6. Convertible Notes and Warrants

On April 21, 2016, the Company entered into a securities purchase agreement to conduct a private offering (the “Convertible Note Financing”) consisting of $23 million in aggregate principal amount of 9% senior convertible notes convertible into shares of common stock (the “Convertible Notes”) and 263,436 warrants to purchase shares of the Company’s common stock (the “Warrants”). The Convertible Notes bear interest at a rate of 9% per year, payable semiannually in arrears on November 1 and May 1 of each year commencing on November 1, 2016. The Convertible Notes mature on May 1, 2021, unless earlier redeemed or converted.

The Convertible Notes are senior unsecured and unsubordinated obligations; rank equal in right of payment to the Company’s existing and future unsecured indebtedness that is not subordinated and are effectively subordinated in right of payment to the Company’s existing and future secured indebtedness.

The Convertible Notes are initially convertible into the Company’s common stock at a conversion rate of 191.9386 shares of common stock per $1,000 principal amount of Convertible Notes, representing an initial effective conversion price of $5.21 per share of common stock. The conversion rate may be subject to adjustment upon the occurrence of certain specified events as provided in the indenture governing the Convertible Notes, dated April 25, 2016 between the Company and U.S. Bank National Association, as trustee (the “Indenture”), but will not be adjusted for accrued but unpaid interest. Upon conversion of a Convertible Note, the Company will settle the conversion obligation in common stock equal to the conversion rate, together with a cash payment, if applicable.

The Convertible Notes are convertible at the option of the holders at any time prior to April 29, 2021. Holders of the Convertible Notes who convert their Convertible Notes in connection with a make-whole fundamental change, as defined in the Indenture, may be entitled to a make-whole premium in the form of an increase to the conversion rate during a specified period following the effective date of the make-whole fundamental change. In addition, upon the occurrence of a fundamental change prior to the maturity date of the Convertible Notes, as defined in the Indenture, holders of the Convertible Notes may require the Company to purchase all or a portion of their Convertible Notes for cash at a price equal to 100% of the principal amount of the Convertible Notes to be purchased plus any accrued but unpaid interest to, but excluding, the fundamental change purchase date.

On or after December 1, 2017, the Company may redeem for cash all or a portion of the Convertible Notes if the last reported sale price of the Company’s common stock is at any time equal to or greater than 200% of the conversion price then in effect for at least twenty trading days immediately preceding the date on which the Company provides notice of redemption, at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date.

The Indenture provides for customary events of default which may result in the acceleration of the maturity of the Notes, including, but not limited to, cross acceleration to certain other indebtedness of the Company and its subsidiaries. In the case of an event of default arising from specified events of bankruptcy or insolvency or reorganization all outstanding Convertible Notes will become due and payable immediately without further action or notice. If any other event of default under the Indenture occurs or is continuing, the trustee or holders of at least 25% in aggregate principal amount of the then outstanding Convertible Notes may declare all of the Convertible Notes to be due and payable immediately.

The Warrants have a five-year term and are exercisable at $5.21 per share of common stock. The exercise price is subject to adjustment in the event of certain stock dividends and distributions, stock splits, stock combinations, reclassifications or similar events or upon any distributions of assets, including cash, stock or other property to the Company’s shareholders. The Warrants are exercisable commencing on the later of October 25, 2016 and the date of the public release of top line data related to the conclusion of the ORBIT-3 and ORBIT-4 Phase 3 pivotal clinical trials for the Company’s investigational product Pulmaquin^® inhaled ciprofloxacin. If, at any time from and after October 25, 2016, the daily volume-weighted average price of the shares of the Company’s common stock for each of ten consecutive trading days exceeds 150% of the Exercise Price, the Company will have the right to call all or a portion of the Warrants for redemption upon twenty business days prior notice to the holders, at a redemption price of $0.01 per Warrant; provided that the holders of the Warrants may elect to exercise their Warrants upon receipt of any redemption notice from the Company.

In accounting for the Convertible Notes and Warrants in the first closing, the Company bifurcated a derivative liability from the debt host and discounted the Convertible Notes for the estimated fair value of the conversion feature and the freestanding Warrants issued in connection with the Convertible Notes. The liability components were measured by estimating their fair value as of the commitment date. On June 9, 2016, the Company obtained Shareholder Approval for the Convertible Notes, the Warrants and the underlying shares, at which point the Conversion Share Cap on the Convertible Notes was lifted. As a result, the bifurcated derivative and warrant liability met the equity classification criteria under ASC 815-40-25 and the liabilities were remeasured at fair value on June 9, 2016 and reclassified to permanent equity. The equity component will not be remeasured in subsequent periods provided that the component continues to meet the conditions necessary for equity classification. The excess of the aggregate face value of the Convertible Notes over the estimated fair value of the liability components is recognized as a debt discount which will be amortized over the term of the Convertible Notes using the effective interest rate method. Amortization of the debt discount is recognized as non-cash interest expense.

On April 25, 2016, the initial closing of the Convertible Notes took place under which the Company raised $20 million from a total of two investors and issued 4,319 Warrants to one investor. Of the $20 million, $19.9 million was financed by Grifols, a related party to the Company, as described in Note 7 below. There were 3,319,820 common shares underlying the conversion feature that was bifurcated as a derivative liability due to the Conversion Share Cap. The Company deposited $1.8 million of the net proceeds into an escrow account after the initial closing to fund, when due, the first two scheduled semi-annual interest payments on the notes. The effective interest rate of the liability component was equal to 22.9% for the three and nine months ended September 30, 2016.

On July 14, 2016, the second and final closing of the Convertible Notes took place under which the Company raised $3 million from a total of two investors and issued 259,117 Warrants. The fair value of the warrants issued in the second closing was $662,000 and was recorded as a component of equity and discount to the debt host. The Company deposited $216,000 of the net proceeds into an escrow account after the second closing to fund, when due, the first two scheduled semi-annual interest payments on the Convertible Notes. The effective interest rate of the liability component was equal to 16.24% for the three and nine months ended September 30, 2016.

The financing costs of $2.4 million incurred in connection with the issuance of the Convertible Notes were allocated to the derivative liability, warrants and Convertible Note components based on their relative fair values. Financing costs of $1.4 million allocated to the Convertible Note host are being amortized using the effective interest rate method and recognized as non-cash interest expense over the expected term of the Convertible Notes. For the three and nine months ended September 30, 2016, financing costs of $61,000 and $997,000, respectively, allocated to the derivative liability and Warrant components were expensed and are included in other expense in the Condensed Consolidated Statement of Operations and Comprehensive Loss.

In connection with the first closing, the derivative and warrant liabilities were measured at fair value using certain estimated inputs, which are classified within Level 3 of the valuation hierarchy. The following assumptions were used in the Black-Scholes Model to measure the fair value of the derivative and warrant liability as of June 9, 2016 (the date of the shareholder vote) and April 21, 2016 (the date of the first closing):


	June 9, 2016			April 21, 2016
Fair value of underlying stock – per share	$	4.48		$	4.55
Risk-free interest rate		1.20	%		1.35	%
Expected life (years)		4.9			5
Expected volatility		73.16	%		73.95	%
Dividend yield		0.0	%		0.0	%

The following table summarizes the activity in the derivative liability and the warrant liability for the nine months ended September 30, 2016:


	Nine Months Ended September 30, 2016
	(in thousands)
	Fair Value December 31, 2015		Fair Value of Instruments Issued		Change in Fair value			Reclassifications to Equity			Fair Value September 30, 2016
Derivative liability	$	—	$	8,748	$	(386	)	$	(8,362	)	$	—
Warrant liability		—		11		—			(11	)		—

Total	$	—	$	8,759	$	(386	)	$	(8,373	)	$	—

For the nine months ended September 30, 2016, the Company recognized a gain of $386,000 and $500 on the derivative and warrant liabilities, respectively, related to the change in fair value from the date of commitment to the date the instruments met the equity classification criteria on June 9, 2016 at which point $8.4 million was reclassified from liabilities to equity. The gain has been recorded in other expense in the Condensed Consolidated Statement of Operations and Comprehensive Loss. There was no activity during the three months ended September 30, 2016 as the share cap provision had expired during the second quarter.

In connection with the second closing, the Warrants issued as a component of equity were measured at fair value using certain estimated inputs, which are classified within Level 3 of the valuation hierarchy. The following assumptions were used in the Black-Scholes Model to measure the fair value of the Warrants as of July 14, 2016:


	July 14, 2016
Fair value of underlying stock – per share	$	4.58
Risk-free interest rate		1.07	%
Expected life (years)		4.78
Expected volatility		72.87	%
Dividend yield		0.0	%

As of September 30, 2016, the Convertible Notes consisted of the following:


	September 30, 2016
	(in thousands, except conversion rate and conversion price)
Principal value	$	23,000
Unamortized debt discount		(8,859	)
Unamortized debt issuance costs		(1,335	)

Carrying value of the convertible notes	$	12,806
Conversion rate (shares of common stock per $1,000 principal amount of notes)		191.9386
Conversion price (per share of common stock)	$	5.21

For the three and nine months ended September 30, 2016, the Company recognized interest expense associated with its Convertible Notes as follows:


	Three months ended September 30, 2016		Nine months ended September 30, 2016
	(in thousands)		(in thousands)
Cash Interest Expense
Coupon interest expense	$	507	$	832
Noncash Interest Expense
Amortization of debt discount	$	340	$	562
Amortization of transaction costs	$	51	$	81

	$	898	$	1,475

As of September 30, 2016, the unamortized debt discount will be amortized over a remaining period of approximately 4.59 years. The if converted value as of September 30, 2016 exceeds the principal balance of the Convertible Notes by approximately $6.3 million. Accrued interest payable at September 30, 2016 is $832,000 and is included in other accrued liabilities.