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ZS PHARMA, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 14, 2014

You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and related notes included elsewhere in this report. This discussion and other parts of this report contain forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, intentions and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled "Risk Factors" included elsewhere in this report.



Overview

We are a biopharmaceutical company focused on the development and commercialization of highly selective, non-absorbed drugs to treat renal, cardiovascular, liver and metabolic diseases. Our proprietary zirconium silicate technology allows us to create highly selective ion traps that can reduce toxic levels of specific electrolytes without disturbing the balance of other electrolytes. Our initial focus is on the development of ZS-9, our product candidate in Phase III development for the treatment of hyperkalemia, a life-threatening condition in which elevated levels of potassium increase the risk of muscle dysfunction, including cardiac arrhythmias and sudden cardiac death. We are advancing ZS-9 through clinical development with the goal of obtaining approval for the treatment of acute and chronic hyperkalemia, regardless of the underlying disease state. We have designed our development program based on input from the FDA and EMA and plan to submit our NDA in the United States and our MAA in Europe in the first half of 2015. If we receive regulatory approval, we intend to commercialize ZS-9 for the treatment of hyperkalemia in the United States with our own specialty sales force targeting nephrologists and cardiologists and intend to seek one or more partners for commercialization in markets outside of the United States. We have completed two clinical studies with ZS-9 that together enrolled 843 patients with hyperkalemia, including patients with CKD, HF, diabetes and those on RAAS inhibitor therapy. Our first in-man study, ZS002, was completed in May 2012 and our first Phase III study, ZS003, was completed in November 2013. Both trials met their pre-specified primary and secondary efficacy endpoints with clinically meaningful and statistically significant results. A second Phase III study, ZS004, began in the first quarter of 2014 and concluded enrollment in early July 2014. Data from the ZS004 study is expected to be announced late in the third quarter or early in the fourth quarter of 2014. We also initiated a long term safety study, ZS005, in June 2014. Upon successful completion of ZS004, we expect to file our NDA with the FDA and our MAA with the EMA in the first half of 2015. We manufacture clinical trial quantities of ZS-9 in-house in two facilities from readily available starting materials using specialized equipment. We are currently in the process of increasing our manufacturing capabilities to support anticipated commercial demand. Additionally, we have established a supply chain to provide us with the materials required to manufacture ZS-9. We expect to significantly increase our investment in our commercial manufacturing process and inventory of ZS-9, and in our commercialization and marketing related activities as we prepare for a possible commercial launch of ZS-9. In February 2014, certain of our investors agreed to invest $55.0 million in consideration of the issuance of shares of our Series D preferred stock, subject to certain conditions. We closed the first $25.0 million tranche of our Series D preferred stock financing on February 28, 2014. On June 17, 2014, our registration statement on Form S-1 (File No. 333-195961) relating to our initial public offering (IPO) of our common stock was declared effective by the Securities and Exchange Commission (SEC). Our shares began trading on The NASDAQ Global Select Market on June 18, 2014. The public offering price of the shares sold in the offering was $18.00 per share. The IPO closed on June 23, 2014 and included 6,836,111 shares of common stock, which included 891,667 shares of common stock issued pursuant to the over-allotment option granted to the underwriters. We received total proceeds from the offering of $114.4 million, net of underwriting discounts and commissions of $8.6 million. After deducting offering expenses of approximately $2.2 million, net proceeds were approximately $112.2 million. Upon the closing of the IPO, all shares of convertible preferred stock then outstanding converted into 11,979,479 shares of common stock. 13



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Financial Overview

We have invested substantially all of our efforts and financial resources to identifying, acquiring, and developing our product candidates, including conducting clinical studies and providing general and administrative support for these operations. To date, we have funded our operations primarily from the sale of convertible preferred stock and equity securities. We have never been profitable and have incurred net losses in each year since inception. Our net losses were $26.9 million and $12.5 million for the six months ended June 30, 2014 and 2013. As of June 30, 2014 we had incurred cumulative net losses of $77.1 million. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and from general and administrative costs associated with our operations.



Revenue

To date, we have not generated any revenues. Our ability to generate product revenues, which we do not expect will occur before 2016, at the earliest, will depend heavily on our obtaining marketing approval from the FDA and EMA for, and, subsequent to that, our successful commercialization of ZS-9.



Research and Development Expenses

Our research and development expenses consist primarily of:

salaries and related costs, including stock-based compensation expense,

for personnel in our research and development functions; costs related to nonclinical studies in animal models;



fees paid to clinical consultants, clinical trial sites and vendors in

conjunction with implementing and monitoring our clinical trials and

acquiring and evaluating clinical trial data, including all related fees,

such as for investigator grants, patient screening fees, laboratory work

and statistical compilation and analysis; costs related to production of clinical supplies, including fees paid to

contract packagers;



costs related to compliance with drug development regulatory requirements;

annual minimum royalty payments to UOP pursuant to a license agreement; and

depreciation and other allocated facility-related and overhead expenses.

We expense both internal and external research and development costs in the periods in which they are incurred. To date, we have focused substantially all of our resources and development efforts on the development of ZS-9.

We expect our research and development expenses to increase during the next few years as we seek to complete our clinical program, pursue regulatory approval of ZS-9 in the United States and internationally and prepare for a possible commercial launch of ZS-9, which, if approved, will require significant investment to increase our manufacturing capabilities to support anticipated commercial demand. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages, primarily due to increased size and greater duration of the related clinical trials, which we expect to be the case for our ZS004 and ZS005 clinical trials. Predicting the timing or the final cost to complete our clinical program and/or validation of our commercial manufacturing and supply processes is difficult and delays or unexpected costs may occur because of many factors, including factors outside of our control. Furthermore, we are unable to predict when or if ZS-9 will receive regulatory approval in the United States or in any other countries with any certainty.



General and Administrative Expenses

Our general and administrative expenses consist primarily of personnel costs, including salaries, benefits and stock-based compensation expense, associated with our executive, finance, business and corporate development and other administrative functions. Other general and administrative expenses include allocated depreciation and facility-related costs, legal costs of pursuing patent protection of our intellectual property and professional fees for consulting, auditing, tax and legal services. 14



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We expect our general and administrative expenses will increase as we expand our operating activities and increase our headcount as we begin to prepare for a potential commercial launch of ZS-9 and to support our operations as a public company. Additionally, we anticipate increased expenses related to audit, legal, regulatory and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums and investor relations costs associated with being a public company.



Interest Income

Interest income consists primarily of interest received or earned on our cash and cash equivalents and marketable securities. We expect interest income to vary each reporting period depending on our average cash and cash equivalents and marketable securities balances during the period and applicable interest rates. To date, our interest income has not been significant in any individual period. Interest Expense Interest expense consists of cash and noncash interest costs related to our borrowings. The noncash interest costs consist of the fair value of shares issued for interest earned on convertible notes during the period the notes were outstanding, the amortization of the beneficial conversion feature of the convertible notes over the period the notes were outstanding, the amortization of the fair value of warrants that were issued in connection with our borrowings, with the initial fair value of the warrants being amortized to interest expense over the term of the governing agreements, and the amortization of other debt issuance costs, primarily legal and banker fees, over the period the notes were outstanding.



Expense to Mark Warrants to Market

Expense to mark warrants to market includes gains and losses from the re-measurement of our liabilities related to our Series B Warrants. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until such time as these instruments were exercised. At that time, the convertible preferred stock warrant liability was reclassified to additional paid- in capital, a component of stockholders' equity (deficit), and we no longer recorded any related periodic fair value adjustments.



Critical Accounting Polices and Significant Estimates

Our financial statements are prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from management's estimates. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. While our significant accounting policies are described in the Notes to our financial statements, we believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management's judgments and estimates.



Clinical Trial Accruals

Clinical trial costs are a component of research and development expenses. We accrue and expense clinical trial activities performed by third parties based upon actual patient enrollment in accordance with agreements established with third-party vendors and clinical sites. We determine the actual expense accrual through review of patient enrollment databases and the agreed-upon fee to be paid for each patient enrolled less any payments made. During the course of a clinical trial, we may adjust our rate of clinical expense recognition if actual results differ from our estimates. We make estimates of our accrued expenses as of each balance sheet date in our financial statements based on the facts and circumstances known to us at that time. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in us reporting amounts that are too high or too low for any particular period. Our clinical trial accrual is dependent, in part, upon the receipt of timely and accurate reporting from clinical sites and other third-party vendors. Through June 30, 2014, there have been no material adjustments to our prior period estimates of accrued expenses for clinical trials. 15



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Stock-Based Compensation

We measure and recognize compensation expense for stock options granted to our employees and directors, based on the estimated fair value of the award on the grant date. Historically, for all periods prior to our initial public offering, the fair values of the shares of common stock underlying our stock-based awards were estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, our board of directors considered, among other things, contemporaneous valuations of our common stock prepared by an unrelated third-party valuation firm. We use the Black-Scholes valuation model to estimate the fair value of stock option awards. The fair value is recognized as expense, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award on a straight-line basis. Vesting terms for certain employee grant agreements did not initially match the terms approved by our board of directors. Accordingly, these options were not considered granted for accounting purposes until a mutual understanding of the terms was obtained through amendment of the grant agreements in January 2014. Certain of these options were considered to have service inception dates in 2013, which resulted in the vested portion of these options being re-measured to fair value throughout 2013.



Prior to the public trading of our common stock, our board of directors exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including:

contemporaneous valuations of our common stock performed by unrelated

third-party valuation firms; our stage of development; our operational and financial performance;



the nature of our services and our competitive position in the marketplace;

the value of companies that we consider peers based on a number of



factors, including similarity to us with respect to industry and business

model;



the likelihood of achieving a liquidity event, such as an initial public

offering or sale given prevailing market conditions, and the nature and

history of our business;



issuances of preferred stock and the rights, preferences and privileges of

our preferred stock relative to those of our common stock; business conditions and projections;



the history of our company and progress of our research and development

efforts and clinical trials; and the lack of marketability of our common stock. For valuations after the completion of our initial public offering, our board of directors determines the fair value of each share of underlying common stock based on the closing price of our common stock as reported by the NASDAQ Global Market on the date of grant.



Convertible Preferred Stock Warrant Liability

Freestanding warrants for shares that were redeemable were classified as liabilities on the balance sheet at their estimated fair value. At the end of each reporting period, changes in estimated fair value during the period were recorded as expense to mark warrants to market. We adjusted the carrying value of these warrants until such time as these instruments were exercised to purchase shares of our Series B preferred stock, which were converted into shares of our common stock upon the consummation our initial public offering. At that time, the liabilities were reclassified to additional paid-in capital, a component of stockholders' deficit. The fair value of the outstanding Series B preferred stock warrants was measured using the Black-Scholes option-pricing model. Inputs used to determine the fair value of the warrants included the fair value of the underlying stock relative to the warrant exercise price at the valuation measurement date, volatility of the price of the underlying Series B preferred stock, the remaining contractual term of the warrants, risk-free interest rates and expected dividends. In order to determine the fair value of our Series B preferred stock underlying the Series B Warrants, our board of directors considered, among other things, contemporaneous valuations of our Series B preferred stock prepared by an unrelated third-party valuation firm. 16



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Net Operating Loss Carryforwards and Research Tax Credit Carryforwards

As of June 30, 2014, we had gross federal income tax net operating loss, or NOL, carryforwards of approximately $58.9 million and federal research tax credit carryforwards of approximately $3.4 million. These NOL carryforwards and research tax credit carryforwards, if not previously used, will begin to expire in 2029. The future utilization of our NOL carryforwards and research tax credit carryforwards will be subject to an annual limitation, pursuant to Section 382 of the Code, as a result of an ownership change that occurred at the time of the closing of the first tranche of Series C redeemable preferred stock in October 2012. Moreover, we may experience ownership changes in the future as a result of subsequent shifts in our stock ownership. As a result, if we earn net taxable income in the future, the limitations on our ability to use our NOL carryforwards and research tax credit carryforwards to reduce U.S. federal tax liability could potentially result in increased future tax liability to us.



Results of Operations

Comparison of the Three Months Ended June 30, 2014 and 2013

Three Months Ended June 30, Change 2014 2013 $ % (unaudited) (in thousands, except percentages) Operating expenses: Research and development $ 9,976$ 6,335$ 3,641 57 % General and administrative 4,554 972 3,582 369 % Total operating expenses 14,530 7,307 7,223 99 % Loss from operations (14,530 ) (7,307 ) (7,223 ) 99 % Interest income (10 ) (8 ) (2 ) 25 % Interest expense 5 4 1 25 % Expense to mark warrants to market 1,774 12 1,762 14,683 % Other - Net loss $ (16,299 )$ (7,315 )$ (8,984 ) 123 % Research and Development. Research and development expenses increased $3.6 million, or 57%, to $10.0 million for the three months ended June 30, 2014 from $6.3 million for the three months ended June 30, 2013. The increase was primarily due to an increase in personnel costs of $2.2 million and in certain other costs by $0.9 million in connection with our expanded clinical and manufacturing activities, as well an increase clinical trial related expenses of $0.6 million attributable to conducting and supporting our ZS004 and ZS005 clinical studies. General and Administrative. General and administrative expenses increased $3.6 million, or 369%, to $4.6 million for the three months ended June 30, 2014 from $1.0 million for the three months ended June 30, 2013. The increase was primarily due to increases of $2.0 million in consulting fees related to medical affairs and medical education, $0.8 million in personnel costs as a result of an increase in headcount to support growth in our operations and $0.8 million in legal and accounting professional fees and other miscellaneous costs associated with our increased activity. Expense to mark warrants to market. Expense to mark warrants to market increased $1.8 million, or 14,683%, for the three months ended June 30, 2014 versus the three months ended June 30, 2013. The increase was due to the increased value of warrants to acquire Series B preferred stock as we approached our initial public offering. 17



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Comparison of the Six Months Ended June 30, 2014 and 2013

Six Months Ended June 30, Change 2014 2013 $ % (unaudited) (in thousands, except percentages) Operating expenses: Research and development $ 15,235$ 10,744$ 4,491 42 % General and administrative 8,571 1,687



6,884 408 %

Total operating expenses 23,806 12,431 11,375 92 % Loss from operations (23,806 ) (12,431 ) (11,375 ) 92 % Interest income (16 ) (20 ) 4 (20 %) Interest expense 8 9 (1 ) (11 %) Expense to mark warrants to market 3,071 121 2,950 2,438 % Other (3 ) - (3 ) Net loss $ (26,866 )$ (12,541 )$ (14,325 ) 114 % Research and Development. Research and development expenses increased $4.5 million, or 42%, to $15.2 million for the six months ended June 30, 2014 from $10.7 million for the six months ended June 30, 2013. The increase was primarily due to an increase in personnel costs of $3.7 million and in certain other costs by $1.3 million in connection with our expanded clinical and manufacturing activities, offset in part by a decrease in clinical trial related expenses of $0.5 million attributable to timing of expenses related to conducting and supporting our Phase III pivotal trials. General and Administrative. General and administrative expenses increased $6.9 million, or 408%, to $8.6 million for the six months ended June 30, 2014 from $1.7 million for the six months ended June 30, 2013. The increase was primarily due to increases of $3.9 million in consulting fees related to medical affairs and medical education, $1.4 million in personnel costs as a result of an increase in headcount to support growth in our operations and $1.6 million in legal and accounting professional fees and other miscellaneous costs associated with our increased activity. Expense to mark warrants to market. Expense to mark warrants to market increased $3.0 million, or 2,438%, for the six months ended June 30, 2014 versus the six months ended June 30, 2013. The increase was due to the increased value of warrants to acquire Series B preferred stock as we approached our initial public offering.



Liquidity and Capital Resources

Due to our significant research and development expenditures, we have generated significant operating losses since our inception. We have funded our operations primarily through sales of our common stock as part of our IPO and sales of our preferred shares of stock. Our expenditures are primarily related to research and development activities. At June 30, 2014, we had available cash and cash equivalents of $130.0 million. Our cash and cash equivalents are currently held in a variety of interest and non-interest bearing accounts at financial institutions and in the future may be invested in a variety of interest-bearing instruments, including investments backed by U.S. government agencies, corporate debt securities and money market accounts. Cash in excess of immediate requirements is invested with a view toward liquidity and capital preservation, and we seek to minimize the potential effects of concentration and degrees of risk. On June 23, 2014, we closed our IPO of 6,836,111 shares of our common stock, which included 891,667 shares of common stock issued pursuant to the option to purchase additional shares granted to the underwriters. The public offering price of the shares sold in the offering was $18.00 per share. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to a registration statement on Form S-1 (File No. 333-195961), which was declared effective by the SEC on June 17, 2014. The total proceeds from the offering to us, net of underwriting discounts and commissions of approximately $8.6 million, were approximately $114.4 million. After deducting offering expenses payable by us of approximately $2.2 million, our net proceeds were approximately $112.2 million. Upon the closing of the IPO, 11,979,479 shares of Preferred Stock and Redeemable Preferred Stock then outstanding automatically converted into 11,979,479 shares of our common stock. 18



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