11. Facility financing agreement

The components of the facility financing agreement recorded as of September 30, 2013 consist of the following (in thousands):


	September 30, 2013
2019 notes
Principal amount	$	80,000
Debt discount-net of amortization		(6,798	)
Unaccreted debt issuance expense		(269	)

Net carrying amount of facility financing obligation	$	72,933

Milestone rights
Principal amount	$	16,276
Debt discount-net of amortization		(51	)
Unaccreted debt issuance expense		(61	)
Less current portion of milestone rights included in other current liabilities		(3,150	)

Net carrying amount included in other liabilities	$	13,013

Commitment Asset
Initial commitment asset fair value	$	13,393
Less Tranche 2 portion of commitment asset		(3,656	)

Commitment asset value included in other assets	$	9,737

On July 1, 2013, the Company entered into the Facility Agreement with Deerfield providing for the sale of up to $160.0 million of 2019 notes to Deerfield in four equal tranches of $40.0 million principal amount. The 2019 notes accrue interest at a rate of 9.75% per annum until maturity in 2019 or their earlier repayment, repurchase, or conversion. A portion of the principal amount of the 2019 notes may be converted into shares of the Company’s common stock (the “Conversion Shares”) at the noteholder’s option. The conversion price will be determined by the volume weighted average price of the Company’s common stock during the 20 trading days immediately preceding the conversion date. The number of Conversion Shares that may be issued upon conversion of all 2019 notes will be limited to an aggregate of 12.0 million shares or such lesser number of shares as may be determined pursuant to the conversion limitations contained in the 2019 notes if the conversion price at which the 2019 notes are actually converted from time to time is greater than $3.33.

Deerfield purchased the first tranche of 2019 notes (the “Tranche 1 Notes”) and Milestone Rights (as defined below) in the aggregate principal amount of $40.0 million. The closing of the second tranche of 2019 notes (the “Tranche 2 Notes”), which was subject to achievement and reporting of certain results from the Company’s two Phase 3 clinical studies of AFREZZA, occurred on September 5, 2013. Deerfield’s obligation to purchase the third tranche of 2019 notes is subject to the repayment of the 2013 notes with the funds made available by the purchase of these 2019 notes. Deerfield’s obligation to purchase the fourth tranche of 2019 notes is subject to receipt of marketing approval of AFREZZA by the FDA and the prior satisfaction of the conditions for the third tranche closing. In addition to the foregoing conditions, Deerfield’s obligation to purchase 2019 notes at any of the two remaining closings is subject to, at each closing, the Conversion Shares issuable upon conversion of all previously sold 2019 notes being freely tradable pursuant to an effective registration statement filed with the SEC or pursuant to Rule 144 under the Securities Act.

The Company is required to repay 25% of the original principal amount of the 2019 notes sold in each tranche on the third, fourth, fifth and sixth anniversaries of the applicable issue dates of such 2019 notes; provided that the entire outstanding principal amount of all 2019 notes will become due and payable no later than December 31, 2019. The Company had the right to prepay the outstanding principal amount of the Tranche 1 Notes at a price equal to 110% of the outstanding principal thereof plus all accrued and unpaid interest as of the date of prepayment if the conditions for the Tranche 2 Notes had not been satisfied. The Company is required to repay any outstanding 2019 notes in full if the Company completes a major transaction (as defined), which includes, but is not limited to, certain mergers and other change of control transactions involving the Company.

The Facility Agreement includes customary representations, warranties and covenants, including, a restriction on the incurrence of additional indebtedness, and a financial covenant which requires the Company’s cash and cash equivalents, which includes available borrowings on the related party note, on the last day of each fiscal quarter to not be less than $25.0 million. As discussed in Note 1 – Basis of Presentation, the Company will need to raise additional capital to support its current operating plans. Due to the uncertainties related to maintaining sufficient resources to comply with the aforementioned covenant, the 2019 notes have been classified as current liabilities in the accompanying balance sheet as of September 30, 2013. In the event of non-compliance, there can be no assurances that the holders of the 2019 notes will not exercise remedies available to them, which may include, among other things, the issuance of a notice of acceleration.

In connection with the issuance of the Tranche 1 Notes and Milestone Rights on July 1, 2013, the Company recorded $52.9 million in value received, which consisted of $39.5 million in cash from the issuance of the Tranche 1 Notes plus a commitment asset (as described further below) with a fair value equal to $13.4 million. In exchange, the Company issued to Deerfield the Tranche 1 Notes and Milestone Rights with estimated fair values equal to $37.1 million and $16.3 million, respectively. The Tranche 1 Notes, the Milestone Rights and the commitment asset were initially recorded at fair value.

The Tranche 1 Notes are classified as short-term debt and are subsequently accounted for at amortized cost. The effective interest rate on the Tranche 1 Notes is 12.19% and a debt discount of approximately $3.3 million recognized on the Tranche 1 Notes is being amortized to interest expense over the term of the Tranche 1 Notes using the effective interest method.

In accordance with the Facility Agreement, the Company reimbursed Deerfield $500,000 for a portion of documented expenses for attorneys, accountants and other professional advisors, and other out-of-pocket expenses Deerfield incurred in connection with the transaction. These costs were allocated between the 2019 notes and the Milestone Rights based upon their relative fair value resulting in $448,737 being allocated to the 2019 notes and included within the debt discount with the remainder being allocated to the Milestone Rights. In addition, the Company incurred a total of $597,529 in debt issuance costs, of which $536,266 was allocated to the 2019 notes and the remainder to the Milestone Rights using the relative fair value allocation method. A portion of the debt issuance costs, or $259,800, related to the third and fourth tranches of 2019 notes are included in other assets.

The commitment asset represents the right to receive additional funding under the second, third and fourth tranches of the Facility Agreement. The fair value of the commitment asset was estimated using the income approach by estimating the fair value of the future tranches using a market debt rate commensurate with the risk of the future tranches and the fair value of the cash expected to be received by the Company and assessing the probability of the commitments being funded in the future. The commitment asset will not be subsequently remeasured but it will be monitored for impairment until future tranches of 2019 notes are drawn. Upon the drawing of additional tranches of 2019 notes, the portion of the commitment asset related to such tranche will be derecognized resulting in a debt discount being recorded on the additional tranches of 2019 notes issued. If the additional funding under the third and fourth tranches ceases to be probable of occurring, the commitment asset will be impaired and will be written off as an expense in the Statement of Operations.

Upon the issuance of the Tranche 2 Notes, the portion of the commitment asset attributed to the Tranche 2 Notes was derecognized and recorded as a debt discount to the Tranche 2 Notes. Therefore, the Tranche 2 Notes were recorded as short-term debt for the $40.0 million received, less a $3.7 million debt discount. The effective interest rate on the Tranche 2 Notes is 12.45% and the debt discount is being amortized over the term of the Tranche 2 Notes using the effective interest method.

The Company identified and evaluated a number of embedded features in the Facility Agreement to determine if they represented embedded derivatives requiring bifurcation and separate accounting pursuant to ASC 815, Derivatives and Hedging. There were two embedded features that required bifurcation and separate accounting and the Company determined that they should be bundled together as a single, compound embedded derivative, bifurcated from the host contract, and accounted for at fair value, with changes in fair value being recorded in the Statement of Operations. Management determined that the value of these embedded derivatives at July 1, 2013 and at September 30, 2013 was insignificant.

Milestone Agreement

In connection with the Facility Agreement, on July 1, 2013, the Company also entered into the Milestone Agreement with the Milestone Purchasers, pursuant to which, the Company sold the Milestone Purchasers the Milestone Rights to receive payments of up to $90.0 million upon the occurrence of specified strategic and sales milestones, including the first commercial sale of an AFREZZA product and the achievement of specified net sales figures. The payments due under the Milestone Rights are subject to pro rata reduction in the event of certain funding failures by Deerfield under the Facility Agreement.

The Milestone Agreement includes customary representations and warranties and covenants by the Company, including restrictions on transfers of intellectual property related to AFREZZA. The Milestone Rights are subject to acceleration in the event the Company transfers its intellectual property related to AFREZZA in violation of the terms of the Milestone Agreement and terminate if the Company exercises its right to prepay the Tranche 1 Notes.

The Milestone Rights were initially recorded as a short-term liability equal to $3.2 million included in Accrued expenses and other current liabilities in the accompanying condensed consolidated balance sheet and a long term liability equal to $13.1 million included in Other liabilities. In determining the fair value of the Milestone Rights, the 13 individual milestone payments were adjusted for both (i) the expected timing and (ii) the probability of achieving the milestones, and then discounted to present value using a discount rate of 17.5%. Once the initial valuation of each specified milestone payment was determined, the individual milestone payments were then aggregated to arrive at a total fair value of $16.3 million. The discount rate was based on the estimated cost of equity which was derived using the capital asset pricing model. In addition, a 5% risk premium was added to the computation of the cost of equity to adjust for non-systemic risk factors, such as the Company’s lack of product diversification and history of financial losses, which were not captured in other model inputs.

The Milestone Rights did not meet the definition of a derivative under ASC 815; therefore the Company analogized to the accounting guidance contained in ASC 470-10-35-4, which addresses indexed debt. As each milestone is achieved, the portion of the initial liability pertaining to the specified milestone will be remeasured to equal the amount of the milestone payment. The change in the balance of the liability that occurs upon remeasurement will be recorded as interest expense in the Statement of Operations. Once the milestone payment is made for a specific milestone event, the remeasured liability pertaining to that specific milestone event will be extinguished. The resulting effect is that the payment required to be made upon the occurrence of the milestone event is allocated between a reduction of the initial liability pertaining to that milestone and an expense representing a return on that portion of the liability paid to the Milestone Purchasers for the achievement of that milestone.

The Company identified and evaluated a number of embedded features in the Milestone Rights to determine if they represented embedded derivatives requiring bifurcation and separate accounting pursuant to ASC 815, Derivatives and Hedging. There were no features in the Milestone Rights that required bifurcation and separate accounting

Security Agreement

In connection with the Facility Agreement, the Company and its subsidiary, MannKind LLC, entered into a Guaranty and Security Agreement (the “Security Agreement”) with Deerfield and HS (collectively, the “Purchasers”), pursuant to which the Company and MannKind LLC each granted the Purchasers a security interest in substantially all of their respective assets, including respective intellectual property, accounts, receivables, equipment, general intangibles, inventory and investment property, and all of the proceeds and products of the foregoing. The Security Agreement includes customary covenants by the Company and MannKind LLC, remedies of the Purchasers and representations and warranties by the Company and MannKind LLC. The security interests granted by us and MannKind LLC will terminate upon repayment of the 2019 notes in full. Our obligations under the Facility Agreement and the Milestone Agreement are also secured by certain mortgages on the Company’s facilities in Danbury, Connecticut and Valencia, California.

Registration Rights Agreement

In connection with the Facility Agreement and the sale of the 2019 notes pursuant thereto, the Company entered into a Registration Rights Agreement with Deerfield (the “Registration Rights Agreement”), pursuant to which the Company agreed to register for sale, the Conversion Shares within a specified time period following the issuance of each tranche of 2019 notes.

Pursuant to the Registration Rights Agreement, the number of aggregate shares of Common Stock included in the initial mandatory registration statement is 12.0 million shares (subject to adjustment in the event of a stock split, stock combination, reclassification, payment of stock dividends, recapitalization, or other similar transactions).

In the event the Company is unable to meet certain requirements of the Registration Rights Agreement specifically related to the filing of the registration statement within specified periods, using its best efforts to obtain effectiveness of the registration statement, or maintaining the effectiveness of the registration statement, the Company will be required to pay additional damages to Deerfield. The additional damages are calculated as 1% of Deerfield’s original principal amount of the relevant tranche of 2019 notes and shall accrue until the earlier of (i) the date on which the registration failure has been cured and (ii) the date on which the Conversion Shares may be disposed of by Deerfield.

In accordance with the accounting guidance contained in ASC 825-20, the contingent obligation to make future payments, or otherwise transfer consideration, under a registration payment arrangement should be recognized and measured in accordance with ASC 450-20. ASC 450-20 requires an accrual to be recorded for a contingent payment if it is both probable of occurring and the amount of the payment can be reasonably estimated. As of September 30, 2013, the Company determined that it is not probable that it will be obligated to pay additional damages to Deerfield pursuant to the Registration Rights Agreement, and therefore no accrual for such contingent payment has been recorded.

Accretion of debt issuance cost and debt discount in connection with the Deerfield financing during the three and nine months ended September 30, 2013 are as follows (in thousands).


	Three months ended September 30, 2013		Nine months ended September 30, 2013
Accretion expense- debt issuance cost	$	8	$	8
Accretion expense- debt discount	$	190	$	190