Summary of Significant Accounting Policies

Financial Statement Preparation and Use of Estimates

The unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q have been prepared by Zogenix, Inc. according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been omitted.

In the opinion of management, the accompanying unaudited consolidated financial statements for the periods presented reflect all adjustments, which are normal and recurring except for the sale of the Company's Zohydro ER business described in Note 5 and the restructuring costs described in Note 6 to these consolidated financial statements, necessary to fairly state the financial position, results of operations and cash flows. These unaudited consolidated financial statements should be read in conjunction with the audited financial statements included in the Company's Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2014, each as filed with the SEC. The Company's Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2014 have not been retroactively revised to reflect the sale of Zohydro ER as a discontinued operation or to reflect the 1-for-8 reverse stock split.

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 may differ from those estimates.

Principles of Consolidation

The unaudited interim consolidated financial statements include the accounts of Zogenix, Inc. and its wholly owned subsidiary Zogenix Europe Limited, which was incorporated under the laws of England and Wales in June 2010. All intercompany transactions and investments have been eliminated in consolidation. Zogenix Europe Limited’s functional currency is the U.S. dollar, the reporting currency of its parent.

Restricted Cash

In connection with its sale of the Zohydro ER business in April 2015, the Company has $10,001,000 of cash in escrow as of September 30, 2015 to fund potential indemnification claims for a period of 12 months from the closing date of the sale.

In connection with its sale of the Sumavel DosePro business in May 2014, the Company had $8,500,000 of cash in escrow as of December 31, 2014 to fund potential indemnification claims for a period of 12 months from the closing date of the sale. The Company received the full amount from escrow in May 2015.

The Company classifies these cash flows as investing activities in the consolidated statement of cash flows as the source of the restricted cash is related to the sales of the Zohydro ER and Sumavel DosePro businesses.

Short-term Investments

Short-term investments consist of shares of Pernix Therapeutics common stock received as partial consideration for the purchase of the Zohydro ER business. The investments are subject to restrictions over disposition, pledging or assignment for six months after the closing date of the Zohydro ER sale as specified in the related asset purchase agreement the Company entered into with Pernix Ireland Limited and Pernix Therapeutics (together with Pernix Ireland Limited, Pernix) dated March 10, 2015 (the Asset Purchase Agreement).

Management has classified these short-term investments as available-for-sale when acquired and evaluates such classification as of each balance sheet date. Short-term investments are carried at fair value, with the unrealized gains and losses, net of tax, reported in other comprehensive loss, a component of stockholders’ equity. Realized gains and losses and declines in fair value considered to be other-than-temporary are included in investment income (loss) on the consolidated statements of operations and comprehensive income (loss) and a new accounting cost basis for the investment is established.

The Company evaluates its short-term investments to assess whether any unrealized loss position is other than temporarily impaired. Factors considered in determining whether a loss is other-than-temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the issuer, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.

Fair Value Measurements

The carrying amount of financial instruments consisting of cash, restricted cash, trade accounts receivable, prepaid expenses and other current assets, accounts payable, accrued expenses and accrued compensation included in the Company’s consolidated financial statements are reasonable estimates of fair value due to their short maturities. Based on the borrowing rates currently available to the Company for loans with similar terms, management believes the fair value of long-term debt approximates its carrying value.

Authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:


Level 1:	Observable inputs such as quoted prices in active markets;


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


Level 3:	Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The Company classifies its cash equivalents within Level 1 of the fair value hierarchy because it values its cash equivalents using quoted market prices. The Company classifies its short-term investments, common stock warrant liabilities and contingent purchase consideration within Level 3 of the fair value hierarchy because they are valued using valuation models with significant unobservable inputs. Assets and liabilities measured at fair value on a recurring basis at September 30, 2015 and December 31, 2014 are as follows (in thousands):



	Fair Value Measurements at Reporting Date Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)	Total
At September 30, 2015
Assets
Cash equivalents⁽¹⁾	$	160,237	—	—	$	160,237
Short-term investments⁽²⁾	$	—	—	5,129	$	5,129
Liabilities
Common stock warrant liabilities⁽³⁾	$	—	—	5,954	$	5,954
Contingent purchase consideration ⁽⁴⁾	$	—	—	51,100	$	51,100
At December 31, 2014
Assets
Cash equivalents⁽¹⁾	$	8,021	—	—	$	8,021
Liabilities
Common stock warrant liabilities⁽³⁾	$	—	—	5,093	$	5,093
Contingent purchase consideration ⁽⁴⁾	$	—	—	53,000	$	53,000


(1)	Cash equivalents are comprised of money market fund shares and are included as a component of cash and cash equivalents on the consolidated balance sheets.

(2)

Short-term investments consist of Pernix Therapeutics common stock which was acquired in conjunction with the sale of the Zohydro ER business in April 2015. The Company ascertains fair value of short-term investments by using quoted prices for Pernix Therapeutics' common stock on a publicly traded market (a Level 1 input) less a lack of marketability discount on the fair value of the investments due to restrictions on when the Company can trade the securities. The Company considers the inputs used to calculate the lack of marketability discount Level 3 inputs and, as a result, categorized the short-term investments as Level 3. The lack of marketability discount was determined by using an "Average-Strike Put Option Model of the Marketability Discount" to value a hypothetical put option to approximate the reduction in value of the stock until the restriction ends. Inputs used to derive the discount included an estimation of the amount of time that the stock will be held subject to trading restrictions based on contracted lock-up period, expected volatility of the stock over the term of the remaining trading restrictions, and assumed lack of dividends during the restriction period. An increase in any of these inputs would increase the discount for lack of marketability and thereby reduce the overall fair value of the short-term investments. As of September 30, 2015, the gross fair value of short-term investments was $5,300,000, and the lack of marketability discount was $200,000. During the three months and nine months ended September 30, 2015, other comprehensive income (loss) included unrealized losses of $3,900,000 and $5,500,000, respectively, and an impairment charge of $5,500,000 which is recorded as loss on short-term investments in the consolidated statements of operations and comprehensive income (loss) for the three and nine months ended September 30, 2015.

(3)

Common stock warrant liabilities are associated with warrants issued in connection with the Company's July 2012 public offering of common stock and warrants (see Note 9) and warrants issued in connection with the financing agreement entered into with Healthcare Royalty Partners (Healthcare Royalty), dated June 30, 2011, (the Healthcare Royalty financing agreement), which are measured at fair value using the Black-Scholes option pricing valuation model. The assumptions used in the Black-Scholes option pricing valuation model for both common stock warrant liabilities were: (a) a risk-free interest rate based on the rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the remaining contractual term of the warrants; (b) an assumed dividend yield of zero based on the Company’s expectation that it will not pay dividends in the foreseeable future; (c) an expected term based on the remaining contractual term of the warrants; and (d) an expected volatility based upon the Company's historical volatility. The significant unobservable input used in measuring the fair value of the common stock warrant liabilities associated with the Healthcare Royalty financing agreement is the expected volatility. Significant increases in volatility would result in a higher fair value measurement. The following additional assumptions were used in the Black-Scholes option pricing valuation model to measure the fair value of the warrants sold in the July 2012 public offering: (a) management's projections regarding the probability of the occurrence of an extraordinary event and the timing of such event; and for the valuation scenario in which an extraordinary event occurs that is not an all cash transaction or an event whereby a public acquirer would assume the warrants, and (b) an expected volatility rate using the Company's historical volatility through the projected date of public announcement of an extraordinary transaction, blended with a rate equal to the lesser of 40% and the 180-day volatility rate obtained from the HVT function on Bloomberg as of the trading day immediately following the public announcement of an extraordinary transaction. The significant unobservable inputs used in measuring the fair value of the common stock warrant liabilities associated with the July 2012 public offering are the expected volatility and the probability of the occurrence of an extraordinary event. Significant increases in volatility would result in a higher fair value measurement and significant increases in the probability of an extraordinary event occurring would result in a significantly lower fair value measurement. The change in the fair value of the common stock warrant liabilities as of September 30, 2015 was primarily driven by the increase in the market price of the Company's common shares at September 30, 2015 as compared against December 31, 2014 measurement dates.

(4)

Contingent purchase consideration was measured at fair value using the income approach based on significant unobservable inputs including management's estimates of the probabilities of achieving specific net sales levels and development milestones and appropriate risk adjusted discount rates. Significant changes of either unobservable input could have a significant effect on the calculation of fair value of the contingent purchase consideration liability.

The following table provides a reconciliation of assets and liabilities measured at fair value using significant unobservable inputs (Level 3) for the nine months ended September 30, 2015 (in thousands):



	Short-term Investments			Contingent Purchase Consideration			Common Stock Warrant Liabilities
Balance at December 31, 2014	$	—		$	53,000		$	5,093
Additions	10,614			—			—
Changes in fair value	(5,485		)	(1,900		)	861
Balance at September 30, 2015	$	5,129		$	51,100		$	5,954

The changes in fair value of the short-term investments shown in the table that are unrealized above are recorded through other comprehensive loss on the consolidated balance sheet. Realized changes in fair value of the short-term investments and other than temporary impairment charges are shown as loss on short-term investments in other income (expense) in the consolidated statements of operations and comprehensive income (loss). The changes in fair value of the liabilities shown in the table above are recorded through change in fair value of contingent consideration in operating expenses and change in fair value of warrant liabilities in other income (expense) in the consolidated statements of operations and comprehensive income (loss).

Net Income (Loss) per Share

Basic net income (loss) per share is calculated by dividing the net income (loss) by the weighted average number of common shares outstanding for the period, reduced by weighted average shares subject to repurchase, without consideration for common stock equivalents. Diluted net income (loss) per share is computed based on the sum of the weighted average number of common shares and potentially dilutive common shares outstanding during the period.

Potentially dilutive common shares consist of shares issuable under equity awards and warrants. Potentially dilutive common shares from equity awards and warrants are determined using the average share price for each period under the treasury stock method. In addition, proceeds from exercise of equity awards and warrants and the average amount of unrecognized compensation expense for equity awards are assumed to be used to repurchase shares. For purposes of this calculation, equity awards and warrants are considered to be common stock equivalents and are only included in the calculation of diluted net income (loss) per share when their effect is dilutive.

The following table presents the computation of basic and diluted net income (loss) per share for continuing and discontinued operations (in thousands, except per share amounts):



	Three Months Ended September 30,
	2015						2014
	Continuing operations			Discontinued operations			Continuing operations			Discontinued operations
Numerator
Net income (loss), basic	$	(12,981	)	$	(1,635	)	$	(1,461	)	$	(11,364	)
Effect of dilutive securities:
Common stock warrants	—			—			—			—
Equity awards	—			—			—			—
	—			—			—			—
Net income (loss), diluted	$	(12,981	)	$	(1,635	)	$	(1,461	)	$	(11,364	)

Denominator
Weighted average common shares outstanding, basic	22,613			22,613			17,630			17,630
Effect of dilutive securities:
Common stock warrants	—			—			—			—
Equity awards	—			—			—			—
Dilutive potential shares of common stock	—			—			—			—
Weighted average common shares outstanding, diluted	22,613			22,613			17,630			17,630

Basic net income (loss) per share	$	(0.57	)	$	(0.07	)	$	(0.08	)	$	(0.64	)
Diluted net income (loss) per share	$	(0.57	)	$	(0.07	)	$	(0.08	)	$	(0.64	)



	Nine Months Ended September 30,
	2015					2014
	Continuing operations			Discontinued operations		Continuing operations			Discontinued operations
Numerator
Net income (loss), basic	$	(29,843	)	$	64,829	$	71,060		$	(41,952	)
Effect of dilutive securities:
Common stock warrants	—			—		(26,021		)	—
Equity awards	—			—		—			—
	—			—		(26,021		)	—
Net income (loss), diluted	$	(29,843	)	$	64,829	$	45,039		$	(41,952	)

Denominator
Weighted average common shares outstanding, basic	20,332			20,332		17,513			17,513
Effect of dilutive securities:
Common stock warrants	—			—		396			396
Equity awards	—			—		—			—
Dilutive potential shares of common stock	—			—		396			396
Weighted average common shares outstanding, diluted	20,332			20,332		17,909			17,909

Basic net income (loss) per share	$	(1.47	)	$	3.19	$	4.06		$	(2.40	)
Diluted net income (loss) per share	$	(1.47	)	$	3.19	$	2.51		$	(2.34	)

There were 1,786,000 and 471,000 dilutive securities (in common stock equivalent shares) from common stock options and restricted stock units excluded from the calculation of diluted net income (loss) during the three and nine months ended September 30, 2015, respectively, because to include them would be anti-dilutive. There were 7,000 and 1,239,000 dilutive securities (in common stock equivalent shares) from common stock options excluded from the calculation of diluted net income (loss) during the three and nine months ended September 30, 2014, respectively, because to include them would be anti-dilutive. There were 32,000 common stock warrants (in common stock equivalent shares) excluded from the calculation of diluted net income (loss) during the three months ended September 30, 2015 because to include them would be anti-dilutive.

Goodwill and Intangible Assets

Goodwill represents the excess of acquisition cost over the fair value of the net assets of acquired businesses. Goodwill

has an indefinite useful life and is not amortized, but instead tested for impairment annually. Intangible assets consist of in-process research and development with an indefinite useful life that is not amortized, but instead tested for impairment until the successful completion and commercialization or abandonment of the associated research and development efforts, at which point the in-process research and development asset is either amortized over its estimated useful life or written-off immediately.

Impairment of Long-Lived Assets

The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.

Revenue Recognition

The Company recognized revenue from contract manufacturing, service fees earned on collaborative arrangements and the sale of Sumavel DosePro prior to its sale in May 2014. The Company also recognizes revenue from the sale of Zohydro ER, which is included in net income (loss) from discontinued operations in the consolidated statement of operations and comprehensive income (loss). Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and title has passed, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (a) the Company’s price to the buyer is substantially fixed or determinable at the date of sale, (b) the buyer has paid the Company, or the buyer is obligated to pay the Company and the obligation is not contingent on resale of the product, (c) the buyer’s obligation to the Company would not be changed in the event of theft or physical destruction or damage of the product, (d) the buyer acquiring the product for resale has economic substance apart from that provided by the Company, (e) the Company does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (f) the amount of future returns can be reasonably estimated. The Company defers recognition of revenue on product shipments of Zohydro ER until the right of return no longer exists, as the Company was not able to reliably estimate expected returns of the product at the time of shipment given the limited sales history of Zohydro ER.

Revenue arrangements with multiple elements are divided into separate units of accounting if certain criteria are met, including whether the delivered element has stand-alone value to the customer. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. The application of the multiple element guidance requires subjective determinations, and requires the Company to make judgments about the individual deliverables and whether such deliverables are separable from the other aspects of the contractual relationship. Deliverables are considered separate units of accounting provided that: (1) the delivered item(s) has value to the customer on a stand-alone basis and (2) if the arrangement 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 determining the units of accounting, the Company evaluates certain criteria, including whether the deliverables have stand-alone value, based on the consideration of the relevant facts and circumstances for each arrangement. In addition, the Company considers whether the buyer can use the other deliverable(s) for their intended purpose without the receipt of the remaining element(s), whether the value of the deliverable is dependent on the undelivered item(s), and whether there are other vendors that can provide the undelivered element(s).

Arrangement consideration that is fixed or determinable is allocated among the separate units of accounting using the relative selling price method, and the applicable revenue recognition criteria, as described above, are applied to each of the separate units of accounting in determining the appropriate period or pattern of recognition. The Company determines the estimated selling price for deliverables within each agreement using vendor-specific objective evidence (VSOE) of selling price, if available, third-party evidence (TPE) of selling price if VSOE is not available, or management's best estimate of selling price (BESP) if neither VSOE nor TPE is available. Determining the BESP for a unit of accounting requires significant judgment. In developing the BESP for a unit of accounting, the Company considers applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the customer and estimated costs.

Contract Manufacturing Revenue

The Company and Endo entered into a supply agreement in connection with the sale of the Sumavel DosePro business to Endo in May 2014. Under the terms of the supply agreement, the Company retains the sole and exclusive right and the obligation to manufacture or supply Sumavel DosePro to Endo. The Company recognizes deferred revenue related to its supply of Sumavel DosePro as contract manufacturing revenue when earned on a "proportional performance" basis as product is delivered. The Company recognizes revenue related to its sale of Sumavel DosePro product, equal to the cost of contract manufacturing plus a 2.5% mark-up, upon the transfer of title to Endo. The Company supplies Sumavel DosePro product based on non-cancellable purchase orders. The Company initially defers revenue for any consideration received in advance of services being performed and product being delivered, and recognizes revenue pursuant to the related pattern of performance, based on total product delivered relative to the total estimated product delivery over the minimum eight year term of the supply agreement. The Company continually evaluates the performance period and will adjust the period of revenue recognition if circumstances change.

In addition, the Company follows the authoritative accounting guidance when reporting revenue as gross when the Company acts as a principal versus reporting revenue as net when the Company acts as an agent. For transactions in which the Company acts as a principal, has discretion to choose suppliers, bears credit risk and performs a substantive part of the services, revenue is recorded at the gross amount billed to a customer and costs associated with these reimbursements are reflected as a component of cost of sales for contract manufacturing services.

Product Revenue, Net

The Company sold Sumavel DosePro through May 2014, and sold Zohydro ER through April 2015, in the United States to wholesale pharmaceutical distributors and retail pharmacies, or collectively the Company's customers, subject to rights of return within a period beginning six months prior to, and ending 12 months following, product expiration. The Company recognized Sumavel DosePro product sales at the time title transferred to its customer, and reduced product sales for estimated future product returns and sales allowances in the same period the related revenue was recognized. The Company is responsible for all returns of Sumavel DosePro product distributed by the Company prior to the sale of the Sumavel DosePro business up to a maximum per unit amount as specified in the sales agreement.

Given the limited sales history of Zohydro ER, the Company was not able to reliably estimate expected returns of the product at the time of shipment. Accordingly, the Company deferred recognition of revenue on Zohydro ER product shipments until the right of return no longer exists, which occurs at the earlier of the time Zohydro ER is dispensed through patient prescriptions or expiration of the right of return. The Company estimates Zohydro ER patient prescriptions dispensed using an analysis of third-party syndicated data. Zohydro ER was launched in March 2014 and, accordingly, the Company did not have a significant history estimating the number of patient prescriptions dispensed. If the Company underestimated or overestimated patient prescriptions dispensed for a given period, adjustments to revenue from discontinued operations may be necessary in future periods. The deferred revenue balance does not have a direct correlation with future revenue recognition as the Company records sales deductions at the time the prescription unit was dispensed. In addition, the costs of Zohydro ER associated with the deferred revenue were recorded as deferred costs, which were included in inventory, until such time the related deferred revenue is recognized. The Company is responsible for returns for product sold prior to the sale of the business on April 24, 2015 and for rebates, chargebacks, and related Health Care Reform fees for product sold until July 8, 2015 per terms of the Asset Purchase Agreement. Revenue for Zohydro ER is included in discontinued operations in the consolidated statement of operations and comprehensive income (loss).

Segment Reporting

Management has determined that the Company operates in one business segment, which is the development and commercialization of pharmaceutical products for people living with central nervous system disorders.

Recent Accounting Pronouncements

In April 2014, the Financial Accounting Standards Board (FASB) issued an accounting update that raises the threshold for disposals to qualify as discontinued operations and allows companies to have significant continuing involvement with and continuing cash flows from or to the discontinued operations. This accounting update also requires additional disclosures for discontinued operations and new disclosures for individually material disposal transactions that do not meet the definition of a discontinued operation. This guidance was effective for fiscal years beginning after December 15, 2014, with early adoption permitted. The Company adopted the guidance in the first quarter of 2015.

In May 2014, the FASB issued new accounting guidance related to revenue recognition. This new standard will replace all current GAAP guidance on this topic and eliminate all industry-specific guidance. The new revenue recognition standard provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration for which the entity expects to be entitled in exchange for those goods or services. This guidance will be effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period, and can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. On July 9, 2015, the FASB deferred the effective date of this standards update to fiscal years beginning after December 15, 2017, with early adoption permitted on the original effective date of fiscal years beginning after December 15, 2016. The Company is evaluating the transition method, timing and impact of adopting this new accounting standard on its financial statements and related disclosures.

In August 2014, the FASB issued guidance which requires management to assess an entity’s ability to continue as a going concern and to provide related disclosures in certain circumstances. Under the new guidance, disclosures are required when conditions give rise to substantial doubt about an entity’s ability to continue as a going concern within one year from the financial statement issuance date. The guidance is effective for annual periods ending after December 15, 2016, and all annual and interim periods thereafter. Early application is permitted. The Company is evaluating the timing and impact of adopting this new accounting standard on its financial statements and related disclosures and does not expect that the adoption of the guidance will have a material impact on the Company’s financial statements.

In April 2015, the FASB issued guidance which requires debt issuance costs related to a recognized debt liability to be presented on the balance sheet as a direct deduction from the debt liability instead of as an asset. The guidance is effective for annual and interim reporting periods beginning on or after December 15, 2016. Early adoption is permitted. The Company is evaluating the timing and impact of adopting this new accounting standard on its financial statements and related disclosures and does not expect that the adoption of the guidance will have a material impact on the Company’s financial statements.

In July 2015, the FASB issued guidance which requires that certain inventory, including inventory measured using the first-in-first-out method, be measured at the lower of cost or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years.

The Company is currently evaluating the timing and impact of adopting this new accounting standard on its financial statements and related disclosures.