Basis of Presentation

Business

Ligand Pharmaceuticals Incorporated (including its subsidiaries, referred to as the "Company" or "Ligand") is a biopharmaceutical company with a business model based on developing or acquiring assets which generate royalty, milestone, or other passive revenue for Ligand and using a lean corporate cost structure. The Company operates in the United States in two business segments: biopharmaceutical asset development and licensing, and manufacturing and licensing Captisol, a formulation technology platform.

Principles of Consolidation

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

Basis of Presentation

The Company’s accompanying unaudited condensed consolidated financial statements as of September 30, 2015 and for the three and nine months ended September 30, 2015 and 2014 have been prepared in accordance with accounting principles generally accepted in the United States (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. Operating results for the three and nine months ended September 30, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015. 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, 2014.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with U.S. 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.

Revision of Immaterial Error

During the three and nine months ended September 30, 2015, a clerical error was identified in the calculation of the projections used in the June 30, 2015 and September 30, 2015 valuation of contingent liabilities related to Cydex contingent value right holders. The error in the June 30, 2015 projection resulted in an understatement of short-term contingent liabilities of $0.6 million as of June 30, 2015, and an overstatement of net income of $0.6 million, or $0.03 per share for the three and six months ended June 30, 2015, respectively. No other error was identified in the other interim period(s) in 2015 or 2014 based on the Company's review in those periods. The impact of correcting the error resulted in an understatement of net income of $0.6 million, or $0.03 per share for the three months ended September 30, 2015. Based on a qualitative and quantitative analysis of the error, the Company concluded that it is immaterial to the interim condensed consolidated financial statements for the three and six months ended June 30, 2015 and had no effect on the trend of financial results. As such, the Company has corrected the error in the condensed consolidated financial statements for the period ended September 30, 2015.

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 by dividing net income by the weighted-average number of common shares and common stock equivalents of all dilutive securities calculated using the treasury stock method and the if-converted method. The total number of potentially dilutive securities including stock options and warrants excluded from the computation of diluted income per share because their inclusion would have been anti-dilutive was 3.3 million and 5.0 million, as of September 30, 2015 and 2014, respectively.

The following table presents the computation of basic and diluted net income per share for the periods indicated (in thousands, except per share amounts):



	Three months ended				Nine months ended
	September 30,				September 30,
	2015		2014		2015		2014
Net income	$	224,539	$	1,280	$	248,857	$	4,969

Shares used to compute basic income per share	19,886,877		20,417,187		19,741,081		20,584,469
Dilutive potential common shares:
Restricted stock	63,324		22,531		55,899		37,387
Stock options	763,856		905,593		922,051		1,010,665
0.75% Convertible Senior Notes, Due 2019	745,591		—		402,941		—
Shares used to compute diluted income per share	21,459,648		21,345,311		21,121,972		21,632,521

Basic net income per share	$	11.29	$	0.06	$	12.61	$	0.24

Diluted net income per share	$	10.46	$	0.06	$	11.78	$	0.23

Cash Equivalents

Cash equivalents consist of all investments with maturities of three months or less from the date of acquisition.

Short-term Investments

Short-term investments primarily consist of investments in debt securities that have effective maturities greater than three months and less than twelve months from the date of acquisition. The Company classifies its short-term investments as "available-for-sale". Such investments are carried at fair value, with unrealized gains and losses included in the statement of comprehensive income (loss). The Company determines the cost of investments based on the specific identification method.

Restricted Investments

Restricted investments consist of certificates of deposit held with a financial institution as collateral under a facility lease and third-party service provider arrangements.

The following table summarizes the various investment categories at September 30, 2015 and December 31, 2014 (in thousands):



	Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value
September 30, 2015
Short-term investments
Bank deposits	$	38,712	$	4	$	(1	)	$	38,715
Corporate bonds	29,347		2		(5		)	29,344
Commercial paper	2,000		—		—			2,000
Asset backed securities	15,995		—		(4		)	15,991
Corporate equity securities	1,917		5,561		—			7,478
Restricted investments	600		—		—			600
	$	88,571	$	5,567	$	(10	)	$	94,128
December 31, 2014
Short-term investments
Corporate equity securities	$	2,179	$	4,954	$	—		$	7,133
Restricted investments	1,261		—		—			1,261
	$	3,440	$	4,954	$	—		$	8,394

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. Inventory levels are analyzed periodically and written down to its net realizable value if it has become obsolete, has a cost basis in excess of its expected net realizable value or is in excess of expected requirements. There were no write downs related to obsolete inventory recorded for the three and nine months ended September 30, 2015 and 2014.

Goodwill and Other Identifiable Intangible Assets

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



	September 30,			December 31,
	2015			2014
Indefinite lived intangible assets
Acquired in-process research and development ("IPR&D")	$	12,556		$	12,556
Goodwill	12,238			12,238
Definite lived intangible assets
Complete technology	15,267			15,267
Less: Accumulated amortization	(3,571		)	(2,999		)
Trade name	2,642			2,642
Less: Accumulated amortization	(619		)	(519		)
Customer relationships	29,600			29,600
Less: Accumulated amortization	(6,934		)	(5,824		)
Total goodwill and other identifiable intangible assets, net	$	61,179		$	62,961

Amortization of definite-lived intangible assets is computed using the straight-line method over the estimated useful life of the asset of 20 years. Amortization expense of $0.6 million and $1.8 million was recognized for each of the three and nine months ended September 30, 2015 and 2014, respectively. Estimated amortization expense for the years ending December 31, 2015 through 2019 is $2.4 million per year. For each of the three and nine months ended September 30, 2015 and 2014, there was no impairment of IPR&D or goodwill.

Commercial License Rights

Commercial license rights represent a portfolio of future milestone and royalty payment rights acquired from Selexis SA ("Selexis") in April 2013 and April 2015. Individual commercial license rights acquired under the agreement are carried at allocated cost and approximate fair value. The carrying value of the license rights will be reduced on a pro-rata basis as revenue is realized over the term of the agreement. Declines in the fair value of individual license rights below their carrying value that are deemed to be other than temporary are reflected in earnings in the period such determination is made. As of September 30, 2015, management does not believe there have been any events or circumstances indicating that the carrying amount of its commercial license rights may not be recoverable.

Property and Equipment

Property and equipment is stated at cost and consists of the following (in thousands):



	September 30,			December 31,
	2015			2014
Lab and office equipment	$	2,182		$	2,232
Leasehold improvements	273			273
Computer equipment and software	632			624
	3,087			3,129
Less accumulated depreciation and amortization	(2,732		)	(2,643		)
Total property and equipment, net	$	355		$	486

Depreciation of equipment is computed using the straight-line method over the estimated useful lives of the assets, which range from three to ten years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful lives or the related lease term. Depreciation expense of $0.1 million and $0.2 million was recognized for each of the three and nine months ended September 30, 2015 and 2014, respectively, which is included in operating expenses.

Other Current Assets

Other current assets consist of the following (in thousands):



	September 30,		December 31,
	2015		2014
Prepaid expenses	$	1,494	$	835
Other receivables	283		685
Co-promote receivable	—		322
Total other current assets	$	1,777	$	1,842

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):



	September 30,		December 31,
	2015		2014
Compensation	$	1,485	$	1,708
Professional fees	443		459
Amounts owed to former licensees	956		925
Royalties owed to third parties	798		705
Other	474		1,069
Total accrued liabilities	$	4,156	$	4,866

Other Long-Term Liabilities

Other long-term liabilities consist of the following (in thousands):



	September 30,		December 31,
	2015		2014
Deposits	$	319	$	411
Deferred rent	291		327
Other	33		32
Total other long-term liabilities	$	643	$	770

Contingent Liabilities

In connection with the Company’s acquisition of CyDex in January 2011, the Company recorded a contingent liability, for amounts potentially due to holders of the CyDex contingent value rights ("CVRs") and former license holders. The liability is periodically assessed based on events and circumstances related to the underlying milestones, royalties and material sales. Any change in fair value is recorded in the Company’s consolidated statement of operations. The carrying amount of the liability may fluctuate significantly and actual amounts paid under the CVR agreements may be materially different than the carrying amount of the liability. The fair value of the liability at September 30, 2015 and December 31, 2014 was $10.5 million and $11.5 million, respectively. The Company recorded a fair-value adjustment to increase the liability by $0.9 million and $3.1 million for the three and nine months ended September 30, 2015, respectively. There was a revenue-sharing payment of $0.8 million and $3.9 million to CyDex CVR holders during the three and nine months ended September 30, 2015, respectively. For the three and nine months ended September 30, 2014, the Company recorded a fair-value adjustment to increase the liability by $2.8 million and $5.6 million, respectively. There was no revenue sharing payment made for the three months ended September 30, 2014 and a revenue-sharing payment of $1.6 million was made during the nine months ended September 30, 2014.

In connection with the Company’s acquisition of Metabasis Therapeutics, Inc. ("Metabasis") in January 2010, the Company issued to Metabasis stockholders four tradable CVRs, one CVR from each of four respective series of CVR, for each Metabasis share. The CVRs will entitle Metabasis stockholders to cash payments as frequently as every six months as cash is received by the Company from proceeds from the sale or partnering of any of the Metabasis drug development programs, among other triggering events. The fair values of the CVRs are remeasured at each reporting date through the term of the related agreement. Any change in fair value is recorded in the Company’s consolidated statement of operations. The carrying amount of the liability may fluctuate significantly based upon quoted market prices and actual amounts paid under the agreements may be materially different than the carrying amount of the liability. The fair value of the liability was estimated to be $4.7 million and $3.7 million as of September 30, 2015 and December 31, 2014, respectively. The Company recorded a decrease in the liability for Metabasis-related CVRs of $3.2 million and an increase of $1.9 million for the three and nine months ended September 30, 2015, respectively. The Company recorded a decrease in the liability for Metabasis-related CVRs of $1.2 million and an increase in the liability of $0.7 million for the three and nine months ended September 30, 2014, respectively. The Company paid Metabasis CVR holders $0.5 million and $0.8 million for the three and nine months ended September 30, 2015, respectively.

Revenue Recognition

Royalties on sales of products commercialized by the Company’s partners are recognized in the quarter reported to Ligand by the respective partner. Generally, the Company receives royalty reports from its licensees approximately one quarter in arrears due to the fact that its agreements require partners to report product sales between 30 and 60 days after the end of the quarter. The Company recognizes royalty revenues when it can reliably estimate such amounts and collectability is reasonably assured. Under this accounting policy, the royalty revenues reported are not based upon estimates and such royalty revenues are typically reported to the Company by its partners in the same period in which payment is received.

Revenue from material sales of Captisol is recognized upon transfer of title, which normally passes upon shipment to the customer, provided all other revenue recognition criteria have been met. All product returns are subject to the Company's credit and exchange policy, approval by the Company and a 20% restocking fee. To date, product returns by customers have not been material to net material sales in any related period. The Company records revenue net of product returns, if any, and sales tax collected and remitted to government authorities during the period.

The Company analyzes its revenue arrangements and other agreements to determine whether there are multiple elements that should be separated and accounted for individually or as a single unit of accounting. For multiple element contracts, arrangement consideration is allocated at the inception of the arrangement to all deliverables on the basis of relative selling price, using a hierarchy to determine selling price. Management first considers vendor-specific objective evidence ("VSOE"), then third-party evidence ("TPE") and if neither VSOE nor TPE exist, the Company uses its best estimate of selling price.

Many of the Company's revenue arrangements for Captisol involve a license agreement with the supply of manufactured Captisol product. Licenses may be granted to pharmaceutical companies for the use of Captisol product in the development of pharmaceutical compounds. The supply of the Captisol product may be for all phases of clinical trials and through commercial availability of the host drug or may be limited to certain phases of the clinical trial process. Management believes that the Company's licenses have stand-alone value at the outset of an arrangement because the customer obtains the right to use Captisol in its formulations without any additional input by the Company.

Other nonrefundable, upfront license fees are recognized as revenue upon delivery of the license, if the license is determined to have standalone value that is not dependent on any future performance by the Company under the applicable collaboration agreement. Nonrefundable contingent event-based payments are recognized as revenue when the contingent event is met, which is usually the earlier of when payments are received or collections are assured, provided that it does not require future performance by the Company. The Company occasionally has sub-license obligations related to arrangements for which it receives license fees, milestones and royalties. The Company evaluates the determination of gross versus net reporting based on each individual agreement.

Sales-based contingent payments from partners are accounted for similarly to royalties, with revenue recognized upon achievement of the sales targets assuming all other revenue recognition criteria for milestones are met. Revenue from development and regulatory milestones is recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (1) the milestone event is substantive, its achievability was not reasonably assured at the inception of the agreement, and the Company has no further performance obligations relating to that event, and (2) collectability is reasonably assured. If these criteria are not met, the milestone payment is recognized over the remaining period of the Company’s performance obligations under the arrangement.

Revenue from research funding under our collaboration agreements is earned and recognized on a percentage-of completion basis as research hours are incurred in accordance with the provisions of each agreement.

In May 2014, the Company entered into a licensing agreement and research collaboration with Omthera Pharmaceuticals, a wholly-owned subsidiary of AstraZeneca. The research collaboration targets the development of novel products that utilize the proprietary Ligand developed LTP TECHNOLOGY™ to improve lipid-lowering activity of certain omega-3 fatty acids. The Company is eligible to receive compensation and reimbursement from Omthera for internal research efforts and external costs incurred, as well as development and regulatory event-based payments. The completion of a proof of concept under the development program would trigger a $1.0 million payment which is determined to be a milestone under the milestone method of accounting as (1) it is an event that can only be achieved in part on the Company's past performance, (2) there was substantive uncertainty at the date the arrangement was entered into that the event would be achieved and (3) it results in additional payment being due to the Company. None of the other event-based payments represents a milestone under the milestone method of accounting. The Company received $0.5 million from Omthera in 2014 under the agreement and recognized $0.4 million as collaborative revenue based on the percentage of completion of the research program at December 31, 2014. No milestone payment or contingent payment was received in 2014 or in the nine months ended September 30, 2015.

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				Nine months ended
	September 30,				September 30,
	2015		2014		2015		2014
Stock-based compensation expense as a component of:
Research and development expenses	$	957	$	1,169	$	3,131	$	2,814
General and administrative expenses	1,879		2,533		6,380		5,981
	$	2,836	$	3,702	$	9,511	$	8,795

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		Nine months ended
	September 30,		September 30,
	2015	2014	2015	2014
Risk-free interest rate	2.0%	1.9%	1.7%-2.0%	1.9%
Dividend yield	—	—	—	—
Expected volatility	50%	67%	50%-58%	68%
Expected term	6.5	6.4	6.6	6.4
Forfeiture rate	8.5%	8.6%	8.5%	8.6%-9.7%

Income Taxes

Income taxes are accounted for under the liability method. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of differences between the tax basis of assets or liabilities and their carrying amounts in the consolidated financial statements. The Company provides a valuation allowance for deferred tax assets if it is more likely than not that these items will expire before we are able to realize their benefit. The Company calculates the valuation allowance in accordance with the authoritative guidance relating to income taxes under ASC 740, Income Taxes, which requires an assessment of both positive and negative evidence that is available regarding the reliability of these deferred tax assets, when measuring the need for a valuation allowance. Developing the provision for income taxes requires significant judgment and expertise in federal and state income tax laws, regulations and strategies, including the determination of deferred tax assets and liabilities and, if necessary, any valuation allowances that may be required for deferred tax assets. The Company's judgments and tax strategies are subject to audit by various taxing authorities. While management believes the Company has provided adequately for its income tax liabilities in its consolidated financial statements, adverse determinations by these taxing authorities could have a material adverse effect on the Company's consolidated financial condition and results of operations.

Segment Reporting

Under ASC 280, Segment Reporting, operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the entity’s chief operating decision maker, in deciding how to allocate resources and in assessing performance. The Company has evaluated this codification and has identified two reportable segments: the development and commercialization of drugs using Captisol technology and the biopharmaceutical company with a business model based on developing or acquiring royalty revenue generating assets and coupling them with a lean corporate cost structure.

Variable Interest Entities

The Company identifies an entity as a variable interest entity ("VIE") if either: (1) the entity does not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) the entity's equity investors lack the essential characteristics of a controlling financial interest. The Company performs ongoing qualitative assessments of its VIEs to determine whether the Company has a controlling financial interest in any VIE and therefore is the primary beneficiary. If the Company is the primary beneficiary of a VIE, it consolidates the VIE under applicable accounting guidance. If the Company is no longer the primary of a VIE or the entity is no longer considered as a VIE as facts and circumstances changed, it deconsolidates the entity under the applicable accounting guidance. Beginning May 2015, the Company deconsolidated Viking Therapeutics ("Viking") a previously reported VIE, and elected to record its investment in Viking under the equity method of accounting as Viking is no longer considered a VIE and the Company does not have voting control or other elements of control that would require consolidation. The investment is subsequently adjusted for the Company’s share of Viking's operating results, and if applicable, cash contributions and distributions, which is reported on a separate line in our condensed consolidated statement of operations called “Equity in net losses of Viking Therapeutics”. On the condensed consolidated balance sheet, the Company reports its investment in Viking on a separate line in the non-current assets section called “Investment in Viking Therapeutics”. See Note 3, Investment in Viking Therapeutics, Inc., for additional details.

Convertible Debt

In August 2014, the Company completed a $245.0 million offering of convertible senior notes, which mature in 2019 and bear interest at 0.75% (the "2019 Convertible Senior Notes"). The Company accounts 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.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers. ASU 2014-09 is effective for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The revenue standard’s core principle is built on the contract between a vendor and a customer for the provision of goods and services. It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled. To accomplish this objective, the standard requires five basic steps: (1) identify the contract with the customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, (5) recognize revenue when (or as) the entity satisfies a performance obligation. Management is currently evaluating the effect the adoption of this standard will have on the Company's financial statements.

In February 2015, FASB issued ASU 2015-02 Consolidation (Topic 810): Amendments to the Consolidation Analysis. ASU 2015-02 changes the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. It is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. Management is currently evaluating the impact of the adoption of ASU 2015-02 on our consolidated financial statements.

In April 2015, FASB issued ASU 2015-03, Interest—Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs. This update was issued to simplify the presentation for debt issuance costs. Upon adoption, such costs shall be presented on our consolidated balance sheets as a direct deduction from the carrying amount of the related debt liability and not as a deferred charge presented in Other assets on our consolidated balance sheets. This amendment will be effective for interim and annual periods beginning on January 1, 2016, and is required to be retrospectively adopted. Management expects to change the presentation on our consolidated balance sheets accordingly for all periods impacted upon the required adoption date.