PALVELLA THERAPEUTICS, INC. 10-K

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes and other financial information included in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties as described under the heading “Forward-Looking Statements” elsewhere in this Annual Report on Form 10-K. You should review the disclosure under the heading “Risk Factors” in this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are a clinical-stage biotechnology company that discovers and develops Anticalin-based drugs to target validated disease pathways in unique and transformative ways. Our clinical pipeline includes an inhaled IL-4Rα antagonist Anticalin protein to treat moderate-to-severe asthma and an immuno-oncology (IO) bispecific targeting 4-1BB and HER2. Proprietary to us, Anticalin proteins are a novel class of therapeutics validated in the clinic and through partnerships with leading pharmaceutical companies. Our core Anticalin technology and platform were developed in Germany, and we have collaborations with major multi-national pharmaceutical companies. In particular, we have an alliance with AstraZeneca to treat respiratory diseases and partnerships with Servier and Seagen, both in IO. Our development programs include: • PRS-060/AZD1402 , our lead respiratory program partnered with AstraZeneca, a drug candidate that antagonizes IL-4Rα, thereby inhibiting IL-4 and IL-13, two cytokines known to be key mediators in the inflammatory cascade that drive the pathogenesis of asthma and other inflammatory diseases. • We continue to research and develop additional respiratory drug candidates beyond PRS-060/AZD1402, both within and outside of the AstraZeneca alliance. In addition to PRS-060/AZD1402, the AstraZeneca alliance includes four respiratory programs, the targets and disease areas of which are undisclosed. We retain co-development and co- 92 commercialization rights to two out of the four programs beyond PRS-060/AZ1402. Our portfolio also includes several respiratory programs outside of the AstraZeneca collaboration. • Cinrebafusp alfa, our lead IO program, is a fusion protein, comprising a HER2-targeting antibody genetically linked to 4-1BB-targeting Anticalin proteins. Cinrebafusp alfa is designed to drive tumor localized T cell activation through tumor-targeted drug clustering mediated by HER2 expressed on tumor cells. This program was the first bispecific T cell co-stimulatory agonist to enter clinical development. • Additional IO drug candidates beyond cinrebafusp alfa that are multispecific Anticalin-based fusion proteins designed to engage immunomodulatory targets, comprising a variety of multifunctional biotherapeutics, including PRS-344, a bispecific antibody-Anticalin fusion protein comprising an PD-L1-targeting antibody genetically fused to Anticalin proteins specific for 4-1BB. PRS-344 is being developed as part of our IO collaboration with Servier. Other IO drug candidates are being developed as part of our collaboration with Servier and Seagen. Our programs are in varying stages: • PRS-060/AZD1402 was tested in a nebulized formulation in 54 healthy volunteers at nominal dose levels ranging from 0.25 mg to 400 mg in a phase 1 SAD study. Data from that study were presented at the American Thoracic Society International Conference in May 2019 showing that PRS-060/AZD1402 was well tolerated when given as single inhaled or intravenous doses to healthy volunteers and there was systemic target engagement (as measured by pSTAT6 inhibition). We presented interim data from the PRS-060/AZD1402 phase 1 MAD study at the European Respiratory Society International Congress in October 2019 and reported that PRS-060/AZD1402 was safe and well tolerated at all doses, led to a statistically significant reduction in FeNO, a validated biomarker for eosinophilic airway inflammation, and showed dose-dependent systemic target engagement in patients with mild asthma and elevated levels of FeNO (≥ 35ppb). In that study, during the treatment period, 30 patients were randomized to receive delivered doses of PRS-060/AZD1402 ranging from 2 mg to 60 mg (5 mg to 150 mg administered through a nebulizer (nominal dose)) twice daily for nine consecutive days and one final dose on the 10th day, and 12 patients were randomized to receive placebo at the same intervals. Statistically significant and pronounced inhibition of FeNO relative to placebo was observed at all doses. When comparing the 20 mg PRS-060/AZD1402 powered cohort (n=12) to placebo, the primary statistical analysis using the Emax model demonstrated a 36% relative reduction in FeNO (p-value <0.0001). Systemic target engagement was dose-dependent and closely aligned with systemic exposure of the drug, consistent with results of the phase 1 SAD study. No systemic target engagement and minimal systemic exposure was observed at the 2 mg dose, suggesting that local target engagement by the drug may be sufficient to reduce airway inflammation, as evidenced by FeNO reduction at that 2 mg dose level. In order to further investigate the safety and efficacy profile of PRS-060/AZD1402, the phase 1 MAD study recruited additional cohorts in 2020. The study has now completed, and we are currently planning to disclose data from these additional cohorts in 2021. • In addition to Ukrainian regulatory approval, AstraZeneca has also recently received ethics approval and regulatory acknowledgement for the phase 2a study of PRS-060/AZD1402 in Australia Patient screening has begun following a COVID-19-related inventory challenge that has been successfully managed. We expect the first patient to be dosed in the second quarter of 2021. The phase 2a study is a two-part, multi-center, placebo-controlled clinical study of PRS-060/AZD1402 that will evaluate PRS-060/AZD1402 at up to three dose levels using a dry powder formulation administered twice daily. The first part of the study will assess the safety and pharmacokinetics of the dry powder formulation in approximately 45 moderate controlled asthmatics. The second part of the study will assess the efficacy, safety and pharmacokinetics of PRS-060/AZD1402 in approximately 360 moderate uncontrolled asthmatics with blood eosinophil count of ≥ 150 cells/μL and FeNO ≥ 25 ppb at screening over four weeks with FEV1 improvement as the primary endpoint. This study of PRS-060/AZD1402, which is being developed for the treatment of moderate-to-severe asthma, is being sponsored, funded and delivered by AstraZeneca. Upon completion of that study, Pieris will have the options to co-develop and, subsequently, co-commercialize PRS-060/AZD1402 in the United States. • Our additional respiratory programs within and outside of the AstraZeneca alliance are in the discovery stage. AstraZeneca has taken full advantage of all available potential new project starts envisioned in the alliance and all four respiratory programs are ongoing. We retain co-development and co-commercialization rights to two out of the four programs beyond PRS-060/AZD1402. Outside of the AstraZeneca collaboration, Pieris continues to advance several proprietary respiratory programs, which are in the discovery stage. • We presented additional interim data from the phase 1 monotherapy study and atezolizumab combination study of cinrebafusp alfa in an oral presentation session at the ESMO Virtual Congress in September 2020. As of the July 2020 cutoff date, 74 patients had been enrolled in the monotherapy study, including 21 additional patients enrolled in the active dose cohorts (≥2.5 mg/kg) since the data were presented at the Society for Immunotherapy of Cancer 2019 Annual Meeting, and 41 patients had been enrolled in the atezolizumab combination therapy study. In the monotherapy study, out of 33 response-evaluable patients at the time of the data cutoff of July 27, 2020, according to RECIST 1.1, one patient with stage 4 rectal adenocarcinoma achieved a confirmed complete response at the 18 mg/kg Q2W dose (cohort 13b), three patients achieved a partial response at the 8 mg/kg Q2W dose (cohort 11b), and stable 93 disease was observed in 13 patients as best response out of 33 evaluable patients across the predicted active dose ranges (cohorts 9-13b), translating to an ORR of 12% and a DCR of 52%. Additionally, a significant expansion of CD8+ T cells in the tumor microenvironment of responders and a substantial increase of peripheral soluble 4-1BB were observed in the active dose cohorts, suggesting 4-1BB-mediated target engagement. Cinrebafusp alfa also showed an acceptable safety profile at all doses and schedules tested in each clinical study. In the atezolizumab combination trial, seven dose cohorts have been evaluated at a Q3W dosing schedule ranging from 0.05 mg/kg to 8 mg/kg in combination with a fixed 1200 mg dose of atezolizumab. In that trial, under RECIST 1.1, four patients achieved a confirmed partial response at active dose levels. We plan to advance cinrebafusp alfa into a phase 2 study for the treatment of HER2-positive gastric cancer in combination with ramucirumab and paclitaxel in 2021. In July 2020, we announced that our phase 1 studies of cinrebafusp alfa were placed on partial clinical hold by the FDA while we conducted an additional in-use stability and compatibility study requested by the FDA. Treatment of currently-enrolled patients continued, although no new patients were enrolled pending resolution of the partial hold. The Company completed the in-use studies it deemed necessary in connection with the partial clinical hold of the cinrebafusp alfa phase 1 studies. As part of the completed studies that supported a robust process for administration of cinrebafusp alfa in the clinical setting, we have optimized the level of an existing excipient to enhance the stability of cinrebafusp alfa under prescribed as well as stressed conditions that could occur in preparation of the drug candidate for patient administration in the real-world clinical setting. In January 2021, FDA lifted the partial clinical hold of the phase 1 studies of cinrebafusp alfa. In August 2020, we entered into the Lilly Agreement with Lilly, pursuant to which we and Lilly will collaborate in a phase 2 clinical study to determine the safety and efficacy of our cinrebafusp alfa in combination with the standard of care regimen for advanced or metastatic gastric cancer, ramucirumab (Cyramza®) and paclitaxel, for the treatment of HER2-positive gastric cancer. • For our additional IO drug candidates, we are conducting activities relating to candidate identification, optimization and preclinical evaluation. ◦ We anticipate filing an IND application for PRS-344, a 4-1BB/PD-L1 bispecific in 2021. ◦ We have successfully completed non-GLP preclinical work for PRS-352 in 2020 and the program is currently under further development at Servier. PRS-352 is a preclinical-stage program within the Servier alliance addressing undisclosed targets for immuno-oncology. ◦ We achieved a key development milestone during 2020 for one of the programs in the Seagen collaboration, a bispecific tumor-targeted costimulatory agonist, triggering a $5.0 million milestone. We also handed the program over to Seagen, which is responsible for further advancement and funding of the asset. The program is one of up to three potential programs in the Seagen alliance, and we believe the achieved milestone further validates our approach and leadership in immuno-oncology bispecifics, complementing the encouraging clinical data seen with cinrebafusp alfa. Since inception, we have devoted nearly all of our efforts and resources to our research and development activities and have incurred significant net losses. For the years ended December 31, 2020 and 2019, we reported net losses of $37.2 million and $25.5 million, respectively. As of December 31, 2020, we had an accumulated deficit of $211.4 million. We expect to continue incurring substantial losses for the next several years as we continue to develop our clinical and preclinical drug candidates and programs. Our operating expenses are comprised of research and development expenses and general and administrative expenses. We have not generated any revenues from product sales to date, and we do not expect to generate revenues from product sales for the foreseeable future. Our revenues for the fiscal years ended December 31, 2020 and 2019 were from license and collaboration agreements with our partners. A significant portion of our operations are conducted in countries other than the United States. Since we conduct our business in U.S. dollars, our main exposure, if any, results from changes in the exchange rates between the euro and the U.S. dollar. At each period end, we remeasure assets and liabilities to the functional currency of that entity (for example, U.S. dollar payables recorded by Pieris Pharmaceuticals GmbH). Remeasurement gains and losses are recorded in the statement of operations line item ‘Other income (expense), net’. All assets and liabilities denominated in euros are translated into U.S. dollars at the exchange rate on the balance sheet date. Revenues and expenses are translated at the weighted average rate during the period. Equity transactions are translated using historical exchange rates. All adjustments resulting from translating foreign currency financial statements into U.S. dollars are included in accumulated other comprehensive loss. Key Financial Terms and Metrics 94 The following discussion summarizes the key factors our management believes are necessary for an understanding of our consolidated financial statements. Revenues We have not generated any revenues from product sales to date and we do not expect to generate revenues from product sales for the foreseeable future. Our revenues for the last two years have been primarily from the license and collaboration agreements with AstraZeneca, Servier and Seagen. The revenues from AstraZeneca, Servier and Seagen have been comprised primarily of upfront payments, research and development services and milestone payments. For additional information about our revenue recognition policy, see “Note 2-Summary of Significant Accounting Policies”. Research and Development Expenses The process of researching and developing drugs for human use is lengthy, unpredictable, and subject to many risks. We expect to continue incurring substantial expenses for the next several years as we continue to develop our clinical and preclinical drug candidates and programs. We are unable, with any certainty, to estimate either the costs or the timelines in which those expenses will be incurred. Our current development plans focus on the following programs: our lead respiratory program, PRS-060/AZD1402 and our other respiratory programs, our IO programs, currently comprised of cinrebafusp alfa as well as multiple additional proprietary and partnered programs, including PRS-344. These programs consume a large proportion of our current, as well as projected, resources. Our research and development costs include costs that are directly attributable to the creation of certain of our Anticalin drug candidates and are comprised of: • internal recurring costs, such as personnel-related costs (salaries, employee benefits, equity compensation and other costs), materials and supplies, facilities and maintenance costs attributable to research and development functions; and • fees paid to external parties who provide us with contract services, such as preclinical testing, manufacturing and related testing and clinical trial activities. General and Administrative Expenses General and administrative expenses consist primarily of salaries, employee benefits, equity compensation, and other personnel-related costs associated with executive, administrative and other support staff. Other significant general and administrative expenses include the costs associated with professional fees for accounting, auditing, insurance costs, consulting and legal services, along with facility and maintenance costs attributable to general and administrative functions. Results of Operations Comparison of Years Ended December 31, 2020 and December 31, 2019 The following table sets forth our revenues and operating expenses for the fiscal years ended December 31, 2020 and 2019 (in thousands): Years ended December 31, 2020 2019 Revenues $ 29,323 $ 46,279 Research and development expenses 46,531 54,996 General and administrative expenses 16,713 18,440 Total operating expenses 63,244 73,436 Interest income 511 1,714 Other (expense) income , net (3,656) (26) Net loss $ (37,230) $ (25,469) Revenues 95 The following table provides a comparison of revenues for the years ended December 31, 2020 and 2019 (in thousands): Years ended December 31, 2020 2019 Increase/(Decrease) Revenue from contracts with customers $ 23,911 $ 32,065 $ (8,154) Collaboration revenue 5,412 14,214 $ (8,802) Total Revenue $ 29,323 $ 46,279 $ (16,956) • The $8.2 million decrease in revenue from contracts with customers for the year ended December 31, 2020 compared to the year ended December 31, 2019 is driven by the following: ◦ Lower net revenue on the AstraZeneca collaboration agreement in 2020 compared to 2019. Revenue in 2019 benefited from the termination of certain performance obligations along with higher level of activities on PRS-060. ◦ Lower revenue on the ASKA arrangement due to delivery of the final clinical report and arrangement completion in 2019. ◦ Overall decrease partially offset by higher net revenue on the Servier collaboration agreement in 2020 compared to 2019. Revenue recorded in 2020 benefited from the discontinuance of an early-stage program. ◦ Overall decrease partially offset by the achievement in 2020 of a $5.0 million milestone related to the go decision on the first program under the Seagen agreement. • Collaboration revenue decreased by $8.8 million in the year ended December 31, 2020 compared to the year ended December 31, 2019. Collaboration revenue recorded in 2019 benefited from the termination of the co-development of PRS-332 by Servier for strategic reasons and ongoing activities across multiple programs. Revenue recorded in 2020 benefited, to a much lesser extent than in 2019, from the discontinuance of an early-stage program. Research and Development Expenses The following table provides a comparison of the research and development expenses for the years ended December 31, 2020 and 2019 (in thousands): Years ended December 31, 2020 2019 Increase/(Decrease) Immuno-oncology $ 12,386 $ 19,669 $ (7,283) Respiratory 9,677 11,634 $ (1,957) Other R&D activities 24,468 23,693 $ 775 Total $ 46,531 $ 54,996 $ (8,465) • the $7.3 million decrease in our immuno-oncology program spending period-over-period is due primarily to an decrease in clinical costs incurred for cinrebafusp alfa due to the partial clinical hold that was in effect for the second half of 2020 and lower drug product manufacturing costs for cinrebafusp alfa, PRS-344, and earlier stage proprietary and partnered discovery programs; • the $2.0 million decrease for our respiratory programs period-over-period is due primarily to decreases to our ongoing CMC costs for PRS-060/AZD1402; • the $0.8 million increase in other research and development activities expenses is mainly due to an increase in allocated facility costs and higher lap equipment service and maintenance costs due to the new Hallbergmoos facility partially offset by lower travel costs due to COVID-19 restrictions and lower clinical costs for PRS-080. General and Administrative Expenses General and administrative expenses was $16.7 million for the year ended December 31, 2020 as compared to $18.4 million for the year ended December 31, 2019. The decrease is due to lower professional service costs partially related to Sarbanes-Oxley readiness activities, lower personnel costs, lower audit expense, and lower overall travel and entertainment costs due to COVID-19 restrictions. This was partially offset by higher legal costs, higher insurance premiums, and higher overall facility costs as the Hallbergmoos site was placed into service in February 2020. Non-operating income (expense), net 96 Our non-operating expense was $3.1 million for the year ended December 31, 2020 as compared to a non-operating income of $1.7 million for the year ended December 31, 2019. This decrease is due to a severely weakening U.S. dollar in 2020 along with lower net interest realized as a result of lower net invested amounts throughout 2020 and a significantly lower interest rate environment. Liquidity and Capital Resources We are subject to risks common to companies in the biotechnology industry, including but not limited to, the need for additional capital, risks of failure of preclinical studies and clinical trials, the need to obtain marketing approval and reimbursement for any drug product candidate that we may identify and develop, the need to successfully commercialize and gain market acceptance of our product candidates, dependence on key personnel, protection of proprietary technology, compliance with government regulations, development of technological innovations by competitors, reliance on third party manufacturers and the ability to transition from pilot-scale production to large-scale manufacturing of products. Through December 31, 2020, we have funded our operations with $451.4 million of cash that has been obtained from the following main sources: $212.9 million from sales of equity; $217.8 million in total payments received under license and collaboration agreements, including $45.2 million for research and development services costs received from our collaboration partners; $14.2 million from government grants and $6.5 million from loans. As of December 31, 2020, we had a total of $70.4 million in cash, cash equivalents and investments. We have incurred losses in every period since inception including the years ended December 31, 2020 and 2019, respectively, and have a total accumulated deficit of $211.4 million as of December 31, 2020. Net losses and negative cash flows have had, and will continue to have, an adverse effect on our stockholders’ equity and working capital. We expect to continue to incur operating losses for at least the next several years. The following table provides a summary of operating, investing, and financing cash flows for the years ended December 31, 2020 and 2019 respectively (in thousands): Years ended December 31, 2020 2019 Net cash used in operating activities $ (45,896) $ (52,467) Net cash provided by investing activities 39,212 9,838 Net cash provided by financing activities 10,115 32,166 Net cash used in operating activities for the year ended December 31, 2020 and 2019 was $45.9 million and $52.5 million, respectively. The change is primarily driven by a pronounced decrease in the impact to cash of deferred revenue due to cancellation of certain performance obligations in 2019 and higher collections of accounts receivable and less prepaid expense activity in the current year, offset by an $11.8 million increase in the net loss in 2020 compared to the same period in 2019 and a decrease in accounts payable and accrued expenses due to higher accruals at year-end 2019 related to the new facility. The change in net cash provided by investing activities for the year ended December 31, 2020 compared to the same period in 2019 is mainly attributable to lower purchases and increased maturities resulting in an overall decrease in investment in the current year compared to 2019 along with an increase in purchases of property and equipment related to our move to a new R&D facility. Financing activities for the year ended December 31, 2020 and 2019 were $10.1 million and $32.2 million, respectively. The change is primarily driven by a decrease in proceeds from financing activities in 2020 compared to the same period in 2019. Financing activities in 2019 benefited from the proceeds of the 2019 private placement (described below). Financing activities in 2020 benefited from the proceeds from a strategic sale on our ATM Program to strengthen our shareholder base. In August 2019, we entered into a sale agreement pursuant to which we may offer and sell shares of its common stock, from time to time, up to an aggregate gross sales proceeds of $50.0 million through an “at the market offering” program, or the ATM Program, under a shelf registration statement on Form S-3 (File No. 333-226725). Through December 31, 2020, we have sold $10.0 million of common shares under the ATM Program. In November 2019, we entered into a securities purchase agreement for a private placement with a select group of institutional investors. The private placement, referred to as the PIPE, consisted of 9,014,960 units, at a price of $3.55 per unit, for gross proceeds of approximately $32.0 million, and net proceeds to us of approximately $31.0 million, after deducting placement agent fees and estimated offering expenses payable by us. Each unit consists of (i) one share of our common stock or 0.001 97 shares of non-voting Series C convertible preferred stock, and (ii) one immediately-exercisable warrant to purchase one share of our common stock with an exercise price of $7.10. In March 2021, we amended our strategic collaboration agreement with Seagen which resulted in their purchase of $13.0 million of our common stock (See Note 3). In March 2021, we also earned a $13.0 million milestone from AstraZeneca related to the initiation of the phase 2a study for PRS-060/AZD1402 and AstraZeneca agreed to purchase $10.0 million of our common stock (See Note 3). Our future success is dependent on our ability to identify and develop our product candidates, expand our corporate infrastructure and ultimately upon our ability to attain profitable operations. We have devoted substantially all of our financial resources and efforts to research and development and general and administrative expenses to support such research and development. We have several research and development programs underway in varying stages of development and we expect that these programs will continue to require increasing amounts of cash for development, conducting clinical trials, and testing and manufacturing of product material. Cash necessary to fund operations will increase significantly over the next several years as we continue to conduct these activities necessary to pursue governmental regulatory approval of clinical-stage programs and other product candidates. Any requirements for additional capital will depend on many factors, including the following: • the scope, rate of progress, results and cost of our clinical studies, preclinical testing and other related activities; • the cost of manufacturing clinical supplies, and establishing commercial supplies, of our drug candidates and any products that we may develop; • the number and characteristics of drug candidates that we pursue; • the cost, timing and outcomes of regulatory approvals; • the cost and timing of establishing sales, marketing and distribution capabilities; • the terms and timing of any collaborative, licensing and other arrangements that we may establish; • the timing, receipt and amount of sales, profit sharing or royalties, if any, from our potential products; • the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; • the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions; and • the effects of the COVID-19 pandemic and the cost and timing of actions taken to contain it. In addition, any unfavorable development or delay in the progress of our core clinical-stage programs including cinrebafusp alfa and PRS-060/AZD1402 could have a material adverse impact on our ability to raise additional capital. We plan to raise additional capital to fulfill our operating and capital requirements through public or private equity financings, utilization of our current ATM program, strategic collaborations, licensing arrangements, and/or the achievement of milestones under our collaborative agreements. The funding requirements of our operating plans, however, are based on estimates that are subject to risks and uncertainties and may change as a result of many factors currently unknown. Although we continue to pursue these funding plans, there is no assurance that we will be successful in obtaining sufficient funding on terms acceptable to us to fund continuing operations, if at all. Until such time as we can generate substantial product revenues, if ever, we expect to finance our cash needs through a combination of equity offerings, debt financings, strategic partnerships and licensing arrangements. The terms of any future financing may adversely affect the holdings or the rights of our existing stockholders. We believe that our currently available funds will be sufficient to fund our operations through at least the next twelve months from the issuance of this Annual Report on Form 10-K. Our belief with respect to our ability to fund operations is based on estimates that are subject to risks and uncertainties. If actual results are different from our estimates, we may need to seek additional funding. If we are unable to obtain additional funding on acceptable terms when needed, we may be required to defer or limit some or all of our research, development, and/or clinical projects Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined under applicable SEC rules. Critical Accounting Policies and Estimates 98 The discussion and analysis of our financial condition and results of operations are based on our 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 management to make estimates and judgments that affect reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses for the periods presented. Management makes estimates and exercises judgment in revenue recognition, share-based payments and income taxes. Judgments must also be made about the disclosure of contingent liabilities, and these estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from those estimates and under different assumptions or conditions. While our significant accounting policies are more fully described in the notes to our consolidated financial statements, we have identified the following accounting policies that we believe require application of management’s most subjective judgments, often requiring the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Our actual results could differ from these estimates and such differences could be material. Revenue Recognition Effective January 1, 2019, we adopted ASC 606. The standard requires a company to recognize revenue when it transfers goods or services to customers in an amount that reflects the consideration that we expect to receive for those goods or services. The standard allows for two transition methods -- full retrospective, in which the standard is applied to each prior reporting period presented, or modified retrospective, in which the cumulative effect of initially applying the standard is recognized at the date of initial adoption. We elected the modified retrospective approach and applied it to contracts not completed at the date of adoption. Therefore, comparative prior periods have not been adjusted. The reported results for 2019 reflect the application of ASC 606 guidance while the reported results for 2018 were prepared under the guidance of FASB ASC Topic 605, Revenue Recognition, or ASC 605. Furthermore, we adopted the contract modification practical expedient set forth in ASC 606 and will reflect the aggregate effect of all modifications that occurred before January 1, 2019 when identifying the satisfied and unsatisfied performance obligations, determining the transaction price and allocating the transaction price to the satisfied and unsatisfied performance obligations. Collaborative Arrangements We consider the nature and contractual terms of an arrangement and assess whether the arrangement involves a joint operating activity pursuant to which we are an active participant and are exposed to significant risks and rewards with respect to the arrangement. If we are an active participant and are exposed to the significant risks and rewards with respect to the arrangement, we account for these arrangements pursuant to ASC 808, Collaborative Arrangements , or ASC 808, and apply a systematic and rational approach to recognize revenue. We classify payments received as revenue and payments made as a reduction of revenue in the period in which they are earned. Revenue from Contracts with Customers In accordance with ASC 606, revenue is recognized when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration to which we expect to be entitled in exchange for these goods and services. To achieve this core principle, we apply the following five steps: 1) identify the customer contract; 2) identify the contract’s performance obligations; 3) determine the transaction price; 4) allocate the transaction price to the performance obligations; and 5) recognize revenue when or as a performance obligation is satisfied. We evaluate all promised goods and services within a customer contract and determines which of such goods and services are separate performance obligations. This evaluation includes an assessment of whether the good or service is capable of being distinct and whether the good or service is separable from other promises in the contract. In assessing whether promised goods or services are distinct, we consider factors such as the stage of development of the underlying intellectual property and the capabilities of the customer to develop the intellectual property on their own or whether the required expertise is readily available . Licensing arrangements are analyzed to determine whether the promised goods or services, which often include licenses, research and development services and governance committee services, are distinct or whether they must be accounted for as part of a combined performance obligation. If the license is considered not to be distinct, the license would then be combined with other promised goods or services as a combined performance obligation. If we are involved in a governance committee, 99 we assess whether our involvement constitutes a separate performance obligation. When governance committee services are determined to be separate performance obligations, we determine the fair value to be allocated to this promised service. Certain contracts contain optional and additional items, which are considered marketing offers and are accounted for as separate contracts with the customer if such option is elected by the customer, unless the option provides a material right which would not be provided without entering into the contract. An option that is considered a material right is accounted for as a separate performance obligation. The transaction price is determined based on the consideration to which we will be entitled in exchange for transferring goods and services to the customer. A contract may contain variable consideration, including potential payments for both milestone and research and development services. For certain potential milestone payments, we estimate the amount of variable consideration by using the most likely amount method. In making this assessment, we evaluate factors such as the clinical, regulatory, commercial and other risks that must be overcome to achieve the milestone. Each reporting period we re-evaluate the probability of achievement of such variable consideration and any related constraints. We will include variable consideration, without constraint, in the transaction price to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. For potential research and development service payments, we estimate the amount of variable consideration by using the expected value method, including any approved budget updates arising from additional research or development services. If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price among the performance obligations on a relative standalone selling price basis unless the transaction price is variable and meets the criteria to be allocated entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation. We allocate the transaction price based on the estimated standalone selling price of the underlying performance obligations or in the case of certain variable consideration to one or more performance obligations. We must develop assumptions that require judgment to determine the stand-alone selling price for each performance obligation identified in the contract. We utilize key assumptions to determine the stand-alone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction and the estimated costs to complete the respective performance obligation. Certain variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated to each performance obligation are consistent with the amount we would expect to receive for each performance obligation. When a performance obligation is satisfied, revenue is recognized for the amount of the transaction price, excluding estimates of variable consideration that are constrained, that is allocated to that performance obligation on a relative standalone selling price basis. Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we are expected to complete its performance obligations under an arrangement. For performance obligations consisting of licenses and other promises, we utilize judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from non- refundable, up-front fees. We evaluate the measure of progress each reporting period and, if necessary, adjusts the measure of performance and related revenue recognition. If the license to our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we will recognize revenue from non-refundable, up-front fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license. Milestones and Royalties We aggregate milestones into four categories: (i) research milestones, (ii) development milestones, (iii) commercial milestones, and (iv) sales milestones. Research milestones are typically achieved upon reaching certain success criteria as defined in each agreement related to developing an Anticalin protein against the specified target. Development milestones are typically reached when a compound reaches a defined phase of clinical research or passes such phase or upon gaining regulatory approvals. Commercial milestones are typically achieved when an approved pharmaceutical product reaches the status for commercial sale, including regulatory approval. Sales milestones are certain defined levels of net sales by the licensee, such as when a product first achieves global sales or annual sales of a specified amount. There is uncertainty that the events to obtain the research and development milestones will be achieved given the nature of clinical development and the stage of our technology. We have thus determined that all research and development milestones 100 will be constrained until it is deemed probable that a significant revenue reversal will not occur. For revenues from research and development milestones, payments will be recognized consistent with the recognition pattern of the performance obligation to which they relate. For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and for which the license is deemed to be the predominant item to which the royalties relate, we recognize revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). Commercial milestones and sales royalties are determined by sales or usage-based thresholds and will be accounted for under the royalty recognition constraint as constrained variable consideration. Contract Balances We recognize a contract asset when we transfer goods or services to a customer before the customer pays consideration or before payment is due, excluding any amounts presented as a receivable (i.e., accounts receivable). A contract asset is an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer. The contract liabilities (i.e., deferred revenue) primarily relate to contracts where we have received payment but has not yet satisfied the related performance obligations. Contingencies Accruals are recorded for loss contingencies when it is probable that a liability has been incurred and the amount of the related loss can be reasonably estimated. We evaluate, on a quarterly basis, developments in legal proceedings and other matters that could cause an increase or decrease in the amount of the liability that has been accrued previously. Considering facts known at the time of the assessment, we determine whether potential losses are considered reasonably possible or probable and whether they are estimable. Based upon this assessment, we carry out an evaluation of disclosure requirements and consider possible accruals in the financial statements. Research and Development Expense Research and development costs are charged to expense as incurred in performing research and development activities. Nonrefundable advance payments for research and development goods or services to be received in the future are deferred and capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed. Research and development expenses are comprised of costs incurred in performing research and development activities, including salaries and benefits, facilities costs, pre-clinical and clinical costs, contract services, consulting, depreciation and amortization expense, and other related costs. Costs associated with acquired technology, in the form of upfront fees or milestone payments, are charged to research and development expense as incurred. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating losses and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted statutory tax rates expected to apply to taxable income in the jurisdictions and years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Based on the level of historical operating results and projections for the taxable income for the future, we have determined that it is more likely than not that our net deferred tax assets will not be realized. Accordingly, we have recorded a full valuation allowance to reduce our net deferred tax assets. We recognize, measure, present and disclose in our financial statements any uncertain tax positions that we have taken or expect to take on a tax return. We operate in multiple jurisdictions, both within and outside the United States, and may be subject to audits from various tax authorities. Management’s judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, liabilities for uncertain tax positions, and any valuation allowance recorded against our net deferred tax assets. We will monitor the extent to which our deferred tax assets may be realized and adjust the valuation allowance accordingly. Our policy is to classify interest and penalties related to unrecognized tax benefits as income tax expense. 101 Recently Issued Accounting Pronouncements We review new accounting standards to determine the expected financial impact, if any, that the adoption of each standard will have. For the recently issued accounting standards that we believe may have an impact on our consolidated financial statements, see “Note 2—Summary of Significant Accounting Policies” in our consolidated financial statements. Smaller Reporting Company Status Currently, we qualify as a smaller reporting company. As a smaller reporting company, we are eligible and have taken advantage of certain exemptions from various reporting requirements that are not available to public reporting companies that do not qualify for this classification, including, but not limited to: • An opportunity for reduced disclosure obligations regarding executive compensation in our periodic and annual reports, including without limitation exemption from the requirement to provide a compensation discussion and analysis describing compensation practices and procedures, • An opportunity for reduced financial statement disclosure in registration statements and in annual reports on Form 10-K, which only requires two years of audited financial statements rather than the three years of audited financial statements that are required for other public companies, • An opportunity for reduced audit and other compliance expenses as we are not subject to the requirement to obtain an auditor’s report on internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act of 2002, and • An opportunity to utilize the non-accelerated filer time-line requirements beginning with our annual report for the year ending December 31, 2020 and quarterly filings thereafter. For as long as we continue to be a smaller reporting company, we expect that we will take advantage of both the reduced internal control audit requirements and the disclosure obligations available to us as a result of this classification. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this item. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our Consolidated Financial Statements required by this Item are as set forth in Item 15 beginning on page F-3 of this Annual Report on Form 10-K. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable.