UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

~~FORM 10-Q~~

☒

FORM 10-Q


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

For the quarterly period ended ~~September 30, 2017~~

March 31, 2019

☐
¨	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 001-37880

Novan, Inc.

(Exact name of registrant as specified in its charter)

~~Delaware~~	~~20-4427682~~



Delaware	20-4427682
(State or other jurisdiction of incorporation or organization	(I.R.S. Employer Identification No.)

4105 Hopson Road Morrisville, North Carolina	27560
(Address of principal executive offices)	(zip code)

(919) 485-8080

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Sections 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 ☒x 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 ☒x No ☐¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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.



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

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. ☒x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐¨ No ☒x

Securities registered pursuant to Section 12(b) of the Act:



Title of Each Class	Trading Symbol(s)	Name of Each Exchange on Which Registered
Common Stock, $0.0001 par value	NOVN	Nasdaq Global Market

As of ~~November 7, 2017,~~May 6, 2019, there were ~~15,990,658~~26,069,734 shares of the registrant’s Common Stock outstanding.

Table of Contents

			~~Page~~

		Page
PART I - FINANCIAL INFORMATION		3
~~ITEM~~Item 1.	Financial Statements	3
	Unaudited Condensed Consolidated Balance Sheets as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018	3
	Unaudited Condensed Consolidated Statements of Operations and Comprehensive Loss for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018	4
	Unaudited Condensed Consolidated Statements of Stockholders’ (Deficit) Equity for the three months ended March 31, 2019 and 2018	5
	Unaudited Condensed Consolidated Statements of Cash Flows for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018	5 6
	Notes to ~~the~~ Unaudited Condensed Consolidated Financial Statements	6 7
~~ITEM~~Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	21 27
~~ITEM~~Item 3.	Quantitative and Qualitative Disclosures about Market Risk	34 42
~~ITEM~~Item 4.	Controls and Procedures	34 43

PART II - OTHER INFORMATION		35 44
~~ITEM~~Item 1.	Legal Proceedings	35 44
~~ITEM~~Item 1A.	Risk Factors	35 44
~~ITEM~~Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	36 44
~~ITEM~~Item 3.	Defaults Upon Senior Securities	37 44
~~ITEM~~Item 4.	Mine Safety Disclosures	37 44
~~ITEM~~Item 5.	Other Information	37 44
~~ITEM~~Item 6.	Exhibits	37 45
	Signatures	39 46

Table of Contents

PART I—FINANCIAL INFORMATION

~~PART I. FINANCIAL INFORMATION~~

Item 1. Financial ~~Statements.~~

Statements

NOVAN, INC.

Condensed Consolidated Balance Sheets

(unaudited)

(in thousands, except share and per share amounts)

September 30, 2017

December 31, 2016

(unaudited)

ASSETS

Current assets:

Cash and cash equivalents

$
10,960

$
34,611

Prepaid expenses and other current assets

580

958

Total current assets

11,540

35,569

Restricted cash

539

539

Intangible assets

75

75

Other assets

206

—

Property and equipment, net

16,738

16,290

Total assets

$
29,098

$
52,473

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:

Accounts payable

$
937

$
3,130

Accrued compensation

2,195

2,305

Accrued outside research and development services

1,176

5,737

Accrued legal and professional fees

369

382

Other accrued expenses

1,595

1,813

Deferred revenue, current portion

2,141

—

Capital lease obligation, current portion

11

10

Total current liabilities

8,424

13,377

Deferred revenue, net of current portion

7,451

—

Capital lease obligation, net of current portion

24

32

Facility financing obligation

7,998

7,998

Total liabilities

23,897

21,407

Commitments and contingencies (Notes 2, 3 and 5)

Stockholders’ equity

Preferred stock $0.0001 par value; 10,000,000 shares designated as of
   September 30, 2017 and December 31, 2016; 0 shares issued and
   outstanding as of September 30, 2017 and December 31, 2016

—

—

Common stock $0.0001 par value; 200,000,000 shares authorized as of
   September 30, 2017 and December 31, 2016; 15,998,908 and 15,949,492
   shares issued as of September 30, 2017 and December 31, 2016;
   15,989,408 and 15,939,992 shares outstanding as of
   September 30, 2017 and December 31, 2016

2

2

Additional paid-in-capital

157,325

154,252

Treasury stock at cost, 9,500 shares as of September 30, 2017 and
   December 31, 2016

(155
)

(155
)
Accumulated deficit

(151,971
)

(123,033
)
Total stockholders’ equity

5,201

31,066

Total liabilities and stockholders’ equity

$
29,098

$
52,473



	March 31, 2019			December 31, 2018
ASSETS
Current assets:
Cash and cash equivalents	$	6,077		$	8,194
Deferred offering costs	49			49
Prepaid expenses and other current assets	1,062			1,107
Total current assets	7,188			9,350
Restricted cash	539			539
Intangible assets	75			75
Other assets	501			530
Property and equipment, net	11,657			15,868
Right-of-use lease assets	1,833			—
Total assets	$	21,793		$	26,362
LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY
Current liabilities:
Accounts payable	$	1,510		$	1,250
Accrued compensation	2,082			1,467
Accrued outside research and development services	817			563
Accrued legal and professional fees	258			498
Other accrued expenses	516			871
Deferred revenue, current portion	4,401			4,401
Lease liabilities, current portion	1,139			11
Total current liabilities	10,723			9,061
Deferred revenue, net of current portion	5,926			2,566
Lease liabilities, net of current portion	5,544			10
Warrant liability	1,628			1,240
Other long-term liabilities	335			289
Facility financing obligation	—			7,998
Total liabilities	24,156			21,164
Commitments and contingencies (Notes 3, 4, 7, 10 and 11)
Stockholders’ (deficit) equity
Common stock $0.0001 par value; 200,000,000 shares authorized as of March 31, 2019 and December 31, 2018; 26,079,234 and 26,066,235 shares issued as of March 31, 2019 and December 31, 2018, respectively; 26,069,734 and 26,056,735 shares outstanding as of March 31, 2019 and December 31, 2018, respectively	3			3
Additional paid-in capital	177,855			177,677
Treasury stock at cost, 9,500 shares as of March 31, 2019 and December 31, 2018	(155		)	(155		)
Accumulated deficit	(180,066		)	(172,327		)
Total stockholders’ (deficit) equity	(2,363		)	5,198
Total liabilities and stockholders’ (deficit) equity	$	21,793		$	26,362

The accompanying notes are an integral part of these condensed consolidated financial statements

Table of Contents

NOVAN, INC.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(unaudited)

(in thousands, except share and per share amounts)

Three Months Ended
September 30,

Nine Months Ended
September 30,

2017

2016

2017

2016

License and collaboration revenue

$
532

$
—

$
1,233

$
—

Research and development services revenue

218

—

286

—

Total revenue

750

—

1,519

—

Operating expenses:

Research and development

5,193

14,988

19,101

37,361

General and administrative

2,762

2,493

10,654

9,327

Total operating expenses

7,955

17,481

29,755

46,688

Operating loss

(7,205
)

(17,481
)

(28,236
)

(46,688
)
Other (expense) income, net

(239
)

7

(702
)

50

Net loss and comprehensive loss

$
(7,444
)

$
(17,474
)

$
(28,938
)

$
(46,638
)
Net loss per share, basic and diluted

$
(0.47
)

$
(5.76
)

$
(1.81
)

$
(17.64
)
Weighted-average common shares outstanding, basic and diluted

15,984,428

3,033,967

15,975,855

2,644,116



	Three Months Ended March 31,
	2019			2018
License and collaboration revenue	$	1,100		$	649
Research and development services revenue	—			9
Total revenue	1,100			658
Operating expenses:
Research and development	4,827			6,335
General and administrative	2,994			2,880
Total operating expenses	7,821			9,215
Operating loss	(6,721		)	(8,557		)
Other (expense) income, net:
Interest income	28			44
Interest expense	—			(262		)
Change in fair value of warrant liability	(388		)	3,558
Other income, net	56			—
Total other (expense) income, net	(304		)	3,340
Net loss and comprehensive loss	$	(7,025	)	$	(5,217	)
Net loss per share, basic and diluted	$	(0.27	)	$	(0.21	)
Weighted-average common shares outstanding, basic and diluted	26,066,064			25,026,890

The accompanying notes are an integral part of these condensed consolidated financial statements

Table of Contents

NOVAN, INC.

Condensed Consolidated Statements of ~~Cash Flows~~

Stockholders’ (Deficit) Equity

(unaudited)

(in ~~thousands)~~

thousands, except share amounts)

Nine Months Ended September 30,

2017

2016

Cash flow from operating activities:

Net loss

$
(28,938
)

$
(46,638
)
Adjustments to reconcile net loss to net cash used in operating activities:

Depreciation and amortization

1,030

575

Share-based compensation

3,006

861

Loss (gain) on disposal of property and equipment

6

(2
)
Changes in operating assets and liabilities:

Prepaid expenses and other current assets

488

479

Accounts payable

(2,077
)

2,182

Accrued compensation

(110
)

849

Accrued outside research and development services

(4,561
)

8,789

Accrued legal and professional fees

(103
)

3

Accrued expenses

(19
)

561

Deferred revenue

9,592

—

Other

(206
)

(25
)
Net cash used in continuing operating activities

(21,892
)

(32,366
)
Net cash used in discontinued operating activities

—

(257
)
Net cash used in operating activities

(21,892
)

(32,623
)
Cash flow from investing activities:

Purchases of property and equipment

(1,807
)

(3,410
)
Proceeds from the sale of property and equipment

8

—

Purchase of intangible asset

—

(75
)
Net cash used in investing activities

(1,799
)

(3,485
)
Cash flow from financing activities:

Proceeds from initial public offering, net of underwriting fees and commissions

—

47,785

Payments related to public offering costs

(20
)

(1,480
)
Proceeds from exercise of stock options

67

34

Purchase of treasury stock

—

(155
)
Payments on capital lease obligation

(7
)

(5
)
Payments on facility lease obligation

—

(95
)
Net cash provided by financing activities

40

46,084

Net (decrease) increase in cash and cash equivalents

(23,651
)

9,976

Cash and cash equivalents as of beginning of period

34,611

45,688

Cash and cash equivalents as of end of period

$
10,960

$
55,664

Supplemental disclosure of non-cash investing and financing activities:

Purchases of equipment with accounts payable and accrued expenses

$
105

$
723

Equipment acquired through capital lease

$
—

$
39

Non-cash addition to facility financing obligation

$
—

$
7,847

Non-cash addition to deferred offering costs

$
90

$
1,710

Conversion of convertible preferred stock and non-voting common stock to voting
common stock

$
—

$
104,798

Deferred offering costs reclassified to additional paid-in-capital

$
—

$
3,190



	Three Months Ended March 31, 2019
				Additional Paid-In Capital		Treasury Stock
	Common Stock								Accumulated
	Shares	Amount							Deficit			Total
Balance as of December 31, 2018	26,056,735	$	3	$	177,677	$	(155	)	$	(172,327	)	$	5,198
Share-based compensation	—	—		168		—			—			168
Exercise of stock options	12,999	—		10		—			—			10
Net loss	—	—		—		—			(7,025		)	(7,025		)
Adoption of new accounting standards (Note 1)	—	—		—		—			(714		)	(714		)
Balance as of March 31, 2019	26,069,734	$	3	$	177,855	$	(155	)	$	(180,066	)	$	(2,363	)

	Three Months Ended March 31, 2018
				Additional Paid-In Capital		Treasury Stock
	Common Stock								Accumulated
	Shares	Amount							Deficit			Total
Balance as of December 31, 2017	16,005,408	$	2	$	158,091	$	(155	)	$	(159,654	)	$	(1,716	)
Share-based compensation	—	—		887		—			—			887
Common stock issued through public offering, net of underwriting discounts, warrants, commissions and offering costs (Note 1)	10,000,000	1		17,387		—			—			17,388
Exercise of stock options	33,334	—		37		—			—			37
Net loss	—	—		—		—			(5,217		)	(5,217		)
Balance as of March 31, 2018	26,038,742	$	3	$	176,402	$	(155	)	$	(164,871	)	$	11,379

The accompanying notes are an integral part of these condensed consolidated financial statements

Table of Contents

NOVAN, INC.

Condensed Consolidated Statements of Cash Flows

(unaudited)

(in thousands)



	Three Months Ended March 31,
	2019			2018
Cash flow from operating activities:
Net loss	$	(7,025	)	$	(5,217	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	503			401
Share-based compensation	214			887
Change in fair value of warrant liability	388			(3,558		)
Changes in operating assets and liabilities:
Prepaid expenses and other current assets	45			(6		)
Accounts payable	242			353
Accrued compensation	615			(1,191		)
Accrued outside research and development services	254			(134		)
Accrued legal and professional fees	(199		)	67
Other accrued expenses	(406		)	(621		)
Deferred revenue	3,360			(645		)
Other long-term assets	(101		)	16
Net cash used in operating activities	(2,110		)	(9,648		)
Cash flow from investing activities:
Purchases of property and equipment	(17		)	(140		)
Proceeds from the sale of property and equipment	—			—
Net cash used in investing activities	(17		)	(140		)
Cash flow from financing activities:
Proceeds from public offering, net of underwriting fees and commissions	—			35,625
Payments related to public offering costs	—			(296		)
Proceeds from exercise of stock options	10			37
Payments on capital lease obligation	—			(2		)
Net cash provided by financing activities	10			35,364
Net (decrease) increase in cash, cash equivalents and restricted cash	(2,117		)	25,576
Cash, cash equivalents and restricted cash as of beginning of period	8,733			3,063
Cash, cash equivalents and restricted cash as of end of period	$	6,616		$	28,639
Supplemental disclosure of non-cash investing and financing activities:
Purchases of property and equipment with accounts payable and accrued expenses	$	69		$	191
Non-cash addition to deferred offering costs	$	—		$	25
Deferred offering costs reclassified to additional paid-in capital	$	—		$	431

Reconciliation to condensed consolidated balance sheets:
Cash and cash equivalents	$	6,077		$	28,100
Restricted cash included in noncurrent assets	539			539
Total cash, cash equivalents and restricted cash shown in the statement of cash flows	$	6,616		$	28,639

The accompanying notes are an integral part of these condensed consolidated financial statements

NOVAN, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(dollar values in thousands, except per share data)

Note 1: Organization and Significant Accounting Policies

Business Description and Basis of Presentation

Novan, Inc. (“Novan” and together with its ~~subsidiary,~~subsidiaries, the “Company”), is a North Carolina-based ~~clinical-stage~~clinical development-stage biotechnology company focused on leveraging nitric oxide’s ~~natural antiviral~~naturally occurring anti-microbial and immunomodulatory mechanisms of action to treat ~~dermatological and oncovirus-mediated diseases.~~a range of diseases with significant unmet needs. Novan was incorporated in January 2006 under the state laws of ~~Delaware and its wholly owned~~Delaware. The wholly-owned subsidiary, Novan Therapeutics, LLC was organized in 2015 under the state laws of North Carolina.

On March 14, 2019, the Company completed registration of a wholly-owned Ireland-based subsidiary, Novan Therapeutics, Limited.

The accompanying condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). The December 31, 2018 year-end condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by U.S. GAAP.

Additionally, the Company’s independent registered public accounting firm report for the December 31, 2018 financial statements included an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern.

Basis of Consolidation

The accompanying condensed consolidated financial statements reflect the operations of the Company and its wholly owned ~~subsidiary.~~subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

On December 30, 2015, the Company completed the distribution of 100% of the outstanding member interests of KNOW Bio, LLC (“KNOW Bio”), a former wholly owned subsidiary of the Company, to Novan’s stockholders (the “Distribution”), pursuant to which KNOW Bio became an independent privately held company. Beginning in the fourth quarter of 2015, KNOW Bio’s financial results for periods prior to the Distribution were reflected in the Company’s consolidated financial statements, retrospectively, as discontinued operations. During the nine months ended September 30, 2016, the Company made payments of accounts payable associated with the discontinued operations that were not assumed by KNOW Bio as part of the Distribution. These payments are classified as discontinued operating activities in the accompanying condensed consolidated statement of cash flows for the nine months ended September 30, 2016.

~~The Company does not own an equity interest in KNOW Bio, but does have variable interests in KNOW Bio through the following contractual arrangements:~~

~~At the time of the Distribution, the Company entered into exclusive sublicense agreements with KNOW Bio, as described in Note 3~~—Collaboration Arrangements. These agreements were amended in October 2017, as described in Note 9—Subsequent Events. The Company’s potential obligation to pay future milestones or royalties to UNC and other licensors in the event of KNOW Bio non-performance under the sublicense arrangements creates a variable interest.

The Company entered into a master development services and clinical supply agreement with KNOW Bio in April 2017 and related statements of work (“SOW”) in the second and third quarters of 2017 (collectively, the “KNOW Bio Services Agreement”). Under the KNOW Bio Services Agreement, the Company is providing certain development and manufacturing services to KNOW Bio’s respiratory drug development subsidiary. Pursuant to applicable guidance in FASB ASC 810-10, ~~Consolidation~~, a service provider arrangement such as the KNOW Bio Services Agreement is deemed a variable interest when a reporting entity has another previously existing variable interest in a legal entity, such as the Company’s sublicense arrangements with KNOW Bio, as described above.

KNOW Bio is advancing work in non-dermatologic nitric oxide therapies through its portfolio of operating subsidiary companies. The Company determined that KNOW Bio is currently a variable interest entity based on a reassessment of variable interest entity characteristics, pursuant to FASB ASC 810-10, ~~Consolidation~~, performed by the Company during the third quarter of 2017. The reassessment was completed in third quarter of 2017 and was required because certain triggering events, including the execution of an additional SOW, occurred during the third quarter of 2017.

The Company has concluded that it is not the primary beneficiary of KNOW Bio and, therefore, does not consolidate KNOW Bio in its condensed consolidated financial statements herein. This conclusion is based on the fact that the Company has no significant power or decision-making authority over KNOW Bio’s drug and medical device development activities, which are the activities most significantly impacting KNOW Bio’s economic performance. Under the KNOW Bio Services Agreement, the Company is providing

certain development and manufacturing services to KNOW Bio on commercial terms. In exchange for these services, KNOW Bio pays service fees for actual time and materials incurred by the Company on a cost-plus basis.

As of September 30, 2017, the Company has a deferred revenue balance of $12 related to services performed under the KNOW Bio Services Agreement. The Company has no exposure to loss as a result of its involvement with KNOW Bio. The Company’s sublicense arrangement with KNOW Bio does expose the Company to potential future risk of loss, whereby the Company is obligated to pay future milestones or royalties to UNC or other licensors in the event of KNOW Bio non-performance under the sublicense arrangement; however, if KNOW Bio failed to pay these obligations, KNOW Bio would be in breach of its agreements with the Company and intellectual property rights would revert back to the Company. See Note 2—Research and Development Agreements for detailed information regarding potential future milestone and royalty payments due to UNC and other licensors. The contractual terms of the KNOW Bio Services Agreement, including upfront payment requirements, cost-plus pricing and timely payment terms, mitigate the current or potential future risk of loss to the Company for services performed under the KNOW Bio Services Agreement.

Liquidity and Ability to Continue as a Going Concern

The Company’s condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. The accompanying condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from uncertainty related to the Company’s ability to continue as a going concern.

The Company has evaluated principal conditions and events that may raise substantial doubt about its ability to continue as a going concern within one year from the date that these financial statements are issued. The Company identified the following conditions:

The Company has reported a net loss in all fiscal periods since inception and, as of ~~September 30, 2017,~~March 31, 2019, the Company had an accumulated deficit of ~~$151,971.~~

$180,066.

As described in Note 13—Subsequent Events, in April 2019 and May 2019 the Company entered into (i) a royalty and milestone payments purchase agreement with a stockholder providing $25,000 of immediate funding, with an additional $10,000 contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020; and (ii) a development funding and royalties agreement with a corporate partner providing $12,000 of immediate funding. The Company believes that its existing cash and cash equivalents, expected contractual payments to be received in connection with previous licensing agreements, and the addition of the $25,000 and $12,000 received through these funding transactions will (i) provide the Company with adequate liquidity to fund its planned operating needs into the first quarter of 2020, including through expected top-line results of the Phase 3 molluscum clinical program targeted in the first quarter of 2020, or before; and (ii) into the second quarter of 2020, if paired with the potential $10,000 funding contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020. As of May 7, 2019, the total of $37,000 of immediate funds related to these two agreements had been received by the Company.

The Company’s primary use of cash is to fund its operating expenses, which consist principally of research and development expenditures necessary to advance its product candidates. The Company has evaluated its

expected, probable future cash flow needs and has determined that it expects to incur substantial losses in the future as it conducts planned operating activities. ~~The Company expects that~~As such, the ~~amount of cash and cash equivalents on hand as of September 30, 2017 will not be~~ ~~sufficient to fund all planned operating activities within one year from the date that these financial statements are issued.~~

~~The~~ Company has concluded that the prevailing conditions ~~faced by the Company~~and ongoing liquidity risks it faces raise substantial doubt about its ability to continue as a going concern. To mitigate these conditions, the Company needs and intends to raise additional funds through equity or debt financings or generate revenues or other payments from collaborative or licensing partners prior to the commercialization of the Company’s product candidates. There can be no assurance that theThe Company will ~~be able~~need substantial additional funding to ~~obtain additional equity or debt financing or generate revenues or other payments from collaborative or licensing partners, on terms acceptable to~~continue its operating activities and make further advancements in its drug development programs beyond those planned in 2019 and certain activities in the ~~Company, on a timely basis or at all.~~ first half of 2020.

The failure of the Company to obtain sufficient funds on acceptable terms, ~~when needed~~or the failure to trigger the $10,000 contingent payment under the Company’s royalty and milestone payments purchase agreement, could have a material adverse effect on the Company’s business and cause the Company to alter or reduce its planned operating activities, including but not limited to delaying, reducing, terminating or eliminating planned product candidate development activities, to conserve its cash and cash equivalents. ~~Such actions~~The Company intends to secure additional capital as needed from non-dilutive sources, including partnerships, collaborations, licensing, grants or other strategic relationships, or through equity or debt financings, which could ~~delay development timelines~~result in dilution.

January 2018 Offering

On January 9, 2018, the Company completed a public offering of its common stock and ~~have a material adverse effect on~~warrants pursuant to the Company’s ~~results~~effective shelf registration statement (the “January 2018 Offering”). The Company sold an aggregate of ~~operations, financial condition~~10,000,000 shares of common stock and ~~market valuation. Additionally, there~~warrants to purchase up to 10,000,000 shares of the Company’s common stock at a public offering price of $3.80 per share of common stock and accompanying warrant. The warrant exercise price is ~~no assurance that~~$4.66 per share and will expire four years from the date of issuance. Net proceeds from the offering were approximately $35,194 after deducting underwriting discounts and commissions and offering expenses of approximately $2,806.

The Company ~~can achieve its development milestones or that its intellectual property rights will not be challenged.~~

incurred costs directly related to (i) the shelf registration statement filing totaling $110 and (ii) the January 2018 Offering completed in January 2018 totaling $370, all of which were initially capitalized and included in deferred offering costs. A pro-rata portion of the shelf registration offering costs and all of the January 2018 Offering costs were reclassified to additional paid-in capital upon completion of the January 2018 Offering.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Unaudited Interim Condensed Consolidated Financial Statements

The accompanying interim condensed consolidated financial statements and the related footnote disclosures are unaudited. These unaudited ~~interim~~ condensed consolidated financial statements have been prepared in accordance with U.S. GAAP and applicable rules and regulations of the Securities and Exchange Commission’s (“SEC”) Rule 10-01 of Regulation S-X for interim financial information. The condensed consolidated financial statements were prepared on the same basis as the audited consolidated financial statements and in the opinion of management, reflect all adjustments of a normal, recurring nature that are necessary for the fair statement of the Company’s financial position and its results of operations and cash flows. The results of operations for interim periods are not necessarily indicative of the results expected for the full fiscal year or any future period. These interim financial statements should be read in conjunction with the financial statements and notes for the year ended December 31, 2018 set forth in the Company’s Annual Report on Form 10-K filed with the ~~Securities and Exchange Commission~~SEC on March ~~20, 2017.~~

~~Leases~~

The Company leases office space and certain equipment under non-cancelable lease agreements. The leases are reviewed for classification as operating or capital leases. For operating leases, rent is recognized on a straight-line basis over the lease period. For capital leases, the Company records the leased asset with a corresponding liability and amortizes the asset over the lease term. Payments are recorded as reductions to the liability with an appropriate interest charge recorded based on the then-outstanding remaining liability.

~~The Company considers the nature~~27, 2019.

Restricted Cash

Restricted cash of the renovations and the Company’s involvement during the construction period of newly leased office space to determine if it is considered to be the owner of the construction project during the construction period. If the Company determines that it is the owner of the construction project, it is required to capitalize the fair value of the building as well as the construction costs incurred, including capitalized interest, on its consolidated balance sheet along with a corresponding financing liability (“build-to-suit accounting”). Upon completion of the construction of the facility under a build-to-suit lease, the Company assesses whether the circumstances qualify for sales recognition under the sale-leaseback accounting guidance. If the lease meets the sale-leaseback criteria, the Company will remove the asset and related financial obligation from the balance sheet and evaluate the lease for treatment as a capital or operating lease. If upon completion of construction, the project does not meet the sale-leaseback criteria, the leased property will be treated as an asset financing for financial reporting purposes. The portion of the facility financing obligation representing the principal that will be repaid in the next 12 months will be classified as a current liability in the consolidated balance sheets, with the remaining portion of the obligation classified as a noncurrent liability. See Note 5—Commitments and Contingencies for further discussion of the Company’s application of this guidance related to the Company’s primary facility lease.

~~Research and Development Expense Accruals~~

The Company is required to estimate its expenses resulting from its obligations under contracts with clinical research organizations, clinical site agreements, vendors, and consultants in connection with conducting clinical trials and preclinical development. The financial terms of these contracts are subject to negotiations which vary from contract to contract, and may result in payment flows that do not match the periods over which materials or services are provided to the Company under such contracts. The Company’s objective is to reflect the appropriate development and clinical trial expenses in its financial statements by matching those expenses with the period in which the services and efforts are expended.

For clinical trials, the Company accounts for these expenses according to the progress of the trial as measured by actual hours expended by contract research organization (CRO) personnel, investigator performance or completion of specific tasks, patient progression, or timing of various aspects of the trial. During the course of a clinical trial, the Company adjusts its rate of clinical trial expense recognition if actual results differ from its estimates. The Company utilizes judgment and experience to estimate its accrued expenses$539 as of each balance sheet date in its financial statements based on facts and circumstances known at that time. Although the Company does not expect its estimates to be materially different from amounts actually incurred, its understanding of status and timing of services performed relative to the actual status and timing of services performed may vary and may result in increases or decreases in research and development expenses in future periods when the actual results become known.

For preclinical development services performed by outside service providers, the Company determines accrual estimates through financial models, taking into account development progress data received from outside service providers and discussions with applicable Company and service provider personnel.

~~Revenue Recognition—Licensing Arrangements~~

The Company entered into a licensing arrangement in the first quarter of 2017, and may enter into additional licensing arrangements in the future, in exchange for non-refundable upfront payments and potential future milestone and royalty payments. Such arrangements include multiple elements, including the sale of licenses and the provision of services. For arrangements that involve the delivery of more than one element, each product, service and/or right to use assets is evaluated 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 licensee. The consideration that is fixed or determinable is then allocated to each separate unit of accounting based on the relative selling prices of each deliverable. The consideration allocated to each unit of accounting is recognized as the related goods and services are delivered, limited to the consideration that is not contingent upon future deliverables. When an arrangement is accounted for as a single unit of accounting, we determine the period over which the performance obligations will be performed and revenue recognized. Management exercises significant judgment in the determination of (i) whether a deliverable has stand-alone value, (ii) whether the deliverable is considered to be a separate unit of accounting and (iii) the estimation of the relative fair value of each deliverable in the arrangement.

The Company recognizes a milestone payment when earned if it is substantive and the Company has no ongoing performance obligations related to the milestone. A milestone payment is considered substantive if it: (i) is commensurate with either the Company’s performance to achieve the milestone or the enhanced value of the delivered item as a result of a specific outcome from the performance to achieve the milestone; (ii) relates solely to past performance; and (iii) is reasonable relative to all of the deliverables and payment terms, including consideration of other potential milestones, within the arrangement.

~~Amounts received prior to satisfying all revenue recognition criteria are recorded as deferred revenue in the accompanying balance sheets. See Note 3~~—~~Collaboration Arrangements for further information and accounting considerations related to licensing arrangements revenue recognition.~~

~~Revenue Recognition—Research and Development Services~~

During 2017, the Company entered into an arrangement to provide research and development services on a fee-for-service basis and may enter into additional arrangements in the future. Under such arrangements, revenue is recognized when all of the following conditions are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) fees are fixed or determinable, and (iv) collection of fees is reasonably assured. The Company’s contract research and development services revenue is recognized in the period in which the services are performed.

During the three and nine months ended September 30, 2017, the Company recognized $218 and $286, respectively, in research and development services revenue for services performed under the KNOW Bio Services Agreement and had current deferred revenue related to these services of $12 as of September 30, 2017.

~~Share-Based Compensation~~

The Company applies the fair value method of accounting for share-based compensation, which requires all such compensation to employees, including the grant of employee stock options, to be recognized in the statement of operations based on its fair value at the measurement date (generally the grant date). The expense associated with share-based compensation is recognized over the requisite service period of each award. For awards with only service conditions and graded-vesting features, we recognize compensation cost on a straight-line basis over the requisite service period. For awards with performance conditions, once achievement of the performance condition becomes probable, compensation cost is recognized over the expected period from the date the performance condition becomes probable to the date the performance condition is expected to be achieved. The Company will reassess the probability of vesting at each reporting period for performance awards and adjust compensation cost based on its probability assessment. Share-based awards granted to non-employee directors as compensation for serving on the Company’s Board of Directors are accounted for in the same manner as employee share-based compensation awards.

The fair value of each option grant is estimated using a Black-Scholes option-pricing model on the grant date using expected volatility, risk-free interest rate, expected life of options and fair value per share assumptions. Due to limited historical data, the Company estimates stock price volatility based on the actual volatility of comparable publicly traded companies over the expected life of the option. In evaluating similarity, the Company considered factors such as industry, stage of life cycle, financial leverage, size and risk profile.

The Company does not have sufficient stock option exercise history to estimate the expected term of employee stock options and thus continues to calculate expected life based on the mid-point between the vesting date and the contractual term, which is in accordance with the simplified method. The expected term for share-based compensation granted to non-employees is the contractual life. The risk-free rate is based on the U.S. Treasury yield curve during the expected life of the option.

~~Income Taxes~~

The Company did not record a federal or state income tax benefit for the three and nine months ended September 30, 2017 and 2016 due to its conclusion that a full valuation allowance is required against the Company’s deferred tax assets.

Deferred tax assets and liabilities are determined based on the temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. In estimating future tax consequences, all expected future events are considered other than enactment of changes in the tax law or rates.

The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position.

~~The Company’s policy for recording interest and penalties is to record them as a component of general and administrative expenses. As of September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, consisted of funds maintained in a separate deposit account to secure a letter of credit for the ~~Company accrued no interest and penalties related~~benefit of the lessor of facility space leased by the Company.

Leases

The Company’s significant accounting policies regarding leases are described in Note 1 of the Notes to ~~uncertain tax positions.~~

~~Tax years that remain subject to examination by federal and state tax jurisdictions date back to~~the Consolidated Financial Statements included in its Annual Report on Form 10-K for the year ended December 31, ~~2008. The Company has not been informed by any tax authorities for any jurisdiction that any of its tax years are under examination.~~

~~The determination of recording or releasing a tax valuation allowance is made, in part, pursuant~~2018. Updates to an assessment performed by management regarding the likelihood that the Company will generate future taxable income against which benefits of its deferred tax assets may or may not be realized. This assessment requires management to exercise judgment and make estimates with respect to its ability to generate taxable income in future periods.

~~In accordance with Section 382 of the Internal Revenue Code of 1986, as amended, a change in equity ownership of greater than 50% within a three-year period results in an annual limitation on~~ the Company’s ~~ability to utilize its net operating loss carryforwards created during~~accounting policies, including impacts from the ~~tax periods prior to~~adoption of new accounting standards, are discussed within the ~~change in ownership. The Company has not determined whether ownership changes exceeding this threshold, including the Company’s initial public offering (“IPO”)~~section below, “Accounting Pronouncements Adopted”, ~~have occurred. If a change in equity ownership has occurred which exceeds the Section 382 threshold, a portion of the Company’s net operating loss carryforwards may be limited.~~

and within Note 7—Commitments and Contingencies.

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~~of common stock equivalents. Diluted net loss per share is calculated by adjusting weighted average shares outstanding for the dilutive effect of common stock equivalents outstanding for the period. Diluted net loss per share is the same as basic net loss per share, since the effects of potentially dilutive securities are ~~antidilutive~~anti-dilutive for all periods presented.

~~All outstanding~~

The following securities, presented on a common stock ~~options and all shares of convertible preferred stock outstanding prior to automatic conversion in the IPO~~equivalent basis, have been excluded from the calculation of weighted average common shares outstanding for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018 because the effect is anti-dilutive due to the net loss reported in each of those periods.

All share amounts presented in the table below represent the total number outstanding as of the end of each period. In addition, as described in Note 10—Share-Based Compensation, the Company’s board granted 1,000,000 stock appreciation rights (“SARs”) on a contingent basis in the third quarter of 2018. These securities are subject to stockholder approval and therefore are not considered outstanding as of March 31, 2019; however, if such securities were to be approved by stockholders, their effect would be anti-dilutive.



	March 31,
	2019	2018
Warrants to purchase common stock associated with January 2018 public offering (Note 9)	10,000,000	10,000,000
Stock options outstanding under the 2008 and 2016 Plans (Note 10)	1,544,857	1,560,134
Inducement options outstanding (Note 10)	100,500	—

Segment and Geographic Information

The Company has determined that it operates in one segment. The Company uses its nitric oxide-based technology to develop product candidates. The Chief Executive Officer, who is the Company’s chief operating decision maker, reviews financial information on an aggregate basis for purposes of allocating resources and evaluating financial performance.

The Company has only had limited revenue since its inception, but all revenue was derived from licensing agreements originating in the United States. All of the Company’s long-lived assets are maintained in the United States.

Although all operations are based in the United States, the Company generated revenue ~~of $1,233, or 81% of total revenue,~~ from its licensing partner in Japan of $1,100 and $649 during the ~~nine~~three months ended ~~September 30, 2017. Revenues are attributed to countries based on~~March 31, 2019 and 2018, respectively. During the ~~location of~~three months ended March 31, 2019 and 2018, substantially all revenue was generated from the Company’s licensing partner ~~or customer.~~

in Japan.

Recently Issued Accounting Standards

Accounting Pronouncements Adopted

~~In March 2016, the FASB issued ASU No. 2016-09,~~

~~Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.~~ The FASB issued ASU 2016-09 to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences. This ASU is effective for annual and interim periods beginning after December 15, 2016, with early adoption permitted. This standard was effective for the Company as of January 1, 2017. The adoption of this standard did not have a material impact on its consolidated financial statements.

~~In October 2016, the FASB issued ASU No. 2016-17,~~ ~~Consolidation (Topic 810): Interests Held through Related Parties That Are under Common Control,~~ which amends the consolidation guidance on how a reporting entity that is a single decision maker of a variable interest entity should treat indirect interests in the entity held through related parties that are under common control. This

guidance is effective for annual periods beginning after December 15, 2016, including interim periods within those annual periods, with early adoption permitted. This ASU was effective for the Company as of January 1, 2017. Adoption of this standard did not have a material impact on its consolidated financial statements.

~~Accounting Pronouncements Being Evaluated~~

In May 2014, the FASB and the International Accounting Standards Board issued a converged standard on the recognition of revenue from contracts with customers. The converged standard has been codified within Topic 606, ~~Revenue from Contracts with Customers~~ of the FASB Accounting Standard Codification (ASC). The objective of the new standard is to establish a single comprehensive revenue recognition model that is designed to create greater comparability of financial statements across industries and jurisdictions. Under the new standard, companies will recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration to which a company expects to be entitled in exchange for those goods or services. The new standard also will require expanded disclosures on revenue recognition and changes in assets and liabilities that result from contracts with customers. As amended, the effective date of the new standard is January 1, 2018 for calendar year end companies. In 2016, the FASB issued additional ASUs to amend Topic 606 and to provide expanded or clarifying guidance associated with the application of certain principles within the revenue recognition model, including the areas of principle and agent, identification of performance obligations, licensing and other improvements and practical expedients.

~~Management is currently conducting an assessment of its revenue contract portfolio and is~~ implementing appropriate changes to the Company’s revenue accounting policies, business processes and internal controls in preparation for adoption of the new standard. Management will complete its implementation process prior to the adoption of the new standard. ~~The Company will adopt the Topic 606 guidance on January 1, 2018 and~~ currently plans to use the full retrospective adoption method, which requires the new standard to be applied to each prior reporting period presented and whereby the cumulative effect of applying the standard would be recognized at the earliest period shown.

In February 2016, the FASB issued ~~ASU~~Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842). This guidance revises the accounting related to leases by requiring lessees to recognize a lease liability and a right-of-use asset for all leases. The new lease guidance also simplifies the accounting for sale and leaseback transactions. In July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases and ASU 2018-11, Leases (Topic 842): Targeted Improvements, and in March 2019, the FASB issued ASU 2019-01, Leases (Topic 842): Codification Improvements. These additional ASUs were issued to provide expanded or clarifying guidance associated with the application of certain principles. Under the guidance, lessees are required to recognize assets and lease liabilities on the balance sheet for most leases including operating leases and provide enhanced disclosures. There are optional practical expedients that a company may elect to apply. The guidance was effective for the Company beginning in its first quarter of 2019.

The Company adopted Topic 842 as of January 1, 2019 using the modified alternative retrospective transition method and initially applied the transition provisions as of January 1, 2019. This transition method allowed the Company to continue to apply the legacy guidance in ASC 840 for periods prior to 2019 and recognize a cumulative-effect adjustment to the opening balance of accumulated deficit as of the date of adoption.

The Company elected the package of transition practical expedients, which, among other things, allowed the Company to keep the historical lease classifications and not have to reassess the lease classification and initial direct costs for any existing or expired leases as of the date of adoption. The Company also made an accounting policy election to apply the short-term lease exception, which allows the Company to exclude leases with an initial term of twelve months or less from the consolidated balance sheets. Lease expense for leases with an initial term of twelve months or less will be recognized over the lease term, similar to the accounting treatment under ASC 840.

As a result of the adoption of Topic 842, the Company derecognized $10,557 of building assets (property, plant and equipment), and the $7,998 facility financing obligation associated with the previously existing build-to-suit arrangement related to its sole corporate and manufacturing facility. The Company also capitalized leasehold improvements and ROU assets of $5,885 and $1,827, respectively, and recorded lease liabilities for operating leases totaling $6,786, as of January 1, 2019. The capitalized leasehold improvement assets recorded as part of the adoption of Topic 842 were previously included within the derecognized building asset as part of the previous build-to-suit arrangement. The Company also recognized an increase of $714 to accumulated deficit related to its de-recognition of its previously recorded build-to-suit arrangement. The impact of the adoption of this guidance is non-cash in nature and did not affect the Company’s cash flows.

See Note 7—Commitments and Contingencies, for additional information related to the adoption of Topic 842.

In June 2018, the FASB issued ASU No. 2018-07 Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This guidance simplifies the accounting for non-employee share-based payment transactions by expanding the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from non-employees. Under the new standard, most of the guidance on stock compensation payments to non-employees would be aligned with the requirements for share-based payments granted to employees. This standard is effective for annual reporting periods beginning after December 15, 2018, ~~and~~including interim reporting periods within those annual reporting periods, with early adoption permitted. This ASU was effective for the Company as of January 1, 2019. The adoption of this new accounting guidance did not have a material impact on the Company’s condensed consolidated financial statements.

Accounting Pronouncements Being Evaluated

In August 2018, the FASB issued ASU No. 2018-13 Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement. This guidance is ~~permitted.~~intended to improve the effectiveness of disclosure requirements on fair value measurements in Topic 820. The new standard modifies certain disclosure requirements and will be effective for annual reporting periods beginning after December 15, 2019. The Company is currently evaluating the impact of adoption of this ASU and does not expect the adoption of this ~~ASU~~new standard to have a material impact on its condensed consolidated financial statements.

In ~~August 2016,~~October 2018, the FASB issued ASU No. ~~2016-15,~~ 2018-17 ~~Statement of Cash Flows~~Consolidation (Topic ~~230)~~810): ~~Classification of Certain Cash Receipts and Cash Payments.~~Targeted Improvements to Related Party Guidance for Variable Interest Entities. ~~The FASB issued ASU 2016-09~~This guidance is intended to improve ~~U.S. GAAP by providing~~the accounting for variable interest entities and whether the entity should be consolidated. This guidance on the cash flow statement classification of eight specific areas where there is existing diversity in practice. The FASB expects that the guidance in this ASU will reduce the current and potential future diversity in practice in such areas. This ASU is effective for annual ~~and interim~~reporting periods beginning after December 15, 2017, with early adoption permitted. The Company plans to adopt this standard on January 1, 2018 and is currently evaluating the impact of the adoption of this ASU on its consolidated financial statements.

~~In November 2016, the FASB issued ASU No. 2016-18,~~ ~~Statement of Cash Flows (Topic 230): Restricted Cash,~~ to improve U.S. GAAP by providing guidance on how to classify and present changes in restricted cash or restricted cash equivalents occurring due to transfers between cash, cash equivalents and restricted cash. This ASU is effective for annual and2019, including interim periods beginning after December 15, 2017, with early adoption permitted. The Company plans to adopt this standard on January 1, 2018 and is currently evaluating the impact of the adoption of this ASU on its consolidated financial statements.

~~In January 2017, the FASB issued ASU No. 2017-01,~~ ~~Business Combinations (Topic 805): Clarifying the Definition of a Business~~, which clarifies the definition of a business to provide additional guidance with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. This ASU is effective for annual periods beginning after December 15, 2017, including interimreporting periods within those ~~periods. The Company plans to adopt this standard on January 1, 2018 and is currently evaluating the impact of the adoption of this ASU on its consolidated financial statements.~~

~~In May 2017, the FASB issued ASU No. 2017-09,~~ ~~Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting,~~ to clarify and reduce diversity in practice and cost and complexity of applying guidance for modifications in Topic 718. Specifically, this ASU further defines which changes to terms or conditions of share-based awards require application of modification accounting in Topic 718. This ASU is effective for annual ~~periods beginning after December 15, 2017, including interim periods within those~~reporting periods, with early adoption permitted. The Company ~~plans to adopt this standard on January 1, 2018 and~~ is ~~currently~~ evaluating the impact of adoption of this ASU and does not currently expect the adoption of this ~~ASU~~new standard to have a material impact on its condensed consolidated financial statements.

Note 2: KNOW Bio, LLC

KNOW Bio is an independent, privately held company with a portfolio of operating subsidiaries that are advancing nitric oxide-based therapies using technology that is proprietary and/or in fields where they have exclusive intellectual property rights. The Company does not own any equity interest in KNOW Bio, has no common management or board representation at KNOW Bio, and the contractual arrangements between the two entities do not provide the Company with decision-making authority or power to influence KNOW Bio’s drug and medical device development activities.

The Company conducted an initial assessment of KNOW Bio under the variable interest consolidation model pursuant to FASB ASC 810, Consolidation, at the time of the Distribution in 2015 and has monitored KNOW Bio during each subsequent reporting period, including two required ASC 810 reassessments performed during 2017. The Company has consistently determined that KNOW Bio should not be consolidated in its consolidated financial statements.

In the fourth quarter of 2018, KNOW Bio and its operating subsidiaries received significant additional equity investments that enable progression of their technology. These events required the Company to conduct another reassessment of variable interest entity characteristics, pursuant to FASB ASC 810-10, Consolidation, in which it determined that KNOW Bio should not be consolidated in its consolidated financial statements.

KNOW Bio Technology Agreements

In connection with the Distribution, the Company entered into exclusive license agreements and sublicense agreements with KNOW Bio, as described below. The agreements will continue for so long as there is a valid patent claim under the respective agreement, unless earlier terminated, and upon expiration, will continue as perpetual non-exclusive licenses. KNOW Bio has the right to terminate each such agreement, for any reason upon 90 days advance written notice to the Company.

License of existing and potential future intellectual property to KNOW Bio. The Company granted to KNOW Bio exclusive licenses, with the right to sublicense, to certain U.S. and foreign patents and patent applications controlled by the Company as of December 29, 2015 (the “KNOW Bio License Agreement”). The Company also granted to KNOW Bio an exclusive license, with the right to sublicense, to any patents and patent applications that became controlled by the Company during the three-year period between the agreement’s effective date and December 29, 2018 related to nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds and other nitric oxide-based therapeutics.

Sublicense of UNC and other third party intellectual property to KNOW Bio. The Company also granted to KNOW Bio exclusive sublicenses, with the ability to further sublicense, under certain of the U.S. and foreign patents and patent applications exclusively licensed to the Company from UNC (the “UNC License Agreement”) and another third party directed towards nitric oxide-releasing compositions, to develop and commercialize products utilizing the licensed technology (the “KNOW Bio Sublicense Agreements”). Under the exclusive sublicense to the UNC patents and applications (the “UNC Sublicense Agreement”), KNOW Bio is subject to the terms and conditions under the UNC License Agreement, including milestone and diligence payment obligations.However, pursuant to the terms of the UNC License Agreement, the Company is directly obligated to pay UNC any future milestones or royalties, including those resulting from actions conducted by the Company’s sublicensees, including KNOW Bio. Therefore, in the event of KNOW Bio non-performance with respect to its obligations under the UNC Sublicense Agreement, the Company would be obligated to make such payments to UNC. KNOW Bio would then become obligated to repay the Company pursuant to the UNC Sublicense Agreement, otherwise KNOW Bio would be in breach of its agreements with the Company and intellectual property rights would revert back to the Company. There were no milestone or royalty payments required during the three months ended March 31, 2019 and 2018.

Amendments to License and Sublicense Agreements with KNOW Bio

The Company and KNOW Bio entered into certain amendments dated October 13, 2017 (the “KNOW Bio Amendments”) to the KNOW Bio License Agreement and KNOW Bio Sublicense Agreements (the “Original KNOW Bio Agreements”) described above. Pursuant to the terms of the KNOW Bio Amendments, the Company re-acquired from KNOW Bio exclusive, worldwide rights under certain U.S. and foreign patents and patent applications controlled by the Company as of the execution date of the Original KNOW Bio Agreements, and patents and patent applications which became controlled by the Company during the three-year period between the execution date of the Original KNOW Bio Agreements and December 29, 2018, directed towards nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds, and other nitric oxide-based therapeutics, to develop and commercialize products for all diagnostic, therapeutic, prophylactic and palliative uses for any disease, condition or disorder caused by certain oncoviruses (the “Oncovirus Field”). The Company also obtained a three-year exclusive option, subject to payment of separate option exercise fees, to include up to four additional specified oncoviruses in the Oncovirus Field.

KNOW Bio also granted to the Company an exclusive license, with the right to sublicense, under any patents and patent applications which became controlled by KNOW Bio during the three-year period between the execution date of the Original KNOW Bio Agreements and December 29, 2018 and directed towards nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds, and other nitric oxide-based therapeutics, but not towards medical devices, to develop and commercialize products for use in the Oncovirus Field. Additionally, KNOW Bio agreed that KNOW Bio would not commercialize any products in the Oncovirus Field during the three-year period between the execution date of the Original KNOW Bio Agreements and December 29, 2018.

Upon execution of the KNOW Bio Amendments, in exchange for the Oncovirus Field rights, the Company paid a non-refundable upfront payment of $250. Products the Company develops in the Oncovirus Field based on Nitricil will not be subject to any further milestones, royalties or sublicensing payment obligations to KNOW Bio under the KNOW Bio Amendments. However, if the Company develops products in the Oncovirus Field that incorporate a certain nitric oxide-releasing composition specified in the KNOW Bio Amendments and (i) are covered by KNOW Bio patents or (ii) materially use or incorporate know-how of KNOW Bio or the Company related to such composition that is created during the three-year period between the execution date of the Original KNOW Bio Agreements and December 29, 2018, the Company would be obligated to make certain contingent milestone and royalty payments to KNOW Bio under the KNOW Bio Amendments.

The rights granted to the Company in the Oncovirus Field in the KNOW Bio Amendments continue for so long as there is a valid patent claim under the Original KNOW Bio Agreements, and upon expiration continue on a perpetual non-exclusive basis, and are subject to the termination rights of KNOW Bio and the Company that are set forth in the Original KNOW Bio Agreements. In addition, under the KNOW Bio Amendments, KNOW Bio may terminate the rights granted to the Company in the Oncovirus Field if: (i) the Company does not file a first investigational new drug (“IND”) application with the FDA for a product in the Oncovirus Field by October 2020; or (ii) the Company does not file a first new drug application (“NDA”) with the FDA by October 2025 for a product in the Oncovirus Field and does not otherwise have any active clinical programs related to the Oncovirus Field at such time.

The KNOW Bio Amendments also provide a mechanism whereby either party can cause a new chemical entity (“NCE”) covered by the Original KNOW Bio Agreements to become exclusive to such party by filing an IND on the NCE. An NCE that becomes exclusive to a party under this provision may not be commercialized by the other party until the later of expiration of patents covering the NCE or regulatory exclusivity covering the NCE. A party who obtains exclusivity for an NCE must advance development of the NCE pursuant to terms of the KNOW Bio Amendments in order to maintain such exclusivity; otherwise, such exclusivity will expire.

The terms of the KNOW Bio Amendments were negotiated at arms-length and do not provide the Company with an ability to significantly influence KNOW Bio or its operations.

Note 2:3: Research and Development Licenses

The Company has entered into various licensing agreements with universities and other research institutions under which the Company receives the rights, and in some cases substantially all of the rights, of the inventors, assignees or co-assignees to produce and market technology protected by certain patents and patent applications. The Company’s primary license agreement is with ~~the University of North Carolina at Chapel Hill (“UNC”)~~UNC and has been described in further detail within the subsection below. The counterparties to the Company’s various other licensing agreements are the University of Akron Research Foundation, Hospital for Special Surgery, Strakan International S.a.r.l., which is a licensee of the University of Aberdeen, KIPAX AB and ~~KIPAX AB. Additionally, see~~ ~~Note 9—Subsequent Events regarding the~~ KNOW ~~Bio license and sublicense agreement amendments executed in October 2017.~~ Bio. The Company is generally required to make milestone payments based on development milestones and will be required to make royalty payments based on a percentage of future sales of covered products or a percentage of sublicensing revenue. As future royalty payments are directly related to future revenues (either sales or sublicensing), future commitments cannot be determined. No accrual for future payments under these agreements has been recorded, as the Company cannot estimate if, when or in what amount payments may become due.

UNC License Agreement

The Amended, Restated and Consolidated License Agreement dated June 27, 2012, as amended, (the “UNC Agreement”) provides the Company with an exclusive license to issued patents and pending applications directed to the Company’s library of Nitricil compounds, including patents issued in the U.S., Japan and Australia, with claims intended to cover NVN1000, the ~~new chemical entity (“NCE”)~~NCE for the Company’s current product candidates. The UNC Agreement requires the Company to pay UNC up to $425 in regulatory and commercial milestones on a licensed product by licensed product basis and a running royalty percentage in the low single digits on net sales of licensed products. Licensed products include any products being developed by the Company or by its ~~sublicensees, KNOW Bio and~~ sublicensees.

~~Sato Pharmaceutical Co., Ltd. (“Sato”), as described further in Note 3—Collaboration Arrangements.Additionally, as described in Note 3—Collaboration Arrangements,~~Unless earlier terminated by the Company ~~made a payment to UNC in February 2017 representing~~at its election, or if the ~~portion of~~Company materially breaches the ~~upfront payment under the license~~ agreement ~~entered into with Sato that was estimated to be directly attributable to the UNC intellectual property rights included in the license to Sato.~~

~~Unless earlier terminated,~~or becomes bankrupt, the UNC Agreement remains in effect on a country by country and licensed product by licensed product basis until the expiration of the last to expire issued patent covering such licensed product in the applicable country.

Note ~~3: Collaboration~~4: Licensing Arrangements

~~KNOW Bio Technology Agreements~~

~~License of existing and potential future intellectual property to KNOW Bio.~~ The Company granted to KNOW Bio exclusive licenses, with the right to sublicense, to certain U.S. and foreign patents and patent applications controlled by the Company as of December 29, 2015 (the “KNOW Bio License Agreement”). The Company also granted to KNOW Bio a non-exclusive license, with the right to sublicense, to any patents and patent applications that may become controlled by the Company during the three years immediately following the agreement’s effective date related to nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing and other nitric oxide-based therapeutics.

~~Sublicense of UNC and other third party intellectual property to KNOW Bio.~~ The Company also granted to KNOW Bio exclusive sublicenses, with the ability to further sublicense, under certain of the U.S. and foreign patents and patent applications exclusively licensed to the Company from UNC and another third party directed towards nitric oxide-releasing compositions, to develop and commercialize products utilizing the licensed technology (the “KNOW Bio Sublicense Agreements”). Under the exclusive sublicense to the UNC patents and applications, KNOW Bio is subject to the terms and conditions under the UNC License Agreement, including milestone and diligence payment obligations. ~~However, the Company is obligated to pay UNC any future milestones or royalties in the event of KNOW Bio non-performance under the sublicense arrangement.~~ In such an event, KNOW Bio would be in breach of its agreements with the Company and intellectual property rights would revert back to the Company. There were no milestone or royalty payments required during the three and nine months ended September 30, 2017 and 2016.

~~See~~ ~~Note 9—Subsequent Events regarding the amendments to the KNOW Bio License Agreement and KNOW Bio Sublicense Agreements executed in October 2017.~~

Sato License Agreement

Significant Terms

On January 12, 2017, the Company entered into a license agreement, and related amendment, with Sato Pharmaceutical Co., Ltd. (“Sato”), relating to SB204, its drug candidate for the treatment of acne vulgaris in Japan (the “Sato Agreement”). Pursuant to the Sato Agreement, the Company granted to Sato an exclusive, royalty-bearing, non-transferable right and license under certain of the Company’s intellectual property rights, with the right to sublicense with the Company’s prior written consent, to develop, use and sell products in Japan that incorporate SB204 in certain topical dosage forms for t hethe treatment of acne vulgaris, and to make the finished form of such products.

On October 5, 2018, the Company and Sato entered into the second amendment (the “Sato Amendment”) to the Sato Agreement (collectively, the “Amended Sato Agreement”). The Sato Amendment expanded the Sato Agreement to include SB206, the Company’s drug candidate for the treatment of viral skin infections. Pursuant to the Amended Sato Agreement, the Company granted to Sato an exclusive, royalty-bearing, non-transferable license under certain of its intellectual property rights, with the right to sublicense with the Company’s prior written consent, to develop, use and sell products in Japan that incorporate SB204 or SB206 in certain topical dosage forms for the treatment of acne vulgaris or viral skin infections, respectively, and to make the finished form of such products. The Company or its designated contract manufacturer will supply finished product to Sato for use in the development of SB204 and SB206 in the licensed territory. The rights granted to Sato do not include the right to manufacture the active pharmaceutical ingredient (“API”) of SB204 or SB206; rather, the parties agreed to negotiate a commercial supply agreement pursuant to which the Company or its designated contract manufacturer ~~will retain~~would be the ~~rights to supply to Sato. The Company, or its designated contract manufacturer, will also supply finished product~~exclusive supplier to Sato of the API for ~~use in~~ the ~~development~~commercial manufacture of ~~SB204~~licensed products in the licensed territory. Under the terms of the Amended Sato Agreement, the Company also has exclusive rights to certain intellectual property that may be developed by Sato in the future, which the Company could choose to use for its own development and commercialization of SB204 or SB206 outside of Japan.

~~Pursuant to~~

Under the ~~terms of the~~Amended Sato Agreement, ~~Sato had an exclusive option to negotiate for the license rights~~ in certain additional territories within Asia, subject to Sato’s payment of a specified option exercise fee. During the third quarter of 2017, Sato elected not to execute this option. This option expired, unexercised on September 30, 2017.

In exchange for the ~~licenses~~SB204 and SB206 license rights granted to Sato, ~~under the Sato Agreement,~~ Sato agreed to pay the Company ~~an upfront payment, as well as additional milestone payments upon achievement of various future development, regulatory and commercial milestones. Pursuant to~~ the ~~terms of the Sato Agreement, Sato was required to pay the Company an~~following:

An upfront payment of 1.25 billion Japanese Yen, ~~(“JPY”)~~or “JPY”, ~~which~~payable in installments of 0.25 billion JPY, 0.5 billion JPY and 0.5 billion JPY on October 5, 2018, February 14, 2019 and September 13, 2019, respectively. This is in addition to the 1.25 billion JPY (approximately $10,813 USD) paid on January 19, 2017 following the execution of the Sato Amendment on January 12, 2017. On October 23, 2018, the Company received ~~in January 2017 in~~ the ~~amount~~first installment from the Amended Sato Agreement of ~~$10,813 when converted to U.S. Dollars. Sato is also required to pay~~0.25 billion JPY (approximately $2,224 USD). On March 14, 2019, the Company received the second installment payment related to the Amended Sato Agreement of 0.5 billion JPY (approximately $4,460 USD).

Up to an aggregate of 1.75 billion JPY (adjusted from 2.75 billion JPY in the Sato Agreement) upon the achievement of various development and regulatory ~~milestones. Under~~milestones, including (i) a 0.25 billion JPY (approximately $2,162 USD) milestone payment received during the ~~Sato Agreement, Sato also agreed to pay~~fourth quarter of 2018 following Sato’s initiation of a Phase 1 trial in Japan and (ii) an aggregate of 1.0 billion JPY that becomes payable upon the ~~Company up~~earlier occurrence of specified fixed future dates or the achievement of milestone events.

Up to an aggregate of 3.9 billion JPY (adjusted from 0.9 billion JPY in ~~milestone payments~~the Sato Agreement) upon the achievement of various commercial milestones. ~~Sato must also pay the Company a~~

A tiered royalty ~~equal to~~ranging from a mid-single digit to a low-double digit percentage (adjusted from a mid-single digit percentage in the Sato Agreement) of net sales of licensed products in the licensed territory, subject to a reduction in the royalty payments in certain circumstances.

The term of the Amended Sato Agreement ~~and~~(and the period during which Sato must pay royalties under the ~~Sato Agreement~~amended license agreement) expires on ~~a licensed product-by-licensed product basis, on~~ the ~~tenth~~twentieth anniversary of the first commercial sale of a licensed product in the licensed field in the licensed ~~territory.~~territory (adjusted from the tenth anniversary of the first commercial sale in the license agreement). The term of the Amended Sato Agreement may be renewed with respect to a licensed product by mutual written agreement of the parties for additional two year periods following expiration of the initial term.

~~The Company,~~ All other material terms of the license agreement remain unchanged by ~~itself or through its designated third party contract manufacturer, is obligated pursuant to~~ the Sato Agreement to supply Sato with all quantities of licensed products required by Sato to develop the licensed products in the licensed field in the licensed territory. As part of the Sato Agreement, the Company and Sato have also agreed to negotiate a commercial supply agreement pursuant to which the Company, by itself or through its designated third party contract manufacturer, would be the exclusive supplier to Sato of the active pharmaceutical ingredient of licensed products for the manufacture of licensed products in the licensed territory.

Amendment.

Sato is responsible for funding the development and commercial costs for the program that are specific to Japan. The Company is obligated to perform certain oversight, review and supporting activities for Sato, including: (i) using commercially reasonable efforts to obtain marketing approval of SB204 and SB206 in the ~~U.S,~~U.S., (ii) sharing all future scientific information the Company may obtain during the term of the Amended Sato Agreement pertaining to SB204 and SB206, (iii) performing certain additional ~~pre-clinical~~preclinical studies if such studies are deemed necessary by the Japanese regulatory authority, up to and not to exceed a total cost of $1,000 and (iv) participating in a joint committee that oversees, reviews and approves Sato’s development and commercialization activities under the Amended Sato Agreement. Additionally, the Company has granted Sato the option to use the Company’s trademarks in connection with the commercialization of licensed products in the licensed territory for no additional consideration, subject to the Company’s approval of such use.

The Amended Sato Agreement may be terminated by (i) Sato without cause upon 120 days’ advance written notice to the Company, (ii) either party in the event of the other party’s uncured material breach upon 60 days’ advance written notice, (iii) force majeure, (iv) either party in the event of the other party’s dissolution, liquidation, bankruptcy or insolvency andand (v) the Company immediately upon written notice if Sato challenges the validity, patentability, or enforceability of any of the Company’s patents or patent applications licensed to Sato under the Amended Sato Agreement. In the event of a termination, no portion of the upfront ~~fee~~fees received from Sato ~~in January 2017 is~~are refundable.

~~Accounting Considerations and~~

Note 5: Revenue Recognition

Sato Agreement

The Company ~~has~~assessed the Sato Agreement in accordance with Topic 606 and concluded that the contract counterparty, Sato, is a customer within the scope of Topic 606. The Company identified the following ~~four performance deliverables~~promises under the Sato Agreement: (i) the grant of the intellectual property license to Sato,, (ii) the obligation to participate in a joint committee that oversees, reviews, and approves Sato’s research and development activities and provides advisory support during Sato’s development process, (iii) the obligation to manufacture and

supply Sato with all quantities of licensed product required for development activities in Japan, and (iv) the ~~grant of an optional right~~stand-ready obligation to ~~use the Company’s trademark.~~ perform any necessary repeat preclinical studies, up to $1,000 in cost. The Company determined that these promises were not individually distinct because Sato can only benefit from these licensed intellectual property rights and services when bundled together; they do not have individual benefit or utility to Sato. As a result, all promises have been combined into a single performance obligation.

The Sato Agreement also ~~contains an obligation~~provides that the two parties agree to ~~manufacture and~~negotiate in good faith the terms of a commercial supply ~~all quantities~~agreement pursuant to which the Company or a third party manufacturer would be the exclusive supplier to Sato of the ~~active pharmaceutical ingredient contained~~API for the commercial manufacture of licensed products in the licensed ~~product manufactured by~~territory. The Company concluded this obligation to negotiate the terms of a commercial supply agreement does not create (i) a legally enforceable obligation under which the Company may have to perform and supply Sato with API for commercial ~~sale~~manufacturing or (ii) a material right because the incremental commercial supply fee consideration agreed upon between the parties in ~~Japan.~~the Sato Agreement is representative of a stand-alone selling price for the supply of API and does not represent a discount. Therefore, this contract provision is not considered to be a promise to deliver goods or services and is not a performance obligation or part of the combined single performance obligation described above.

Amended Sato Agreement

On October 5, 2018, the Company and Sato entered into the Amended Sato Agreement. The Sato Amendment expanded the Sato Agreement to include SB206, the Company’s drug candidate for the treatment of viral skin infections. The Company assessed the Amended Sato Agreement in accordance with Topic 606 and concluded the contract modification should incorporate the additional goods and services provided for in the Amendment into the existing, partially satisfied single bundled performance obligation that will continue to be delivered to Sato over the remaining development period. This contract modification accounting is concluded to be appropriate as the additional goods and services conveyed under the Sato Amendment were determined to not be distinct from the single performance obligation, and the additional consideration provided did not reflect the standalone selling price of those additional goods and services. As such, the Company recorded a cumulative adjustment as of the amendment execution date to reflect revenue that would have been recognized cumulatively for the partially completed bundled performance obligation.

The Company concluded that the following consideration would be included in the transaction price as they were (i) received prior to March 31, 2019, or (ii) payable upon specified fixed dates in the future and are not contingent upon clinical or regulatory success in Japan:

The 1.25 billion JPY (approximately $10,813 USD) original upfront payment received on January 19, 2017 following the execution of the Sato Agreement on January 12, 2017.

A milestone payment of 0.25 billion JPY (approximately $2,162 USD) received during the fourth quarter of 2018 following Sato’s initiation of a Phase 1 trial in Japan.

The Sato Amendment upfront payment of 1.25 billion JPY, payable in installments of 0.25 billion JPY, 0.5 billion JPY and 0.5 billion JPY on October 5, 2018, February 14, 2019 and September 13, 2019, respectively. On October 23, 2018, the Company received the first installment from the Amended Sato Agreement of 0.25 billion JPY (approximately $2,224 USD). On March 14, 2019, the Company received the second installment payment related to the Amended Sato Agreement of 0.5 billion JPY (approximately $4,460 USD).

An aggregate of 1.0 billion JPY in non-contingent milestone payments that become payable upon the earlier occurrence of specified fixed dates in the future or the achievement of specified milestone events.

The following table presents the Company’s contract assets and contract liabilities balances for the periods indicated.



	Contract Asset		Contract Liability		Net Deferred Revenue
December 31, 2018	$	17,790	$	24,757	$	6,967

March 31, 2019	$	13,330	$	23,657	$	10,327

	Short-term Deferred Revenue		Long-term Deferred Revenue		Net Deferred Revenue
December 31, 2018	$	4,401	$	2,566	$	6,967

March 31, 2019	$	4,401	$	5,926	$	10,327

The Company has recorded the Sato Agreement and Amended Sato Agreement transaction price, including the upfront payments received and the unconstrained variable consideration, as deferred revenue (comprised of (i) a contract liability; net of (ii) a contract asset). The change in the net deferred revenue balance during the three months ended March 31, 2019 was associated with the receipt of the second installment payment of 0.5 billion JPY (approximately $4,460 USD, and recognition of license and collaboration revenue associated with the Company’s performance during the period (continued amortization of deferred revenue). During the three months ended March 31, 2019 and 2018, the Company recognized $1,100 and $649, respectively, in license and collaboration revenue under this ~~commercial supply obligation was~~agreement.

The Company has concluded that the above consideration is probable of not resulting in a ~~contingent deliverable because SB204 is not yet a commercially approved product~~significant revenue reversal and therefore included in the transaction price and is allocated to the single performance obligation. No other variable consideration under the Amended Sato Agreement is probable of not resulting in a significant revenue reversal as of March 31, 2019 and therefore, is currently ~~subject to additional clinical studies prior to commercial approval in Japan. The Company considered~~fully constrained and excluded from the ~~provisions of the multiple-elements arrangement guidance and determined that none of the deliverables have standalone value because~~ Sato’s ability to utilize the value of the licensed intellectual property rights is limited absent the delivery of the other elements of the arrangement. In particular, the Company has maintained control of the methods and expertise necessary to manufacture and supply the active pharmaceutical ingredient in the licensed product, which limits the utility and causes an ~~interdependency of the remaining elements on the delivery of~~ ~~quantities of licensed product required for development activities in Japan. As a result, all deliverables have been~~ ~~combined into a single unit of accounting.~~

transaction price.

The Company evaluated the timing of delivery for each of the ~~deliverables~~obligations and concluded that ~~its obligation to participate on~~a time-based input method is most appropriate because Sato is accessing and benefiting from the ~~joint committee during~~intellectual property and technology (the predominant items of the combined performance obligation) ratably over the duration of Sato’s estimated development ~~process would be~~period in Japan. Although the ~~last delivered element~~Company concluded that the intellectual property is functional rather than symbolic, the services provided under the ~~arrangement and therefore would~~performance obligation are provided over time. Therefore, the allocated transaction price will be recognized using a time-based input method that results in straight-line recognition over the ~~basis for revenue recognition~~Company’s performance period.

Prior to the Sato Amendment, the Company estimated the Sato Agreement development time line for the ~~combined unit of accounting. The Company began~~SB204 product candidate to ~~participate on the joint committee~~be approximately 5 years, starting in ~~March~~February 2017 and ~~currently estimates that its participation will continue through~~completing in the first quarter of 2022. ~~This~~With the Amended Sato Agreement, the Company and Sato are now advancing both the SB204 and SB206 product candidates for the Japan territory. The parties are working collaboratively to reach agreement with respect to the Japan territory development plan, including a corresponding time ~~period~~line and estimated duration for the development programs in whole. As of March 31, 2019, the estimated time line is 7.5 years. The Company notes that it monitors and reassesses the ~~Company’s~~ estimated performance period ~~which the Company montiors and reassesses~~for purposes of revenue recognition during each reporting period. ~~The total upfront~~Therefore, if the duration of the development program time line is affected by the establishment or subsequent adjustments to a mutually agreed upon SB204 and SB206 development plan in the Japan territory, the Company will adjust its estimated performance period for revenue recognition purposes accordingly, as needed.

In future periods, the Company will lift the variable consideration ~~under this agreement~~constraint from each contingent payment when there is no longer a probable likelihood of significant revenue reversal. When the constraint is lifted from a milestone payment, the Company will recognize the incremental transaction price using the same time-based input method that is being used to recognize the revenue, which results in straight-line recognition over the performance period. If the Company’s performance is not yet completed at the time that the constraint is lifted, a cumulative catch-up adjustment will be recognized in the period. If no other performance is required by the Company at the time the constraint is lifted, the Company expects to recognize all revenue associated with such milestone payments at the time that the constraint is lifted.

Contract costs—Sato Agreement

The Company has incurred certain fees and costs in the process of obtaining the Amended Sato Agreement that were payable upon contract execution and, therefore, have been recognized as ~~license~~other assets and ~~collaboration revenue~~amortized as general and administrative expense on a straight-line basis over the same estimated performance ~~period. Prior~~period being used to recognize the associated revenue. These fees are associated with the following two arrangements and are described as follows:

The Company entered into an agreement with a third party to assist the Company in exploring the licensing opportunity which led to the third quarter of 2017, Company had estimated that its participation in the joint committee would continue through third quarter of 2021. The change in estimate resulted in a $69 decrease in revenue recognized during the three months ended September 30, 2017 as compared to the revenue that would have been recognized using the previously estimated performance period. The change in estimate does not affect the total amount of revenue expected to be recognized over the termexecution of the Sato Agreement.

~~As described in Note 1—Organization and Significant Accounting Policies, the Company intends to adopt FASB ASC Topic 606,~~ ~~Revenue from Contracts with Customers,~~ ~~guidance on January 1, 2018, and is currently evaluating the impact that Topic 606 will have on reported revenues in 2017 and in future periods~~.

The Company ~~determined that~~is obligated to pay the ~~future contingent~~third party a low-single-digit percentage of all upfront and milestone payments meet the definition of a milestone. The development and regulatory milestones are not considered to be substantive because they do not relate solely to past performance. Accordingly, revenue for the achievement of development milestones will be recognized over the performance period, assuming collectability is reasonably assured. The revenue for the achievement of regulatory milestones will be recognized over the ten year commercial term of the Sato Agreement. As of September 30, 2017, no amounts have been recognized as license and collaboration revenue for any of these potential future milestones and all the contingent payments remained eligible for achievement as of September 30, 2017.

~~During the three and nine months ended September 30, 2017,~~ the Company ~~recognized $532 and $1,233, respectively, in license and collaboration revenue~~receives from Sato under ~~this agreement. The deferred revenue balance pertaining to~~ the Amended Sato ~~Agreement as of September 30, 2017 was $9,580, including $2,129 and $7,451 in current and non-current deferred revenue, respectively.~~

~~Contract Acquisition Costs~~

Agreement.

The intellectual property rights granted to Sato under the Sato Agreement include certain intellectual property rights which the Company has licensed from UNC. Under the Company’s license agreement with UNC described in Note 2—3—Research and Development Licenses, the Company is obligated to pay UNC a running royalty percentage in the low single digits on net sales of licensed products, including net sales that may be generated by Sato. Additionally, the Company ~~made a payment~~is obligated to make payments to UNC ~~in February 2017 representing~~that represent the portion of the Sato upfront ~~payment~~and milestone payments that ~~was~~were estimated to be directly attributable to the UNC intellectual property rights included in the license to Sato.

The Company also entered into an agreement with a third party to assist the Company in exploring the licensing opportunity which led to the execution of the Sato Agreement. The Company paid a fee of $216 to the third party upon execution of

Performance Obligations under the Sato Agreement

The net amount of existing performance obligations under long-term contracts unsatisfied as of March 31, 2019 was $10,327. The Company expects to recognize approximately 19% of the remaining performance obligations as revenue over the next 12 months, and ~~is obligated~~the balance thereafter. The Company applied the practical expedient and does not disclose information about variable consideration related to ~~pay~~sales-based or usage-based royalties promised in exchange for a license of intellectual property. This expedient specifically applied to the ~~third party a low-single-digit percentage of any future~~sales-based milestone payments that are present in the Amended Sato Agreement (3.9 billion JPY), as well as percentage-based royalty payments in the Sato Agreement that are contingent upon future sales.

Research and Development Services to KNOW Bio

As described in Note 2—Know Bio, LLC, the Company ~~may receive from Sato~~entered the KNOW Bio Services Agreement during 2017 and provided research and development services on a fee-for-service basis. After assessing revenue according to the five-step model of ASC 606, the Company determined that contract research and development services revenue should be recognized in the period in which the services are performed. During the three months ended March 31, 2019 and 2018, the Company recognized $0 and $9, respectively, in research and development services revenue for services performed under the ~~Sato~~KNOW Bio Services Agreement.

The fees associated with payments made to UNC and the third party have been capitalized as other assets, including current and noncurrent portions, in the accompanying balance sheet and are being amortized as general and administrative expense on a straight-line basis over the same estimated period used to recognize revenue on the upfront payment received from Sato.

Note 4:6: Property and Equipment, Net

Property and equipment consisted of the following:

September 30,

December 31,

2017

2016

Computer equipment

$
517

$
500

Furniture and fixtures

559

504

Laboratory equipment

6,660

5,723

Office equipment

166

106

Building related to facility lease obligation

10,557

10,557

Leasehold improvements

951

1,338

19,410

18,728

Less: Accumulated depreciation and amortization

(2,672
)

(2,438
)

$
16,738

$
16,290



	March 31, 2019			December 31, 2018
Computer equipment	$	575		$	577
Furniture and fixtures	312			312
Laboratory equipment	7,494			7,442
Office equipment	400			400
Building related to facility lease obligation	—			10,557
Leasehold improvements	7,053			1,168
Property and equipment, gross	15,834			20,456
Less: Accumulated depreciation and amortization	(4,177		)	(4,588		)
Total property and equipment, net	$	11,657		$	15,868

Depreciation and amortization expense was ~~$391~~$503 and ~~$1,030~~$401 for the three ~~and nine~~ months ended ~~September 30, 2017, respectively,~~March 31, 2019 and ~~$187~~2018, respectively.

Table of Contents

See Note 1—Organization and ~~$575~~Significant Accounting Policies and Note 7—Commitments and Contingencies regarding the adoption of Topic 842, Leases, and its impact to property and equipment, net for the three ~~and nine months~~month ended ~~September 30, 2016.~~

March 31, 2019.

Note 5:7: Commitments and Contingencies

Lease Obligations

The Company leases office space and certain equipment under non-cancelable lease agreements.

Prior to January 1, 2019, the Company applied the accounting guidance in ASC 840, Leases, to its lease agreements. The leases were reviewed for classification as operating or capital leases. For operating leases, rent was recognized on a straight-line basis over the lease period. For capital leases, the Company recorded the leased asset with a corresponding liability and amortized the asset over the lease term. Payments were recorded as reductions to the liability with an appropriate interest charge recorded based on the then-outstanding remaining liability.

The Company considered the nature of the renovations and the Company’s involvement during the construction period of previously leased office space to determine if it is considered to be the owner of the construction project during the construction period. If the Company determined that it was the owner of the construction project, it was required to capitalize the fair value of the building as well as the construction costs incurred, including capitalized interest, on its consolidated balance sheet along with a corresponding financing liability (“build-to-suit accounting”). Upon completion of the construction of the facility under a build-to-suit lease, the Company assessed whether the circumstances qualified for sales recognition under the sale-leaseback accounting guidance. If the lease met the sale-leaseback criteria, the Company would remove the asset and related financial obligation from the balance sheet and evaluate the lease for treatment as a capital or operating lease. If upon completion of construction, the project did not meet the sale-leaseback criteria, the leased property was treated as an asset financing for financial reporting purposes. The portion of the facility financing obligation representing the principal that was to be repaid in the following 12 months was classified as a current liability in the condensed consolidated balance sheets, with the remaining portion of the obligation classified as a noncurrent liability.

Beginning January 1, 2019, the Company applies the accounting guidance in ASC 842, Leases. As such, the Company assesses all arrangements, that convey the right to control the use of property, plant and equipment, at inception, to determine if it is, or contains, a lease based on the unique facts and circumstances present in that arrangement. For those leases identified, the Company determines the lease classification, recognition, and measurement at the lease commencement date. For arrangements that contain a lease the Company: (i) identifies lease and non-lease components; (ii) determines the consideration in the contract; (iii) determines whether the lease is an operating or financing lease; and (iv) recognizes lease Right of Use (“ROU”) assets and corresponding lease liabilities. Lease liabilities are recorded based on the present value of lease payments over the expected lease term. The corresponding ROU asset is measured from the initial lease liability, adjusted by (i) accrued or prepaid rents; (ii) remaining unamortized initial direct costs and lease incentives; and (iii) any impairments of the ROU asset. The interest rate implicit in the Company’s lease contracts is typically not readily determinable and as such, the Company uses its incremental borrowing rate based on the information available at the lease commencement date, which represents an internally developed rate that would be incurred to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments in a similar economic environment. The weighted average discount rate utilized on our operating lease liabilities as of March 31, 2019 was 9.85%. The weighted average remaining lease term for our operating leases as of March 31, 2019 was 7.25 years.

Primary Facility Lease

In August 2015, the Company entered into a lease agreement for approximately 51,000 rentable square feet of facility space in Morrisville, North Carolina, commencing in April ~~2016.~~ 2016 (the “Primary Facility Lease”). The initial term of the ~~lease agreement~~Primary Facility Lease extends through June 30, 2026. The Company has an option to extend the ~~lease agreement~~Primary Facility Lease by five years upon completion of the initial lease ~~term.~~term; however, the renewal period was not included in the calculation of the lease obligation. Current contractual base rent payments are ~~$93~~$95 per month, subject to a three percent increase annually over the term of the ~~lease agreement.~~

~~Pursuant~~Primary Facility Lease.

Prior to January 1, 2019, the ~~Company’s~~Company applied the accounting ~~policy and applicable~~ guidance in ASC ~~840,~~ ~~Leases~~,840. Based on that guidance, the facility ~~is being~~was accounted for as an asset financing, with the building asset and related facility financing obligation remaining on the Company’s balance sheet. The building asset iswas being depreciated over a 25 year period and the facility financing obligation ~~is being~~was amortized so that the net carrying value of the building asset and the facility financing obligation ~~are~~were to be equivalent at the end of the initial term of the lease agreement. Monthly rental payments ~~will be~~were allocated between principal and interest expense associated with the facility financing obligation, as well as grounds rent expense of $8 per month.

The Company ~~has~~had recorded an asset related to the building and construction costs within property and equipment of $10,557 as of ~~September 30, 2017.~~December 31, 2018. The non-current facility lease obligation on the Company’s condensed consolidated balance sheet iswas $7,998 as of ~~September 30, 2017 and~~ December 31, ~~2016.~~2018. During the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2018, the Company recognized interest expense related to the primary facility lease of $261, and ~~$783, respectively, including $29~~there was $41 of accrued interest included in other accrued expenses as of ~~September 30, 2017.~~

~~Operating Leases~~

December 31, 2018.

The Company ~~leased~~adopted Topic 842 as of January 1, 2019 using the modified retrospective transition method and initially applied the transition provisions as of January 1, 2019. This transition method allowed the Company to continue to apply the legacy guidance in ASC 840 for periods prior to 2019 and recognize a cumulative-effect adjustment to the opening balance of accumulated deficit as of the date of adoption.

The Company elected the package of transition practical expedients, which, among other things, allowed the Company to keep the historical lease classifications and not have to reassess the lease classification for any existing leases as of the date of adoption. The Company also made an accounting policy election to apply the short-term lease exception, which allows the Company to exclude leases with an initial term of twelve months or less from the consolidated balance sheets.

As a result of the adoption of Topic 842, the Company derecognized $10,557 of building asset (property, plant and equipment), and $7,998 of facility ~~under a non-cancelable operating~~financing obligation associated with previously existing build-to-suit arrangement related to its sole corporate and manufacturing facility. The Company also capitalized leasehold improvements and ROU assets of $5,885 and $1,827, respectively, and recorded lease ~~that expired in April 2017. Rent expense~~liabilities for operating leases ~~totaled $94~~totaling $6,786, as of January 1, 2019. The capitalized leasehold improvement assets recorded as part of the adoption of Topic 842 were previously included within the derecognized building asset as part of the previous build-to-suit arrangement. The Company also recognized an increase of $714 to accumulated deficit related to its de-recognition of its previously recorded build-to-suit arrangement.

The Company has elected to separate lease components (fixed rent payments) with non-lease components (common-area maintenance costs) on our real estate assets. Fixed lease payments on operating leases are recognized over the expected term of the lease on a straight-line basis. Variable lease expenses that are not considered fixed are expensed as incurred. Fixed and ~~$345~~variable lease expense on operating leases is recognized within operating expenses within our condensed consolidated statements of operations. We have elected the short-term lease exemption and, therefore, do not recognize a ROU asset or corresponding liability for lease arrangements with an original term of 12 months or less.

Rent expense, including both short-term and variable lease components associated with the primary facility lease, was $157 and $42 for the three ~~and nine~~ months ended ~~September 30, 2017, respectively,~~March 31, 2019 and ~~$165 and $374~~2018, respectively.

The Company’s supplemental non-cash disclosure for its ROU assets obtained in exchange for lease liabilities was $1,827 for the three ~~and nine~~ months ended ~~September 30, 2016, respectively.~~

March 31, 2019.

At January 1, 2019, maturities of operating lease liabilities over each of the next five years and thereafter were as follows:



	Operating Leases
2019	$	1,170
2020	1,205
2021	1,241
2022	1,278
2023	1,317
Thereafter	3,467
Total minimum lease payments	$	9,678
Less imputed interest	(2,871		)
Total lease liability	$	6,807

Primary Facility Sublease

In July 2018, the Company and a third-party tenant entered into a sublease of approximately 6,400 square feet of office space at the Company’s headquarters. The sublease has a three-year, non-cancellable term and provides for monthly rental income to the Company of approximately $12 per month through July 2021. The Company has classified the sublease as an operating lease pursuant to classification criteria in ASC 842 and is recognizing the rental income on a straight-line basis over the lease term.

Contingencies

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

See ~~Note 9—Subsequent Events regarding~~Legal Proceedings below for further discussion of pending legal proceedings that arose in November 2017. Aside from these matters, the Company is not currently a party to any material legal proceedings and is not aware of any claims or actions pending or threatened against the Company that the Company believes could have a material adverse effect on the Company’s business, operating results, cash flows orclaims.

~~financial statements. In the future, the Company might from time to time become involved in litigation relating to claims arising from its ordinary course of business.~~

The Company has entered into, and expects to continue to enter into, contracts in the normal course of business with various third parties who support its clinical trials, preclinical research studies and other services related to its development activities. The scope of the services under these agreements can generally be modified at any time, and these agreements can generally be terminated by either party after a period of notice and receipt of written notice. There have been no material contract terminations as of ~~September~~March 31, 2019.

Legal Proceedings

In prior filings, the Company reported that it was subject to putative stockholder class action lawsuits that were filed in November 2017 in the United States District Court for the Middle District of North Carolina against the Company and certain of its current and former directors and officers, which were consolidated under the case name In re Novan, Inc. Securities Litigation. The consolidated amended complaint filed by the designated lead plaintiff asserted claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to the Company’s Phase 3 clinical trials of SB204. On June 14, 2018, the Company filed a motion to dismiss the consolidated amended complaint. On November 30, ~~2017.~~

~~Indemnification~~

2018, a federal magistrate judge entered an order recommending that the district court grant the Company’s motion. The plaintiff filed objections to this recommendation and the Company filed a response. On January 28, 2019, the district court adopted the magistrate judge’s recommendation, dismissed the action with prejudice and entered judgment in favor of the Company and against the plaintiff. The plaintiff did not appeal this dismissal and judgment. As such, the Company has concluded that this matter is closed.

Other than as described above, the Company is not currently a party to any material legal proceedings and is not aware of any claims or actions pending or threatened against the Company that the Company believes could have a material adverse effect on the Company’s business, operating results, cash flows or financial statements. In the future, the Company might from time to time become involved in litigation relating to claims arising from its ordinary course of business, the Company has entered into contractual arrangements under which it has agreed to provide indemnification of varying scope and terms to business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the Company’s breach of such agreements and out of intellectual property infringement claims made by third parties. In these circumstances, payment may be conditional on the other party making a claim pursuant to the procedures specified in the particular contract.

The Company’s obligations under these agreements may be limited in terms of time or amount, and in some instances, the Company may have recourse against third parties for certain payments. The terms of such obligations vary.

It is not possible to make a reasonable estimate of the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. No material indemnification liabilities were identified or accrued in the accompanying financial statements.

business.

Compensatory Obligations

In conjunction with the departures of ~~two~~three former Company officers in ~~March~~2019 and ~~May of 2017,~~2018, the Company entered into separation and general release agreements ~~with both individuals~~ that included separation benefits consistent with the Company’s obligations under their previously existing employment agreements for “separation from service” for “good reason.” The ~~resulting combined~~Company recognized related severance expense ~~recognized in~~of $878 and $332 during the three ~~and nine~~ months ended ~~September 30, 2017, totaled zero~~March 31, 2019 and ~~approximately $793,~~2018, respectively. The remaining accrued severance obligation in respect of the ~~two~~three former officers was ~~$439~~$621 as of ~~September 30, 2017,~~March 31, 2019, which is included in accrued compensation in the accompanying condensed consolidated balance sheet. The Company also recognized ~~zero and approximately $374 in~~non-cash stock compensation expense of $0 and $212 during the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019 and 2018, respectively, related to the accelerated vesting of the former officers’ stock options.

In ~~June 2017,~~November 2018, the Company ~~reduced~~realigned its overall employee ~~workforce~~headcount to reduce ~~operating expenditures and preserve cash on hand. Employee~~certain fixed costs. Total employee severance costs associated with this action ~~were $224,~~are expected to be $306, of which ~~were~~$61 was expensed during the ~~second quarter~~three months ended March 31, 2019. As of ~~2017. The remaining~~March 31, 2019, severance costs of $82 were accrued ~~severance obligation was $48 as~~in the accompanying consolidated balance sheet.

See Note 10—Share-Based Compensation regarding the contingent award of ~~September 30, 2017.~~

Stock Appreciation Rights granted in August 2018.

See Note 11—Tangible Stockholder Return Plan regarding the Tangible Stockholder Return Plan adopted in August 2018.

Note 6:8: Stockholders’ Equity

Capital Structure

~~Authorized Shares~~.

In conjunction with the completion of the ~~IPO~~Company’s initial public offering in September 2016, the Company further amended its amended and restated certificate of incorporation and amended and restated its bylaws. The amendment provides for 210,000,000 authorized shares of capital stock, of which 200,000,000 shares have been designated as $0.0001 par value common stock and 10,000,000 shares have been designated as $0.0001 par value preferred stock.

Common Stock

The Company’s common stock has a par value of $0.0001 per share and consists of 200,000,000 authorized shares as of March 31, 2019 and December 31, 2018. There were 26,069,734 and 26,056,735 shares of voting common stock outstanding as of March 31, 2019 and December 31, 2018, respectively.

The Company had reserved shares of common stock for future issuance as follows:



	March 31, 2019	December 31, 2018
Outstanding stock options (Note 10)	1,645,357	1,671,666
Warrants to purchase common stock issued in January 2018 Offering (Note 9)	10,000,000	10,000,000
For possible future issuance under 2016 Stock Plan (Note 10)	703,519	699,376
	12,348,876	12,371,042

Preferred Stock

The Company’s amended and restated certificate of incorporation provides the Company’s board of directors with the authority to issue $0.0001 par value preferred stock from time to time in one or more series by adopting a resolution and filing a certificate of designations. Voting powers, designations, preferences, dividend rights, conversion rights and liquidation preferences shall be stated and expressed in such resolutions. There were 10,000,000 shares designated as preferred stock and no shares outstanding as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016.~~

2018.

~~Common Stock~~

~~Authorized, Issued~~

Note 9: Warrants

The Company evaluates its financial assets and ~~Outstanding Common Shares~~

~~The Company’s~~liabilities subject to fair value measurements on a recurring basis to determine the appropriate level in which to classify them for each reporting period, pursuant to the fair value measurements policy described in Note 1—Organization and Significant Accounting Policies. This determination requires significant judgments to be made.

On January 9, 2018, the Company sold an aggregate of 10,000,000 shares of common stock ~~has~~and issued warrants to purchase up to 10,000,000 shares of common stock at a ~~par value~~public offering price of ~~$0.0001~~$3.80 per share of common stock and accompanying warrant. Pursuant to the warrant agreement and form of warrant dated January 9, 2018 (the “Warrant Agreement”), the warrant exercise price is $4.66 per share and ~~consists~~the warrants will expire four years from the date of ~~200,000,000 authorized shares~~issuance.

The Warrant Agreement includes a provision whereby the exercisability of the warrants may be limited if, upon exercise, the warrant holder or any of its affiliates would beneficially own more than 4.99% (or an amount up to 9.99% if the holder so elects) of the Company’s common stock. The Warrant Agreement also provides that the aforementioned exercise limitation provision is not applicable to any warrant holder that beneficially owns 10.0% or more of the Company’s outstanding common stock immediately following the closing of the January 2018 Offering and the issuance of the accompanying warrants.

If, at any time the warrants are outstanding, any fundamental transaction occurs, as described in the Warrant Agreement and generally including any consolidation or merger whereby another entity acquires more than 50% of the Company’s outstanding common stock, or the sale of all or substantially all of its assets, the successor entity must assume in writing all of the obligations to the warrant holders. Additionally, in the event of a fundamental transaction, the Warrant Agreement provides that each warrant holder will have the right to require the Company, or its successor, to repurchase the warrants for an amount of cash equal to the Black-Scholes value of the remaining unexercised portion of the warrants. Further, the Warrant Agreement states that the volatility input used to derive such Black-Scholes value is the greater of the Company’s historical volatility or 100%. Due to the provision that the warrant holder has the option to receive a cash settlement, equal to the Black-Scholes fair value of the remaining unexercised portion of the warrant, in the event that there is a fundamental transaction, the Company has classified the warrants as liabilities in accordance with ASC 480, Distinguishing Liabilities from Equity.

There were no exercises of warrants during the three months ended March 31, 2019 and 2018. The following table presents the Company’s warrant liability measured at fair value on a recurring basis as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016. There were 15,989,408 and 15,939,992 shares~~2018:



	March 31, 2019
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Liabilities:
Warrant liability	$	—	$	—	$	1,628	$	1,628
Total liabilities at fair value	$	—	$	—	$	1,628	$	1,628

	December 31, 2018
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Liabilities:
Warrant liability	$	—	$	—	$	1,240	$	1,240
Total liabilities at fair value	$	—	$	—	$	1,240	$	1,240

The fair value of ~~voting~~the common stock ~~outstanding~~warrants is estimated using a valuation model that approximates a Monte Carlo simulation model, which takes into consideration the probability of a fundamental transaction occurring during the contractual term of the warrants. This valuation model, which includes inputs classified as Level 3 in the fair value hierarchy, estimated a fair value of $0.16 and $0.12 per common stock warrant as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, respectively. The inputs to the valuation model that approximates a Monte Carlo simulation model are presented below.



	March 31, 2019			December 31, 2018
Estimated dividend yield	—			—
Expected volatility	81.21%-100%			77.74%-100%
Risk-free interest rate	2.21		%	2.46		%
Expected term (years)	2.78			3.02
Fair value per share of common stock underlying the warrant	$	0.96		$	0.83
Warrant exercise price	$	4.66		$	4.66

Due to the Company’s limited historical stock price data, the Company estimates stock price volatility based on the actual historical volatility of a group of comparable publicly traded companies observed over a historical period equal to the expected life of the warrant.

The increase of $388 and decrease of $3,558 in fair value of the warrants for the three months ended March 31, 2019 and 2018, respectively, are included as components of other income and expense in the Company’s condensed consolidated statements of operations and comprehensive loss. The change in the warrant liability and the corresponding unrealized loss/gain recognized during the three months ended March 31, 2019 and 2018 is primarily due to the fluctuations in the market price of the Company’s underlying common stock from the date of issuance to March 31, 2019, in addition to fluctuations in the other valuation model inputs.

The following table summarizes ~~common stock share activity~~the change in the fair value of the warrant liability, which is valued using significant unobservable Level 3 inputs, for the ~~nine~~three months ended ~~September 30, 2017:~~

March 31, 2019 and 2018:

	~~Common Stock~~

~~Balance as of December 31, 2016~~		~~15,939,992~~
~~Exercise of stock options~~		~~49,416~~
~~Balance as of September 30, 2017~~		~~15,989,408~~

~~The Company had reserved shares of common stock for future issuance as follows:~~

September 30, 2017

December 31, 2016

Outstanding stock options

1,333,153

825,130

For possible future issuance under 2016 Stock Plan (Note 7)

1,106,501

615,207

2,439,654

1,440,337



	Three Months Ended March 31,
	2019		2018
Beginning Balance	$	1,240	$	—
Issuance	$	—	$	17,806
Revaluations Included In Earnings	$	388	$	(3,558	)
Exercises	$	—	$	—
Expirations	$	—	$	—
Ending Balance	$	1,628	$	14,248

Note ~~7: Stock Option Plan~~

~~2008~~10: Share-Based Compensation

2016 Stock Plan

During ~~2008,~~the three months ended March 31, 2019, the Company ~~adopted the 2008 Stock Plan (the “2008 Plan”). As amended, a total of 1,416,666 shares of common stock were reserved for issuance~~continued to administer and grant awards under the 2008 Plan. Eligible plan participants included employees, directors, and consultants. The 2008 Plan permitted the granting of incentive stock options, nonqualified stock options, and other stock-based awards. As further described below, as of September 20, 2016, no additional awards will be granted under the 2008 Plan.

~~2016 Stock Plan~~

~~Effective September 20, 2016 (the “Effective Date”), the Company adopted~~ the 2016 Incentive Award Plan (the “2016 Plan”). ~~The 2016 Plan is~~, the ~~successor to the 2008 Plan. As~~Company’s only active equity incentive plan. Certain of the ~~Effective Date, no additional awards will be granted under the 2008 Plan, but all~~Company’s outstanding and exercisable stock ~~awards granted under the 2008 Plan prior to the Effective Date will~~options remain subject to the terms of the Company’s 2008 ~~Plan. Any shares associated with stock awards previously granted under~~Stock Plan (the “2008 Plan”), which is the ~~2008 Plan that are forfeited subsequent~~predecessor to the ~~Effective Date~~2016 Plan and became inactive upon adoption of the 2016 Plan ~~are not eligible for future issuance under~~effective September 20, 2016.

On August 16, 2018, the ~~2016 Plan.~~ ~~All awards granted on and after the Effective Date will be subject to the terms~~board of the 2016 Plan. The 2016 Plan provides for the grant of the following awards: (i) incentive stock options, (ii) nonstatutory stock options, (iii) stock appreciation rights, (iv) restricted stock awards, (v) restricted stock unit awards and (vi) other stock awards. Eligible plan participants include employees, directors and consultants. An aggregate of 833,333 shares of the Company’s common stock were initially available for issuance under awards granted pursuant to the 2016 Plan, which shares may be authorized but unissued shares, treasury shares, or shares purchased in the open market.

~~On June 5, 2017, the Company’s stockholders~~ approved an amendment to the 2016 Plan, subject to stockholder approval, to increase the number of shares reserved under the 2016 Plan by 1,000,000 and to increase the award limit on the maximum aggregate number of shares of the Company’s common stock that may be ~~issued pursuant~~granted to ~~awards under~~any one person during any calendar year from 250,000 to 1,000,000 shares of the ~~2016 Plan by an additional 1,200,000 shares.~~Company’s common stock. All other material terms of the 2016 Plan otherwise ~~remained~~remain unchanged.

Stock Appreciation Rights

On August 8, 2018, the Company entered into an employment agreement with G. Kelly Martin (the “Employment Agreement”). The Employment Agreement provided for 1,000,000 SARs granted on a contingent basis that shall be considered irrevocably forfeited and voided in full if the Company fails to obtain stockholder approval for an amendment to the 2016 Plan, described above. If such approval is not obtained, the Company will pay Mr. Martin the cash equivalent of the value of the SARs.

The SARs entitle Mr. Martin to a payment (in cash, shares of common stock or a combination of both) equal to the fair market value of one share of the Company’s common stock on the date of exercise less the exercise price of $3.80 per share. The SARs will vest in full on February 1, 2020. The SARs will be deemed automatically exercised and settled as of February 1, 2020, provided Mr. Martin remains continuously employed with the Company through such date unless vesting is otherwise expressly accelerated pursuant to the SAR Agreement.

Due to the cash settlement feature of the SAR grant, subject to stockholder approval, these share-based payment awards should be classified as liabilities and the amount of compensation cost recognized must be based on the fair value of those liabilities. Therefore, the obligation is recorded as a liability on the Company’s condensed consolidated balance sheet at the estimated fair value on the date of issuance and is re-valued each subsequent reporting period with adjustments to the fair value recognized as share-based compensation expense in the condensed consolidated statements of operations.

During the three months ended March 31, 2019, the Company recorded employee share-based compensation expense related to the SARs of $7. There was no share-based compensation expense related to SARs during the three months ended March 31, 2018. In addition, the corresponding obligation is recorded within other long-term liabilities on the Company’s condensed consolidated balance sheet as of March 31, 2019.

Inducement Grants

In May 2018, the Company awarded nonstatutory stock options to purchase an aggregate of 100,500 shares of common stock to newly-hired employees, not previously employees or directors of the Company, as inducements material to the individuals’ entering into employment with the Company within the meaning of Nasdaq Listing Rule 5635(c)(4) (the “Inducement Grants”). The Inducement Grants have a grant date of May 31, 2018 and an exercise price of $3.15 per share. The Inducement Grants

were awarded outside of the Company’s 2016 Plan, pursuant to Nasdaq Listing Rule 5635(c)(4), but have terms and conditions generally consistent with the Company’s 2016 Plan and vest over three years, with one-third of the award vesting on each annual anniversary of the employee’s employment commencement date, subject to the employee’s continued service as an employee through the vesting period.

Stock Compensation Expense

During the three months ended March 31, 2019 and 2018, the Company recorded employee share-based compensation expense for equity-based awards of $214 and $887, respectively. Total share-based compensation expense for equity-based awards included in the condensed consolidated statements of operations and comprehensive loss is as follows:



	Three Months Ended March 31,
	2019		2018
Research and development	$	61	$	420
General and administrative	153		467
	$	214	$	887

Stock option activity for the three months ended March 31, 2019 is as follows:



	Shares Subject to Outstanding Options		Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Options outstanding as of December 31, 2018	1,671,666		$	5.42
Options granted	147,500		1.31
Options forfeited	(160,810	)	4.64
Options exercised	(12,999	)	0.76
Options outstanding as of March 31, 2019	1,645,357		$	5.17	7.37	$	—

As of ~~September 30, 2017,~~March 31, 2019, there were ~~1,106,501~~a total of 1,645,357 stock options outstanding, including 100,500 inducement grants awarded in May 2018. In addition, there were 703,519 shares available for future issuance under the 2016 ~~Plan.~~

~~Under both~~Plan as of March 31, 2019.

Note 11: Tangible Stockholder Return Plan

Performance Plan

On August 2, 2018, the ~~2008~~Company’s board of directors approved and established the Tangible Stockholder Return Plan, which is a performance-based long-term incentive plan (the “Performance Plan”). The Performance Plan was effective immediately upon approval and expires on March 1, 2022. The Performance Plan covers all employees, including the ~~2016~~Company’s executive officers, consultants and other persons deemed eligible by the Company’s compensation committee. The core underlying metric of the Performance Plan ~~options to purchase~~is the achievement of two share price goals for the Company’s common stock, ~~may~~which if achieved, would represent measurable increases in stockholder value.

The Performance Plan is tiered, with two separate tranches, each of which has a distinct share price target (measured as the average publicly traded share price of the Company’s common stock on the Nasdaq stock exchange for a 30 consecutive trading day period) that will, if achieved, trigger a distinct fixed bonus pool. The share price target for the first tranche and related bonus pool are $11.17 per share and $25,000, respectively. The share price target for the second tranche and related bonus pool are $25.45 per share and $50,000, respectively. The compensation committee has discretion to distribute the bonus pool related to each tranche among eligible participants by establishing individual minimum bonus amounts before, as well as by distributing the remainder of the applicable pool after, the achievement of each tranche specific share price target. Otherwise, if the Company does not achieve one or both related share price targets, as defined, no portion of the bonus pools will be ~~granted~~paid.

The Performance Plan provides for the distinct fixed bonus pools to be paid in the form of cash. However, the compensation committee has discretion to pay any bonus due under the Performance Plan in the form of cash, shares of the Company’s common stock or a combination thereof, provided that the Company’s stockholders have approved the reservation of shares of the Company’s common stock for such payment.

The Performance Plan permits the compensation committee to make bonus awards subject to varying payment terms, including awards that vest and are payable immediately upon achieving an applicable share price target as well as awards that pay over an extended period (either with or without ongoing employment requirements). The Performance Plan contemplates that no bonus award payments will be delayed beyond 24 months for named executive officers or more than 12 months for all other participants.

For purposes of determining whether a share price target has been met, the share price targets will be adjusted in the event of any stock splits, cash dividends, stock dividends, combinations, reorganizations, reclassifications or similar events. In the event of a change in control, as defined in the Performance Plan, during the term of the Performance Plan, a performance bonus pool will be generated based on pro-rata progress toward achievement of the applicable share price target through the date of the change in control.

The Company has concluded that the Performance Plan is within the scope of ASC718, Compensation—Stock Compensation as the underlying plan obligations are based on the potential attainment of certain market share price targets of the Company’s common stock. Any awards under the Performance Plan would be payable, at the discretion of the Company’s compensation committee following the achievement of the applicable share price target, in cash, shares of the Company’s common stock, or a ~~price no less than~~combination thereof, provided that, prior to any payment in common stock, the Company’s stockholders have approved the reservation of shares of the Company’s common stock for such payment.

ASC 718 requires that a liability-based award should be classified as a liability on the Company’s condensed consolidated balance sheets and the amount of compensation cost recognized should be based on the fair value of the liability. When a ~~common stock share~~liability-based award includes both a service and market condition, the market condition is taken into account when determining the appropriate method to estimate fair value and the compensation cost is amortized over the estimated service period. Therefore, the liability associated with the Performance Plan obligation is recorded within other long-term liabilities on the Company’s condensed consolidated balance sheets at the estimated fair value on the date of ~~grant.~~ issuance and is re-valued each subsequent reporting period end. The Company recognizes share-based compensation expense within operating expenses in the condensed consolidated statements of operations, including adjustments to the fair value of the liability-based award, on a straight-line basis over the requisite service period.

The fair value ~~shall be~~of obligations under the ~~closing sales~~Performance Plan are estimated using a Monte Carlo simulation approach. The Company’s common stock price is simulated under the Geometric Brownian Motion framework under each simulation path. The other assumptions for the Monte Carlo simulation include the risk-free interest rate, estimated volatility and the expected term. Expected stock price volatility is based on the actual historical volatility of a ~~share as quoted on any established securities exchange for such grant date or~~group of comparable publicly traded companies observed over a historical period equal to the ~~last preceding date for which such quotation exists. Vesting terms of options issued are determined by the board of directors or compensation committee~~expected remaining life of the ~~board.~~plan. The ~~Company’s~~fair value of the underlying common stock ~~options vest~~is the published closing market price on the Nasdaq Global Market as of each reporting date. The risk-free interest rate is based on ~~terms~~the U.S. Treasury yield curve in effect on the ~~stock option agreements and have a maximum~~date of valuation equal to the remaining expected life of the plan. The dividend yield percentage is zero because the Company does not currently pay dividends, nor does it intend to do so during the expected term of ~~ten years.~~

~~Stock Compensation Expense~~

the plan. The expected life of bonus awards under the Performance Plan is assumed to be equivalent to the remaining contractual term based on the estimated service period including the service inception date of the plan participants and the contractual end of the Performance Plan.

During the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, the Company recorded employee share-based compensation expense related to the Performance Plan of ~~$871 and $3,006, respectively. During the three and nine months ended September 30, 2016, the Company recorded employee share-~~

$39.

~~based compensation expense of $327 and $861, respectively. Total share-based compensation expense included in the condensed consolidated statements of operations is as follows:~~

Three Months Ended September 30,

Nine Months Ended September 30,

2017

2016

2017

2016

Research and development

$
475

$
95

$
1,301

$
274

General and administrative

396

232

1,705

587

$
871

$
327

$
3,006

$
861

~~Stock option activity for the nine months ended September 30, 2017 is as follows:~~

Shares
Subject to
Outstanding
Options

Weighted-
Average
Exercise
Price Per
Share

Weighted-
Average
Remaining
Contractual
Term (in years)

Aggregate
Intrinsic
Value

Options outstanding as of December 31, 2016

825,130

$
11.27

Options granted

830,945

5.13

Options forfeited

(273,506
)

13.93

Options exercised

(49,416
)

1.36

Options outstanding as of September 30, 2017

1,333,153

$
7.27

8.84

$
1,236

Note 8:12: Related Party Transactions

Members of the Company’s board of directors held ~~1,585,916 and 1,561,916~~782,083 shares of the Company’s common stock as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016, respectively.~~

2018.

In June 2017, G. Kelly Martin ~~assumed~~was appointed as the ~~role of~~Company’s Interim Chief Executive Officer before being named as the Company’s Chief Executive Officer ~~on an interim basis.~~in April 2018. Mr. Martin ~~also~~ continues to serve as a member of the Company’s board of ~~directors. Mr. Martin~~directors and previously served as chief executive officer of Malin Corporation plc until October 1, 2017. Malin Corporation plc is the parent company of Malin Life Sciences Holdings Limited (“Malin”), ~~a greater than~~which beneficially owns approximately 10% ~~shareholder~~ of the ~~Company, until October 1, 2017. Mr. Martin has not received any additional compensation for his service as the~~ Company’s ~~Chief Executive Officer during the three and nine months ended September 30, 2017. Mr. Martin continues to be compensated pursuant to the Company’s non-employee director compensation policy.~~

Upon stepping into the Company’s Chief Executive Officer role, Mr. Martin engaged a number of Malin employees to assist him in certain strategic and tactical initiatives and activities. The Company has agreed to reimburse Malin for its out-of-pocket expenses for Mr. Martin and other Malin employees related to this effort. During the three and nine months ended September 30, 2017, the Company has accrued $230 in out-of-pocket travel expenses owed to Malin. These expenses are expected to be reimbursed in the fourth quarter of 2017.

outstanding common stock.

Two of the Company’s directors ~~are~~during 2018 were also affiliated with ~~Malin, including~~Malin. Sean Murphy, who isresigned from the Company’s board in September 2018, was an executive officer and a director of Malin, and is an executive vice president of Malin Corporation ~~plc, and~~plc. In addition, Robert A. Ingram, ~~who is~~the Company’s executive chairman of the board, was also a director of Malin Corporation plc until July 2018.

Cilatus BioPharma

During the three months ended March 31, 2019 and 2018, the Company incurred costs of $94 and $198, respectively, in relation to a development and manufacturing consulting agreement with Cilatus BioPharma AG, which is majority-owned by Malin Corporation plc.

These costs are expensed as incurred and are classified as research and development expenses in the accompanying condensed consolidated statements of operations and comprehensive loss. Estimated fees remaining under the current statements of work are approximately $140, and are expected to be incurred throughout the remainder of 2019.

Health Decisions

On October 25, 2018, the Company announced the formation of a dedicated women’s health business unit as well as a foundational collaboration with Health Decisions, Inc. (“Health Decisions”). Health Decisions is a full-service contract research organization specializing in clinical studies of therapeutics for women’s health indications. The Company’s women’s health business unit is led by Paula Brown Stafford, who also is a shareholder and serves on the board of directors of Health Decisions.

Note 9:13: Subsequent Events

~~Shelf Registration Filing~~

Royalty and Milestone Payments Purchase Agreement with Reedy Creek Investments LLC

On ~~October 2, 2017,~~April 29, 2019, the Company ~~filed a shelf registration statement on Form S-3 with the SEC, which the SEC declared effective on October 10, 2017. The registration statement contained a prospectus which covers:~~

~~(i)~~

the offering, issuance and sale by the Company of up to a maximum aggregate offering price of $150,000 of the Company’s common stock, preferred stock, debt securities, warrants, and units, including those that may be issued upon conversion of, in exchange for or upon exercise of any such securities; and

~~(ii)~~

~~the offering, issuance and sale of~~ ~~up to 2,623,485 shares of the Company’s common stock~~ by Malin, the Company’s largest stockholder. These common stock shares represent Malin’s total shareholding in the Company as of October 2, 2017. Malin requested that the Company register all of the shares it presently holds to facilitate its ability to utilize the shares as collateral. Malin represented to our board of directors that it has no present intention to sell its shares or monetize its shareholding but reserves its right to manage its balance sheet and equity positions going forward. Malin

confirmed it remains supportive of the management team and board of Novan, the potential application of the underlying technology platform in broad dermatological indications and the value proposition of the Company.

The Company incurred costs directly related to the shelf registration statement filing totaling $110 which were capitalized and included in prepaid expenses and other current assets in the accompanying balance sheet as of September 30, 2017.

~~Amendments to License and Sublicense Agreements with KNOW Bio~~

~~The Company and KNOW Bio~~ entered into ~~certain amendments dated October 13, 2017~~a royalty and milestone payments purchase agreement (the ~~“KNOW Bio Amendments”~~“Purchase Agreement”) with Reedy Creek Investments LLC (“Reedy Creek”), pursuant to the KNOW Bio License Agreement and KNOW Bio Sublicense Agreements (collectively, the “KNOW Bio Agreements”) described in Note 3—Collaboration Arrangements. Pursuant to the terms of the KNOW Bio Amendments, t~~he Company re-acquired from KNOW Bio exclusive, worldwide rights under certain U.S. and foreign patents and patent applications controlled by the Company as of the execution date of the~~ ~~KNOW Bio~~ ~~Agreements, and patents and patent applications~~ which ~~may become controlled by the Company during the three years immediately following the execution date of~~ ~~KNOW Bio~~ Agreements, directed towards nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds, and other nitric oxide-based therapeutics, to develop and commercialize products for all diagnostic, therapeutic, prophylactic and palliative uses for any disease, condition or disorder caused by certain oncoviruses (the “Oncovirus Field”). KNOW Bio also granted to the Company an exclusive license, with the right to sublicense, under any patents and patent applications which may become controlled by KNOW Bio during the three years immediately following the execution date of the ~~KNOW Bio~~ Agreements and directed towards nitric oxide-releasing compositions and methods of manufacturing thereof, including methods of manufacturing Nitricil compounds, and other nitric oxide-based therapeutics, but not towards medical devices, to develop and commercialize products for use in the Oncovirus Field. Additionally, KNOW Bio agreed that KNOW Bio will not commercialize any products in the Oncovirus Field during the first three years following the execution date of the ~~KNOW Bio~~ ~~Agreements.~~

~~The Company is obligated to make the following fixed and contingent payments in exchange for the rights granted~~Reedy Creek provided funding to the Company in an initial amount of $25,000, which the ~~Oncovirus Field:~~

~~(i)~~

~~A nominal non-refundable upfront payment due upon execution of the KNOW Bio Amendments.~~

~~(ii)~~

~~For products that incorporate a certain nitric oxide-releasing composition specified in the~~ ~~KNOW Bio~~ Amendments and (i) are covered by KNOW Bio patents or (ii) materially use or incorporate know-how of KNOW Bio or the Company related to such composition that is created during the three years immediately following the execution date of the ~~KNOW Bio~~ ~~Agreements (“Covered Products”), the Company must make the following payments to KNOW Bio:~~

~~A milestone payment upon the first time each Covered Product is approved by the U.S. Food and Drug Administration (“FDA”) for marketing in the Oncovirus Field;~~

A royalty in the low single digits on net sales of Covered Products in the Oncovirus Field until the later of the expiration of the KNOW Bio patents covering the applicable Covered Product or the expiration of regulatory exclusivity on the applicable Covered Product; and

In the event the Company sublicenses the rights to a Covered Product to a third party in the Oncovirus Field, the Company must pay KNOW Bio a low double digit percentage of any clinical development or NDA approval milestones the Company receives from the sublicensee for the Covered Product in the Oncovirus Field.

~~Nitricil is not~~Company will use primarily to pursue the ~~nitric oxide-releasing composition specified in~~development, regulatory approval and commercialization (including through out-license agreements and other third party arrangements) activities for SB206, a topical anti-viral gel being developed for the ~~KNOW Bio~~ ~~Amendments as~~treatment of molluscum contagiosum, and advancing programmatically such activities with respect to SB204, a once-daily, topical monotherapy being developed for the ~~subject~~treatment of acne vulgaris, and SB414, a topical cream-based product candidate being developed for the ~~foregoing payments. As such, products based on Nitricil are not subject to the foregoing milestone, royalty and sublicensing payment obligations.~~

~~The rights granted~~treatment of atopic dermatitis. Reedy Creek will also provide additional funding to the Company inof $10,000 contingent upon the Oncovirus Field in the KNOW Bio Amendments continue for so long as there is a valid patent claim under the KNOW Bio Agreements, and upon expiration continue on a perpetual non-exclusive basis, and are subject to the termination rights of KNOW Bio andachievement by the Company ~~that are set forth in the KNOW Bio Agreements. In addition, under the KNOW Bio Amendments, KNOW Bio may terminate the rights granted to the Company in the Oncovirus Field if:~~of SB206 clinical trial success, defined as (i) the ~~Company does not file a first investigational new drug (“IND”) application with~~achievement, no later than March 31, 2020, of statistically significant rates of complete clearance of lesions for molluscum contagiosum in humans at week 12 in each of the two Phase 3 clinical trials or any other primary endpoint required or accepted by the FDA for athe SB206 product, or (ii) equivalent achievement (as agreed upon by the parties).

Pursuant to the Purchase Agreement, the Company will pay Reedy Creek ongoing quarterly payments, calculated based on an applicable percentage per product of any upfront fees, milestone payments, royalty payments or equivalent payments received by the Company pursuant to any out-license agreement for SB204, SB206 or SB414 in the ~~Oncovirus Field~~United States, Mexico or Canada, net of any upfront fees, milestone payments, royalty payments or equivalent payments paid by ~~October 2020; or (ii)~~ the Company ~~does not file a first new drug application (“NDA”)~~to third parties pursuant to any agreements under which the Company has in-licensed intellectual property with ~~the FDA by October 2025 for a product~~respect to such products in the ~~Oncovirus Field~~United States, Mexico or Canada. The applicable percentage used for determining the ongoing quarterly payments for each product ranges from 10% for SB206 to 20% for SB204 and ~~does~~SB414, provided that the applicable percentage for each product will be 25% for fees or milestone payments received by the Company (but not ~~otherwise have any active clinical programs related~~royalty payments received by the Company) until Reedy Creek has received payments under the Purchase Agreement equal to the ~~Oncovirus Field at such time.~~

~~The Company also obtained a three-year exclusive option to include within~~total funding amount provided by Reedy Creek under the Company’s rights described above in the Oncovirus Field the development and commercialization of products for all diagnostic, therapeutic, prophylactic and palliative uses for any disease, condition or disorder caused by up to four other specified oncoviruses (the “Option Field”).Purchase Agreement. If the Company ~~elects~~decides to ~~exercise~~commercialize any product on its ~~option, it~~own following regulatory approval, as opposed to commercializing through an out-license agreement or other third party arrangement, the Company will be obligated to pay ~~an exercise fee for each oncovirus for which the option is exercised, and the additional rights included in the~~

~~Oncovirus Field as~~Reedy Creek a ~~result~~low single digits royalty on net sales of such products.

Reedy Creek beneficially owns approximately 15% of the ~~option exercise will be subject~~Company’s outstanding common stock and approximately 3.9 million warrants, all of which was acquired during the Company’s public offering of common stock and accompanying warrants in January 2018. Accordingly, Reedy Creek is a related party of the Company. The aforementioned transaction was evaluated and approved pursuant to the ~~same payment obligations for Covered Products, conditions, and termination rights as described above for the Oncovirus Field.~~

~~The KNOW Bio Amendments also provide a mechanism whereby either~~Company’s existing related party can cause a new chemical entity (“NCE”) covered by the KNOW Bio Agreements to become exclusive to such party by filing an IND on the NCE. An NCE that becomes exclusive to a party under this provision may not be commercialized by the other party until the later of expiration of patents covering the NCE or regulatory exclusivity covering the NCE. A party who obtains exclusivity for an NCE must advance development of the NCE pursuant to terms of the KNOW Bio Amendments in order to maintain such exclusivity; otherwise, such exclusivity will expire.

transactions policy. The terms of the ~~KNOW Bio Amendments~~Purchase Agreement were determined by the Company’s audit committee to be negotiated at arms-length and ~~do not provide~~approximate market terms between third parties.

Development Funding and Royalties Agreement with Ligand Pharmaceuticals Incorporated

On May 4, 2019, the Company entered into a development funding and royalties agreement (the “Funding Agreement”) with ~~an ability~~Ligand Pharmaceuticals Incorporated (“Ligand”), pursuant to ~~significantly influence KNOW Bio~~which Ligand provided funding to the Company of $12,000, which the Company will use to pursue the development and regulatory approval of SB206, a topical anti-viral gel being developed for the treatment of molluscum contagiosum.

Pursuant to the Funding Agreement, the Company will pay Ligand up to $20,000 in milestone payments upon the achievement by the Company of certain regulatory and commercial milestones associated with SB206 or ~~its operations.~~

~~Legal Proceeding~~

~~The~~any product that incorporates or uses NVN1000, the active pharmaceutical ingredient for the Company’s clinical stage product candidates, for the treatment of molluscum contagiosum. In addition to the milestone payments, the Company ~~is subject~~will pay Ligand tiered royalties ranging from 7% to ~~putative stockholder class action lawsuits that were filed in November 2017~~10% based on aggregate annual net sales of such products in the United States, ~~District Court for the Middle District~~Mexico or Canada.

Table of North Carolina against the Company and certain of its current and former directors and officers. The lawsuits were filed on behalf of a putative class of all persons who purchased or otherwise acquired the Company’s securities (1) pursuant or traceable to the Company’s IPO, or (2) on the open market between September 21, 2016 and January 26, 2017. The lawsuits assert claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to the Company’s Phase 3 clinical trials of SB204. The complaints seek, among other things, an unspecified amount of compensatory damages and attorneys’ fees and costs on behalf of the putative class. The Company believes that the claims lack merit and intends to defend the lawsuits vigorously. However, there can be no assurance that a favorable resolution will be obtained in such lawsuits, and the actual costs may be material.

Contents

Item 2.2: Management’s Discussion and Analysis of Financial Condition and Results of ~~Operations.~~

Operations

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q and our audited financial statements and notes thereto for the year ended December 31, ~~2016~~2018 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March ~~20, 2017.~~

27, 2019.

In addition to historical information, this discussion and analysis contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q are forward-looking statements. These statements are often identified by the use of words such as “believe,” “contemplate,” “continue,” “due,” “goal,” “objective,” “plan,” “seek,” “target,” “expect,” “believe,” “anticipate,” “intend,” “may,” “will,” “would,” “could,” “should,” “potential,” “predict,” “project,” or “estimate,” ~~or “continue”~~ and similar expressions or variations. These statements are based on the beliefs and assumptions of our management based on information currently available to management. 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. Except as may be required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

These forward-looking statements are subject to numerous risks, including, without limitation, the following:

We will need substantial additional funding and as of March 31, 2019, we had an accumulated deficit of $180.1 million. If we are unable to raise capital when needed, we would be forced to delay, reduce, terminate or eliminate our product development programs, or eventual commercialization efforts.

We have entered into and rely on, and may enter into and rely on other, strategic relationships for the further development and commercialization of our product candidates and if we are unable to enter into such relationships on favorable terms or at all, or if such relationships are unsuccessful, if disputes arise between us and our strategic partners or if we fail to trigger contingent payments under such strategic relationships, we may be unable to realize the potential economic benefit of those product candidates.

Clinical drug development involves a lengthy and expensive process with an uncertain outcome, and results of earlier studies and trials may not be predictive of future trial results.

Delay or termination of planned clinical trials for our product candidates could result in unplanned expenses or significantly adversely impact our commercial prospects with respect to, and ability to generate revenues from, such product candidates.

We may not be able to achieve the objectives described in the section entitled “Overview—Key Product Candidate Development Updates” below. The results of any further development activities may not be sufficient to support a new drug application, or NDA, submission for any of our product candidates, or regulatory approval of our product candidates.

The regulatory approval processes of the Food and Drug Administration, or FDA, are lengthy, time-consuming and inherently unpredictable, and if we are ultimately unable to obtain regulatory approval for our product candidates, our business will be substantially harmed.

We specialize solely in developing nitric oxide-based therapeutics to treat ~~dermatological and oncovirus-mediated~~a range of diseases with significant unmet needs, and if we do not successfully achieve regulatory approval for any of our product candidates or successfully commercialize them, we may not be able to continue as a business.

~~We will need~~The issuance of shares upon exercise of our outstanding warrants and options may cause substantial ~~additional funding~~dilution to our existing stockholders and asreduce the trading price of ~~September 30, 2017, we had an accumulated deficit of $152.0 million. If we are unable to raise capital when needed, we would be forced to delay, reduce, terminate or eliminate~~ our ~~product development programs.~~

common stock.

As a result of our operating losses and negative cash flows from operations, the report of our independent registered public accounting firm on our December 31, ~~2016~~2018 financial statements included an explanatory paragraph indicating that there is substantial doubt about our ability to continue as a going concern.

We rely on third parties to conduct some of our preclinical studies and all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize any of our product candidates.

Table of Contents

We ~~rely on third parties to~~currently manufacture clinical ~~drug supplies for us and parties with which we contract,~~trial materials internally and we intend to ~~rely on~~utilize third parties, including Orion Corporation, or Orion, to ~~produce~~manufacture components of our clinical trial materials and, potentially, commercial supplies of any approved product ~~candidate. Failure of those third parties to obtain approval of the FDA or comparable regulatory authorities, to provide us with~~candidates. If we do not have sufficient quantities of ~~drug product or to provide sufficient quantities of drug product~~clinical trial materials at acceptable quality levels ~~or prices~~and within established timelines, it could adversely impact our development and potential future commercialization of any of our product candidates or result in our breaching our obligations to others.

Unexpected delays in our ability to manufacture our NVN1000 active pharmaceutical ingredient, or ~~any other Nitricil NCEs, including NVN3100,~~the associated drug product in a deliverable form, in our facility or at a third party manufacturer, and our ability to complete an agreement for the manufacture of our active pharmaceutical ingredient, for support of our development and/or commercialization activities could adversely affect our development and commercialization timelines and result in increased costs of our development programs.

We intend to rely on third parties to manufacture raw materials and drug product components utilized in clinical trial materials for us and parties with which we contract. Failure to transfer technology and processes to a third party effectively or failure of those third parties to obtain approval of and maintain compliance with the FDA or comparable regulatory authorities, to provide us with sufficient quantities of raw materials and drug product components or to provide such raw materials or drug product components at acceptable quality levels or prices could adversely impact our development and potential future commercialization of any of our product candidates or result in our breaching our obligations to others.

Our product candidates may pose safety issues, cause adverse events, have side effects or have other properties that could delay or prevent their regulatory approval, limit the commercial profile of an approved label or result in significant negative consequences following marketing approval, if any.

~~Even if we obtain marketing approval for any product candidates, the products may become subject to unfavorable third-party coverage or reimbursement policies.~~

Our product candidates, if approved, will face significant competition, and our failure to effectively compete may prevent us from achieving significant market penetration.

If we are unable to obtain and maintain patent protection for our product candidates, or if the scope of the patent protection obtained is not sufficiently broad, our competitors could develop and commercialize technology and products similar or identical to ours, and our ability to successfully commercialize our technology and product candidates may be impaired.

Changes to our leadership team or operational resources could prove disruptive to our operations and have adverse consequences for our business and operating results.

We recently ~~changed~~broadened the focus of our ~~near-term~~ product development strategy, and there can be no guarantee that these areas of our platform will be successful or the most profitable.

We may rely on strategic relationships for the further development and commercialization of product candidates outside our current core areas of focus, and if we are unable to enter into such relationships on favorable terms or at all, or if such relationships are unsuccessful, we may be unable to realize the potential economic benefit of those product candidates.

For a further discussion of risks that could cause or contribute to differences between actual results and those implied by forward-looking statements, see the “Risk Factors” section of the Annual Report on Form 10-K ~~and our subsequent Quarterly Reports~~filed with the SEC on ~~Form 10-Q.~~

March 27, 2019.

Novan® is a registered trademark of our company in the United States. This Quarterly Report on Form 10-Q also includes trademarks, trade names and service marks that are the property of other organizations. Solely for convenience, our trademarks and trade names referred to in this Quarterly Report on Form 10-Q appear without any “™” or “®” symbol, but those references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the rights of any applicable licensor, to these trademarks and trade names.

Overview

We are a ~~clinical-stage~~clinical development-stage biotechnology company focused on leveraging nitric oxide’s ~~natural antiviral~~naturally occurring anti-microbial and immunomodulatory mechanisms of action to treat ~~dermatological and oncovirus-mediated diseases.~~a range of diseases with significant unmet needs. Nitric oxide plays a vital role in the natural immune system response against microbial pathogens and is a critical regulator of inflammation. Our ability to harness nitric oxide and its multiple mechanisms of action has enabled us to create a platform with the potential to generate differentiated ~~first-in-class~~ product candidates.

The two key components of our nitric oxide platform are our proprietary Nitricil technology, which drives the creation of new chemical entities, or NCEs, and our ~~topical~~ formulation science, both of which we use to tune our product candidates for specific

Table of Contents

indications. ~~We believe that our~~Our ability to ~~conveniently~~ deploy nitric oxide in a solid form, on demand and in localized formulations allows us the potential to ~~significantly~~ improve patient outcomes in a variety of diseases.

We are advancing strategic development programs in the ~~fields~~field of ~~virology~~dermatology, while also further expanding the platform into women’s health and ~~immunology with product candidates SB206, SB414 and NVN3100.~~GI therapeutic areas. We ~~also~~ have clinical-stage dermatology drug candidates with ~~anti-acne~~multi-factorial (SB204), anti-viral (SB206), anti-fungal (SB208) and ~~antifungal (SB208) applications, which we intend~~anti-inflammatory (SB414) mechanisms of action. We are also conducting preclinical work on NCEs and formulations for oncovirus-mediated diseases in the women’s health field and for inflammatory diseases in the gastroenterological, or GI, field. Further advancement of these development activities is dependent upon our ability to ~~advance through~~access additional capital from non-dilutive sources, including partnerships, collaborations, licensing, grants or other strategic relationships, or through equity or debt financings, which could result in dilution. We are actively pursuing these capital sourcing pathways through ongoing business development discussions around our late-stage assets and the broader dermatology platform.

As of March 31, 2019, we ~~are currently exploring.~~

~~Key Drug Development Updates~~

had cash and cash equivalents of $6.1 million and negative working capital of $3.5 million. As described below in “Business Updates”, in late April 2019 and early May 2019 we entered into (i) a royalty and milestone payments purchase agreement with a stockholder providing $25.0 million of immediate funding, with an additional $10.0 million contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020; and (ii) a development funding and royalties agreement with a corporate partner providing $12.0 million of immediate funding. We ~~recently deepened~~believe that our ~~platform focus~~existing cash and cash equivalents, expected contractual payments to be received in connection with previous licensing agreements, and the addition of the $25.0 million and $12.0 million received through these funding transactions will (i) provide us with adequate liquidity to fund our planned operating needs into the first quarter of 2020, including through expected top-line results of the Phase 3 molluscum clinical program targeted in the ~~fields~~first quarter of ~~virology~~2020, or before; and ~~immunology. In October, we completed a transaction~~(ii) into the second quarter of 2020, if paired with KNOW Bio, LLC, or KNOW Bio, granting us exclusive worldwide rights for certain oncovirus applications of nitric oxide-based products. An oncovirus is a virus that causes cancer. The agreement allows us to expand our viral platform by exploring nitric oxide’s antiviral activity against neoplasias and carcinomas caused by high-risk human papillomavirus, or HPV. We intend to focus HPV-related development on localized therapies to treat HPV-associated sexually transmitted infections, including pre-cancerous lesionsthe potential $10.0 million funding contingent upon achieving successful top-line results of the ~~cervix~~SB206 Phase 3 clinical trials no later than March 31, 2020.

We expect that we will continue to incur substantial expenses as we continue clinical trials and ~~anus. The intellectual property rights also allow~~preclinical studies for, ~~potential future translations of nitric oxide as a treatment for rare~~ and ~~orphan diseases caused by other double stranded DNA viruses including Kaposi’s sarcoma-associated herpesvirus (HHV-8)~~research and ~~Merkel cell polyomavirus (MCV). The terms of this transaction are further described in “Note 9—Subsequent Events” to the accompanying condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.~~

~~Additionally, we have leveraged promising preclinical data demonstrating mechanistic evidence of nitric oxide’s potential as a treatment for inflammatory skin diseases and initiated the clinical~~ development of, our ~~immunology program with~~product candidates and maintain, expand and protect our intellectual property portfolio. We will need additional funding to continue our operating activities and make further advancements in our drug development programs.

During 2018, we focused existing resources and capital on the ~~commencement~~clinical advancement of aour anti-viral (SB206) and anti-inflammatory (SB414) product candidates. We conducted and completed our SB206 Phase ~~1b clinical~~2 trial for the treatment of ~~psoriasis. Top line results for the~~molluscum. In addition, we completed two complementary Phase 1b ~~trial are targeted in the second quarter of 2018. Also, we are targeting to begin a Phase 1b trial~~clinical trials with SB414 in ~~adults~~patients with psoriasis and atopic ~~dermatitis before year end with top line results targeted in~~dermatitis. Also, during 2018, we pursued and received further guidance from the ~~third quarter of 2018.~~

~~Below is a summary of selected key developments related to~~FDA regarding the U.S. regulatory pathway for our ~~drug candidates during or subsequent to the third quarter of 2017 and certain upcoming milestones.~~

•

~~SB204 for the Treatment of Acne Vulgaris~~—We recently held a productive guidance meeting with the U.S. Food and Drug Administration, or FDA, to obtain clinical and regulatory clarity around the SB204 program. The FDA advised that it believed one additional pivotal trial would be needed for the purposes of replication and interpretation of clinical trial findings. The FDA indicated that the success criteria for the additional trial, including the definition of the investigators global assessment score, should be the same as the one used in the previously completed Phase 3 pivotal trials. Based on the FDA feedback, we believe that an additional Phase 3 trial should be completed prior to NDA submission. The FDA also indicated that no further preclinical or clinical safety studies beyond those ongoing would be required for the NDA submission and that our existing safety population of more than 2,600 patients was sufficient for submission of a new molecular entity.

~~In November 2017, we~~ ~~agreed in principle to a business structure that would enable further development and advancement of the~~ SB204 ~~program via third-party financing and third-party execution of an additional Phase 3 pivotal trial~~. Under the transaction contemplated by the non-binding term sheet, a new entity established by the third party would provide both the necessary capital to fund and the clinical expertise to execute an additional Phase 3 pivotal trial for SB204. The financial return to the new entity would be a pre-determined multiple of the costs incurred to execute the trial, assuming successful completion of the trial and Novan’s election to retain all rights to the asset (SB204). The new entity would also be entitled to a milestone payment upon NDA approval, as well as potential future sales-based milestone payments tied to the commercial success of SB204 and potential future payments related to certain agreed variations of SB204 that may be subsequently developed. If Novan does not make the election to retain the asset (SB204), the new entity would be granted an exclusive license to SB204 in all geographies apart from Japan, with proceeds from any monetization of the licensed technology being split between the new entity and Novan after returning a multiple of the execution costs to the new entity. In connection with the proposed transaction, the new entity would be granted an option to acquire shares of Novan’s common stock (currently anticipated to be approximately 500,000 shares) at an exercise price determined by the trailing 30 day average just prior to the execution of definitive agreements.

~~The parties have entered into an exclusive negotiation period and anticipate finalizing binding definitive agreements~~product candidate for the ~~proposed transaction and clinical trial execution following the parties’ joint discussion~~treatment of ~~the Phase 3 pivotal trial protocol with the FDA in the first quarter of 2018.~~

acne vulgaris.

Key Product Candidate Development Updates

SB206, a Topical ~~Antiviral~~Anti-viral Treatment for Viral Skin Infections

—

~~External Genital Warts~~

Following a clinically successful Phase 2 dose-ranging trial and a positive end-of-Phase 2 meeting with the FDA, we are targeting the initiation of a maximal use pharmacokinetic trial for SB206 in the first half of 2018. This Phase 1 trial advances the development of SB206 for a number of indications but is not a prerequisite for beginning the Phase 3 pivotal trials in external genital warts. We are ~~also evaluating conducting~~ ~~Phase 3 pivotal trials~~developing SB206 as a topical anti-viral gel for the treatment of ~~external genital warts caused by HPV, along~~viral skin infections, with ~~related open label long term safety testing to evaluate recurrence rates and multiple courses of treatment.~~

a current focus on molluscum contagiosum. Molluscum ~~Contagiosum~~

~~Also at the end-of-Phase 2 meeting for SB206, we had a constructive discussion with the FDA regarding expansion of the SB206 program into the treatment of molluscum contagiosum,~~is a contagious skin infection caused by the molluscipoxvirus. Molluscum affects approximately six million people in the U.S. ~~annually, mostly children.~~annually. The greatest incidence is in children aged one to 14 years. The average time to resolution is 13 months, however, 13% of children experience lesions that may not resolve in 24 months. There is no FDA-approved treatment for ~~molluscum~~molluscum. More than half of patients diagnosed with the infection are untreated. The majority of patients that receive treatment are treated with painful procedures and ~~practitioners~~the remaining are often ~~prescribe~~prescribed products ~~approved~~indicated for the treatment of external genital ~~warts to patients with molluscum.~~ warts.

We believe that observational ~~learning~~learnings from an in-licensed topical nitric oxide technology study showing clinically meaningful complete clearance rates of baseline molluscum lesions, combined with our SB206 program knowledge, ~~provides~~provided a logical pathway for SB206 development in the molluscum indication. We ~~are targeting~~submitted an investigational new drug application, or IND, to the ~~initiation of~~FDA in December 2017 and initiated a Phase 2 clinical trial utilizing SB206 for the treatment of molluscum in the first quarter of ~~2018~~2018. The Phase 2 multi-center, randomized, double-blind, vehicle-controlled, ascending dose clinical trial evaluated the efficacy, safety and tolerability of SB206 in 256 patients, ages 2 and above, with ~~top line~~molluscum. Patients were treated with one of three concentrations of SB206 or vehicle for up to 12 weeks. The primary endpoint was the proportion of patients achieving complete clearance of all molluscum lesions at Week 12. We announced top-line results ~~targeted~~from this Phase 2 clinical trial in the fourth quarter of 2018.

~~HPV-associated Sexually Transmitted Infections~~

~~During~~ SB206 demonstrated statistically significant results in the ~~24-month period 2013 through 2014, 22.7%~~clearance of all molluscum lesions at Week 12, with signs of efficacy evident as early as Week 2 with the 12% once-daily dose. The safety and tolerability profiles were favorable overall with no serious adverse events reported, including the most effective dose, SB206 12% once-daily.

Table of Contents

With the full results from this Phase 2 trial made available, we held an end-of-Phase 2 (Type B) meeting with the FDA in early March 2019. Based on this meeting and the written minutes received, we target commencing the Phase 3 development program for molluscum including two pivotal clinical trials in the second quarter of 2019 with SB206 12% once-daily as the active treatment arm. We are completing our clinical development plan for these trials, have engaged a contract research organization, or CRO, for the execution of the ~~total U.S. adult population had high-risk genital HPV – approximately 70 million people. HPV strains 16~~pivotal trials, have conducted certain clinical start-up procedures and ~~18 are~~plan to begin recruiting patients in May 2019. The Phase 3 multi-center, randomized, double-blind, vehicle-controlled, parallel group clinical trials will evaluate the ~~most prevalent HPV-associated sexually transmitted infections,~~efficacy and safety of SB206 12% once-daily in 680 patients (2:1 active:vehicle randomization), ages 6 months and above, with molluscum. Patients will be treated once-daily with SB206 or ~~STIs. In some cases, these infections can progress~~vehicle for up to ~~neoplasias~~12 weeks, with visits at Screening/Baseline, Week 2, Week 4, Week 8, Week 12 and ~~eventually, cancers. HPV-16 and HPV-18 cause approximately 60%~~safety follow-up at Week 24. The primary endpoint is the proportion of patients achieving complete clearance of all ~~oral cancers~~molluscum lesions at Week 12. We target patient enrollment initiation in this program during the ~~U.S.~~second quarter of 2019 and 70% of cervical cancers. We are targeting the initiation of a Phase 1b pharmacology clinical trial to evaluate the effects of SB206 against eradicating high-risk HPV-16 and HPV-18 topically in otherwise asymptomatic volunteerstarget top line results in the first ~~half of 2018 with top lines results targeted in the fourth~~ quarter of ~~2018.~~

~~In addition to the exploration of SB206 as a therapy for HPV-associated STIs, we are also developing NVN3100, a new chemical entity,~~2020, or NCE, for the treatment of high risk neoplasias, including cervical and anal neoplasias, caused by HPV-16 and HPV-18. We are targeting the initiation of preclinical studies, including IND-enabling studies, in the first half of 2018 and we are targeting an IND submission to the FDA by the end of 2018.

before.

SB414, a Topical Cream for the Treatment of Inflammatory Skin Diseases—

~~We submitted an investigational new drug application, or IND,~~

In 2018, we completed two complementary Phase 1b clinical trials with SB414 in patients with atopic dermatitis and psoriasis. The design of these complementary trials was to evaluate the safety, tolerability and pharmacokinetics of SB414. The trials were also designed to assess overall and specific target engagement through a reduction of key inflammatory biomarkers, also known as pharmacodynamic assessment.

Atopic Dermatitis

We initiated a Phase 1b trial with SB414 in adults with mild-to-moderate atopic dermatitis in December 2017. In the Phase 1b trial, 48 adults with mild-to-moderate atopic dermatitis with up to 30% body surface area at baseline, were randomized to receive one of 2% SB414 cream, 6% SB414 cream, or vehicle, twice daily for two weeks. In the complementary Phase 1b trial for mild-to-moderate chronic plaque psoriasis, 36 adults received SB414 6% cream or vehicle twice daily for four weeks.

We received and analyzed the preliminary top line results from the Phase 1b clinical trials during the second and third quarters of 2018. In the atopic dermatitis trial, Biomarkers from the Th2, Th17 and Th22 inflammatory pathways known to be highly relevant and indicative of atopic dermatitis, including Interleukin-13, or IL-13, IL-4R, IL-5, IL-17A and IL-22, were downregulated after two weeks of treatment with SB414 2%. The changes in Th2 and Th22 biomarkers and clinical efficacy assessed as the percent change in Eczema Area Severity Index scores were highly correlated in the SB414 2% group. Additionally, the proportion of patients achieving a greater than or equal to 3-point improvement on the pruritus (itch) numeric rating scale after two weeks of treatment was greater for patients treated with SB414 2% compared to patients treated with vehicle.

The 2% or 6% doses of SB414 in the trial did not result in any serious adverse events, and SB414 2% was more tolerable with no patients discontinuing treatment in the trial due to application site reactions. SB414 at the 6% dose was not consistently effective in reducing biomarkers across both the atopic dermatitis and psoriasis trials. This lack of consistent biomarker movement could potentially be explained by the increased irritation score experienced by patients treated with SB414 6%. Additionally, SB414 6% showed detectable systemic exposure in a subset of patients, which cleared in nearly all affected patients within 12 hours, in both the atopic dermatitis and psoriasis trials. Given the successful downregulation of key biomarkers, favorable tolerability and lack of systemic exposure with SB414 2%, we intend to initiate non-clinical studies in the second quarter of 2019 to support the Phase 2 program launch, targeted for the ~~treatment of inflammatory skin diseases to the FDA during third~~fourth quarter of ~~2017.~~

~~Psoriasis~~

2019. We ~~have~~expect that we will need to obtain additional financing or strategic partnering in order to complete the Phase 2 clinical program.

Psoriasis

We initiated clinical development of SB414, our first use of our nitric oxide platform in the field of ~~immunology. The~~immunology by dosing the first patient ~~was dosed~~ in October 2017 in a Phase 1b clinical trial to evaluate SB414 in a cream for the treatment of psoriasis. Earlier in 2017, we presented mechanistic evidence for SB414, demonstrating a statistically significant reduction in composite psoriasis scores and an inhibition of IL-17A and IL-17F in an animal model.

The purpose of the Phase 1b trial iswas to evaluate safety and to assess target engagement through a reduction of key pro-inflammatory biomarkers like interleukin-17, or IL-17, before progressing to Phase 2 clinical trials. According to a recent peer-reviewed article in the British Journal of Dermatology, IL-17 is known to be or is likely to be related to the mechanism and severity of a number of inflammatory skin disorders, including psoriasis, acne, atopic dermatitis, rosacea and alopecia areata. Earlier this year, we presented mechanistic evidence for SB414, demonstrating a statistically significant reduction in composite psoriasis scores and an inhibition of IL-17a and IL-17f in an animal model. Top line results for

In the Phase 1b trial ~~are targeted~~for mild-to-moderate chronic plaque psoriasis, 36 adults received SB414 6% cream or vehicle twice daily for four weeks. We received and analyzed the preliminary top line results from this Phase 1b clinical trial during the second and

Table of Contents

third quarters of 2018. SB414 at the 6% dose did not result in any serious adverse events, but SB414 at the 6% dose was not consistently effective in reducing biomarkers across the trial. This lack of consistent biomarker movement could potentially be explained by the increased irritation score experienced by patients treated with SB414 6%. Additionally, SB414 6% showed detectable systemic exposure in a subset of patients, which cleared in nearly all affected patients within 12 hours. Based on the results of the Phase 1b trial in psoriasis, we will potentially explore the use of lower doses of SB414 in psoriasis, subject to obtaining additional financing or strategic partnering.

SB204, for the Treatment of Acne Vulgaris

In the second quarter of ~~2018.~~

~~Atopic Dermatitis~~

~~In two in vivo models that assess critical components of atopic dermatitis disease pathology, SB414 displayed potent anti-staphylococcal activity~~2018, we conducted a Type C meeting to further discuss the path forward for our SB204 candidate and dose-dependent inhibition of inflammation comparable to betamethasone, a mid-potency corticosteroid used to treat patients with atopic dermatitis. Based on preclinical data generated to date and documented literature on nitric oxide’s mechanisms of action, we believe that SB414 cream has the potential to offer non-steroidal,

~~immunomodulatory activity and anti-staphylococcal activity~~possible Phase 3 programs for the treatment of ~~atopic dermatitis. Additionally, SB414 cream is an occlusive formulation allowing~~acne vulgaris with the FDA, and the potential for ~~pH control in~~proceeding with a more narrowly defined patient segmentation. In that meeting, our focus was centered specifically on the ~~skin and a possible reduction in trans-epidermal water loss, both important factors for treating the disease. We are targeting the initiation of a Phase 1b trial with SB414 in adults with atopic dermatitis before year end with top line results targeted in~~severe patient population. In the third quarter of ~~2018.~~

2018, the FDA provided feedback in their minutes on two paths forward for the acne indication, confirming the need for one additional pivotal trial for moderate-to-severe acne patients prior to a NDA submission or, as an alternative, additional preliminary trials for a severe-only patient population.

Following receipt of FDA feedback via written minutes, we have determined that the most pragmatic development pathway for us will be to conduct one additional pivotal Phase 3 trial in moderate-to-severe acne patients. We ~~need~~have completed our clinical development plan for this additional trial and ~~intend~~have conducted certain initial clinical start-up procedures for a targeted trial initiation during the second half of 2019, subject to ~~access~~obtaining additional ~~capital through equity~~ financing or ~~debt financing~~strategic partnering.

Business Updates

Royalty and Milestone Payments Purchase Agreement with Reedy Creek Investments LLC

On April 29, 2019, we entered into a royalty and milestone payments purchase agreement, or ~~collaborative, licensing~~the Purchase Agreement, with Reedy Creek Investments LLC, or Reedy Creek, pursuant to which Reedy Creek provided us funding in an initial amount of $25.0 million, which we will use primarily to pursue the development, regulatory approval and commercialization (including through out-license agreements and other third party arrangements) activities for SB206, for the treatment of molluscum, and advancing programmatically other activities with respect to SB414, for atopic dermatitis, and SB204, for acne. Reedy Creek will also provide $10.0 million of additional funding contingent upon our achievement of SB206 clinical trial success, defined as (i) the achievement, no later than March 31, 2020, of statistically significant rates of complete clearance of lesions for molluscum contagiosum in humans at week 12 in each of the two Phase 3 clinical trials or any other primary endpoint required or accepted by the FDA for the SB206 product, or (ii) equivalent achievement (as agreed upon by the parties). Pursuant to the Purchase Agreement, we will pay Reedy Creek ongoing quarterly payments, calculated based on an applicable percentage per product of any upfront fees, milestone payments, royalty payments or equivalent payments received by us pursuant to any out-license agreement for SB204, SB206 and SB414 in the United States, Mexico or Canada, net of any upfront fees, milestone payments, royalty payments or equivalent payments paid by us to third parties pursuant to any agreements under which we have in-licensed intellectual property with respect to such products.

The applicable percentage used for determining the ongoing quarterly payments for each product ranges from 10% for SB206 to 20% for SB414 and SB204, provided that the applicable percentage for each product will be 25% for fees or milestone payments received by us (but not royalty payments received by us) until Reedy Creek has received payments under the Purchase Agreement equal to the total funding amount provided by Reedy Creek under the Purchase Agreement. If we decide to commercialize SB204, SB206 or SB414 on our own following regulatory approval, as opposed to commercializing through an out-license agreement or other ~~non-dilutive sources~~third party arrangement, we will be obligated to pay Reedy Creek a low single digits royalty on net sales of ~~capital. Further advancement~~such products.

Development Funding and Royalties Agreement with Ligand Pharmaceuticals Incorporated

On May 4, 2019, we entered into a development funding and royalties agreement, or the Funding Agreement, with Ligand Pharmaceuticals Incorporated, or Ligand, pursuant to which Ligand provided us funding of $12.0 million, which we will use to pursue the development and regulatory approval of SB206, for the treatment of molluscum.

Pursuant to the Funding Agreement, we will pay Ligand up to $20.0 million in milestone payments upon the achievement by us of certain regulatory and commercial milestones associated with SB206 or any product that incorporates or uses NVN1000, the active pharmaceutical ingredient for our ~~development programs, as described above, is dependent upon our ability to access this capital and our financial priorities.~~

~~Corporate Updates—Organizational and Governance Structure Alignment with Current Strategy~~

~~We are repositioning our organizational and governance structure to align with~~clinical stage product candidates, for the ~~aforementioned drug development strategy.~~treatment of molluscum. In addition to the ~~recent additions at~~milestone payments, we will pay Ligand tiered royalties ranging from 7% to 10% based on aggregate annual net sales of such products in the ~~board~~United States, Mexico or Canada.

Table of Contents

Drug Substance and ~~executive management team levels,~~Drug Product Agreements

On October 15, 2018, we established a strategic alliance with Orion, a Finnish full-scale pharmaceutical company with broad experience in manufacturing. The alliance enables Orion to manufacture our topical nitric oxide-releasing product candidates on our behalf and on the behalf of our global strategic partners. We have executed a master contract manufacturing agreement to enable technology transfer and manufacturing of clinical trial materials for future clinical trials with our topical product candidates. We plan to transfer the technology for the manufacture of SB204 and intend for Orion to be able to manufacture the drug product, or the finished dosage form of the gel, in accordance with our established manufacturing processes, in compliance with applicable regulatory guidelines, as appropriate for clinical trials and alongside our current internal manufacturing capabilities. While the initial framework of the agreement enables the manufacture of SB204, the companies plan to evaluate expanding the agreement to include other product candidates for the manufacture of clinical trial materials and, potentially, commercial quantities. Importantly, this alliance is intended to support major global markets in which we and our partners pursue regulatory approvals for our product candidates and complements our present internal capability.

We have selected a preferred CMO to manufacture our API upon completion of the transfer of manufacturing processes and analytical methods. In March 2019, we signed a letter of intent with a full-scale API manufacturer, a CMO, for the production of our proprietary drug substance. The scope of this initial letter of intent includes the process and analytical method transfer necessary to advance the development and large-scale manufacture of our drug substance.

Our relationships with the aforementioned third party manufacturers are integral to our operating strategy which includes an increased utilization of and reliance upon third party vendors and strategic partners for the performance of activities, processes and services that (i) do not result in the generation of significant new intellectual property and (ii) can leverage existing robust infrastructure, systems, and facilities as well as associated subject matter expertise. Our strategic objective is to reduce our own internal resources, facilities, and infrastructure of capabilities that have historically performed such activities, processes and services. While we will incur certain discrete costs as we transition to this new operating strategy, we believe it will ultimately provide operating efficiencies and allow us to direct a greater portion of our capital towards the generation of new technologies and intellectual property.

Addition of Gastrointestinal Disease as a Therapeutic Focus

In January 2019, we announced the addition of GI diseases as a therapeutic focus area as part of our overall science and business strategy. This decision is based on the connection between the multi-factorial pathologies of GI diseases and the demonstrable anti-microbial and anti-inflammatory properties of Novan’s nitric oxide technology. Nitric oxide produced in the GI tract regulates many of its functions including the secretion of mucous for protection against physical, chemical, and microbial injury, perfusion of blood through the GI tissue, mitigation of white blood cell adherence to GI tissue to protect from injury and the healing and repair of ulcers. We intend to initially focus on pediatric GI diseases given the favorable safety profile of nitric oxide and our existing pre-clinical and clinical data. We believe that our initial expansion into GI will require minimal investment due to our ability to leverage current technology experience and assets.

Corporate Updates

Executive Management Team

During early 2019 we repositioned our organizational structure to support our current business strategy and to further strengthen the alignment of our significant scientific and drug development expertise to our short, intermediate and long-term opportunities. In addition to the changes described below, we ~~expect a continued~~plan to continue certain targeted ~~expansion of our internal resources~~repositioning activities during ~~the remainder of 2017 and into 2018~~2019 in alignment with our strategy.

In January 2019 we announced the following:


◦	Paula Brown Stafford was promoted to President and the newly created role of Chief Operating Officer while remaining a member of the Board of Directors.


◦	Dr. Carri Geer was promoted to Senior Vice President and Chief Technology Officer of Novan and will be responsible for integrating formulation and analytical science with clinical translation in order to modify existing molecules and generate NCE opportunities.


◦	Dr. Elizabeth Messersmith, Senior Vice President, was promoted to the role of Chief Development Officer with oversight of the clinical, medical, statistical, and regulatory activities of the Company. Dr. Messersmith joined us in the role of Senior Vice President of Clinical Operations in May 2018.

~~In August 2017, Paula Brown Stafford, the Company’s Chief Development Officer, was appointed to the Board~~

Table of Directors. In September 2017, Machelle Sanders, Secretary of the North Carolina Department of Administration, was appointed to the Board of Directors as a non-employee Director and, in November 2017, was also appointed to the Company’s Compensation Committee. We believe that the addition of Ms. Sanders and Ms. Stafford complements and expands the experience of our Board of Directors in targeted areas.

Contents


◦	John M. Gay was promoted to Vice President of Finance and was appointed to serve as our Principal Financial Officer and Corporate Secretary, while continuing to serve as Corporate Controller. Mr. Gay joined us in the role of Senior Director of Finance, Corporate Controller in May 2018.


◦	Dr. Nathan Stasko stepped down as President and from the Board of Directors, as contemplated by his amended and restated employment agreement to occur following the appointment of G. Kelly Martin as Chief Executive Officer. Dr. Stasko subsequently resigned from all of his positions with the Company, including as Chief Scientific Officer.

◦

Jeff N. Hunter, our former Executive Vice President and Chief Business Officer, resigned from the Company, including from serving as our principal financial officer and Corporate Secretary, effective January 31, 2019. We entered into a consulting agreement with Mr. Hunter, which provides that Mr. Hunter will provide supporting consulting services related to two ongoing corporate development projects through September 30, 2019.

~~In September 2017, Tomoko Maeda-Chubachi, M.D., Ph.D. was appointed as Vice President of Medical Dermatology,~~To support the current business strategy and to expand our expertise in ~~which she will help drive the strategy, design~~scientific translation and ~~execution of our development programs by providing medical input. Dr. Maeda-Chubachi is a licensed dermatologist and has 15 years of dermatology~~overall drug development, ~~experience, with a strong focus on inflammatory skin diseases including psoriasis and atopic dermatitis.~~

~~Corporate Updates—Other~~

~~On October 2, 2017,~~ we ~~filed a shelf registration statement on Form S-3 with~~continue to promote talent from within the ~~SEC, which~~organization as well as selectively add professionals from outside the ~~SEC declared effective on October 10, 2017. The registration statement contained a prospectus which covers:~~

~~(iii)~~

the offering, issuance and sale by us of up to a maximum aggregate offering price of $150 million of our common stock, preferred stock, debt securities, warrants, and units, including those that may be issued upon conversion of, in exchange for or upon exercise of any such securities; and

Company.

~~(iv)~~

~~the offering, issuance and sale of~~ ~~up to 2,623,485 shares of our common stock~~ by Malin, our largest stockholder. These common stock shares represent Malin’s total shareholding in Novan as of October 2, 2017. Malin requested that we register all of the shares it presently holds to facilitate its ability to utilize the shares as collateral. Malin represented to our board of directors that it has no present intention to sell its shares or monetize its shareholding but reserves its right to manage its balance sheet and equity positions going forward. Malin confirmed it remains supportive of the management team and board of Novan, the potential application of the underlying technology platform in broad dermatological indications and the value proposition of the Company.

Financial Overview

Since our inception in 2006, we have devoted substantially all of our efforts to developing our nitric oxide platform technology and resulting product candidates, including conducting preclinical and clinical trials and providing general and administrative support for these operations. We conduct these activities in a single operating segment. We have not generated any revenue from product sales and, to date, have funded our operations through a variety of sources described in further detail within the “Liquidity and Capital Resources” section below. From inception through ~~September 30, 2017,~~March 31, 2019, we have raised total equity and debt proceeds of ~~$148.7~~$184.0 million to fund our ~~operations.~~ operations, including $4.5 million (or 0.5 billion JPY) in March 2019 from Sato Pharmaceutical Co., Ltd., or Sato, representing the second installment of an upfront payment of 1.25 billion JPY under our amended license agreement with Sato. In addition, in April 2019 and May 2019, respectively, we entered into the Purchase Agreement with Reedy Creek, providing $25.0 million of immediate funding, with an additional $10.0 million contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020, and the Funding Agreement with Ligand, providing $12.0 million of immediate funding. To date, we have focused our funding activities on equity, debt and strategic relationships. However, other historical forms of funding have included payments received from licensing and supply arrangements, government research contracts and grants and contract development manufacturing services.

We have never generated revenue from product sales and have incurred net losses in each year since ~~inception and, as~~inception. As of ~~September 30, 2017,~~March 31, 2019, we had an accumulated deficit of ~~$152.0~~$180.1 million. We incurred net losses of ~~$28.9~~$7.0 million and ~~$46.6~~$5.2 million induring the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, respectively. We expect to continue to incur substantial losses in the future as we conduct our planned operating activities. We do not expect to generate revenue from product sales unless and until we obtain regulatory approval from the FDA for our clinical-stage product candidates. If we obtain regulatory approval for any of our product candidates, ~~there will be~~we and/or our commercial partners would expect to incur significant ~~commercialization~~ expenses related to product sales, marketing, manufacturing and distribution.

~~In addition, we~~

We expect that we will continue to incur substantial expenses as we continue clinical trials and preclinical studies for, and research and development of, our product candidates and maintain, expand and protect our intellectual property portfolio. ~~As a result, we~~We will need substantial additional funding to support our planned and future operating activities. Adequate future funding may not be available to us on acceptable terms, or at all. The current market value of our common stock may negatively impact funding options

and the acceptability of funding terms. Additionally, we expect future advancement of our product candidates to occur after the formation of additional partnering, collaborations, licensing, grants or other strategic relationships. Our failure to enter into such additional relationships, the termination or failure of our current strategic relationships, including a failure to receive any contingent payments under such strategic relationships, or our failure to obtain sufficient additional funds on acceptable terms as and when needed could cause us to alter or reduce our planned operating activities, including but not limited to delaying, reducing, terminating or ~~discontinuing~~eliminating planned product candidate development activities, to conserve our cash and cash ~~equivalents.~~equivalents or to dissolve and liquidate our assets or seek protection under bankruptcy laws. Such actions could delay development timelines and have a material adverse effect on our business, results of operations, financial condition and market valuation. As further discussed in our condensed consolidated financial statements and related footnotes included in this Quarterly Report on Form 10-Q, these matters raise substantial doubt about our ability to continue as a going concern.

Table of Contents

Please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” for further discussion of our current liquidity and our future funding needs.

Components of ~~Our~~our Results of Operations

Revenue

~~Licensing~~

License and collaboration revenue consists of the amortization of ~~a non-refundable $10.8 million upfront payment received~~certain fixed and variable consideration under the Sato license agreement wethat was entered into during the first quarter of 2017, ~~with~~as amended in October 2018, or the Amended Sato ~~Pharmaceuticals, Ltd. (“Sato”).~~Agreement, that (i) has been received to date in the form of upfront and milestone payments; or (ii) are future, non-contingent milestone payments that become payable upon the earlier occurrence of specified fixed dates in the future or the achievement of specified milestone events. This consideration is being recognized on a straight-line basis over the estimated performance period of approximately 7.5 years, from February 2017 through the third quarter of 2024. The material terms of the Amended Sato Agreement and related revenue recognition are described within ~~“Note 3—Collaboration Arrangements”~~Note 4—Licensing Arrangements, and Note 5—Revenue Recognition to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.The $10.8 million upfront consideration under this agreement is being recognized on a straight-line basis over the estimated performance period, which is currently March 2017 through the first quarter of 2022.

Research and development services revenue is associated with the master development services and clinical supply agreement and related statements of work, or collectively the KNOW Bio Services Agreement, we entered into with KNOW Bio. Under the KNOW Bio Services Agreement, we are providing certain development and manufacturing services to KNOW Bio in exchange for service fees currently expected to total approximately $0.9 million. We recognized approximately $0.2 million and $0.3 million of services revenue during the three and nine months ended September 30, 2017, respectively, and expect to perform the remaining services and recognize the remaining revenue during the fourth quarter of 2017 and the first half of 2018. We may also provide additional development and manufacturing services to KNOW Bio under future statements of work. We do not expect the fees received under the KNOW Bio Services Agreement to significantly increase the period over which our cash and cash equivalents can fund our operating expenses. Our accounting policies pertaining to KNOW Bio are included in “Note 1—Organization and Significant Accounting Policies” to the accompanying condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.

~~We will adopt FASB ASC Topic 606,~~ ~~Revenue from Contracts with Customers,~~ guidance on January 1, 2018. We are currently conducting an assessment of the impact that Topic 606 will have on reported revenues in 2017 and in future periods, including revenues associated with the Sato Agreement and the KNOW Bio Services Agreement. Additional information about our adoption of Topic 606 is included in “Note 1—Organization and Significant Accounting Policies” to the accompanying condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.

Research and Development Expenses

Since our inception, we have focused our resources on our research and development activities, including conducting preclinical studies and clinical trials, manufacturing development efforts and activities related to regulatory filings for our product candidates. Research and development expenses, including those paid to third parties for which there is no alternative use, are expensed as they are incurred. Research and development expenses include:

external research and development expenses incurred under agreements with contract research organizations, ~~or CROs,~~ investigative sites and consultants to conduct our clinical trials and preclinical ~~and non-clinical~~ studies;

costs to acquire, develop and manufacture supplies for clinical trials and preclinical studies ~~including fees paid~~at our facilities;

costs to establish drug substance and drug product manufacturing capabilities, and to develop and manufacture such drug substance and drug product, with external contract manufacturing ~~organizations, or CMOs;~~

organizations;

legal and other professional fees related to compliance with FDA requirements;

licensing fees and milestone payments incurred under license agreements;

salaries and related costs, including ~~stock-based~~share-based compensation and travel expenses, for personnel in our research and development functions; and

facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent, maintenance of facilities, utilities, equipment and other supplies.

From inception through ~~September 30, 2017,~~March 31, 2019, we have incurred approximately ~~$107.8~~$141.7 million in research and development expenses to develop, expand or otherwise improve our nitric oxide platform and resulting product ~~candidates.~~candidates, as well as costs incurred to generate research and development services revenue. The table below sets forth our external research and development expenses incurred for current product candidates and unallocated internal research and development expenses for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016.~~2018. All research and development salaries and related personnel costs, as well as certain manufacturing costs, ~~and~~ facilities expenses and costs incurred to generate research and development services revenue, are included in unallocated internal research and development expenses.

Three Months Ended September 30,

Nine Months Ended September 30,

2017

2016

2017

2016

(in thousands)

(in thousands)

External:

SB204

$
1,263

$
11,597

$
6,828

$
27,298

SB206

133

538

(158
)

2,322

SB208

(27
)

600

362

1,242

SB414

317

16

1,642

310

Other programs

—

66

4

249

Unallocated internal research and development expenses

3,507

2,171

10,423

5,940

Total research and development expenses

$
5,193

$
14,988

$
19,101

$
37,361



	Three Months Ended March 31,
	2019		2018
	(in thousands)
External:
SB204	$	77	$	600
SB206	649		1,083
SB208	7		15
SB414	39		785
Unallocated internal research and development expenses	4,055		3,852
Total research and development expenses	$	4,827	$	6,335

Table of Contents

We expect that for the foreseeable future, the substantial majority of our research and development efforts will be focused on our current clinical programs and on our future pipeline development. ~~Major~~During the three months ended March 31, 2019, our major clinical ~~and preclinical~~ development activities ~~conducted during the three and nine months ended September 30, 2017 are summarized as follows:~~

•

~~For SB204, we completed a 40-week long term safety trial in eligible patients~~were primarily associated with acne who had previously completed 12 weeks of treatment in the related Phase 3 pivotal trials of SB204 in the third quarter of 2017. We previously completed the related Phase 3 pivotal trials earlier in 2017. We recently held a productive guidance meeting with the U.S. Food and Drug Administration, or FDA, to obtain clinical and regulatory clarity around the SB204 program. The FDA advised that an additional pivotal trial should be conducted. We do not intend to utilize our own capital resources to conduct this trial; rather, we intend to advance the SB204 program towards NDA submission through a partnership strategy as described in the “Overview—Key Drug Development Updates” section above.

~~For~~ SB206 molluscum program, where we completed aour Phase 2 clinical ~~trial for the treatment of external genital warts and announced top-line results in the fourth quarter of 2016. The SB206~~ program ~~expense credit of $0.2 million in the nine months ended September 30, 2017 relates primarily to a $0.4 million favorable change in our accrued Phase~~activities, held an end-of-Phase 2 ~~trial cost estimate recognized in the first quarter of 2017 as we obtained final trial activity data and reached an agreement on final trial costs~~meeting with the FDA, and conducted Phase 3 clinical ~~research organization that conducted the trial.~~

program start-up activities.

~~For SB208, we initiated a Phase 2 clinical development program in July 2016 and announced top-line results in April 2017.~~

For SB414, we completed our preclinical studies, submitted an IND to the FDA during the third quarter of 2017, and we conducted start-up activities associated with Phase 1b trials in patients with psoriasis and with atopic dermatitis.

We expect ~~to continue~~ to incur substantial research and development expenses in the future as we develop our ~~SB206 and SB414~~ clinical product candidates and ~~as we develop new chemical entities,~~for other existing or ~~NCEs, for use in oncovirus therapies.~~future product candidates. In particular, with our existing capital resources, we expect to continue to incur substantial external development service provider fees and other research and development costs through the remainder of 2017 and into 2018 associated with the development plan summarized in the “Overview—Key Drug Development Updates” section above. Although we expect external research and development expenses associated with such clinical development activities to be substantial, we expect such expenses to be lower in 2017 than external research and development expenses incurred in 2016. Nonetheless, we also expect our internal research and development personnel costs to increase during the remainder of ~~2017~~2019 as we: (i) conduct SB206 molluscum Phase 3 program activities; (ii) conduct certain preclinical studies and prepare to initiate a Phase 2 clinical trial in ~~fiscal year 2018 as we~~the SB414 atopic dermatitis program; (iii) continue to progress drug product manufacturing capability transfer activities to Orion; (iv) initiate and conduct ~~a targeted expansion of our internal resources~~expected API manufacturing capability transfer activities to one or more third party CMOs; and (v) conduct other platform technology research and development, including developing NCEs, formulations and delivery devices in ~~support of our drug development strategy.~~ the dermatology, GI and women’s health fields.

We may decide to revise our plans or the related timing, depending on information we learn through our research and development activities, our ability to access additional capital, our ability to enter into strategic arrangements and our financial priorities.

The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate the nature, timing or costs required to complete the remaining development of our current product candidates or any future product candidates. This is due to the numerous risks and uncertainties associated with the development of product candidates. See the “Risk Factors” section in our Annual Report on Form 10-K filed with the SEC on March ~~20, 2017 and subsequent Quarterly Reports on Form 10-Q, including this Quarterly Report on Form 10-Q,~~27, 2019, for a discussion of the risks and uncertainties associated with our research and development projects.

General and Administrative Expenses

Our general and administrative expenses consist primarily of salaries and related costs, including ~~stock-based~~share-based compensation and travel expenses for personnel in our executive, finance, ~~commercial,~~ corporate development and other administrative functions. Other general and administrative expenses include allocated depreciation and facility-related costs, legal costs of pursuing patent protection of our intellectual property, insurance coverage and professional services fees for auditing, tax, general legal, litigation defense and other corporate and administrative services.

We expect to continue to incur substantial general and administrative expenses during the remainder of ~~2017 and in fiscal year 2018 that are incurred~~2019 in support of our product development operating activities and as necessary to operate in a public company environment. Significant general and administrative expenses associated with operations in a public company environment include legal, accounting, regulatory and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, directors’ and officers’ liability insurance premiums and investor relations activities.

However, we do expect litigation defense fees to decrease during 2019 as we concluded that the putative stockholder class action lawsuits, as described in the section entitled Note 7—Commitments and Contingencies—Legal Proceedings to the unaudited interim financial statements in this Quarterly Report on Form 10-Q, are substantially complete.

Other ~~(Expense)~~ Income (Expense), net

Other income (expense) ~~income,~~, net consists primarily of (i) ~~lease interest expense on~~fair value adjustments to our ~~primary facility lease financing obligation,~~warrant liability; (ii) interest income earned on cash and cash ~~equivalents~~equivalents; and (iii) other miscellaneous income and expenses. We expect ~~to continue to incur interest expense on our primary facility lease financing obligation during 2017 and throughout~~continued fluctuations in the ~~remainder~~fair value of the ~~initial lease term that expires~~warrant liability, based primarily on fluctuations in ~~2026.~~

the market value of our common stock.

Table of Contents

Results of Operations

Comparison of Three Months Ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~

2018

The following table sets forth our results of operations for the periods indicated:

Three Months Ended September 30,

2017

2016

$ Change

% Change

(in thousands, except percentages)

License and collaboration revenue

$
532

$
—

532

*

Research and development services revenue

218

—

218

*

Total revenue

750

—

750

*

Operating expenses:

Research and development

5,193

14,988

(9,795
)

(65
)%
General and administrative

2,762

2,493

269

11
%
Total operating expenses

7,955

17,481

(9,526
)

(54
)%
Operating loss

(7,205
)

(17,481
)

10,276

59
%
Other (expense) income, net

(239
)

7

(246
)

*

Net loss and comprehensive loss

$
(7,444
)

$
(17,474
)

$
10,030

57
%
* Not Meaningful



	Three Months Ended March 31,
	2019			2018			$ Change			% Change
	(in thousands, except percentages)
License and collaboration revenue	$	1,100		$	649		$	451		69	%
Research and development services revenue	—			9			(9		)	(100	)%
Total revenue	1,100			658			442			67	%
Operating expenses:
Research and development	4,827			6,335			(1,508		)	(24	)%
General and administrative	2,994			2,880			114			4	%
Total operating expenses	7,821			9,215			(1,394		)	(15	)%
Operating loss	(6,721		)	(8,557		)	1,836			(21	)%
Other (expense) income, net:
Interest income	28			44			(16		)	(36	)%
Interest expense	—			(262		)	262			(100	)%
Change in fair value of warrant liability	(388		)	3,558			(3,946		)	(111	)%
Other income, net	56			—			56			100	%
Total other (expense) income, net	(304		)	3,340			(3,644		)	(109	)%
Net loss and comprehensive loss	$	(7,025	)	$	(5,217	)	$	(1,808	)	35	%

Revenue

License and collaboration revenue of ~~$0.5~~$1.1 million and $0.6 million for the three months ended ~~September 30, 2017 is~~March 31, 2019 and 2018, respectively, was associated with our performance during the period and the related ~~to the~~ amortization of athe non-refundable upfront ~~payment received~~and expected milestone payments under the Amended Sato ~~Agreement, which was executed in January 2017.~~ Agreement.

Research and development ~~services revenue of $0.2~~expenses

Research and development expenses were $4.8 million for the three months ended ~~September 30, 2017~~ ~~is associated with development services we performed under the KNOW Bio Services Agreement.~~

~~Research and development expenses~~

~~Research and development expenses were $5.2~~March 31, 2019, compared to $6.3 million for the three months ended ~~September 30, 2017 compared to $15 million for the three months ended September 30, 2016.~~March 31, 2018. The decrease of ~~$9.8~~$1.5 million, or 24%, was primarily due to the ~~recent~~ completion of certain clinical trials in our active development programs, including the two ~~parallel~~SB414 Phase ~~3 pivotal~~1b trials ~~(first quarter~~in the atopic dermatitis and psoriasis indications, which resulted in a decrease of ~~2017)~~$0.7 million; the SB206 molluscum Phase 2 clinical trial program, which resulted in a decrease of $0.4 million; and the ~~long term~~long-term safety trial ~~(third quarter of 2017)~~ in the SB204 program, which resulted in a decrease of ~~$10.3~~$0.5 million.

We also had an increase in unallocated internal research and development expenses of $0.2 million ~~the Phase 2 clinical trial for SB206~~due to a $0.5 million increase in ~~the fourth quarter of 2016,~~facility and manufacturing costs, which resulted in a decrease of $0.4 million and the Phase 2 clinical trial for SB208 program, which resulted in a decrease of $0.6 million. In addition, other programs decreased by $0.1 million. These program cost decreases werewas partially offset by a $0.3 million ~~increase in SB414 program costs as we (i) completed preclinical studies in preparation for the~~

~~IND submitted in the third quarter of 2017 and (ii) conducted clinical start-up activities associated with the two Phase 1b trials in patients with psoriasis and atopic dermatitis.~~

~~In addition, other unallocated internal research and development expenses increased by $1.3 million due to a $0.7 million increase~~decrease in research and development personnel ~~costs and a $0.6 million increase in facility and manufacturing~~ costs. The $0.7 million increase in personnel costs is associated with the targeted expansion of our organizational structure in support of our current development strategy and the increase includes $0.4 million of non-cash stock compensation expense associated with recent awards granted to our research and development personnel. The $0.6$0.5 million increase in facility and manufacturing costs is primarily ~~due to operating in~~associated with (i) drug substance manufacturing campaigns conducted at our ~~current headquarters and manufacturing facility in~~ Morrisville, North Carolina facility and (ii) allocated rental expense following the January 1, 2019 adoption of FASB Accounting Standards Update No. 2016-02, Leases (Topic 842), which was reported as interest expense in previous reporting periods prior to adoption of Topic 842.

The $0.3 million net decrease in personnel costs is primarily due (i) a $0.4 million decrease in non-cash stock compensation expense and (ii) a $0.3 million decrease in recurring salaries and benefits due to reductions in research and development personnel between the comparative periods, which were partially offset by (iii) a $0.4 million discrete severance expense charge in the first quarter of 2019 associated with the departure of our former Chief Scientific Officer. The decrease in non-cash stock compensation expense is associated with (i) the forfeiture of stock options previously held by former officers and employees who departed the Company prior to or during ~~2017,~~the first quarter of 2019 and (ii) expense associated with the annual grant of stock option awards to all employees during the first quarter of 2018, which ~~we began to occupy~~did not recur in ~~October 2016.~~

the first quarter of 2019 after the establishment of the Performance Plan in the third quarter of 2018.

Table of Contents

General and administrative expenses

General and administrative expenses were ~~$2.8~~$3.0 million for the three months ended ~~September 30, 2017 and $2.5~~March 31, 2019, compared to $2.9 million for the three months ended ~~September 30, 2016.~~March 31, 2018. The increase of ~~$0.3~~approximately $0.1 million, isor 4%, was primarily due to ana $0.2 million increase ~~of $0.7 million~~ in professional services ~~insurance, board~~costs primarily associated with a capital sourcing exploration process, which culminated in the second quarter of 2019 with the execution of the two non-dilutive funding transactions described in the section entitled “Overview—Business Updates,” partially offset by a $0.1 million decrease in general and administrative personnel and related costs.

The $0.1 million net decrease in general and administrative personnel and related costs is comprised of a $0.3 million decrease in non-cash stock compensation expense, which was partially offset by a $0.2 million net increase in severance charges and other ~~administrative costs necessary~~one-time compensatory payments. The $0.3 million decrease in non-cash stock compensation expense is associated with (i) the forfeiture of stock options previously held by former officers and employees who departed the Company prior to ~~support~~or during the first quarter of 2019 and (ii) expense associated with the annual grant of stock option awards to all employees during the first quarter of 2018, which did not recur in the first quarter of 2019 after the establishment of the Performance Plan in the third quarter of 2018. The $0.2 million net increase in severance charges and other one-time compensatory payments is comprised of (i) a $0.5 million discrete charge in the first quarter of 2019 primarily related to severance and one-time payments associated with the departure of our ~~operations as a public company. This increase~~former chief business officer in January 2019, which was partially offset by ~~decreases in personnel related costs of~~(ii) a $0.3 million ~~and market research costs~~discrete severance charge in the first quarter of ~~$0.1 million.~~

2018 associated with the departure of our former chief commercial officer in January 2018.

Other (expense) income, net

Other income (expense) ~~income,~~, net was ~~($0.2)~~$0.3 million expense for the three months ended ~~September 30, 2017,~~March 31, 2019, compared to ~~approximately $7,000~~$3.3 million income for the three months ended ~~September 30, 2016.~~March 31, 2018. The net expense increase of approximately ~~$0.2~~$3.6 million was primarily due to the ~~recognition of approximately $0.3 million of lease interest expense on our primary facility lease financing obligation, following the completion~~change in fair value of the ~~facility’s build-out phase in December 2016. This interest expense incurred during the three months ended September 30, 2017 was partially offset by less than $0.1~~warrant liability of $3.9 million, ~~of interest income earned on cash and cash equivalents.~~

~~Comparison of Nine Months Ended September 30, 2017 and 2016~~

~~The following table sets forth our results of operations for the periods indicated:~~

Nine Months Ended September 30,

2017

2016

$ Change

% Change

(in thousands, except percentages)

License and collaboration revenue

$
1,233

$
—

$
1,233

*

Research and development services revenue

286

—

286

*

Total revenue

1,519

—

1,519

*

Operating expenses:

Research and development

19,101

37,361

(18,260
)

(49
)%
General and administrative

10,654

9,327

1,327

14
%
Total operating expenses

29,755

46,688

(16,933
)

(36
)%
Operating loss

(28,236
)

(46,688
)

18,452

40
%
Other (expense) income, net

(702
)

50

(752
)

(1504
)%
Net loss and comprehensive loss

$
(28,938
)

$
(46,638
)

$
17,700

38
%
* Not Meaningful

~~Revenue~~

~~License and collaboration revenue of $1.2 million for the nine months ended September 30, 2017 was related to the amortization of a non-refundable upfront payment received under the Sato Agreement, which was executed in January 2017~~. ~~Research and development services revenue of $0.3 million for the nine months ended September 30, 2017~~ ~~is associated with development services we performed under the KNOW Bio Services Agreement.~~

~~Research and development expenses~~

Research and development expenses were $19.1 million for the nine months ended September 30, 2017, compared to $37.4 million for the nine months ended September 30, 2016. The decrease of $18.3 million was primarily due to the recent completion of certain clinical trials in our active development programs, including the two parallel Phase 3 pivotal trials (first quarter of 2017) and the long term safety trial (third quarter of 2017) in the SB204 program, which resulted in a decrease of $20.5 million, the Phase 2 clinical trial

for SB206, which resulted in a decrease of $2.5 million and the Phase 2 clinical trial for SB208, which resulted in a decrease of $0.9 million. In addition, other programs decreased by $0.2 million. These program cost decreases were partially offset by a ~~$1.3~~$0.3 million ~~increase~~decrease in SB414 program costs as we (i) conducted and completed preclinical studies in preparation for the IND submitted in third quarter 2017 and (ii) conducted clinical start-up activities associated with the two Phase 1b trials in patients with psoriasis and atopic dermatitis.

In addition, other unallocated internal research and development expenses increased by $4.5 million due to a $2.7 million increase in research and development personnel costs and a $1.8 million increase in facility and manufacturing costs. The $2.7 million increase in personnel costs includes $0.6 million in cash severance costs associated with a workforce reduction and the departure of our former Chief Medical Officer, both of which occurred in the second quarter of 2017, and a related $0.2 million increase in non-cash stock compensationinterest expense associated with ~~the accelerated vesting of option awards. The remaining increase in personnel costs includes an increase in stock compensation expense of $0.8 million associated with awards recently granted to~~ our ~~research and development personnel and $1.1 million~~ ~~associated with~~ ~~the targeted expansion of our organizational structure in support of our current development strategy. The $1.8 million increase in facilities and manufacturing costs is primarily due to operating in our current headquarters and manufacturing facility in~~ Morrisville, North Carolina ~~during 2017, which~~facility lease. Following the adoption of Topic 842 on January 1, 2019, we ~~began to occupy in October 2016~~.

~~General and administrative expenses~~

General and administrative expenses were $10.7 million for the nine months ended September 30, 2017, compared to $9.3 million for the nine months ended September 30, 2016. The increase of $1.4 million is primarily due to an increase of $2.3 million in professional services, insurance, board compensation and other administrative costs necessary to support our operations asno longer report a ~~public company. In addition, there was a net increase of $0.7 million in personnel costs primarily due to severance costs related to a workforce reduction and the departure~~portion of our ~~former Chief Financial Officer,~~ ~~including $0.5 million of cash severance~~lease costs and $0.3 million in related non-cash stock compensation expense associated with the accelerated vesting of option awards. Other changes in personnel costs during the comparative periods included a $0.8 million increase in non-cash stock compensation expense associated with recently granted awards, a $0.2 million increase in travel-related costs and a $1.1 million decrease in salaries, benefits and accrued bonus compensation costs following the aforementioned resource realignment events occurring in 2017~~. These increases were partially offset by decreases of $1.4 million in market research and related costs and $0.2 million in general corporate costs.~~

~~Other (expense) income, net~~

Other (expense) income, net was ($0.7) million expense for the nine months ended September 30, 2017, compared to approximately $50,000 income for the nine months ended September 30, 2016. The net expense increase of approximately $0.8 million was due to the recognition of approximately $0.8 million ofas interest ~~expense on our primary facility lease financing obligation beginning in the first quarter of 2017, following the completion of the facility’s build-out phase in December 2016.~~

expense.

Liquidity and Capital Resources

Since our inception through ~~September 30, 2017,~~March 31, 2019, we have financed our operations primarily with ~~$148.7~~$184.0 million in net proceeds from the issuance and sale of equity securities and convertible debt securities, including $35.2 million in net proceeds from the sale of common stock and accompanying warrants in the January 2018 Offering and $44.6 million in net proceeds from the sale of common stock in our 2016 initial public ~~offering, or our IPO.~~offering. Other historical forms of funding have included payments received from licensing and supply arrangements and government research contracts and grants. We received an upfront payment of approximately $10.8 million following the execution of the Sato Agreement in the first quarter of 2017 for the exclusive right to develop, use and sell SB204 in certain topical dosage forms in Japan for the treatment of acne vulgaris.

In addition, we received a milestone payment of approximately $2.2 million in the fourth quarter of 2018, related to the initiation of a Phase 1 trial in Japan in the third quarter of 2018. Under the terms of the Sato Amendment which expanded the Sato Agreement to include SB206, we also received a payment of $2.2 million (or 0.25 billion JPY) in October 2018 and a payment of $4.5 million (or 0.5 billion JPY) in March 2019, representing the first and second installments of an upfront payment of 1.25 billion JPY. The remaining installment of 0.5 billion JPY is payable on September 13, 2019.

As of ~~September 30, 2017,~~March 31, 2019, we had ~~$11.0 million of~~ cash and cash ~~equivalents.~~ equivalents of $6.1 million and negative working capital of $3.5 million. As described below, in late April 2019 and early May 2019, respectively, we entered into (i) the Purchase Agreement with Reedy Creek, providing $25.0 million of immediate funding, with an additional $10.0 million contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020; and (ii) the Funding Agreement with Ligand, providing $12.0 million of immediate funding. We believe that our existing cash and cash equivalents, expected contractual payments to be received in connection with previous licensing agreements, and the addition of the $25.0 million and $12.0 million received through these funding transactions will (i) provide us with adequate liquidity to fund our planned operating needs into the first quarter of 2020, including through expected top-line results of the Phase 3 molluscum clinical program targeted in the first quarter of 2020, or before; and (ii) into the second quarter of 2020, if paired with the potential $10.0 million funding contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020. Although we secured additional capital in April 2019 and May 2019, as described in the section below, we have concluded that the prevailing conditions and ongoing liquidity risks we face raise substantial doubt about our ability to continue as a going concern. We need substantial additional funding to continue our operating activities and make further advancements in our drug development programs beyond those planned in 2019 and certain activities in the first half of 2020.

Our cash and cash equivalents are held in a variety of interest-bearing instruments, including money market accounts. Cash in excess of immediate requirements is invested with a view toward liquidity and capital preservation, and we seek to minimize the potential effects of concentration and degrees of risk.

Table of Contents

Royalty and Milestone Payments Purchase Agreement with Reedy Creek Investments LLC

On April 29, 2019, we entered into the Purchase Agreement with Reedy Creek, pursuant to which Reedy Creek provided us funding in an initial amount of $25.0 million, which we will use primarily to pursue the development, regulatory approval and commercialization (including through out-license agreements and other third party arrangements) activities for SB206, for the treatment of molluscum, and advancing programmatically other activities with respect to SB414, for atopic dermatitis, and SB204, for acne. Reedy Creek will also provide $10 million of additional funding contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020. Pursuant to the Purchase Agreement, we will pay Reedy Creek ongoing quarterly payments, calculated based on an applicable percentage per product of any upfront fees, milestone payments, royalty payments or equivalent payments received by us pursuant to any out-license agreement for the products in the United States, Mexico or Canada, net of any upfront fees, milestone payments, royalty payments or equivalent payments paid by us to third parties pursuant to any agreements under which we have in-licensed intellectual property with respect to the products.

The applicable percentage used for determining the ongoing quarterly payments for each product ranges from 10% for SB206 to 20% for SB414 and SB204, provided that the applicable percentage for each product will be 25% for fees or milestone payments received by us (but not royalty payments received by us) until Reedy Creek has received payments under the Purchase Agreement equal to the total funding amount provided by Reedy Creek under the Purchase Agreement. If we decide to commercialize any product on its own following regulatory approval, as opposed to commercializing through an out-license agreement or other third party arrangement, we will be obligated to pay Reedy Creek a low single digits royalty on net sales of the products.

Development Funding and Royalties Agreement with Ligand Pharmaceuticals Incorporated

On May 4, 2019, we entered into the Funding Agreement with Ligand, pursuant to which Ligand provided us funding of $12.0 million, which we will use to pursue the development and regulatory approval of SB206, for the treatment of molluscum.

Pursuant to the Funding Agreement, we will pay Ligand up to $20.0 million in milestone payments upon the achievement by us of certain regulatory and commercial milestones associated with SB206 or any product that incorporates or uses NVN1000, the active pharmaceutical ingredient for our clinical stage product candidates, for the treatment of molluscum. In addition to the milestone payments, we will pay Ligand tiered royalties ranging from 7% to 10% based on aggregate annual net sales of the products in the United States, Mexico or Canada.

Expansion of Partnership with Sato in Japanese Territory

On October 5, 2018, we and Sato entered into the second amendment to the initial license agreement dated January 12, 2017, or the Sato Amendment. The initial license agreement had focused on the development and commercialization of SB204 for the treatment of acne vulgaris in Japan. The Sato Amendment also provides Sato with the exclusive rights to develop and commercialize SB206 and related dosage forms for the treatment of viral skin infections, including but not limited to molluscum contagiosum and external genital warts, in Japan. Under the terms of the Sato Amendment, we will receive an upfront payment from Sato totaling 1.25 billion JPY (approximately $11.1 million USD) to be paid in three installments over a 12 months period. We received the first installment of 0.25 billion JPY (approximately $2.2 million USD) in October 2018 and the second installment of 0.5 billion JPY (approximately $4.5 million USD) in March 2019. The third installment of 0.5 billion JPY becomes payable in September 2019. The Sato Amendment also provides for an aggregate of 1.0 billion JPY in additional non-contingent milestone payments that become payable upon the earlier occurrence of specified fixed dates in the future or the achievement of specified milestone events.

Primary Facility Lease Financing

Our approximately 51,000 square foot leased facility in Morrisville, North Carolina serves as our corporate headquarters and ~~primary~~sole research, development and ~~drug compound~~ manufacturing facility. We entered into the ten-year, non-cancellable lease agreement in 2016, currently have ~~accounted for this~~approximately seven years remaining under the lease ~~as a capitalized asset~~term and currently have approximately $9.4 million in remaining minimum lease payments.

In July 2018, the Company and a ~~corresponding~~third-party tenant entered into a sublease of approximately 6,400 square feet of office space, or approximately 12% of total facility ~~financing obligation on~~square footage, at our ~~balance sheets. We began recognizing interest expense associated with~~Morrisville, North Carolina headquarters. The sublease has a three-year, non-cancellable term and provides for monthly rental income to the Company of approximately $12,000 per month through July 2021. The remaining rental income from this ~~financing obligation in the first quarter of 2017, following the completion~~sublease is expected to offset approximately 3.5% of the ~~build-out phase in December 2016. See “Note 1—Organization~~total remaining minimum lease payments per our underlying lease agreement.

Table of Contents

As part of our broader strategic plan to shift our operating cost structure characteristics from fixed to variable, we are actively pursuing efforts to further reduce or offset our remaining fixed lease obligation. We have engaged a commercial real estate broker and ~~Significant Accounting Policies” and “Note 5—Commitments and Contingencies” to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q~~are currently marketing our Morrisville, North Carolina headquarters facility for ~~further discussion of the accounting for this lease.~~

sublease or assignment.

Cash Flows

The following table sets forth our cash flows for the periods indicated:

Nine Months Ended September 30,

2017

2016

(in thousands)

Net cash provided by (used in):

Continuing operating activities

$
(21,892
)

$
(32,366
)

Continuing investing activities

(1,799
)

(3,485
)

Continuing financing activities

40

46,084

Net decrease in cash and cash equivalents –
discontinued operations

—

(257
)

Net decrease in cash and cash equivalents

$
(23,651
)

$
9,976



	Three Months Ended March 31,
	2019			2018
	(in thousands)
Net cash (used in) provided by:
Operating activities	$	(2,110	)	$	(9,648	)
Investing activities	(17		)	(140		)
Financing activities	10			35,364
Net (decrease) increase in cash, cash equivalents and restricted cash	$	(2,117	)	$	25,576

Net Cash Used in ~~Continuing~~ Operating Activities

During the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2019, net cash used in operating activities was ~~$21.9~~$2.1 million and consisted primarily of a net loss of ~~$28.9~~$7.0 million, with adjustments for non-cash amounts related primarily to depreciation expense of ~~$1.0~~$0.5 million, ~~stock-based~~share-based compensation expense for both equity-based and liability-based awards of ~~$3.0~~$0.2 million, increase in fair value of warrant liability of $0.4 million and a ~~$3.0~~$3.8 million favorable change in other operating assets and liabilities. The favorable ~~net~~ change in assets and liabilities was primarily due to (i) a $3.4 million increase in deferred revenue following the receipt of an additional upfront installment payment under the Amended Sato Agreement during the first quarter of ~~$10.8~~2019; and (ii) a $0.6 million ~~following~~increase in accrued compensation associated with severance obligations to two former officers who resigned during the ~~execution~~first quarter of ~~the Sato Agreement. This increase was~~2019. These changes were partially offset by ~~decreases~~a $0.2 million net decrease in accounts payable and accrued ~~expense balances~~expenses associated with ~~our outside research and development activities during~~ the ~~period, including a $4.6 million decrease in accrued outside research and development services. The decrease in payables and accruals for these services was primarily related to~~timing between the ~~Phase 3 pivotal trials and long term safety trial in our SB204 program~~incurrence of service fees and the ~~Phase 2 clinical trial in our SB206 program. In addition, we had approximately $0.5~~contractual invoicing and payment terms for such services. Our total accrued compensation balance was $2.0 million ~~in accrued severance costs~~ as of ~~September 30, 2017,~~March 31, 2019, which we ~~expect~~target to ~~settle through cash disbursements during~~reduce over the ~~fourth quarter~~remainder of ~~2017~~2019 as we make payments of approximately $0.7 million for accrued fiscal year 2018 employee bonuses and ~~first half of 2018.~~

approximately $0.6 million for remaining severance payments to former officers.

During the ~~nine~~three months ended ~~September 30, 2016,~~March 31, 2018, net cash used in operating activities was ~~$32.4~~$9.6 million and consisted primarily of a net loss of ~~$46.6~~$5.2 million, with adjustments for non-cash amounts related primarily to depreciation expense of ~~$0.6~~$0.4 million, ~~stock-based~~share-based compensation expense for both equity-based and liability-based awards of $0.9 million, decrease in fair value of warrant liability of $3.6 million and a ~~$12.8~~$2.2 million ~~favorable change~~net decrease in other operating assets and liabilities. The ~~favorable~~ net ~~change~~decrease in assets and liabilities was primarily due to ~~increases~~a $1.2 million decrease in ~~accounts payable and~~ accrued ~~expense balances~~compensation following the payment of annual employee bonuses in the first quarter of 2018, a $0.6 million decrease in other accrued expenses following the payment of various accrued expenses during the period, including ~~an $8.8~~$0.2 million ~~increase~~ in ~~accrued outside research and development services. The increase~~travel costs paid to Malin Life Sciences Holdings Limited, or Malin, in ~~accruals for these services was primarily~~the first quarter of 2018 related to ~~(i) our increased development program~~certain strategic and tactical initiatives and activities performed by Malin employees that did not recur in ~~2016, including~~ the ~~commencement~~first quarter of 2019, and ~~conduct~~a $0.6 million decrease in deferred revenue associated with the continued recognition of ~~our SB204 Phase 3 clinical trials, SB206 Phase 2 clinical trial,~~licensing revenues from the Sato Agreement during 2018. These decreases were partially offset by a favorable change in prepaid expenses and ~~SB208 Phase 2 clinical program;~~other current assets and ~~(ii) the timing~~accounts payable of ~~the invoicing and payment for such services.~~

$0.3 million.

Net Cash Used in ~~Continuing~~ Investing Activities

During the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2019, net cash used in investing activities was ~~$1.8~~minimal and consisted of purchases of laboratory and manufacturing equipment.

During the three months ended March 31, 2018, net cash used in investing activities was $0.1 million, which primarily related to purchases of laboratory equipment and leasehold improvements at our facility in Morrisville, North Carolina.

During the nine months ended September 30, 2016, net cash used in investing activities was $3.5 million, which represented purchases of property and equipment of $3.4 million and the purchase of intangible assets of $0.1 million. The purchases of property and equipment in 2016 are primarily associated with facility upfits and laboratory equipment needed to build out our research, development and manufacturing capabilities at our new headquarters and manufacturing facility in Morrisville, North Carolina.

Net Cash Provided by ~~Continuing~~ Financing Activities

During the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2019, net cash provided by financing activities was less than $0.1 million ~~consisting~~and consisted primarily of proceeds from the exercise of stock ~~options, which were partially offset by offering costs.~~

options.

Table of Contents

During the ~~nine~~three months ended ~~September 30, 2016,~~March 31, 2018, net cash provided by financing activities was ~~$46.1~~$35.4 million, consisting primarily of ~~$44.6 million in~~ net proceeds from our ~~initial public offering. Net proceeds from our IPO included $1.7~~offering of common stock and warrants in January 2018, after deducting underwriting discounts and offering expenses.

Capital Requirements

As of March 31, 2019, we had cash and cash equivalents of $6.1 million and negative working capital of $3.5 million. As described above, in late April 2019 and early May 2019, respectively, we entered into (i) the Purchase Agreement with Reedy Creek, providing $25.0 million of ~~offering costs included~~immediate funding, with an additional $10.0 million contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020; and (ii) the Funding Agreement with Ligand, providing $12.0 million of immediate funding. We believe that our existing cash and cash equivalents, expected contractual payments to be received in ~~accounts payable~~connection with previous licensing agreements, and ~~accrued expenses~~the addition of the $25.0 million and $12.0 million received through these funding transactions will (i) provide us with adequate liquidity to fund our planned operating needs into the first quarter of 2020, including through expected top-line results of the Phase 3 molluscum clinical program targeted in the first quarter of 2020, or before; and (ii) into the second quarter of 2020, if paired with the potential $10.0 million funding contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020. Although we secured additional capital in April 2019 and May 2019, we have concluded that the prevailing conditions and ongoing liquidity risks we face raise substantial doubt about our ability to continue as a going concern. We need substantial additional funding to continue our operating activities and make further advancements in our drug development programs beyond those planned in 2019 and certain activities in the first half of ~~September 30, 2016, which have since been settled through cash disbursements.~~

2020.

~~Capital Requirements~~

To date, we have not generated any revenue from product sales. We do not know when, or if, we will generate any revenue from product sales. We do not expect to generate revenue from product sales unless, and until, we obtain regulatory approval of ~~and commercialize~~ one of our current or future product ~~candidates.~~candidates and achieve successful commercialization by a strategic partner or by ourselves. We anticipate that we will continue to generate losses for the foreseeable future, and we expect the losses to increase as we continue the development of, and seek regulatory approvals for, our product candidates and begin ~~to commercialize~~any commercialization activities of any approved products. We are subject to all of the risks ~~incident~~inherent in the development of new pharmaceutical products, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown factors that may adversely affect our business.

Our ~~primary use of cash is~~ability to ~~fund~~continue to operate our ~~operating expenses, which consist principally of research and development expenditures necessary~~business, including our ability to advance our ~~clinical-stage product candidates. Based~~development programs, is dependent upon our ~~current operating plan, we anticipate we have sufficient cash and cash equivalents~~ability to operate into the first quarter of 2018. We anticipate that we will need substantial additional funding to continue our operating activities and make further advancements in each of our drug development programs, as summarized in the “Overview—Key Drug Development Updates” section above. Specifically, we anticipate that additional funding will be required to conduct and complete our planned clinical trials and nonclinical studies in our SB206 and SB414 programs, as well as the development of NVN3100 as a new chemical entity for treatment of high risk neoplasias. We are currently reviewing various potential financing options to fund our continued and planned operations for advancement of these product candidates within our current core focus, including traditional public or private equity financings, as well as debt and other structured facilities. We are also currently ~~pursuing a partnering strategy for advancement of the SB204 program, as described in further detail in the~~ ~~“Overview—Key Drug Development Updates” section above.~~ If we are not successful in executing the currently contemplated transaction for our SB204 program, or if we are not successful in identifying a partner for any other product candidate that is outside of our current core focus, we will need to raiseaccess additional capital ~~resources to advance that program.~~through non-dilutive sources, including partnerships, collaborations, licensing, grants or other strategic relationships, and/or the issuance of debt or equity securities, which could result in dilution. We may ~~decide to~~ revise our activities or ~~the relevant~~their timing depending on the availability of additional funding, partnership opportunities and our financial priorities. We completed two non-dilutive funding transactions in April 2019 and May 2019 and continue to explore other potential non-dilutive business development activities around the developmental and commercial rights to the clinical-stage assets in our platform, including various geographic and indication-specific opportunities.

As we continue to attempt to raise additional capital, there can be no assurance that we will be able to obtain it on terms acceptable to us, on a timely basis, or at all. A failure to obtain sufficient funds on acceptable terms when needed could cause us to alter or reduce our planned operating activities to conserve our cash and cash equivalents, including but not limited to delaying planned activities directly related to or in support of product candidate development. Our anticipated expenditure levels may change if we ~~make adjustments to~~adjust our current operating plan. Such actions could delay development timelines and have a material adverse effect on our results of operations, financial condition and market valuation. As of ~~September 30, 2017,~~March 31, 2019, we had an accumulated deficit of ~~$152.0~~$180.1 million and there is substantial doubt about our ability to continue as a going ~~concern if we do not secure adequate additional financing.~~

concern.

We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all of our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical products, we are unable to estimate the exact amount or timing of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to:

the initiation, progress, timing, costs, results, and evaluation of results of trials for our clinical-stage product candidates, including ~~SB206, SB414, SB204 and SB208;~~

trials conducted by us or potential future partners;

the progress, timing, costs and results of development and preclinical study activities relating to other potential applications of our nitric oxide ~~platform, including NVN3100;~~

platform;

the number and characteristics of product candidates that we pursue;

Table of Contents

our ability to enter into strategic relationships ~~for~~to support the continued development of certain product candidates and the success of those arrangements;

our success in ~~scaling~~optimizing the size and capability of our current manufacturing ~~process;~~

facility and related processes to meet our strategic objectives;

our success in the technical transfer of methods and processes related to our drug substance and drug product manufacturing with our current and/or potential future contract manufacturing partners;

the outcome, timing and costs of seeking regulatory approvals;

the occurrence and timing of potential development and regulatory milestones achieved by Sato, our licensee for SB204 and SB206 in Japan;

the terms and timing of any future collaborations, licensing, consulting, financing or other arrangements that we may enter into;

whether we are able to obtain the contingent $10.0 million payout under the Purchase Agreement with Reedy Creek contingent upon achieving successful top-line results of the SB206 Phase 3 clinical trials no later than March 31, 2020;

the amount and timing of any payments we may be required to make, or that we may receive, in connection with the licensing, filing, prosecution, defense and enforcement of any patents or other intellectual property rights;

the costs of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights;

defending against intellectual property related claims;

the costs associated with any potential future securities litigation, and the outcome of that litigation;

the extent to which we in-license or acquire other products and technologies; and

subject to receipt of marketing approval, revenue received from commercial sales or ~~outlicensing~~out licensing of our product candidates.

We also expect to incur capital expenditures as we continue to invest in information technology systems and equipment to meet our strategic objectives, including at our corporate headquarters and manufacturing facility in Morrisville, North Carolina.

Contractual Obligations and Contingent Liabilities

Except for compensatory obligations described in ~~“Note 5—~~Note 7—Commitments and ~~Contingencies”~~Contingencies to the accompanying condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, there were no material changes during the three months ended March 31, 2019 in our commitments under contractual obligations, as disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K filed with the SEC on March ~~20, 2017.~~

27, 2019.

Off-Balance Sheet Arrangements

We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under SEC rules.

Table of Contents

Jumpstart Our Business Startups Act of 2012 (JOBS Act)

In April 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for an “emerging growth company.” As an “emerging growth company,” we are electing not to take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards, and, as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth public companies. Section 107 of the JOBS Act provides that our decision not to take advantage of the extended transition period is irrevocable. We have chosen to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, as an “emerging growth company” we are not required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Act, (iii) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation-related items, such as the correlation between executive compensation and performance and comparisons of the chief executive officer’s compensation to median employee compensation. We may remain an emerging growth company until the last day of ~~the fiscal year following the fifth anniversary of the completion of our IPO.~~2021. However, if certain events occur prior to ~~the end of~~ such ~~five-year period,~~date, including if we become a “large accelerated filer,” our annual gross revenue equals or exceeds $1.07 billion or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to ~~the end of~~ such ~~five-year period.~~

date.

Critical Accounting Policies and Use of Estimates

Our management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with ~~accounting principles generally accepted in the United States, or~~U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue and expenses during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions. Our significant accounting policies are more fully described in ~~“Note~~Note 1—Organization and Significant Accounting ~~Policies”~~Policies to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and in ~~“Note~~Note 1—Organization and Significant Accounting ~~Policies”~~Policies to our audited consolidated financial statements contained in our Annual Report on Form 10-K filed with the SEC on March ~~20, 2017.~~27, 2019. During the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, there were no material changes to our critical accounting policies, except as presented ~~below.~~below:

Leases

Effective January 1, 2019, we adopted ASU No. 2016-02,

~~Revenue Recognition—Licensing Arrangements~~

Leases (Topic 842) using the modified retrospective transition method and established our lease accounting policy pursuant to this new standard. We ~~entered into a licensing arrangement~~initially applied the transition provisions at January 1, 2019, which allowed us to continue to apply the legacy guidance in ~~the first quarter of 2017,~~ASC 840 for periods prior to 2019. Our policy, and ~~may enter into additional licensing arrangements~~related significant judgments and estimates used to recognize right-of-use assets and lease liabilities under our policy, is described in ~~the future, in exchange for non-refundable upfront payments~~Note 1—Organization and ~~potential future milestone~~Significant Accounting Policies and ~~royalty payments. Such arrangements include multiple elements, including the sale of licenses~~Note 7—Commitments and the provision of services. For arrangements that involve the delivery of more than one element, each product, service and/or right to use assets is evaluated to determine whether it qualifies as a separate unit

~~of accounting. This determination is based on whether the deliverable has “stand-alone value”~~Contingencies to the ~~licensee. The consideration that is fixed or determinable is then allocated to each separate unit of accounting based~~condensed financial statements included elsewhere in this Quarterly Report on the relative selling prices of each deliverable. The consideration allocated to each unit of accounting is recognized as the related goods and services are delivered, limited to the consideration that is not contingent upon future deliverables. When an arrangement is accounted for as a single unit of accounting, we determine the period over which the performance obligations will be performed and revenue recognized. Management exercises significant judgment in the determination of (i) whether a deliverable has stand-alone value, (ii) whether the deliverable is considered to be a separate unit of accounting and (iii) the estimation of the relative fair value of each deliverable in the arrangement.

We recognize a milestone payment when earned if it is substantive and we have no ongoing performance obligations related to the milestone. A milestone payment is considered substantive if it: (i) is commensurate with either our performance to achieve the milestone or the enhanced value of the delivered item as a result of a specific outcome from the performance to achieve the milestone; (ii) relates solely to past performance; and (iii) is reasonable relative to all of the deliverables and payment terms, including other potential milestone consideration, within the arrangement.

~~Revenue Recognition—Research and Development Services~~

We recently entered into an arrangement to provide research and development services on a fee-for-service basis and may enter into additional arrangements in the future. Under such arrangements, revenue is recognized when all of the following conditions are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) fees are fixed or determinable, and (iv) collection of fees is reasonably assured. Our contract research and development services revenue is recognized in the period in which the services are performed.

Form 10-Q.

Recent Accounting Pronouncements

Recently issued accounting pronouncements that we have adopted or are currently evaluating are described in detail within ~~“Note~~Note 1—Organization and Significant Accounting ~~Policies”~~Policies to the accompanying unaudited condensed consolidated financial statements included ~~within~~in Item 1 of this Quarterly Report on Form 10-Q.

I~~tem~~

Item 3. Quantitative and Qualitative Disclosures About Market ~~Risk.~~

~~Our primary exposure to market risk is limited to our cash and cash equivalents, all~~Risk

Not applicable.

Table of which have maturities of less than three months. The primary objectives of our investment activities are the preservation of principal and maintenance of liquidity for the purpose of funding operations and maximizing total return. The related interest income sensitivity is affected by changes in the general level of short-term U.S. interest rates. We place our cash and cash equivalents with high-credit quality financial institutions. Our investment policy prohibits us from holding corporate bonds, auction rate securities, asset-backed securities, municipal obligations, structured investment vehicles, extendable commercial paper or collateralized debt/loan obligations.

As of September 30, 2017, we had cash and cash equivalents of $11.0 million. We believe that an immediate one percentage point increase or decrease in interest rates would not materially affect the fair value of these cash equivalents. We do not believe that our cash and cash equivalents have significant risk of default or illiquidity and do not expect our operating results or cash flows to be affected significantly by a sudden change in market interest rates. While we believe our cash and cash equivalents do not contain excessive risk, we cannot provide absolute assurance that in the future our investments will not be subject to adverse changes in fair value. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits.

Following the execution of the Sato Agreement in January 2017, we have become exposed to Japanese yen foreign exchange risk because this transaction is denominated in Japanese yen. All foreign transactions settle on the applicable spot exchange basis at the time such payments are made, and all monetary balances are translated to U.S. dollars using the period-end exchange rate. A hypothetical 10% change in the exchange rate between the Japanese yen and the U.S. dollar during any of the periods presented would not have had a significant impact on our results of operations, financial position or financial performance.

Contents

Item 4. Controls and ~~Procedures.~~

Procedures

(a) Evaluation of Disclosure Controls and Procedures

The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act, refers to controls and procedures that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation,

controls and procedures designed to ensure that such information is accumulated and communicated to a company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

In designing and evaluating our disclosure controls and procedures, management recognizes that disclosure controls and procedures, no matter how well conceived and operated, cannot provide absolute assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected.

Our management, with the participation of our ~~Chief Executive Officer~~principal executive and ~~our Chief Financial Officer,~~financial officers, has evaluated the effectiveness of our disclosure controls and procedures as of ~~September 30, 2017,~~March 31, 2019, the end of the period covered by this Quarterly Report on Form 10-Q. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost benefit relationship of possible controls and procedures. Based upon such evaluation, our ~~Chief Executive Officer~~principal executive and ~~our Chief Financial Officer~~financial officers have concluded that our disclosure controls and procedures were effective as of such date at the reasonable assurance level.

(b) Changes in Internal Controls Over Financial Reporting

There have not been any changes in our internal controls over financial reporting during our fiscal quarter ended ~~September 30, 2017~~March 31, 2019 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Table of Contents

PART II—OTHER INFORMATION

Item 1. Legal ~~Proceedings.~~

~~We are~~Proceedings

In prior filings, we reported that we were subject to putative stockholder class action lawsuits that were filed in November 2017 in the United States District Court for the Middle District of North Carolina against us and certain of our current and former directors and ~~officers.~~officers, which were consolidated under the case name In re Novan, Inc. Securities Litigation. The ~~lawsuits were~~consolidated amended complaint filed ~~on behalf of a putative class of all persons who purchased or otherwise acquired our securities (1) pursuant or traceable to our IPO, or (2) on~~by the ~~open market between September 21, 2016 and January 26, 2017. The lawsuits assert~~designated lead plaintiff asserted claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to our Phase 3 clinical trials of SB204. ~~The complaints seek, among other things,~~On June 14, 2018, we filed a motion to dismiss the consolidated amended complaint. On November 30, 2018, a federal magistrate judge entered an ~~unspecified amount of compensatory damages and attorneys’ fees and costs on behalf of the putative class. We believe~~order recommending that the ~~claims lack merit~~district court grant our motion. The plaintiff filed objections to this recommendation and ~~intend to defend~~we filed a response. On January 28, 2019, the ~~lawsuits vigorously. However, there can be no assurance~~district court adopted the magistrate judge’s recommendation, dismissed the action with prejudice and entered judgment in favor of us and against the plaintiff. The plaintiff did not appeal this dismissal and judgment. As such, we have concluded that ~~a favorable resolution will be obtained in such lawsuits, and the actual costs may be significant.~~

this matter is closed.

Other than as described above, we are not currently a party to any material legal proceedings and are not aware of any claims or actions pending or threatened against us that we believe could have a material adverse effect on our business, operating results, cash flows or financial statements. In the future, we may from time to time become involved in litigation relating to claims arising from our ordinary course of business.

Item 1A. Risk Factors.

There have been no material changes to the risk factors disclosed in the Annual Report on Form 10-K filed with the SEC on March ~~20, 2017, except as set forth in our subsequent Quarterly Report on Form 10-Q filed with the SEC on August 11, 2017 and as set forth below.~~

~~We recently changed the focus of our near-term product development strategy, and there can be no guarantee that these areas of our platform will be successful or the most profitable.~~

We recently initiated a strategic shifting of priorities to turn our near-term product development focus to the application of nitric oxide technology in viral infections and inflammatory skin diseases, which signifies a change from our prior focus on multi-factorial diseases, particularly acne. We plan to use our limited cash resources and any new funds we raise to support our newly prioritized core areas of focus, including clinical development of product candidates in these areas and preclinical studies on potential future product candidates. It is possible that current and future product candidates outside these core areas of current focus would achieve regulatory approval more rapidly or have greater commercial success, resulting in better returns for stockholders. Additionally, if we are unable

to raise additional capital to support the advancement of our current development priorities, we may have to delay, curtail or eliminate one or more of our programs and potentially change our growth strategy.

We may rely on strategic relationships for the further development and commercialization of product candidates outside our current core areas of focus, and if we are unable to enter into such relationships, or if such relationships are unsuccessful, we may be unable to realize the potential economic benefit of those product candidates.

We are exploring alternative pathways for continued development of product candidates outside our current core areas of focus. For example, we have entered into a non-binding term sheet for the collaborative development of SB204. If we are unable to enter into strategic relationships on terms that are beneficial to us, or at all, we may not have sufficient capital to continue developing or commercialize our product candidates that are outside of our current core focus. Even if we enter into such a strategic relationship, we may have to relinquish a significant portion of the future economic value of the underlying product candidate in connection with the applicable transaction and may be limited in our ability, or unable, to recover such value.

~~Our ability to enter into successful strategic relationships for the continued development of one or more of our product candidates may be impaired by several factors, including, among others, that:~~

~~we will face significant competition in seeking appropriate strategic partners, and the negotiation process is likely to be time-consuming and complex;~~

27, 2019.

strategic partners may not devote the necessary resources to complete development activities because of limited financial or scientific resources or the belief that other product candidates may have a higher likelihood of obtaining approval or potentially generate a greater return on investment;

strategic partners may fail to properly maintain or defend our intellectual property rights, where applicable, or may use proprietary information in a way that may expose us to potential loss or liability;

~~we are likely to have limited control over decisions of strategic partners that may result in significant delays or the termination of development of our product candidates;~~

~~strategic partners may develop a product that competes, directly or indirectly, with our product candidates, or may choose to pursue alternative technologies, including those of our competitors; and~~

disputes between us and our strategic partners concerning the research, development or commercialization of our product candidates or our arrangements with respect to our product candidates could lead to ligation or arbitration that would be costly and detract time from development.

Further, if a strategic relationship terminates or is otherwise unsuccessful, we may need to seek out and establish an alternative arrangement. This may not be possible, or we may not be able to do so on terms which are acceptable to us, in which case, it may be necessary for us to cease the development of the applicable product candidate or candidates, or conduct the remaining clinical development on our own and with our own funds.

We have been named as a defendant in putative securities class action lawsuits. These, and potential similar or related litigation, could result in substantial damages and may divert management's time and attention from our business.

As described in Part II—Item 1—“Legal Proceedings,” putative stockholder class action lawsuits have been filed against us and certain of our current and former directors and officers. These lawsuits were filed on behalf of a putative class of all persons who purchased or otherwise acquired our securities (1) pursuant or traceable to our IPO, or (2) on the open market between September 21, 2016 and January 26, 2017. The lawsuits assert claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to our Phase 3 clinical trials of SB204. The complaints seek, among other things, an unspecified amount of compensatory damages and attorneys’ fees and costs on behalf of the putative class. We believe that the claims lack merit and intend to defend the lawsuits vigorously, but there can be no assurance that a favorable resolution will be obtained in any of these matters. An unfavorable resolution in such lawsuits, whether by final judgment or an unfavorable settlement, could have a material adverse effect on our business, financial condition, results of operations and cash flows. Additionally, the actual cost of the litigation may be significant, and the litigation may divert management's time and attention from our business.

Item 2. Unregistered Sales of Equity Securities and Use of ~~Proceeds.~~

Proceeds

Unregistered Sales of Equity Securities

None.

~~Use of Proceeds from Initial Public Offering~~

On September 20, 2016, the SEC declared our Registration Statement on Form S-1 (File No. 333-213276) effective for our initial public offering, which closed on September 26, 2016, pursuant to which we sold an aggregate of 4,715,000 shares of our common stock, including the underwriters option to purchase 615,000 additional shares, at a price to the public of $11.00 per share for aggregate gross proceeds of $51.9 million. As a result, we received net proceeds of $~~44.6~~ ~~million (after underwriters’ discounts, commissions, and reimbursements totaling $4.1~~ ~~million and additional offering related costs of $3.2 million). The managing underwriter of the offering was Piper Jaffray & Co.~~

The net proceeds of the IPO have been invested in accordance with our investment policy. There has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus dated September 20, 2016 and filed with the SEC on September 22, 2016.

Issuer Purchases of Equity Securities

None.

Item 3. Defaults Upon Senior Securities.

Not applicable.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

~~None.~~

Not applicable.

Table of Contents

Item 6. ~~Exhibits.~~

Exhibits

INCORPORATED BY REFERENCE
EXHIBIT NO.

DESCRIPTION

Filed Herewith

FORM

File No.

ExhibIt

Filing Date

10.1

Letter Agreement dated August 10, 2017, by and between Novan, Inc. and William L. Hodges.

10-Q

001-37880

10.5

August 11, 2017

31.1

Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

X

31.2

Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

X

32.1

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

X

The following exhibits are being filed herewith or are being incorporated by reference and are numbered in accordance with Item 601 of Regulation S-K:

INCORPORATED BY REFERENCE

EXHIBIT NO.

DESCRIPTION

Filed Herewith

FORM

File No.

Exhibit

Filing Date

10.1

Separation and General Release Agreement, dated January 4, 2019, by and between Novan, Inc. and Nathan Stasko.

8-K

001-37880

10.1

January 7, 2019

10.2

Employment Agreement, dated January 29, 2019, by and between Novan, Inc. and Paula Brown Stafford.

10-K

001-37880

10.14

March 27, 2019

10.3

Separation and General Release Agreement, dated January 29, 2019, by and between Novan, Inc. and Jeff N. Hunter.

10-K

001-37880

10.16

March 27, 2019

10.4

†

Consulting Agreement, dated January 29, 2019, by and between Novan, Inc. and Jeff N. Hunter.

10-K

001-37880

10.17

March 27, 2019

31.1

Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS

XBRL Instance Document.

101.SCH

XBRL Taxonomy Extension Schema Document.

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document.

101.DEF

XBRL Taxonomy Extension Definition Document.

101.LAB

XBRL Taxonomy Extension Label Linkbase Document.

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document.



†	Confidential treatment has been granted with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission.

Table of Contents

~~INCORPORATED BY REFERENCE~~

~~EXHIBIT NO.~~

~~DESCRIPTION~~

~~Filed Herewith~~

~~FORM~~

~~File No.~~

~~ExhibIt~~

~~Filing Date~~

~~32.2~~

~~Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.~~

~~101.INS~~

~~XBRL Instance Document.~~

~~101.SCH~~

~~XBRL Taxonomy Extension Schema Document.~~

~~101.CAL~~

~~XBRL Taxonomy Extension Calculation Linkbase Document.~~

~~101.DEF~~

~~XBRL Taxonomy Extension Definition Document.~~

~~101.LAB~~

~~XBRL Taxonomy Extension Label Linkbase Document.~~

~~101.PRE~~

~~XBRL Taxonomy Extension Presentation Linkbase Document.~~

SIGNATURES

~~SIGNATURES~~

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

~~Novan, Inc.~~

Novan, Inc.

By:		/s/ G. Kelly Martin
		G. Kelly Martin
		~~Interim~~ Chief Executive Officer (Principal Executive Officer)
~~By:~~		~~/s/ William Hodges~~
		~~William Hodges~~ ~~Interim Chief~~/s/ John M. Gay
		John M. Gay
		Vice President of Finance and Corporate Controller (Principal Financial ~~Officer~~ ~~(Principal Financial~~Officer)

		/s/ Andrew J. Novak
		Andrew J. Novak
		Vice President of Accounting and Business Operations (Principal Accounting Officer)

Date: ~~November 9, 2017~~

May 15, 2019

	September 30, 2017			December 31, 2016
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	10,960		$	34,611
Prepaid expenses and other current assets		580		958
Total current assets		11,540			35,569
Restricted cash		539			539
Intangible assets		75			75
Other assets		206			—
Property and equipment, net		16,738			16,290
Total assets	$	29,098		$	52,473
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	937		$	3,130
Accrued compensation		2,195			2,305
Accrued outside research and development services		1,176			5,737
Accrued legal and professional fees		369			382
Other accrued expenses		1,595			1,813
Deferred revenue, current portion		2,141			—
Capital lease obligation, current portion		11			10
Total current liabilities		8,424			13,377
Deferred revenue, net of current portion		7,451			—
Capital lease obligation, net of current portion		24			32
Facility financing obligation		7,998			7,998
Total liabilities		23,897			21,407
Commitments and contingencies (Notes 2, 3 and 5)
Stockholders’ equity
Preferred stock $0.0001 par value; 10,000,000 shares designated as of September 30, 2017 and December 31, 2016; 0 shares issued and outstanding as of September 30, 2017 and December 31, 2016		—			—
Common stock $0.0001 par value; 200,000,000 shares authorized as of September 30, 2017 and December 31, 2016; 15,998,908 and 15,949,492 shares issued as of September 30, 2017 and December 31, 2016; 15,989,408 and 15,939,992 shares outstanding as of September 30, 2017 and December 31, 2016		2			2
Additional paid-in-capital		157,325			154,252
Treasury stock at cost, 9,500 shares as of September 30, 2017 and December 31, 2016		(155	)		(155	)
Accumulated deficit		(151,971	)		(123,033	)
Total stockholders’ equity		5,201			31,066
Total liabilities and stockholders’ equity	$	29,098		$	52,473

	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016

License and collaboration revenue	$	532		$	—		$	1,233		$	—
Research and development services revenue		218			—			286			—
Total revenue		750			—			1,519			—
Operating expenses:
Research and development		5,193			14,988			19,101			37,361
General and administrative		2,762			2,493			10,654			9,327
Total operating expenses		7,955			17,481			29,755			46,688
Operating loss		(7,205	)		(17,481	)		(28,236	)		(46,688	)
Other (expense) income, net		(239	)		7			(702	)		50
Net loss and comprehensive loss	$	(7,444	)	$	(17,474	)	$	(28,938	)	$	(46,638	)
Net loss per share, basic and diluted	$	(0.47	)	$	(5.76	)	$	(1.81	)	$	(17.64	)
Weighted-average common shares outstanding, basic and diluted		15,984,428			3,033,967			15,975,855			2,644,116

	Nine Months Ended September 30,
	2017			2016
Cash flow from operating activities:
Net loss	$	(28,938	)	$	(46,638	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,030			575
Share-based compensation		3,006			861
Loss (gain) on disposal of property and equipment		6			(2	)
Changes in operating assets and liabilities:
Prepaid expenses and other current assets		488			479
Accounts payable		(2,077	)		2,182
Accrued compensation		(110	)		849
Accrued outside research and development services		(4,561	)		8,789
Accrued legal and professional fees		(103	)		3
Accrued expenses		(19	)		561
Deferred revenue		9,592			—
Other		(206	)		(25	)
Net cash used in continuing operating activities		(21,892	)		(32,366	)
Net cash used in discontinued operating activities		—			(257	)
Net cash used in operating activities		(21,892	)		(32,623	)
Cash flow from investing activities:
Purchases of property and equipment		(1,807	)		(3,410	)
Proceeds from the sale of property and equipment		8			—
Purchase of intangible asset		—			(75	)
Net cash used in investing activities		(1,799	)		(3,485	)
Cash flow from financing activities:
Proceeds from initial public offering, net of underwriting fees and commissions		—			47,785
Payments related to public offering costs		(20	)		(1,480	)
Proceeds from exercise of stock options		67			34
Purchase of treasury stock		—			(155	)
Payments on capital lease obligation		(7	)		(5	)
Payments on facility lease obligation		—			(95	)
Net cash provided by financing activities		40			46,084
Net (decrease) increase in cash and cash equivalents		(23,651	)		9,976
Cash and cash equivalents as of beginning of period		34,611			45,688
Cash and cash equivalents as of end of period	$	10,960		$	55,664
Supplemental disclosure of non-cash investing and financing activities:
Purchases of equipment with accounts payable and accrued expenses	$	105		$	723
Equipment acquired through capital lease	$	—		$	39
Non-cash addition to facility financing obligation	$	—		$	7,847
Non-cash addition to deferred offering costs	$	90		$	1,710
Conversion of convertible preferred stock and non-voting common stock to voting common stock	$	—		$	104,798
Deferred offering costs reclassified to additional paid-in-capital	$	—		$	3,190

	September 30,			December 31,
	2017			2016

Computer equipment	$	517		$	500
Furniture and fixtures		559			504
Laboratory equipment		6,660			5,723
Office equipment		166			106
Building related to facility lease obligation		10,557			10,557
Leasehold improvements		951			1,338
		19,410			18,728
Less: Accumulated depreciation and amortization		(2,672	)		(2,438	)
	$	16,738		$	16,290

	September 30, 2017		December 31, 2016

Outstanding stock options		1,333,153		825,130
For possible future issuance under 2016 Stock Plan (Note 7)		1,106,501		615,207
		2,439,654		1,440,337

	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016

Research and development	$	475	$	95	$	1,301	$	274
General and administrative		396		232		1,705		587
	$	871	$	327	$	3,006	$	861