BASIS OF PRESENTATION

Financial Statement Presentation

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto as of and for the year ended December 31, 2014 included in the Apricus Biosciences, Inc. and subsidiaries (the “Company”) Annual Report on Form 10-K (“Annual Report”) filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 16, 2015. The accompanying financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. In the opinion of management, the accompanying condensed consolidated financial statements for the periods presented reflect all adjustments, consisting of only normal, recurring adjustments, necessary to fairly state the Company’s financial position, results of operations and cash flows. Certain prior year items in the statement of cash flows have been reclassified to conform to the current year presentation. The condensed consolidated balance sheet was derived from audited financial statements, but does not include all GAAP disclosures. The unaudited condensed consolidated financial statements for the interim periods are not necessarily indicative of results for the full year. The preparation of these unaudited condensed consolidated financial statements requires the Company to make estimates and judgments that affect the amounts reported in the financial statements and the accompanying notes. The Company’s actual results may differ from these estimates under different assumptions or conditions.

Liquidity

The accompanying unaudited condensed consolidated financial statements have been prepared on a basis that contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The Company had an accumulated deficit of approximately $306.5 million as of September 30, 2015 and recorded a net loss of approximately $16.7 million for the nine months ended September 30, 2015. The Company has principally been financed through the sale of its common stock and other equity securities, debt financings and up-front payments received from commercial partners for the Company’s products under development.

In February 2015, the Company entered into subscription agreements with certain purchasers pursuant to which it sold an aggregate of 6,043,955 shares of its common stock and issued warrants to purchase up to an additional 3,021,977 shares of its common stock. Each share of common stock was sold at a price of $1.82 and included one half of a warrant to purchase a share of common stock. The warrants have an exercise price of $1.82 per share, became exercisable beginning six months and one day after the date of issuance and will expire on the seventh anniversary of the date of issuance. The total net proceeds from the offering were $10.9 million after deducting expenses of approximately $0.1 million. The subscription agreements grant certain of the purchasers preemptive rights to participate in future equity issuances by the Company, subject to certain exceptions, and require that the Company obtain permission from certain of the purchasers prior to selling shares under its committed equity financing facility with Aspire Capital Fund, LLC (“Aspire Capital”).

In July 2015, the Company borrowed the remaining $5.0 million under its Loan and Security Agreement (the “Credit Facility”) with Oxford Finance LLC (“Oxford”) and Silicon Valley Bank (“SVB”) (Oxford and SVB are referred to together as the “Lenders”).

Between the $10.0 million borrowed from the Lenders, the access to additional capital under its committed equity financing facility, the $10.9 million received from the Company’s February 2015 financing, and cash received from Vitaros^® royalties and product sales, the Company believes it has sufficient cash reserves and access to cash to fund its base operations through the fourth quarter of 2016. This includes the completion of its fispemifene phase 2b clinical trial, support of the commercialization of Vitaros^®, and other general operating activities.

Although the Company believes it has sufficient cash reserves and access to cash to fund its base operations through the fourth quarter of 2016, the Company will need to raise substantial additional funds to finance other anticipated net cash outflows over the next year. These activities could include resubmission of a Vitaros^®United States NDA, continued development of Room Temperature Vitaros^®, as well as future clinical studies for fispemifene and RayVa^™. If the Company is unable to maintain sufficient financial resources, including by raising additional funds when needed, its business, financial condition and results of operations will be materially and adversely affected. There can be no assurance that the Company will be able to obtain the needed financing on acceptable terms or at all. Additionally, equity or debt financings may have a dilutive effect on the holdings of the Company’s existing stockholders.

Warrant Liabilities

The Company’s outstanding common stock warrants issued in connection with its February 2015 financing are classified as liabilities in the accompanying condensed consolidated balance sheets as they contain provisions that require the Company to maintain active registration of the shares underlying such warrants, which is considered outside of the Company’s control. The warrants were recorded at fair value using the Black-Scholes option pricing model. The fair value of these warrants is re-measured at each financial reporting period with any changes in fair value being recognized as a component of other income (expense) in the accompanying condensed consolidated statements of operations.

Fair Value Measurements

The Company determines the fair value measurements of applicable assets and liabilities based on a three-tier fair value hierarchy established by accounting guidance and prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted market prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions. Financial assets and liabilities that are measured or disclosed at fair value on a recurring basis, and are classified within the Level 3 designation include the common stock warrant liabilities. None of the Company’s non-financial assets and liabilities are recorded at fair value on a non-recurring basis.

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The following table presents the Company’s fair value hierarchy for assets and liabilities measured at fair value on a recurring basis (in thousands):



	Quoted Market Prices for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
As of September 30, 2015
Warrant liability related to February 2015 financing	$	—	$	—	$	3,273	$	3,273

The common stock warrant liabilities are recorded at fair value using the Black-Scholes option pricing model. The following weighted-average assumptions were used in determining the fair value of the common stock warrant liabilities valued using the Black-Scholes option pricing model as of September 30, 2015:



Risk-free interest rate	1.45		%
Volatility	92.6		%
Dividend yield	—		%
Expected term	6.38
Weighted average fair value	$	1.08

The following table is a reconciliation for all liabilities measured at fair value using Level 3 unobservable inputs (in thousands):



	Warrant liability
Balance as of December 31, 2014	$	—
Issuance of warrants in connection with February 2015 financing	5,077
Change in fair value measurement of warrant liability, included in other income	(1,804		)
Balance as of September 30, 2015	$	3,273

Of the inputs used to value the outstanding common stock warrant liabilities as of September 30, 2015, the most subjective input is the Company’s estimate of expected volatility. If volatility increased to 150%, the weighted average fair market value of the common stock warrants outstanding would increase by approximately $0.9 million, or 26.5%.

Revenue Recognition

The Company generates revenues from licensing technology rights and the sale of products. The Company recognizes revenue when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the Company’s price to the buyer is fixed or determinable; and (4) collectability is reasonably assured.

Payments received under commercial arrangements, such as licensing technology rights, may include non-refundable fees at the inception of the arrangements, milestone payments for specific achievements designated in the agreements, and royalties on the sale of products. The Company considers a variety of factors in determining the appropriate method of accounting under its license agreements, including whether the various elements can be separated and accounted for individually as separate units of accounting. Deliverables under the arrangement will be separate units of accounting, provided (i) a delivered item has value to the customer on a standalone basis; and (ii) the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in the Company’s control.

Multiple Element Arrangements

The Company accounts for revenue arrangements with multiple elements by separating and allocating consideration according to the relative selling price of each deliverable. If an element can be separated, an amount is allocated based upon the relative selling price of each element. The Company determines the relative selling price of a separate deliverable using the price it charges other customers when it sells that product or service separately. If the product or service is not sold separately and third party pricing evidence is not available, the Company will use its best estimate of selling price.

Milestones

Revenue is recognized when earned, as evidenced by written acknowledgment from the collaborator or other persuasive evidence that the milestone has been achieved, provided that the milestone event is substantive. A milestone event is considered to be substantive if its achievability was not reasonably assured at the inception of the arrangement and the Company’s efforts led to the achievement of the milestone (or if the milestone was due upon the occurrence of a specific outcome resulting from the Company’s performance). Events for which the occurrence is either contingent solely upon the passage of time or the result of a counterparty’s performance are not considered to be milestone events. If both of these criteria are not met, the milestone payment is recognized over the remaining minimum period of the Company’s performance obligations under the arrangement, if any. The Company assesses whether a milestone is substantive at the inception of each arrangement.

License Fee Revenue

The Company defers recognition of non-refundable upfront license fees if it has continuing performance obligations, without which the licensed data, technology, or product has no utility to the licensee separate and independent of its performance under the other elements of the applicable arrangement. Non-refundable, up-front fees that are not contingent on any future performance by the Company and require no consequential continuing involvement on the Company’s part are recognized as revenue when the license term commences and the licensed data, technology or product is delivered. The specific methodology for the recognition of the revenue is determined on a case-by-case basis according to the facts and circumstances of the applicable agreement.

Product Sales Revenue

The Company has supply and manufacturing agreements with certain of its licensee partners for the manufacture and delivery of Vitaros^®product. These agreements do not permit the Company’s licensee partners to return product, unless the product sold to the licensee partner is delivered with a short-dated shelf life as specified in each respective license agreement, if applicable. In those cases, the Company defers revenue recognition until the right of return no longer exists, which is the earlier of: (i) evidence that the product has been sold to an end customer or (ii) the right of return has expired. As such, the Company does not have a sales and returns allowance recorded as of September 30, 2015.

Royalty Revenue

The Company relies on its commercial partners to sell its Vitaros^® product in approved markets and receives royalty revenue from its commercial partners based upon the amount of those sales. Royalty revenues are computed on a quarterly basis, typically one quarter in arrears, and at the contractual royalty rate pursuant to the terms of each respective license agreement.

Cost of Product Sales

The Company’s cost of product sales includes direct material and manufacturing overhead associated with production. Cost of product sales is also affected by manufacturing efficiencies, allowances for scrap or expired material and additional costs related to initial production quantities of new products. Cost of product sales also includes the cost of one-time manufactured samples provided to the Company’s licensee partners free of charge.

Deferred Cost of Product Sales

Deferred cost of product sales is stated at the lower of cost or market and includes product sold where title has transferred, but the criteria for revenue recognition have not been met. The Company’s deferred cost of product sales is included in prepaid expenses and other current assets in the condensed consolidated balance sheets.

Loss Per Common Share

Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the same period. Diluted net loss per share is computed by dividing net loss by the weighted average number of common and common equivalent shares outstanding during the same period. Common equivalent shares may include stock options, restricted stock, warrants or shares related to convertible notes. The Company excludes common stock equivalents from the calculation of diluted net loss per share when the effect is anti-dilutive.

The following securities that could potentially decrease net loss per share in the future are not included in the determination of diluted loss per share as they are anti-dilutive:



	Three and Nine Months Ended September 30,
	2015	2014
Outstanding stock options	4,355,435	3,698,671
Outstanding warrants	10,034,099	6,185,492
Convertible notes payable	—	482,283
Restricted stock	—	6,250

Stock-Based Compensation

The Company estimates the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The Company also issues performance-based shares which represent a right to receive a certain number of shares of common stock based on the achievement of corporate performance goals and continued employment during the vesting period. At each reporting period, the Company reassesses the probability of the achievement of such corporate performance goals and adjusts expense as necessary.

The following table presents the weighted average assumptions used by the Company to estimate the fair value of stock option grants using the Black-Scholes option-pricing model, as well as the resulting weighted average fair values:



	Nine Months Ended September 30,
	2015			2014
Risk-free interest rate	1.37%-1.87%			1.58% - 2.1%
Volatility	66.85%-101.54%			79.34%-80.75%
Dividend yield	—		%	—		%
Expected term	5.25-6.46 years			5.25- 6.69 years
Forfeiture rate	11.54		%	3.60		%
Weighted average fair value	$	1.07		$	1.61

A summary of the Company’s stock option activity under all stock option plans during the nine months ended September 30, 2015 is as follows (in thousands):



	Number of Shares		Weighted Average Exercise Price
Outstanding as of December 31, 2014	3,956		$	2.58
Granted	1,393		$	1.44
Exercised	(41	)	$	2.05
Cancelled	(953	)	$	3.54
Outstanding as of September 30, 2015	4,355		$	2.01

The following table summarizes the total stock-based compensation expense resulting from share-based awards recorded in the Company’s condensed consolidated statements of operations (in thousands):



	Three Months Ended September 30,				Nine Months Ended September 30,
	2015		2014		2015		2014
Research and development	$	55	$	70	$	142	$	227
General and administrative	244		349		770		1,229
Total	$	299	$	419	$	912	$	1,456

Segment Information

The Company operates under one segment which develops pharmaceutical products.

Recent Accounting Pronouncements

In November 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share is More Akin to Debt or to Equity. This update clarifies how current guidance should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. In addition, it clarifies that in evaluating the nature of a host contract, an entity should assess the substance of the relevant terms and features (that is, the relative strength of the debt-like or equity-like terms and features given the facts and circumstances) when considering how to weight those terms and features. The effects of initially adopting the new standard should be applied on a modified retrospective basis to existing hybrid financial instruments issued in a form of a share as of the beginning of the fiscal year for which the amendments are effective. Retrospective adoption is permitted to all relevant prior periods. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The Company is currently in the process of evaluating whether the adoption of this update will have a material effect on its condensed consolidated financial statements and related disclosures.

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The amendments in this update will require management to assess, at each annual and interim reporting period, the entity’s ability to continue as a going concern and, if management identifies conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued, to disclose in the notes to the entity’s financial statements the principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern, management’s evaluation of their significance, and management’s plans that alleviated or are intended to alleviate substantial doubt about the entity’s ability to continue as a going concern. This new standard is effective for annual periods ending after December 15, 2016 and early adoption is permitted. The Company is currently in the process of evaluating whether the adoption of this update will have a material effect on its condensed consolidated financial statements and related disclosures.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires entities to recognize revenue to depict the transfer of promised 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. Entities may use a full retrospective approach or report the cumulative effect as of the date of adoption. On July 9, 2015, the FASB voted to defer the effective date by one year to December 15, 2017 for interim and annual reporting periods beginning after that date. Early adoption of ASU 2014-09 is permitted but not before the original effective date (annual periods beginning after December 15, 2016). The Company is currently in the process of evaluating whether the adoption of this update will have a material effect on its condensed consolidated financial statements and related disclosures.