NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Nature of Business and Recent Developments

Arrowhead Pharmaceuticals, Inc. develops medicines that treat intractable diseases by silencing the genes that cause them.  Using a broad portfolio of RNA chemistries and efficient modes of delivery, Arrowhead therapies trigger the RNA interference mechanism to induce rapid, deep and durable knockdown of target genes. RNA interference (“RNAi”) is a mechanism present in living cells that inhibits the expression of a specific gene, thereby affecting the production of a specific protein. Arrowhead’s RNAi-based therapeutics leverage this natural pathway of gene silencing. The Company's pipeline includes ARO-APOC3 for hypertriglyceridemia, ARO-ANG3 for dyslipidemia, ARO-HSD for liver disease, ARO-ENaC for cystic fibrosis, ARO-HIF2 for renal cell carcinoma, ARO-LUNG2 as a candidate to treat chronic obstructive pulmonary disorder (“COPD”) and ARO-COV for treatment for the current novel coronavirus that causes COVID-19 and other possible future pulmonary-borne pathogens. ARO-JNJ1, ARO-JNJ2 and ARO-JNJ3 are being developed for undisclosed liver-expressed targets under a collaboration agreement with Janssen Pharmaceuticals, Inc. (“Janssen”).  ARO-AAT for liver disease associated with alpha-1 antitrypsin deficiency (“AATD”) was out-licensed to Takeda Pharmaceuticals U.S.A., Inc. (“Takeda”) in October 2020. JNJ3989 (formerly referred to as ARO-HBV) for chronic hepatitis B virus was out-licensed to Janssen in October 2018.  Olpasiran (formerly referred to as AMG 890 or ARO-LPA) for cardiovascular disease was out-licensed to Amgen Inc. (“Amgen”) in 2016.

Arrowhead operates lab facilities in Madison, Wisconsin and San Diego, California, where the Company’s research and development activities, including the development of RNAi therapeutics, are based. The Company’s principal executive offices are located in Pasadena, California.

During the first quarter of fiscal year 2021, the Company continued to develop its pipeline and partnered candidates.  The Company hosted a key opinion leader webinar on its cardiometabolic candidates, ARO-APOC3 and ARO-ANG3. The Company presented positive interim clinical data from AROAAT2002, an open-label Phase 2 clinical study of ARO-AAT, the Company’s second-generation investigational RNAi therapeutic being developed as a treatment for the rare genetic liver disease associated with AATD.  The Company also announced positive clinical data on its cardiometabolic candidates, ARO-APOC3 and ARO-ANG3, at the American Heart Association (“AHA”) Scientific Session 2020.  Finally, the Company announced a collaboration with Takeda to co-develop and co-commercialize ARO-AAT for alpha-1 antitrypsin-associated liver disease.  See Note 2 for more information regarding the collaboration with Takeda.

The Company’s partnered candidates under its collaboration agreements also continue to progress.  Janssen began dosing patients in a Phase 2b triple combination study called REEF-1, designed to enroll up to 450 patients with chronic hepatitis B infection. In connection with the start of this study, Arrowhead earned a $25.0 million milestone payment under the Company’s License Agreement with Janssen (“Janssen License Agreement”).  The Company is currently performing discovery, optimization and preclinical research and development for ARO-JNJ1, ARO-JNJ2 and ARO-JNJ3 for Janssen as part of the Company’s Research Collaboration and Option Agreement with Janssen (“Janssen Collaboration Agreement”).  Under the terms of the Janssen agreements taken together, the Company has received $175.0 million as an upfront payment, $75.0 million in the form of an equity investment by Johnson & Johnson Innovation-JJDC, Inc. (“JJDC”) in Arrowhead Common Stock, two $25.0 million milestone payments and may receive up to $1.6 billion in development and sales milestones payments for the Janssen License Agreement, and up to $1.9 billion in development and sales milestone payments for the three additional targets covered under the Janssen Collaboration Agreement.  The Company is further eligible to receive tiered royalties on product sales up to mid-teens under the Janssen License Agreement and up to low teens under the Janssen Collaboration Agreement.  

The Company’s collaboration agreement with Amgen for Olpasiran (previously referred to as AMG 890 or ARO-LPA), (the “Second Collaboration and License Agreement” or “Olpasiran Agreement”), continues to progress.  In July 2020, Amgen initiated a Phase 2 clinical study, which resulted in a $20.0 million milestone payment to the Company.  The Company has received $35.0 million in upfront payments, $21.5 million in the form of an equity investment by Amgen in the Company’s Common Stock, $30.0 million in milestone payments, and may receive up to an additional $400.0 million in remaining development, regulatory and sales milestone payments.  The Company is eligible to receive up to low double-digit royalties for sales of products under the Olpasiran Agreement.

NOTE 2. COLLABORATION AND LICENSE AGREEMENTS

Amgen Inc.

On September 28, 2016, the Company entered into two Collaboration and License Agreements and a Common Stock Purchase Agreement with Amgen. Under one of the collaboration and license agreements (the “Second Collaboration and License Agreement” or “Olpasiran Agreement”), Amgen has received a worldwide, exclusive license to Arrowhead’s novel, RNAi Olpasiran (previously referred to as AMG 890 or ARO-LPA) program. These RNAi molecules are designed to reduce elevated lipoprotein(a), which is a genetically validated, independent risk factor for atherosclerotic cardiovascular disease. Under the other collaboration and license agreement (the “First Collaboration and License Agreement” or the “ARO-AMG1 Agreement”), Amgen received an option to a worldwide, exclusive license for ARO-AMG1, an RNAi therapy for an undisclosed genetically validated cardiovascular target. In both agreements, Amgen is wholly responsible for clinical development and commercialization. Under the terms of the agreements taken together, the Company has received $35.0 million in upfront payments, $21.5 million in the form of an equity investment by Amgen in the Company’s Common Stock, and $30.0 million in milestone payments, and may receive up to an additional $400.0 million in remaining development, regulatory and sales milestone payments. The Company is further eligible to receive up to low double-digit royalties for sales of products under the Olpasiran Agreement. In July 2019, Amgen informed the Company that it would not be exercising its option for an exclusive license for ARO-AMG1, and as such, there will be no further milestone or royalty payments under the ARO-AMG1 Agreement.    

The Company substantially completed its performance obligations under the Olpasiran Agreement and the ARO-AMG1 Agreement.  Future milestones and royalties achieved will be recognized in their entirety when earned. In July 2020, Amgen initiated a Phase 2 clinical study, which resulted in a $20.0 million milestone payment to the Company. During the three months ended December 31, 2020 and 2019, the Company recognized $0 and $0, respectively.  As of December 31, 2020, there were $0 in contract assets recorded as accounts receivable and $0 contract liabilities recorded as current deferred revenue on the Company’s Consolidated Balance Sheets.

Janssen Pharmaceuticals, Inc.

On October 3, 2018, the Company entered into the Janssen License Agreement and the Janssen Collaboration Agreement with Janssen, part of the Janssen Pharmaceutical Companies of Johnson & Johnson.  The Company also entered into a Stock Purchase Agreement (“JJDC Stock Purchase Agreement”) with JJDC.  Under the Janssen License Agreement, Janssen has received a worldwide, exclusive license to the Company’s JNJ-3989 (ARO-HBV) program, the Company’s third-generation subcutaneously administered RNAi therapeutic candidate being developed as a potential therapy for patients with chronic hepatitis B virus infection. Beyond the Company’s Phase 1/2 study of JNJ-3989 (ARO-HBV), Janssen is also wholly responsible for clinical development and commercialization of JNJ-3989.  Under the Janssen Collaboration Agreement, Janssen will be able to select three new targets against which Arrowhead will develop clinical candidates.  These candidates are subject to certain restrictions and do not include candidates that already were in the Company’s pipeline.  The Company will perform discovery, optimization and preclinical research and development, entirely funded by Janssen, which on its own or in combination with Janssen development work, is sufficient to allow the filing of a U.S. Investigational New Drug application or equivalent, at which time Janssen will have the option to take an exclusive license. If the option is exercised, Janssen will be wholly responsible for clinical development and commercialization of each optioned candidate.  Under the terms of the agreements taken together, the Company has received $175.0 million as an upfront payment, $75.0 million in the form of an equity investment by JJDC in Arrowhead Common Stock under the JJDC Stock Purchase Agreement, and two $25.0 million milestone payments, and may receive up to $1.6 billion in development and sales milestones payments for the Janssen License Agreement, and up to $1.9 billion in development and sales milestone payments for the three additional targets covered under the Janssen Collaboration Agreement.  The Company is further eligible to receive tiered royalties up to mid-teens under the Janssen License Agreement and up to low teens under the Janssen Collaboration Agreement on product sales.  

The Company has evaluated these agreements in accordance with the new revenue recognition standard that became effective for the Company on October 1, 2018.  The adoption of the new revenue standard did not have a material impact on the balances reported when evaluated under the superseded revenue standard.  At the inception of these agreements, the Company has identified one distinct performance obligation.  Regarding the Janssen License Agreement, the Company determined that the key deliverables included the license and certain R&D services including the Company’s responsibility to complete the Phase 1/2 study of JNJ-3989 (ARO-HBV) and the Company’s responsibility to ensure certain manufacturing of JNJ-3989 (ARO-HBV) drug product is completed and delivered to Janssen (the “Janssen R&D Services”).  Due to the specialized and unique nature of these Janssen R&D Services, and their direct relationship with the license, the Company determined that these deliverables represent one distinct bundle and thus, one performance obligation.  The Company also determined that Janssen’s option to require the Company to develop up to three new targets is not a material right, and thus, not a performance obligation at the onset of the agreement.  The consideration for this option is accounted for separately.

NOTE 3. PROPERTY AND EQUIPMENT

Depreciation and amortization expense for property and equipment for the three months ended December 31, 2020 and 2019 was $1.4 million and $0.8 million, respectively.

NOTE 4. INVESTMENTS

Investments at December 31, 2020 primarily consisted of corporate bonds that have maturities of less than 36 months and marketable equity securities. The Company’s corporate bonds consist of both short-term and long-term bonds and are classified as “held-to-maturity” on the Company’s Consolidated Balance Sheets. The Company’s marketable equity securities consist of mutual funds that invest in U.S. government bonds, U.S. government agency bonds, corporate bonds and other asset backed debt securities. Dividends from these funds are automatically reinvested.  The Company may also invest excess cash balances in certificates of deposits, money market accounts, government-sponsored enterprise securities, corporate bonds and/or commercial paper.  The Company accounts for its held to maturity investments in accordance with FASB ASC 320, Investments – Debt and Equity Securities and its marketable equity securities in accordance with ASC 321, Investments – Equity Securities.  

NOTE 5. INTANGIBLE ASSETS

Intangible assets subject to amortization include patents and a license agreement capitalized as part of the Novartis RNAi asset acquisition in March 2015. The license agreement associated with the Novartis RNAi asset acquisition is being amortized over the estimated life remaining at the time of acquisition, which was 21 years, and the accumulated amortization of the asset is $0.9 million.  The patents associated with the Novartis RNAi asset acquisition are being amortized over the estimated life remaining at the time of acquisition, which was 14 years, and the accumulated amortization of the assets is $9.1 million. Amortization expense for the three months ended December 31, 2020 and 2019 was $0.4 million and $0.4 million, respectively. Amortization expense is expected to be $1.3 million for the remainder of 2021, $1.7 million in 2022, $1.7 million in 2023, $1.7 million in 2024, $1.7 million in 2025 and $6.8 million thereafter.

NOTE 6. STOCKHOLDERS’ EQUITY

At December 31, 2020, the Company had a total of 150,000,000 shares of capital stock authorized for issuance, consisting of 145,000,000 shares of Common Stock, par value $0.001 per share, and 5,000,000 shares of Preferred Stock, par value $0.001 per share.

At December 31, 2020, 103,194,240 shares of Common Stock were outstanding.  At December 31, 2020, 7,635,023 shares of Common Stock were reserved for issuance upon exercise of options and vesting of restricted stock units granted or available for grant under Arrowhead’s 2004 Equity Incentive Plan and 2013 Incentive Plan, as well as for inducement grants made to new employees.

NOTE 7. COMMITMENTS AND CONTINGENCIES

Litigation

From time to time, the Company may be subject to various claims and legal proceedings in the ordinary course of business.  If the potential loss from any claim, asserted or unasserted, or legal proceeding is considered probable and the amount is reasonably estimable, the Company will accrue a liability for the estimated loss.  There were no contingent liabilities recorded as of the three months ended December 31, 2020.

Purchase Commitments

In the normal course of business, the Company enters into various purchase commitments for the manufacture of drug components, for toxicology studies and for clinical studies.  As of December 31, 2020, these future commitments were estimated at approximately $100.2 million, of which approximately $85.0 million is expected to be incurred in remaining fiscal year 2021.

Technology License Commitments

The Company has licensed from third parties the rights to use certain technologies for its research and development activities, as well as in any products the Company may develop using these licensed technologies. These agreements and other similar agreements often require milestone and royalty payments.  Milestone payments, for example, may be required as the research and development process progresses through various stages of development, such as when clinical candidates enter or progress through clinical trials, upon a new drug application and upon certain sales level milestones.  These milestone payments could amount to the mid to upper double-digit millions of dollars. During the three months ended December 31, 2020 and 2019, the Company did not reach any milestones. In certain agreements, the Company may be required to make mid to high single-digit percentage royalty payments based on a percentage of the sales of the relevant products.     

NOTE 8. LEASES

Leases

In April 2019, the Company entered into a lease for its corporate headquarters in Pasadena, California.  The 91 month office building lease between the Company and 177 Colorado Owner, LLC is for approximately 24,000 square feet of office space located at 177 E. Colorado Blvd, Pasadena, California.  The increased capacity of this new office space compared to the Company’s prior corporate headquarters will accommodate increased personnel as the Company’s pipeline of drug candidates expands and moves closer to market. Lease payments began on September 30, 2019 and are estimated to total approximately $8.7 million over the term.  The lease expires on April 30, 2027.  The Company has paid approximately $3.5 million for leasehold improvements, net of tenant improvement allowances.  The lease contains an option to renew for one term of five years. The exercise of this option was not determined to be reasonably certain and thus was not included in lease liabilities on the Company’s Consolidated Balance Sheet at December 31, 2020. On October 23, 2020, the Company signed a lease expansion to add an additional approximately 24,000 square feet of office space at the same location for its corporate headquarters. The lease commencement date is expected to be in July 2021, after certain leasehold improvements are completed, and the lease expires in April 2027. The lease payments for the expansion are expected to total $6.9 million.  The Company anticipates paying approximately $4.0 million of leasehold improvements, net of tenant improvement allowances.  The increased capacity of this additional office space compared to the Company’s current corporate headquarters will accommodate increased personnel as the Company’s pipeline of drug candidates expands and moves closer to market. 

In January 2016, the Company entered into a lease for its research facility in Madison, Wisconsin.  The lease was for approximately 60,000 square feet of office and laboratory space and had an expiration date of September 30, 2026. The lease was amended in January 2019 and May 2020 to expand the rentable square feet by an additional 40,000 total square feet and extended the lease expiration date to September 30, 2031. Lease payments are estimated to total approximately $26.2 million for the term. The Company anticipates paying approximately $11.0 million of leasehold improvements for the additional 40,000 square feet, net of tenant improvement allowances. The lease contains two options to renew for two terms of five years. The exercise of these options were not determined to be reasonably certain and thus was not included in lease liabilities on the Company’s Consolidated Balance Sheet at December 31, 2020.  In November 2020 and December 2020, two amendments were signed to expand the rentable square space by an additional 10,743 square feet and these amendments added a total of approximately $1.2 million of lease payments for the remainder of the term.            

In March 2020, the Company entered into a sublease agreement (the “Sublease”) with Halozyme, Inc. for additional research and development facility space in San Diego, California.  The Sublease provides additional space needed to accommodate the recent growth of the Company’s personnel and discovery efforts. The sublease is for approximately 21,000 rentable square feet.  The term of the Sublease commenced on April 1, 2020 and will end on January 14, 2023.  Sublease payments are estimated to total approximately $2.0 million over the term.

NOTE 9. STOCK-BASED COMPENSATION

Arrowhead has two plans that provide for equity-based compensation. Under the 2004 Equity Incentive Plan and the 2013 Incentive Plan, as of December 31, 2020, 509,210 and 5,102,360 shares, respectively, of Arrowhead’s Common Stock are reserved for the grant of stock options, stock appreciation rights, restricted stock awards and performance unit/share awards to employees, consultants and others. No further grants may be made under the 2004 Equity Incentive Plan.  As of December 31, 2020, there were options granted and outstanding to purchase 509,210 and 2,320,640 shares of Common Stock under the 2004 Equity Incentive Plan and the 2013 Incentive Plan, respectively, and there were 2,385,200 restricted stock units granted and outstanding under the 2013 Incentive Plan. Also, as of December 31, 2020, there were 1,260,503 shares reserved for options and 762,950  shares reserved for restricted stock units issued as inducement grants to new employees outside of equity compensation plans.

Stock-based compensation expense related to stock options for the three months ended December 31, 2020 and 2019 was $3.1 million and $1.6 million, respectively.  For non-qualified stock options, the expense creates a timing difference, resulting in a deferred tax asset, which is fully reserved by a valuation allowance.

The grant date fair value of the options granted by the Company for the three months ended December 31, 2020 and 2019 was $6.8 million and $8.6 million, respectively.  

The intrinsic value of the options exercised during the three months ended December 31, 2020, and 2019 was $32.0 million and $21.6 million, respectively.