INSPIRE MEDICAL SYSTEMS, INC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes to those statements included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Some of the numbers included herein have been rounded for the convenience of presentation. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under Part I. "Item 1A. Risk Factors'' and elsewhere in this Annual Report on Form 10-K. Overview We are a medical technology company focused on the development and commercialization of innovative and minimally invasive solutions for patients with OSA. Our proprietary Inspire system is the first and only FDA-approved neurostimulation technology that provides a safe and effective treatment for moderate to severe OSA. We have developed a novel, closed-loop solution that continuously monitors a patient's breathing and delivers mild hypoglossal nerve stimulation to maintain an open airway. Inspire therapy is indicated for patients with moderate to severe OSA who do not have significant central sleep apnea and do not have a complete concentric collapse of the airway at the soft palate level. In addition, patients in theU.S. must have been confirmed to fail or be unable to tolerate positive airway pressure treatments, such as CPAP, and be 22 years of age or older, though there are no similar requirements for patients inEurope . We sell our Inspire system to hospitals and ASCs in theU.S. and in select countries inEurope through a direct sales organization. Our direct sales force engages in sales efforts and promotional activities focused on ENT physicians and sleep centers. In addition, we highlight our compelling clinical data and value proposition to increase awareness and adoption amongst referring physicians. We build upon this top-down approach with strong direct-to-patient marketing initiatives to create awareness of the benefits of our Inspire system and drive demand through patient empowerment. This outreach helps to educate thousands of patients on our Inspire therapy and frequently results in patient leads. We increased the number of employees in our sales, marketing, and reimbursement organizations from 40 as ofDecember 31, 2015 to 186 as ofDecember 31, 2019 . Although our sales and marketing efforts are directed at patients and physicians because they are the primary users of our technology, we consider the hospitals and ASCs where the procedure is performed to be our customers, as they are the purchasing agents of our Inspire system. Our customers are reimbursed the cost required to treat each patient through various third-party payors, such as commercial payors and government agencies. Our Inspire system is currently reimbursed primarily on a per-patient prior authorization basis for patients covered by commercial payors, on a case-by-case basis for patients covered by Medicare, and underU.S. government contract for patients who are treated by theVeterans Health Administration . To date, more than 430 commercial payors have prior authorized for patients' treatment with our Inspire therapy. We have currently secured positive coverage policies with 52 U.S. commercial payors, including most large national commercial insurers. InJune 2018 ,Japan's Ministry of Health, Labour and Welfare approved our Inspire therapy to treat 79 -------------------------------------------------------------------------------- Table of Contents moderate to severe OSA, and we are currently seeking reimbursement coverage inJapan . For the year endedDecember 31, 2019 , 89.8% of our revenue was derived in theU.S. and 10.2% was derived inEurope . No single customer accounted for more than 10% of our revenue. We rely on third-party suppliers to manufacture our Inspire system and its components. Many of these suppliers are currently single source suppliers. We seek to maintain higher levels of inventory to protect ourselves from supply interruptions, and, as a result, we are subject to the risk of inventory obsolescence and expiration, which could lead to inventory impairment charges. In theU.S. , our products are shipped directly to our customers on a purchase order basis, primarily by a third-party vendor with a facility inTennessee , although we do ship some products from our facility inMinnesota . Warehousing and shipping operations for our European customers are handled by a third-party vendor with facilities located inthe Netherlands . Customers do not have the right to return non-defective product, nor do we place product on consignment. Our sales representatives do not maintain trunk stock. Since our inception in 2007, we have financed our operations primarily through sales of our Inspire system, private placements of our convertible preferred securities, amounts borrowed under our credit facility, the initial public offering of our common stock that closed inMay 2018 (our "IPO"), and the offering of our common stock that closed inDecember 2018 (our "follow-on offering"). We have devoted significant resources to research and development activities related to our Inspire system, including clinical and regulatory initiatives to obtain marketing approval, and sales and marketing activities. For the year endedDecember 31, 2019 , we generated revenue of$82.1 million with a gross margin of 83.4% and a net loss of$33.2 million compared to revenue of$50.6 million with a gross margin of 80.1% and a net loss of$21.8 million for the year endedDecember 31, 2018 , and revenue of$28.6 million with a gross margin of 78.9% and a net loss of$17.5 million for the year endedDecember 31, 2017 . Our accumulated deficit as ofDecember 31, 2019 was$180.2 million . We have invested heavily in product development. Our research and development activities have been centered on driving continuous improvements to our Inspire therapy. We have also made significant investments in clinical studies to demonstrate the safety and efficacy of our Inspire therapy and to support regulatory submissions. We intend to make significant investments building our sales and marketing organization by increasing the number ofU.S. sales representatives and continuing our direct-to-patient marketing efforts in existing and new markets throughout theU.S. and inEurope . We also intend to continue to make investments in research and development efforts to develop our next generation Inspire systems and support our future regulatory submissions for expanded indications and for new markets such asEurope ,Japan , andAustralia . Because of these and other factors, we expect to continue to incur net losses for the next several years and we expect to require substantial additional funding, which may include future equity and debt financings. OnMay 7, 2018 , we completed our IPO by issuing 7,762,500 shares of common stock, at a public offering price of$16.00 per share, for net proceeds of approximately$112.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. OnDecember 11, 2018 , we completed the follow-on offering that included our offer and sale of 1,875,000 shares of common stock and the selling stockholders' offer and sale of 1,000,000 shares of common stock, at a public offering price of$40.00 per share. We received net proceeds of approximately$69.8 million after deducting underwriting discounts and commissions and offering expenses. We received no proceeds from the sale of our common stock by the selling shareholders. Components of Our Results of Operations Revenue We derive primarily all of our revenue from the sale of our Inspire system to hospitals and ambulatory service centers in theU.S. and select countries inEurope . Recent revenue growth has been driven by, and we expect continued growth as a result of, increased patient and physician awareness of the Inspire system, additional sales representatives, an increase in approvals of prior authorization submissions, and additional positive coverage policies. Any reversal in these recent trends, however, could have a negative impact on our future revenue. In addition, we have expanded our sales and marketing organization to help us drive and support revenue growth and intend to continue this expansion. Moreover, we expect that our revenue growth will be positively impacted by, and to the extent we obtain, additional positive coverage policies. Our revenue has fluctuated, and we expect 80 -------------------------------------------------------------------------------- Table of Contents our revenue to continue to fluctuate, from quarter to quarter due to a variety of factors. For example, we have historically experienced seasonality in our first and fourth quarters. Cost of Goods Sold and Gross Margin Cost of goods sold consists primarily of acquisition costs for the components of the Inspire system, overhead costs, scrap, and inventory obsolescence, as well as distribution-related expenses such as logistics and shipping costs, net of costs charged to customers. The overhead costs include the cost of material procurement, depreciation expense for production equipment, warranty replacement costs, and operations supervision and management personnel, including employee compensation, stock-based compensation, supplies, and travel. We expect overhead costs as a percentage of revenue to continue to decrease as our sales volume increases. We expect cost of goods sold to increase in absolute dollars primarily as, and to the extent, our revenue grows. We calculate gross margin as gross profit divided by revenue. Our gross margin has been and we expect it will continue to be affected by a variety of factors, including manufacturing costs, the average selling price of our Inspire system, the implementation of cost-reduction strategies, inventory obsolescence costs, which generally occur when new generations of our Inspire system are introduced, and to a lesser extent the sales mix between theU.S. andEurope as our average selling price in theU.S. tends to be higher than inEurope . Our gross margin may increase over the long term to the extent our production volumes increase and we receive discounts on the costs charged by our contract manufacturers, thereby reducing our per unit costs. However, our gross margin may fluctuate from quarter to quarter due to seasonality. Research and Development Expenses Research and development expenses consist primarily of product development, engineering, clinical studies to develop and support our products, regulatory expenses, testing, consulting services and other costs associated with the next generation versions of the Inspire system. These expenses include employee compensation, including stock-based compensation, supplies, materials, consulting, and travel expenses related to research and development programs. Additionally, these expenses include clinical trial management, payments to clinical investigators, data management and travel expenses for our various clinical trials. We expect research and development expenses to increase in the future as we develop next generation versions of our Inspire system and continue to expand our clinical studies to secure positive coverage policies from private commercial payors in theU.S. and enter into new markets including additional European countries,Japan , andAustralia . We expect research and development expenses as a percentage of revenue to vary over time depending on the level and timing of initiating new product development efforts and new clinical development activities. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of compensation for personnel, including base salaries, stock-based compensation expense and commissions related to our sales organization, finance, information technology, and human resource functions, as well as spending related to marketing, sales operations, and training and reimbursement personnel. Other selling, general and administrative expenses include training physicians, travel expenses, advertising, direct-to-patient promotional programs, conferences, trade shows and consulting services, professional services fees, audit fees, insurance costs and general corporate expenses, including facilities-related expenses. We expect selling, general and administrative expenses to continue to increase as we expand our commercial infrastructure to both drive and support our planned growth in revenue and as we increase our headcount and expand administrative personnel to support our growth and operations as a public company including finance personnel and information technology services. Additionally, we anticipate increased expenses related to audit, legal, and tax-related services associated with maintaining compliance with exchange listing andSEC requirements, director and officer insurance premiums and investor relations costs associated with being a public company. We also expect to see an increase in our stock-based compensation expense with grants of restricted stock or options and shares of our common stock purchased pursuant to our employee stock purchase plan. 81 -------------------------------------------------------------------------------- Table of Contents Other (Income) Expense, Net Other (income) expense, net consists primarily of interest expense payable under our credit facility and interest income. Other items include fair value adjustments related to convertible preferred stock warrants, which were accounted for as a liability and marked-to-market at each reporting period. Immediately prior to the closing of our IPO, our outstanding convertible preferred stock warrants automatically converted into warrants to purchase shares of our common stock. Results of Operations Year EndedDecember 31, 2019 Compared to Year EndedDecember 31, 2018 Year Ended December 31, Change 2019 2018 $ % (in thousands, except percentages) Revenue$ 82,050 $ 50,593 $ 31,457 62.2 % Cost of goods sold 13,643 10,056 3,587 35.7 % Gross profit 68,407 40,537 27,870 68.8 % Gross margin 83.4 % 80.1 % Operating expenses: Research and development 12,839 7,388 5,451 73.8 % Selling, general and administrative 90,465 53,527 36,938 69.0 % Total operating expenses 103,304 60,915 42,389 69.6 % Operating loss (34,897) (20,378) (14,519) 71.2 % Other (income) expense, net (1,694) 1,450 (3,144) (216.8) % Loss before income taxes (33,203) (21,828) (11,375) 52.1 % Income taxes 40 - 40 n/a Net loss$ (33,243) $ (21,828) $ (11,415) 52.3 % Revenue Revenue increased$31.5 million , or 62.2%, to$82.1 million for the year endedDecember 31, 2019 compared to the year endedDecember 31, 2018 . The increase was attributable to an increase in sales of our Inspire system of$29.3 million in theU.S. and an increase of$2.2 million inEurope , primarily inGermany . Revenue information by region is summarized as follows: Year Ended December 31, 2019 2018 Change Amount % of Revenue Amount % of Revenue $ % (in thousands, except percentages) United States$ 73,660 89.8 %$ 44,378 87.7 %$ 29,282 66.0 % Europe 8,390 10.2 % 6,215 12.3 % 2,175 35.0 % Total revenue$ 82,050 100.0 %$ 50,593 100.0 %$ 31,457 62.2 % Revenue generated in theU.S. was$73.7 million for the year endedDecember 31, 2019 , an increase of$29.3 million or 66.0% over the year endedDecember 31, 2018 . Revenue growth in theU.S. was due to increased market penetration in existing territories, the expansion into new territories, increased physician and patient awareness of our Inspire system, a greater number of prior authorization approvals, additional positive coverage policies and, to a lesser extent, an increase in our average selling price as a result of the introduction of the new sensing lead on the Inspire system to the U.S. market inFebruary 2019 . 82 -------------------------------------------------------------------------------- Table of Contents Revenue generated inEurope was$8.4 million in the year endedDecember 31, 2019 , an increase of$2.2 million or 35.0% over the year endedDecember 31, 2018 . Revenue growth inEurope was primarily due to increased market penetration in existing territories, the expansion into new territories, and increased physician and patient awareness of our Inspire system. Cost of Goods Sold and Gross Margin Cost of goods sold increased$3.5 million , or 35.7%, to$13.6 million for the year endedDecember 31, 2019 compared to$10.1 million for the year endedDecember 31, 2018 . The increase was primarily due to increased purchases of manufactured products due to higher sales volume of our Inspire system. Gross margin was 83.4% for the year endedDecember 31, 2019 compared to 80.1% for the year endedDecember 31, 2018 . Gross margin for the year endedDecember 31, 2019 was higher primarily due to the introduction of the new sensing lead on the Inspire system in theU.S. inFebruary 2019 which has a higher gross margin than the previous sensor, as well as manufacturing efficiencies. Research and Development Expenses Research and development expenses increased$5.4 million , or 73.8%, to$12.8 million for the year endedDecember 31, 2019 compared to$7.4 million for the year endedDecember 31, 2018 . This change was primarily due to an increase of$3.4 million for ongoing research and development costs, including initial development of the next generation Inspire therapy system and$2.0 million of compensation and employee-related expenses, mainly as a result of increased headcount. Selling, General and Administrative Expenses Selling, general and administrative expenses increased$37.0 million , or 69.0%, to$90.5 million for the year endedDecember 31, 2019 compared to$53.5 million for the year endedDecember 31, 2018 . The primary driver of this increase was an increase of$22.5 million in compensation, including salaries, commissions, and stock-based compensation, travel and other employee-related expenses, mainly as a result of increased headcount. In addition, selling, general and administrative expenses increased by$3.9 million due to legal fees, financial audit fees, insurance costs, and other corporate costs which increased primarily as a result of being a public company during the entire year endedDecember 31, 2019 compared to being a public company during only part of the same prior year period, as well as out-sourced information technology services and facilities costs. Other drivers included an increase of$9.0 million of marketing, primarily consisting of direct-to-patient initiatives, and an increase of$1.6 million of regulatory and reimbursement costs, which increased primarily due to market access consulting services used to obtain positive coverage policies. Other (Income) Expense, Net Other (income) expense, net changed by$3.2 million , or 216.8%, to$1.7 million of income for the year endedDecember 31, 2019 compared to$1.5 million of expense for the year endedDecember 31, 2018 . Interest income increased$1.9 million due to our higher cash, cash equivalents and investments balances. Interest expense decreased$1.2 million , primarily due to the lack of the$0.6 million fair value adjustment taken during the year endedDecember 31, 2018 on our previously outstanding convertible preferred stock warrants. Year EndedDecember 31, 2018 Compared to Year EndedDecember 31, 2017 For a discussion of our results of operations for the year endedDecember 31, 2017 , including a year-to-year comparison between 2018 and 2017, refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report Form 10-K for the year endedDecember 31, 2018 . Liquidity and Capital Resources As ofDecember 31, 2019 , we had cash, cash equivalents and investments of$155.7 million and an accumulated deficit of$180.2 million , compared to cash, cash equivalents and investments of$188.2 million and an 83 -------------------------------------------------------------------------------- Table of Contents accumulated deficit of$146.9 million as ofDecember 31, 2018 . As ofDecember 31, 2019 , we had$24.5 million of outstanding borrowings under our credit facility. No borrowings remain available under this credit facility. OnMay 7, 2018 , we completed our IPO by issuing 7,762,500 shares of common stock, at a public offering price of$16.00 per share, for net proceeds of approximately$112.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. OnDecember 11, 2018 , we completed the follow-on offering that included our offer and sale of 1,875,000 shares of common stock and the selling stockholders' offer and sale of 1,000,000 shares of common stock, at a public offering price of$40.00 per share. We received net proceeds of approximately$69.8 million after deducting underwriting discounts and commissions and offering expenses. We received no proceeds from the sale of our common stock by the selling shareholders. Our sources of capital have historically been from private placements of our convertible preferred securities, sales of our Inspire system, borrowings under credit facilities and registered offerings of our common stock. As ofDecember 31, 2019 , we had raised a total of$119.1 million in net proceeds from private placements of our convertible preferred securities and$181.8 million from registered equity offerings. We believe that our existing cash resources will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months. We may also seek liquidity through additional securities offerings or through borrowings under a new credit facility. Cash Flows The following table presents a summary of our cash flow for the periods indicated: Year Ended December 31, 2019 2018 2017 (in thousands) Net cash provided by (used in): Operating activities$ (32,846) $ (18,694) $ (15,791) Investing activities (43,559) (83,389) (7,600) Financing activities 1,964 190,383 25,661 Effect of exchange rate on cash 13 33 -
(Decrease) increase in cash and cash equivalents
Operating Activities Net cash used in operating activities was$32.8 million for 2019 and consisted of a net loss of$33.2 million , an increase in net operating assets of$6.6 million , and non-cash charges of$7.0 million . The non-cash charges consisted of stock-based compensation, accretion of the debt discount, non-cash lease expense, stock issued for services rendered, and depreciation and amortization, offset by the non-cash income related to the accretion of the investment discount, and other, net. Operating assets, which includes accounts receivable, inventories, and prepaid expenses and other current assets, increased generally due to increased revenues year-over-year. Operating liabilities, which includes accrued expenses and accounts payable, increased generally due to our increased business volume year-over-year and the costs to support the growth of our operations, including compensation and personnel-related costs. Net cash used in operating activities was$18.7 million for 2018 and consisted of a net loss of$21.8 million , an increase in net operating assets of$0.9 million and non-cash charges of$2.3 million . Net operating assets consisted primarily of accrued expenses, accounts payable, accounts receivable, and prepaid expenses and other assets to support the growth of our operations. Non-cash charges consisted primarily of stock-based compensation, the change in fair value of preferred stock warrants, accretion of debt discount, and depreciation, offset by the non-cash income related to the accretion of the investment discount. Net cash used in operating activities was$15.8 million in 2017 and consisted of a net loss of$17.5 million , a decrease in net operating assets of$0.8 million and non-cash charges of$0.9 million . Net operating assets 84 -------------------------------------------------------------------------------- Table of Contents consisted primarily of accounts receivable and inventory to support the growth of our operations and accrued compensation as annual bonuses were paid. Non-cash charges consisted primarily of depreciation and stock-based compensation. Investing Activities Net cash used in investing activities for 2019 was$43.6 million and consisted primarily of purchases of investments of$178.1 million , partially offset by proceeds from sales or maturities of investments of$137.3 million . Purchases of property and equipment were$2.7 million . Net cash used in investing activities for 2018 was$83.4 million and consisted primarily of purchases of investments of$115.5 million , offset by proceeds from sales or maturities of investments of$32.3 million . Purchases of property and equipment were$0.2 million . Net cash used in investing activities for 2017 was$7.6 million and consisted primarily of purchases of investments of$9.0 million , offset by proceeds from sales or maturities of investments of$1.8 million . Purchases of property and equipment were$0.4 million . Financing Activities Net cash provided by financing activities was$2.0 million for 2019 and consisted of$1.4 million in proceeds from the issuance of common stock from the employee stock purchase plan and$1.1 million in proceeds from the exercise of stock options and warrants, partially offset by a$0.5 million final payment fee due upon the amendment of our credit facility. Net cash provided by financing activities was$190.4 million for 2018 and consisted primarily of$181.8 million of net proceeds from public offerings of our common stock and borrowings of$8.0 million under our credit facility. Net cash provided by financing activities was$25.7 million in 2017 and consisted primarily of$25.0 million of net proceeds from the issuance of Series F convertible preferred stock, borrowings of$1.0 million under our credit facility less$0.5 million of expenses and$0.2 million in proceeds from the exercise of stock options. Indebtedness InAugust 2015 , we entered into a loan and security agreement withOxford Finance LLC ("Oxford Finance"), as lender and collateral agent. The loan and security agreement initially provided for a term A loan facility in the amount of$15.5 million , which was fully funded on the closing date, and a term B loan facility in an amount of at least$3.5 million but no more than$10.0 million , to be available in the future subject to our achievement of certain revenue milestones. We refer to our term A loan facility and our term loan B facility together as our credit facility. InFebruary 2017 , we amended the loan and security agreement to, among other things, increase borrowings under the term A loan facility by$1.0 million , increase the minimum amount of the term B loan facility to$5.0 million and reduce the maximum amount of the term B loan facility to$9.0 million . InFebruary 2018 , we borrowed$8.0 million under the term B loan facility. InMarch 2019 , we amended the loan and security agreement. Following such amendment, outstanding borrowings under the credit facility bear interest at an annual rate equal to the sum of (i) the greater of (A) the 30 dayU.S. LIBOR rate reported in The Wall Street Journal on the last business day of the month that immediately precedes the month in which the interest will accrue or (B) 2.50%, plus (ii) 5.10%; provided, however, under no circumstances will the basic rate be less than 7.60%. We are required to make monthly payments of interest only throughApril 1, 2022 . Following the interest-only period, we will be required to make monthly payments of interest and principal in 24 consecutive monthly installments. Outstanding borrowings under the credit facility mature onMarch 1, 2024 . On the maturity date, in addition to our regular monthly payments of principal and accrued interest, we will be required to make a payment of 3.50% of the total amount borrowed under the credit facility, which we refer to as the Final Payment, unless we have already made such payment in connection with an acceleration or prepayment of borrowings under the credit facility. 85 -------------------------------------------------------------------------------- Table of Contents Borrowings under the facility are pre-payable at our option in whole, but not in part, together with all accrued and unpaid interest thereon and, if not previously made, the Final Payment, subject to a prepayment fee of 3.0% if such borrowings are prepaid prior toMarch 27, 2020 , 2.0% if such borrowings are prepaid on or afterMarch 27, 2020 but prior toMarch 27, 2021 and 1.0% if such borrowings are on or afterMarch 27, 2021 and prior to maturity. We are also required to prepay the amounts outstanding under the credit facility upon the occurrence of certain customary events of default, as well as the occurrence of certain material adverse events. The credit facility also includes certain customary affirmative and negative covenants, but does not include any financial covenants. The credit facility is secured by substantially all of our personal property other than our intellectual property. We were in compliance with all covenants under the credit facility as ofDecember 31, 2019 . InAugust 2015 , we issued toOxford Finance warrants to purchase 12,404 and 17,176 shares of our Series E convertible preferred stock, having an exercise price of$2.62 per share. InFebruary 2017 andFebruary 2018 , we issued warrants toOxford Finance to purchase 29,197 and 233,577 shares, respectively, of our Series F convertible preferred stock, having an exercise price of$1.37 per share. Each of the warrants described above has a term of 10 years. Upon the closing of the IPO, the warrants to purchase 630,372 shares of preferred stock at a weighted average exercise price of$1.46 per share became exercisable to purchase 100,558 shares of common stock at a weighted average exercise price of$9.38 per share. Warrants to purchase 93,963 shares of common stock were exercised during 2018, and the warrants to purchase 6,595 shares of common stock were exercised during 2019. No warrants remain outstanding atDecember 31, 2019 . Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by applicable regulations of theSEC , that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations and Commitments Our contractual obligations and commitments as ofDecember 31, 2019 are summarized in the table below: Payments Due by Year Less than More than ($ in thousands) Total 1 year 1 - 3 years 3 - 5 years 5 years Recorded contractual obligations: Long-term debt (1)$ 24,500 $ -$ 9,188 $ 15,312 $ - Operating lease liabilities 828 828 - - - Unrecorded contractual obligations: Interest payments on long-term debt (2) 6,219 1,893 3,539 787 - Purchase obligations 23,739 23,739 - - - Real estate obligation (3) 7,425 1 651 2,379 4,394
Total contractual obligations
13,378
(1) Represents principal payments only. See Note 5 to our audited financial statements for more information. (2) Variable interest is assumed atDecember 31, 2019 rates. Under the terms of the credit facility, a final payment fee of 3.50% is due at the earlier of maturity or prepayment. This amount is not included in the table above. (3) Real estate obligation represents the legally binding minimum lease payments for a lease signed but not yet commenced. See Note 4 to our audited financial statements for more information. 86 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in theU.S. requires management to make estimates and assumptions that affect the amounts reported in the audited financial statements and accompanying notes included elsewhere in this Annual Report on Form 10-K. We believe that such estimates have been based on reasonable and supportable assumptions and the resulting estimates are reasonable for use in the preparation of the audited financial statements. Actual results could differ from these estimates. Significant areas requiring management estimates or judgments include the following key financial areas: Revenue Recognition We recognize revenue in accordance with Accounting Standards Codification ("ASC") Topic 606, Revenue from Contracts with Customers ("ASC 606"), which we adopted effectiveJanuary 1, 2019 using the modified retrospective approach. The adoption of ASC 606 did not have a material impact on the amount and timing of revenue recognized in our financial statements. Revenues from product sales are recognized when the customer obtains control of the product, which occurs at a point in time, either upon shipment of the product or receipt of the product, depending on shipment terms. Our standard shipping terms are free on board shipping point, unless the customer requests that control and title to the inventory transfer upon delivery. In those cases where shipping and handling costs are billed to customers, we classify the amounts billed as a component of cost of goods sold. Revenue is measured as the amount of consideration we expect to receive, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, which is based on the invoiced price, in exchange for transferring products. All revenue is recognized when we satisfy our performance obligations under the contract. The majority of our contracts have a single performance obligation and are short term in nature. Sales taxes and value added taxes in foreign jurisdictions that are collected from customers and remitted to governmental authorities are accounted for on a net basis and therefore are excluded from net sales. Shipping and handling costs associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of goods sold. Variable consideration related to certain customer sales incentives is estimated based on the amounts expected to be paid based on the agreement with the customer using probability assessments. We offer customers a limited right of return for our product in case of non-conformity or performance issues. We estimate the amount of our product sales that may be returned by our customers based on historical sales and returns. As our historical product returns to date have been immaterial, we have not recorded a reduction in revenue related to variable consideration for product returns. Stock-Based Compensation We maintain an equity incentive plan to provide long-term incentives for eligible employees, consultants, and members of the board of directors. The plan allows for the issuance of non-statutory and incentive stock options to employees and non-statutory stock options to consultants and directors. We also offer an employee stock purchase plan which allows participating employees to purchase shares of our common stock at a discount through payroll deductions. We recognize equity-based compensation expense for awards of equity instruments to employees and directors based on the grant date fair value of those awards in accordance with ASC Topic 718, Stock Compensation ("ASC 718"). ASC 718 requires all equity-based compensation awards to employees and directors, including grants of restricted shares and stock options, to be recognized as expense in the statements of operations and comprehensive loss based on their grant date fair values. We estimate the fair value of stock options using the Black-Scholes option pricing model. The fair value of each purchase under the employee stock purchase plan is 87 -------------------------------------------------------------------------------- Table of Contents estimated at the beginning of the offering period using the Black-Scholes option pricing model. We have not granted any restricted shares. We have not granted any stock-based awards to our consultants. The Black-Scholes option pricing model requires the input of certain subjective assumptions, including (i) the expected share price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate and (iv) the expected dividend yield. Due to the lack of a public market for the trading of our common stock and a lack of company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. The group of representative companies have characteristics similar to us, including stage of product development and focus on the life science industry. We use the simplified method, which is the average of the final vesting tranche date and the contractual term, to calculate the expected term for options granted to employees and directors as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. The risk-free interest rate is based on aU.S. governmentTreasury instrument whose term is consistent with the expected term of the stock options. We use an assumed dividend yield of zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. We expense the fair value of our equity-based compensation awards granted to employees and directors on a straight-line basis over the associated service period, which is generally the period in which the related services are received. We account for award forfeitures as they occur. Inventories Inventories are valued at the lower of cost or net realizable value, computed on a first-in, first out basis. We estimate the recoverability of our inventory by reference to internal estimates of future demands and product life cycles, including expiration of inventory prior to sale. We regularly review inventory quantities on-hand for excess and obsolete inventory and, when circumstances indicate, incur charges to write down inventories to their net realizable value. The determination of a reserve for excess and obsolete inventory involves management exercising judgment to determine the required reserve, considering future demand, product life cycles, introduction of new products and current market conditions. The reserve for excess and obsolete inventory was less than$0.1 million and$0.8 million as ofDecember 31, 2019 and 2018, respectively. Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates that will be in effect when the differences are expected to reverse. Valuation allowances against deferred tax assets are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. As we have historically incurred operating losses, we have recorded a full valuation allowance against our net deferred tax assets, and there is no provision for income taxes other than the accrual for uncertain tax benefits recorded during the year endedDecember 31, 2019 . Our policy is to record interest and penalties expense related to uncertain tax positions as other expense in the statements of operations and comprehensive loss. Recent Accounting Pronouncements A discussion of recent accounting pronouncements is included in Note 2 to our financial statements contained in this Annual Report on Form 10-K. JOBS Act Prior toDecember 31, 2019 , we were an "emerging growth company" as defined by the JOBS Act. The JOBS Act provides that an emerging growth company can take advantage of the extended transition period for complying with new or revised accounting standards. This allows an emerging growth company to delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We elected to avail ourselves of this exemption prior toDecember 31, 2019 , and as a result, our financial statements prior to 88
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Table of Contents that date may not have been comparable to the financial statements of issuers who are required to comply with the effective dates for new or revised accounting standards that are applicable to public companies. Subject to certain conditions, as an emerging growth company we also were able to rely on certain of the exemptions and reduced reporting requirements of the JOBS Act, including without limitation, from providing an auditor's attestation report on our system of internal control over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002 and from complying with any requirement that may be adopted by thePublic Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor's report providing additional information about the audit and the financial statements, known as the auditor discussion and analysis. Because we no longer qualify as an emerging growth company, we are no longer able to take advantage of the extended transition period for the adoption of certain accounting standards or of the reduced disclosure and other benefits available to emerging growth companies, including our exemption from providing our auditor's attestation on our system of internal control over financial reporting, which is included in this Annual Report on Form 10-K.
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