Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The Company’s accompanying unaudited condensed consolidated financial statements have been prepared in accordance with GAAP for interim financial information. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations of the Company and its subsidiaries, have been included. Interim financial results are not necessarily indicative of the results that may be expected for the full year. These financial statements should be read in conjunction with the consolidated financial statements and notes therein included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 filed on February 28, 2017.

The accompanying condensed consolidated financial statements include Ligand and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation

Upon the occurrence of certain circumstances, holders of the 2019 Convertible Senior Notes may redeem all or a portion of their notes, which may require the use of a substantial amount of cash. At March 31, 2017, we had a working capital deficit of $52.3 million, which includes the 2019 Convertible Senior Notes that are currently redeemable as of March 31, 2017 but excludes another $26.9 million that is classified as mezzanine equity. As noted in Note 3, the debt may change from current to non-current period over period, primarily as a result of changes in the Company’s stock price. Management believes that it is remote that holders of the notes would choose to convert their notes early because the fair value of the security that a noteholder can currently realize in an active market is greater than the conversion value the noteholder would realize upon early conversion. In the unlikely event that all the debt was converted, we have three business days following a 50 trading day observation period from the conversion date to pay the principal in cash. We have positive operating income and positive cash flow from operations since December 31, 2013 and, accordingly, while there can be no assurance, we believe we have the ability to raise additional capital through an S-3 registration or via alternative financing arrangements such as convertible or straight debt.

Significant Accounting Policies

The Company describes its significant accounting policies in Note 1 to the financial statements in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2016.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and the accompanying notes. Actual results may differ from those estimates.

Accounting Pronouncements Recently Adopted

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which is intended to simplify several aspects of the accounting for stock-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The Company adopted ASU 2016-09 in the first quarter of fiscal year 2017. As a result of the adoption, the Company recorded a $17.9 million cumulative-effect adjustment to retained earnings for the recognition of excess tax benefits generated by the settlement of stock-based awards in prior periods and a discrete income tax benefit of $0.9 million to the income tax provision for excess tax benefits generated by the settlement, in the first quarter of fiscal year 2017, of stock-based awards. As allowed by the new guidance, the Company has elected to account for equity award forfeitures as they occur, and recorded a $0.3 million cumulative-effect adjustment to retained earnings for this accounting change in prior periods.

Recent Accounting Pronouncements

In May 2014, the FASB issued new guidance related to revenue recognition, ASU 2014-09, Revenue from Contracts with Customers (“ASC 606”), which outlines a comprehensive revenue recognition model and supersedes most current revenue recognition guidance. The new guidance requires a company to recognize revenue upon transfer of goods or services to a customer at an amount that reflects the expected consideration to be received in exchange for those goods or services. ASC 606 defines a five-step approach for recognizing revenue, which may require a company to use more judgment and make more estimates than under the current guidance. Two methods of adoption are permitted: (a) full retrospective adoption, meaning the standard is applied to all periods presented; or (b) modified retrospective adoption, meaning the cumulative effect of applying the new guidance is recognized at the date of initial application as an adjustment to the opening retained earnings balance.

We are undertaking a substantial effort to be ready for adoption of ASC 606. Some of our contracts have distinct terms which will need to be evaluated separately. Although we have not completed our assessment and are in the process of reviewing our contracts, we anticipate that this standard will have a material impact on our consolidated financial statements by accelerating the timing of revenue recognition for revenues related to royalties, and potentially certain contingent milestone based payments. We intend to adopt ASC 606 starting as of January 1, 2018 using the modified retrospective method.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 modifies certain aspects of the recognition, measurement, presentation, and disclosure of financial instruments. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, and early adoption is permitted. We do not expect the adoption of this standard to have a material impact on our financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This new standard will make eight targeted changes to how cash receipts and cash payments are presented and classified in the statement of cash flows. The standard is effective for us in the first quarter of 2018. The standard will require adoption on a retrospective basis unless it is impracticable to apply, in which case we would be required to apply the amendments prospectively as of the earliest date practicable. We are currently evaluating the impact of our pending adoption of ASU 2016-15 on our consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805), Clarifying the Definition of a Business, which changes the definition of a business to assist entities with evaluating when a set of assets acquired or disposed of should be considered a business. The new standard requires an entity to evaluate if substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets; if so, the set would not be considered a business. The new standard also requires a business to include at least one substantive process and narrows the definition of outputs. We expect that these provisions will reduce the number of transactions that will be considered a business. The new standard is effective for interim and annual periods beginning on January 1, 2018, and may be adopted earlier. The standard would be applied prospectively to any transaction occurring on or after the adoption date. We are currently evaluating the impact that this new standard will have on our consolidated financial statements.

Short-term Investments

The Company's investments consist of the following at March 31, 2017 and December 31, 2016 (in thousands):



	March 31, 2017									December 31, 2016
	Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value		Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value

Short-term investments
Bank deposits	$	61,605	$	23	$	(10	)	$	61,618	$	40,715	$	19	$	—		$	40,734
Corporate bonds	32,237		2		(17		)	32,222		11,031		—		(5		)	11,026
Commercial paper	23,328		1		(5		)	23,324		33,074		2		(9		)	33,067
Agency bonds	—		—		—			—		7,294		1		—			7,295
U.S Government Bonds	11,020		—		(6		)	11,014		7,508		—		(1		)	7,507
Municipal Bonds	18,143		2		(1		)	18,144		19,624		—		(11		)	19,613
Corporate equity securities	300		2,111		—			2,411		1,512		1,542		—			3,054
	$	146,633	$	2,139	$	(39	)	$	148,733	$	120,758	$	1,564	$	(26	)	$	122,296

Inventory

Inventory, which consists of finished goods, is stated at the lower of cost or market value. The Company determines cost using the first-in, first-out method.

Goodwill and Other Identifiable Intangible Assets

Goodwill and other identifiable intangible assets consist of the following (in thousands):



	March 31,			December 31,
	2017			2016
Indefinite lived intangible assets
IPR&D	$	12,246		$	12,246
Goodwill	72,207			72,207
Definite lived intangible assets
Complete technology	182,577			182,577
Less: Accumulated amortization	(15,104		)	(12,792		)
Trade name	2,642			2,642
Less: Accumulated amortization	(817		)	(784		)
Customer relationships	29,600			29,600
Less: Accumulated amortization	(9,154		)	(8,784		)
Total goodwill and other identifiable intangible assets, net	$	274,197		$	276,912

Commercial License Rights

Commercial License Rights consist of the following (in thousands):



	March 31,			December 31,
	2017			2016
CorMatrix	$	17,696		$	17,696
Selexis	8,602			8,602
	26,298			26,298
Less: accumulated amortization	(668		)	(477		)
Total commercial license rights, net	$	25,630		$	25,821

Equity-Method Investment

The Company has approximately 26.3% equity ownership in Viking as of March 31, 2017. The Company records its investment in Viking under the equity method of accounting. The investment is subsequently adjusted for the Company’s share of Viking's operating results, and if applicable, cash contributions and distributions. As of March 31, 2017 and December 31, 2016, the carrying amounts of the Company's investment in Viking were $7.3 million and $8.3 million, respectively. The market value of the Company's equity investment in Viking was $9.2 million as of March 31, 2017. The Company also has outstanding warrants to purchase 1.5 million shares of Viking's common stock at an exercise price of $1.50 per share at March 31, 2017. The Company recorded the warrants at the fair value of $0.8 million and $0.7 million at March 31, 2017 and December 31, 2016, respectively. See Note 2 Fair Value Measurement for details.

In addition, the Company currently has an active MLA with Viking, under which the Company licensed Viking the rights to five programs. The Company is entitled to receive contingent event-based payments and royalties from Viking based on the progression and eventual sale of any products being developed by Viking under the MLA. No such payment was earned or recognized during three months ended March 31, 2017 and 2016.

The Company also has a convertible note receivable from Viking under the LSA. Under the terms of the LSA, the principal amount outstanding accrues interest at a fixed rate of 2.5% with maturity date of May 21, 2017. On May 8, 2017, the Company entered into an amendment to the LSA, which amends to, among other things, (i) extend the maturity date of the outstanding convertible notes receivable under the LSA from May 21, 2017 to May 21, 2018 and (ii) cause Viking to pay to the Company, no later than July 15, 2017, a cash amount of $0.2 million, which payment shall reduce first the accrued and unpaid interest and second the unpaid principal amount on the Viking Note by $0.50 for each $1.00 of value. The Company elected to record the convertible notes at fair value, which was $3.2 million at March 31, 2017 and December 31, 2016. See Note 2 Fair Value Measurement for details.

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):



	March 31,		December 31,
	2017		2016
Compensation	$	1,356	$	2,603
Professional fees	799		829
Amounts owed to former licensees	890		899
Royalties owed to third parties	989		942
Other	646		1,124
Total accrued liabilities	$	4,680	$	6,397

Stock-Based Compensation

Stock-based compensation expense for awards to employees and non-employee directors is recognized on a straight-line basis over the vesting period until the last tranche vests. The following table summarizes stock-based compensation expense recorded as components of research and development expenses and general and administrative expenses for the periods indicated (in thousands):



	Three months ended
	March 31,
	2017		2016
Stock-based compensation expense as a component of:
Research and development expenses	$	3,939	$	1,585
General and administrative expenses	2,106		2,533
	$	6,045	$	4,118

The fair-value for options that were awarded to employees and directors was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions:



	Three months ended
	March 31,
	2017	2016
Risk-free interest rate	2.1%	1.5%
Dividend yield	—	—
Expected volatility	47%	50%
Expected term	6.9	6.6

Lease Obligations

The Company describes its operating lease obligations in Note 5 to the financial statements in Item 8 of its Annual Report on Form 10-K for the year ended December 31, 2016. There were no significant changes in the Company's operating lease commitments during the first three months of 2017.

Convertible Debt

In August 2014, the Company completed a $245.0 million offering of 2019 Convertible Senior Notes, which bear interest at 0.75%. The Company accounted for the 2019 Convertible Senior Notes by separating the liability and equity components of the instrument in a manner that reflects the Company's nonconvertible debt borrowing rate. As a result, the Company assigned a value to the debt component of the 2019 Convertible Senior Notes equal to the estimated fair value of similar debt instruments without the conversion feature, which resulted in the Company recording the debt instrument at a discount. The Company is amortizing the debt discount over the life of the 2019 Convertible Senior Notes as additional non-cash interest expense utilizing the effective interest method.

Upon the occurrence of certain circumstances, holders of the 2019 Convertible Senior Notes may redeem all or a portion of their notes, which may require the use of a substantial amount of cash. At March 31, 2017, we had a working capital deficit of $52.3 million, which includes the 2019 Convertible Senior notes that are currently redeemable as of March 31, 2017 but excludes another $26.9 million that is classified as mezzanine equity. As noted in Note 3, the debt may change from current to non-current period over period, primarily as a result of changes in the Company’s stock price. Management believes that it is remote that holders of the notes would choose to convert their notes early because the fair value of the security that a noteholder can currently realize in an active market is greater than the conversion value the noteholder would realize upon early conversion. In the unlikely event that all the debt was converted, we have three business days following a 50 trading day observation period from the convert date to pay the principal in cash. We have positive operating income and positive cash flow from operations since December 31, 2013 and, accordingly, while there can be no assurance, we believe we have the ability to raise additional capital through an S-3 registration or via alternative financing arrangements such as convertible or straight debt.

Income Per Share

Basic income per share is calculated by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted income 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 2019 Convertible Senior Notes, stock options and restricted stock. The 2019 Convertible Senior Notes have a dilutive impact when the average market price of the Company’s common stock exceeds the applicable conversion price of the notes. Potentially dilutive common shares from stock options and restricted stock are determined using the average share price for each period under the treasury stock method. In addition, proceeds from exercise of stock options and the average amount of unrecognized compensation expense for restricted stock are assumed to be used to repurchase shares. In loss periods, basic net loss per share and diluted net loss per share are identical because the otherwise dilutive potential common shares become anti-dilutive and are therefore excluded.

The following table presents the calculation of weighted average shares used to calculate basic and diluted earnings per share:



	Three months ended
	March 31,
	2017	2016
Weighted average shares outstanding:	20,937,627	20,707,926
Dilutive potential common shares:
Restricted stock	185,745	66,736
Stock options	954,509	759,581
2019 Convertible Senior Notes	941,308	749,736
Shares used to compute diluted income per share	23,019,189	22,283,979
Potentially dilutive shares excluded from calculation due to anti-dilutive effect	3,711,067	3,493,425