Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The Company’s condensed consolidated financial statements include the financial statements of Ligand and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. We have included all adjustments, consisting only of normal recurring adjustments, which we considered necessary for a fair presentation of our financial results. These unaudited condensed consolidated financial statements and accompanying notes should be read together with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. Interim financial results are not necessarily indicative of the results that may be expected for the full year.

Reclassifications

Certain amounts in the prior period combined financial statements have been reclassified to conform with the current period presentation.

Significant Accounting Policies

The Company describes its significant accounting policies in Note 1 to the financial statements in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2017.

Use of Estimates

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

Accounting Standards Recently Adopted

Revenue Recognition - In May 2014, the FASB issued new guidance related to revenue recognition, ASU 2014-09, Revenue from Contracts with Customers (“ASC 606”), which outlines a comprehensive revenue recognition model and supersedes most current revenue recognition guidance. The new guidance requires a company to recognize revenue upon transfer of goods or services to a customer at an amount that reflects the expected consideration to be received in exchange for those goods or services. ASC 606 defines a five-step approach for recognizing revenue, which may require a company to use more judgment and make more estimates than under the current guidance. We adopted this new standard as of January 1, 2018, by using the modified-retrospective method.

Financial Instruments - In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10), which requires equity investments (other than those accounted for under the equity method or those that result in consolidation) to be measured at fair value, with changes in fair value recognized in net income. We have strategic investments, including Viking, that fall under this guidance update. We have adopted ASU 2016-01 effective January 1, 2018 as a cumulative-effect adjustment and reclassified $2.6 million unrealized gains on equity investments, net of tax, from accumulated other comprehensive income to accumulated deficit on our consolidated balance sheet. Effective January 1, 2018, our results of operations include the changes in fair value of these financial instruments. See Viking subsection below for further information on the Viking investment.

Statement of Cash Flows - In August 2016 the FASB issued ASU No. 2016-15 Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments. The new standard clarifies certain aspects of the statement of cash flows, and aims to reduce diversity in practice regarding how certain transactions are classified in the statement of cash flows. This standard was effective January 1, 2018. The Company adopted ASU No. 2016-15 effective January 1, 2018. We have updated our presentation of payments to CVR holders and other contingency payments to conform to the standard and have revised our prior year cash flows accordingly.

Accounting Standards Not Yet Adopted

Financial Instruments - In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which amends the impairment model by requiring entities to use a forward-looking approach based on expected losses to estimate credit losses on certain types of financial instruments, including trade receivables and available for sale debt securities. The ASU is effective for us beginning in the first quarter of 2020, with early adoption permitted. We are currently evaluating the impact of ASU 2016-13 on the consolidated financial statements.

We do not believe that any other recently issued, but not yet effective accounting pronouncements, if adopted, would have a material impact on our consolidated financial statements or disclosures.

Revenue

Our revenue is generated primarily from royalties on sales of products commercialized by the Company's partners, Captisol material sales, license fees and development and regulatory milestone payments.

On January 1, 2018, we adopted ASC 606 which amends the guidance for recognition of revenue from contracts with customers by using the modified-retrospective method applied to those contracts that were not completed as of January 1, 2018. The results for reporting periods beginning January 1, 2018, are presented in accordance with the new standard, although comparative information has not been restated and continues to be reported under the accounting standards and policies in effect for those periods. See Note 1, Summary of significant accounting policies, to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2017 for the accounting associated with revenue prior to the adoption of ASC 606.

Upon adoption, we recorded a net decrease of $25.4 million to accumulated deficit due to the cumulative impact of adopting the new standard—with the impact related primarily to the acceleration of royalty revenue, net of related deferred tax impact. The adoption of this new standard resulted in higher reported total revenues and operating income in the second quarter of 2018 of $10.4 million and lower reported total revenue and operating income in the first half of 2018 of $1.5 million, compared to what reported amounts would have been under the prior standard. Our accounting policies under the new standard were applied prospectively and are noted below.

Royalties, License Fees and Milestones

We receive royalty revenue on sales by our partners of products covered by patents that we own. We do not have future performance obligations under these license arrangements. We generally satisfy our obligation to grant intellectual property rights on the effective date of the contract. However, we apply the royalty recognition constraint required under the guidance for sales-based royalties which requires a sales-based royalty to be recorded no sooner than the underlying sale. Therefore, royalties on sales of products commercialized by the Company’s partners are recognized in the quarter the product is sold. Our partners generally report sales information to us on a one quarter lag. Thus, we estimate the expected royalty proceeds based on an analysis of historical experience and interim data provided by our partners including their publicly announced sales. Differences between actual and estimated royalty revenues are adjusted for in the period in which they become known, typically the following quarter. Our royalty revenue estimates recorded in the first quarter of 2018 did not differ materially from actual results.

Our contracts with customers often will include future contingent milestone based payments. We include contingent milestone based payments in the estimated transaction price when there is a basis to reasonably estimate the amount of the payment. These estimates are based on historical experience, anticipated results and our best judgment at the time. If the contingent milestone based payment is sales-based we apply the royalty recognition constraint and record revenue when the underlying sale has taken place. Significant judgments must be made in determining the transaction price for our sales of intellectual property. Because of the risk that products in development with our partners will not reach development based milestones or receive regulatory approval, we generally recognize any contingent payments that would be due to us upon or after the development milestone or regulatory approval.

Material Sales

We recognize revenue when control of Captisol material or intellectual property license rights is transferred to our customers in an amount that reflects the consideration we expect to receive from our customers in exchange for those products. This process involves identifying the contract with a customer, determining the performance obligations in the contract, determining the contract price, allocating the contract price to the distinct performance obligations in the contract, and recognizing revenue when the performance obligations have been satisfied. A performance obligation is considered distinct from other obligations in a contract when it provides a benefit to the customer either on its own or together with other resources that are readily available to the customer and is separately identified in the contract. We consider a performance obligation satisfied once we have transferred control of the product, meaning the customer has the ability to use and obtain the benefit of the Captisol material or intellectual property license right. We recognize revenue for satisfied performance obligations only when we determine there are no uncertainties regarding payment terms or transfer of control. Sales tax and other taxes we collect concurrent with revenue-producing activities are excluded from revenue. We expense incremental costs of obtaining a contract when incurred if the expected amortization period of the asset that we would have recognized is one year or less or the amount is immaterial. We did not incur any incremental costs of obtaining a contract during the periods reported.

Depending on the terms of the arrangement, we may also defer a portion of the consideration received because we have to satisfy a future obligation. We use an observable price to determine the stand-alone selling price for separate performance obligations or a cost plus margin approach when one is not available. We have elected to recognize the cost for freight and shipping when control over Captisol material has transferred to the customer as an expense in cost of sales.

The timing of revenue recognition, billings and cash collections results in billed accounts receivable, unbilled receivables (contract assets), and customer advances and deposits (contract liabilities) on the Consolidated Balance Sheet. Except for royalty revenue, we generally receive payment at the point we satisfy our obligation or soon after. Therefore, we do not generally carry a contract asset or contract liability balance.

The Company has revenue sharing arrangements whereby certain revenue proceeds are shared with a third party. The revenue standard requires an entity to determine whether it is a principal or an agent in these transactions by evaluating the nature of its promise to the customer. The Company received a $4.6 million milestone payment from a license partner in the first six months of 2018 of which $3.0 million was paid to a third-party in-licensor. The Company recorded net revenue of $1.6 million as it believes it was an agent in the transaction. The Company records amounts due to third-party in-licensors as general and administrative expenses when it is the principal in the transaction.

Disaggregation of Revenue

Under ASC 605, the legacy revenue standard, the Company would have reported total royalty revenue of $21.1 million in the second quarter of 2018, disaggregated as follows: Promacta $15.6 million, Kyprolis $3.4 million, Evomela $1.6 million and Other $0.5 million. In 2017 royalty revenue continues to be reported in accordance with ASC 605 and was $14.2 million for the second quarter of 2017 or disaggregated as follows: Promacta $9.7 million, Kyprolis $2.9 million, Evomela, $1.3 million and Other $0.3 million and $38.4 million for the first half of 2017 or disaggregated as follows: Promacta $26.4 million, Kyprolis $7.5 million, Evomela $3.1 million and Other $1.4 million. Under ASC 606, royalty revenue was $31.4 million in second quarter of 2018 or disaggregated as follows: Promacta $24.8 million, Kyprolis $4.7 million, Evomela $1.2 million and Other $0.7 million and $52.2 million the first half of 2018 or disaggregated as follows: Promacta $40.4 million, Kyprolis $8.1 million, Evomela $2.8 million and Other $0.9 million.

The following table represents disaggregation of Material Sales and License fees, milestone and other (in thousands):



		Three months ended				Six months ended
		June 30,				June 30,
		2018		2017		2018		2017
Material Sales
	Captisol	$	7,612	$	5,550	$	12,003	$	6,672
License fees, milestones and other
	License Fees	$	47,981	$	666	$	74,936	$	3,538
	Milestone	1,919		4,497		4,744		5,505
	Other	1,135		3,071		2,301		3,108
		$	51,035	$	8,234	$	81,981	$	12,151

Short-term Investments

The Company's investments consist of the following at June 30, 2018 and December 31, 2017 (in thousands):



	June 30, 2018									December 31, 2017
	Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value		Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value

Short-term investments
Bank deposits	$	361,826	$	36	$	(79	)	$	361,783	$	80,095	$	6	$	(42	)	$	80,059
Corporate bonds	84,275		1		(138		)	84,138		55,335		—		(96		)	55,239
Commercial paper	243,544		10		(12		)	243,542		27,933		—		(20		)	27,913
U.S. Government bonds	112,403		14		(20		)	112,397		8,939		—		(10		)	8,929
Agency bonds	—		—		—			—		4,991		—		(1		)	4,990
Municipal bonds	2,023		—		(13		)	2,010		2,028		—		(13		)	2,015
Corporate equity securities	135		1,463		—			1,598		207		1,689		—			1,896
	$	804,206	$	1,524	$	(262	)	$	805,468	$	179,528	$	1,695	$	(182	)	$	181,041

Inventory

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

Goodwill and Other Identifiable Intangible Assets

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



	June 30,			December 31,
	2018			2017
Indefinite lived intangible assets
IPR&D	$	2,410		$	7,923
Goodwill	85,961			85,959
Definite lived intangible assets
Complete technology	228,413			222,900
Less: accumulated amortization	(29,078		)	(23,301		)
Trade name	2,642			2,642
Less: accumulated amortization	(982		)	(916		)
Customer relationships	29,600			29,600
Less: accumulated amortization	(11,004		)	(10,264		)
Total goodwill and other identifiable intangible assets, net	$	307,962		$	314,543

Commercial License Rights

Commercial license rights consist of the following (in thousands):



	June 30,			December 31,
	2018			2017
Aziyo and CorMatrix	$	17,696		$	17,696
Selexis	8,602			8,602
	$	26,298		$	26,298
Less: accumulated amortization	(5,861		)	(6,772		)
Total commercial rights, net	$	20,437		$	19,526

Commercial license rights represent a portfolio of future milestone and royalty payment rights acquired from Selexis in April 2013 and April 2015 and CorMatrix in May 2016. Individual commercial license rights acquired are carried at allocated cost and approximate fair value. In May 2017, the Company entered into a Royalty Agreement with Aziyo pursuant to which the Company will receive royalties from certain marketed products that Aziyo acquired from CorMatrix. The Company accounts for the Aziyo commercial license right as a financial asset in accordance with ASC 310 and amortizes the commercial license right using the "effective interest" method whereby the Company forecasts expected cash flows over the term of the arrangement to arrive at an annualized effective interest. The annual effective interest associated with the forecasted cash flows from the Royalty Agreement with Aziyo as of June 30, 2018 is 26%. Revenue is calculated by multiplying the carrying value of the commercial license right by the effective interest.

Viking

The Company's equity ownership interest in Viking decreased in the first quarter of 2018 to approximately 12.4% due to Viking's financing events in February 2018. As a result, in February 2018, the Company concluded that it did not exert significant influence over Viking and discontinued accounting for its investment in Viking under the equity method. The market value of the Company's equity investment in Viking was $59.8 million as of June 30, 2018 and as a result the Company recorded an unrealized gain of $32.3 million and $53.5 million in Gain (loss) from Viking in its condensed consolidated statement of operations for the three and six months ended June 30, 2018, respectively.

The Company also has outstanding warrants to purchase 1.5 million shares of Viking's common stock at an exercise price of $1.50 per share. The Company recorded the warrants at fair value of $12.3 million and $3.8 million at June 30, 2018 and December 31, 2017, respectively. As a result, the Company recorded an unrealized gain of $7.7 million and $8.5 million in Gain (loss) from Viking in its condensed consolidated statement of operations for the three and six months ended June 30, 2018, respectively.

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):



	June 30,		December 31,
	2018		2017
Compensation	$	3,166	$	4,085
Professional fees	367		430
Amounts owed to former licensees	468		396
Royalties owed to third parties	2,245		954
Other	3,066		1,512
Total accrued liabilities	$	9,312	$	7,377

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				Six months ended
	June 30,				June 30,
	2018		2017		2018		2017
Stock-based compensation expense as a component of:
Research and development expenses	$	2,096	$	1,928	$	3,863	$	5,867
General and administrative expenses	2,716		2,696		5,504		4,802
	$	4,812	$	4,624	$	9,367	$	10,669

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		Six months ended
	June 30,		June 30,
	2018	2017	2018	2017
Risk-free interest rate	2.8%	2.1%	2.8%	2.1%
Dividend yield	—	—	—	—
Expected volatility	36%	47%	34%	47%
Expected term	5.8	6.5	5.7	6.8

Derivatives

In May 2018, the Company issued $750 million aggregate principal amount of 0.75% convertible senior notes (the '2023 Notes') as further described in “Footnote 3. Convertible Senior Notes.” Concurrently with the issuance of the notes, the Company entered into a series of convertible note hedge and warrant transactions which in combination are designed to reduce the potential dilution to the Company's stockholders and/or offset the cash payments the Company is required to make in excess of the principal amount upon conversion of the notes. The conversion option associated with the 2023 Notes temporarily met the criteria for an embedded derivative liability which required bifurcation and separate accounting. In addition, the note hedge and warrants were also temporarily classified as a derivative asset and liability, respectively, on the Company’s consolidated balance sheet. As a result of shareholder approval to increase the number of authorized shares of the Company's common stock on June 19, 2018, as discussed in “Footnote 3. Convertible Senior Notes” the derivative asset and liabilities were reclassified to additional paid-in capital. Changes in the fair value of these derivatives were reflected in Other expense, net in our Condensed Consolidated Statements of Operations.

The following table summarizes the inputs and assumptions used in the Black-Scholes model to calculate the fair value of the assets and the inputs and assumptions used in the Binomial model to calculate the fair value of the derivative liabilities associated with the 2023 Notes:



	As of May, 22 2018	As of June 19, 2018
Common stock price	$187.09	$195.91
Exercise price, conversion premium and bond hedge	$248.48	$248.48
Exercise price, warrant	$315.38	$315.38
Risk-free interest rate	2.9%	2.8%
Volatility	30%-35%	30%-35%
Dividend yield	—	—
Annual coupon rate	0.75%	0.75%
Remaining contractual term (in years)	5.00	4.98

In addition, on May 22, 2018, the Company amended its 2019 Notes making an irrevocable election to settle the entire note in cash. As a result, the Company reclassified from equity to derivative liability the fair value of the conversion premium as of May 22, 2018. Amounts paid in excess of the principal amount will be offset by an equal receipt of cash under the corresponding convertible bond hedge. As a result, the Company reclassified from equity to derivative asset the fair value of the bond hedge as of May 22, 2018. The Company engaged a third-party valuation firm with expertise in valuing financial instruments to determine the fair value of the conversion option derivative liability and bond hedge derivative asset. Changes in the fair value of these derivatives are reflected in Other expense, net in our Condensed Consolidated Statements of Operations.

The following table summarizes the inputs and assumptions used in the Black-Scholes model to calculate the fair value of the derivative assets and the inputs and assumptions used in the Binomial model to calculate the fair value of the derivative liability associated with the 2019 Notes:



	As of May, 22 2018	As of June 30, 2018
Common stock price	$187.09	$207.17
Exercise price, conversion premium and bond hedge	$75.05	$75.05
Risk-free interest rate	2.47%	2.43%
Volatility	30%-35%	30%-35%
Dividend yield	—	—
Annual coupon rate	0.75%	0.75%
Remaining contractual term (in years)	1.25	1.14

Lease Obligations

The Company describes its operating lease obligations in Note 5 to the financial statements in Item 8 of its Annual Report on Form 10-K for the year ended December 31, 2017. There were no significant changes in the Company's operating lease commitments during the first six months of 2018.

Income Per Share

Basic income per share is calculated by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted income per share is computed based on the sum of the weighted average number of common shares and potentially dilutive common shares outstanding during the period.

Potentially dilutive common shares consist of shares issuable under the 2023 Notes, warrants associated with the 2019 Notes and 2023 Notes, stock options and restricted stock. The 2023 Notes have a dilutive impact when the average market price of the Company’s common stock exceeds the applicable conversion price of the notes. The 2019 Notes were amended to require cash settlement of the conversion premium for conversion notices received after May 22, 2018 and therefore do not have a dilutive impact subsequent to May 22, 2018. The warrants have a dilutive effect to the extent the market price per share of common stock exceeds the applicable exercise price of the warrants. Potentially dilutive common shares from stock options and restricted stock are determined using the average share price for each period under the treasury stock method. In addition, proceeds from exercise of stock options and the average amount of unrecognized compensation expense for restricted stock are assumed to be used to repurchase shares. In loss periods, basic net loss per share and diluted net loss per share are identical because the otherwise dilutive potential common shares become anti-dilutive and are therefore excluded.

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



	Three months ended		Six months ended
	June 30,		June 30,
	2018	2017	2018	2017
Weighted average shares outstanding:	21,211,877	21,012,611	21,209,467	20,974,738
Dilutive potential common shares:
Restricted stock	59,605	156,054	61,782	170,900
Stock options	1,132,781	967,533	1,126,196	961,021
2019 Convertible Senior Notes	1,051,852	1,079,702	1,385,475	1,010,505
Warrants	981,807	—	835,329	—
Shares used to compute diluted income per share	24,437,922	23,215,900	24,618,249	23,117,164
Potentially dilutive shares excluded from calculation due to anti-dilutive effect	2,091,908	3,811,813	1,120,156	3,761,440