Description of Operations and Summary of Significant Accounting Policies

12 Months Ended

Dec. 31, 2011

Description of Operations and Summary of Significant Accounting Policies

Description of Operations and Summary of Significant Accounting Policies

1. Description of Operations and Summary of Significant Accounting Policies

Description of Operations

        Theravance, Inc. (the Company or Theravance) is a biopharmaceutical company with a pipeline of internally discovered product candidates and strategic collaborations with pharmaceutical companies. Theravance is focused on the discovery, development and commercialization of small molecule medicines across a number of therapeutic areas including respiratory disease, bacterial infections, and central nervous system (CNS)/pain. By leveraging the Company's proprietary insight of multivalency to drug discovery, Theravance is pursuing a best-in-class strategy designed to discover superior medicines in areas of significant unmet medical need.

Principles of Consolidation

        The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Management's Estimates

        The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

Segment Reporting

        The Company has determined that it operates in a single segment which is the research and development of human therapeutics. Revenues are generated primarily from the Company's collaborations with GlaxoSmithKline plc (GSK), located in the United Kingdom and, through 2011, Astellas Pharma Inc. (Astellas), located in Japan. All long-lived assets are maintained in the United States.

Cash and Cash Equivalents

        The Company considers all highly liquid investments purchased with a maturity of three months or less on the date of purchase to be cash equivalents. Cash equivalents are carried at cost, which approximates fair value.

        Under certain lease agreements and letters of credit, the Company has pledged cash and cash equivalents as collateral. Restricted cash related to such agreements was $0.9 million as of December 31, 2011 and December 31, 2010.

Marketable Securities

        The Company determines the appropriate classification of its marketable securities, which consist of debt securities, at the time of purchase and reevaluates such designation at each balance sheet date. All of the marketable securities are classified as available-for-sale and carried at estimated fair values and reported in either cash equivalents or marketable securities. Unrealized gains and losses on available-for-sale securities are reported in accumulated other comprehensive income as a separate component of stockholders' net capital deficiency. Interest, amortization of purchase premiums and discounts, and realized gains and losses on sales of securities are included in interest and other income. The cost of securities sold is based on the specific identification method.

        The Company regularly reviews all of its investments for other-than-temporary declines in fair value. The Company's review includes the consideration of the cause of the impairment, including the creditworthiness of the security issuers, the number of securities in an unrealized loss position, the severity and duration of the unrealized losses, whether the Company has the intent to sell the securities and whether it is more likely than not that the Company will be required to sell the securities before the recovery of their amortized cost basis. When the Company determines that the decline in fair value of an investment is below the amortized cost basis and the decline is other-than-temporary, the Company reduces the carrying value of the security and records a loss for the amount of such decline.

Fair Value of Financial Instruments

        Financial instruments include cash equivalents, marketable securities, related party receivables, accounts payable, accrued liabilities and convertible subordinated notes. Marketable securities are carried at estimated fair value. The carrying value of cash equivalents, receivables from related party, accounts payable and accrued liabilities approximate their fair value due to the relatively short nature of these instruments. Convertible subordinated notes are described in Note 7.

Concentration of Credit Risks

        The Company invests in a variety of financial instruments and, by its policy, limits the amount of credit exposure with any one issuer, industry or geographic area for investments other than instruments backed by the U.S. federal government.

Notes Receivable

        The Company provided loans to certain employees to assist them primarily with the purchase of a primary residence, which collateralizes the resulting loans. There was no interest receivable related to the loans as of December 31, 2011 and December 31, 2010. The outstanding loans have maturity dates ranging from July 2012 through May 2014.

Inventory

        Inventory is stated at the lower of cost or market value and is included in prepaid and other current assets in the accompanying consolidated balance sheets. Inventory is comprised of VIBATIV® active pharmaceutical ingredient. VIBATIV® has a limited shelf life. Astellas purchased VIBATIV® inventory from the Company at a cost of $1.2 million in 2011 and $2.0 million in 2010. The Company expensed inventory, on an average cost basis, that was no longer realizable of $0.5 million in 2011, $0.8 million in 2010 and $1.2 million in 2009. Inventory was valued at zero at December 31, 2011 and $1.7 million at December 31, 2010.

Property and Equipment

        Property, equipment and leasehold improvements are stated at cost and depreciated using the straight-line method as follows:

Leasehold improvements	Shorter of remaining lease terms or useful life
Equipment, furniture and fixtures	5 - 7 years
Software and computer equipment	3 years

Capitalized Software

        The Company capitalizes certain costs related to direct material and service costs for software obtained for internal use. Capitalized software costs are depreciated over 3 years.

Impairment of Long-Lived Assets

        Long-lived assets include property and equipment. The carrying value of long-lived assets is reviewed for impairment whenever events or changes in circumstances indicate that the asset may not be recoverable. An impairment loss is recognized when the total of estimated future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount.

Bonus Accruals

        The Company has short-term bonus programs for eligible employees. Bonuses are determined based on various criteria, including the achievement of corporate, departmental and individual goals. Bonus accruals are estimated based on various factors, including target bonus percentages per level of employee and probability of achieving the goals upon which bonuses are based. The Company's management periodically reviews the progress made towards the goals under the bonus programs. As bonus accruals are dependent upon management's judgments of the likelihood of achieving the various goals, it is possible for bonus expense to vary significantly in future periods if changes occur in those management estimates.

Deferred Rent

        Deferred rent consists of the difference between cash payments and the recognition of rent expense on a straight-line basis for the buildings the Company occupies. Rent expense is being recognized ratably over the life of the leases. Because the Company's facility operating leases provide for rent increases over the terms of the leases, average annual rent expense during the first 1.5 years of the leases exceeded the Company's actual cash rent payments. Also included in deferred rent are lease incentives of $2.6 million as of December 31, 2011, which is being recognized ratably over the life of the leases.

Revenue Recognition

        The Company recognizes revenue in accordance with Financial Accounting Standards Board (FASB) Subtopic ASC 605-25, "Revenue Recognition-Multiple-Element Arrangements." As of January 1, 2011, the Company adopted on a prospective basis the accounting updates to guidance ASC 605 "Revenue Recognition", subtopic ASC 605-25 "Revenue with Multiple Element Arrangements" and subtopic ASC 605-28 "Revenue Recognition-Milestone Method", which provides accounting guidance for revenue recognition for arrangements with multiple deliverables and guidance on defining the milestone and determining when the use of the milestone method of revenue recognition for research and development transactions is appropriate, respectively. The adoption of ASC 605-25 "Revenue with Multiple Element Arrangements" and the election of the milestone method under subtopic ASC 605-28 "Revenue Recognition-Milestone Method" did not have a material impact on the Company's consolidated financial statements. However, these updates will result in different accounting treatment for future new collaboration arrangements and substantive milestones earned after the dates of adoption.

        The Company's revenues are related primarily to its collaboration arrangements with GSK and, through 2011, with Astellas (see Note 3, "Collaboration Arrangements" for more information). The Company's arrangements provide for various types of payments to the Company, including non-refundable upfront fees and milestone payments and royalty payments. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and collectability is reasonably assured.

        For multiple-element arrangements entered into prior to January 1, 2011, the Company determined the deliverables under its collaboration agreements with GSK and Astellas did not meet the criteria required for separate accounting units for the purposes of revenue recognition. As a result, the Company recognized revenue from non-refundable, upfront fees and development milestone payments ratably over the term of its performance under the agreements. These upfront or milestone payments received, pending recognition as revenue, are recorded as deferred revenue and are classified as a short-term or long-term liability on the balance sheet to be amortized over the period of deferral. The Company periodically reviewed the estimated performance periods of its contracts based on the progress of its programs.

        In accordance with ASC Subtopic 808-10, "Collaborative Arrangement," and pursuant to the Company's agreement with Astellas, the Company recognized as revenue the net impact of transactions with Astellas related to VIBATIV® inventory including revenue specifically attributable to any sales, and cost of inventory either transferred or expensed as unrealizable.

        The Company recognizes royalty revenue on net sales in the period in which the royalties are earned based on net sales reporting provided by the Company's former collaboration partner, Astellas.

        The Company has been reimbursed by GSK and Astellas for certain external development costs under their respective collaboration agreements. Such reimbursements have been reflected as a reduction of research and development expense and not as revenue.

        For multiple-element arrangements entered into, or materially modified, subsequent to January 1, 2011, each deliverable within a multiple deliverable revenue arrangement is accounted for as a separate unit of accounting if both of the following criteria are met: (1) the delivered item or items have value to the customer on a standalone basis and (2) for an arrangement that includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the Company's control.

        In addition, multiple deliverable revenue arrangement consideration is allocated at the inception of an arrangement to all deliverables using the relative selling price method. The Company also applies a selling price hierarchy for determining the selling price of a deliverable, which includes (1) vendor-specific objective evidence, if available, (2) third-party evidence, if vendor-specific objective evidence is not available, and (3) estimated selling price if neither vendor-specific nor third-party evidence is available.

        Where a portion of non-refundable upfront license or other payments, or milestone payments received are allocated to continuing performance obligations under the terms of a collaborative agreement, it will be recorded as deferred revenue and recognized as revenue ratably over the term of its estimated performance period under the agreement. The Company determines the estimated performance periods and they are periodically reviewed based on the progress of the related program. The effect of a change made to an estimated performance period and therefore revenue recognized ratably would occur on a prospective basis in the period that the change was made.

        Deferred revenue associated with a non-refundable payment received under a collaborative agreement that the performance obligations are terminated will result in an immediate recognition of any remaining deferred revenue in the period that termination occurred provided that all performance obligations have been satisfied.

        For milestones earned after January 1, 2011, the Company recognizes revenue from milestone payments when (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement and (ii) the Company does not have ongoing performance obligations related to the achievement of the milestone earned. Milestone payments are considered substantive if all of the following conditions are met: the milestone payment (a) is commensurate with either the Company's performance to achieve the milestone or the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the Company's performance to achieve the milestone, (b) relates solely to past performance, and (c) is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement. See Note 3, "Collaboration Arrangements," for analysis of each milestone event deemed to be substantive or non-substantive.

Research and Development Costs

        Research and development costs are expensed in the period that services are rendered or goods are received. Research and development costs consist of salaries and benefits, laboratory supplies and facility costs, as well as fees paid to third parties that conduct certain research and development activities on behalf of the Company, net of certain external research costs reimbursed by GSK and, through 2011, Astellas.

Preclinical Study and Clinical Study Expenses

        Most of the Company's preclinical studies and all of its clinical studies have been performed by third-party contract research organizations (CROs). Some CROs bill monthly for services performed, while others bill based upon milestones achieved. The Company reviews the activities performed under the significant contracts each quarter. For preclinical studies, the significant factors used in estimating accruals include the percentage of work completed to date and contract milestones achieved. For clinical study expenses, the significant factors used in estimating accruals include the number of patients enrolled and percentage of work completed to date. Vendor confirmations are obtained for contracts with longer duration when necessary to validate the Company's estimate of expenses. The Company's estimates are highly dependent upon the timeliness and accuracy of the data provided by its CROs regarding the status of each program and total program spending and adjustments are made when deemed necessary.

Fair Value of Stock-Based Compensation Awards

        Stock-based compensation arrangements currently include the following awards granted under the 2004 Equity Incentive Plan (2004 Plan) and the 2008 New Employee Equity Incentive Plan (2008 Plan): stock options, restricted stock unit awards (RSUs), performance-contingent RSUs, restricted stock awards (RSAs), and performance-contingent RSAs. In addition, purchases of common stock by the Company's employees at a discount to the market price during offering periods under the Company's Employee Stock Purchase Plan (ESPP). Under the 2004 Plan and 2008 Plan, stock options may be granted with an exercise price not less than 100% of the fair market value of the common stock on the date of grant. Stock options are generally granted with terms of up to ten years and vest over a period of four years.

        The Company uses the Black-Scholes option pricing model to estimate the fair value of options granted under its equity incentive plans and rights to acquire stock granted under its employee stock purchase plan. The Black-Scholes option valuation model requires the use of assumptions, including the expected term of the award and the expected stock price volatility. The Company used the "simplified" method as described in Staff Accounting Bulletin No. 107 for the expected option term because the usage of its historical exercise data is limited due to post-IPO exercise restrictions. Beginning April 1, 2011, the Company used its historical volatility to estimate expected stock price volatility. Prior to April 1, 2011, the Company used peer company price volatility to estimate expected stock price volatility due to the Company's limited historical common stock price volatility since its initial public offering in 2004. RSUs and RSAs are measured based on the fair market values of the underlying stock on the dates of grant.

        Stock-based compensation expense was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company's estimated annual forfeiture rates for stock options, RSUs and RSAs are based on its historical forfeiture experience.

        The estimated fair value of stock options, RSUs and RSAs is expensed on a straight-line basis over the expected term of the grant and the fair value of performance-contingent RSUs and RSAs is expensed during the term of the award when the Company determines that it is probable that certain performance milestones will be achieved. Compensation expense for purchases under the ESPP is recognized based on the estimated fair value of the common stock during each offering period and purchase discount percentage.

        The Company has not recognized, and does not expect to recognize in the near future, any tax benefit related to employee stock-based compensation costs as a result of the full valuation allowance on the Company's net deferred tax assets including deferred tax assets related to its net operating loss carryforwards.

Income Taxes

        The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized.

Comprehensive Loss

        Comprehensive loss is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) consists of changes in unrealized gains and losses on the Company's available-for-sale securities. Comprehensive income or loss for the years ended December 31, 2011, 2010 and 2009 has been presented in the Company's Consolidated Statements of Stockholders' Net Capital Deficiency.

Related Parties

        Transactions with GSK are described in Note 3, "Collaboration Arrangements".

        Robert V. Gunderson, Jr. is a director of the Company. The Company has engaged Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP, of which Mr. Gunderson is a partner, as its primary legal counsel. Fees are incurred in the ordinary course of business were $0.3 million in 2011, $0.7 million in 2010, and $0.4 million in 2009.

Recent Accounting Update

        In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-05, "Presentation of Comprehensive Income" an update to Accounting Standards Codification (ASC) Topic 220, "Comprehensive Income". This update requires that all nonowner changes in stockholders' equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This update is to be applied retrospectively and is effective for financial statements issued for fiscal years, and interim periods within those years, beginning after December 15, 2011, and interim and annual periods thereafter. This update will be effective for the Company January 1, 2012. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.