NOTE

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying interim condensed consolidated financial statements have been prepared in accordance with the accounting principles generally accepted in the United States of America (“GAAP”) and with the instructions for Form

-Q and Regulation S-

Accordingly, they do

not

include all of the information and notes required for complete financial statements. These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company

’s Form

-K filed with the Securities and Exchange Commission (“SEC”) on

March 23, 2017.

The unaudited condensed consolidated financial statements include the accounts of the Company and its consolidated subsidiaries, as applicable.

All intercompany accounts and transactions have been eliminated in consolidation.

Reclassifications

Prior period amounts in the accompanying consolidated balance sheets have been reclassified to conform to current period presentation. The reclassifications did

not

change total assets, total liabilities, or total stockholders

’ equity. Prior period amounts in the accompanying consolidated statements of operations and comprehensive loss have also been reclassified to conform to current period presentation. The reclassifications did

not

change the net loss or loss per share.

Additionally,

prior period amounts in the accompanying consolidated statements of cash flow have also been reclassified to conform to current period presentation. The reclassifications did

not

change net cash used in operating activities, net cash used in investing activities, or net cash provided by financing activities.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, DermaBay, Inc., as applicable. DermaBay, Inc. was dissolved by the Company in

April 2016.

All inter-company accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates include useful lives for property and equipment and related depreciation calculations, estimated amortization periods for payments received from product development and license agreements as they relate to revenue recognition, assumptions for valuing options and warrants, and income taxes. Actual results could differ from those estimates.

Unaudited Interim Financial Information

The accompanying interim condensed consolidated financial statements and related disclosures are unaudited, have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for a fair statement of the results of operations for the periods presented.

The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does

not

include all disclosures required by GAAP. The condensed consolidated results of operations for any interim period are

not

necessarily indicative of the results to be expected for the full year or for any other future year or interim period.

Cash and Cash Equivalents

The Company considers all highly-liquid instruments with a stated maturity of

three

months or less at the date of purchase to be cash equivalents. Cash and cash equivalents are stated at cost, which app

roximates fair value. As of

September 30, 2017,

and

December 31, 2016,

the Company’s cash and cash equivalents were held in

two

highly-rated, major financial institutions in the United States.

Concentrations of Credit Risk and Major Partners

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash and cash equivalents. The Company maintains deposits of

cash and cash equivalents with

two

highly-rated, major financial institutions in the United States.

Deposits in these banks

may

exceed the amount of federal insurance provided on such deposits. The Company does

not

believe it is exposed to significant credit risk due to the financial position of the financial institutions in which these deposits are held.

During the

nine

months ended

September 30, 2017

and

2016,

revenues were derived primarily from sales of Avenova directly to doctors through the Company’s webstore and to

three

major distribution partners.

During the

three

months and

nine

months ended

September 30, 2017

and

2016,

revenues from our major distribution or collaboration partners greater than

10%

were as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
Major distribution or collaboration partner	2017			2016			2017			2016
Distributer A		25	%		21	%		24	%		18	%
Distributer B		24	%		21	%		24	%		19	%
Distributer C		23	%		16	%		21	%		15	%

As of

September

30,

2017

and

December 31, 2016,

accounts receivable from our major distribution partners greater than

10%

were as follows:

Major distribution partner	September 30, 2017			December 31, 2016
Distributer A		30	%		22	%
Distributer B		22	%		24	%
Distributer C		31	%		31	%

The Company relies on

two

contract sole source manufacturers to produce its finished goods. The Company does

not

have any manufacturing facilities and intends to continue to rely on

third

parties for the supply of finished goods. Third party manufacturers

may

not

be able to meet the Company

’s needs with respect to timing, quantity or quality.

Fair Value of Financial Assets and Liabilities

Financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities are carried at cost, which management believes approximates fair value due to the short-term nature of these instruments. Our warrant liability is carried at fair value.

The Company measures the fair value of financial assets and liabilities based on GAAP guidance, which defines fair value, establishes a framework for measuring fair value, and requires disclosures

about fair value measurements.

Under GAAP, fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy is also established, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs

when measuring fair value. There are

three

levels of inputs that

may

be used to measure fair value:

Level

– quoted prices in active markets for identical assets or liabilities;

Level

– quoted prices for similar assets and liabilities in active markets or inputs that are observable; and

Level

– inputs that are unobservable (for example, cash flow modeling inputs based on assumptions).

Allowance for Doubtful Accounts

The Company charges bad debt expense and records an allowance for doubtful accounts when management believes it to be unlikely that specific invoices will be collected. Management identifies amounts due that are in dispute and it believes are unli

kely to be collected. As of

September 30, 2017

and

December 31, 2016,

management reserved

$28

thousand and

$10

thousand, respectively, primarily based on specific amounts that were in dispute and were over

120

days past due at those dates.

Inventory

Inventory is comprised of

(

) raw materials and supplies, such as bottles, packaging materials, labels, boxes, pumps; (

) goods in progress, which are normally unlabeled bottles; and (

) finished goods. We utilize contract manufacturers to produce our products and the cost associated with manufacturing is included in inventory. At

September 30, 2017

and

December 31, 2016,

management had recorded an allowance for excess and obsolete inventory and lower of cost or estimated net realizable value adjustments of

$139

thousand and

$196

thousand, respectively.

Inventory is stated at the lower of cost or estimated net realizable value determined by the

first

-in,

first

-out method.

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the related assets of

five

seven

years for office and laboratory equipment,

three

years for computer equipment and software and

seven

years for furniture and fixtures. Leasehold improvements are depreciated over the shorter of

seven

years or the lease term.

The costs of normal maintenance, repairs, and minor replacements are charged to operations when incurred.

Impairment of Long-Lived Assets

The Company accounts for long-lived assets in accordance with GAAP, which requires that companies consider whether events or changes in facts and circumstances, both internally and externally,

may

indicate that an impairment of long-lived assets held for use are present. Management periodically evaluates the carrying value of long-lived assets. During the

first

quarter of fiscal year

2016,

the Company impaired a note receivable which was deemed to

longer be collectable, as the originator of the loan is

not

in business and the collateral held against the loan did

not

possess value in an amount sufficient to satisfy the loan. As a result, a

$91

thousand impairment charge was recorded to research and de

velopment expense during the

nine

months ended

September 30, 2016.

There were

impairment charges during the

nine

months ended

September 30, 2017.

Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are

not

expected to be sufficient to recover the carrying amount of the asset, the assets are written down to their estimated fair values and the loss is recognized in the statements of operations.

Comprehensive Income (Loss)

Accounting Standards Codification (“ASC”)

220,

Comprehensive Income

requires that an entity’s change in equity or net assets during a period from transactions and other events from non-owner sources be reported. The Company reports unrealized gains and losses on its available-for-sale securities as other comprehensive income (loss).

Revenue Recognition

The Company sells products through a limited number of distributors and via its webstore. The Company generally records product sales upon shipment to the final customer for its webstore sales and upon shipment from its distributor to the final customers for its major distribution partners.

The Company recognizes product revenue when: (i) persuasive evidence that a sale 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 customer has the right to return the product is recognized at the time of sale only if: (i) the Company

’s price to the customer is substantially fixed or determinable at the date of sale, (ii) the customer has paid the Company, or the customer is obligated to pay the Company and the obligation is

not

contingent on resale of the product, (iii) the customer's obligation to the Company would

not

be changed in the event of theft or physical destruction or damage of the product, (iv) the customer acquiring the product for resale has economic substance apart from that provided by the Company, (v) the Company does

not

have significant obligations for future performance to directly bring about resale of the product by the customer, and (vi) the amount of future returns can be reasonably estimated. If these factors were to vary, the resulting change could have a material effect on the Company’s revenue recognition and on the Company’s results of operations.

Product Revenue Allowances

Product revenue is recognized net of cash consideration paid to our customers and wholesalers, for services rendered by the wholesalers in accordance with the

wholesalers’ agreements, and include a fixed rate per prescription shipped and monthly program management and data fees. These services are

not

deemed sufficiently separable from the customers' purchase of the product; therefore, they are recorded as a reduction of revenue at the time of revenue recognition.

Other product revenue allowances include certain prompt pay discounts and allowances offered to our customers, program rebates and chargebacks. These product revenue allowances are recognized as a reduction of revenue or as a selling expense at the later of the date at which the related revenue is recognized or the date at which the allowance is offered. Calculating certain of these items involves estimates and judgments based on sales or invoice data, contractual terms, utilization rates, new information regarding changes in these programs

’ regulations and guidelines that would impact the amount of the actual rebates or chargebacks. We review the adequacy of product revenue allowances on a quarterly basis. Amounts accrued for product revenue allowances are adjusted when trends or significant events indicate that adjustment is appropriate and to reflect actual experience.

Other Revenue

License and collaboration revenue is primarily generated through agreements with strategic partners for the development and commercialization of the Company

’s product candidates. The terms of the agreements typically include non-refundable upfront fees, funding of research and development activities, and payments based upon achievement of certain milestones and royalties on net product sales. In accordance with authoritative guidance, the Company analyzes its multiple element arrangements to determine whether the elements can be separated. The Company performs its analysis at the inception of the arrangement and as each product or service is delivered. If a product or service is

not

separable, the combined deliverables are accounted for as a single unit of accounting, and revenue is recognized over the performance obligation period. The Company recognizes other revenue when the following criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred, and risk of loss has passed; the seller’s price to the buyer is fixed or determinable; and collectability is reasonably assured. If these factors were to vary, the resulting change could have a material effect on the Company’s revenue recognition and results of operations.

Cost of Goods Sold

Cost of goods sold includes

third

party manufacturing costs, shipping costs, and other costs of goods sold. Cost of goods sold also includes any necessary allowance for excess and obsolete inventory along with lower of cost and estimated net realizable value.

Research and Development Costs

The Company charges research and development costs to expense as incurred. These costs include salaries and benefits for research and development personnel, costs associated with clinical trials managed by contract research organizations, and other costs associated with research, development and regulatory activities. Research and development costs

may

vary depending on the type of item or service incurred, location of performance or production, level of availability of the item or service, and specificity required in production for certain compounds. The Company uses external service providers to conduct clinical trials, to manufacture supplies of product candidates and to provide various other research and development-related products and services. The Company

’s research, clinical and development activities are often performed under agreements it enters with external service providers. The Company estimates and accrues the costs incurred under these agreements based on factors such as milestones achieved, patient enrollment, estimates of work performed, and historical data for similar arrangements. As actual costs are incurred, the Company adjusts its accruals. Historically, the Company’s accruals have been consistent with management’s estimates and

material adjustments to research and development expenses have been recognized. Subsequent changes in estimates

may

result in a material change in the Company’s expenses, which could also materially affect its results of operations.

Patent Costs

Patent costs, including legal expenses, are expensed in the period in which they are incurred. Patent expenses are included in general and administrative expenses in the consolidated statements of operations and comprehensive loss.

Stock-Based Compensation

The Company accounts for stock-based compensation under the provisions of Accounting Standards Update (“ASU”)

No.

2014

12,

Compensation-Stock Compensation (Topic

718

)

. Under the fair value recognition provisions, stock-based compensation expense is measured at the grant date for all stock-based awards to employees and directors and is recognized as expense over the requisite service period, which is generally the vesting period. Forfeitures are estimated at the time of grant and reduce compensation expense ratably over the vesting period. This estimate is adjusted periodically based on the extent to which actual forfeitures (Equity-Based Compensation) differ, or are expected to differ, from the previous estimate. See Note

of the Notes to Consolidated Financial Statements for further information regarding stock-based compensation expense and the assumptions used in estimating that expense. For stock options granted to employees, the fair value of the stock options is estimated using a Black-Scholes-Merton option pricing model.

Stock-based compensation arrangements with non-employees are recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest. Non-employee stock-based compensation charges are amortized over the vesting period on a straight-line basis. For stock options granted to non-employees, the fair value of the stock options is estimated using a Black-Scholes-Merton option pricing model.

Income Taxes

The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recognized if it is more likely than

not

that some portion or the entire deferred tax asset will

not

be recognized.

Common Stock Warrant Liability

For warrants that are issued or modified and there is a deemed possibility that the Company

may

have to settle the warrants in cash, or for warrants the Company issues or modifies that contain an exercise price adjustment feature that reduces the exercise price of the Company

’s common stock eligible for purchase thereunder in the event that the Company subsequently issues equity instruments at a price lower than the exercise price of the warrants, the Company records the fair value of the issued or modified warrants as a liability at each balance sheet date and records changes in the estimated fair value as a non-cash gain or loss on the consolidated statements of operations and comprehensive loss. The fair values of these warrants have been determined using the Binomial Lattice (“Lattice”) valuation model, which provides for assumptions regarding volatility, call and put features and risk-free interest rates within the total period to maturity. These values are subject to a significant degree of the Company’s judgment. For additional information regarding the Company’s outstanding warrants, see Note

of the Notes to Consolidated Financial Statements (Warrant Liability).

Net (Loss) per Share

The Company computes net (loss) per share by presenting both basic and diluted (loss) per share (“EPS”).

Basic EPS is computed by dividing net (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period, including stock options and warrants, using the treasury stock method, using the if-converted method. In computing diluted EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Potentially dilutive common share equivalents are excluded from the diluted EPS computation in net loss periods since their effect would be anti-dilutive. During the

three

and

nine

months ended

September 30, 2017

and

2016,

there was

difference between basic and diluted EPS due to the Company’s net losses. The following table sets forth the calculation of basic EPS and diluted EPS:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands, except per share data)	2017			2016			2017			2016

Net loss	$	(2,447	)	$	(3,736	)	$	(8,196	)	$	(11,503	)

Basic Shares		15,324			10,913			15,306			7,481
Add: shares issued upon assumed exercise of stock options and warrants		—			—			—			—
Diluted shares		15,324			10,913			15,306			7,481

Basic and diluted net loss per share	$	(0.16	)	$	(0.34	)	$	(0.54	)	$	(1.54	)

The following outstanding stock options and stock warrants were excluded from the diluted net loss per share computation, as their effect would have been anti-dilutive:

	As of
	September 30,
(in thousands)	2017		2016
Period end stock options to purchase common stock		2,893		1,502
Period end common stock warrants		544		929
		3,437		2,431

Recent Accounting Pronouncements

May 2014,

the Financial Accounting Standards Board (“

FASB”) issued ASU

No.

2014

09,

Revenue from Contracts with Customers

(Topic

606

). In

August 2015

and

March,

April,

May

and

December 2016,

the FASB issued additional amendments to the new revenue guidance relating to reporting revenue on a gross versus net basis, identifying performance obligations, licensing arrangements, collectability, noncash consideration, presentation of sales tax, transition, and clarifying examples. This new standard will replace all current GAAP guidance on this topic and eliminate all industry-specific guidance. The new revenue recognition guidance provides a unified model to determine how revenue is recognized. The core principle of the guidance is that an entity should 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. In doing so, companies will need to use more judgment and make more estimates than under today’s guidance. These

may

include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price, and allocating the transaction price to each performance obligation. ASU

2014

as amended is effective for interim and annual reporting periods beginning after

December 15, 2017

, and permits companies to adopt the standard early. The Company plans to adopt the new standard effective

January 1, 2018

, with a modified retrospective transition applying the new guidance to the most current period presented with the cumulative effect of changes reflected in the opening balance of retained earnings in the most current period presented.

While the Company is still in the process of assessing the potential impact of this new standard on its consolidated financial statements, the Company has identified transactions which, under current guidance are recognized upon shipment from its distributor to the final customers for its major distribution partners will be recognized upon transfer of control to its major distribution partners at the amount of consideration that the Company expects to be entitled to. As a result, the Company will record contract liabilities for the invoiced amounts that are estimated to be subject to significant reversal, including product revenue allowances for cash consideration paid to customers for services, discounts, rebate programs, chargebacks, and product returns. The constraint on variable consideration for product returns will be a new estimation resulting from the earlier recognition under the new guidance.

The Company has identified license and collaboration reve

nue

for which contract deliverables are currently accounted for as a combined unit of accounting because products or services are

not

separable

. Under the new guidance, the Company has identified separate performance obligations that are capable of being distinct. As a result, the transaction price under these arrangements, including upfront fees and milestone payments,

will be allocated differently to

each performance

obligation and

may

be recognized at earlier points in time or with a different pattern of performance over time.

The Company identified the following performance obligations in its preliminary review of the license and collaboration agreements:

●

Exclusive distribution rights in the product territory

●

Regulatory submission and approval services

●

Development services

●

Sample supply, free of charge

●

Incremental discounts and product supply prepayments representing a material right to the customer

The Company has found that based upon the relative estimated selling prices of each performance obligation, the licenses typically makes up the majority of the transaction price allocation for each

contract. Because the licenses have been classified under the new guidance as “right to use,” for which the customers right to the intellectual property is transferred at a point in time, under the new rules the revenue for each license will be considered recognized at contract inception. Based on these findings, the Company estimates a significant majority of the current deferred revenue balance related to its license and collaboration agreements will be allocated to performance obligations that were satisfied in periods prior to adoption and included in the cumulative adjustment to retained earnings upon adoption.

The Company is still evaluating its major distribution agreements and its license and collaboration agreements and assessing the impact of adoption of the new standard to its consolidated financial statements. The Company will continue to monitor additional modifications, clarifications or interpretations undertaken by the FASB that

may

impact its current conclusions, and will expand its analysis to include any new or modified revenue arrangements prior to adoption. The Company expects to complete such efforts by the

fourth

quarter of

2017.

August 2014,

FASB issued ASU

2014

15,

Presentation of Financial Statements

–

Going Concern (Subtopic

205

): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern

. This new standard provides guidance around management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosure if substantial doubt exists. The new standard is effective for annual periods ending after

December 15, 2016

and for annual periods and interim periods thereafter. Early adoption is permitted. The Company previously adopted ASU

2014

15.

For adoption impact, see Note

to the financial statements under “

Liquidity.

”

July 2015,

the FASB issued ASU

No.

2015

11,

Inventory (Topic

330

): Simplifying the Measurement of Inventory

, which changes the measurement principle for inventory from the lower of cost or market to the lower of cost and net realizable value. ASU

No.

2015

defines net realizable value as estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The new guidance must be applied on a prospective basis and was effective for the Company in the

first

quarter of fiscal year

2017.

The adoption and implementation of ASU

2015

did

not

result in a material impact to the Company’s consolidated financial statements.

January 2016,

the FASB issued ASU

2016

01,

Financial Instruments – Overall (Subtopic

825

)

Recognition and Measurement of Financial Assets and Financial Liabilities

, which provides guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. This guidance will be effective for the Company beginning in the

first

quarter of fiscal year

2018.

The Company is evaluating the effects of the adoption of this guidance to its consolidated financial statements.

February 2016,

the FASB issued ASU

2016

02,

Leases (Topic

842

)

, which supersedes the lease accounting requirements in

Leases (Topic

840

)

. ASU

2016

requires a dual approach for lessee accounting under which a lessee would account for leases as finance leases or operating leases. Both finance leases and operating leases will result in the lessee recognizing a right-of-use asset and a corresponding lease liability. For finance leases, the lessee would recognize interest expense and amortization of the right-of-use asset, and for operating leases, the lessee would recognize a straight-line total lease expense. The guidance also requires qualitative and specific quantitative disclosures to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities, including significant judgments and changes in judgments. This guidance is effective beginning in the

first

quarter of fiscal year

2019.

The Company is evaluating the effects of the adoption of this guidance on its consolidated financial statements.

March 2016,

the FASB issued ASU

2016

09,

Compensation – Stock Compensation (Topic

718

): Improvements to Employee Share-Based Payment Accounting,

which is intended to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This guidance was effective beginning in the

first

quarter of fiscal year

2017.

The adoption and implementation of ASU

2016

did

not

result in a material impact to the Company’s consolidated financial statements.

August 2016,

the FASB issued ASU

2016

15,

Classification of Certain Cash Receipts and Cash Payments (Topic

230

which addresses

eight

specific issues regarding the treatment of cash flow. This update is effective for the Company for its fiscal year

2018.

The Company is currently evaluating the effects of the adoption of ASU

2016

to its consolidated financial statements.

November 2016,

the FASB issued ASU

2016

18,

Statement of Cash Flows (Topic

230

that will require entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. This update is effective for the Company for its fiscal year

2018.

The Company is currently evaluating the effects of the adoption of ASU

2016

to its consolidated financial statements.

July 2017,

the FASB issued ASU

2017

11,

Earnings Per Share (Topic

260

), Distinguishing Liabilities from Equity (Topic

480

), Derivatives and Hedging (Topic

815

): I. Accounting for Certain Financial Instruments with Down Round Features and II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception

Part I applies to entities that issue financial instruments such as warrants, convertible debt or convertible preferred stock that contain down round features. Part II simply replaces the indefinite deferral for certain mandatorily redeemable noncontrolling interests and mandatorily redeemable financial instruments of nonpublic entities contained within Accounting Standards Codification (ASC) Topic

480

with a scope exception and does

not

impact the accounting for these mandatorily redeemable instruments. This ASU is effective for public companies for the annual reporting periods beginning after

December 15, 2018,

and interim periods within those annual periods. Early adoption is permitted. The Company is currently evaluating the effects of the adoption of ASU

2017

to its consolidated financial statements.