UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark one)

For the quarterly period ended September 30, 2017

2018

For the transition period from ___________ to ______________.

Commission file number: 000-24477

DIFFUSION PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)

1317 Carlton Avenue, Suite 400200
Charlottesville, VA 22902
(Address of principal executive offices, including zip code)

(434) 220-0718

(Registrant’sRegistrant’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.

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 Act).Yes ☐   No ☒

The number of shares of common stock outstanding at November 10, 20171, 2018 was 14,521,73050,643,429 shares.

DIFFUSION PHARMACEUTICALS INC.

FORM 10-Q

SEPTEMBER 30, 2017

2018

INDEX

Unless the context otherwise requires, in this report, references to the “Company,” “we,” “our” or “us” refer to Diffusion Pharmaceuticals Inc. and its subsidiaries, and references to “common stock” refer to the common stock, par value $0.001 per share, of the Company and references to "Series A convertible preferred stock" refer to the Series A convertible preferred stock, par value $0.001 per share, of the Company. On August 17, 2016, the Company effected a 1-for-10 reverse split of its common stock. Unless noted otherwise, any share or per share amounts in this report, the accompanying unaudited condensed consolidated financial statements and related notes give retroactive effect to this reverse stock split.

This report contains the following trademarks, trade names and service marks of ours: Diffusion. All other trade names, trademarks and service marks appearing in this quarterly report on Form 10-Q are the property of their respective owners. We have assumed that the reader understands that all such terms are source-indicating. Accordingly, such terms appear without the trade name, trademark or service mark notice for convenience only and should not be construed as being used in a descriptive or generic sense.

Diffusion Pharmaceuticals Inc. (“Diffusion” or the “Company”), a Delaware corporation, is a clinical stage biotechnology company focused on extending the life expectancy of cancer patients by improving the effectiveness of current standard-of-care treatments, including radiation therapy and chemotherapy. The Company is developing its lead product candidate, trans sodium crocetinate (“TSC”) for use in many cancer types in which tumor oxygen deprivation ("hypoxia") is known to diminish the effectiveness of current treatments. TSC is designed to target the cancer’scancer’s hypoxic micro-environment, re-oxygenating treatment-resistant tissue and making the cancer cells more susceptible to the therapeutic effects of standard-of-care radiation therapy and chemotherapy. The U.S. Food and Drug Administration (“FDA”) provided Diffusion with final protocol guidance for a Phase 3 trialOther possible uses of TSC in newly diagnosed inoperable GBM patientsinclude the treatment of hypoxic conditions such as stroke, cardiovascular disease, neurodegenerative disease and the Company plans to begin the trial by the end of 2017.emergency medicine.

The Company has not generated any revenues from product sales and has funded operations primarily from the proceeds of private placements of its membership units (prior to the Merger),public offerings, convertible notesdebt and convertible preferred stock. Substantial additional financing will be required by the Company to continue to fund its research and development activities. No assurance can be given that any such financing will be available when needed or that the Company’sCompany’s research and development efforts will be successful.

The Company regularly explores alternative means of financing its operations and seeks funding through various sources, including public and private securities offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. In March 2017,On January 22, 2018, the Company completed a $25.0 million private placementclosed an underwritten public offering of 15,000,000 shares of the Company’s common stock, par value $0.001 per share (“Common Stock”) and warrants to purchase 15,000,000 shares of Common Stock. At the closing, the Company also issued warrants to purchase an additional 1,970,625 shares of Common Stock pursuant to the underwriter’s partial exercise of its securities byoverallotment option. The shares of Common Stock and warrants were sold at a combined public offering units consistingprice of one$0.80 per share and warrant for total proceeds of approximately $10.8 million. The warrants have an exercise price of $0.80 per share and a term of five years from the date of issuance. In addition, at the closing, the Company issued to designees of the underwriter of the offering warrants to purchase up to 750,000 shares of Common Stock. The underwriter’s warrants have an exercise price of $1.00, a term of five years from the date of issuance and otherwise substantially similar terms to the form of investor warrant. As a result of the offering, all outstanding shares of the Company's Series A convertible preferred stock and a warrant to purchase one share of common stock for each share of Series A convertible preferred stock purchased in the offering. The Company sold 12,376,329 units and received approximately $22.1 million in aggregate net cash proceeds from the private placement, after deducting commissions and other expenses of approximately $2.9 million. In addition, the Company granted to its placement agent in the offering warrants to purchase an aggregate 1,179,558converted into 21,006,918 shares of common stock as compensation for its services.Common Stock (including accrued dividends paid-in-kind and issuance of shares in respect of the “make-whole” adjustment feature thereof).

The Company currently does not have any commitments to obtain additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. On March 2, 2018, the Company received a written notice from the staff of the Listing Qualifications Department of the Nasdaq Stock Market LLC (the "Staff") indicating the Company was not in compliance with Nasdaq Listing Rule 5550(a)(2) (the "Minimum Bid Price Rule") because the bid price for the Company’s common stock had closed below $1.00 per share for the previous 30 consecutive business days. In accordance with Nasdaq Listing Rule 5810(c)(3)(A), the Company had 180 calendar days from the date of such notice, or until August 29, 2018, to regain compliance with the minimum bid price requirement. To regain compliance, the bid price for the Company’s Common Stock must close at $1.00 per share or more for a minimum of 10 consecutive business days. On August 30, 2018, the Company received a written notice from the Staff providing that, although the Company had not regained compliance with the Minimum Bid Price Rule by August 29, 2018, in accordance with Nasdaq Listing Rule 5810(c)(3)(F), the Staff had determined that the Company is eligible for an additional 180 calendar days from the date of such notice, or until February 25, 2019, to regain compliance with the Minimum Bid Price Rule.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In the event the Company is unable to regain compliance, it could adversely affect the Company’s ability to obtain future funding. If the Company cannot obtain the necessary funding, it will need to delay, scale back or eliminate some or all of its research and development programs or enter into collaborations with third parties toto; commercialize potential products or technologies that it might otherwise seek to develop or commercialize independently,independently; consider other various strategic alternatives, including a merger or sale of the Company,Company; or cease operations. If the Company engages in collaborations, it may receive lower consideration upon commercialization of such products than if it had not entered into such arrangements or if it entered into such arrangements at later stages in the product development process.

On May 26, 2017, At the Company receivedCompany’s 2018 Annual Meeting of Stockholders on June 14, 2018, the Company’s stockholders approved an amendment to the Company’s certificate of incorporation to effect a written notice from NASDAQ indicating the Company was not in compliance with Nasdaq Listing Rule 5550(b)(2) because the market valuereverse stock split of the Company’s listed securities had been below $35.0 million forshares of the previous 30 consecutive business days. NASDAQ also noted that asCompany’s common stock at a ratio of such datenot less than 1-to-2 and not greater than 1-to-15, with the Company also did not meetexact ratio and effective time of the alternative requirements under Nasdaq Listing Rule 5550(b)(1), duereverse stock split to be determined by the Company's failure to maintain stockholders' equityCompany’s Board of Directors, if at least $2.5 million, or Nasdaq Listing Rule 5550(b)(3), due to the Company's failure to generate net income from continuing operations during its last fiscal year or during two of its last three fiscal years. See Note 12 for further details.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSall.

The Company has prepared its financial statements assuming that it will continue as a going concern, which contemplates realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses since inception and it expects to generate losses from operations for the foreseeable future primarily due to research and development costs for its potential product candidates, which raises substantial doubt about the Company’s ability to continue as a going concern. VariousThe Company currently has no sources of revenue and its ability to continue as a going concern is dependent on its ability to raise capital to fund its future business plans. Additionally, volatility in the capital markets and general economic conditions in the United States may be a significant obstacle to raising the required funds. These factors raise substantial doubt about its ability to continue as a going concern. The financial statements included herein do not include any adjustments that might be necessary should the Company be unable to continue as a going concern. If the going concern basis were not appropriate for these financial statements, adjustments would be necessary in the carrying value of assets and liabilities, the reported expenses and the balance sheet classifications used.

Operations of the Company are subject to certain risks and uncertainties including various internal and external factors that will affect whether and when the Company’s product candidates become approved drugs and the extent ofhow significant their market share. The regulatory approval and market acceptanceshare will be, some of which are outside of the Company’s proposed future products (if any),control. The length of time and cost of developing and commercializing these product candidates and/or failure of them at any stage of the drug approval process will materially affect the Company’s financial condition and future operations. The Company believes its cash and cash equivalents and certificate of deposit at September 30, 20172018 are sufficient to fund operations through June 2018. in to September 2019.

The Summary of Significant Accounting Policies included in the Company's Form 10-K for the year ended December 31, 2016,2017, filed with the Securities and Exchange Commission on March 31, 2017April 2, 2018 have not materially changed, except as set forth below.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information as found in the Accounting Standard Codification (“ASC”) and Accounting Standards Updates (“ASUs”) of the Financial Accounting Standards Board (“FASB”), and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (the “SEC”). In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements of the Company include all normal and recurring adjustments (which consist primarily of accruals, estimates and assumptions that impact the unaudited interim condensed consolidated financial statements) considered necessary to present fairly the Company’s financial position as of September 30, 2017,2018, its results of operations for the three and nine months ended September 30, 20172018 and 20162017 and cash flows for the nine months ended September 30, 20172018 and 2016.2017. Operating results for the nine months ended September 30, 20172018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.2018. The unaudited interim condensed consolidated financial statements presented herein do not contain the required disclosures under GAAP for annual financial statements. The accompanying unaudited interim condensed consolidated financial statements should be read in conjunction with the annual audited financial statements and related notes as of and for the year ended December 31, 20162017 filed with the SEC on Form 10-K on March 31, 2017.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSApril 2, 2018.

Use of Estimates

The preparation of the unaudited interim condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of assets and liabilities at the date the financial statements and reported amounts of expense during the reporting period. Actual results could differ from those estimates. Due to the uncertainty of factors surrounding the estimates or judgments used in the preparation of the unaudited interim condensed consolidated financial statements, actual results may materially vary from these estimates. Estimates and assumptions are periodically reviewed and the effects of revisions are reflected in the unaudited interim condensed consolidated financial statements in the period they are deemed necessary.

Cash and Cash Equivalents and Certificate of Deposit

The Company considers any highly liquid investments, such as money market funds, with an original maturity of three months or less to be cash and cash equivalents. The Company's certificate of deposit has a maturity greater than three months but within one year of the date of purchase. This certificate of deposit is classified as held-to-maturity, and the estimated fair value of the investment approximates its amortized cost.

Fair Value of Financial Instruments

The carrying amounts of the Company’sCompany’s financial instruments, including cash equivalents, certificate of deposit, accounts payable, and accrued expenses approximate fair value due to the short-term nature of those instruments. As of September 30, 2017, the fair value of the Company's outstanding Series B convertible note was approximately $0.5 million. As of December 31, 2016,2017, the fair value of the Company’s outstanding 2016 convertible note and Series B convertible notedebt was approximately $2.0 million and $0.6 million, respectively. The 2016 convertible note was paid in full during the three month period ended September 30, 2017.million. The fair value of the convertible notes isdebt was determined using a binomial lattice model that utilizes certain unobservable inputs that fall within Level 3 of the fair value hierarchy.

Offering CostsConvertible Debt

Offering costs are either expensed upon completion or abandonmentUpon maturity of the related financing or offset against the proceeds of the offering, depending upon the accounting treatment of the offering. Offering costs consist principally of legal costs incurred through the balance sheet date related to the Company’s private placement financings and are recognized in other assets on the consolidated balance sheet. During the three months ended September 30, 2017, management decided to not move forward with the Series B financing, which was originally contemplatedconvertible debt during the second quarter of 2018, the Company repaid the outstanding principal and disclosed ininterest of approximately $0.6 million and $40,000, respectively. As such, the Company's definitive proxy statement filed with the Securities and Exchange Commission on May 1, 2017, and expensed $98,000Company does not have any debt outstanding as of previously capitalized offering costs related to the financing.September 30, 2018.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Intangible AssetsAsset and Goodwill

In connection with the Merger, the Company acquired indefinite-lived In-Process ResearchGoodwill and Development Assets (“IPR&D”) RES-529 and RES-440, with estimated fair values of $8.6 million and $1.0 million, respectively, and recognized $6.9 million in goodwill. In the third quarter of 2016, the IPR&D asset associated with RES-440 was abandoned and written downintangible assets deemed to $0. RES-529 and goodwillhave indefinite lives are assessednot amortized but rather are tested at least annually for impairment, on each of October 1or when circumstances indicate that the carrying amount of the Company’sasset may not be recoverable. If the carrying value of the reporting unit exceeds fair value, goodwill is considered impaired. In January 2017, the FASB issued revised guidance that simplifies the test for goodwill impairment, effective for fiscal year or more frequentlyyears beginning after December 15, 2019, with early adoption permitted. Under the revised guidance, if a reporting unit’s carrying value exceeds its fair value, an impairment indicators exist.charge will be recorded to reduce the reporting unit to fair value. Prior to the revised guidance, the amount of the impairment was the difference between the carrying value of the goodwill and the "implied" fair value, which was calculated as if the reporting unit had just been acquired and accounted for as a business combination. The Company has a single reporting unit and all goodwill relates to that reporting unit. The Company's RES-529 intangible asset and goodwill are assessed for impairment annually on October 1 of the Company’s fiscal year or more frequently if impairment indicators exist. There werewas no impairment indicatorsto the Company’s RES-529 intangible asset recognized during the three or impairmentsnine months ended September 30, 2018 and 2017. During the three months ended September 30, 2018, the Company recorded a non-cash goodwill impairment of $4.2 million (see Note 5).

Income Taxes

On December 22, 2017 the President of the United States signed into law the Tax Cuts and Jobs Act ("The 2017 Tax Act"), which resulted in significant changes from previous tax law. Among other things, the 2017 Tax Act reduced the federal corporate income tax rate to RES-529 or goodwill21% from 34% effective January 1, 2018 and also changed the net operating loss carryforwards’ period such that all net operating losses generated in 2018 and into the future now have an indefinite life. As a result of the change in net operating loss carryforward period, during the three and nine months ended September 30, 2017.2018, the Company recognized an income tax benefit of $0.2 million and $0.5 million, respectively, to reflect the adjustment allowed by the 2017 Tax Act to utilize indefinite deferred tax liabilities as a source of income against indefinite lived portions of the Company’s deferred tax assets.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Net (Loss) Income (Loss) Per Common Share

For the three and nine months ended September 30, 2017, the Company used the two-class method to compute basic net income per common share because the Company hashad issued securities ("Series(Series A convertible preferred stock")stock) that entitleentitled the holder to participate in dividends and earnings of the Company. Under this method, net income is reduced by any dividends earned during the period. The remaining earnings ("undistributed earnings") are(undistributed earnings) were allocated to common stock and the Series A convertible preferred stock to the extent that the Series A convertible preferred stock maywas entitled to share in earnings. In periodsearnings as if all of net loss, losses are not allocated to participating securities as the holders of such securities have no obligation to fund losses.earnings for the period had been distributed. The total earnings allocated to common stock is then divided by the weighted average commonnumber of outstanding shares outstandingto which the earnings are allocated to determine the basic earnings per share. The two-class method is not applicable during periods with a net loss, as the holders of the convertible preferred stock would have no obligation to fund losses.

Diluted net (loss) income per common share is computed under the two-class method by using the weighted-average number of shares of common stock outstanding, plus, for periods with net income attributable to common stockholders, the potential dilutive effects of stock options, unvested restricted stock, warrants, and convertible debt. In addition, the Company analyzed the potential dilutive effect of the previously outstanding Series A convertible preferred stock under the “if-converted” method when calculating diluted earnings per share, in which it was assumed that the previously outstanding convertible preferred stock converted into common stock at the beginning of the period or when issued, if later. The Company would report the more dilutive of the approaches (two class or “if-converted”) as its diluted net (loss) income per share during the period.

For the periods in which the Company reported a net loss, there was no dilutive effect under either the two-class or “if-converted” method. For the three months ended September 30, 2017, the Company presented diluted net income per common share using the two-class method, which was more dilutive than the “if-converted” method.

For purposes of calculating diluted loss per common share, the denominator includes both the weighted average common shares outstanding and the number of common stock equivalents if the inclusion of such common stock equivalents would be dilutive. Dilutive common stock equivalents potentially include stock options, unvested restricted stock awards and warrants using the treasury stock method. The diluted loss per common share calculation is further affected by an add-back of change in fair value of warrant liability to the numerator under the assumption that the change in fair value of warrant liability would not have been incurred if the warrants had been converted into common stock. In addition, the Company considers the potential dilutive impact of its convertible debt instruments using the "if-converted" method. In addition, the Company considers the potential dilutive impact of its convertible preferred shares using the “if-converted” method if more dilutive than the two-class method. For convertible preferred shares, the two-class method was more dilutive than the “if-converted” method for the three months ended September 30, 2017.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSTATEMENTS

The following table sets forth the computation of basic and diluted earnings per share:

The following potentially dilutive securities outstanding as of September 30, 20172018 and 20162017 have been excluded from the computation of diluted weighted average shares outstanding, as they would be anti-dilutive:

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Amounts in the table reflect the common stock equivalents of the noted instruments.

As a result of the offering of its common stock consummated in January 2018, all outstanding shares of the Company's Series A convertible preferred stock converted into shares common stock. See Note 6 of these unaudited interim condensed consolidated statements for further details.

Recent Accounting Pronouncements

In August 2018, the FASB issued ASU 2018-03, Disclosure Framework- Changes to the Disclosure Requirements for Fair Value Measurements, which changes the fair value measurement disclosure requirements of ASC 820. The goal of the ASU is to improve the effectiveness of ASC 820's disclosure requirements. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2019 and interim periods within those years. The Company is currently evaluating the potential impact of the adoption of this standard on its related disclosures.

In June 2018, the FASB issued ASU 2018-07, Improvements to Nonemployee Share-Based Accounting, which simplifies the accounting for share-based payments granted to nonemployees for goods and services. The ASU supersedes ASC 505-50 and expands the scope of ASC 718 to include all share-based payment arrangements related to the acquisition of goods and services from both nonemployees and employees. As a result, most of the guidance in ASC 718 associated with employee share-based payments, including most of its requirements related to classification and measurement, applies to nonemployee share-based payment arrangements.  ASU 2018-07 generally requires an entity to use a modified retrospective transition approach, with a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption, for all (1) liability-classified nonemployee awards that have not been settled as of the adoption date and (2) equity-classified nonemployee awards for which a measurement date has not been established. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2019 and interim periods within those years. The Company is currently evaluating the potential impact of the adoption of this standard on its consolidated results of operations, financial position and cash flows and related disclosures.

In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. The first part of this update addresses the complexity of accounting for certain financial instruments with down round features and the second part addresses the complexity of distinguishing liabilities from equity. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2018 and interim periods within those years. The Company is currently evaluating the potential impact of the adoption of this standard on its consolidated results of operations, financial position and cash flows and related disclosures.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In MayJanuary 2017, the FASB issued ASU No. 2017-09, 2017-04, Modification Accounting for Share-Based Payment ArrangementsIntangibles-Goodwill and Other (Topic 350), which amends the scope of modification accounting for share-based payment arrangements. The ASU provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under ASC 718. Specifically, an entity would not apply modification accounting if the fair value, vesting conditions, and classification of the awards are the same immediately before and after the modification. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption is permitted, including adoption in any interim period. The Company does not expect this new guidance to have a material impact on its condensed consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation – Improvements to Employee Share-Based Payment Accounting, which simplifies several aspects of the accounting for employee share-based payment transactions includinggoodwill impairments by eliminating step 2 from the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classificationgoodwill impairment test. Instead, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the statementtotal amount of cash flows. The guidance is applicablegoodwill allocated to public business entities for fiscal years beginning after December 15, 2016 and interim periods within those years. The Company adopted this standard in 2017 by electing to account for forfeitures in the period that they occur. Under ASU 2016-09, accounting changes adopted using the modified retrospective method must be calculated as of the beginning of the period adopted and reported as a cumulative-effect adjustment. As a result, the Company recognized cumulative-effect adjustment of approximately $1,000 on January 1, 2017.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The FASB issued the update to require the recognition of lease assets and liabilities on the balance sheet of lessees.reporting unit. The standard will be effective for fiscal years beginning after December 15, 2018,2019, including interim periods within such fiscal years. The ASU requires a modified retrospective transition method with the option to elect a package of practical expedients. Early adoption is permitted.allowed for all entities as of January 1, 2017, for annual and any interim impairment tests occurring on or after January 1, 2017. The Company is currently evaluatingearly adopted this standard in the potential impactthird quarter of 2018. See Note 5 for further discussion of the adoption of this standard on its consolidated results of operations, financial position and cash flows and related disclosures.

Reverse Merger with RestorGenex

On January 8, 2016, the Company completed a reverse merger transaction with RestorGenex. The Company entered into the Merger transaction in an effort to provide improved access to the capital markets in order to obtain the resources necessary to accelerate development of TSC in multiple clinical programs and continue to build an oncology-focused company.

The purchase price was calculated as follows:

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Merger transaction has been accounted for using the acquisition method of accounting, which requires thatCompany's intangible assets, acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The valuation technique utilized to value the IPR&D was the cost approach.

The following table summarizes the allocation of the purchase price to the assets acquired and liabilities assumed as of the acquisition date:

Qualitative factors supporting the recognition of goodwill due to the Merger transaction include the Company’s anticipated enhanced ability to secure additional capital and gain access to capital market opportunities as a public company and the potential value created by having a more well-rounded clinical development portfolio by adding the earlier stage products acquired in the reverse merger transaction to the Company’s later stage product portfolio. The goodwill is not deductible for income tax purposes.

Pro Forma Financial Information (Unaudited)

The following pro forma financial information reflects the condensed consolidated results of operations of the Company as if the acquisition of RestorGenex had taken place on January 1, 2016. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed date.

Non-recurring pro forma transaction costs directly attributable to the Merger were $1.6 million for the nine months ended September 30, 2016 and have been deducted from the net loss presented above. The costs deducted from the nine months ended September 30, 2016 period includes a success fee of $1.1 million and approximately 46,000 shares of common stock with a fair market value of $0.5 million paid to a financial adviser upon the closing of the Merger on January 8, 2016. Additionally, RestorGenex incurred approximately $3.0 million in severance costs as a result of resignations of executive officers immediately prior to the Merger and approximately $2.7 million in share based compensation expense as a result of the acceleration of vesting of stock options at the time of the Merger. These costs are excluded from the pro forma financial information for the nine months ended September 30, 2016. No such costs were recorded in the three and nine months ended September 30, 2017 or in the three months ended September 30, 2016.including goodwill.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSTATEMENTS

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which supersedes the guidance in ASC 840, Leases. ASC 842 will be effective for the Company on January 1, 2019, and the Company expects to apply the practical expedients allowed by the standard. See Note 8 for details of the Company's current lease arrangement. While the Company continues to evaluate the provisions of ASC 842 to determine how it will be impacted, the primary effect of adopting the new standard will be to record assets and obligations for current operating leases. The adoption of ASC 842 is not expected to have a material impact on the Company's results of operations or cash flows.

Prepaid expenses, deposits and other current assets consisted of the following:

Other accruedAccrued expenses and other current liabilities consisted of the following:

Goodwill is the excess of the cost of an acquired entity over the net amounts assigned to tangible and intangible assets acquired and liabilities assumed. The componentsCompany applies ASC 350 “Goodwill and Other Intangible Assets,” which requires testing goodwill for impairment on an annual basis. The Company evaluates goodwill on a consolidated basis as the Company is organized as a single reporting unit. The Company completes its annual impairment test on October 1 each year, or more frequently if triggering events indicate a possible impairment. The Company considers certain triggering events when evaluating whether an interim goodwill impairment analysis is warranted. Among these would be a significant long-term decrease in the market capitalization of debtthe Company. The Company’s market capitalization was below the carrying value of equity throughout the third quarter and as a result, management concluded that the carrying value of goodwill may not be recoverable and that a triggering event requiring an interim assessment of goodwill impairment had occurred during the three months ended September 30, 2018.

Management performed the goodwill impairment assessment using a market approach to estimate the fair value of the Company using the Company's market capitalization. This fair value was derived by multiplying the Company's shares outstanding by the average daily close prices of the Company's stock during the third quarter. The carrying value of the Company's net equity exceeded its fair value, and accordingly, the Company recognized a $4.2 million non-cash impairment charge to goodwill that reduced the carrying value to fair value. The following table shows the changes in the carrying value of goodwill during the nine months ended September 30, 2018:

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSc

The Company has an indefinite-lived In-Process Research and Development Asset (IPR&D) called RES-529, which has a balance of $8.6 million at both September 30, 20172018 and December 31, 2016 are as follows:

Upon maturity of the 2016 Convertible Notes during the third quarter of 2017, the Company repaid the outstanding principal and interest of $1.9 million and $0.1 million, respectively. The accrued interest related2017. RES-529 is a PI3K/Akt/mTOR pathway inhibitor in preclinical development for oncology. There was no impairment to the Company’s Series B Convertible Note is included within accrued expenses and other current liabilities withinRES-529 intangible asset recognized during the unaudited condensed consolidated balance sheets. As ofthree or nine months ended September 30, 2017, the Company had accrued interest of approximately $36,000.2018 or 2017.

In contemplation of completing the private placement described below, the Company amended and restated its articles of incorporation and authorized 13,750,000 shares of Series A convertible preferred stock. The Company has classified its Series A convertible preferred stock outside of stockholders’ equity because the shares contain deemed liquidation rights that are contingent redemption features not solely within the control of the Company.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Series A Convertible Preferred2018 Common Stock TransactionOffering

In March 2017,January 2018, the Company completed a $25.0 million private placemententered into an Underwriting Agreement (the “Agreement”) pursuant to which it issued 15,000,000 shares of its securities in which the Company offeredCommon Stock and sold units consisting of one share of the Company’s Series A convertible preferred stock and a warrantwarrants to purchase one share of common stock for each share of Series A convertible preferred stock purchased in the offering. Each share of Series A convertible preferred stock entitles the holder to an 8.0% cumulative dividend payable in15,000,000 shares of our common stock on a semi-annual basis. The holders may, at their option, convert each share of Series A convertible preferred stock into one share of the Company’s common stock based on the initial conversion price of $2.02 per share, subject to adjustment. Each warrant entitles the holder to purchase one share of common stock atCommon Stock with an initial exercise price of $2.22, subject to adjustment and expires on the fifth anniversary of their original issuance date.

The Company sold 12,376,329 units in the private placement and received approximately $22.1 million in aggregate net$0.80 per share for cash proceeds after deducting commissions and other expenses of approximately $2.9$10.8 million. In addition, as compensation for its services, the Company granted to its placement agentthe underwriter in the offeringtransaction an option (the “Over-Allotment Option”) to purchase, in the aggregate, 2,250,000 shares of Common Stock (the “Option Shares”) and warrants to purchase an aggregate of 1,179,558up to 2,250,000 shares of common stock atCommon Stock (the “Option Warrants”). The underwriter exercised its right to purchase a portion of the Option Warrants and received an additional 1,970,625 warrants to purchase Common Stock with an initial exercise price $0.80 per share.

 In addition, at the closing, the Company issued to designees of $2.22the underwriter warrants to purchase up to 750,000 shares of Common Stock. The underwriter’s warrants have an exercise price of $1.00 per share, which expire ona term of five years from the fifth anniversarydate of their original issuance date.and otherwise substantially similar terms to the form of the investor warrant.

During its evaluation of equity classification for the common stockCommon Stock warrants, the Company considered the conditions as prescribed within ASC 815-40, Derivatives and Hedging, Contracts in an Entity’s own Equity (“ASC 815-40”). The conditions within ASC 815-40 are not subject to a probability assessment. The warrants do not fall under the liability criteria within ASC 480 Distinguishing Liabilities from Equity as they are not puttable and do not represent an instrument that has a redeemable underlying security. The warrants do meet the definition of a derivative instrument under ASC 815, but are eligible for the scope exception as they are indexed to the Company’s own stock and would be classified in permanent equity if freestanding.

As a result of the Company is obligated to issue a variable numberCompany's Common Stock offering in January 2018, all outstanding shares of shares to settle the cumulative dividends on theCompany's Series A convertible preferred stock the Company cannot assert there will be sufficient authorizedconverted into 21,006,918 shares available to settle the warrantsof Common Stock of which (i) 8,306,278 shares were issued in connection with the Series A offering. Accordingly, these warrants are classified as liabilities. The Company will continue to classify such warrants as liabilities until they are exercised, expire, or are no longer required to be classified as liabilities.

As the fair value of the warrants upon issuance was in excess of the proceeds of the Series A offering, there are no proceeds allocated to the Series A convertible preferred stock. The excess fair value of the warrants over the gross proceeds of the Series A offering and the fair value of the warrants granted to its placement agent was $10.2 million in the aggregate and was recorded as warrant related expenses in the statement of operations for the nine months ended September 30, 2017.

Dividends

The Company shall pay a cumulative preferential dividend on each share of the Series A convertible preferred stock outstanding at a rate of 8.0% per annum, payable only in shares of common stock, semi-annually in arrears on April 1 and October 1 of each year commencing on October 1, 2017. This cumulative preferential dividend is not subject to declaration. The Company recognized approximately $0.4 million and $0.9 million in dividends, respectively, for the three and nine months ended September 30, 2017. 

Voting

Subject to certain preferred stock class votes specified in the Certificate of Designation of Preferences, Rights and Limitations of the Series A Convertible Preferred Stock (the “Certificate of Designation”) or as required by law, the holders of the Series A convertible preferred stock votes together with the holders of common stock as a single class on an adjusted as-converted basis. In accordance with NASDAQ listing rules, in any matter voted on by the holders of our common stock, each shareautomatic conversion of Series A convertible preferred stock entitles(ii) 1,032,219 shares were issued upon settlement of accrued dividends and (iii) 11,668,421 shares were issued for the holder thereof to a number of votes based upon the closing price of our common stock on the NASDAQ Capital Market on the date of issuance of such shares of Series A convertible preferred stock. Accordingly, shares of Series A convertible preferred stock issued in the initial closingsettlement of the private placement on March 14, 2017 are entitled to 0.84874 votes per share and shares“make-whole” adjustment feature. A deemed dividend of Series A Preferred Stock issued in$8.2 million was recognized for the final closingvalue of the private placement on March 31, 2017 are entitled to 0.50627 votes per share, in each case, subject tocommon shares issued for the settlement of the make-whole adjustment as described in the Certificate of Designation.feature.

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Liquidation Preference

The Series A convertible preferred stock is senior to the common stock. In the event of a liquidation, dissolution or winding up of the Company, either voluntary or involuntary, or in the event of a deemed liquidation event, which includes a sale of the Company as defined in the Certificate of Designation, the holders of the Series A convertible preferred stock shall be entitled to receive their original investment amount. If upon the occurrence of such event, the assets and funds available for distribution are insufficient to pay such holders the full amount to which they are entitled, then the entire remaining assets and funds legally available for distribution shall be distributed ratably among the holders of the Series A convertible preferred stock in proportion to the full amounts to which they would otherwise be entitled.

Conversion

The Series A convertible preferred stock is convertible, at the holder’s option, into common stock. At the Company’s option, the Series A convertible preferred stock can be converted into common stock upon (a) the thirty-day moving average of the closing price of the Company’s common stock exceeding $8.00 per share, (b) a financing of at least $10.0 million or (c) upon the majority vote of the voting power of the then outstanding shares of Series A convertible preferred stock. The conversion price of the Series A convertible preferred stock is subject to adjustment as described in the Certificate of Designation.

Upon any conversion, any unpaid dividends shall be payable to the holders of Series A convertible preferred stock. During the three and nine months ended September 30, 2017, 2,125,306 and 4,052,297 shares of Series A convertible preferred stock, respectively, were converted into common stock. During the three and nine months ended September 30, 2017, approximately $0.1 million and $0.2 million in accrued dividends, respectively, were converted into 62,701 and 88,436 shares of common stock, respectively.

Make-Whole Provision

Until March 2020 and subject to certain exceptions, if the Company issues at least $10.0 million of its common stock or securities convertible into or exercisable for common stock at a per share price less than $2.02 (such lower price, the “Make-Whole Price”) while any shares of Series A convertible preferred stock remain outstanding, the Company will be required to issue to these holders of Series A convertible preferred stock a number of shares of common stock equal to the additional number of shares of common stock that such shares of Series A convertible preferred stock would be convertible into if the conversion price of such shares was equal to 105% of the Make-Whole Price (the “Make-Whole Adjustment”). The Make-Whole Adjustment was evaluated and was not required to be bifurcated from the Series A convertible preferred stock.STATEMENTS

Common Stock Warrants

As of September 30, 2017,2018, the Company had the following warrants outstanding to acquire shares of its common stock:

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

During the nine months ended September 30, 2017, 13,0002018, 421,221 warrants issued prior to the Merger, expired. These common stockexpired and no warrants will expire periodically through 2019. The common stock warrants issued in connection with the March 2017 Series A private placement expire in March 2022. During the three and nine months ended September 30, 2017, the Company recognized a net gain of $8.4 million and $5.8 million in warrant related charges associated with the Series A private placement, which consisted primarily of the change in fair value of the common stock warrants from issuance and the excess fair value of the common stock warrants over the gross cash proceeds of the Series A offering. were exercised.

2015 Equity Plan

The Diffusion Pharmaceuticals Inc. 2015 Equity Plan, as amended (the "2015 Equity Plan"), provides for increases to the number of shares reserved for issuance thereunder each January 1, equal to 4.0% of the total shares of the Company’sCompany’s common stock outstanding as of the immediately preceding December 31, unless a lesser amount is stipulated by the Compensation Committee of the Company's Board of Directors. Accordingly, 413,825580,785 shares were added to the reserve as of January 1, 2017,2018, which shares may be issued in connection with the grant of stock-based awards, including stock options, restricted stock, restricted stock units, stock appreciation rights and other types of awards as deemed appropriate, in each case, in accordance with the terms of the 2015 Equity Plan. As of September 30, 2017,2018, there were 114,29127,268 shares of common stock available for future issuance under the 2015 Equity Plan.

The Company recorded stock-based compensation expense in the following expense categories of its unaudited interim condensed consolidated statements of operations for the periods indicated:

DIFFUSION PHARMACEUTICALS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSTATEMENTS

The following table summarizes the activity related to all stock option grants to employees and non-employees for the nine months ended September 30, 2017:2018:

Non-employee Stock Options

Non-employee stock options are remeasured to fair value each period using a Black-Scholes option-pricing model until the options vest. DuringThe Company did not grant any stock options to non-employees during the nine months ended September 30, 2017, the Company granted 9,394 stock options to non-employees.2018. The total fair value of non-employee stock options vested during the three months ended September 30, 20172018 and 20162017 was approximately $7,000$1,000 and $0.2 million,$7,000, respectively. The total fair value of non-employee stock options vested during the nine months ended September 30, 20172018 and 20162017 was approximately $83,000$3,000 and $0.7 million,$83,000, respectively. At September 30, 2017,2018, there were 18,5725,166 unvested options subject to remeasurement and approximately $26,000$2,000 of unrecognized compensation expense that will be recognized over a weighted-average period of 1.641.26 years.

Employee Stock Options

During the nine months ended September 30, 2017,2018, the Company granted 330,647660,000 stock options to employees. The weighted average grant date fair value of stock option awards granted to employees was $2.12$0.86 during the nine months ended September 30, 2017.2018. During the three months ended September 30, 20172018 and 20162017 the Company recognized stock-based compensation expense of $0.3 million and $0.1$0.3 million, respectively. During the nine months ended September 30, 20172018 and 2016,2017, the Company recognized stock-based compensation expense $0.9of $1.0 million and $0.4$0.9 million, respectively. No options were exercised during any of the periods presented. At September 30, 2017,2018, there was $2.8$2.1 million of unrecognized compensation expense that will be recognized over a weighted-average period of 5.335.2 years.

Options granted were valued using the Black-Scholes option-pricing model and the weighted average assumptions used to value the options granted during the first nine months ofended September 30, 2018 and 2017 were as follows:

Restricted Stock Awards

As of September 30, 2017,2018, there were 4,599no unvested shares of restricted stock. During the threenine months ended September 30, 20172018 and 2016,2017, there were 1,5333,066 and 1,5344,599 shares that vested, respectively and the Company recognized stock-based compensation expense of approximately $3,000 and $3,000, respectively. During the nine months ended September 30, 2017 and 2016, there were 4,599 and 4,603 shares that vested, respectively and the Company recognized stock-based compensation expense of approximately $9,000$6,000 and $9,000, respectively. At September 30, 2017, there was approximately $9,000 of unrecognized compensation expense that will be recognized over a weighted-average period of less than 1.0 year.