13. Business Combination

9 Months Ended

Sep. 30, 2015

Business Combinations [Abstract]

13. Business Combination

Note 13. Business Combination

Consideration paid by the Company for the business it purchased is allocated to the assets and liabilities acquired based upon their estimated fair values as of the date of the acquisition. The excess of the purchase price over the estimated fair values of the assets acquired and liabilities assumed is recorded as goodwill.

Zohydro ER Acquisition

On April 24, 2015, Pernix completed the acquisition of the pharmaceutical product line, Zohydro ER, including an abuse-deterrent pipeline and all related intellectual property, a favorable supplier contract and an associated liability payable, and a specified quantity of inventory associated therewith, from Zogenix, Inc. ("Zogenix"). There were no other tangible or intangible assets acquired and liabilities assumed related to the Zohydro ER product line from Zogenix. The total purchase price consisted of an upfront cash payment of $80.0 million including a deposit of $10.0 million in an escrow fund, stock consideration of $11.9 million issued in common stock of Pernix, $927,000 for specified quantity of inventory, and regulatory and commercial milestones of up to $283.5 million including a $12.5 million milestone payment upon approval of ZX007 abuse-deterrent extended-release hydrocodone tablet and up to $271.0 million in potential sales milestones if the Zohydro ER product line achieves certain agreed-upon net sales targets.

Zohydro ER is an extended-release form of hydrocodone indicated for the management of pain severe enough to require daily, around-the-clock, long-term opioid treatment and for which alternative treatment options are inadequate. Zohydro ER does not contain acetaminophen, unlike many immediate-release hydrocodone products, such as Vicodin and Lortab, reducing the risk for potential liver toxicity due to overexposure of acetaminophen. The active ingredient, hydrocodone, is the most commonly prescribed opioid in the U.S., with over 114 million prescriptions in 2014. The FDA approved the new drug application ("NDA") for Zohydro ER in October 2013 and the product was launched in March 2014.

The Zohydro ER product line acquisition was accounted for as a business combination in accordance with ASC 805 Business Combinations ("ASC 805") which, among other things, requires assets acquired and liabilities assumed to be measured at their acquisition date fair values. The purchase price allocation was preliminary and included the use of estimates based on information that was available to management at the time these unaudited condensed consolidated financial statements were prepared. The Company believed that the estimates used were reasonable and the significant effects of the Zohydro ER acquisition were properly reflected. However, the estimates are subject to change as additional information becomes available and is assessed by the Company.

During the three months ended September 30, 2015, management recorded measurement period adjustments related to recognition of intangible assets from a favorable supplier contract amounting to $1.9 million and a liability payable to the seller amounting to $2.4 million, which increased goodwill by $514,000. The recording of additional intangible assets resulted in additional amortization expense of $1.4 million in the condensed consolidated statements of operations for the three and nine months ended September 30, 2015. These measurement period adjustments are recorded as current period adjustments in accordance with ASU 2015-16.

The following table summarizes the consideration paid to acquire Zohydro ER and amounts recognized for assets acquired and liabilities assumed as of the acquisition date as well as adjustments made during the measurement period after the acquisition date to the amounts initially recorded on the acquisition date (in thousands):

		Amounts previously recognized as of the acquisition date (April 24, 2015)		Measurement Period Adjustments		Amounts Recognized as of September 30, 2015
Purchase price:
Cash consideration paid to Zogenix	$	70,000	$	-	$	70,000
Escrow fund deposited at the time of closing(1)		10,000		-		10,000
Purchased product inventory(2)		927		-		927
Common stock issued(3)		11,926		-		11,926
Liability relating to supplier contract(4)		-		2,414		2,414
Fair value of contingent consideration payable to Zogenix (5)		29,327		-		29,327
Total purchase price	$	122,180	$	2,414	$	124,594
Estimated fair value of assets acquired:
Intangible assets(6):
Zohydro - Developed technology	$	67,400	$	-	$	67,400
IPR&D		54,600		-		54,600
Supplier Contract		-		1,900		1,900
Amount attributable to assets acquired	$	122,000	$	1,900	$	123,900
Goodwill(7)	$	180	$	514	$	694

(1)	In accordance with the asset purchase agreement, the Company has deposited $10.0 million in an escrow fund to be held for a period of 12 months from the closing date as a security to pay, or be applied against, any losses incurred by the Company that are subject to the general representations, warranties and indemnification obligations of Zogenix. The Company is considered to be the legal and tax owner of the fund until the expiration of the escrow period of 12 months. Accordingly, the amount of $10.0 million in the escrow fund is recognized as restricted cash and consideration payable to Zogenix. Restricted cash is presented separately under current assets while the consideration payable is included in current liabilities in the condensed consolidated balance sheets.
(2)	Under the asset purchase agreement, the Company purchased a specified quantity of Generation 1 version of Zohydro ER product line from Zogenix on the closing date for $927,000. Shortly before the closing date, the Generation 2 version of Zohydro ER with Beadtek was approved by the FDA and was announced by the Company to be launched in the immediate future. This announcement for the launch of Zohydro ER with Beadtek made the Generation 1 version of Zohydro ER obsolete and unsellable in the market. As a result, the fair value of the Generation 1 product inventory acquired from Zogenix has been estimated to be de-minimis on the closing date.
(3)	Under the asset purchase agreement, the number of common shares issued to Zogenix equaled $20.0 million divided by the closing price of common stock on a trading day immediately preceding the purchase agreement date. The closing price of the common stock of Pernix on March 9, 2015 (i.e. trading day immediately preceding the purchase agreement date) was $11.89. Accordingly, Pernix issued 1,682,086 shares of common stock to Zogenix ($20.0 million/$11.89 per share). The common stock issued by the Company is measured at fair value at the closing date (i.e. April 24, 2015) in accordance with the measurement guidance in ASC 805. The closing price of the common stock of the Company on the closing date was $7.09 and accordingly the fair value of common stock issued by the Company on the closing date was determined to be $11.9 million. $16,820 representing the par value of 1,682,086 shares at $0.01 per share was recorded in common stock and the remaining amount of $11.9 million was recorded in Additional paid-in capital.
(4)	The measurement period adjustments for intangible assets represents recognition of intangible assets related to a favorable supplier contract. The Company assumed the supplier contract from the seller that had favorable terms for the supply of the product. The intangible assets recognized are amortized over the life of the supplier contract. The measurement period adjustments for a liability payable to the seller represents the amount owed by the Company to Zogenix for the difference between the notional net selling price stipulated in the Asset Purchase Agreement and the discounted price as stipulated in the supplier contract with respect to a particular product.
(5)	Contingent consideration includes (a) $12.5 million milestone payment payable upon approval of ZX007 abuse-deterrent extended-release hydrocodone tablet, and (b) up to $271 million payable if the Zohydro ER product line achieves certain agreed-upon net sales targets. Each type of contingent consideration has been recognized as a separate unit of account. In accordance with the provisions of ASC 805-30-25-5, each unit of contingent consideration is recognized at the acquisition date fair value. The acquisition date fair value of the contingent consideration linked to FDA approval is $10.3 million and the fair value of the contingent consideration linked to achievement of net sales target is $19.0 million. The total contingent consideration of $29.3 million is classified in other long-term liabilities and is marked to its current fair value of $25.7 million as of September 30, 2015. Such fair values are determined based on a probabilistic model with weights assigned on the likelihood of the Company achieving the sales target in the future. Each unit of contingent consideration is classified as a liability in the condensed consolidated balance sheets and will be subsequently measured at fair value on each reporting date. Any change in fair values between the reporting dates will be recognized in the condensed consolidated statements of operations.
(6)	As of the effective time of the acquisition, identifiable intangible assets are required to be measured at fair value and these acquired assets could include assets that are not intended to be used or sold or that are intended to be used in a manner other than their highest and best use. For purposes of these condensed consolidated financial statements, it is assumed that all assets will be used in a manner that represents the highest and best use of those assets, but it is not assumed that any market synergies will be achieved.
	The fair value of identifiable assets is determined primarily using the "income method," which starts with a forecast of all expected future cash flows. Some of the more significant assumptions inherent in the development of intangible asset values, from the perspective of a market participant, include: the amount and timing of projected future cash flows (including net revenue, cost of product sales, research and development costs, sales and marketing expenses, income tax expense, capital expenditures and working capital requirements) as well as estimated contributory asset charges; the discount rate selected to measure the risks inherent in the future cash flows; and the assessment of the asset's life cycle and the competitive trends impacting the asset, among other factors. The consolidated financial statements include estimated identifiable intangible assets representing core technology intangibles valued at $67.4 million, and in-process research and development ("IPR&D") intangibles valued at $54.6 million. The core technology intangible assets represent developed technology of products approved for sales in the market, which we refer to as marketed products, and have finite useful lives. They are amortized on a straight-line basis over a period of 4.6 years. These estimates will be adjusted accordingly if the final identifiable intangible asset valuation generates results, including corresponding useful lives and related amortization methods, which differ from the pro forma estimates, or if the above scope of intangible assets is modified. The IPR&D are considered indefinite-lived intangible assets until the completion of abandonment of the associated research and development efforts. Accordingly, during the development period, these assets are not amortized but subject to an annual impairment review. The final valuation is expected to be completed within 12 months from the completion of the acquisition.
(7)	Goodwill is calculated as the difference between the acquisition date fair value of the consideration expected to be transferred and the values assigned to the assets acquired. Goodwill is not amortized but tested for impairment on an annual basis or when indications for impairment exist.

Pro forma Impact of Acquisition

The following pro forma combined results of operations are provided for the three and nine months ended September 30, 2015 and 2014, as though the Zohydro ER acquisition had been completed as of January 1, 2014. These supplemental pro forma results of operations are provided for illustrative purposes only and do not purport to be indicative of the actual results that would have been achieved by the combined company for the periods presented or that may be achieved by the combined company in the future. The pro forma results of operations do not include any cost savings or other synergies that resulted, or may result, from the Zohydro ER acquisition or any estimated costs that will be incurred to integrate the Zohydro ER product line. Future results may vary significantly from the results in this pro forma information because of future events and transactions, as well as other factors (in thousands, except for per share data):

		Three Months Ended				Nine Months Ended
		September 30,				September 30,
		2015		2014		2015		2014
		(unaudited)				(unaudited)
Revenue	$	48,615	$	35,394	$	138,453	$	74,537
Net loss	$	(11,492)	$	(31,617)	$	(87,063)	$	(85,121)
Pro forma net loss per common share:
Basic	$	(0.19)	$	(0.83)	$	(1.72)	$	(2.26)
Diluted	$	(0.19)	$	(0.83)	$	(1.72)	$	(2.26)

The Company's historical financial information was adjusted to give effect to the pro forma events that were directly attributable to the Zohydro ER acquisition and factually supportable. The unaudited pro forma consolidated results include historical revenues and expenses of assets acquired in the acquisition with the following adjustments:

• Adjustment to recognize incremental amortization expense based on the fair value of intangibles acquired;
• Adjustment to recognize incremental interest expense and amortization of debt issuance costs for debt issued in connection with the acquisition;
• Eliminate transaction costs and non-recurring charges directly related to the acquisition that were included in the historical results of operations for Pernix;
• Adjustment to recognize pro forma income tax based on income tax benefit on the amortization of intangible assets at the statutory tax rate of Ireland (12.50%), and the income tax benefit on the interest expense at the statutory tax rate of the United States (37.21%).

For the three and nine months ended September 30, 2015, the Company has recognized revenue for Zohydro ER subsequent to the closing of April 24, 2015 in the amount of $5.4 million and $9.3 million, respectively and net loss of $12.2 million and $17.6 million, respectively. Non-recurring transaction costs of $3.3 million related to the acquisition for the nine months ended September 30, 2015 are included in the condensed consolidated statements of operations in selling, general and administrative expense. These non-recurring transaction costs have been excluded from the pro forma results in the above table.