16. Facility financing agreement

The components of the Facility Agreement recorded as of December 31, 2013 consist of the following (in thousands):


	December 31, 2013
2019 notes
Principal amount	$	120,000
Principal converted to equity		(6,500	)
Debt discount-net of amortization		(10,834	)
Unaccreted debt issuance expense		(366	)

Net carrying amount of facility financing agreement	$	102,300

The Company’s Facility Agreement principal repayment schedule is comprised of payments beginning on the third anniversary of each issued tranche, totaling $28,375,000 annually, commencing on July 1, 2016 and ending on December 9, 2019, for a total amount of $113,500,000.


Milestone rights
Initial milestone rights fair value	$	16,276
Debt discount-net of amortization		(51	)
Unaccreted debt issuance expense		(61	)
Less current portion of milestone rights included in other current liabilities		(3,151	)

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	)
Less Tranche 3 portion of commitment asset		(4,580	)

Commitment asset value included in other assets	$	5,157

Accretion of debt issuance cost and debt discount in connection with the Deerfield financing during the three and twelve months ended December 31, 2013 are as follows (in thousands).


	Three months ended December 31, 2013		Twelve months ended December 31, 2013
Accretion expense- debt issuance cost	$	34	$	42
Accretion expense- debt discount	$	923	$	1,113

On July 1, 2013, the Company entered into the Facility Agreement 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 was converted into shares of the Company’s common stock as described under “Conversion Option” below.

Deerfield purchased the first tranche of 2019 notes (the “Tranche 1notes”) and Milestone Rights (as defined below) in the aggregate principal amount of $40.0 million on July 1, 2013. 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 purchase of the third tranche of 2019 notes occurred on December 9, 2013 (the “Tranche 3 Notes”), and was 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 shares of common stock 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 is required to repay any outstanding 2019 notes in full if the Company completes certain Major Transactions (as defined in the Facility Agreement), which include, but are 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 principal stockholder 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 December 31, 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 $128,008, related to the fourth tranche 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 fourth tranche 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.

Upon the issuance of the Tranche 3 notes, the portion of the Commitment Asset attributed to the Tranche 3 Notes was derecognized and recorded as a debt discount to the Tranche 3 notes. Therefore, the Tranche 3 notes were recorded as short-term debt for the $40.0 million received, less a $5.0 million debt discount. The effective interest rate on the Tranche 3 notes is 13.49% and the debt discount is being amortized over the term of the Tranche 3 notes using the effective interest method.

Milestone Rights

In connection with the execution of the Facility Agreement, on July 1, 2013, the Company issued Milestone Rights to the Milestone Purchasers. The Milestone Rights provide the Milestone Purchasers certain 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.

The Company analyzed the Milestone Rights under the provisions of ASC 815 Derivatives and Hedging and determined that the instruments do not meet the definition of a freestanding derivative. Since the Company has not elected to apply the fair value option to the Milestone Rights, the Company has initially recorded the Milestone Rights at their estimated fair value and accounted for the Milestone Rights as a liability by applying the indexed debt guidance contained in paragraphs ASC 470-10-25-3 and 35-4.

The initial fair value estimate of the Milestone Rights was calculated using the income approach in which the cash flows associated with the specified contractual payments were adjusted for both the expected timing and the probability of achieving the milestones discounted to present value using a selected market discount rate. 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 liability will be remeasured as the specified milestone events are achieved. Specifically, as each milestone event is achieved, the portion of the initially recorded Milestone Rights liability that pertains to such milestone event being achieved will be remeasured to the amount of the related milestone payment. The resulting change in the balance of the Milestone Rights liability due to such remeasurement will be recorded in the Company’s Statement of Operations as interest expense. Furthermore, the Milestone Rights liability will be reduced upon each such milestone payment being paid. As a result, each milestone payment would be effectively allocated between a reduction of the initially recorded Milestone Rights liability and an expense representing a return on a portion of the Milestone Rights liability paid to the Milestone Purchasers for the achievement of the related milestone event.

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. 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 and tranche B notes, if applicable (see Note 18), 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 shares issuable upon conversion of the 2019 notes 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 was 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). (See Note 18.)

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 shares issuable upon conversion 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 December 31, 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.

Embedded Derivatives

The Company identified and evaluated a number of embedded features in the notes issued under the Facility Agreement to determine if they represented embedded derivatives requiring bifurcation and separate accounting pursuant to ASC 815. In the Tranche 1 notes, we determined that the Contingent Prepayment Option and Tax Gross-Up features were embedded derivatives requiring bifurcation from the Tranche 1 notes. These features were evaluated by the Company and deemed to have a de-minimus value. Based on our analysis of the Tranche 2 notes, only one feature (the Tax Gross-Up) was required to be bifurcated. Similar to the conclusions reached in our analysis of the embedded features contained in the Tranche 1 notes, the Tax Gross-Up feature was deemed to have a de-minimus value. In analyzing the Tranche 3 notes, we identified four 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. The four embedded derivatives contained in the Tranche 3 notes were the Conversion Option, Major Transaction Put Option, Acceleration upon a Legal Judgment Against the Company in Excess of $100,000, and Tax Gross-Up. The four embedded features, discussed in detail below, were evaluated together as a single compound derivative to determine the fair value of the derivative with the exception of the Tax Gross-Up feature which was deemed to have a de-minimus value. At the time of the issuance of Tranche 3, management determined that the value of these embedded derivatives at December 9, 2013, and at December 31, 2013 was immaterial.

Conversion Option

As of December 31, 2013, a portion of the 2019 notes was convertible into fully paid shares of the Company’s common stock from and after the 11^th trading day following the public release, by the Company, of the Phase III data for the Product and until the second business day immediately prior to the final payment date, at a conversion price equal to the volume weighted average price (“VWAP”) per share of the stock during the 20 trading days immediately preceding the Purchaser’s election to convert. The number of Conversion Shares issuable upon a conversion shall be determined by dividing the Conversion Amount by the Conversion Price.

The number of shares issuable upon conversion of the 2019 notes was limited to the extent that Deerfield would otherwise acquire shares, that would cause the beneficial ownership of Deerfield and their affiliates to exceed 9.985% of the total number of shares of Common Stock then issued and outstanding.

The 2019 notes provided that Deerfield may exercise this conversion right for (i) up to 12.0 million shares of stock if the Conversion Price is $3.33 per share or less, (ii) up to 6.0 million shares of stock if the Conversion Price is $6.67 per share or more, and (iii) up to $40.0 million of principal if the Conversion Price is between $3.33 and $6.67 per share (collectively, the “Applicable Limits”).

As of December 31, 2013, Deerfield had converted $6.5 million principal amount of the 2019 notes to equity, resulting in an issuance of 1,293,224 shares of the Company’s common stock. Upon the conversion, the principal balance of the notes were recorded in equity and the loss was recognized in the Statement of Operations for the difference between the principal amount of the notes converted and their carrying amount (which included unamortized discount and debt issuance costs).

Major Transaction Put Option

The Facility Agreement requires that the Company give Deerfield notice of a Major Transaction at least 20 days prior to the anticipated effective date for such transaction, or if the Company has outstanding any class of publicly traded securities, not later than 2 business days following the public announcement thereof. Upon receiving such notice, if the successor entity does not meet the Qualification Criteria, then the Purchasers may exercise the put option, in their sole discretion, requiring the Company to repay the notes in full at an amount equal to the sum of the outstanding principal amount of the notes plus all interest accrued and unpaid on such date. Furthermore, in the event that the Purchaser exercises their rights under the Major Transaction Put Option, the obligations under the Milestone Agreement shall not terminate.

Acceleration upon a Legal Judgment Against the Company in Excess of $100,000

The Facility Agreement contains various events of default, including an event of default triggered in the event that a legal judgment is made against the Company in excess of $100,000, and the judgment remains unstayed on the appeal, undischarged, unbounded or undismissed for a period of 90 days from the date of judgment. Upon the occurrence and during the continuance of an event of default, the note holders have the option to cause the outstanding principal amount of the 2019 notes plus all accrued and unpaid interest to become immediately due and payable.

Tax Gross-Up

The Facility Agreement requires that if the Company is required by law to deduct any tax from any amount payable under the Agreement or any other Transaction Document, then the sum payable shall be increased by as much as necessary to compensate for such deduction. In addition, the Company will reimburse Deerfield for any future stamp or documentary taxes, or similar other charges or levies, incurred by Deerfield. The tax gross-up obligations do not apply to any payments under the Milestone Agreement.