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CYTODYN INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.

July 10, 2014

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the other sections of this Annual Report, including our consolidated financial statements and related notes set forth in Item 8. This discussion and analysis contains forward-looking statements, including information about possible or assumed results of our financial condition, operations, plans, objectives and performance that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated and set forth in such forward-looking statements.

Business Highlights

During fiscal 2014, the Company commenced several initiatives to advance its lead product candidate, PRO 140. The following is a brief summary of key accomplishments:

Raised $14.5 million in capital through a private equity offering; Engaged a full service clinical research organization to manage our regulatory affairs, CMC activities and clinical trials; Advanced PRO 140 from a frozen bulk drug substance state through "fill and finish" and delivered finished drug product to Drexel University College of Medicine for its self-sponsored, NIH-funded clinical trials of PRO 140; Obtained FDA approval and commenced a self-sponsored, self-funded Phase 2b clinical trial for a PRO 140 monotherapy study referred to as treatment substitution; and Prepared and delivered finished drug product of PRO 140 for our first self-sponsored Phase 2b clinical trial, our treatment substitution study. 18


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Results of Operations

Results of operations for the year ended May 31, 2014, compared to May 31, 2013 are as follows:

For the years ended May 31, 2014 and 2013, we had no activities that produced revenues from operations.

For the years ended May 31, 2014 and 2013, we had net losses of approximately $12.4 million and $9.6 million, respectively. The increase in net loss of approximately $2.8 million for fiscal 2014 over fiscal 2013 was primarily attributable to increased amortization of discount on convertible debt, which is reported as interest expense, coupled with higher research and development expenses, offset by lower general and administrative costs and legal fees.

Total operating expenses for the years ended May 31, 2014 and 2013, are as follows: 2014 2013 General and administrative: Salaries and other compensation $ 900,000$ 1,411,000 Stock-based compensation 928,000 3,262,000 Accounting and consulting 216,000 421,000 Other 1,063,000 1,110,000 Total general and administrative 3,107,000 6,204,000 Legal 672,000 946,000 Research and development 3,982,000 620,000 Amortization and depreciation 352,000 223,000 Total operating expenses $ 8,113,000$ 7,993,000

The increase in fiscal 2014 total operating expenses of approximately $120,000, or 1.5%, over fiscal 2013 was primarily related to the increase in research and development expenditures and patent amortization, which is attributable to our PRO 140 patent portfolio. These comparably higher expenses for fiscal 2014 were offset by a reduction in stock-based compensation, legal, salary and consulting expenses as compared to fiscal 2013.

Salaries and other compensation decreased approximately $511,000, or 36.2%, from approximately $1,411,000 in fiscal year 2013 to approximately $900,000 for the year ended May 31, 2014. The decrease in fiscal 2014 from fiscal 2013 was due to the reduction in the number of employees and lower incentive compensation.

Stock-based compensation decreased approximately $2,334,000, or 71.5%, from approximately $3,262,000 for the year ended May 31, 2013, to approximately $928,000 for the year ended May 31, 2014. The decrease primarily related to the acceleration of vesting in fiscal 2013 of certain options granted to the Company's former CEO in connection with his Transition Agreement (see Note 11 to the Company's financial statements include under Item 8 below), and to fewer stock options awarded in fiscal 2014.

Accounting and consulting expenses decreased approximately $205,000, or 48.7%, from $421,000 in fiscal year 2013 to approximately $216,000 for the year ended May 31, 2014. The decrease in accounting and consulting expenses for fiscal 2014 as compared to fiscal 2013 reflects a more efficient utilization of third party resources.

Legal expenses decreased approximately $274,000, or 29%, from approximately $946,000 for the year ended May 31, 2013 to approximately $672,000 for the year ended May 31, 2014. The trend in the Company's legal expenses will depend on the Company's future capital raising efforts, complexity of certain regulatory filings, effective management of intellectual property, and continued strengthening of the internal staff.

Research and development ("R&D") expenses of approximately $4.0 million for fiscal 2014 rose approximately $3.4 million over fiscal 2013. The fiscal 2014 expenditures were primarily focused on (1) CMC activities to advance PRO 140 from a frozen bulk drug substance state through a finished drug product for Drexel's clinical trials and the Company's preparations for future manufacturing requirements and (2) clinical trial development and management.

Other operating expenses of $1,063,000 for fiscal 2014 declined approximately $47,000, or 4.2%, from fiscal 2013 owing to lower expense levels for travel, insurance and corporate governance, offset in part by higher patent fees, as compared to fiscal 2013.

For fiscal 2014, the Company realized a non-cash gain of approximately $184,000 in connection with the negotiated settlements of previously accrued expenses, for which approximately $46,000 was related to legal fees and $138,000 to research and development expenses.



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The increase in interest expense of approximately $2,562,000 in fiscal 2014 over fiscal 2013 was primarily attributable to a full year of interest and amortization of debt discount associated with the Company's convertible promissory notes, as compared to eight months in fiscal 2013. Generally accepted accounting principles require the recognition of debt discounts when the conversion option is beneficial at the commitment date. The debt discounts represent the sum of the intrinsic value of the conversion option and the fair value of the detachable warrants issued with the notes. The combined discounts are limited to the note proceeds. The value of the debt discount is amortized over the term of the note as interest expense and the amortization is accelerated upon conversion. Interest expense for fiscal 2014 also includes approximately $193,000 of non-cash expense related to the value of warrants issued to induce the conversion of certain notes.

The future trends in all of our expenses will be driven, in part, by the future outcomes of our clinical trials and the correlative effect on general and administrative expenses, especially FDA regulatory requirements, in addition to the possibility that all or a portion of the holders of the Company's outstanding convertible notes may elect to convert their notes into common stock, which would reduce future interest expense. See, in particular, Item 1A "Risk Factors" above.

Liquidity and Capital Resources

We had cash and cash equivalents of approximately $4.9 million as of May 31, 2014, compared with $0.6 million as of May 31, 2013. The net increase in our cash and cash equivalents over a year ago was attributable to the $14.5 million private equity offering completed in October 2013, offset in part by net cash used in operating activities of $7.4 million, $2.2 million for offering costs and $1.0 million for debt repayments.

As of May 31, 2014, the Company had working capital of approximately $3.3 million, which compares to negative working capital of $2.4 million at May 31, 2013.

Cash Flows

Net cash used in operating activities was approximately $7.4 million during fiscal year 2014, which represents an increase of approximately $4.0 million from net cash used in operating activities of approximately $3.4 million in fiscal 2013. The increase in the net cash used in operating activities for fiscal 2014 as compared to fiscal 2013 was primarily attributable to an increase in research and development expenses of $3.4 million, offset in part by higher non-cash interest expense related to the amortization of debt discount and inducement of conversion of certain convertible debt.

The reduction of cash used in investing activities of approximately $3.5 million for fiscal 2014 as compared to fiscal 2013 reflects the purchase of PRO 140 in the prior fiscal year.

Cash flows provided by financing activities of approximately $11.7 million during fiscal 2014 increased approximately $4.5 million over fiscal 2013. The increase in cash provided by financing activities was principally due to a private equity offering that provided net cash of approximately $11.6 million, after offering costs of approximately $2.1 million, and the effect of conversion of certain convertible notes in the principal amount of $850,000 which were converted in connection with the private equity offering. During fiscal year 2014, the Company issued $1.2 million of convertible notes, of which $250,000 in principal amount was repaid. The Company also paid, at maturity, a note to a related party in the principal amount of $500,000 and another convertible note in principal amount of $250,000.

As mentioned above, we have no activities that produced revenue in fiscal year 2013 and 2014 and have sustained operating losses since inception. Our ability to continue as a going concern is dependent upon our ability to raise financing until we can commence sales operations and achieve a level of profitability. Since inception, we have financed our activities principally from the sale of public and private equity securities and proceeds from notes payable. We intend to finance our future development activities and our working capital needs largely from the sale of debt and equity securities, combined with additional funding from other traditional financing sources.

As of the date of this filing, it is management's conclusion that the probability of achieving certain future scientific research milestones is not reasonably determinable, such that the future milestone payments payable to Progenics and its sub-licensors are deemed contingent consideration and therefore are not currently accrued in our financial statements.

The Company is current with its interest payment obligations to all note holders and is in compliance with all other terms of outstanding promissory notes. As of May 31, 2014, the Company had a total of approximately $4.3 million outstanding in face amount of convertible promissory notes. In the event our promissory notes, which mature as early as October 1, 2015, do not convert into shares of common stock, the Company's ability to continue as a going concern will be contingent upon its ability to raise additional capital to meet these obligations, or refinance. If the Company is unsuccessful in raising additional capital or refinancing in the future, it may be required to cease its operations.

We have not generated revenue to date, and will not generate product revenue in the foreseeable future. We expect to continue to incur operating losses as we proceed with our clinical trials with respect to PRO 140 and continue to advance it through the product development and regulatory process. In addition to increasing research and development expenses, we expect general and administrative and manufacturing costs to increase, as we add personnel and other administrative expenses associated with our current efforts.



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In furtherance of our business strategy and subsequent to fiscal year-end 2014, the Company entered into a manufacturing agreement with a contract manufacturing organization to initiate preparations for the potential future manufacturing of additional PRO 140. In the event this agreement is terminated by the Company, it will incur financial penalties up to $1.9 million determined by the date the notice of termination is delivered in relation to the anticipated manufacturing date. If the notice is delivered more than three months in advance of the anticipated manufacturing date, the penalty is approximately $1.1 million, or approximately $1.9 million thereafter.

Under the Asset Purchase Agreement (the "Asset Purchase Agreement"), dated July 22, 2012, between the Company and Progenics Pharmaceuticals, Inc. ("Progenics"), the Company acquired from Progenics its proprietary HIV viral-entry inhibitor drug candidate PRO 140 ("PRO 140"), a humanized anti-CCR5 monoclonal antibody, as well as certain other related assets, including the existing inventory of bulk PRO 140 drug product, intellectual property, certain related licenses and sublicenses, and U.S. Food and Drug administration ("FDA") regulatory filings. On October 16, 2012, the Company paid $3,500,000 in cash to Progenics to close the acquisition transaction. The Company is also required to pay Progenics the following milestone payments and royalties: (i) $1,500,000 at the time of the first dosing in a U.S. Phase 3 trial or non-US equivalent; (ii) $5,000,000 at the time of the first US new drug application approval by the FDA or other non-U.S. approval for the sale of PRO 140; and (iii) royalty payments of up to five percent (5%) on net sales during the period beginning on the date of the first commercial sale of PRO 140 until the later of (a) the expiration of the last to expire patent included in the acquired assets, and (b) 10 years, in each case determined on a country-by country basis. Payments to Progenics are in addition to payments due under a Development and License Agreement, dated April 30, 1999 (the "PDL License"), between Protein Design Labs (now AbbVie Inc.) and Progenics, which was assigned to us in the PRO 140 transaction, pursuant to which we must pay additional milestone payments and royalties as follows: (i) $1,000,000 upon initiation of a Phase 3 clinical trial; (ii) $500,000 upon filing a Biologic License Application with the FDA or non-U.S. equivalent regulatory body; (iii) $500,000 upon FDA approval or approval by another non-U.S. equivalent regulatory body; and (iv) royalties of up to 7.5% of net sales for the longer of 10 years and the date of expiration of the last to expire licensed patent. Additionally, the PDL License provides for an annual maintenance fee of $150,000 until royalties paid exceed that amount.

Going Concern

We will require additional funding in order to continue with research and development efforts.

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred losses for all periods presented and has a substantial accumulated deficit. As of May 31, 2014, these factors, among others, raise substantial doubt about the Company's ability to continue as a going concern.

The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company's continuation as a going concern is dependent upon its ability to obtain additional operating capital, complete development of its product candidates, obtain FDA approval, outsource manufacturing of its products, and ultimately to attain profitability. The Company intends to seek additional funding through debt and equity offerings or licensing agreements or strategic alliances to implement its business plan. There are no assurances, however, that the Company will be successful in these endeavors.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates.

We believe that the following critical policies affect our more significant judgments and estimates used in preparation of our consolidated financial statements.



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We use the Black-Scholes option pricing model to estimate the fair value of stock-based awards on the date of grant utilizing certain assumptions that require judgments and estimates. These assumptions include estimates for volatility, expected term, and risk-free interest rates in determining the fair value of the stock-based awards.

We issue common stock, stock options and warrants to consultants for various services. Costs for these transactions are measured at the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more readily measurable. This determination requires judgment in terms of the consideration being measured.

We have issued convertible promissory notes with detachable warrants to purchase common stock. The conversion options are fixed, but beneficial to the note holders at the respective commitment dates. The valuation of the beneficial conversion feature of the notes and of the warrants gives rise to the recognition of a debt discount, which requires the use of certain assumptions inherent in the Black-Scholes option pricing model, including various judgments and estimates.

As discussed in Note 11 to the consolidated financial statements, we have significant contingent potential milestone and royalty liabilities. We must estimate the likelihood of paying these contingent liabilities periodically based on the progress of our clinical trials.

We estimated an amount that is a probable indicator of our rescission liability and recorded rescission liabilities at May 31, 2014 and May 31, 2013 of $378,000 and $536,500, respectively. These amounts represent the believed potential rescission liability as of the dates presented, excluding any contingent interest payable to investors who accept the rescission right and forfeit their shares. For the purpose of calculating and disclosing rescission liability, the Company has assumed that portions of the state claims are barred by the statutes of limitations of certain states. Although the Company has assumed that affirmative defenses based upon the expiration of the statutes of limitations in these states may be generally available to bar these state claims, it has not had legal counsel undertake a detailed analysis of case law that might apply to defer or avoid application of a bar to such claims; thus, if rescission claims are made for those assumed to be barred by a statute of limitations and such claims are contested by the Company, until such affirmative defenses are ruled upon in a proceeding adjudicating the rights at issue, no assurances can be made that, if asserted, such defenses would actually bar the rescission claims in these states. See Note 3 to our consolidated financial statements in Item 8 for further information.

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Source: Edgar Glimpses

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