ntra_Current folio

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2017

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-37478

NATERA, INC.

(Exact Name of Registrant as Specified in Its Charter)


Delaware	01‑0894487
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)


201 Industrial Road, Suite 410 San Carlos, CA	94070
(Address of Principal Executive Offices)	(Zip Code)

(650) 249‑9090

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer	☐	Accelerated filer	☒
Non-accelerated filer	☐ (Do not check if a smaller reporting company)	Smaller reporting company	☐
Emerging growth company	☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

As of October 30, 2017, the number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, was 53,768,979.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements. The forward-looking statements are contained principally in the sections titled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” but are also contained elsewhere in this report. Forward-looking statements include information concerning our future results of operations and financial position, strategy and plans, and our expectations for future operations. Forward-looking statements include all statements that are not historical facts and, in some cases, can be identified by terms such as "believe," "may," "will," "estimate," "continue," "anticipate," "design," "intend," "expect," "could," "plan," "potential," "predict," "seek," "should," "would" or the negative version of these words and similar expressions.

Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements, including those described in "Risk Factors" and elsewhere in this report. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our beliefs and assumptions only as of the date of this report. In light of the significant uncertainties in these forward-looking statements, you should not regard these statements as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified time frame, or at all. You should read this report completely and with the understanding that our actual future results may be materially different from what we expect.

These forward-looking statements include, but are not limited to, statements concerning the following:

our expectation that, for the foreseeable future, a significant portion of our revenues will be derived from sales of Panorama;

our ability to increase demand for Panorama, obtain favorable coverage and reimbursement determinations from third-party payers, and expand geographically;

our expectation that Panorama will be adopted for broader use in average-risk pregnancies and for the screening of microdeletions and that third-party payer reimbursement will be available for these applications;

our expectations of the reliability, accuracy, and performance of Panorama, as well as expectations of the benefits to patients, providers, and payers of Panorama;

our ability to successfully develop additional revenue opportunities and expand our product offerings to include new tests, including in the field of cancer diagnostics;

the effect of improvements in our cost of goods sold;

the effect of changes in the way we account for our revenue;

the scope of protection we establish and maintain for, and developments or disputes concerning, our intellectual property or other proprietary rights;

competition in the markets we serve;

our ability to successfully commercialize our cloud-based distribution model;

our reliance on collaborators such as medical institutions, contract laboratories, laboratory partners, and other third parties;

our ability to operate our laboratory facility and meet expected demand;

our reliance on a limited number of suppliers, including sole source suppliers, which may impact our availability to maintain a continued supply of laboratory instruments and materials and to run our tests;

our expectations of the rate of adoption of Panorama and of any of our other current or future tests by laboratories, clinics, clinicians, payers, and patients;

our ability to complete clinical studies and publish clinical data in peer-reviewed medical publications regarding Panorama and any of our future tests;

our ability to successfully commercialize our EvercordTM cord blood and tissue banking service offering;

our reliance on our partners to market and offer Panorama in the United States and in international markets;

our estimates regarding our costs and risks associated with our international operations and international expansion;

PART I – FINANCIAL INFORMATION

ITEM 1.FINANCIAL STATEMENTS

Natera, Inc.

Condensed Consolidated Balance Sheets

(In thousands)


	September 30,		December 31,
	2017		2016
Assets		(unaudited)		(Note 2)
Current assets:
Cash and cash equivalents	$	11,211	$	15,256
Restricted cash, current portion		45		1,092
Short-term investments		135,017		130,860
Accounts receivable, net of allowance of $1,795 in 2017 and $1,890 in 2016		7,342		13,396
Inventory		9,188		6,414
Prepaid expenses and other current assets		6,437		7,097
Total current assets		169,240		174,115
Property and equipment, net		30,417		32,289
Restricted cash, long term portion		342		342
Other assets		4,057		3,934
Total assets	$	204,056	$	210,680
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	3,753	$	11,479
Accrued compensation		9,428		11,067
Other accrued liabilities		23,022		19,879
Deferred revenue		1,041		574
Short-term debt financing		50,097		49,624
Warrants		4,189		3,792
Total current liabilities		91,530		96,415

Long-term debt financing		73,202		—
Deferred rent, net of current portion		9,140		7,789
Total liabilities		173,872		104,204

Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock, $0.0001 par value: 750,000 shares authorized at both September 30, 2017 and December 31, 2016, respectively; 53,708 and 52,665 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively		6		5
Additional paid in capital		467,234		453,044
Accumulated deficit		(436,660)		(345,848)
Accumulated other comprehensive loss		(396)		(725)
Total stockholders’ equity		30,184		106,476
Total liabilities and stockholders’ equity	$	204,056	$	210,680

See accompanying notes to the unaudited interim condensed consolidated financial statements.

Natera, Inc.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

(In thousands, except per share data)


	Three months ended				Nine months ended
	September 30,				September 30,
	2017		2016		2017		2016
Revenues
Product revenues	$	55,331	$	53,090	$	153,520	$	165,457
Licensing and other revenues		1,325		799		3,654		2,318
Total revenues		56,656		53,889		157,174		167,775
Cost and expenses
Cost of product revenues		33,558		33,761		100,355		97,074
Cost of licensing and other revenues		1,054		500		2,516		500
Research and development		12,609		11,345		37,045		30,403
Selling, general and administrative		34,478		34,938		106,369		98,573
Total cost and expenses		81,699		80,544		246,285		226,550
Loss from operations		(25,043)		(26,655)		(89,111)		(58,775)
Interest expense		(1,477)		(146)		(1,878)		(383)
Interest and other (expense) income, net		(437)		887		450		1,403
Loss before income taxes		(26,957)		(25,914)		(90,539)		(57,755)
Income tax expense		(162)		(103)		(273)		(103)
Net loss	$	(27,119)	$	(26,017)	$	(90,812)	$	(57,858)
Unrealized gain on available-for-sale securities, net of tax		67		(609)		329		1,750
Comprehensive loss	$	(27,052)	$	(26,626)	$	(90,483)	$	(56,108)

Net loss per share (Note 11):
Basic	$	(0.51)	$	(0.50)	$	(1.71)	$	(1.13)
Diluted	$	(0.51)	$	(0.50)	$	(1.71)	$	(1.13)
Weighted-average number of shares used in computing basic and diluted net loss per share:
Basic		53,447		52,012		53,100		51,301
Diluted		53,447		52,012		53,100		51,301

See accompanying notes to the unaudited interim condensed consolidated financial statements.

Natera, Inc.

Condensed Consolidated Statements of Cash Flows

(unaudited)

(In thousands)


	Nine months ended
	September 30,
	2017		2016
Operating activities
Net loss	$	(90,812)	$	(57,858)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		5,320		4,177
Stock-based compensation		8,406		7,965
Premium amortization and discount accretion on investment securities		703		1,145
Amortization of debt discount		51		—
Inventory excess adjustments		413		—
Loss on disposal of property and equipment		12		—
Impairment of assets		576		407
Non-cash interest accrual		1,825		383
Loss (gain) on investments		55		(192)
Loss (gain) from changes in fair value of warrants		397		(91)
Provision for doubtful accounts		(93)		354
Changes in operating assets and liabilities:
Accounts receivable		6,147		(3,900)
Inventory		(3,187)		(1,156)
Prepaid expenses and other current assets		660		(4,057)
Restricted cash		1,047		54
Other assets		476		(3,028)
Accounts payable		(4,548)		1,653
Accrued compensation		(1,639)		1,662
Other accrued liabilities		3,724		1,552
Deferred revenue		467		432
Deferred rent, net of current portion		1,351		6,092
Net cash used in operating activities		(68,649)		(44,406)

Investing activities
Purchases of investments		(184,263)		(48,519)
Proceeds from sale of investments		55,352		59,185
Proceeds from maturity of investments		124,325		34,000
Purchases of property and equipment, net		(9,147)		(14,577)
Net cash (used in) provided by investing activities		(13,733)		30,089

Financing activities
Proceeds from exercise of stock options		1,834		2,722
Proceeds from issuance of common stock under employee stock purchase plan		1,503		970
Borrowings under long-term debt facility		75,000		—
Borrowings under credit facility		—		8,000
Repayment under credit facility		—		(1,000)
Net cash provided by financing activities		78,337		10,692

Net decrease in cash		(4,045)		(3,625)
Cash at beginning of period		15,256		28,947
Cash at end of period	$	11,211	$	25,322

See accompanying notes to the unaudited interim condensed consolidated financial statements.

Natera, Inc.

Notes to Unaudited Interim Condensed Consolidated Financial Statements

1. Description of Business

Natera, Inc. (the "Company") was formed in the state of California as Gene Security Network, LLC in November 2003 and incorporated in the state of Delaware in January 2007. The Company’s mission is to change the management of genetic disease worldwide. The Company operates a laboratory certified under the Clinical Laboratory Improvement Amendments ("CLIA") providing a host of preconception and prenatal genetic testing services. The Company determines its operating segments based on the way it organizes its business to make operating decisions and assess performance. The Company has only one segment, which is the discovery, development and commercialization of genetic testing services, and it has a subsidiary that operates in the state of Texas.

The Company's product offerings include its Panorama Non-Invasive Prenatal Test ("NIPT") that screens for chromosomal abnormalities of a fetus typically with a blood draw from the mother; Vistara (“Vistara”), a single-gene mutations screening test performed to identify single-gene disorders; Horizon Carrier Screening ("Horizon") to determine carrier status for a large number of severe genetic diseases that could be passed on to the carrier’s children; Spectrum Pre-implantation Genetic Screening ("PGS") and Spectrum Pre-implantation Genetic Diagnosis ("PGD") to analyze chromosomal anomalies or inherited genetic conditions during an in vitro fertilization ("IVF") cycle to select embryos with the highest probability of becoming healthy children; Anora Products of Conception ("POC") test to rapidly and extensively analyze fetal chromosomes to understand the cause of miscarriage; Non-Invasive Paternity Testing ("PAT"), to determine paternity by analyzing the fragments of fetal deoxyribonucleic acid ("DNA") in a pregnant mother's blood and a blood sample from the alleged father(s), which is marketed and sold by a licensee from whom the Company receives a royalty. All testing is available principally in the United States and Europe. The Company also offers Constellation (“Constellation”), a cloud-based software product that allows laboratory customers to gain access through the cloud to the Company’s algorithms and bioinformatics in order to validate and launch tests based on the Company’s technology. The Company also offers Evercord, which is a cord blood and cord tissue processing and storage service; and SignateraTM, a circulating tumor DNA technology that analyzes and tracks mutations specific to an individual's tumor, for research use only by oncology researchers and biopharmaceutical companies.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information. In the opinion of management, the unaudited interim condensed consolidated financial information includes only adjustments of a normal recurring nature necessary for a fair presentation of the results of operations, financial position, changes in stockholders’ equity, and cash flows. The results of operations for the three and nine months ended September 30, 2017, are not necessarily indicative of the results for the full year or the results for any future periods. The condensed consolidated balance sheet as of December 31, 2016 has been derived from audited financial statements at that date, these financial statements should be read in conjunction with the audited financial statements, and related notes for the year ended December 31, 2016 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 16, 2017.

Liquidity Matters

The Company has incurred net losses since its inception and anticipates net losses and negative operating cash flows for the near future. For the nine months ended September 30, 2017, the Company had a net loss of $90.8 million, and as of September 30, 2017, it had an accumulated deficit of $436.7 million. At September 30, 2017, the Company had $11.2 million in cash and cash equivalents, $135.0 million in marketable securities, $50.1 million of outstanding balance of the Credit Line (as defined below in Note 8) including accrued interest, and $73.2 million of net carrying amount of the 2017 Term Loan (as defined below). While the Company has introduced multiple products that are generating revenues,

these revenues have not been sufficient to fund all operations. Accordingly, the Company has funded the portion of operating costs that exceeds revenues through a combination of equity issuances, debt issuances, and other financings.

The Company continues to develop and commercialize future products and, consequently, it will need to generate additional revenues to achieve future profitability and may need to raise additional equity or debt financing. If the Company raises additional funds by issuing equity securities, its stockholders would experience dilution. Additional debt financing, if available, may involve covenants restricting its operations or its ability to incur additional debt. Any additional debt financing or additional equity that the Company raises may contain terms that are not favorable to it or its stockholders and requires significant debt service payments, which diverts resources from other activities. Additional financing may not be available at all, or in amounts or on terms acceptable to the Company. If the Company is unable to obtain additional financing, it may be required to delay the development and commercialization of its products and significantly scale back its business and operations.

On August 8, 2017, the Company entered into a debt financing agreement with OrbiMed Royalty Opportunities II, LP (“OrbiMed”) pursuant to a senior secured term loan facility (the “2017 Term Loan”). The 2017 Term Loan has a maximum borrowing capacity of $100.0 million, of which the Company borrowed $75.0 million on the closing date of August 8, 2017. The remaining $25.0 million is available to be borrowed at the Company’s option at any time through December 31, 2018, subject to standard conditions. The amounts borrowed under the 2017 Term Loan will primarily be used for general corporate purposes and to fund and support the Company’s business and operations. Interest will accrue on the outstanding balance of the loan at a rate equal to the sum of (i) 8.75% plus (ii) the higher of 1.00% or LIBOR. The 2017 Term Loan has an eighty-four month term and will mature in August 2024. The Company will be required to make interest payments over the term of the loan, with repayment of the full outstanding balance on the maturity date. The Company’s obligations under the 2017 Term Loan are secured by substantially all of the Company’s assets, including its intellectual property, subject to certain customary exceptions. As a fee in consideration of OrbiMed’s funding commitment, the Company issued 300,000 shares of its common stock to OrbiMed on August 14, 2017.

Based on the Company’s current business plan, the Company believes that its existing cash and marketable securities will be sufficient to meet its anticipated cash requirements for at least 12 months after November 8, 2017.

Principles of Consolidation

The accompanying condensed consolidated financial statements include all the accounts of the Company and its subsidiary. The Company established a subsidiary that operates in the state of Texas in December 2014 to support the Company’s laboratory and operational functions, which became active in the second quarter of 2015. All intercompany balances and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions about future events that affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Significant items subject to such estimates include the allowance for doubtful accounts, accrued liability for potential refund requests, stock-based compensation, the fair value of common stock and warrants, as well as income tax uncertainties. These estimates and assumptions are based on management's best estimates and judgment. Management regularly evaluates its estimates and assumptions using historical experience and other factors, including contractual terms and statutory limits; however, actual results could differ from these estimates and could have an adverse effect on the Company's financial statements.

Fair Value

The Company discloses the fair value of financial instruments for financial assets and liabilities for which the value is practicable to estimate. Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price) and the Company currently carries its warrants at fair value according to the fair value measurement guidance.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and money market deposits with financial institutions.

Restricted Cash

The Company discloses both short-term and long-term restricted cash. Short-term restricted cash consists of cash deposits held to secure commercial letters of credit issued by financial institutions, and the balance was insignificant as of September 30, 2017. Long-term restricted cash consists of $0.3 million deposit per credit card terms.

Investments

Management determines the appropriate classification of securities at the time of purchase and reevaluates such determination at each balance sheet date. The Company generally classifies its entire investment portfolio as available-for-sale. The Company views its available-for-sale portfolio as available for use in current operations. Accordingly, the Company classifies all investments as short-term, even though the stated maturity may be more than one year from the current balance sheet date. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), which is a separate component of stockholders’ equity.

Risk and Uncertainties

Financial instruments that potentially subject the Company to credit risk consist of cash, accounts receivable and investments. The Company limits its exposure to credit loss by placing its cash in financial institutions with high credit ratings. The Company's cash may consist of deposits held with banks that may at times exceed federally insured limits. The Company performs evaluations of the relative credit standing of these financial institutions and limits the amount of credit exposure with any one institution.

The Company bills third-party payers for certain tests performed. The amount that is ultimately received from the payer for the Company’s claim and the timing of such payments are subject to the determination of the payer based on the nature of the test performed and their view of the Company’s business practices with respect to collections of plan deductibles and co-payments from patients and other activities. This determination can impact both the amount and timing of when the Company’s invoices are collected. Payers may also withhold payments and request refunds of prior payments if the payer asserts that the Company has not performed in accordance with the policies of these payers.

The Company performs evaluations of financial conditions for clinics and laboratory partners and generally does not require collateral to support credit sales. For the three and nine months ended September 30, 2017, there were no customers exceeding 10% of total revenues on an individual basis. One customer accounted for 13% of total revenues for the three months ended September 30, 2016, and there were no customers exceeding 10% of total revenues on an individual basis for the nine months ended September 30, 2016. As of September 30, 2017, there were no customers with an outstanding balance exceeding 10% of net accounts receivable, and as of December 31, 2016, one customer, Bio-Reference, had an outstanding balance of approximately 52% of net accounts receivable, which was collected in full by the Company in February 2017.

Revenue Recognition

The Company generally bills an insurance carrier, a clinic or a patient for tests it sells upon delivery of the test results. The Company also bills patients directly for out-of-pocket costs not covered by their insurance carriers representing co-pays and deductibles in accordance with their insurance carrier and health plans. For tests performed, where an agreed-upon reimbursement rate or fixed fee and a predictable history or likelihood of collections exists, the Company recognizes revenues upon delivery of the test report to the prescribing physician based on the established billing rate less other adjustments such as reserves for retractions and refunds to arrive at the amount that the Company expects to collect. In all other situations, as the Company does not have a sufficient history of collection and is not able to determine collectability, the Company recognizes revenues when cash is received. The Company may not get reimbursed for tests completed if the tests are not covered under the insurance carrier’s reimbursement policies or the Company is not a qualified provider to

the insurance carrier, or if the tests were not previously authorized. From time to time, the Company receives requests for refunds of payments previously made by insurance carriers. The Company has established an accrued liability for potential refund requests based on its experience, which is accounted for as reductions in revenues in the statement of operations and comprehensive loss. During the three months ended September 30, 2017, $3.7 million was reversed from this accrued liability and recognized as revenue.

In cases where the Company sells its tests through its laboratory partners, the majority of the laboratory partners bill the patient, clinic, or insurance carrier for the performance of the Company's tests.

For tests sold through a limited number of its laboratory partners, the Company bills directly to a patient, clinic or insurance carrier, or a combination of the insurance carrier and patient for the fees. The Company considers its services rendered when it delivers reports of its test results to the laboratory partner, clinic or patient. When the Company has contracted fixed rates for its services and collectability of its revenues is reasonably assured, it recognizes revenues upon delivery of test reports. The fixed fees identified in contracts with laboratory partners change only if a pricing amendment is agreed upon between both parties. For cases in which there is no fixed price established with a laboratory partner, the Company then recognizes revenues from partner distributed tests on a cash basis.

Certain of the Company's arrangements include multiple deliverables. For revenue arrangements with multiple deliverables, the Company evaluates each deliverable to determine whether it qualifies as a separate unit of accounting. This determination is based on whether the deliverable has "stand-alone value" to the customer and whether a general right of return exists. The consideration that is fixed or determinable is then allocated to each separate unit of accounting based on the relative selling price of each deliverable. The consideration allocated to each unit of accounting is recognized as the related goods or services are delivered, limited to the consideration that is not contingent upon future deliverables. The Company uses judgment in identifying the deliverables in its arrangements, assessing whether each deliverable is a separate unit of accounting, and in determining the best estimate of selling price for certain deliverables. The Company also uses judgment in determining the period over which the deliverables are recognized in certain of its arrangements. Any amounts received that do not meet the criteria for revenue recognition are recorded as deferred revenue until such criteria are met.

The Company recognizes revenue from its cloud-based distribution service offering, Constellation. The Company grants its licensees licenses to use certain of the Company’s proprietary intellectual property and the Company’s cloud-based software and provides other services to support the use of the Company's proprietary technology by its licensees. The Company’s proprietary software is used in connection with the analysis of DNA sequence data in a manner yielding a result indicating the likely presence or absence of full or partial chromosomal abnormalities. The licensees do not have the right to possess the Company’s software, but rather receive the software as a service. The revenues are recognized on an accrual basis (assuming all revenue recognition criteria are met) under the terms of the related agreements and are included in licensing and other revenues in the statements of operations and comprehensive loss.

The Company recognizes revenues from Evercord for the collection and storage of newborn cord blood and cord tissue units. Deliverables consist of: (i) the provision of a collection kit and the processing of newborn cord blood and cord tissue units, which are considered delivered at the beginning of the process (the “processing services”), with revenue for this deliverable recognized after the collection and successful processing of the cord blood and cord tissue units, and (ii) the storage of the cord blood and cord tissue units (the “storage services”), for either an annual fee or a prepayment covering an extended period or the lifetime of the newborn donor, with revenue for this deliverable recognized ratably over the applicable storage period. The Company bundles its processing services together with the first year of storage, and each of them has its own standalone value to customers, and therefore, represents a separate deliverable. The selling price for the processing services and the storage services are estimated based on the best estimate of selling price because the Company does not have vendor-specific objective evidence or third-party evidence of selling price for these elements. Evercord revenues are reported in licensing and other revenues in the statements of operations and comprehensive loss.

Cost of Product Revenues

The components of cost of product revenues are material and service costs, personnel costs, including stock-based compensation expense, equipment and infrastructure expenses associated with testing samples, electronic medical record,

order and delivery systems, shipping charges to transport samples, third-party test fees and allocated overhead including rent, information technology costs, equipment depreciation and utilities. Costs associated with the performance of diagnostic services are recorded as tests are processed.

Cost of Licensing and Other Revenues

The components of cost of licensing and other revenues are material costs associated with test kits, engineering costs incurred by the research and development team to improve and maintain the Constellation software platform, and amortization of Constellation software development costs. Costs also include collection kits consumed during the processing of cord blood samples, processing service and storage of the cord blood samples, and freight charged to transport the samples to the storage facility.

Stock‑Based Compensation

Stock‑based compensation is related to stock options and restricted stock units (“RSUs”) granted to the Company’s employees and is measured at the grant date based on the fair value of the award. The fair value is recognized as expense over the requisite service period, which is generally the vesting period of the respective awards. No compensation cost is recognized when the requisite service has not been met and the awards are therefore forfeited.

The Company uses the Black‑Scholes option‑pricing model to estimate the fair value of stock options issued to employees and non-employees. The measurement of stock-based compensation is subject to periodic adjustments as the underlying equity instruments vest, and the resulting change in value, if any, is recognized in the Company's statements of operations and comprehensive loss during the period that the related services are rendered.

The Black-Scholes option-pricing model requires the input of the Company's expected stock price volatility, the expected term of the awards, a risk-free interest rate, and expected dividends. Determining these assumptions requires significant judgment. The expected term was based on the simplified method and the volatility rate was based on that of publicly traded companies in the DNA sequencing, diagnostics, or personalized medicine industries. When selecting the public companies in these industries to be used in the volatility calculation, companies were selected with comparable characteristics to the Company, including enterprise value and financial leverage. Companies were also selected with historical share price volatility sufficient to meet the expected term of the Company's stock options. The historical volatility data was computed using the daily closing prices for the selected companies' shares during the equivalent period of the calculated expected term of the Company's stock options. The expected term of the non-employee option grants was based on their remaining contractual life at the measurement date. The risk-free interest rate assumption was based on U.S. Treasury instruments with maturities that were consistent with the option's expected term. The expected dividend assumption was based on the Company's history and expectation of dividend payouts.

Starting January 1, 2016, the Company began using a different approach to estimate the expected term of its stock option awards, which involves calculating the average of (1) its employees’ historical stock option exercise behavior, and (2) the weighted-average of the time-to-vesting and the total contractual life of the options. The Company applied this change in methodology prospectively and accounted for it as a change in accounting estimate.

Warrants

The Company accounts for warrants to purchase shares of its common stock as a liability at fair value on the balance sheet date because the Company may be obligated to redeem these warrants at some point in the future. The warrants are subject to re-measurement at each balance sheet date, with changes in fair value of the warrants recognized as a gain or loss in interest and other income in the statements of operations and comprehensive loss. The Company will continue to adjust the liability for changes in fair value until such time that the warrants are converted or expire.

Capitalized Software Held for Internal Use

The Company capitalizes costs of software purchased for internal use during the application development stage of a project and amortizes those costs over their estimated useful lives of three years. The net book value of capitalized

software held for internal use was $2.5 million and $1.3 million as of September 30, 2017 and December 31, 2016, respectively. Amortized expense for amounts previously capitalized for both the three months ended September 30, 2017 and 2016 was $0.3 million and $0.2 million, respectively. Amortized expense for amounts previously capitalized for the nine months ended September 30, 2017 and 2016 was $0.7 million and $0.4 million, respectively.

Accumulated Other Comprehensive Loss

Comprehensive loss and its components encompass all changes in equity other than those with stockholders, and include net loss, unrealized gains and losses on available-for-sale marketable securities.


	Balance at						Balance at
	December 31,				Reclassification		September 30,
	2016		Increase		Adjustment		2017
	(in thousands)
Unrealized (loss) gain on available-for-sale securities, net of tax	$	(725)	$	274	$	55	$	(396)
Total accumulated other comprehensive (loss) income, net of tax	$	(725)	$	274	$	55	$	(396)

Net Loss per Share

Basic net loss per share is calculated by dividing net loss by the weighted-average shares outstanding during the period, without consideration for potential dilutive shares. Diluted net loss per share is calculated by adjusting the weighted-average shares outstanding for the dilutive effect of potential dilutive shares outstanding for the period, determined using the if-converted method. For purposes of the diluted net loss per share calculation, outstanding common stock options, RSUs, ESPP, unvested shares subject to repurchase, and warrants are considered potential dilutive shares but are excluded from this calculation as the result becomes anti-dilutive, unless the consideration of any one of them gives a dilutive effect.

Property and Equipment

Property and equipment, including purchased and internally developed software, are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which are generally three years. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the assets or the remaining term of the lease, whichever is shorter.

Impairment of Long-lived Assets

The Company periodically evaluates the carrying value of its long-lived assets for indicators of possible impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. The Company then compares the carrying amount of the long-lived assets with the future net undiscounted cash flows expected to be generated by such asset. Should an impairment exist, the impairment loss would be measured based on the excess carrying value of the asset over the asset’s fair value determined using discounted estimates of future cash flows. See Note 5 for more detail regarding assets impairment.

Recent Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed below, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.

Recently Adopted Accounting Pronouncements

In July 2015, the FASB issued Accounting Standards Update No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory (“ASU 2015-11”). ASU 2015-11 simplifies the subsequent measurement of inventory by replacing today’s lower of cost or market test with a lower of cost and net realizable value test. The guidance applies only to inventories for which cost is determined by methods other than last-in first-out (“LIFO”) and the retail inventory method (“RIM”). Entities that use LIFO or RIM will continue to use existing impairment models (e.g., entities using LIFO would apply the lower of cost or market test). The Company adopted ASU 2015-11 in the first quarter of 2017, and the adoption did not have a material impact on its financial statements and related disclosures.

In November 2015, the FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”), which simplifies the presentation of deferred taxes by requiring that deferred tax assets and liabilities be presented as noncurrent on the balance sheet. The Company adopted ASU 2015-17 prospectively in the first quarter of 2017, which did not result in a material impact on its financial statements as a full valuation allowance has been reserved against the deferred tax assets and liabilities on the Company’s balance sheet as of September 30, 2017.

In March 2016, the FASB issued Accounting Standards Update No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). The new guidance requires any excess tax benefits (“windfalls”) and tax deficiencies (“shortfalls”) associated with vested or settled share-based awards to be recognized in the income statement rather than additional paid-in capital, which is to be applied prospectively. Further, windfalls will be required to be presented as an operating activity rather than as an outflow from operating activity and an inflow to financing activity, as required by the existing guidance. The Company adopted this new presentation guidance prospectively in the first quarter of 2017, which did not result in a material impact to its financial statements as a full valuation allowance has been reserved against the deferred tax assets and liabilities due to significant losses incurred since the Company’s inception. Therefore, there is no cumulative-effect adjustment required upon adoption of this new guidance. In addition, ASU 2016-09 allows entities to withhold tax equivalent shares up to the employees’ maximum individual tax rate in the relevant jurisdiction without having to account for the award as a liability-based award, and this guidance is to be applied using the modified retrospective approach, with a cumulative-effect adjustment to opening retained earnings. This new guidance is not applicable to the Company as it does not have a practice of withholding shares nor offering net-share settlement, and the Company does not withhold taxes exceeding its minimum statutory tax rate. ASU 2016-09 also permits forfeitures to be either estimated, as required by the existing guidance, or recognized when they occur. The change in the accounting for forfeitures is required to be applied using a modified retrospective approach, with a cumulative-effect adjustment to opening retained earnings. Upon adoption of this new guidance in the first quarter of 2017, the Company made an accounting policy election to continue estimating forfeitures as required by the existing guidance, which did not result in a cumulative-effect adjustment.

New Accounting Pronouncements Not Yet Adopted

In May 2014, the FASB issued Accounting Standards Update No. 2014‑09, Revenue from Contracts with Customers (“ASU 2014‑09”) to provide guidance on revenue recognition. To date, the Company’s revenues have been derived primarily from contracts with insurance carriers, patients, clinics and licensing arrangements. Approximately 84% of the Company’s revenues are recognized on cash basis, and based on the Company’s preliminary assessment, this portion of revenues may be recognized at an earlier date than in the period of actual cash receipt. Consideration is received from either patients, clinics, or insurance carriers and/or any combination of the three, and licensees. Some of these arrangements, whether sell-in or sell-through, have similar characteristics and are being evaluated collectively as a portfolio under the five-step process prescribed by the new revenue standard. Currently, the Company has begun to perform preliminary analysis on its contracts with in-network and out-of-network insurance carriers, and estimates that the impact would be material upon adoption of ASU 2014-09. This new guidance will be effective for the Company in the first quarter of 2018, with early adoption permitted starting the first quarter of 2017. Upon adoption, ASU 2014-09 can be applied retrospectively to all periods presented or using the modified retrospective approach, which requires a cumulative-effect adjustment to be recorded in the opening balance of retained earnings only in the most current period presented. The Company has not yet determined which method will be used upon adoption, and will plan on adopting the new guidance in the first quarter of 2018.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (“ASU 2016-02”). ASU 2016-02 is aimed at making leasing activities more transparent and comparable, and requires substantially all leases be

recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases currently accounted for as operating leases. ASU 2016-02 is effective for the Company in the fiscal year beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company expects that the adoption of ASU 2016-02 will increase its lease assets and correspondingly increase its lease liabilities in its financial statements.

In August 2016, the FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (A Consensus of the Emerging Issues Task Force) (“ASU 2016-15”). The purpose of ASU 2016-15 is to limit diversity in the classification of certain transactions in the statement of cash flows. Such transactions include (1) debt prepayment or debt extinguishment costs, (2) settlement of zero-coupon bonds, (3) contingent consideration payments made after a business combination, (4) proceeds from insurance claims settlement, (5) proceeds from settlement of life insurance policies, and (6) distributions of equity method investments. ASU 2016-15 will be effective for the Company in the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year. The Company does not expect the adoption of this new guidance to have a material impact on its financial statements.

In November 2016, the FASB issued Accounting Standards Update No. 2016-18 (“ASU 2016-08”), Statement of Cash Flows (Topic 230): Restricted Cash (“ASU 2016-18”). The purpose of ASU 2016-18 is to eliminate the diversity in classifying and presenting changes in restricted cash in the statement of cash flows. The new guidance requires restricted cash to be combined with cash and cash equivalents when reconciling the beginning and ending balances of cash on the statement of cash flows, thereby no longer requiring transactions such as transfers between restricted and unrestricted cash to be treated as a cash flow activity. Further, the new guidance requires the nature of the restrictions to be disclosed, as well as a reconciliation between the balance sheet and the statement of cash flows on how restricted and unrestricted cash are segregated. The new guidance will be effective for the Company in the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year, with early adoption permitted. The Company does not expect the adoption of this new guidance to have a material impact on its financial statements.

In May 2017, the FASB issued Accounting Standards Update No. 2017-09 (“ASU 2017-09”), Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. The purpose of this ASU is to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The new guidance will be effective for the Company in the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year, with early adoption permitted. The Company is currently evaluating the impact of adopting ASU 2017-09 on its financial statements.

3. Fair Value Measurements

The Company's financial assets and liabilities carried at fair value are comprised of investment assets that include money market and investments, and a liability for common stock warrants.

The fair value accounting guidance requires that assets and liabilities be carried at fair value and classified in one of the following three categories:

Level I: Quoted prices in active markets for identical assets and liabilities that the Company has the ability to access

Level II: Observable market‑based inputs or unobservable inputs that are corroborated by market data, such as quoted prices, interest rates, and yield curves

Level III: Inputs that are unobservable data points that are not corroborated by market data.

This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.

Assets and Liabilities That Are Measured at Fair Value on a Recurring Basis

The following table represents the fair value hierarchy for the Company’s financial assets and financial liabilities measured at fair value on a recurring basis:


	September 30, 2017								December 31, 2016
	Level I		Level II		Level III		Total		Level I		Level II		Level III		Total
	(in thousands)
Financial Assets:
Money market deposits	$	286	$	—	$	—	$	286	$	10,777	$	—	$	—	$	10,777
U.S. Treasury securities		84,279		—		—		84,279		57,442		—		—		57,442
U.S. agency securities		—		38,970		—		38,970		—		56,114		—		56,114
Municipal securities		—		11,768		—		11,768		—		17,304		—		17,304
Total financial assets	$	84,565	$	50,738	$	—	$	135,303	$	68,219	$	73,418	$	—	$	141,637

Current Liabilities:
Warrants	$	—	$	—	$	4,189	$	4,189	$	—	$	—	$	3,792	$	3,792
Total financial liabilities	$	—	$	—	$	4,189	$	4,189	$	—	$	—	$	3,792	$	3,792

During the three and nine months ended September 30, 2017, the Company did not make any transfers between Level I and Level II assets.

The Company's warrants to purchase common stock are valued using Level III inputs; the Company used inputs from a Black-Scholes model with market volatility that is determined for comparable companies in the same business sector. The carrying amounts of cash, accounts receivable, and accounts payable approximate their fair value and are excluded from the table above.

In April 2013, the Company entered into a senior secured term loan with a third‑party lender, which consisted of a credit agreement, royalty agreement, warrants, and loan commitment. Based upon the Company's evaluation, the senior secured term loan constituted a liability with embedded derivative features that was accounted for separately as mark-to-market instruments. In addition, adjustments to the embedded royalty feature were recorded as interest expense as they occurred, offset to the carrying amount of the debt (with the eventual cash outlay to settle such amounts recorded against the carrying amount of the debt). Based on the Company's evaluation, it was determined that the warrants granted are detachable and therefore are a stand-alone component of the senior secured term loan to be fair valued using Level III inputs as a separate derivative. In October 2015, the Company repaid the entire borrowings under the senior secured term loan.

The following table provides a roll forward of the fair value, as determined by Level III inputs, of the warrants for the nine months ended September 30, 2017:


	Warrants
	(in thousands)
Balance at December 31, 2016	$	3,792
Change in fair value		397
Balance at September 30, 2017	$	4,189

Warrants

The significant unobservable inputs used in the fair value of warrants are derived from the Company's common stock valuation that is based on inputs from a Black-Scholes option-pricing model, with the expected term of 5.5 years, risk-free interest rate of 1.98%, and market volatility of 61.8% that was determined for comparable companies in the same business sector. The inherent risk in the market volatility is the selection of companies with similar business attributes to the Company.

4. Financial Instruments

The Company has invested a portion of its cash assets in conservative, income earning, and liquid investments. Cash equivalents and investments, all of which are classified as available-for-sale securities, consisted of the following:


	September 30, 2017								December 31, 2016
	Amortized Cost		Gross Unrealized Gain		Gross Unrealized (Loss)		Estimated Fair Value		Amortized Cost		Gross Unrealized Gain		Gross Unrealized (Loss)		Estimated Fair Value
	(in thousands)
Money market deposits	$	286	$	—	$	—	$	286	$	10,777	$	—	$	—	$	10,777
U.S. Treasury securities		84,550		8		(279)		84,279		57,846		—		(404)		57,442
U.S. agency securities		39,106		—		(136)		38,970		56,261		—		(147)		56,114
Municipal securities		11,757		15		(4)		11,768		17,478		—		(174)		17,304
Total	$	135,699	$	23	$	(419)	$	135,303	$	142,362	$	—	$	(725)	$	141,637

Classified as:
Cash equivalents							$	286							$	10,777
Short-term investments								135,017								130,860
Total							$	135,303							$	141,637

The Company invests in U.S. Treasuries, U.S. agency and high quality municipal bonds which mature at par value and are all paying their coupons on schedule. The Company has therefore concluded there is currently no other than temporary impairment of its investments and will continue to recognize unrealized gains and losses in other comprehensive income (loss). During the three and nine months ended September 30, 2017, the Company had immaterial realized gains and losses. The Company uses the specific investment identification method to calculate realized gains and losses and amounts reclassified out of other comprehensive income to net income. As of September 30, 2017, the Company has 15 investments in an unrealized loss position in its portfolio. The Company earned interest income of $0.3 million and $0.8 million during the three and nine months ended September 30, 2017, respectively.

The following table summarizes the Company’s portfolio of available-for-sale securities by contractual maturity as of September 30, 2017:


	September 30, 2017
	Amortized Cost		Fair Value
	(in thousands)
Less than one year	$	86,061	$	85,999
Greater than one year but less than five years		49,352		49,018
Total	$	135,413	$	135,017

5. Balance Sheet Components

Property and Equipment, net

The Company’s property and equipment consisted of the following:


		September 30,		December 31,
	Useful Life	2017		2016
		(in thousands)
Machinery and equipment	3-5 years	$	31,515	$	27,303
Furniture and fixtures	3 years		1,216		1,087
Computer equipment	3 years		1,951		861
Capitalized software held for internal use	3 years		4,081		2,172
Leasehold improvements	Lesser of useful life or lease term		10,668		10,444
Construction-in-process			6,149		9,759
			55,580		51,626
Less: Accumulated depreciation and amortization			(25,163)		(19,337)
Total Property and Equipment, net		$	30,417	$	32,289

During the nine months ended September 30, 2017, the Company recorded an asset impairment charge of $0.6 million in cost of product revenues in the statements of operations and comprehensive loss. This charge was recorded following an impairment analysis completed in the fourth quarter of 2016 on certain sequencing and automation equipment whose service lives were determined to be significantly shorter than initially expected. Those equipment were completely phased out in January 2017 as the Company began its transition to the next generation of sequencing and automation equipment to help streamline its production workflows.

Other Assets

In April 2016, the Company entered into a four-year agreement with a health insurance carrier whereby in return for partial exclusivity and the right to pricing benefits the Company agreed to pay total consideration of $3.2 million. The total consideration was paid in the third quarter of 2016. As of September 30, 2017 and December 31, 2016, $2.0 million and $2.6 million of deferred costs related to the total consideration paid were included in other long-term assets, respectively. The deferred costs are being amortized ratably over the four-year term of the agreement and for the three and nine months ended September 30, 2017, the Company amortized $0.2 million and $0.6 million of such costs, respectively, which was recorded as a reduction of product revenue in the statements of operations and comprehensive loss.

In August 2017, the Company entered into the 2017 Term Loan with OrbiMed and issued 300,000 shares of its common stock in exchange for OrbiMed’s initial and remaining funding commitments (as described in Note 8). The consideration had a fair value of $2.4 million and is accounted for as a debt discount. The Company has classified $1.8 million of the debt discount as a direct reduction from the outstanding debt balance, while $0.6 million remains in

noncurrent assets for the unused borrowing capacity of $25.0 million. The debt discount is being amortized on a straight-line basis over the term of the loan. For the three months ended September 30, 2017, amortization of the debt discount was insignificant. As of September 30, 2017, total unamortized debt discount was $0.6 million.

Accrued Compensation

The Company’s accrued compensation consisted of the following:


	September 30,		December 31,
	2017		2016
	(in thousands)
Accrued paid time off	$	1,801	$	1,892
Accrued commissions		2,951		3,868
Accrued bonuses		1,950		2,387
Other accrued compensation		2,726		2,920
Total accrued compensation	$	9,428	$	11,067

Other Accrued Liabilities

The Company’s other accrued liabilities consisted of the following:


	September 30,		December 31,
	2017		2016
	(in thousands)
Reserves for refunds to insurance carriers	$	8,138	$	7,535
Accrued charges for outsourced testing		6,033		3,261
Testing and laboratory materials from suppliers		1,151		543
Other accrued expenses		3,466		4,521
Marketing and corporate affairs		1,005		202
Legal, audit and consulting fees		289		180
Accrued shipping charges		370		467
Sales tax payable		351		459
Accrued specimen service fees		958		469
Accrued rent		766


		Page

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Part I — Financial Information
	Item 1. Financial Statements (unaudited)	5
	Condensed Consolidated Balance Sheets at September 30, 2017 and December 31, 2016	5
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three and Nine Months Ended September 30, 2017 and 2016	6
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016	7
	Notes to Unaudited Interim Condensed Consolidated Financial Statements	8
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	29
	Item 3. Quantitative and Qualitative Disclosures About Market Risk	44
	Item 4. Controls and Procedures	44

Part II — Other Information
	Item 1. Legal Proceedings	45
	Item 1A. Risk Factors	46
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	85
	Item 3. Defaults Upon Senior Securities	85
	Item 4. Mine Safety Disclosures	85
	Item 5. Other Information	85
	Item 6. Exhibits	85
	Signatures	88