Phaserx 10Q 2017 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period endedJune 30, 2017

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

For the transition period from _______ to _______

Commission file number:001-37772

PhaseRx, Inc.

(Exact name of registrant as specified in its charter)

Delaware		20-4690620
(State or other jurisdiction		(I.R.S. Employer Identification No.)
of incorporation or organization)

410 W. Harrison Street, Suite 300
Seattle, Washington		98119
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code:(206) 805-6300

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YesxNo¨

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YesxNo¨

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

Large accelerated filer¨

Accelerated filer¨

Non-accelerated filer¨(Do not check if a smaller reporting company)

Smaller reporting companyx

Emerging growth companyx

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¨Nox

As of August 9, 2017, the registrant had 11,690,329 shares of common stock outstanding.

PHASERX, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2017

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.	3

Consolidated Balance Sheets as of June 30, 2017 (unaudited) and December 31, 2016	3

Unaudited Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2017 and 2016	4

Unaudited Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended June 30, 2017 and 2016	5

Unaudited Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2017 and 2016	6

Notes to Unaudited Consolidated Financial Statements	7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.	18

Item 3. Quantitative and Qualitative Disclosures About Market Risk.	29

Item 4. Controls and Procedures.	29

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.	30

Item 1A. Risk Factors.	30

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.	31

Item 3. Defaults Upon Senior Securities.	32

Item 4. Mine Safety Disclosures.	32

Item 5. Other Information.	32

Item 6. Exhibits.	32

SIGNATURES	33

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

PhaseRx, Inc.

Consolidated Balance Sheets

(in thousands, except share and per share amounts)

	June 30, 2017			December 31, 2016
	(unaudited)
Assets
Current assets
Cash and cash equivalents	$	4,941		$	9,983
Marketable securities		3,421			5,496
Prepaids and other current assets		615			698
Total current assets		8,977			16,177
Property and equipment, net		229			271
Total assets	$	9,206		$	16,448

Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	493		$	515
Accrued liabilities		548			884
Accrued interest		49			49
Current portion of term loan payable		1,747			576
Total current liabilities		2,837			2,024
Term loan payable, net of debt discount and current portion		4,140			5,127
Total liabilities		6,977			7,151

Stockholders’ equity
Preferred stock, $0.0001 par value, 5,000,000 shares authorized at June 30, 2017 and December 31, 2016; no shares issued and outstanding at June 30, 2017 and December 31, 2016		-			-
Common stock; $0.0001 par value; 50,000,000 shares authorized at June 30, 2017 and December 31, 2016; 11,690,329 shares issued and outstanding at June 30, 2017 and December 31, 2016		1			1
Additional paid-in capital		79,474			78,773
Accumulated other comprehensive income		1			3
Accumulated deficit		(77,247	)		(69,480	)
Total stockholders' equity		2,229			9,297
Total liabilities and stockholders' equity	$	9,206		$	16,448

See Notes to Consolidated Financial Statements

PhaseRx, Inc.

Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended June 30						Six Months Ended June 30
	2017			2016			2017			2016

Operating expenses
Research and development	$	2,255		$	1,416		$	4,581		$	2,850
General and administrative		1,065			880			2,654			1,559
Noncash financial advising fees		-			7,515			-			7,515
Total operating expenses		3,320			9,811			7,235			11,924
Loss from operations		(3,320	)		(9,811	)		(7,235	)		(11,924	)
Interest income		22			6			47			6
Interest expense		(241	)		(1,389	)		(476	)		(1,589	)
Other income, net		-			110			-			190
Total other income (expense)		(219	)		(1,273	)		(429	)		(1,393	)
Net loss attributable to common stockholders	$	(3,539	)	$	(11,084	)	$	(7,664	)	$	(13,317	)
Net loss per share attributable to common stockholders, basic and diluted	$	(0.30	)	$	(1.84	)	$	(0.66	)	$	(4.05	)
Shares used in computation of basic and diluted net loss per share attributable to common stockholders		11,690			6,013			11,690			3,288

See Notes to Consolidated Financial Statements

PhaseRx, Inc.

Consolidated Statements of Comprehensive Loss

(In thousands)

(unaudited)

	Three Months Ended June 30						Six Months Ended June 30
	2017			2016			2017			2016
Net loss	$	(3,539	)	$	(11,084	)	$	(7,664	)	$	(13,317	)

Other comprehensive income:
Unrealized gain (loss) on marketable securities		(3	)		14			(2	)		14
Comprehensive loss	$	(3,542	)	$	(11,070	)	$	(7,666	)	$	(13,303	)

See Notes to Consolidated Financial Statements

PhaseRx, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

	Six Months Ended June 30
	2017			2016
Operating activities
Net loss	$	(7,664	)	$	(13,317	)

Adjustments to reconcile net loss to net cash used in operating activities:
Noncash financial advising fees		-			7,515
Amortization of debt discount		184			1,426
Depreciation and amortization		42			92
Stock-based compensation		598			156
Noncash interest expense		-			115
Preferred stock warrant liability		-			(190	)

Changes in operating assets and liabilities
Prepaids and other current assets		83			(117	)
Accounts payable		(22	)		146
Accrued liabilities		(336	)		77
Deferred rent		-			(27	)
Net cash used in operating activities		(7,115	)		(4,124	)

Investing activities
Purchases of marketable securities		(5,427	)		(5,979	)
Maturities of marketable securities		7,500			-
Purchases of property and equipment		-			(157	)
Net cash provided by (used in) investing activities		2,073			(6,136	)

Financing activities
Proceeds from issuance of common stock, net of issuance costs		-			16,475
Proceeds from issuance of term loan, net of issuance costs		-			5,693
Proceeds from issuance of original issue discount promissory note		-			400
Payment of original issue discount promissory note		-			(400	)
Net cash provided by financing activities		-			22,168
Net increase (decrease) in cash and cash equivalents		(5,042	)		11,908

Cash and cash equivalents
Beginning of period		9,983			3,290
End of period	$	4,941		$	15,198

Noncash investing and financing activities:
Accretion of Series A preferred stock	$	-		$	4
Cash paid during the period for interest		291			-
Conversion of preferred stock into common stock		-			25,716
Conversion of notes payable into common stock		-			19,404
Conversion of bridge loan into common stock		-			4,086
Debt discount for beneficial conversion feature on bridge loan		-			1,021
Warrant liability reclassified to equity upon expiration		-			535
Debt discount for warrant issued in connection with term loan payable		-			205

See Notes to Consolidated Financial Statements

Notes to Unaudited Consolidated Financial Statements

1. Business and Basis of Presentation

PhaseRx, Inc. (referred to as “PhaseRx”, the “Company,” “we,” “us,” or “our”) was incorporated in the State of Delaware on March 9, 2006 and is located in Seattle, Washington. We are a biopharmaceutical company developing a portfolio of products for the treatment of inherited enzyme deficiencies in the liver using intracellular enzyme replacement therapy, or i-ERT. Our i-ERT approach is enabled by our proprietary Hybrid messenger RNA, or mRNA, Technology platform, which allows synthesis of the missing enzyme inside the cell. Our initial product portfolio targets the three urea cycle disorders ornithine transcarbamylase deficiency, or OTCD, argininosuccinate lyase deficiency, or ASL deficiency, and argininosuccinate synthetase deficiency, or ASS1 deficiency.

Liquidity

We have financed our operations since inception primarily through the sale of preferred and common stock and the issuance of convertible notes and term loans. We anticipate that we will continue to incur losses, and that such losses will increase over the next several years due to development costs associated with our drug candidate PRX-OTC. We expect that our research and development and general and administrative expenses will continue to increase and, as a result, we will need additional capital to fund our operations, which we may raise through a combination of equity offerings, debt financings, other third-party funding and other collaborations and strategic alliances. The Company’s ability to continue as a going concern is dependent upon its ability to obtain additional equity or debt financing and, ultimately, to generate revenue. Those factors raise substantial doubt about the Company’s ability to continue as a going concern.

We believe our cash, cash equivalents and marketable securities balance of $8.4 million at June 30, 2017, is sufficient to fund our operations until March 31, 2018. Assuming we can raise sufficient cash to fund our operations beyond March 31, 2018, we expect to file an IND application for PRX-OTC with the FDA in 2018, conduct Phase 2a/2b single- and repeat-dose clinical proof of concept studies in OTCD patients that are expected to generate Phase 2a safety and efficacy data, including measurement of reduction in blood ammonia in the second half of 2018 and Phase 2b (repeat-dose) safety and efficacy data in the first half of 2019.

Basis of Presentation

The accompanying interim consolidated financial statements are unaudited. The accompanying unaudited consolidated financial statements reflect, in the opinion of our management, all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of financial position, results of operations, comprehensive loss and cash flows for each period presented in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted from the accompanying consolidated statements. These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our 2016 annual report on the Form 10-K. The accompanying consolidated financial information as of December 31, 2016 has been derived from the audited 2016 consolidated financial statements included in our 2016 annual report on the Form 10-K filed with the Securities and Exchange Commission on March 27, 2017. Operating results for the three and six months ended June 30, 2017 are not necessarily indicative of results that may be expected for the year ending December 31, 2017, or any other future period.

2. Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of PhaseRx and its wholly owned subsidiary, PhaseRx Ireland Limited. All material intercompany transactions and balances have been eliminated in consolidation.

Reclassification

Certain balances from prior period have been reclassified in order to conform to the current period presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires our management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

In preparing these consolidated financial statements, management has made its best estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, fair value measurements, financing activities, accruals and other contingencies.

Cash Equivalents and Marketable Securities

We invest our excess cash in investment grade short- to intermediate-term fixed income securities. Such investments are included in cash and cash equivalents or marketable securities, on the balance sheets, classified as available-for-sale and reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (loss). Realized gains and losses on the sale of these securities are recognized in net income or loss. We consider all highly liquid investments with original maturities at purchase of 90 days or less to be cash equivalents, an investment with a maturity greater than twelve months from the balance sheet date as long-term marketable securities and a maturity less than twelve months as short-term at the balance sheet date. Our cash equivalents and marketable securities consist principally of commercial paper and money market securities.

Interest earned on securities is included in interest income. Gains are recognized when realized in our statements of operations. Losses are recognized when realized or when we have determined that an other-than-temporary decline in fair value has occurred. The cost of securities sold is based on the specific identification method.

We periodically evaluate whether declines in fair values of our investments below their cost are other-than-temporary. This evaluation consists of several qualitative and quantitative factors regarding the severity and duration of the unrealized loss as well as our ability and intent to hold the investment until a forecasted recovery occurs. Factors considered include quoted market prices, recent financial results and operating trends, credit quality of debt instrument issuers, other publicly available information that may affect the value of our investments, duration and severity of the decline in value, and our strategy and intentions for holding the investment. Additionally, we assess whether it is more likely than not we will be required to sell any investment before recovery of its amortized cost basis.

Fair Value of Financial Instruments

We establish the fair value of our assets and liabilities using the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We established a fair value hierarchy based on the inputs used to measure fair value. The three levels of the fair value hierarchy are as follows:

Level 1: Quoted prices in active markets for identical assets or liabilities.

Level 2: Inputs, other than the quoted prices in active markets that are observable either directly or indirectly.

Level 3: Unobservable inputs in which little or no market data exists, therefore determined using estimates and assumptions developed by us, which reflect those that a market participant would use.

We measure and report at fair value our cash equivalents and marketable securities. The carrying value of accounts payable and accrued liabilities approximate their respective fair values due to their relative short maturities. The carrying value of our Hercules term loan approximates fair value because the interest rate is reflective of the rate we could obtain on debt with similar terms and conditions.

We may apply the fair value option to any eligible financial assets or liabilities, which permits an instrument by instrument irrevocable election to account for selected financial assets and liabilities at fair value. To date, we have not applied this election.

Research and Development Costs

Research and development costs are expensed as incurred. Research and development costs include salaries and personnel-related costs, consulting fees, fees paid for contract research services, the costs of laboratory supplies, equipment and facilities, license fees and other external costs. Non-refundable advance payments for goods or services to be received in the future for use in research and development activities are deferred and capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed.

Stock-Based Compensation

We have granted stock options with performance conditions to certain executive officers, directors and nonemployee consultants. At each reporting date, we evaluate whether the achievement of the performance conditions is probable. Compensation expense is recorded over the appropriate service period based upon our assessment of achievement of each performance condition or the occurrence of the event which will trigger the options to vest.

Comprehensive Loss

Comprehensive loss is comprised of net loss and other comprehensive income or loss. Other comprehensive income or loss consists of unrealized gains and losses on marketable securities.

Net Loss Per Share

The computation of basic and diluted net loss per share attributable to common stockholders is calculated by dividing net loss attributable to common stockholders by the weighted average shares outstanding during the period and excludes all outstanding stock options and warrants from the calculation of diluted net loss per common share, as all such securities are anti-dilutive to the computation for all the periods presented. For the three and six months ended June 30, 2017, the computation of diluted net loss per share excluded 2,179,606 shares. For the three and six months ended June 30, 2016, the computation of diluted net loss per share excluded 1,222,289 shares.

The following table presents the calculation of basic and diluted net loss per share attributable to common stockholders (in thousands, except per share amounts):

	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016

Net loss attributable to common stockholders	$	(3,539	)	$	(11,084	)	$	(7,664	)	$	(13,317	)

Weighted average shares used in computation of basic and diluted net loss per share attributable to common stockholders		11,690			6,013			11,690			3,288

Basic and diluted net loss per share attributable to common stockholders	$	(0.30	)	$	(1.84	)	$	(0.66	)	$	(4.05	)

Concentration of Risk

We maintain our cash, cash equivalents and investments with high quality, accredited financial institutions. These amounts at times may exceed federally insured limits. We have not experienced any credit losses in such accounts and do not believe we are exposed to significant risk on these funds. Our cash and cash equivalents balances of $4.7 million and $9.8 million as of June 30, 2017 and December 31, 2016, respectively, were uninsured.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standard Update, or ASU, No. 2014-09,Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in ASC 605,Revenue Recognition. This ASU is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The ASU is effective for public entities for annual periods beginning after December 15, 2017. In June 2015, the FASB deferred for one year the effective date of the new revenue guidance, with an option that would permit companies to adopt the guidance as early as the original effective date. Early adoption prior to the original effective date is not permitted. We are evaluating the impact this guidance may have on our revenue recognition and new required disclosures, but do not expect that the adoption will have a material impact on our financial statements.

In February 2016, the FASB issued ASU 2016-02,Leases (Topic 842). The ASU is intended to provide more transparent and economically neutral information about the assets and liabilities that arise from leases than previous guidance. The ASU is effective for public entities for annual periods beginning on or after December 15, 2018. Early adoption is permitted, and adoption must be applied on a modified retrospective basis. We are evaluating the impact of this guidance on our financial statements.

In June 2016, the FASB issued ASU 2016-13,Financial Instruments: Credit Losses that changes the impairment model for most financial instruments, including trade receivables from an incurred loss method to a new forward-looking approach, based on expected losses. The estimate of expected credit losses will require entities to incorporate considerations of historical information, current information and reasonable and supportable forecasts. This ASU is effective for us in the first quarter of 2020 and must be adopted using a modified retrospective transition approach. We are evaluating the impact of this guidance but do not expect that the adoption will have a material impact on our financial statements.

In August 2016, the FASB issued ASU 2016-15,Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments that clarifies how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The ASU is effective for us in the first quarter of 2018 with early adoption permitted and must be applied retrospectively to all periods presented. We are evaluating the impact of this guidance but do not expect that the adoption will have a material impact on our financial statements.

In May 2017, the FASB issued ASU 2017-09,Compensation – Stock Compensation, which is intended to provide clarity and reduce diversity in practice as well as cost and complexity when applying the guidance to a change to the terms or conditions of a share-based payment award. This ASU is effective for annual reporting periods beginning after December 15, 2017 and interim periods within those fiscal years with early adoption permitted. We are evaluating the impact of this guidance but do not expect that the adoption will have a material impact on our financial statements.

3. Cash Equivalents and Marketable Securities

The following tables summarize securities available-for-sale at cost and fair market value by contractual maturity (in thousands):

	June 30, 2017
	Cost or Amortized Cost		Fair Value

Due in one year or less	$	3,420	$	3,421
Due after one year through two years		-		-

	$	3,420	$	3,421

	December 31, 2016
	Cost or Amortized Cost		Fair Value

Due in one year or less	$	5,493	$	5,496
Due after one year through two years		-		-

	$	5,493	$	5,496

We did not incur any realized gains and losses on sales of available-for-sale securities for the three and six months ended June 30, 2017 and 2016. None of the securities have been in a continuous unrealized loss position for more than 12 months as of June 30, 2017.

The following tables summarize fair value of marketable securities available-for-sale and the gross unrealized gains and losses (in thousands):

	June 30, 2017
	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Commercial paper	$	3,420	$	1	$	-	$	3,421

	$	3,420	$	1	$	-	$	3,421

	December 31, 2016
	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Commercial paper	$	5,493	$	3	$	-	$	5,496

	$	5,493	$	3	$	-	$	5,496

Fair values were determined for each individual security in the investment portfolio. We utilize third-party pricing services for all security valuations. We review the pricing methodology, including the collection of market information, used by the third-party pricing services. On a periodic basis, we also review and validate the pricing information received from the third-party providers.

4. Term Loan

On June 7, 2016, we entered into a Loan and Security Agreement (the “Loan Agreement”) by and among us, the several banks and other financial institutions or entities from time to time parties to the Loan Agreement (the “Lenders”) and Hercules Capital, Inc. (“Hercules”), in its capacity as administrative agent for itself and the Lenders, pursuant to which the Lenders funded $6 million to us (the “Term Loan”). The Term Loan is secured by substantially all of our assets other than our intellectual property.

The Term Loan bears interest at a floating annual rate equal to the greater of (i) 9.25% and (ii) the sum of (a) 9.25%, plus (b) the prime rate as reported by The Wall Street Journal minus 3.50%, resulting in a rate of 10.00% as of June 30, 2017. We are required to make interest payments in cash on the first business day of each month, beginning on July 1, 2016. The Term Loan will begin amortizing on July 3, 2017, in equal monthly installments of principal and interest, with such payments beginning on July 3, 2017, and continuing on the first business day of each month thereafter until the Term Loan is repaid. The final maturity date of the Term Loan is December 2, 2019. Upon repayment of the term loan, we are required to pay an end of term charge to the Lenders equal to 5.85% of the aggregate original principal amount of all Term Loan advances extended by the Lenders to us.

At our option, we may prepay all or any portion of the outstanding principal balance and all accrued and unpaid interest with respect to the principal balance being prepaid of the Term Loan, subject to a prepayment fee of 2% of the amount prepaid if the prepayment occurs after June 7, 2017 but on or prior to June 7, 2018, or 1% of the amount prepaid if the prepayment occurs after June 7, 2018.

In connection with the Loan Agreement, we also issued to Hercules Technology III, L.P., as the sole Lender on June 7, 2016, a warrant to purchase up to 63,000 shares of common stock at an exercise price of $5.00 per share. The warrant may be exercised either for cash or on a cashless “net exercise” basis. The warrant is immediately exercisable and expires on June 7, 2021.

The total debt discount, inclusive of the end of term charge and other fees, amounted to $659,000 related to this Term Loan is being amortized to interest expense over the term of the Term Loan.

5. Fair Value Measurements

The following table sets forth the fair value of our assets measured at fair value at June 30, 2017 and December 31, 2016 (in thousands):

	June 30, 2017
Description	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Money market	$	3,860	$	3,860	$	-	$	-
Commercial paper		3,670		-		3,670		-

Total financial assets	$	7,530	$	3,860	$	3,670	$	-

Add Cash:		832

Total cash, cash equivalents and marketable securities	$	8,362

	December 31, 2016
Description	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Money market	$	7,731	$	7,731	$	-	$	-
Commercial paper		7,544		-		7,544		-

Total financial assets	$	15,275	$	7,731	$	7,544	$	-

Add Cash:		204

Total cash, cash equivalents and marketable securities	$	15,479

6. Stock-Based Compensation

We granted incentive stock options to employees and nonqualified stock options to members of the board of directors for their services on the board of directors and to nonemployee consultants for their consulting services. Options, in general, either vest in 48 equal monthly installments or 25% on the first year anniversary and 1/48^th of the granted options monthly thereafter, such that options are fully vested on the four-year anniversary of the date of grant.

					Weighted
					Average		Average
			Weighted		Remaining		Intrinsic
	Number of		Average		Contractual		Value
	Stock Options		Exercise Price		Life		(in thousands)
Outstanding as of December 31, 2016		1,751,473	$	2.5434

Options granted		351,000		1.3386

Outstanding at June 30, 2017		2,102,473	$	2.3422		8.41	$	217,463

Exercisable at June 30, 2017		691,918	$	2.0834		6.91	$	159,604

At June 30, 2017, we had unrecognized compensation cost of $1.2 million which will be recognized over the weighted-average remaining service period of approximately 2.0 years.

Stock-based compensation expense has been included in the Statement of Operations as follows (in thousands):

	Three months ended June 30				Six months ended June 30
	2017		2016		2017		2016

Research and development	$	78	$	21	$	204	$	30
General and administrative		178		117		394		126
	$	256	$	138	$	598	$	156

The fair value of the stock options was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions during the six months ended June 30, 2017 and 2016:

	Six Months Ended			Six Months Ended
	June 30, 2017			June 30, 2016

Weighted average estimated fair value per share	$	0.75		$	2.71

Weighted average assumptions:
Dividend yields		-			-
Expected term (years)		5.7			6.0
Risk free interest rate		1.9	%		1.5	%
Volatility		80.3	%		80.3	%

The risk-free interest rates used in the Black-Scholes option pricing model are based on the implied yield currently available in United States Treasury securities at maturity with an equivalent term. We have limited stock option exercise information. Accordingly, the expected term of stock options granted was calculated using the simplified method, which represents the average of the contractual term of the stock option and the weighted-average vesting period of the stock option. We have not declared or paid any dividends and do not currently expect to do so in the foreseeable future. The value of our underlying common stock was determined by the board of directors, which relied in part upon the report of third party valuation specialists and input from our management prior to the IPO. Expected volatility is based on an average volatility of stock prices for a group of similar publicly traded companies. The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing model.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis summarizes the significant factors affecting our operating results, financial condition, liquidity and cash flows as of and for the periods presented below. The following discussion and analysis should be read in conjunction with our unaudited interim consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. Unless the context provides otherwise, all references in this Quarterly Report on Form 10-Q to “PhaseRx,” “we,” “us,” “our,” the “Company,” or similar terms, refer to PhaseRx, Inc. and its directly and indirectly owned subsidiaries on a consolidated basis.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy, prospective products, product approvals, timing and likelihood of success, plans and objectives of management for future operations, and future results of current and anticipated products are forward-looking statements. These statements involve known and unknown risks, uncertainties and other important 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.

In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “could,” “intend,” “target,” “project,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions. The forward-looking statements in this Quarterly Report on Form 10-Q are only predictions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition and results of operations. These forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q and are subject to a number of risks, uncertainties and assumptions described under the sections in this Quarterly Report on Form 10-Q entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2016 annual report on the Form 10-K filed with the Securities and Exchange Commission on March 27, 2017. Because forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified and some of which are beyond our control, you should not rely on these forward-looking statements as predictions of future events. The events and circumstances reflected in our forward-looking statements may not be achieved or occur and actual results could differ materially from those projected in the forward-looking statements. Moreover, we operate in an evolving environment. New risk factors and uncertainties may emerge from time to time, and it is not possible for us to predict all risk factors and uncertainties. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained herein, whether as a result of any new information, future events, changed circumstances or otherwise.

Overview

We are a biopharmaceutical company developing a portfolio of products for the treatment of inherited enzyme deficiencies in the liver using intracellular enzyme replacement therapy, or i-ERT. Our lead compound, PRX-OTC to treat ornithine transcarbamylase deficiency, or OTCD, one of the urea cycle disorders, is in preclinical development and is expected to generate safety and clinical efficacy data in 2018. We are not aware of any other enzyme replacement therapies for intracellular enzyme deficiencies currently being marketed for inherited enzyme deficiencies in the liver and believe that the commercial potential for i-ERT remains untapped and is similar in size to the $4.8 billion worldwide market for conventional ERT, which includes drugs such as Cerezyme. Our i-ERT approach is enabled by our proprietary Hybrid mRNA Technology platform, which allows synthesis of the missing enzyme inside the cell. Our initial product portfolio targets the three urea cycle disorders: OTCD; ASL deficiency and ASS1 deficiency. We have preclinical proofs of concept for the treatment of OTCD and ASL deficiency which show significant reductions in the level of blood ammonia, which we believe is an approvable endpoint by the FDA for the demonstration of efficacy in human clinical trials for the treatment of the urea cycle disorders. To our knowledge, there are no ERT products on the market to treat these diseases, because the urea cycle reaction occurs inside the cell and is inaccessible to the administered enzyme. In contrast, we expect delivery of the missing enzyme using i-ERT with our Hybrid mRNA Technology to be a promising approach to treat these patients. Beyond the urea cycle disorders, we believe there are a significant number of inherited disorders of metabolism in the liver that are candidates for our therapeutic approach and that our Hybrid mRNA Technology can be adapted to develop mRNA therapeutics for the treatment of other inherited liver disorders using our platform.

Our i-ERT approach is accomplished by delivering normal copies of the mRNA that make the missing enzyme inside the liver cell, thereby enabling proper physiological function and correcting the disease. A key challenge with mRNA therapeutics historically has been their satisfactory delivery into the patients’ cells. We believe that our Hybrid mRNA Technology addresses these difficulties and enables synthesis of the desired protein in the hepatocyte, which is the chief functional cell type in the liver harboring the metabolic cycles that need to be corrected in metabolic liver diseases. We believe our technology is superior to alternative technologies because, based upon peer-reviewed journal articles and presentations of our competitors and our internal preclinical studies, it results in high-level synthesis of the desired protein in the hepatocyte, is well tolerated in multiple species and can be repeat-dosed without loss of effectiveness, thus enabling treatment of chronic conditions.

We are focused on inherited, single-gene disorders of metabolism in the liver that result in deficiency of an intracellular enzyme and thus have been unable to be treated with conventional ERT. Some inherited orphan liver diseases, such as the lysosomal storage disorders, can be successfully treated with conventional ERT. However, this approach does not work for many of the inherited orphan liver diseases, including the urea cycle disorders, because the missing enzyme is inside the cell, and the administered enzyme is unable to get inside the target cell where it is needed to be therapeutically active. Our approach is to deliver mRNA encoding the missing enzyme into the cell using our Hybrid mRNA Technology, such that the mRNA makes the missing enzyme inside the cell, restores the intracellular enzyme function and corrects the disease.

As noted above, our initial focus is on urea cycle disorders, which are a group of rare genetic diseases generally characterized by the body’s inability to remove ammonia from the blood. The urea cycle consists of several enzymes, including OTC, ASL and ASS1. Since the urea cycle reactions occur inside the cell, conventional ERT does not work as a treatment for these disorders. Urea cycle disorders are caused by a genetic mutation that results in a deficiency of one of the enzymes of the urea cycle that is responsible for removing ammonia from the bloodstream, causing elevated levels of ammonia in the blood. The elevated ammonia then reaches the brain through the circulation, where it causes cumulative and permanent neurological damage, and can result in coma and death. Currently marketed ammonia scavengers such as Ravicti (glycerol phenylbutyrate) and Buphenyl (sodium phenylbutyrate) remove some of the excess ammonia but do not alter the underlying disease mechanism, therefore, liver transplant is the only currently available cure for urea cycle disorders. Our goal is to treat the urea cycle disorders by intravenous delivery of mRNA that makes the relevant missing urea cycle enzyme inside the cell, thus reinstating control of blood ammonia. We believe that anticipated improvements in newborn screening and the availability of corrective therapy will lead to improved diagnosis and survival rates among patients with urea cycle disorders.

We have three therapeutic urea cycle disorder programs under development: PRX-OTC to treat OTCD, PRX-ASL to treat ASL deficiency and PRX-ASS1 to treat ASS1 deficiency. Preclinical efficacy has been established for PRX-OTC with two biological measures, including normalization of the level of ammonia in the blood. In June 2016, we selected PRX-OTC as our lead product candidate and demonstrated preclinical proof of concept for the treatment of a second product candidate, PRX-ASL. In 2016, we initiated scale up of the manufacturing of PRX-OTC, and in November 2016, we announced positive safety results from our single escalating dose response study in non-human primates using our Hybrid mRNA Technology. In November 2016, PRX-OTC received orphan drug designation from the FDA. In April 2017, PRX-OTC received orphan medicinal product designation from the European Commission. We have received feedback on our PRX-OTC development program from both the FDA and the European Commission. We intend to initiate IND-enabling studies in the second half of 2017 and plan to start manufacturing clinical supplies of the lead urea cycle disorder product candidate consistent with cGMP in 2018. We plan to file an IND application for PRX-OTC with the FDA in 2018, conduct Phase 2a/2b single- and repeat-dose clinical proof of concept studies in OTCD patients that are expected to generate Phase 2a safety and efficacy data, including measurement of reduction in blood ammonia in the second half of 2018 and Phase 2b (repeat-dose) safety and efficacy data in the first half of 2019.

We believe our cash, cash equivalents and marketable securities balance of $8.4 million at June 30, 2017, is sufficient to fund our operations until March 31, 2018. We are exploring various financing options including equity funding and strategic collaborations. However, there are no assurances that we will be successful in obtaining the level of financing needed for our operations. Assuming we can raise sufficient cash to fund our operations beyond March 31, 2018, we expect to file an IND application for PRX-OTC with the FDA in 2018, conduct Phase 2a/2b single- and repeat-dose clinical proof of concept studies in OTCD patients that are expected to generate Phase 2a safety and efficacy data, including measurement of reduction in blood ammonia in the second half of 2018 and Phase 2b (repeat-dose) safety and efficacy data in the first half of 2019.

Financial Overview

Our operations have been funded, to date, primarily through the sale of our common stock in the IPO, debt financing, a series of private placements of convertible preferred stock and issuance of convertible notes and warrants.

Operating Losses

Since our inception, we have incurred significant operating losses. Our net losses were $3.5 million and $11.1 million for the three months ended June 30, 2017 and 2016, respectively. Our net losses were $7.7 million and $13.3 million for the six months ended June 30, 2017 and 2016, respectively. As of June 30, 2017, we had an accumulated deficit of $77.2 million. We expect to continue to incur significant expenses and operating losses over the next several years. Our net losses may fluctuate significantly from quarter to quarter and from year to year. We anticipate that our expenses will increase as we plan to conduct our preclinical studies, scale up the manufacturing process, advance our research programs into clinical trials, continue to discover, validate and develop additional product candidates, expand and protect our intellectual property portfolio, and hire additional development and scientific personnel.

Revenue

We currently do not have any products approved for sale in any jurisdiction and have not generated any revenue from product sales.

Research and Development Expenses

Our research and development expenses consist primarily of costs incurred for our research activities, including our drug discovery efforts, and the development of our product candidates, which include the following:

•

employee-related expenses, including salaries, benefits, travel and stock-based compensation;

•

external research and development expenses incurred under arrangements with third parties, such as consulting fees, research testing and preclinical studies of our product candidates;

•

laboratory supplies, and acquiring, developing and manufacturing preclinical study materials;

•

license fees; and

•

costs of facilities, depreciation and other expenses.

Research and development costs are expensed as incurred. In certain circumstances, we will make non-refundable advance payments to purchase goods and services for future use pursuant to contractual arrangements. In those instances, we defer and recognize an expense in the period that we receive or consume the goods or services.

At any point in time, we typically have various early stage research and drug discovery projects ongoing. Our internal resources, employees and infrastructure are not directly tied to any one research or drug discovery project and are typically deployed across multiple projects. As such, we do not maintain information regarding the costs incurred for these early stage research and drug discovery programs on a project-specific basis.

The nature and efforts required to complete a prospective research and development project are typically indeterminable at very early stages when research is primarily conceptual and may have multiple applications. Once a focus towards developing a specific product candidate has been developed, we obtain more visibility into the efforts that may be required to reach conclusion of the development phase. However, there are inherent risks and uncertainties in developing novel biologics in a rapidly-changing industry environment. To obtain approval of a product candidate from the FDA, we must, among other requirements, submit data supporting safety and efficacy as well as detailed information on the manufacture and composition of the product candidate. In most cases, this entails extensive laboratory tests and preclinical and clinical trials. The collection of this data, as well as the preparation of applications for review by the FDA, is costly in time and effort, and may require significant capital investment.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and related benefits, including stock-based compensation, related to our executive, finance and support functions. Other general and administrative expenses include allocated facility related costs not otherwise included in research and development expenses, professional fees for auditing, tax, investor relations, legal services, market research, intellectual property and travel expenses.

Interest Expense

On June 7, 2016, we entered into a loan and security agreement by and among us, the several banks and other financial institutions or entities from time to time parties to the loan and security agreement and Hercules, in its capacity as administrative agent for itself and the Lenders, pursuant to which the Lenders funded $6 million of the term loan, and we received $5.7 million, net of issuance costs.

The Term Loan bears interest at a floating annual rate equal to the greater of (i) 9.25% and (ii) the sum of (a) 9.25%, plus (b) the prime rate as reported by The Wall Street Journal minus 3.50%, resulting in a rate of 10.00% as of June 30, 2017. We are required to make interest payments in cash on the first business day of each month, beginning on July 1, 2016. The Term Loan begins amortizing on July 3, 2017, in equal monthly installments of principal and interest, with such payments beginning on July 3, 2017, and continuing on the first business day of each month thereafter until the Term Loan is repaid. The final maturity date of the Term Loan is December 2, 2019. Upon repayment of the term loan, we are required to pay an end of term charge to the Lenders equal to 5.85% of the aggregate original principal amount of all Term Loan advances extended by the Lenders to us.

On May 2, 2016, we issued an original issue discount promissory note in the aggregate amount of $440,000 payable to a lender in exchange for a $400,000 loan. The note was repaid after the closing of the IPO.

Critical Accounting Policies and Estimates

Our management’s discussion and analysis of our financial condition and results of operations are based on our audited and unaudited consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses and stock-based compensation. We base our estimates on historical experience, known trends and events, and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

While our significant accounting policies are described in more detail in the notes to our audited consolidated financial statements included in our 2016 annual report on the Form 10-K filed with the Securities and Exchange Commission on March 27, 2017, we believe the following accounting policies to be most critical to the judgments and estimates used in the preparation of our financial statements.

Research and Development Costs

Research and development costs are expensed as incurred. Research and development costs include salaries and personnel related costs, consulting fees, fees paid for contract research services, the costs of laboratory supplies, equipment and facilities, license fees and other external costs. Non-refundable advance payments for goods or services to be received in the future for use in research and development activities are deferred and capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed.

Fair Value of Financial Instruments

Level 1: Quoted prices in active markets for identical assets or liabilities.

Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly.

Level 3: Unobservable inputs in which little or no market data exists, therefore determined using estimates and assumptions developed by us, which reflect those that a market participant would use.

Stock-Based Compensation

We expense the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of such instruments. We use the Black-Scholes option pricing model to calculate the fair value of any equity instruments on the grant date. We recognize stock-based compensation, on the graded-vesting method as expense over the requisite service period. The use of the Black-Scholes option pricing model requires management to make assumptions with respect to volatility, expected option term and, prior to the IPO, the fair value of our common stock. Measurement of stock-based compensation for options granted to non-employees is subject to periodic adjustment as the underlying equity instruments vest. We have granted options with performance conditions to certain executive officers, directors and non-employee consultants. At each reporting date, we evaluate whether the achievement of the performance conditions is probable. Compensation expense is recorded over the appropriate service period based upon our assessment of the achievement of each performance condition or the occurrence of the event which will trigger the options to vest.

We recorded stock-based compensation expense in the Statements of Operations as follows (in thousands):

	Three months ended June 30				Six months ended June 30
	2017		2016		2017		2016

Research and development	$	78	$	21	$	204	$	30
General and administrative		178		117		394		126
	$	256	$	138	$	598	$	156

All stock options are granted at a price no less than the fair value per share of our common stock. Prior to the IPO, the fair value of our common stock underlying options granted was determined by the board of directors who relied, in part, upon independent third party valuation analyses and input from our management on each grant date. We used valuation techniques and methods that rely on recommendations by the American Institute of Certified Public Accountants, or AICPA, in its Accounting and Valuation Guide,Valuation of Privately-Held-Company Equity Securities Issued as Compensation , 2013, and conformed to generally accepted valuation practices.

JOBS Act

Section 107 of the Jumpstart Our Business Startups Act, or JOBS Act, provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other companies.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standard Update, or ASU, No. 2014-09,Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in ASC 605,Revenue Recognition. This ASU is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The ASU is effective for public entities for annual periods beginning after December 15, 2017. In June 2015, the FASB deferred for one year the effective date of the new revenue guidance, with an option that would permit companies to adopt the standard as early as the original effective date. Early adoption prior to the original effective date is not permitted. We are evaluating the impact this guidance may have on our revenue recognition and new required disclosures, but do not expect that the adoption will have a material impact on our financial statements.

Results of Operations

Comparison of Three and Six Months Ended June 30, 2017 and June 30, 2016

The following table sets forth information concerning our operating results for the three and six months ended June 30, 2017 and 2016 (in thousands):

	Three Months Ended June 30						Six Months Ended June 30
	2017			2016			2017			2016

Statement of operations data:

Operating expenses
Research and development	$	2,255		$	1,416		$	4,581		$	2,850
General and administrative		1,065			880			2,654			1,559
Noncash financial advising fees		-			7,515			-			7,515
Total operating expenses		3,320			9,811			7,235			11,924
Loss from operations		(3,320	)		(9,811	)		(7,235	)		(11,924	)
Interest income		22			6			47			6
Interest expense		(241	)		(1,389	)		(476	)		(1,589	)
Other income, net		-			110			-			190
Total other expense		(219	)		(1,273	)		(429	)		(1,393	)
Net loss	$	(3,539	)	$	(11,084	)	$	(7,664	)	$	(13,317	)

Research and Development Expenses

Research and development expenses were $2.3 million for the three months ended June 30, 2017, compared to $1.4 million for the three months ended June 30, 2016, and $4.6 million for the six months ended June 30, 2017, compared to $2.9 million for the six months ended June 30, 2016.

The increase of $839,000, or 59%, in the three months ended June 30, 2017, was primarily due to an increase in research activities to execute the development plan of our lead drug candidate, PRX-OTC. In the three months ended June 30, 2017, costs for preclinical studies and scaling up manufacturing increased by $591,000 and our payroll costs increased by $168,000 and noncash stock-based compensation increased by $45,000.

The increase of $1.7 million or 61% in the six months ended June 30, 2017, was also primarily due to an increase in research activities in connection with execution of the development plan for our lead drug candidate, PRX-OTC. During the six months ended June 30, 2017, costs for preclinical studies and scaling up of manufacturing increased by $1.2 million, our payroll costs increased by $317,000 and noncash stock-based compensation increased by $153,000.

General and Administrative Expenses

General and administrative expenses were $1.1 million for the three months ended June 30, 2017, compared to $880,000 for the three months ended June 30, 2016, and $2.7 million for the six months ended June 30, 2017, compared to $1.6 million for the six months ended June 30, 2016.

The increase of $185,000, or 21%, in the three months ended June 30, 2016, was primarily due to an increase in the costs associated with being a publicly-traded company of $114,000, an increase in payroll costs of $102,000 which includes an increase in noncash stock compensation expense of $57,000 and an increase in patent legal costs of $71,000, offset by a decrease in travel and consulting costs related to our IPO in 2016.

The increase of $1.1 million, or 70%, in the six months ended June 30, 2017, was primarily due to an increase of $411,000 due to costs associated with meeting requirements for being a publicly-traded company, including legal, consulting, insurance, board fees, audit fees and investor relation fees. Additionally, payroll costs increased by $339,000 due to $253,000 in increased stock compensation expense and $84,000 from increased headcount. We also incurred market research analysis costs of $267,000.

Noncash Financial Advising Fees

We did not incur any noncash financial advising fees during the three and six months ended June 30, 2017, compared to $7.5 million of noncash financial advising fees during the three and six months ended June 30, 2016.

In December 2015, we engaged Palladium Capital Advisors, LLC, or Palladium, to serve as a non-exclusive agent in connection with a bridge loan financing and as a non-exclusive advisor in connection with our IPO and for the provision of general capital markets advice. Prior to the consummation of the bridge loan financing, we determined, following discussions with Palladium, to request certain of our stockholders to transfer an aggregate of 1,393,880 shares of our common stock to Titan Multi-Strategy Fund I, LTD, or Titan, and certain of its third-party designees at a nominal purchase price in order to induce Titan to serve as the initial committed investor in the bridge financing and also in expectation of receiving other support from Titan, Palladium and their respective contacts in connection with our then proposed IPO, including introductions to certain prospective underwriters. The sales of shares were completed immediately prior to the IPO. We recorded the fair value of this stock amounting to $7.0 million, based on the IPO price of $5.00 per share, as a noncash financial advising fee to reflect the economic benefits that we received from the contributions by our principal stockholders.

We also issued Palladium, as consideration for serving as a non-exclusive advisor, 112,000 shares of our common stock in June 2016. We valued the stock based on the IPO price of $5.00 per share as we determined that the fair market value of the stock was more readily determinable than the fair value of the services received. The $560,000 fair value of the stock was recorded as a non cash financial advising fee during the three months ended June 30, 2016.

Interest Income

Interest income was approximately $22,000 for the three months ended June 30, 2017, compared to $6,000 for the three months ended June 30, 2016, and $47,000 for the six months ended June 30, 2017, compared to $6,000 for the six months ended June 30, 2016. We did not have any marketable securities held for investment in 2016 until after our IPO in May 2016.

Interest Expense

Interest expense was $241,000 for the three months ended June 30, 2017, compared to $1.4 million for the three months ended June 30, 2016. Interest expense was $476,000 for the six months ended June 30, 2017, compared to $1.6 million for the six months ended June 30, 2016.

The interest expense recorded in the three and six months ended June 30, 2017, was related to the Hercules Term Loan. The interest expense recorded in the three and six months ended June 30, 2016, was related to the amortization of the debt discounts of our convertible notes and the amortization of the value of the beneficial conversion feature and the interest expense of the convertible bridge loan. The convertible notes and loan were converted to common stock upon the IPO in May 2016 (See detailed disclosure under “Liquidity and Capital Resources” below).

Liquidity and Capital Resources

From inception to June 30, 2017, we have incurred an accumulated deficit of $77.2 million. We have financed our operations since inception primarily with the net proceeds of approximately $16.5 million from the sale of our common stock in our IPO in May 2016, the net proceeds of $5.7 million from Hercules Term Loan, $25.7 million from the sales of shares of our convertible preferred stock and $20.2 million from the issuance of convertible notes and warrants. We also received a $1.5 million upfront fee pursuant to a development agreement in 2014. At June 30, 2017, we had $8.4 million of cash, cash equivalents and marketable securities, which we believe is sufficient to fund our operations until March 31, 2018. We anticipate that we will continue to incur losses, and that such losses will increase over the next several years due to development costs associated with our urea cycle disorder programs. Our expected recurring losses and negative cash flows from operations raise substantial doubt about our ability to continue as a going concern. We expect that our research and development and general and administrative expenses will continue to increase and, as a result, we will need additional capital to fund our operations, which we may raise through a combination of equity offerings, debt financings, other third-party funding and other collaborations and strategic alliances. We are exploring various financing options including equity funding and strategic collaboration. However, there are no assurances that we will be successful in obtaining the level of financing needed for our operations. If we are unsuccessful, we may need to reduce activities, curtail or cease operations.

Initial Public Offering

On May 23, 2016, we closed our IPO and sold 3,700,000 shares of common stock at a price of $5.00 per share to the public. The aggregate net proceeds received by us from the offering, net of underwriting discounts and commissions and offering expenses, were $16.5 million.

Hercules Loan – June 2016 Loan and Security Agreement

On June 7, 2016, we entered into a loan and security agreement by and among us, the several banks and other financial institutions or entities from time to time parties to the loan and security agreement and Hercules, in its capacity as administrative agent for itself and the lenders, pursuant to which the lenders funded $6 million of the term loan, and we received $5.7 million, net of related expenses. The Term Loan is secured by substantially all of our assets other than our intellectual property.

The Term Loan bears interest at a floating annual rate equal to the greater of (i) 9.25% and (ii) the sum of (a) 9.25%, plus (b) the prime rate as reported by The Wall Street Journal minus 3.50%, resulting in a rate of 10.00% as of June 30, 2017. Beginning on July 1, 2016, we are required to make interest payments in cash on the first business day of each month. The Term Loan begins amortizing on July 3, 2017, in equal monthly installments of principal and interest, with such payments beginning on July 3, 2017, and continuing on the first business day of each month thereafter until the Term Loan is repaid. The final maturity date of the Term Loan is December 2, 2019. Upon repayment of the Term Loan, we are required to pay an end of term charge to the Lenders equal to 5.85% of the aggregate original principal amount of all Term Loan advances extended by the Lenders to us.

At our option, we may prepay all or any portion of the outstanding principal balance and all accrued and unpaid interest with respect to the principal balance being prepaid of the Term Loan, subject to a prepayment fee of 2.00% of the amount prepaid if the prepayment occurs after June 7, 2017 but on or prior to June 7, 2018, or 1.00% of the amount prepaid if the prepayment occurs after June 7, 2018.

Convertible Loan- Bridge Loan Financing - December 2015 Loan and Security Agreement

On December 11, 2015, we issued a promissory note to Titan Multi-Strategy I, LTO (“Titan”) in exchange for $500,000. On December 21, 2015, we entered into a loan and security agreement with 17 investors, which was subsequently amended on April 6, 2016, pursuant to which Titan converted its note and certain investors made new term loans to us in the aggregate principal amount of $4.0 million. The term loans closed on December 21, 2015, and we received from the escrow agent net proceeds of approximately $3.2 million, after deducting certain fees and expenses. Interest accrued on the term loans at the rate of 5% per annum. The entire outstanding principal amount of the term loans together with all accrued and unpaid interest thereon converted into shares of our common stock upon the closing of our IPO.

Convertible Notes

Prior to 2016 we issued to investors, including beneficial owners of more than 5% of our capital stock, convertible promissory notes, in the aggregate principal amount of $16.2 million and seven-year warrants to purchase shares of the same class and series of capital stock into which the notes convert. The notes carried interest at a rate of 8% per annum. On December 11, 2015, the noteholders agreed that for purposes of calculating the number of conversion shares, the notes ceased accruing interest as of December 31, 2015. The accrued interest payable on convertible notes payable totaled $3.2 million as of December 31, 2015. Immediately prior to the consummation of the IPO, the convertible notes and unpaid accrued interest thereon were converted into 2,788,880 shares of our common stock, and the seven-year warrants to purchase 2,452,242 shares of preferred stock with an exercise price of $0.01 were exercised on a cashless basis to purchase 303,096 shares of our common stock. Warrants to purchase 1,049,999 shares of preferred stock with an exercise price of $1.00 expired upon the IPO.

Promissory Note

We believe our existing cash, cash equivalents and marketable securities as of June 30, 2017 will be sufficient to meet our anticipated cash requirements until March 31, 2018. We intend to pursue a combination of sales of additional equity securities and strategic partnerships to further finance our operations. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we currently expect. There are no assurances however, that we will be successful in obtaining the level of financing needed for our operations.

Our primary uses of cash are to fund operating expenses, research and development expenditures and to pay interest and principle payments of our loan. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses.

Our future capital requirements are difficult to forecast and will depend on many factors, including:

•

the initiation, progress, timing, costs and completion of preclinical studies of our lead product and potential product candidates;

	•	the number and characteristics of product candidates that we pursue;

	•	the progress, costs and results of our clinical trials;

	•	the terms and timing of any other strategic alliance, licensing and other arrangements that we may establish;

	•	the outcome, timing and cost of regulatory approvals;

	•	delays that may be caused by changing regulatory requirements;

	•	the costs and timing of hiring new employees to support our continued growth;

	•	the costs required for operating a public company; and

	•	the extent to which we acquire or invest in businesses, products or technologies.

The following table shows a summary of our cash flows for the six months ended June 30, 2017 and 2016 (in thousands):

	Six Months Ended June 30
	2017			2016
	(unaudited)
Net cash provided by (used in)
Operating activities	$	(7,115	)	$	(4,124	)
Investing activities		2,073			(6,136	)
Financing activities		-			22,168
	$	(5,042	)	$	11,908

Operating Activities

Net cash used in operating activities increased to $7.1 million for the six months ended June 30, 2017, from $4.1 million for the six months ended June 30, 2016. The increase in net cash used in the six months ended June 30, 2017, was primarily due to an increase in PRX-OTC development expense payments of $883,000, an increase in payroll costs of approximately $542,000, an increase in bonus payments of $422,000, an additional $412,000 in costs associated with being a publicly-traded company, $291,000 in interest paid on our term loan, $273,000 for market research studies and additional facilities costs of $60,000.

Investing Activities

Net cash provided by investing activities was $2.1 million for the six months ended in June 30, 2017, compared to cash used in investing activities of $6.1 million for the six months ended June 30, 2016. The $2.1 million of cash provided by investment activities in the six months ended June 30, 2017, is the net amount of cash generated from the maturities and the purchases of our marketable securities. The $6.1 million of cash used by investment activities in the six months ended June 30, 2016 was primarily due to the purchase of marketable securities for $6.0 million and property and equipment purchases in the amount of $157,000.

Financing Activities

Net cash provided by financing activities decreased from $22.2 million for the six months ended June 30, 2016 to zero for the six months ended June 30, 2017. The net cash provided by financing activities in the six months ended June 30, 2016, was due to the net proceeds of $16.5 million from our IPO and the net proceeds of $5.7 million from the Hercules Loan received in June 2016.

Off Balance Sheet Arrangements

We have not engaged in any off-balance sheet financing arrangements through special purpose entities.

Emerging Growth Company Status

Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to “opt out” of such extended transition period, 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 companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

We have elected to avail ourselves of the following provisions of the JOBS Act:

•

not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act;

•

reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements and registration statements; and

•

exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

As a smaller reporting company, we have elected scaled disclosure obligations and therefore are not required to provide this information.

Item 4. Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures. Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Securities Exchange Act of 1934, as amended (the “Exchange Act”) Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Form 10-Q, have concluded that, based on such evaluation, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

(b) Changes in Internal Controls. There were no changes in our internal control over financial reporting, identified in connection with the evaluation of such internal control that occurred during the quarter ended June 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. We are not currently a party to any legal proceedings, the adverse outcome of which, in our management’s opinion, individually or in the aggregate, would have a material adverse effect on the results of our operations or financial position. There are no material proceedings in which any of our directors, officers or affiliates or any registered or beneficial stockholder of more than 5% of our common stock is an adverse party or has a material interest adverse to our interest.

Item 1A. Risk Factors.

The Risk Factors included in our annual report for the year ended December 31, 2016, on Form 10-K, filed with the Securities and Exchange Commission on March 27, 2017, have not materially changed, except for the following:

Risks Relating to Our Financial Condition and Capital Requirements

Our financial statements for the three and six months ended June 30, 2017, contain an explanatory paragraph in the footnotes that expresses substantial doubt as to our ability to continue as a going concern, which could prevent us from obtaining new financing on reasonable terms or at all.

Because we have had recurring losses and negative cash flows from operating activities and have significant future commitments, substantial doubt exists regarding our ability to continue as a going concern. Such doubts regarding our ability to continue as a going concern may adversely affect our ability to obtain new financing on reasonable terms or at all.

Risks Related to Ownership of our Common Stock

Our common stock could be delisted from The Nasdaq Capital Market if we fail to regain compliance with the minimum bid price requirement of $1.00 per share for continued listing within the time period required by the Nasdaq Listing Rules.

On August 8, 2017, we received written notice from the Listing Qualifications Department of the Nasdaq Stock Market (“Nasdaq”) indicating that, based upon the closing bid price of our common stock for the last 30 consecutive business days, we did not meet the minimum bid price of $1.00 per share required for continued listing on The Nasdaq Capital Market pursuant to Nasdaq Listing Rule 5550(a)(2). In accordance with Nasdaq Listing Rule 5810(c)(3)(A), we have 180 calendar days, or until February 5, 2018, to cure the deficiency and regain compliance with the minimum bid price requirement. In order to cure the deficiency, the closing bid price of our common stock would have to be $1.00 or higher for a minimum of ten consecutive business days during the initial 180-day compliance period.

If we do not regain compliance by February 5, 2018, an additional 180 days may be granted to regain compliance if we (i) meet the continued listing requirement for market value of publicly held shares and all other initial listing standards for The Nasdaq Capital Market (except for the bid price requirement) and (ii) provide written notice to Nasdaq of our intention to cure the deficiency during the second 180-day compliance period, by effecting a reverse stock split, if necessary. If we meet these requirements, Nasdaq will inform us that we have been granted an additional 180 calendar days. However, if it appears to Nasdaq that we will not be able to cure the deficiency, or if we are otherwise not eligible, Nasdaq will provide notice that our common stock will be subject to delisting. At that time, we may appeal Nasdaq’s delisting determination to a Hearings Panel. There can be no assurance that we will be able to regain compliance with the minimum bid price requirement or will otherwise be in compliance with other Nasdaq listing criteria.

If our common stock is delisted from The Nasdaq Capital Market, our ability to raise capital in the future may be limited. Delisting could also result in less liquidity for our stockholders and a lower stock price. Such a delisting would likely have a negative effect on the price of our common stock and would impair your ability to sell or purchase our common stock when you wish to do so. Although we expect to take actions to restore our compliance with Nasdaq’s listing requirements, we can provide no assurance that any action taken by us would be successful, or that any such action would stabilize the market price or improve the liquidity of our common stock.

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

(a) Unregistered Sales of Equity Securities

None.

(b) Use of Proceeds

On May 17, 2016, the Registration Statement on Form S-1 (File No. 333-210811) for our IPO of common stock was declared effective by the Securities and Exchange Commission, pursuant to which we sold an aggregate 3,700,000 shares of common stock at a public offering price of $5.00 per share for an aggregate offering price of $18.5 million. Laidlaw & Company (UK) Ltd. and Roth Capital Partners, LLC acted as joint book-running managers, and Laidlaw & Company (UK) Ltd. acted as the representative of the underwriters. We received net proceeds from the IPO of approximately $16.5 million, after deducting approximately $2.0 million of underwriting discounts, commissions and offering expenses. None of these expenses consisted of payments made by us to directors, officers or persons owning 10% or more of our common stock or to their associates, or to our affiliates.

As of June 30, 2017, approximately $13.9 million of the $16.5 million of net proceeds from our IPO had been used, of which approximately $440,000 was used to pay off the original issue discount promissory note, $184,000 was used to achieve preclinical proof of concept for the treatment of a second urea cycle disorder and approximately $426,000 was used to select a urea cycle disorder product candidate for further development, $1.4 million was used in preclinical activities, $6.4 million was used to scale up the manufacturing of PRX-OTC and $5.0 million was used in general and administrative expenses. None of these payments consisted of payments made by us to directors, officers or persons owning 10% or more of our common stock or to their associates, or to our affiliates, other than payments made in the ordinary course of business to officers for salaries and to non-employee directors as compensation for board or board committee services and as fees for consulting services.

We expect to use the proceeds from our IPO in connection with our ongoing activities as described in our final prospectus dated May 17, 2016, filed with the Securities and Exchange Commission pursuant to Rule 424(b)(4) under the Securities Act on May 18, 2016, as we:

scale up the manufacturing of the lead urea cycle disorder product candidate;

complete GMP-manufacturing and GLP-compliant toxicology studies; and

file an IND application with the FDA for this product candidate.

We have broad discretion in the use of the net proceeds from our IPO. We may find it necessary or advisable to use the net proceeds from this offering for other purposes than those described in our final prospectus.

The Registration Statement on Form S-1 included a prospectus to be used in connection with the potential resale by certain selling stockholders of up to an aggregate of 1,021,525 shares of our common stock issuable upon mandatory conversion of certain of our outstanding loans upon completion of the IPO. We did not receive any proceeds from the sale by selling stockholders of shares of common stock registered on the Registration Statement on Form S-1.

(c) Issuer Purchases of Equity Securities

We did not repurchase any of our equity securities during the quarter ended June 30, 2017.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None.

Item 6. Exhibits.

See Index to Exhibits.

SIGNATURES

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

	PHASERX, INC.

Date: August 10, 2017	By:	/s/ Robert Overell
		Robert W. Overell
		Chief Executive Officer
		(Principal Executive Officer and Principal Financial Officer)

Date: August 10, 2017	By:	/s/ Shing-Yin Tsui
		Shing-Yin (Helen) Tsui
		Senior Vice President, Finance and Secretary
		(Principal Accounting Officer)

EXHIBIT INDEX

Exhibit No.		Description

3.1		Fourth amended and Restated Certificate of Incorporation, as amended, as presently in effect (incorporated by reference to Exhibit 3.1 to Current Report on Form 8-K filed with the Securities and Exchange Commission on May 23, 2016)

3.2		Amended and Restated Bylaws, as presently in effect (incorporated by reference to Exhibit 3.2 to Current Report on Form 8-K filed with the Securities and Exchange Commission on May 23, 2016)

4.1		Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-1/A filed with the Securities and Exchange Commission on May 2, 2016)

4.2		PhaseRx, Inc. Second Amended and Restated Investors’ Rights Agreement, dated November 17, 2014, by and among PhaseRx, Inc. by and among PhaseRx, Inc., Series A Investors listed on Exhibit A thereto, Series A-1 Investor listed on Exhibit A-1 thereto and the Founders listed on Exhibit B thereto (incorporated by reference to Exhibit 4.2 to Registration Statement on Form S-1 filed with the Securities and Exchange Commission on April 18, 2016)

10.1		Engagement Letter, dated June 14, 2017, by and between PhaseRx, Inc. and H.C. Wainwright & Co., LLC (incorporated by reference to Exhibit 10.46 to Amendment No. 1 to Registration Statement on Form S-1 filed with the Securities and Exchange Commission on July 5, 2017)

10.2		Amendment to the Engagement Letter, dated June 30, 2017, by and between PhaseRx, Inc. and H.C. Wainwright & Co., LLC (incorporated by reference to Exhibit 10.47 to Amendment No. 1 to Registration Statement on Form S-1 filed with the Securities and Exchange Commission on July 5, 2017)

31.1*		Certification of the Principal Executive Officer and Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*		Certification of the Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1*		Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2*		Certification of Principal Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101*		The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2017, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of June 30, 2017 (unaudited) and December 31, 2016, (ii) Unaudited Consolidated Statements of Operations for the three and six months ended June 30, 2017 and 2016, (iii) Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2017 and 2016, and (iv) Notes to Unaudited Consolidated Financial Statements

* Filed herewith.

+ Management contract or compensatory plan or arrangement.

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Phaserx (PZRX) Inactive 10-Q2017 Q2 Quarterly report

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