2.	Summary of Significant Accounting Policies

Financial Statement Preparation and Use of Estimates

The unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q have been prepared by Zogenix, Inc. according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been omitted.

In the opinion of management, the accompanying unaudited consolidated financial statements for the periods presented reflect all adjustments, which are normal and recurring, necessary to fairly state the financial position, results of operations and cash flows. These unaudited consolidated financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 filed with the SEC on March 12, 2012.

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from those estimates.

Principles of Consolidation

The unaudited interim consolidated financial statements include the accounts of Zogenix, Inc. and its wholly owned subsidiary Zogenix Europe Limited, which was incorporated under the laws of England and Wales in June 2010. All intercompany transactions and investments have been eliminated in consolidation. Zogenix Europe Limited’s functional currency is the U.S. dollar, the reporting currency of its parent.

Fair Value Measurements

The carrying amount of financial instruments consisting of cash, trade accounts receivable, prepaid expenses and other current assets, accounts payable, accrued expenses, accrued compensation, borrowings under the revolving credit facility, and current portion of long-term debt, included in the Company’s consolidated financial statements are reasonable estimates of fair value due to their short maturities. Based on the borrowing rates currently available to the Company for loans with similar terms, management believes the fair value of long-term debt approximates its carrying value. The long-term liability for the two annual tail payments due to Astellas Pharma US, Inc. (Astellas) (See Note 4) for the termination of the Company’s co-promotion agreement were measured at fair value using a present value technique, which incorporated the Company’s own credit risk as measured by the most recent round of debt financing with Healthcare Royalty Partners (Healthcare Royalty) (formerly Cowen Healthcare Royalty Partners II, L.P.).

Authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:


Level 1:		Observable inputs such as quoted prices in active markets;

Level 2:		Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and

Level 3:		Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

We classify our cash equivalents within Level 1 of the fair value hierarchy because we value our cash equivalents using quoted market prices. We classify our common stock warrant liabilities and embedded derivative liabilities within Level 3 of the fair value hierarchy because they are valued using valuation models with significant unobservable inputs. Assets and liabilities measured at fair value on a recurring basis at September 30, 2012 and December 31, 2011 are as follows (in thousands):


	Fair Value Measurements at Reporting Date Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
At September 30, 2012
Assets
Money market fund shares⁽¹⁾	$	45,592		0		0	$	45,592

Liabilities
Common stock warrant liabilities⁽²⁾	$	0		0		24,915	$	24,915
Embedded derivative liabilities⁽³⁾	$	0		0		679	$	679

At December 31, 2011
Assets
Money market fund shares⁽¹⁾	$	49,752		0		0	$	49,752

Liabilities
Common stock warrant liability⁽⁴⁾	$	0		0		345	$	345
Embedded derivative liabilities⁽³⁾	$	0		0		845	$	845

(1)	Money market fund shares are included as a component of cash and cash equivalents on the consolidated balance sheets.

(2)

Common stock warrants are measured at fair value using the Black-Scholes option pricing valuation model and the assumptions identified in (4) below. The following additional assumptions were used in the Black-Scholes option pricing valuation model to measure the fair value of the warrants sold in the July 2012 Offering: (a) management’s projections regarding the probability of the occurrence of an extraordinary event that would require cash settlement of the warrants; and for the valuation scenario in which an extraordinary event occurs, (b) a volatility rate of no more than 40%, as defined in the warrant agreement. Significant increases in the probability of an extraordinary event occurring would result in a significantly lower fair value measurement.

(3)

Embedded derivative liabilities measured at fair value using various discounted cash flow valuation models are included as a component of other long-term liabilities on the consolidated balance sheets. The assumptions used in the discounted cash flow valuation models include: (a) management’s revenue projections and a revenue sensitivity analysis based on possible future outcomes; (b) probability weighted net cash flows based on the likelihood of Healthcare Royalty receiving revenue interest payments over the term of the financing agreement; (c) probability of bankruptcy; (d) weighted average cost of capital that included the addition of a company specific risk premium to account for uncertainty associated with the Company achieving future cash flows; (e) the probability of a change in control occurring during the term of the Healthcare Royalty financing agreement; and (f) the probability of an exercise of the embedded derivative instruments. The significant unobservable inputs used in measuring the fair value of the embedded derivatives are management’s revenue projections. Significant decreases in these significant inputs would result in a higher fair value measurement.

(4)

Common stock warrants are measured at fair value using the Black-Scholes option pricing valuation model. The assumptions used in the Black-Scholes option pricing valuation model were: (a) a risk-free interest rate based on the rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the remaining contractual term of the warrants; (b) an assumed dividend yield of zero based on the Company’s expectation that it will not pay dividends in the foreseeable future; (c) an expected term based on the remaining contractual term of the warrants; and (d) given the Company’s lack of relevant historical data due to the Company’s limited historical experience, an expected volatility based upon the historical volatility of comparable companies whose share prices have been publicly available for a sufficient period of time. The significant unobservable input used in measuring the fair value of the warrant liabilities is the expected volatility based upon the historical volatility of comparable companies. Significant increases in the volatility of comparable companies would result in a higher fair value measurement.

The following table provides a reconciliation of liabilities measured at fair value using significant observable inputs (Level 3) for the nine months ended September 30, 2012 (in thousands):


	Common Stock Warrant Liabilities		Embedded Derivative Liabilities
Balance at December 31, 2011	$	345	$	845
Issuance of common stock warrants		20,959		0
Changes in fair value		3,611		(166	)

Balance at September 30, 2012	$	24,915	$	679

Changes in fair value of the liabilities shown in the table above are recorded through a change in fair value of warrant liabilities and change in fair value of embedded derivatives in other income (expense) in the consolidated statements of operations.

Net Loss per Share

Basic net loss per share is calculated by dividing the net loss by the weighted average number of common shares outstanding for the period reduced by weighted average shares subject to repurchase, without consideration for common stock equivalents. Diluted net loss per share is computed by dividing the net loss by the weighted average number of common share equivalents outstanding for the period determined using the treasury-stock method and as-if converted method, as applicable. For purposes of this calculation, stock options and warrants are considered to be common stock equivalents and are only included in the calculation of diluted net loss per share when their effect is dilutive.

The following table presents the computation of basic and diluted net loss per share (in thousands, except per share amounts):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Numerator
Net loss	$	(19,282	)	$	(22,038	)	$	(46,743	)	$	(60,199	)
Denominator
Weighted average common shares outstanding		90,370			37,320			73,790			35,132
Weighted average shares subject to repurchase		0			0			0			(5	)

Weighted average shares outstanding, basic and diluted		90,370			37,320			73,790			35,127

Basic and diluted net loss per share	$	(0.21	)	$	(0.59	)	$	(0.63	)	$	(1.71	)

The following table presents potentially dilutive securities not included in the calculation of diluted net loss per share because to do so would be anti-dilutive (in thousands, of common equivalent shares):


	Three and Nine Months Ended September 30,
	2012		2011
Common stock warrants		16,285		508
Common stock options and restricted stock units		9,476		3,441

		25,761		3,949

Segment Reporting

Management has determined that the Company operates in one business segment, which is the commercialization and development of pharmaceutical products.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (FASB) issued accounting guidance related to fair value measurements and disclosures to achieve common fair value measurements and disclosures between GAAP and International Financial Reporting Standards. This guidance clarifies the application of certain existing fair value measurement guidance and expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. This guidance is effective on a prospective basis for annual and interim reporting periods beginning on or after December 15, 2011. The Company adopted this guidance on January 1, 2012 and it did not have a material impact on the Company’s results of operations.

In June 2011, the FASB issued an Accounting Standards Update which requires entities to present reclassification adjustments included in other comprehensive income on the face of the financial statements and allows entities to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate consecutive statements. It also eliminates the option for entities to present components of other comprehensive income as part of the statement of changes to stockholders equity. The updated guidance is effective for fiscal and interim periods beginning after December 15, 2011, with early adoption permitted. The Company adopted this guidance on January 1, 2012 and it did not have a material impact on the Company’s results of operations.