Commitments and Contingencies

Lease Obligations

Primary Facility Lease

In August 2015, the Company entered into a lease agreement for approximately 51,000 rentable square feet of facility space in Morrisville, North Carolina, commencing in April 2016 (the “Primary Facility Lease”). The initial term of the Primary Facility Lease extends through June 30, 2026. The Company has an option to extend the Primary Facility Lease by five years upon completion of the initial lease term. Current contractual base rent payments are $95 per month, subject to a three percent increase annually over the term of the Primary Facility Lease.

As a result of the nature of and the involvement in the renovations during the construction period of the leased space, the Company was the “deemed owner,” for accounting purposes only, of the construction project and was required to capitalize the fair value of the building as well as the construction costs incurred by either the landlord or the Company on its consolidated balance sheet pursuant to FASB ASC 840, Leases, and the accounting policy described in Note 1—Organization and Significant Accounting Policies. The Company determined that the facility was substantially complete as of December 31, 2016 because the Company began to utilize the facility for all intended purposes, including primary research, development and drug compound manufacturing operations, in addition to administrative and corporate headquarters activities. Following the determination that the facility was substantially complete, the Company assessed the facility for sale-leaseback criteria qualification, which could result in a de-recognition of the building asset and the related financing obligation. The Company concluded that the facility did not meet the sale-leaseback criteria due to the Company’s continuing involvement in the leased facility. As a result, the facility is being accounted for as an asset financing, with the building asset and related facility financing obligation remaining on the Company’s balance sheet. The building asset is being depreciated over a 25 year period and the facility financing obligation will be amortized so that the net carrying value of the building asset and the facility financing obligation are equivalent at the end of the initial term of the lease agreement. Monthly rental payments will be allocated between principal and interest expense associated with the facility financing obligation, as well as grounds rent expense of $8 per month.

The Company has recorded an asset related to the building and construction costs within property and equipment of $10,557 as of December 31, 2018 and 2017. The non-current facility lease obligation on the Company’s consolidated balance sheet is $7,998 as of December 31, 2018 and 2017. During the years ended December 31, 2018 and 2017, the Company recognized interest expense related to the primary facility lease of $1,044, and $1,044, respectively, including $41 and $37 of accrued interest included in other accrued expenses as of December 31, 2018 and 2017, respectively.

Rent expense associated with the primary facility lease, comprised of monthly grounds rent and common area maintenance costs, was $308 and $355 for the years ended December 31, 2018 and 2017, respectively.

Future minimum payments, including interest, required under the Company’s primary facility lease agreement, accounted for as an asset financing as of December 31, 2018 are as follows:



	Build-to-Suit Lease
2019	$	1,170
2020	1,205
2021	1,241
2022	1,278
2023	1,317
Thereafter	3,467
Total minimum lease payments	$	9,678

In May 2018, the Company entered into a sublease agreement under the Primary Facility Lease whereby the Company is the lessor and is subleasing approximately 6,400 square feet of office space to a third party at its leased headquarters facility in Morrisville, North Carolina. The sublease will expire in July 2021, unless sooner terminated in accordance with the provisions of the sublease. If for any reason, the lease between the Company and its landlord is terminated, the sublease will simultaneously terminate. The annual rent payments due to the Company, beginning August 2018, are approximately $141 per year, subject to a three percent increase annually over the term of the sublease agreement. The Company recognized $59 of rental income for the year ended December 31, 2018, included as a component of other income and expense in the Company’s consolidated statements of operations and comprehensive loss.

Operating Leases

Rent expense for operating leases totaled $308 and $440 for the years ended December 31, 2018 and 2017, respectively.

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of business activities. The Company accrues a liability for such matters when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. See Legal Proceedings below for further discussion of pending legal claims.

The Company has entered into, and expects to continue to enter into, contracts in the normal course of business with various third parties who support its clinical trials, preclinical research studies and other services related to its development activities. The scope of the services under these agreements can generally be modified at any time, and these agreements can generally be terminated by either party after a period of notice and receipt of written notice. There have been no material contract terminations as of December 31, 2018.

Legal Proceedings

In prior filings, the Company reported that it was subject to putative stockholder class action lawsuits that were filed in November 2017 in the United States District Court for the Middle District of North Carolina against the Company and certain of its current and former directors and officers, which were consolidated under the case name In re Novan, Inc. Securities Litigation. The consolidated amended complaint filed by the designated lead plaintiff asserted claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to the Company’s Phase 3 clinical trials of SB204. On June 14, 2018, the Company filed a motion to dismiss the consolidated amended complaint. On November 30, 2018, a federal magistrate judge entered an order recommending that the district court grant the Company’s motion. The plaintiff filed objections to this recommendation and the Company filed a response. On January 28, 2019, the district court adopted the magistrate judge’s recommendation, dismissed the action with prejudice and entered judgment in favor of the Company and against the plaintiff. The plaintiff did not appeal this dismissal and judgment. As such, the Company has concluded that this matter is closed.

Other than as described above, the Company is not currently a party to any material legal proceedings and is not aware of any claims or actions pending or threatened against the Company that the Company believes could have a material adverse effect on the Company’s business, operating results, cash flows or financial statements. In the future, the Company might from time to time become involved in litigation relating to claims arising from its ordinary course of business.

Compensatory Obligations

In conjunction with the departures of three former Company officers in 2018 and 2017, the Company entered into separation and general release agreements that included separation benefits consistent with the Company’s obligations under their previously existing employment agreements for “separation from service” for “good reason.” The Company recognized related severance expense of $332 and $793 during the years ended December 31, 2018 and 2017, respectively. The accrued severance obligation in respect of the three former officers was fully paid as of December 31, 2018. The Company also recognized approximately $212 and $374 in stock compensation expense during the years ended December 31, 2018 and 2017, respectively, related to the accelerated vesting of the former officers’ stock options.

In November 2018, the Company realigned its overall employee headcount to reduce certain fixed costs. Total employee severance costs associated with this action are expected to be $306, of which $196 was expensed during the year-ended December 31, 2018. As of December 31, 2018, severance costs of $37 were accrued in the accompanying consolidated balance sheet.

In June 2017, the Company reduced its overall employee workforce to reduce operating expenditures and preserve cash on hand. Employee severance costs associated with this action were $224, which were expensed during the second quarter of 2017. These severance costs were fully paid as of December 31, 2017.

See “Note 10-Share-Based Compensation” regarding the Stock Appreciation Rights issued in August 2018.

See “Note 11-Tangible Stockholder Return Plan” regarding the Tangible Stockholder Return Plan adopted in August 2018.