8 million, partially offset by net non-cash charges of $55.6 million. The net non-cash charges were primarily related to acquired in-process research and development of $29.6 million and stock-based compensation expense of $23.4 million. During the nine months ended September 30, 2021, net cash used in operating activities was $122.9 million, which consisted of a net loss of $135.0 million and a change in net operating assets and liabilities of $9.2 million, partially offset by net non-cash charges of $21.3 million. The change in net operating assets and liabilities was primarily due to an increase of $6.1 million in prepaid expenses and other current assets and a decrease of $3.4 million in accounts payable and accrued liabilities due to the timing of payments and lower outstanding accounts payable balances for our contract research organizations. The net non-cash charges were primarily related to stock-based compensation expense of $18.2 million. Net Cash Provided by (Used in) Investing Activities During the nine months ended September 30, 2022, net cash used in investing activities was $129.4 million, which was comprised primarily of purchases of marketable securities of $377.3 million, cash paid for IPR&D related to the acquisition of Ducentis of $15.5 million and a milestone payment made to AstraZeneca of $7.5 million, partially offset by the proceeds from the maturities of marketable securities of $271.1 million. During the nine months ended September 30, 2021, net cash used in investing activities was $99.5 million, which was comprised primarily of purchases of marketable securities of $244.3 million, partially offset by the proceeds from the maturities of marketable securities of $145.6 million. 39 Table of Contents Net Cash Provided by Financing Activities During the nine months ended September 30, 2022, net cash provided by financing activities was $300.8 million, which was comprised primarily of the net cash proceeds received from our August 2022 public stock offering of $161.6 million, our August 2022 debt facility draw down of $125.0 million, and our March 2022 sale of stock under our ATM facility of $14.5 million. During the nine months ended September 30, 2021, net cash provided by financing activities was $209.1 million, which was comprised primarily of the net cash proceeds received from the follow-on financing in February 2021 of $207.5 million. Funding Requirements We have historically incurred significant losses and negative cash flows from operations since our inception and had an accumulated deficit of $647.7 million as of September 30, 2022. We had cash, cash equivalents, and marketable securities of $477.0 million as of September 30, 2022. Upon FDA approval of ZORYVE, we drew down an additional $125.0 million under the Loan Agreement and, as of September 30, 2022, had $200.0 million outstanding, with an additional $25.0 million in funding that may become available subject to the satisfaction of specified conditions. We also received $161.6 million from the closing of the public offering of our common stock in August 2022. See Notes 1 and 8 to the unaudited condensed consolidated financial statements for additional information. We believe that our existing capital resources will be sufficient to meet the projected operating requirements for at least 12 months from the date of issuance of its financial statements. If our available cash balances, amounts available under the Loan Agreement, and anticipated future cash flows from operations are insufficient to satisfy our liquidity requirements, we may need to fund our operations through the sale of our equity securities, accessing or incurring additional debt, entering into licensing or collaboration agreements with partners, grants, or other sources of financing. There can be no assurance that sufficient funds will be available to us at all or on attractive terms when needed from these sources. If we are unable to obtain additional funding from these or other sources when needed it may be necessary to significantly reduce our current rate of spending through reductions in staff and delaying, scaling back, or stopping certain research and development programs. Insufficient liquidity may also require us to relinquish rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose. 40 Table of Contents We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development, and commercialization of pharmaceutical products, we are unable to estimate the exact amount of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to: • the timing, receipt, and amount of sales of any current and future products. • the scope, progress, results, and costs of researching and developing our lead product candidates or any future product candidates, and conducting nonclinical studies and clinical trials, in particular our planned or ongoing clinical studies of roflumilast cream in plaque psoriasis and atopic dermatitis, roflumilast foam in scalp and body psoriasis, ARQ-252 in chronic hand eczema and vitiligo, and ARQ-255 in alopecia areata; • suspensions or delays in the enrollment, issues with data collection, or changes to the number of subjects we decide to enroll in our ongoing clinical trials as a result of the COVID-19 pandemic, competing trials or otherwise; • the number and scope of clinical programs we decide to pursue, and the number and characteristics of any product candidates we develop or acquire; • the timing of, and the costs involved in, obtaining regulatory reviews and approvals for our product candidates; • the cost of manufacturing any current and future products and product candidates, including any products we successfully commercialize, including costs associated with building out our supply chain; • the cost of commercialization activities for any current and future products that are approved for sale, including marketing, sales, and distribution costs, and any discounts or rebates to channel to obtain access; • our ability to establish and maintain strategic collaborations, licensing, or other arrangements and the financial terms of any such agreements that we may enter into; • the costs related to milestone payments due to AstraZeneca, Hengrui, or any future collaboration or licensing partners upon the achievement of negotiated milestones; • any product liability or other lawsuits related to our products; • the expenses needed to attract and retain skilled personnel; and • the costs involved in preparing, filing, prosecuting, maintaining, defending, and enforcing our intellectual property portfolio. Indebtedness On December 22, 2021 we entered into a Loan Agreement with SLR and the lenders party thereto. Pursuant to the Loan Agreement, the lenders agreed to extend term loans to us in an aggregate principal amount of up to $225.0 million, comprised of: (i) a tranche A term loan of $75.0 million, (ii) a tranche B-1 term loan of $50.0 million, (iii) a tranche B-2 term loan of up to $75.0 million, available in minimum increments of $15.0 million, and (iv) a tranche C term loan of up to $25.0 million. We refer to the tranche A, tranche B, and tranche C term loans together as our Term Loans. As security for the obligations under the Loan Agreement, we granted SLR, for the benefit of the lenders, a continuing security interest in substantially all of our assets, including our intellectual property, subject to certain exceptions. The tranche A term loan was funded on December 22, 2021. Each tranche B term loan is available following delivery to SLR of satisfactory evidence that we have received FDA Approval of roflumilast cream for an indication relating to the treatment of patients with plaque psoriasis, which we refer to as the FDA Approval. With the approval of ZORYVE, we drew down $125.0 million on the tranche B term loans, which we received in August 2022. See Notes 1 and 8 to the unaudited condensed consolidated financial statements for additional information. The tranche C term loan is available following the achievement of a net product revenue milestone of $110.0 million, calculated on a trailing six month basis. The tranche C term loan will remain available for funding until September 30, 2024. 41 Table of Contents Principal amounts outstanding under the Term Loans will accrue interest at a floating rate equal to the applicable rate in effect from time to time, as determined by SLR on the third business day prior to the funding date of the applicable Term Loan and on the first business day of the month prior to each payment date of each Term Loan. The applicable rate is a per annum interest rate equal to 7.45% plus the greater of (a) 0.10% and (b) the per annum rate published by the Intercontinental Exchange Benchmark Administration Ltd. (or on any successor or substitute published rate) for a term of one month, subject to a replacement with an alternate benchmark rate and spread in certain circumstances. On September 30, 2022, the rate was 10.08%. Interest payments are payable monthly following the funding of any Term Loan. Any principal amounts outstanding under the Term Loans, if not repaid sooner, are due and payable on January 1, 2027, or the Maturity Date. We may voluntarily prepay principal amounts outstanding under the Term Loans in minimum increments of $5.0 million, subject to a prepayment premium of (i) 3.0% of the principal amount of such Term Loan so prepaid prior to December 22, 2022, (ii) 2.0% of the principal amount of such Term Loan so prepaid after December 22, 2022 and prior to December 22, 2023, or (iii) 1.0% of the principal amount of such Term Loan so prepaid after December 22, 2023 and prior to December 22, 2025. If the Term Loans are accelerated due to, among others, the occurrence of a bankruptcy or insolvency event, we are required to make certain mandatory prepayments, including fees applicable by reason of such prepayment. The Loan Agreement contains customary representations and warranties and customary affirmative and negative covenants, including, among others, restrictions on our ability to merge or consolidate with any other entity, to incur additional indebtedness, or to pay any dividends or other distributions on capital stock. We have also agreed to a financial covenant whereby, beginning with the month ending December 31, 2023, we must generate net product revenue in excess of specified amounts for applicable measuring periods; provided, however, that such financial covenant shall not apply if our average market capitalization over the trailing five day period prior to the last day of any measurement month is equal to or in excess of $400.0 million. We were in compliance with all covenants under the Loan Agreement as of September 30, 2022. In addition, the Loan Agreement contains customary events of default that entitle the lenders to cause any indebtedness under the Loan Agreement to become immediately due and payable, and to exercise remedies against us and the collateral securing the Term Loans. Upon the occurrence and for the duration of an event of default, an additional default interest rate, or the Default Rate, equal to 4.0% per annum will apply to all obligations owed under the Loan Agreement. In connection with the Loan Agreement, we are obligated to pay (i) a final fee equal to 6.95% of the aggregate original principal amount of the Term Loans funded upon the earliest to occur of the Maturity Date, the acceleration of any Term Loan and the prepayment, refinancing, substitution or replacement of any Term Loan and (ii) a certain amount of lenders’ expenses incurred in connection with the execution of the Loan Agreement. Additionally, in connection with the Loan Agreement, we entered into an Exit Fee Agreement, whereby we agreed to pay an exit fee in the amount of 3.0% of each Term Loan funded upon (i) any change of control transaction or (ii) a revenue milestone, calculated on a trailing six month basis. Notwithstanding the prepayment or termination of the Term Loan, the exit fee will expire 10 years from the date of the Loan Agreement. 42 Table of Contents Contractual Obligations and Contingent Liabilities The following summarizes our significant contractual obligations as of September 30, 2022. Facility Operating Lease In April 2020, we amended our lease agreement for our facility in Westlake Village, California to relocate to a new expanded space including 22,643 square feet. The lease payment term for the new space began on December 30, 2020 and will terminate 91 months thereafter, with a renewal option term of five years. We have a one-time option to cancel the lease after month 67. The lease is subject to fixed rate escalation increases with an initial base rent of $76,000 per month and includes rent free periods aggregating approximately one year. The amended lease agreement required that we deliver a letter of credit to the landlord of $1.5 million upon occupying the space, which is allowed to be reduced throughout the lease period as rent obligations are met. Accordingly, as of September 30, 2022, we have a letter of credit and related restricted cash account of $1.2 million. The total commitment under the operating lease agreement is $6.0 million, including $0.3 million for the remaining three months of 2022, $1.0 million for each of the years 2023 through 2027, and $0.7 million for the year 2028. See Note 7 to the unaudited condensed consolidated financial statements for additional information. Long-Term Debt Obligations As of September 30, 2022, we had $200.0 million outstanding under our Loan Agreement. Upon FDA approval of ZORYVE, we drew down an additional $125.0 million under the Loan Agreement which we received on August 2, 2022. After this draw down, we have $25.0 million in additional funding remaining that may become available subject to the satisfaction of specified conditions. See Notes 1 and 8 to the unaudited condensed consolidated financial statements for additional information. The total commitment under the Loan Agreement as of September 30, 2022 is $305.3 million, including $5.4 million for the remaining three months of 2022, $21.5 million for each of the years 2023 through 2026, and $213.9 million for 2027. These amounts do not represent or include any future draw downs, but instead represent only the contractually obligated minimum payments of interest, principal, and loan fees related to the funding of the $75.0 million tranche A term loan on December 22, 2021 and the $125.0 million tranche B term loan on August 2, 2022. License Agreements The terms of certain of our license agreements require us to pay potential future milestone payments based on product development and commercial success. The amount and timing of such obligations are unknown or uncertain. These potential obligations are further described in Note 6 to the unaudited condensed consolidated financial statements. Manufacturing Agreements We have entered into manufacturing supply agreements for the commercial supply of ZORYVE, which include certain minimum purchase commitments. Firm future purchase commitments under these agreements are approximately $2.9 million within the next three months, with an annual commitment of approximately $2.1 million for the year 2023, and approximately $0.6 million per year for 2024 and 2025. This amount does not represent all of the our anticipated purchases, but instead represents only the contractually obligated minimum purchases or firm commitments of non-cancelable minimum amounts. 43 Table of Contents Indemnification In the normal course of business, we enter into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. Our exposure under these agreements is unknown because it involves claims that may be made against us in the future, but have not yet been made. To date, we have not paid any claims or been required to defend any action related to our indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations. In accordance with our certificate of incorporation and bylaws, we have indemnification obligations to our officers and directors for specified events or occurrences, subject to some limits, while they are serving at our request in such capacities. There have been no claims to date, and we have director and officer insurance that may enable us to recover a portion of any amounts paid for future potential claims. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under SEC rules. Critical Accounting Policies and Use of Estimates The preparation of our condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the notes to the financial statements. Some of those judgments can be subjective and complex, and therefore, actual results could differ materially from those estimates under different assumptions or conditions. A summary of our critical accounting policies is presented in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the year ended December 31, 2021. We began to sell ZORYVE in August 2022. As such, we identified additional critical accounting policies as of September 30, 2022 related to revenue, accounts receivable, inventory, and intangibles, further described in Note 2 to the Condensed Consolidated Financial Statements, “Summary of Significant Accounting Policies” to our financial statements. Other than these policies, there were no material changes to our critical accounting policies during the nine months ended September 30, 2022. Recent Accounting Pronouncements See Note 2 to our unaudited condensed consolidated financial statements.