Note

Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of expenses incurred during the reporting period. Actual results could differ from those estimates and such differences could be material to the Company’s financial position and results of operations.

Significant estimates and assumptions include the valuation of equity instruments and equity-linked instruments, including the valuation of the Company’s common stock and the valuation of the Company’s common stock options for purposes of accounting for stock-based compensation, and accruals for clinical trials and the valuation allowances on deferred tax assets.

Concentration of Credit Risk and Other Risks and Uncertainties

Financial instruments that potentially subject the Company to concentration of credit risk consist of cash and cash equivalents. Cash and cash equivalents are deposited in demand and money market accounts with established financial institutions and, at times, such balances with any

one

financial institution

may

be in excess of the Federal Deposit Insurance Corporation insured limits. To date, the Company has

not

experienced any losses on its deposits of cash and cash equivalents.

The Company operates in a dynamic and highly competitive industry and believes that changes in any of the following areas could have a material adverse effect on the Company's future financial position, results of operations, or cash flows: ability to obtain future financing; advances and trends in new technologies and industry standards; results of clinical trials; regulatory approval and market acceptance of the Company's products; development of sales channels; certain strategic relationships; litigation or claims against the Company based on intellectual property, patent, product, regulatory, or other factors; and the Company's ability to attract and retain employees necessary to support its growth.

The Company’s postoperative pain reduction product candidate, brivoligide, is an oligonucleotide. The Company currently uses Nitto-Denko Avecia, Inc. (“Avecia”) as a single supplier for the brivoligide drug substance. There are currently a limited number of oligonucleotide manufacturers with commercial scale capabilities globally. While the Company intends to develop secondary sources for manufacturing of its drug candidates in the future, there can be

assurance that it will be able to do so on commercially reasonable terms, or at all. Any interruption in the supply of this key material could significantly delay the research and development process or increase the expenses for development and commercialization of the Company’s product candidates. The quality of materials can be critical to the performance of a drug delivery technology. Therefore, the lack of a reliable source that provides a consistent supply of high quality materials would harm the Company. At

September 30, 2019,

this vendor represented

26%

of total accounts payable.

September 30, 2019,

three

vendors represented

26%,

26%

and

23%

of total accounts payable, respectively. One of these vendors supported clinical study activities and accounted for

26%

of the total accounts payable. The

second

vendor supported manufacturing activities and accounted for

26%

of the total accounts payable. The

third

vendor supported general and administrative activities associated with the Merger and the next round of equity financing. At

December 31, 2018,

three

vendors represented

52%,

26%

and

15%

of total accounts payable. Two of these vendors supported general and administrative activities, primarily associated with the Merger and next round of equity financing, which accounted for

67%

of the total accounts payable. The remaining vendor supported clinical study activities.

Clinical Trial Accruals

The Company’s clinical trial accruals are based on patient enrollment and related costs at clinical investigator sites as well as for the services received and efforts expended pursuant to contracts with multiple research institutions and contract research organizations (“CROs”) that conduct and manage clinical trials on the Company’s behalf. The Company accrues expenses related to clinical trials based on contracted amounts applied to the level of patient enrollment and activity according to the clinical trial protocol. If timelines or contracts are modified based upon changes in the clinical trial protocol or scope of work to be performed, the Company modifies the estimates of accrued expenses accordingly. To date, the Company has had

significant adjustments to accrued clinical trial expenses.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with a maturity of

three

months or less on the date of acquisition to be cash and cash equivalents.

Property and Equipment, Net

Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed using a straight-line method over the estimated useful lives of the assets, generally

three

five

years. Leasehold improvements are amortized over the shorter of the estimated useful life of the asset or the remaining term of the lease.

Expenditures for repairs and maintenance are charged to expense as incurred. Upon disposition of an asset, the cost and related accumulated depreciation are removed from the accounts and the resulting gain or loss is reflected in the statements of operations.

Impairment of Long-Lived Assets

The Company's long-lived assets and other assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset

may

not

be recoverable. Recoverability of an asset to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds its fair value. As of

September 30, 2019

and

December 31, 2018,

the Company had

not

experienced any impairment losses on its long-lived assets.

Restricted Cash

September 30, 2019,

the Company had

$198,000

restricted from withdrawal and held by a bank in the form of a secured money market account as collateral for Oxford in conjunction with a debt amendment that occurred in

January 2019.

In addition, as of

September 30, 2019

and

December 31, 2018,

the Company had

$55,000

restricted and held by a bank as collateral for a letter of credit provided to the Company’s facility landlord.

Stock-Based Compensation

Stock-based compensation is measured at the grant date based on the fair value of the award. The fair value of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service period, which is generally the vesting period. The Company recognizes forfeitures as they occur.

The Company uses the Black-Scholes option-pricing model (the "Black-Scholes model") as the method for determining the estimated fair value of stock options.

Expected Term

—

The expected term represents the period that the Company's stock-based awards are expected to be outstanding and is determined using the simplified method.

Expected Volatility

—

Expected volatility is estimated using comparable public companies’ volatility for similar terms.

Expected Dividend

—

The Black-Scholes model calls for a single expected dividend yield as an input. Other than the dividend paid in connection with the Merger, the Company has never paid dividends and has

plans to pay dividends.

Risk-Free Interest Rate

—

The risk-free interest rate used in the Black-Scholes model is based on the U.S. Treasury

zero

-coupon issues in effect at the time of grant for periods corresponding with the expected term of the option.

Research and Development

Research and development expenses consist of personnel costs, including salaries, benefits and stock-based compensation, preclinical studies, clinical studies performed by CROs, materials and supplies, licenses and fees, and overhead allocations consisting of various administrative and facilities related costs. The Company charges research and development costs, including clinical study costs, to expense when incurred.

Collaboration Agreement

June 2018,

the Company entered into a collaboration agreement with twoXAR, an artificial intelligence-driven drug discovery company, in order to identify potential product candidates for the treatment of endometriosis. In

May 2019,

the Company made a collaboration initiation payment of

$75,000,

which was charged to research and development expenses when incurred.

June 2019,

Adynxx received an initial set of candidate predictions from twoXAR. The Company has initiated a review of the potential products to determine if any are viable candidates for further research and development.

Grant Reimbursements

December 2018,

the Company received a Notice of Award from the National Institute on Drug Abuse (“NIDA”), part of the National Institutes of Health (“NIH”), to support the clinical development of its lead product candidate, brivoligide. NIH grants provide funds for certain types of expenditures in connection with research and development activities over a contractually defined period. The maximum funding expected to be available under this grant for qualified expenditures over the

two

-year period through

December 2020

is approximately

$5.7

million.

January 1, 2019,

the Company adopted Accounting Standards Update (ASU)

2018

08,

“Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made.” Based on this guidance, the Company determined that grant payments received met the definition of a ‘conditional contribution’ (versus an exchange contract) because (i) the Company has limited discretion in the way the funds

may

be spent, which creates a barrier to entitlement, and (ii) the grant contains provisions that release the awarding agency from the obligation to transfer funds that are

not

expended at the time the award is terminated. The Company recognizes grant reimbursements as a contra operating expense and reflects this as a component of its loss from operations in the period during which the qualifying expenses are incurred and the related services rendered, provided that the applicable performance obligations have been met.

For the

three

and

nine

months ended

September 30, 2019,

the Company incurred qualified expenses and recognized

$0.7

million and

$1.9

million of grant reimbursements, respectively.

Income Taxes

The Company accounts for income taxes using the asset and liability method whereby deferred tax asset and liability account balances are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company provides a valuation allowance, if necessary, to reduce deferred tax assets to their estimated realizable value.

In evaluating the ability to recover its deferred income tax assets, the Company considers all available positive and negative evidence, including its operating results, ongoing tax planning, and forecasts of future taxable income on a jurisdiction-by-jurisdiction basis. In the event the Company determines that it would be able to realize its deferred income tax assets in the future in excess of their net recorded amount, it would make an adjustment to the valuation allowance, which would reduce the provision for income taxes. Conversely, in the event that all or part of the net deferred tax assets are determined

not

to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made.

The Company recognizes the tax benefit from uncertain tax positions in accordance with GAAP, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in a company's tax return.

Net Loss per Basic and Diluted Share

Net loss per basic common share is computed on the basis of the net loss for the period divided by the weighted average number of common shares outstanding during the period. Diluted net loss per share is based upon the weighted average number of common shares and of common share equivalents outstanding when dilutive. Common share equivalents include outstanding stock options, warrants and non-vested restricted stock which are included under the treasury share method when dilutive. In periods when losses are reported, the weighted-average number of common shares outstanding excludes common stock equivalents, because their inclusion would be antidilutive.

Convertible Preferred Stock Warrants

December 31, 2018,

freestanding warrants to acquire shares of convertible preferred stock were classified as liabilities on the accompanying balance sheet. These warrants were subject to remeasurement at fair value at each balance sheet date, and any change in fair value is recognized as a component of other income or expense. In connection with the Merger, the warrants were exchanged into warrants that

longer met the definition of a derivative and thus, the balance was reclassified into equity during the

three

and

nine

months ended

September 30, 2019.

Debt Modifications and Extinguishments

When the Company modifies debt, it accounts for the impact of such modification in accordance with Accounting Standards Codification (“ASC”)

470

50,

Debt: Modifications and Extinguishments

, which requires modification to debt instruments to be evaluated to assess whether the modifications are considered “substantial modifications”. A substantial modification of terms shall be accounted for like an extinguishment. Based on the guidance relied upon and the analysis performed, the Company determined that the

October 2018

modification of the

March 2018

and

September 2018

Notes, to add an additional conversion option in the event of a reverse merger, was considered to be a “substantial modification”. As a result, it treated this modification as an ‘extinguishment’ of those debts and recognized

$11,000

of net gain from this debt extinguishment in other income in

October 2018.

All other changes to debt provisions were

not

considered substantial and were treated as debt modifications, with the exception of the modification in

August 2019

which was accounted for as a troubled debt restructuring.

Derivative Instruments

ASC

815

15,

Derivatives and Hedging: Embedded Derivatives

, generally provides

three

criteria that, if met, require companies to bifurcate conversion options from their host instruments and account for them as freestanding derivative financial instruments. These

three

criteria include circumstances in which (a) the economic characteristics and risks of the embedded derivative instrument are

not

clearly and closely related to the economic characteristics and risks of the host contract, (b) the hybrid instrument that embodies both the embedded derivative instrument and the host contract is

not

re-measured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur and (c) a separate instrument with the same terms as the embedded derivative instrument would be considered a derivative instrument subject to the requirement of ASC

815.

September 30, 2019

and

December 31, 2018,

the Company maintained outstanding Notes which contained various embedded derivative features. In particular, these Notes contained the following features:

) A share settled redemption in a qualified preferred stock financing; and

) The right to an accelerated cash repayment in the event of a change in control.

These embedded features were

not

considered clearly and closely related to the debt host, therefore, they were bifurcated and accounted for separately from the debt host as a derivative liability. Derivative financial liabilities are initially recorded at fair value, with gains and losses arising from changes in fair value recognized in the statement of operations at each period end while such instruments are outstanding.

As of

September 30, 2019,

and

December 31, 2018,

the Company determined that there was

fair value associated with the embedded derivatives that remained with the outstanding convertible notes. See

‘Note

- Term Loans and Convertible Promissory Notes’

for further discussion of the Notes and the bifurcated derivative liability.

Fair Value of Financial Instruments

ASC

820

10,

Fair Value Measurement

, provides a framework for measuring fair value under GAAP and requires expanded disclosures regarding fair value measurements. The standard defines fair value as an exit price, representing the amount that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. The standard also establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair value. The standard describes

three

levels of inputs that

may

be used to measure fair value:

Level

—

Unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access as of the measurement date.

Level

—

Inputs other than quoted prices included within Level

that are directly observable for the asset or liability or indirectly observable through corroboration with observable market data.

Level

—

Unobservable inputs for the asset or liability only used when there is little, if any, market activity for the asset or liability at the measurement date.

This hierarchy requires the use of observable market data when available and to minimize the use of unobservable inputs when determining fair value.

The following table presents the Company’s fair value hierarchy for its warrant liability measured at fair value on a recurring basis at

December 31, 2018 (

in thousands):

	As of December 31, 2018
	Level 1		Level 2		Level 3		Total
Financial liabilities
Warrant liability	$	-	$	-	$	140	$	140
Total financial liabilities	$	-	$	-	$	140	$	140

The Level

derivative at

December 31, 2018

consisted of a warrant liability of Private Adynxx that, at

December 31, 2018,

was exerciseable into preferred shares that were potentially redeemable. In connection with the Merger, the warrants were exchanged into warrants that

longer met the definition of a derivative and thus, the balance was reclassified into equity in

May 2019.

The change in fair value of the warrant liability for the

three

and

nine

months ended

September 30, 2019

and

2018

are as follows (in thousands):

	Three months ended September 30,				Nine months ended September 30,
	2019		2018		2019			2018
Fair value, beginning of period	$	-	$	42	$	140		$	42
Change in fair value of preferred stock warrants		-		1		94			1
Exchange of warrants upon Merger		-		-		(234	)		-
Fair value at end of period	$	-	$	43	$	-		$	43

The carrying amounts reported in the accompanying balance sheets for cash and cash equivalents, accounts payable and accrued liabilities approximate their fair value due to their short maturities. The fair value of the Company’s term loan is based on the borrowing rate currently available to the Company for borrowings with similar terms and maturity and approximates its carrying value.

Derivative liability instruments are considered Level

when their fair values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least

one

significant model assumption or input is unobservable. Level

liability instruments consist of the preferred stock warrant liability and derivative liability, for both of which there is

observable market data for the determination of fair value and requires significant management judgment and estimation.

While the Company’s Notes contain embedded derivative liabilities, the Company determined that the fair value of these liabilities were

zero

September 30, 2019

and

December 31, 2018.

See ‘

Note

- Term Loans and Convertible Promissory Notes’

for further discussion on the derivative liability activity.

The change in fair value of the derivative liability relating to the Notes for the

three

and

nine

months ended

September 30, 2019

and

2018

is summarized below (in thousands):

	Three months ended September 30,					Nine months ended September 30,
	2019		2018			2019		2018

Fair value, beginning of period	$	-	$	436		$	-	$	-
Embedded derivative liability from the issuance of Notes		-		369			-		864
Change in value of embedded derivatives		-		(152	)		-		(211	)
Fair value at end of period	$	-	$	653		$	-	$	653

Discontinued Operations

Discontinued operations represent the activities of the AquaMed business that was assumed in connection with the Merger and subsequently spun off during the

three

months ended

June 30, 2019.

See ‘

Note

– Reverse Merger’

. There are

ongoing activities or obligations associated with discontinued operations at

September 30, 2019.

Recently Adopted Accounting Pronouncements

Lease Accounting

February 2016,

the FASB issued ASU

No.

2016

02,

Leases (Topic

842

) (“ASU

2016

02”

). ASU

2016

is intended to improve financial reporting of leasing transactions by requiring organizations that lease assets to recognize assets and liabilities for the rights and obligations created by leases that extend more than

twelve

months on the balance sheet. This accounting update also requires additional disclosures surrounding the amount, timing, and uncertainty of cash flows arising from leases. ASU

2016

is effective for financial statements issued for annual and interim periods beginning after

December

15,

2018

for public business entities. A modified retrospective transition approach is required, applying the new standard to all leases existing at the date of initial application. An entity

may

choose to use either (

) its effective date or (

) the beginning of the earliest comparative period presented in the financial statements as its date of initial application. The Company adopted the new standard on

January 1, 2019

and used the effective date as its date of initial application. Consequently, the Company has

not

adjusted prior period amounts.

The Company has elected the package of practical expedients permitted in ASC Topic

842.

Accordingly, the Company accounted for its existing operating leases as operating leases under the new guidance, without reassessing (a) whether the contracts contain a lease under ASC Topic

842,

(b) whether classification of the operating leases would be different in accordance with ASC Topic

842,

or (c) whether the unamortized initial direct costs would have met the definition of initial direct costs in ASC Topic

842

at lease commencement.

The most significant impact from the adoption of this standard was the recognition of right-of-use (“ROU”), assets and lease obligations on the balance sheet for operating leases. This standard did

not

have a material impact on the Company’s cash flows from operations and operating results. As a result of the adoption of the new lease accounting guidance, the Company recognized on

January

2019

(a) a lease liability of approximately

$227,000,

which represents the present value of the remaining lease payments of approximately

$239,000,

discounted using the Company’s incremental borrowing rate of

9.41%,

and (b) a right-of-use asset of approximately

$227,000

which represents the lease liability of

$227,000.

The ROU asset is being amortized over the remaining term of the lease of

twelve

months from

January 1, 2019.

Recent Accounting Pronouncements

Not

Yet Effective

August 2018,

the FASB issued

No.

ASU

2018

13,

Changes to the Disclosure Requirements for Fair Value Measurement (Topic

820

). This ASU eliminates, adds and modifies certain disclosure requirements for fair value measurements as part of its disclosure framework project. This ASU is effective for fiscal years beginning after

December 15, 2019,

including interim periods within that fiscal year, with early adoption permitted. The Company is currently assessing whether these amendments will have a material effect on its financial statements.