Organization and Summary of Significant Accounting Policies

The Company

AcelRx Pharmaceuticals, Inc., or the Company or AcelRx, was incorporated in Delaware on

July 13, 2005

as SuRx, Inc., and in

January 2006,

the Company changed its name to AcelRx Pharmaceuticals, Inc. The Company’s operations are based in Redwood City, California.

AcelRx is a specialty pharmaceutical company focused on the development and commercialization of innovative therapies for use in medically supervised settings. DSUVIA

(known as DZUVEO in Europe) and Zalviso

, are

both focused on the treatment of acute pain, and each utilize sufentanil, delivered via a non-invasive route of sublingual administration, exclusively for use in medically supervised settings. On

November 2, 2018,

the U.S. Food and Drug Administration, or FDA, approved DSUVIA for use in adults in a certified medically supervised healthcare setting, such as hospitals, surgical centers, and emergency departments, for the management of acute pain severe enough to require an opioid analgesic and for which alternative treatments are inadequate. In

June 2018,

the European Commission, or EC, granted marketing approval of DZUVEO for the treatment of patients with moderate-to-severe acute pain in medically monitored settings. AcelRx is further developing a distribution capability and commercial organization to continue to market and sell DSUVIA in the United States. The commercial launch of DSUVIA in the United States occurred in the

first

quarter of

2019.

In geographies where AcelRx decides

not

to commercialize products by itself, including for DZUVEO in Europe, the Company

may

seek to out-license commercialization rights. The Company currently intends to commercialize and promote DSUVIA/DZUVEO outside the United States with

one

or more strategic partners, although it has

not

yet entered into any such arrangement. The timing of the resubmission of the Zalviso new drug application, or NDA, is dependent upon the finalization of the FDA’s new opioid approval guidelines and process. AcelRx intends to seek regulatory approval for Zalviso in the United States and, if successful, potentially promote Zalviso either by itself or with strategic partners. Zalviso is approved in Europe and is currently being commercialized by Grünenthal GmbH, or Grünenthal.

DSUVIA/DZUVEO

DSUVIA, known as DZUVEO in Europe, approved by the FDA in

November 2018

and approved by the EC in

June 2018,

is indicated for use in adults in a certified medically supervised healthcare setting, such as hospitals, surgical centers, and emergency departments, for the management of acute pain severe enough to require an opioid analgesic and for which alternative treatments are inadequate. DSUVIA was designed to provide rapid analgesia via a non-invasive route and to eliminate dosing errors associated with IV administration. DSUVIA is a single-strength solid dosage form administered sublingually via a single-dose applicator, or SDA, by healthcare professionals. Sufentanil is an opioid analgesic currently marketed for intravenous, or IV, and epidural anesthesia and analgesia. The sufentanil pharmacokinetic profile when delivered sublingually avoids the high peak plasma levels and short duration of action observed with IV administration.

DSUVIA was approved with a Risk Evaluation and Mitigation Strategy, or REMS, which restricts distribution to certified medically supervised healthcare settings in order to prevent respiratory depression resulting from accidental exposure. DSUVIA is only distributed to facilities certified in the DSUVIA REMS program following attestation by an authorized representative to comply with appropriate dispensing and use restrictions of DSUVIA. To become certified, a healthcare setting is required to train their healthcare professionals on the proper use of DSUVIA and have the ability to manage respiratory depression. DSUVIA is

not

available in retail pharmacies or for outpatient use. As part of the REMS program, the Company monitors distribution and audits wholesalers’ data, evaluates proper usage within the healthcare settings and monitors for any diversion and abuse. AcelRx will de-certify healthcare settings that are non-compliant with the REMS program.

Zalviso

Zalviso delivers

mcg sufentanil sublingually through a non-invasive delivery route via a pre-programmed, patient-controlled analgesia, or PCA, system. Zalviso is approved in Europe and is in late-stage development in the United States. The Company had initially submitted to the FDA an NDA seeking approval for Zalviso in

September 2013

but received a complete response letter, or CRL, on

July 25, 2014.

Subsequently, the FDA requested an additional clinical study,

IAP312,

designed to evaluate the effectiveness of changes made to the functionality and usability of the Zalviso device and to take into account comments from the FDA on the study protocol. In the

IAP312

study, for which top-line results were announced in

August 2017,

Zalviso met safety, satisfaction and device usability expectations. These results will supplement the

three

Phase

trials already completed in the Zalviso NDA resubmission.

December 16, 2013,

AcelRx and Grünenthal entered into a Collaboration and License Agreement, or the License Agreement, which was amended effective

July 17, 2015

and

September 20, 2016,

or the Amended License Agreement, which grants Grünenthal rights to commercialize the Zalviso PCA system, or the Product, in the

European Union, or EU, member states, at the time of the agreement, plus Switzerland, Liechtenstein, Iceland, Norway and Australia (collectively, the Territory) for human use in pain treatment within, or dispensed by, hospitals, hospices, nursing homes and other medically supervised settings, (collectively, the Field). In

September 2015,

the EC approved the marketing authorization application, or MAA, previously submitted to the EMA, for Zalviso for the management of acute moderate-to-severe post-operative pain in adult patients. On

December 16, 2013,

AcelRx and Grünenthal, entered into a Manufacture and Supply Agreement, or the MSA, and together with the License Agreement, the Agreements. Under the MSA, the Company will exclusively manufacture and supply the Product to Grünenthal for the Field in the Territory. On

July 22, 2015,

the Company and Grünenthal amended the MSA, or the Amended MSA, effective as of

July 17, 2015.

The Amended MSA and the Amended License Agreement are referred to as the Amended Agreements.

The Company has incurred recurring operating losses and negative cash flows from operating activities since inception. Although Zalviso was approved for sale in Europe on

September 18, 2015,

the Company sold the majority of the royalty rights and certain commercial sales milestones it is entitled to receive under the Amended License Agreement with Grünenthal to PDL BioPharma, Inc., or PDL, in a transaction referred to as the Royalty Monetization. The FDA approved DSUVIA in

November 2018

and the Company began its commercial launch of DSUVIA in the

first

quarter of

2019.

As a result, the Company expects to continue to incur operating losses and negative cash flows until such time as DSUVIA has gained market acceptance and generated significant revenues.

Except as the context otherwise requires, when we refer to "we," "our," "us," the "Company" or "AcelRx" in this document, we mean AcelRx Pharmaceuticals, Inc., and its consolidated subsidiary. “DZUVEO” is a trademark, and “ACELRX”, “DSUVIA” and “Zalviso” are registered trademarks, all owned by AcelRx Pharmaceuticals, Inc. This report also contains trademarks and trade names that are the property of their respective owners.

Basis of Presentation

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Actual results could differ from those estimates.

Reclassifications

Certain prior year amounts in the Consolidated Financial Statements have been reclassified to conform to the current year's presentation. In particular, the amount reported in the Consolidated Balance Sheets as restricted cash has been reclassified to other assets at

December 31, 2018,

the amounts reported in the Consolidated Balance Sheets as deferred rent and contingent put option liability have been reclassified to other long-term liabilities at

December 31, 2018,

and Zalviso product sales revenue has been reclassified to product sales from contract and other collaboration in the Consolidated Statements of Comprehensive Loss.

Principles of Consolidation

The Consolidated Financial Statements include the accounts of the Company and its wholly owned subsidiary, ARPI LLC, which was formed in

September 2015

for the sole purpose of facilitating the Royalty Monetization with PDL of the expected royalty stream and milestone payments due from the sales of Zalviso in the European Union by its commercial partner, Grünenthal, pursuant to the Amended License Agreement. All intercompany accounts and transactions have been eliminated in consolidation. Refer to Note

“Liability Related to Sale of Future Royalties” for additional information.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Management evaluates its estimates on an ongoing basis including critical accounting policies. Estimates are based on historical experience and on various other market-specific and other relevant assumptions that the Company believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are

not

readily apparent from other sources. Actual results could differ from those estimates.

Cash, Cash Equivalents and Short-Term Investments

The Company considers all highly liquid investments with an original maturity (at date of purchase) of

three

months or less to be cash equivalents. Cash and cash equivalents consist of cash on deposit with banks.

All marketable securities are classified as available-for-sale and consist of commercial paper, U.S. government sponsored enterprise debt securities and corporate debt securities. These securities are carried at estimated fair value, which is based on quoted market prices or observable market inputs of almost identical assets, with unrealized gains and losses included in accumulated other comprehensive income (loss). The amortized cost of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization and accretion is included in interest income or expense. The cost of securities sold is based on specific identification. The Company’s investments are subject to a periodic impairment review for other-than-temporary declines in fair value. The Company’s review includes the consideration of the cause of the impairment including the creditworthiness of the security issuers, the number of securities in an unrealized loss position, the severity and duration of the unrealized losses and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in the market value. When the Company determines that the decline in fair value of an investment is below its accounting basis and this decline is other-than-temporary, it reduces the carrying value of the security it holds and records a loss in the amount of such decline.

Fair Value of Financial Instruments

The Company measures and reports its cash equivalents, investments and financial liabilities at fair value. Fair value is defined as the exchange price that would be received for an asset or an exit price paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy defines a

three

-level valuation hierarchy for disclosure of fair value measurements as follows:

Level I—Unadjusted quoted prices in active markets for identical assets or liabilities;

Level II—Inputs other than quoted prices included within Level I that are observable, unadjusted quoted prices in markets that are

not

active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities; and

Level III—Unobservable inputs that are supported by little or

market activity for the related assets or liabilities.

The categorization of a financial instrument within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Segment Information

The Company operates in a single segment, the development and commercialization of product candidates and products for the treatment of pain. The Company’s net product sales revenue relates to sales in the United States. The Company’s collaboration revenue relates to the Amended License Agreement with Grünenthal to commercialize Zalviso in the countries of the European Union, Switzerland, Liechtenstein, Iceland, Norway and Australia. The Company’s contract and other revenue relates to the U.S. Department of Defense funding that supported the development of DSUVIA in the United States.

Concentration of Risk

The Company invests cash that is currently

not

being used for operational purposes in accordance with its investment policy in debt securities of U.S. government sponsored agencies and overnight deposits. The Company is exposed to credit risk in the event of default by the institutions holding the cash equivalents and available-for-sale securities to the extent recorded on the Consolidated Balance Sheets.

The Company relies on a single

third

-party supplier for the supply of sufentanil, the active pharmaceutical ingredient in DSUVIA and Zalviso, and various sole-source

third

-party contract manufacturer organizations to manufacture the DSUVIA SDA and Zalviso drug cartridge and device components, including the controller, the dispenser kit and the accessories.

DSUVIA is available in the U.S. for distribution primarily through a limited number of wholesalers and is

not

available in retail pharmacies. Zalviso is sold in Europe by the Company’s collaboration partner, Grünenthal. Revenue and accounts receivable are concentrated with these customers.

Accounts Receivable,

The Company has receivables from its distributors and collaboration partner, Grünenthal. To date, the Company has

not

had a bad debt allowance because of the limited number of financially sound customers who have historically paid their balances timely. The need for a bad debt allowance is evaluated each reporting period based on the Company’s assessment of the credit worthiness of its customers or any other potential circumstances that could result in bad debt.

The Company has

not

experienced any losses with respect to the collection of its accounts receivable and believes that the entire accounts receivable balance as of

December 31, 2019

is collectible.

Inventories

, net

Inventories are valued at the lower of cost or net realizable value. Cost is determined using the

first

-in,

first

-out method for all inventories. Inventory includes the cost of the active pharmaceutical ingredients, or API, raw materials and

third

-party contract manufacturing and packaging services. Indirect overhead costs associated with production and distribution are allocated to the appropriate cost pool and then absorbed into inventory based on the units produced or distributed, assuming normal capacity, in the applicable period. Indirect overhead costs in excess of normal capacity are recorded as period costs in the period incurred. DSUVIA was approved by the FDA in

November 2018.

Prior to FDA approval, all manufacturing costs for DSUVIA were expensed to research and development. Upon FDA approval, manufacturing costs for DSUVIA manufactured for commercial sale have been capitalized.

The Company's policy is to write down inventory that has become obsolete, inventory that has a cost basis in excess of its expected net realizable value and inventory in excess of expected requirements. The Company periodically evaluates the carrying value of inventory on hand for potential excess amount over demand using the same lower of cost or net realizable value approach as that used to value the inventory. Because the predetermined, contractual transfer prices the Company is receiving from Grünenthal are less than the direct costs of manufacturing, all Zalviso inventories are carried at net realizable value.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, generally

three

five

years. Leasehold improvements are amortized over the shorter of the estimated useful life of the improvements or the remaining lease term. Expenditures for repairs and maintenance, which do

not

extend the useful life of the property and equipment, are expensed as incurred. Upon retirement, the asset cost and related accumulated depreciation are relieved from the accompanying Consolidated Balance Sheets. Gains and losses associated with dispositions are reflected as a component of other expense in the accompanying Consolidated Statements of Comprehensive Loss.

Impairment of Long-Lived Assets

The Company periodically assesses the impairment of long-lived assets and, if indicators of asset impairment exist, the Company assesses the recoverability of the affected long-lived assets by determining whether the carrying value of such assets can be recovered through an analysis of the undiscounted future expected operating cash flows. If impairment is indicated, the Company records the amount of such impairment for the excess of the carrying value of the asset over its estimated fair value. For example, if the Company is

not

successful in its commercialization of DSUVIA, and if approved, Zalviso, purchased equipment and manufacturing-related facility improvements the Company has made at its contract manufacturers could become impaired. The Company

may

determine that it is

longer probable that the Company will realize the future economic benefit associated with the costs of these assets through future manufacturing activities, and if so, the Company would record an impairment charge associated with these assets.

Contingent put option

The contingent put option associated with the Company’s Loan Agreement with Oxford is recorded as a liability. Changes in the fair value of the contingent put option are recognized as interest income and other income (expense), net in the Consolidated Statements of Comprehensive Loss. For further discussion, see Note

“Long-Term Debt”.

Leases

February 2016,

the FASB issued Accounting Standards Update, or ASU,

No.

2016

02,

Leases (Topic

842

)

, to enhance the transparency and comparability of financial reporting related to leasing arrangements. The Company adopted the standard effective

January 1, 2019.

At the inception of an arrangement, the Company determines whether the arrangement is or contains a lease based on the unique facts and circumstances present. Operating lease liabilities and their corresponding right-of-use assets are recorded based on the present value of lease payments over the expected lease term. The interest rate implicit in lease contracts is typically

not

readily determinable. As such, the Company utilizes its incremental borrowing rate, which is the rate incurred to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. Certain adjustments to the right-of-use asset

may

be required for items such as initial direct costs paid or incentives received.

Lease expense is recognized over the expected term on a straight-line basis. Operating leases are recognized on the balance sheet as right-of-use assets, operating lease liabilities current and operating lease liabilities non-current. As a result, the Company

longer recognizes deferred rent on the balance sheet.

Revenue from Contracts with Customers

Beginning

January

2018,

the Company has followed the provisions of Accounting Standards Codification, or ASC, Topic

606,

Revenue from Contracts with Customers

. This guidance provides a unified model to determine how revenue is recognized. The Company recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company sells its products primarily through wholesale distributors.

In determining the appropriate amount of revenue to be recognized as it fulfills its obligations under its agreements, the Company performs the following steps: (i) identification of the promised goods or services in the contract; (ii) determination of whether the promised goods or services are performance obligations, including whether they are distinct in the context of the contract; (iii) measurement of the transaction price, including the constraint on variable consideration; (iv) allocation of the transaction price to the performance obligations based on estimated selling prices; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.

Product sales revenue

Revenues from product sales are recognized when distributors obtain control of the Company’s product, which occurs at a point in time, upon delivery to such distributors. These distributors subsequently resell the product to certified medically supervised healthcare settings. In addition to distribution agreements with these customers, the Company enters into arrangements with group purchasing organizations, or GPOs, and other certified medically supervised healthcare settings that provide for privately negotiated discounts with respect to the purchase of its products. Revenue from product sales is recorded at the transaction price, net of estimates for variable consideration consisting of distributor fees, GPO discounts, GPO administrative fees and returns. Variable consideration is recorded at the time product sales are recognized resulting in a reduction in product revenue. The amount of variable consideration that is included in the transaction price

may

be constrained and is included in the net sales price only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue recognized will

not

occur in a future period. Variable consideration is estimated using the most-likely amount method, which is the single-most likely outcome under a contract and is typically at the stated contractual rate. Where appropriate, these estimates take into consideration a range of possible outcomes that are probability-weighted in accordance with the expected value method under ASC Topic

606

for relevant factors. These factors include current contractual and statutory requirements, specific known market events and trends, industry data, and/or forecasted customer buying and payment patterns. Actual amounts of consideration ultimately received

may

differ from the Company’s estimates. If actual results vary materially from the Company’s estimates, the Company will adjust these estimates, which will affect revenue from product sales and earnings in the period such estimates are adjusted. These estimates include:

●

Distributor Fees – The Company offers contractually determined fees to its distributors.

●

GPO Discounts - The Company offers discounts to GPO members. These discounts are taken when the GPO members purchase DSUVIA from the Company’s distributors, who then charge the discount amount back to the Company.

●

GPO Administrative Fees - The Company pays administrative fees to GPOs for services and access to data. These fees are based on contracted terms and are paid after the quarter in which the product was purchased by the GPOs’ members.

●

Returns – The Company allows its distributors to return product for credit up to

months after its product expiration date. As such, there

may

be a significant period of time between the time the product is shipped and the time the credit is issued on returned product.

●

Prompt Pay Discounts – The Company offers cash discounts to its distributors, generally

of the sales price, as an incentive for prompt payment. The Company accounts for cash discounts by reducing accounts receivable by the prompt pay discount amount and recognizes the discount as a reduction of revenue in the same period the related revenue is recognized.

The Company believes its estimated allowance for product returns requires a high degree of judgment and is subject to change based on its limited experience and certain quantitative and qualitative factors. The Company believes its estimated allowances for distributor fees, GPO discounts and GPO administrative fees and prompt pay discounts do

not

require a high degree of judgment because the amounts are settled within a relatively short period of time.

Amounts accrued for product revenue allowances and related accruals are evaluated each reporting period and adjusted when trends or significant events indicate that a change in estimate is appropriate and to reflect actual experience. Product revenue-related liabilities are recorded in the Company’s Consolidated Balance Sheets as accrued liabilities, while prompt pay discounts are recorded in the Company’s Consolidated Balance Sheets as a reduction in accounts receivable. The Company will continue to assess its estimates of variable consideration as it accumulates additional historical data and will adjust these estimates accordingly. Changes in product revenue allowance estimates could materially affect the Company’s results of operations and financial position.

Contract and other

collaboration

revenue

The Company entered into award contracts with U.S. Department of Defense, or the DoD, to support the development of DSUVIA. These contracts provided for the reimbursement of qualified expenses for research and development activities. Revenue under these arrangements was recognized when the related qualified research expenses were incurred. The Company was entitled to reimbursement of overhead costs associated with the study costs under the DoD arrangements. The Company estimated this overhead rate by utilizing forecasted expenditures. Final reimbursable overhead expenses were dependent on direct labor and direct reimbursable expenses throughout the life of each contract, which increased or decreased based on actual expenses incurred.

The Company generates revenue from collaboration agreements. These agreements typically include payments for upfront signing or license fees, cost reimbursements for development and manufacturing services, milestone payments, product sales, and royalties on licensee’s future product sales. Product sales related revenue under these collaboration agreements is classified as product sales revenue, while other revenue generated from collaboration agreements is classified as contract and other collaboration revenue.

Performance Obligations

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account in ASC Topic

606.

The Company’s performance obligations include delivering product to its distributors, commercialization license rights, development services, services associated with the regulatory approval process, joint steering committee services, demonstration devices, manufacturing services, material rights for discounts on manufacturing services, and product supply.

The Company has optional additional items in contracts, which are considered marketing offers and are accounted for as separate contracts when the customer elects such options. Arrangements that include a promise for future commercial product supply and optional research and development services at the customer’s or the Company’s discretion are generally considered as options. The Company assesses if these options provide a material right to the licensee and if so, such material rights are accounted for as separate performance obligations. If the Company is entitled to additional payments when the customer exercises these options, any additional payments are recorded in revenue when the customer obtains control of the goods or services.

Transaction Price

The Company has both fixed and variable consideration. Variable consideration for product revenue is described as Net product sales in the Consolidated Statements of Comprehensive Loss. For collaboration agreements, non-refundable upfront fees and product supply selling prices are considered fixed, while milestone payments are identified as variable consideration when determining the transaction price. Funding of research and development activities is considered variable until such costs are reimbursed at which point, they are considered fixed. The Company allocates the total transaction price to each performance obligation based on the relative estimated standalone selling prices of the promised goods or services for each performance obligation.

At the inception of each arrangement that includes milestone payments, the Company evaluates whether the milestones are considered probable of being achieved and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal would

not

occur, the value of the associated milestone (such as a regulatory submission by the Company) is included in the transaction price. Milestone payments that are

not

within the control of the Company, such as approvals from regulators, are

not

considered probable of being achieved until those approvals are received.

For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, the Company recognizes revenue at the later of (a) when the related sales occur, or (b) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied).

Allocation of Consideration

As part of the accounting for collaboration arrangements, the Company must develop assumptions that require judgment to determine the stand-alone selling price of each performance obligation identified in the contract. Estimated selling prices for license rights and material rights for discounts on manufacturing services are calculated using an income approach model and can include the following key assumptions: the development timeline, sales forecasts, costs of product sales, commercialization expenses, discount rate, the time which the manufacturing services are expected to be performed, and probabilities of technical and regulatory success. For all other performance obligations, the Company uses a cost- plus margin approach.

Timing of Recognition

Significant management judgment is required to determine the level of effort required under collaboration arrangements and the period over which the Company expects to complete its performance obligations under the arrangement. The Company estimates the performance period or measure of progress at the inception of the arrangement and re-evaluates it each reporting period. This re-evaluation

may

shorten or lengthen the period over which revenue is recognized. Changes to these estimates are recorded on a cumulative catch up basis. If the Company cannot reasonably estimate when its performance obligations either are completed or become inconsequential, then revenue recognition is deferred until the Company can reasonably make such estimates. Revenue is then recognized over the remaining estimated period of performance using the cumulative catch-up method. Revenue is recognized for products at a point in time when control of the product is transferred to the customer in an amount that reflects the consideration the Company expects to be entitled to in exchange for those product sales, which is typically once the product physically arrives at the customer, and for licenses of functional intellectual property at the point in time the customer can use and benefit from the license. For performance obligations that are services, revenue is recognized over time proportionate to the costs that the Company has incurred to perform the services using the cost-to-cost input method.

Cost of Goods Sold

Cost of goods sold for product revenue includes

third

party manufacturing costs, shipping and handling costs, and indirect overhead costs associated with production and distribution which are allocated to the appropriate cost pool and recognized when revenue is recognized. Indirect overhead costs in excess of normal capacity are recorded as period costs in the period incurred.

Under the Amended Agreements with Grünenthal, the Company sells Zalviso to Grünenthal at predetermined, contractual transfer prices that are less than the direct costs of manufacturing and recognizes indirect costs as period costs where they are in excess of normal capacity and

not

recoverable on a lower of cost or net realizable value basis. Cost of goods sold for Zalviso shipped to Grünenthal includes the inventory costs of API,

third

-party contract manufacturing costs, packaging and distribution costs, shipping, handling and storage costs, depreciation and costs of the employees involved with production.

Research and Development Expenses

Research and development costs are charged to expense when incurred. Research and development expenses include salaries, employee benefits, including stock-based compensation, consultant fees, laboratory supplies, costs associated with clinical trials and manufacturing, including contract research organization fees, other professional services and allocations of corporate costs. The Company reviews and accrues clinical trial expenses based on work performed, which relies on estimates of total costs incurred based on patient enrollment, completion of patient studies and other events.

Advertising

Expenses

Advertising costs are expensed as incurred. Advertising expenses were

$1.1

million,

$0.5

million and

$0.0

million for the years ended

December 31, 2019,

2018

and

2017,

respectively, and are included in selling, general and administrative expenses in the Consolidated Statements of Comprehensive Loss.

Stock-Based Compensation

Compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and restricted stock units related to the

2011

Equity Incentive Plan, or

2011

EIP, and employee share purchases related to the

2011

Employee Stock Purchase Plan, or ESPP, is based on estimated fair values at grant date. The Company determines the grant date fair value of the awards using the Black-Scholes option-pricing model and generally recognizes the fair value as stock-based compensation expense on a straight-line basis over the vesting period of the respective awards.

The Black-Scholes option pricing model requires inputs such as expected term, expected volatility and risk-free interest rate. These inputs are subjective and generally require significant analysis and judgment to develop. The Company uses its historical option exercise experience and the volatility of its common stock as the basis for its assumptions regarding expected term and volatility. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant commensurate with the expected life assumption. Effective

January 1, 2017,

the Company adopted ASU

2016

and elected to recognize forfeitures when they occur using a modified retrospective approach, which did

not

have a material impact on its Consolidated Financial Statements.

Non-Cash Interest Income (Expense) on Liability Related to Sale of Future Royalties

September 2015,

the Company sold certain royalty and milestone payment rights from the sales of Zalviso in the European Union by its commercial partner, Grünenthal, pursuant to the License Agreement, as then amended, to PDL for gross proceeds of

$65.0

million. The Company continues to have significant continuing involvement in the Royalty Monetization primarily due to an obligation to supply Zalviso to Grünenthal. Under the relevant accounting guidance, because of the Company’s significant continuing involvement, the Royalty Monetization is accounted for as a liability that is being amortized using the effective interest method over the life of the arrangement. In order to determine the amortization of the liability, the Company is required to estimate the total amount of future royalty and milestone payments to be received by ARPI LLC and payments made to PDL, up to a capped amount of

$195.0

million, over the life of the arrangement. The aggregate future estimated royalty and milestone payments (subject to the capped amount), less the

$61.2

million of net proceeds the Company received, are amortized as interest expense over the life of the liability. Consequently, the Company imputes interest on the unamortized portion of the liability and records interest expense, or interest income, as these estimates are updated.

There are a number of factors that could materially affect the amount and timing of royalty and milestone payments from Zalviso in Europe, most of which are

not

within the Company’s control. Such factors include, but are

not

limited to, the success of Grünenthal’s sales and promotion of Zalviso, changing standards of care, the introduction of competing products, manufacturing or other delays, intellectual property matters, adverse events that result in governmental health authority imposed restrictions on the use of Zalviso, significant changes in foreign exchange rates as the royalties remitted to ARPI LLC are made in U.S. dollars, and other events or circumstances that could result in reduced royalty payments from European sales of Zalviso, all of which

may

result in a reduction of non-cash royalty revenues and the non-cash interest expense over the life of the Royalty Monetization. Conversely, if sales of Zalviso in Europe are more than expected, the non-cash royalty revenues and the non-cash interest expense recorded by the Company would be greater over the term of the Royalty Monetization. The Company periodically assesses the expected royalty and milestone payments using a combination of historical results, internal projections and forecasts from external sources. To the extent such payments are greater or less than the Company’s initial estimates or the timing of such payments is materially different than its original estimates, the Company will prospectively adjust the amortization of the liability and the interest rate. Because estimated sales forecasts and payments

may

vary over the life of the Royalty Monetization, the Company

may

be required to recognize interest income as the imputed interest rate is adjusted prospectively to reflect the revised effective interest rate over the term of the Royalty Monetization.

The Company records non-cash royalty revenues and non-cash interest income (expense), net, within its Consolidated Statements of Comprehensive Loss over the term of the Royalty Monetization.

When the expected payments under the Royalty Monetization are lower than the gross proceeds of

$65.0

million received, the Company defers recognition of any probable contingent gain until the Royalty Monetization liability expires.

Comprehensive Loss

Comprehensive loss is comprised of net loss and other comprehensive income (loss) and is disclosed in the Consolidated Statements of Comprehensive Loss. For the Company, other comprehensive income (loss) consists of changes in unrealized gains and losses on the Company’s investments.

Income Taxes

Deferred tax assets and liabilities are measured based on differences between the financial reporting and tax basis of assets and liabilities using enacted rates and laws that are expected to be in effect when the differences are expected to reverse. The Company records a valuation allowance for the full amount of deferred assets, which would otherwise be recorded for tax benefits relating to operating loss and tax credit carryforwards, as realization of such deferred tax assets cannot be determined to be more likely than

not.

Net Loss per Share of Common Stock

The Company’s basic net loss per share of common stock is calculated by dividing the net loss by the weighted average number of shares of common stock outstanding for the period. The diluted net loss per share of common stock is computed by giving effect to all potential common stock equivalents outstanding for the period determined using the treasury stock method. For purposes of this calculation, convertible preferred stock, options to purchase common stock, restricted stock subject to repurchase, restricted stock units, warrants to purchase convertible preferred stock and warrants to purchase common stock were considered to be common stock equivalents. In periods with a reported net loss, such common stock equivalents are excluded from the calculation of diluted net loss per share of common stock if their effect is antidilutive. For additional information regarding the net loss per share, see Note

“Net Loss per Share of Common Stock”.

Recently Adopted Accounting Pronouncement

August 29, 2018,

the Financial Accounting Standards Board, or FASB, issued ASU

No.

2018

15,

“

Intangibles – Goodwill and Other – Internal Use Software (Subtopic

350

)”

. The FASB’s new guidance aligns the requirements for capitalizing implementation costs in a Cloud Computing Arrangement, or CCA, service contract with the requirements for capitalizing implementation costs incurred for an internal-use software license.

The amendments in ASU

No.

2018

require the entity to present the expense related to the capitalized implementation costs in the same line item in the statement of income as the fees associated with the hosting element (service) of the arrangement and classify payments for capitalized implementation costs in the statement of cash flows in the same manner as payments made for fees associated with the hosting element. The entity is also required to present the capitalized implementation costs in the statement of financial position in the same line item that a prepayment for the fees of the associated hosting arrangement would be presented.

ASU

No.

2018

is effective for public business entities for fiscal years beginning after

December 15, 2019,

and interim periods within those fiscal years. Early adoption is permitted, including adoption in any interim period for which financial statements have

not

been issued. Entities can choose to adopt the new guidance (

) prospectively to eligible costs incurred on or after the date this guidance is

first

applied or (

) retrospectively. The Company early adopted ASU

No.

2018

effective

January 1, 2019

under the prospective method, which did

not

have a material effect on the Company’s results of operations, financial condition or cash flows.

August 2018,

the U.S. Securities and Exchange Commission, or SEC, published Release

No.

10532,

Disclosure Update and Simplification,

or DUSTR, which adopted amendments to certain disclosure requirements that have become redundant, duplicative, overlapping, outdated or superseded, in light of other SEC disclosure requirements, U.S. Generally Accepted Accounting Principles, or GAAP, or changes in the information environment. While most of the DUSTR amendments eliminate outdated or duplicative disclosure requirements, the final rule amends the interim financial statement requirements to include a reconciliation of changes in stockholders’ (deficit) equity in the notes or as a separate statement for each period for which a statement of comprehensive loss is required to be filed. The new interim reconciliation of changes in stockholders’ (deficit) equity has been included in the Company's interim financial statements effective

January 1, 2019.

February 2016,

the FASB issued ASU

No.

2016

02,

Leases (Topic

842

)

, which establishes a new lease accounting model for lessees. In

January,

July

and

December 2018,

the FASB issued additional amendments to the new lease guidance relating to, transition, and clarification. The

July 2018

amendment, ASU

No.

2018

11,

Leases (Topic

842

): Targeted Improvements

, provided an optional transition method that allows entities to elect to apply the standard prospectively at its effective date, versus recasting the prior periods presented. The new standard establishes a right-of-use, or ROU, model that requires a lessee to record an ROU asset and a lease liability on the balance sheet for all leases with terms longer than

months. Disclosure requirements have been enhanced with the objective of enabling financial statement users to assess the amount, timing, and uncertainty of cash flows arising from leases. ASU

No.

2016

became effective for the Company on

January 1, 2019.

The Company has implemented the standard using an optional transition method that allows the Company to initially apply the new leases standard as of the adoption date and recognize a cumulative-effect adjustment to the opening balance of accumulated deficit in the period of adoption. In connection with the adoption, the Company has elected to utilize the package of practical expedients, including: (

)

not

reassess the lease classification for any expired or existing leases, (

)

not

reassess the treatment of initial direct costs as they related to existing leases, and (

)

not

reassess whether expired or existing contracts are or contain leases. In addition, the Company elected the hindsight practical expedient to determine the lease term for existing leases. The election of the hindsight practical expedient resulted in the extension of the lease term for the Company’s embedded lease.

The adoption of the new leases standard resulted in the following adjustments to the Consolidated Balance Sheets as of

January 1, 2019 (

in thousands):

	Increase/(Decrease)
Operating lease right-of-use assets	$	4,730
Accrued liabilities (a)	$	(100	)
Operating lease liabilities	$	484
Operating lease liabilities, net of current portion	$	4,610
Deferred rent, net of current portion	$	(416	)
Accumulated deficit (b)	$	(153	)

	(a)	Represents current portion of Deferred rent reclassified to Operating lease liabilities.

	(b)	Represents cumulative-effect adjustment upon adoption of ASU No. 2016 - 02.

The adoption of ASU

No.

2016

02,

the new leases standard, did

not

impact previously reported financial results because the impact to prior periods was reflected as a cumulative-effect adjustment to the accumulated deficit under the optional transition method.

Recently Issued Accounting Pronouncements

June 2016,

the FASB issued ASU

2016

13,

“

Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments,

” or ASU

2016

13.

ASU

2016

replaces the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. ASU

2016

is effective for the Company beginning

January 1, 2023,

with early adoption allowed beginning

January 1, 2020.

May 2019,

the FASB issued ASU

2019

05,

“

Financial Instruments – Credit Losses”

, or ASU

2019

05,

to allow entities to irrevocably elect the fair value option for certain financial assets previously measured at amortized cost upon adoption of the new credit losses standard. The new effective dates and transition align with those of ASU

2016

13.

Management is currently assessing the date of adoption and the impact ASU

2016

and ASU

2019

will have on the Company, but it does

not

anticipate adoption of these new standards to have a material impact on the Company’s financial position, results of operations and cash flows.