1. Nature of business and basis of presentation

Mersana Therapeutics, Inc. is a clinical stage company located in Cambridge, Massachusetts. The Company is advancing a proprietary pipeline of targeted oncology therapeutics leveraging multiple proprietary platforms, including its Dolaflexin® antibody drug conjugate (ADC) platform. The Company’s first product candidate, XMT-1522, an ADC designed to address a much broader population of patients with HER2-antigen expressing tumors than served by currently approved HER2 therapies, is currently in a Phase 1 dose escalation study. The Company’s second clinical stage product candidate, XMT-1536, an ADC targeting NaPi2b, an antigen broadly expressed in certain types of cancer, is also in a Phase 1 dose escalation study. In addition, the Company has established a strategic partnership with Takeda Pharmaceutical Company Limited (Takeda) under which Takeda obtained rights to XMT‑1522 outside of the United States and Canada. The Company has also established strategic research and development partnerships with Takeda and Merck KGaA for the development and commercialization of additional ADC product candidates against a limited number of targets selected by the Company’s partners based on the Company’s Dolaflexin platform. The Company has other earlier stage platforms, including Dolasynthen and Alkymer and is developing an ADC platform for immuno-oncology indications.

The Company is subject to risks common to companies in the biotechnology industry, including but not limited to, risks of failure of preclinical studies and clinical trials, the need to obtain marketing approval and reimbursement for any drug product candidate that it may identify and develop, the need to successfully commercialize and gain market acceptance of its product candidates, dependence on key personnel, protection of proprietary technology, compliance with government regulations, development of technological innovations by competitors, reliance on third party manufacturers and the ability to transition from pilot-scale production to large-scale manufacturing of products.

On September 17, 2018, the Company announced that the U.S. Food and Drug Administration (FDA) lifted the partial clinical hold that had been imposed on the Phase 1 study of XMT-1522 that was announced on July 19, 2018. As part of its plan to resume dosing in the study, the Company made changes to the study protocol, including a once-every-four-week dosing regimen, increased monitoring and exclusion of patients with advanced hepatic impairment. The partial clinical hold, the protocol changes and the approval process for the protocol changes have resulted in a change in the expected timeline for clinical results for XMT-1522.  Selection of a recommended Phase 2 dose is expected in mid-2019.

 

On July 3, 2017, the Company completed an initial public offering (IPO), in which the Company issued and sold 5,000,000 shares of its common stock at a public offering price of $15.00 per share, for aggregate gross proceeds of $75,000. The Company received $67,420 in net proceeds after deducting $7,580 of underwriting discounts and commissions and offering costs. On August 2, 2017, the Company issued and sold 51,977 shares of common stock at $15.00 per share for gross proceeds of $780 upon the partial exercise of the underwriters’ overallotment option. The Company received net proceeds of $725 after deducting $55 in underwriting discounts and commissions.

In connection with preparing for the IPO, the Company effected a 1-for-4.5 reverse stock split of the Company’s common stock. The reverse stock split became effective on June 15, 2017. The par value and authorized shares of common stock and convertible preferred stock were not adjusted as a result of the reverse stock split. All share and per share amounts in the financial statements and the notes thereto have been retroactively adjusted for all periods presented to give effect to this reverse stock split, including reclassifying an amount equal to the reduction in par value of common stock to additional paid-in capital.

The Company has incurred net losses since inception. The Company’s net loss was $41,825 for the nine months ended September 30, 2018 and $38,707 for the year ended December 31, 2017. The Company expects to continue to incur operating losses for at least the next several years.  As of September 30, 2018, the Company had an accumulated deficit of $141,734. The future success of the Company is dependent on its ability to identify and develop its product candidates, and ultimately upon its ability to attain profitable operations. The Company has devoted substantially all of its financial resources and efforts to research and development and general and administrative expense to support such research and development. The Company’s net losses may fluctuate significantly from quarter to quarter and year to year. Net losses and negative cash flows have had, and will continue to have, an adverse effect on the Company’s stockholders' deficit and working capital. The Company believes that its existing cash, cash equivalents and marketable securities as of September 30, 2018, will enable it to fund its current operating plan for at least the next twelve months, which the Company expects will allow it to achieve initial clinical data readouts for its two clinical stage development programs, select recommended Phase 2 doses and continue to advance its earlier assets.

The Company’s unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP) and the rules and regulations of the Securities and Exchange Commission (SEC). Any reference in these notes to applicable guidance is meant to refer to the authoritative United States generally accepted accounting principles as found in the Accounting Standards Codification (ASC) and Accounting Standards Updates (ASU) of the Financial Accounting Standards Board (FASB). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted from this report, as is permitted by such rules and regulations. Accordingly, these financial statements should be read in conjunction with the audited financial statements as of and for the year ended December 31, 2017 and the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 28, 2018.

The unaudited condensed consolidated financial statements have been prepared on the same basis as the audited financial statements. In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements contain all adjustments which are necessary to present fairly the Company’s financial position as of September 30, 2018, the results of its operations for the three and nine months ended September 30, 2018 and 2017 and cash flows for the nine months ended September 30, 2018 and 2017. Such adjustments are of a normal and recurring nature, other than the adjustments associated with the adoption of ASC Topic 606, Revenue from Contracts with Customers (Topic 606). The results for the three and nine months ended September 30, 2018 are not necessarily indicative of the results for the year ending December 31, 2018, or for any future period.

Effective January 1, 2018, the Company adopted the requirements of Topic 606 using the modified retrospective method as discussed below in Note 2: Summary of Significant Accounting Policies. All 2018 amounts and disclosures set forth in this Quarterly Report on Form 10-Q reflect these changes.

2. Summary of Significant Accounting Policies

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements include those of the Company and its subsidiary, Mersana Securities Corp. All intercompany balances and transactions have been eliminated.

Use of Estimates

The preparation of the Company’s unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, equity, revenue, expenses and related disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. On an ongoing basis, the Company’s management evaluates its estimates, which include, but are not limited to, management’s judgments with respect to the performance obligations and estimated selling prices within its revenue arrangements, accrued expenses, valuation of stock-based awards and income taxes. Actual results could differ from those estimates.

The Company utilized significant estimates and assumptions in determining the fair value of its common stock prior to the Company’s IPO. The Company has utilized various valuation methodologies in accordance with the framework of the American Institute of Certified Public Accountants Technical Practice Aid, Valuation of Privately‑Held Company Equity Securities Issued as Compensation, to estimate the fair value of its common stock. Each valuation methodology includes estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, including external market conditions, the prices at which the Company sold shares of preferred stock, the superior rights and preferences of securities senior to the Company’s common stock at the time of, and the likelihood of, achieving a liquidity event, such as an initial public offering or sale. Significant changes to the key assumptions used in the valuations could result in different fair values of common stock at each valuation date.

Segment Information

Operating segments are defined as components of an enterprise about which separate discrete information is available for evaluation by the chief operating decision-maker in deciding how to allocate resources and assess performance. The Company and the Company's chief operating decision-maker, the Company's chief executive officer, view the Company's operations and manage its business as a single operating segment, which is the business of discovering and developing ADCs.

Research and Development

The Company expenses all costs incurred in performing research and development activities. Research and development expenses include salaries and benefits, materials and supplies, preclinical expenses, manufacturing expenses, stock-based compensation expense, depreciation of equipment, contract services and other outside expenses. Costs of certain development activities, such as manufacturing, are recognized based on an evaluation of the progress to completion of specific tasks. Payments for these activities are based on the terms of the individual arrangements, which may differ from the pattern of costs incurred, and are reflected in the financial statements as prepaid or accrued research and development costs. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are deferred and capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed. Costs associated with collaboration agreements are included in research and development expense.

Revenue Recognition

Effective January 1, 2018, the Company adopted the provisions of Topic 606, using the modified retrospective transition method.  Under this method, the Company recorded the cumulative effect of initially applying the new standard to all contracts in process as of the date of adoption.  This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. 

The adoption of the new revenue recognition guidance resulted in increases of $2,031 in deferred revenue and accumulated deficit as of January 1, 2018. For the three months ended September 30, 2018, revenue increased by $2, net loss decreased by $2 and basic and diluted net loss per share decreased by $0.00, based on revenue recognition under Topic 606 as compared to the Company’s prior revenue recognition methodology under ASC 605 Revenue Recognition. For the nine months ended September 30, 2018, revenue decreased by $570, net loss increased by $570 and basic and diluted net loss per share increased by $0.02, based on revenue recognition under Topic 606 as compared to the Company’s prior revenue recognition methodology under ASC 605 Revenue Recognition. These changes were primarily caused by the differences in determining and allocating transaction price under Topic 606.

The Company enters into collaboration agreements which are within the scope of Topic 606, under which the Company licenses rights to its technology and certain of the Company’s product candidates and performs research and development services for third parties.  The terms of these arrangements typically include payment of one or more of the following: non-refundable, up-front fees; reimbursement of research and development costs; development, regulatory and commercial milestone payments; and royalties on net sales of licensed products.  

Under Topic 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services.  To determine the appropriate amount of revenue to be recognized for arrangements determined to be within the scope of Topic 606, the Company performs the following five steps: (i) identification of the promised goods or services in the contract; (ii) determination of whether the promised goods or services are performance obligations; (iii) measurement of the transaction price, including the constraint on variable consideration; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.   The Company only applies the five-step model to contracts when it is probable that the entity will collect consideration it is entitled to in exchange for the goods or services it transfers to the customer. 

The promised good or services in the Company’s arrangement typically consist of license rights to the Company’s intellectual property and research and development services.  The Company also has optional additional items in contracts, which are considered marketing offers and are accounted for as separate contracts with the customer if such option is elected by the customer, unless the option provides a material right which would not be provided without entering into the contract.  Performance obligations are promised goods or services in a contract to transfer a distinct good or service to the customer.  Promised goods or services are considered distinct when (i) the customer can benefit from the good or service on its own or together with other readily available resources or (ii) the promised good or service is separately identifiable from other promises in the contract.  In assessing whether promised good or services are distinct, the Company considers factors such as the stage of development of the underlying intellectual property, the capabilities of the customer to develop the intellectual property on their own or whether the required expertise is readily available.

The Company estimates the transaction price based on the amount expected to be received for transferring the promised goods or services in the contract.  The consideration may include both fixed consideration or variable consideration.  At the inception of each arrangement that includes variable consideration and at each reporting period, the Company evaluates the amount of potential payment and the likelihood that the payments will be received.  The Company utilizes either the most likely amount method or expected amount method to estimate the amount expected to be received based on which method better predicts the amount expected to be received.  If it is probable that a significant revenue reversal would not occur, the variable consideration is included in the transaction price. We assessed each of our revenue generating arrangements in order to determine whether a significant financing component exists and concluded that a significant financing component does not exist in any of our arrangements because: (a) the promised consideration approximates the cash selling price of the promised goods and services or any significant difference is due to factors other than financing; and (b) timing of payment approximates the transfer of goods and services and performance is over a relatively short period of time within the context of the entire term of the contract.

The Company’s contracts often include development and regulatory milestone payments. At contract inception and at each reporting period, the Company evaluates whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method.  If it is not probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price.  Milestone payments that are not within the Company’s control or the licensee’s control, such as regulatory approvals, are not included in the transaction price.  At the end of each subsequent reporting period, the Company re-evaluates the probability of achievement of such development milestones and any related constraint, and if necessary, adjusts its estimate of the overall transaction price.  Any such adjustments are recorded on a cumulative catch-up basis, which would affect license, collaboration and other revenues and earnings in the period of adjustment.

For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, the Company recognizes revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied).  To date, the Company has not recognized any royalty revenue resulting from any of the Company’s collaboration arrangements.

The Company allocates the transaction price based on the estimated standalone selling price of the underlying performance obligations or in the case of certain variable consideration to one or more performance obligations.  The Company must develop assumptions that require judgment to determine the stand-alone selling price for each performance obligation identified in the contract.  The Company utilizes key assumptions to determine the stand-alone selling price, which may include other comparable transactions, pricing considered in negotiating the transaction and the estimated costs to complete the respective performance obligation.  Certain variable consideration is allocated specifically to one or more performance obligations in a contract when the terms of the variable consideration relate to the satisfaction of the performance obligation and the resulting amounts allocated to each performance obligation are consistent with the amounts the Company would expect to receive for each performance obligation.   

For performance obligations consisting of licenses and other promises, the Company utilizes judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from non-refundable, up-front fees.  The Company evaluates the measure of progress each reporting period and, if necessary, adjusts the measure of performance and related revenue recognition.  If the license to the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company will recognize revenue from non-refundable, up-front fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license.

The Company receives payments from its customers based on billing schedules established in each contract. Such billings generally have 30 day terms. Up-front payments and fees are recorded as deferred revenue upon receipt or when due until the Company performs its obligations under these arrangements. Amounts are recorded as accounts receivable when the right to consideration is unconditional.

Collaborative Arrangements

The Company records the elements of its collaboration agreements that represent joint operating activities in accordance with ASC Topic 808, Collaborative Arrangements (ASC 808). Accordingly, the elements of the collaboration agreements that represent activities in which both parties are active participants and to which both parties are exposed to the significant risks and rewards that are dependent on the commercial success of the activities, are recorded as collaborative arrangements. The Company considers the guidance in ASC Topic 606 in determining the appropriate treatment for the transactions between the Company and its collaborative partners and the transactions between the Company and third parties. Generally, the classification of transactions under the collaborative arrangements is determined based on the nature and contractual terms of the arrangement along with the nature of the operations of the participants. To the extent revenue is generated from a collaboration, the Company will recognize its share of the net sales on a gross basis if it is deemed to be the principal in the transactions with customers, or on a net basis if it is instead deemed to be the agent in the transactions with customers, consistent with the guidance in Topic 606.

Fair Value Measurements

Fair value is defined as the price that would be received upon sale of an asset or paid to transfer a liability between market participants at measurement dates. ASC Topic 820 Fair Value Measurement (ASC 820) establishes a three-level valuation hierarchy for instruments measured at fair value. The hierarchy is based on the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

Level 1—Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2—Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3—Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Cash and Cash Equivalents

The Company considers all highly liquid investments with an original maturity, or a remaining maturity at the time of purchase, of three months or less to be cash equivalents. The Company invests excess cash primarily in money market funds, commercial paper and government agency securities, which are highly liquid and have strong credit ratings. These investments are subject to minimal credit and market risks. Cash and cash equivalents are stated at cost, which approximates market value.

The following amounts were presented as cash, cash equivalents and restricted cash:

 

Marketable Securities

Short-term marketable securities consist of investments with maturities greater than three months and less than one year from the balance sheet date. Long-term marketable securities consist of investments with maturities greater than one year that are not expected to be used to fund current operations. The Company classifies all of its marketable securities as available-for-sale. Accordingly, these investments are recorded at fair value. Amortization and accretion of discounts and premiums are recorded as interest income within other income. Unrealized gains and losses on available-for-sale securities are included in other comprehensive loss as a component of stockholders’ equity until realized.

Other Assets

The Company recorded other assets of $1,804 and $371 as of September 30, 2018 and December 31, 2017, respectively. The September 30, 2018 amount is comprised of restricted cash of $371 held as security deposits for a standby letter of credit related to a facility lease and a corporate credit card program and $1,433 held by a service provider. The December 31, 2017 amount is comprised of restricted cash.

Accounting for Stock-based Compensation

The Company accounts for its stock-based compensation in accordance with ASC Topic 718 Compensation—Stock Compensation (ASC 718). ASC 718 requires all stock-based payments to employees and directors to be recognized as expense in the statements of operations based on their grant date fair values. Expense related to stock awards to non-employees is required to be recognized in the statement of operations based on the awards' vesting date fair values. The Company estimates the fair value of options granted using the Black-Scholes option pricing model.

The Black-Scholes option pricing model requires inputs based on certain subjective assumptions, including (i) the expected stock price volatility, (ii) the calculation of expected term of the award, (iii) the risk-free interest rate and (iv) the expected dividends. Due to the lack of a public market for the Company's common stock prior to completion of the IPO and a lack of company-specific historical and implied volatility data, the Company has based its estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. The computation of expected volatility is based on the historical volatility of a representative group of companies with similar characteristics to the Company, including stage of product development and life science industry focus. The Company uses the simplified method as prescribed by the SEC Staff Accounting Bulletin No. 107, Share-Based Payment, to calculate the expected term for options granted to employees as it does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For options granted to non-employees, the Company utilizes the contractual term of the arrangement as the basis for the expected term assumption. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected term of the stock options. The expected dividend yield is assumed to be zero as the Company has never paid dividends and has no current plans to do so.

There were significant judgments and estimates inherent in the determination of the fair value of our common stock prior to the closing of the IPO. These estimates and assumptions include a number of objective and subjective factors, including external market conditions, the prices at which the Company sold shares of preferred stock, the superior rights and preferences of securities senior to its common stock at the time of, and the likelihood of, achieving a liquidity event, such as an IPO or sale.

In the first quarter of 2017, the Company made an accounting policy election to recognize forfeitures as they occur upon adoption of guidance per ASU No. 2016-09. The adoption of this ASU did not have a material impact on the Company's financial statements.

Net Loss per Share

Basic net loss per common share is calculated by dividing the net loss attributable to common stockholders by the weighted-average number of common shares outstanding during the period, without consideration for potentially dilutive securities. Diluted net loss per share is computed by dividing the net loss attributable to common stockholders by the weighted-average number of common shares and potentially dilutive securities outstanding for the period determined using the treasury stock and if-converted methods.

For purposes of the diluted net loss per share calculation, convertible preferred stock, warrants to purchase common stock and options to purchase common stock are considered to be potentially dilutive securities, but are excluded from the calculation of diluted net loss per share because their effect would be anti-dilutive and therefore, basic and diluted net loss per share were the same for all periods presented.

The following table sets forth the outstanding potentially dilutive securities that have been excluded from the calculation of diluted net loss per share because to include them would be anti-dilutive (in common stock equivalent shares):

 

Patent Costs

The Company expenses patent application and related legal costs as incurred and classifies such costs as general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.

Income Taxes

The Company accounts for income taxes using the liability method.  The difference between the financial statement and tax basis of the assets and liabilities is determined annually. Deferred income tax assets and liabilities are computed using the tax laws and rates that are expected to apply for periods in which such differences reverse. Valuation allowances are established, if necessary, to reduce the deferred tax asset to the amount that will more likely than not be realized.

The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.

Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of net loss and other comprehensive income (loss). For the three and nine months ended September 30, 2018 and 2017, other comprehensive loss consisted of unrealized gain (loss) on marketable securities.

Concentration of Credit Risk and Off-Balance Sheet Risk

The Company has no financial instruments with off-balance sheet risk, such as foreign exchange contracts, option contracts, or other foreign hedging arrangements. Financial instruments that potentially subject the Company to concentrations of credit risk primarily consist of cash equivalents and marketable securities. Under its investment policy, the Company limits amounts invested in such securities by credit rating, maturity, industry group, investment type and issuer, except for securities issued by the U.S. government. The Company is not exposed to any significant concentrations of credit risk from these financial instruments. Cash, cash equivalents, and marketable securities are deposited with federally insured financial institutions in the United States and may, at times, exceed federally insured limits. Management believes that the financial institutions that hold the Company’s deposits are financially credit worthy and, accordingly, minimal risk exists with respect to those balances. Generally, these deposits may be redeemed upon demand and therefore bear minimal interest rate risk.

Recently Issued Accounting Pronouncements

In January 2016, the FASB issued ASU No. 2016-01 Financial Instruments (ASU No. 2016-01) related to the recording of financial assets and financial liabilities. Under the amended guidance, equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) are to be measured at fair value with changes in fair value recognized in net income (loss). However, an entity has the option to measure equity investments without readily determinable fair values either (i) at fair value or (ii) at cost, adjusted for changes in observable prices minus impairment. Changes in measurement under either alternative will be recognized in net income (loss). The amended guidance became effective January 1, 2018. The Company adopted the new standard effective January 1, 2018. Based on the Company’s current investment holdings, the adoption of this new standard did not have a material impact on its consolidated financial position or results of operations.

In February 2016, the FASB issued ASU No. 2016-02, Leases (ASU No. 2016-02), which will replace the existing guidance in ASC 840, Leases. The updated standard aims to increase transparency and comparability among organizations by requiring lessees to recognize lease assets and lease liabilities on the balance sheet and requiring disclosure of key information about leasing arrangements. This standard is effective for the Company in the fiscal year beginning after December 15, 2018, but early adoption is permissible. The Company is currently evaluating the potential impact that ASU No. 2016-02 may have on its financial position and results of operations.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. The new standard clarifies certain aspects of the statement of cash flows, including the classification of contingent consideration payments made after a business combination and several other clarifications not currently applicable to the Company. The new standard also clarifies that an entity should determine each separately identifiable source or use within cash receipts and cash payments on the basis of the nature of the underlying cash flows. In situations in which cash receipts and payments have aspects of more than one class of cash flows and cannot be separated by source or use, the appropriate classification should depend on the activity that is likely to be the predominant source or use of cash flows for the item. The Company adopted the new standard effective January 1, 2018. The adoption of this standard did not have a material impact on the Company’s consolidated statement of cash flows.

In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows: Restricted Cash (ASU No. 2016-18). The amendments in this update require that amounts generally described as restricted cash and restricted cash equivalents be included within cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The Company adopted the new standard effective January 1, 2018. The adoption of this standard did not have a material impact on the Company’s consolidated statement of cash flows.

In May 2017, the FASB issued ASU No. 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. This guidance is intended to provide clarity and reduce diversity in practice as to when changes to the terms or conditions of share-based payments are accounted for as modifications. Under this new guidance, entities will apply modification accounting if the fair value, vesting conditions or classification of the award changes. This guidance will be effective for annual reporting periods beginning after December 15, 2017, including interim periods within those annual reporting periods, and early adoption is permitted. The guidance per ASU 2017-09 is to be adopted prospectively to an award modified on or after the adoption date. The Company adopted the new standard effective January 1, 2018. The adoption of this standard did not have a material impact on the Company’s consolidated statement of cash flows.

In November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (Topic 808):Clarifying the Interaction between Topic 808 and Topic 606. The main provisions of ASU 2018-18 include: (i) clarifying that certain transactions between collaborative arrangement participants should be accounted for as revenue when the collaborative arrangement participant is a customer in the context of a unit of account and (ii) precluding the presentation of transactions with collaborative arrangement participants that are not directly related to sales to third parties together with revenue. This guidance will be effective for annual reporting periods beginning after December 15, 2019, including interim periods within those annual reporting periods, and early adoption is permitted. The guidance per ASU 2018-18 is to be adopted retrospectively to the date of initial application of Topic 606. The Company is currently evaluating the potential impact that ASU No. 2018-18 may have on its financial position and results of operations.

 

3. Collaboration agreements

Takeda XMT-1522 strategic partnership

In January 2016, the Company entered into a Development Collaboration and Commercial License Agreement with Takeda through its wholly owned subsidiary, Millennium Pharmaceuticals, Inc. for the development and commercialization of XMT-1522 (the XMT-1522 Agreement). Under the XMT-1522 Agreement, Takeda was granted the exclusive right to commercialize XMT-1522 outside of the United States and Canada. Under the XMT-1522 Agreement, the Company is responsible for conducting certain Phase 1 development activities for XMT-1522, including the ongoing Phase 1 clinical study, at its own expense. Takeda has the option to conduct Phase 1 development activities at its own expense within its territory. The parties agreed to collaborate on the further development of XMT-1522 in accordance with a global development plan (Post-Phase 1 Development). The parties agreed to share equally all clinical stage manufacturing costs and any Post-Phase 1 Development costs incurred in the performance of activities for the purpose of obtaining regulatory approval in either the United States or Canada and in certain other major markets in the rest of the world. Each party will be responsible for all Post-Phase 1 Development costs incurred in the performance of activities solely for the purpose of obtaining regulatory approval in such party's territory. Each party may conduct independent development of XMT-1522, subject to certain restrictions.

The Company received an upfront payment of $26,500 upon execution of the XMT-1522 Agreement. In addition, the Company was entitled to a milestone payment of $20,000 upon achievement of the IND Clearance Date (as defined therein). The Company achieved the IND Clearance Date in October 2016.

In addition to the milestone payment upon achievement of the IND Clearance Date, the Company is entitled to receive future development, regulatory and commercial milestones of up to $288,000, consisting of $87,000 of development milestones, $128,000 of regulatory milestones and $73,000 of commercial milestones, as well as royalties in the low to mid teens on net sales of XMT-1522 in Takeda’s territory during the applicable royalty term. There are development milestones payable upon the achievement of nine separate events: the initiation of Phase 2 clinical trials and Phase 3 clinical trials for four separate specified patient populations and the initiation of a Phase 3 clinical trial for one additional unspecified patient population. There are 14 regulatory milestones, which are payable upon regulatory submissions, regulatory approvals and pricing approvals, as applicable, for the U.S., European Union and Japanese markets for up to four separate patient populations and multiple label indications. In addition, a regulatory milestone is payable upon the receipt of regulatory and pricing approval in two specified markets other than the United States, the European Union or Japan. There are three individual commercial milestones, which are payable upon the attainment of certain thresholds for annual net sales. The next potential milestone the Company will be eligible to receive is a development milestone of $12,000 related to the initiation of a Phase 2 clinical trial.

The XMT-1522 Agreement expires upon the expiration of the royalty term for XMT-1522, after which time, Takeda will have a perpetual, royalty-free license. However, Takeda may terminate the XMT-1522 Agreement in its entirety for convenience upon 30 days' prior written notice at any time up to the initiation of the first Phase 2 clinical study of XMT-1522 or upon 90 days' prior written notice following the initiation of the first Phase 2 clinical study of XMT-1522. Each party may terminate the XMT-1522 Agreement in its entirety upon bankruptcy or similar proceedings of the other party and in its entirety or on a country-by-country basis upon an uncured material breach of the agreement by the other party. Following termination, XMT-1522 will revert to the Company for further development and commercialization.

Takeda strategic research and development partnership

In March 2014, the Company entered into a Research Collaboration and Commercial License Agreement with Takeda through Takeda’s wholly owned subsidiary, Millennium Pharmaceuticals, Inc. (the 2014 Agreement). The 2014 Agreement was amended in January 2015 and amended and restated in January 2016 (the 2016 Restated Agreement). The agreements initially provided Takeda with the right to develop ADCs directed to a total of seven exclusive targets, designated by Takeda, over a specified period of time. Takeda will be responsible for the product development and marketing of any products resulting from this collaboration.  To date, the Company has received $24,800 in non-refundable upfront fees, technology access fees or option exercise fees. 

For the two targets initially under the 2014 Agreement, the Company initially granted a research license upon designation of a target.  To receive a development and commercialization license for these designated targets, Takeda was required to pay an additional option exercise fee of $1,300.  For the remaining five targets, the Company grants a research, development and commercialization license upon the designation of a target.

For each designated target, the Company and Takeda develop research plans to evaluate Takeda's antibodies as ADCs incorporating the Company's technology. The Company receives service fees for its efforts under the research plans. The goal of the research plans is to provide Takeda with sufficient information to formally nominate a development candidate and begin Investigational New Drug Application (IND), enabling studies or cease development on the designated target. 

As of September 30, 2018, Takeda had designated four targets and received development and commercialization licenses for the first, third and fourth designated targets and a research license for the second designated target.  Takeda has limited replacement rights for two designated targets, subject to certain contractual restrictions.  Takeda is required to pay $500 to utilize the second limited replacement right.

As of September 30, 2018, if products are successfully developed and commercialized, the Company would be entitled to receive aggregate milestones of up to $474,750 for all eligible designated targets consisting of $50,250 in development milestones, $153,000 in regulatory milestones, and $271,500 in commercial milestones. The total milestones payable on each of the remaining eligible three targets are $158,250. There are four individual development milestones per target, which are payable upon the filing of an IND application and the initiation of Phase 1 through Phase 3 clinical trials. There are eight individual regulatory milestones per target. These are payable upon regulatory submissions, regulatory approvals and pricing approvals, as applicable, for the U.S., European Union and Japanese markets and regulatory approvals for both a second and third indication. There are six individual commercial milestones, which are payable upon the first commercial sale in each of the U.S., European Union and Japanese markets and upon the attainment of three separate defined thresholds for annual net sales. The next potential milestone payment the Company will be eligible to receive is a development milestone of $750 related to the filing of an IND. The Company is also entitled to receive royalties on product sales, if any, during the applicable royalty term. Royalties payable on the remaining designated targets are in the mid to high single digits.

The Company may elect to exercise an option to co-develop and co-commercialize one product incorporating either Takeda's fifth, sixth or seventh target in the United States for a payment of $15,000. If the Company elects to exercise the option to co-develop and co-commercialize a product, the Company will share in 50% of the profits related to the United States. The Company will be responsible for 50% of costs incurred specifically for the United States and 30% of global development costs. Any costs incurred specifically for a foreign country will be borne 100% by Takeda. If the Company elects to co-develop and co-commercialize a product, certain regulatory milestones and royalties related to the United States for that target would not be paid by Takeda.

Unless earlier terminated, the 2016 Restated Agreement will expire upon the expiration of the last royalty term for a product under the agreement, after which time, Takeda will have a perpetual, royalty-free license. Except with respect to the target antigen of a product for which the Company exercised its option to co-develop and co-commercialize in the United States, Takeda may terminate the 2016 Restated Agreement in its entirety or with respect to any target for convenience upon 45 days' prior written notice. Each party may terminate the 2016 Restated Agreement in its entirety upon bankruptcy or similar proceedings of the other party or upon an uncured material breach of the agreement by the other party. However, if such breach only relates to one target, the agreement may only be terminated with respect to such target.

Accounting Analysis

For periods prior to January 1, 2018, the Company applied the provisions of ASC 605 in accounting for these arrangements.  Refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 28, 2018 for the accounting analysis under these provisions.

Under ASC 605 and Topic 606, the Company has concluded that the 2016 Restated Agreement and the XMT-1522 Agreement should be accounted for as one arrangement due in part because the agreements are with the same party and were negotiated and executed contemporaneously. Further, in applying the contract modification practical expedient, the Company has aggregated the effect of all modifications through the initial date of application of Topic 606 for the purposes of (i) identifying the satisfied and unsatisfied performance obligations, (ii) determining the transaction price and (iii) allocating the transaction price to the satisfied and unsatisfied performance obligations. 

The performance obligations and the allocated transaction price as of the date of initial application of Topic 606 are as follows:

The Company has concluded the license related to each of the designated targets is not distinct from the research services performed related to each of the designated targets as Takeda cannot obtain the benefit of the license without the related research services.  Each license to a designated target and the related services performance obligation is considered distinct from every other license to a designated target and related services performance obligation as each research plan is pursued independent of the any other research plans for other designated targets.  Further, the material rights provided in the agreement provide Takeda incremental rights for either no additional consideration or for additional fees that contain a significant discount.  The material rights are distinct from the other performance obligations in the arrangement as they are options in the contract and are not required for Takeda to obtain the benefit of the other promised goods or services in the arrangement. 

Similarly, the Company concluded that the XMT-1522 license and the related research and development services, including the Phase 1 development and the transfer certain materials and know how related to the Company's manufacturing processes are one performance obligation. The license to the Company's intellectual property is not distinct from the research and related development services that the Company is obligated to perform. Takeda would not have the ability to realize the value of the license without the Company performing the related services.

The Company has concluded that the Post-Phase 1 Development activities under the XMT-1522 Agreement represent joint operating activities in which both parties are active participants and of which both parties are exposed to significant risks and rewards that are dependent on the commercial success of the activities. Accordingly, the Company is accounting for the Post-Phase 1 Development activities in accordance with ASC 808 and they are not considered revenue elements under Topic 606. For the three months ended September 30, 2018 and 2017 and the nine months ended September 30, 2018 and 2017, the Company was billed approximately $2,210,  $924,  $5,013 and $1,719, respectively, from Takeda representing the Company's share of Post-Phase 1 Development costs incurred by Takeda. These amounts have been reflected as research and development costs in the consolidated statement of operations. The Company did not perform any Post-Phase 1 Development activities or incur any associated costs prior to January 1, 2018.   During the three months ended September 30, 2018 and 2017 and the nine months ended September 30, 2018 and 2017, the Company billed Takeda $1,165,  $0,  $2,959 and $0, respectively, related to ASC 808 costs.

As of the date of initial application of Topic 606, the total transaction price for the 2016 Restated Agreement and the XMT-1522 Agreement was $86,123, which included approximately $14,023 of fees associated with research and development activities which had been or were expected to be provided.  The Company utilizes the expected value approach to estimate the amount of consideration related to the fees associated with development and research services.  The Company utilizes the most likely amount approach to estimate any development and regulatory milestone payments to be received.  As of the date of initial application of Topic 606, there were no milestone payments, which had not been received, included in the estimated transaction price.  The Company considered the stage of development and the remaining risks associated with the remaining development required to achieve the milestone, as well as whether the achievement of the milestone is outside the control of the Company or Takeda.  The milestone payment amounts were fully constrained, as a result of the uncertainty whether any of the associated milestones would be achieved.  The Company has determined that any commercial milestones and sales based royalties will be recognized when the related sales occur as they were determined to relate predominantly to the license granted and therefore have also been excluded from the transaction price.  The Company will re-evaluate the transaction price in each reporting period and as uncertain events are resolved or other changes in circumstances occur. In the third quarter of 2018, the Company revised its estimate for fees associated with research and development activities under the XMT-1522 Agreement to $9,755. The revised total transaction price for the 2016 Restated Agreement and the XMT-1522 Agreement is $86,429. 

The transaction price was allocated to the performance obligations based on the relative estimated standalone selling prices of each performance obligation or, in the case of certain variable consideration, to one or more performance obligations.  The estimated standalone selling prices for performance obligations which include a license and research services, was developed using the estimated selling price of the license and an estimate of the overall effort to perform the research service and an estimated market rate for research services. The estimated standalone selling price of the licenses was established based on comparable transactions.  The estimated standalone selling price for the material rights and rights to future technological improvements were developed based on the estimated selling prices of a license or rights received and any fees payable upon exercise of the associated option, as well as considering the probability that additional technology would be made available or the probability the counterpart would utilize the technology or exercise the option. The estimated standalone selling price for the joint research committee services was developed using an estimate of the time and costs incurred to participate in the committees.

The Company will recognize revenue related to the performance obligations, which include research licenses or an exclusive development and commercialization license and the related research services, over the estimated period of the research and development services using a proportional performance model. The Company measures proportional performance based on the costs incurred relative to the total estimated costs of the research.  To the extent that the Company receives fees for the research services as they are performed, these amounts are recorded as deferred revenue. Revenue related to material rights will be recognized when the option is exercised, unless there are additional research services that the Company is required to perform related to the designated target (in which case revenue will be recognized based on the proportional performance model) or at the time the option right lapses. To the extent that the Company receives a fee upon exercise of the option, such amounts are recorded as deferred revenue. Revenue related to the material rights related to replacement rights will be recognized over the research term of the replacement target once the replacement right is exercised or at the time the right lapses unused. To the extent that the Company receives a fee upon exercise of the replacement right, such amounts are recorded as deferred revenue. Revenue related to future technological improvements and joint research committee services will be recognized ratably over the performance period (which in the case of the joint research committee services approximates the time and cost incurred), which is expected to be ten years and six years, respectively. The Company will reassess the estimated remaining term at each subsequent reporting period.

For the three months ended September 30, 2018 and 2017 and the nine months ended September 30, 2018 and 2017, the Company recorded total revenue of $82,  $5,768,  $4,697 and $12,052, respectively, related to its efforts under the 2016 Restated Agreement and the XMT-1522 Agreement. Included in accounts receivable as of September 30, 2018 and December 31, 2017 was $32 and $454, respectively, related to the Takeda agreements. Included in accounts payable as of September 30, 2018 was $530 related to the Takeda agreements. During the quarter ended September 30, 2018, the Company revised its estimate of the total costs to complete research services under the 2016 Restated Agreement and the XMT-1522 Agreement, which changed the total consideration to be received under the agreements and the amount of revenue recognized in the three months and nine months ended September 30, 2018. The Company recognized approximately $1,380 less for the three months and nine months ended September 30, 2018 as a result of the Company’s change in estimate. The change in estimate increased the net loss by $1,380 for the three months and nine months ended September 30, 2018, or $0.06 per common share. 

As of September 30, 2018, the Company had $41,104 of deferred revenue related to the Takeda agreements that will be recognized over the remaining performance periods for the applicable obligations.

Takeda invested $10,000 as part of the Company’s IPO.

Merck KGaA

In June 2014, the Company entered into a Collaboration and Commercial License Agreement with Merck KGaA (the Merck KGaA Agreement). Upon the execution of the agreement, Merck KGaA paid the Company a nonrefundable technology access fee of $12,000 for the right to develop ADCs directed to six exclusive targets over a specified period of time. No additional fees are due when a target is designated and the commercial license to the target is granted. Merck KGaA will be responsible for the product development and marketing of any products resulting from this collaboration.  All six targets were designated prior to 2018.

Under the terms of the agreement, the Company and Merck KGaA develop research plans to evaluate Merck KGaA's antibodies as ADCs incorporating the Company's technology. The Company receives fees for its efforts under the research plans. The goal of the research plans is to provide Merck KGaA with sufficient information to formally nominate a development candidate and begin IND-enabling studies or cease development on the designated target.

In addition to the payments received for research and development activities performed on behalf of Merck KGaA, the Company is also eligible to receive up to a total of $780,000 in future milestones related to all targets under the agreement, plus low to mid single digit royalties on the commercial sales of any resulting products during the applicable royalty term. The total milestones are categorized as follows: development milestones—$84,000; regulatory milestones—$264,000; and sales milestones—$432,000. There are six individual development milestones per target, payable upon the completion of various activities from the delivery of ADCs meeting defined specifications, through the dosing in a Phase 3 clinical trial. There are five regulatory milestones, which are payable upon regulatory approvals for a first indication in each of the U.S., European Union and Japanese markets and regulatory approvals for both a second and a third indication in the United States. There are three individual commercial milestones, which are payable upon the attainment of certain defined thresholds for annual net sales.

Prior to 2018, the Company had received $3,000 related to development milestones under the agreement.   There have been no additional milestone payments in the nine months ended September 30, 2018.  The next potential milestone payment the Company will be eligible to receive will be a development milestone of $500 on Merck KGaA's designation of a preclinical development candidate for any target. Revenue will be recognized upon achievement of the milestone. The Company and Merck KGaA may also enter into a future supply agreement to provide clinical study material should Merck KGaA pursue clinical development of any candidates nominated under the agreement.

Unless earlier terminated, the agreement will expire upon the expiration of the last royalty term for a product under the agreement, after which time, Merck KGaA will have a perpetual, royalty-free license, or if Merck KGaA does not designate any ADC product candidates produced by the Company under the agreement as preclinical development candidates, upon the expiration of the last to expire research program. Merck KGaA may terminate the agreement in its entirety or with respect to any target for convenience upon 60 days' prior written notice. Each party may terminate the Merck KGaA Agreement in its entirety upon bankruptcy or similar proceedings of the other party or upon an uncured material breach of the agreement by the other party. However, if such breach only relates to one target, the agreement may only be terminated with respect to such target.

In May 2018, the Company entered into a Supply Agreement with Merck KGaA (the Merck KGaA Supply Agreement). Under the terms of the agreement, the Company will provide Merck KGaA preclinical non-GMP ADC Drug Substance and clinical GMP Drug Substance for use in clinical trials associated with one of the antibodies designated under the Merck KGaA Agreement. The Company receives fees for its efforts under the Merck KGaA Supply Agreement and reimbursement equal to the supply cost.

Accounting Analysis

For periods prior to January 1, 2018, the Company applied the provisions of ASC 605 in accounting for this arrangement.  Refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 28, 2018 for the accounting analysis under these provisions.

By applying the contract modification practical expedient, the Company has aggregated the effect of all modifications through the initial date of application of Topic 606 for the purposes of (i) identifying the satisfied and unsatisfied performance obligations, (ii) determining the transaction price and (iii) allocating the transaction price to the satisfied and unsatisfied performance obligations. 

The Company identified the following performance obligations under the agreement: (i) exclusive license and research services for six designated targets, (ii) rights to future technological improvements and (iii) participation of project team leaders and providing joint research committee services.

The Company has concluded that each license for a designated target is not distinct from the research services performed related to the designated target as Merck KGaA cannot obtain the benefit of the license without the related research services.  Each license for a designated target and the related services performance obligation is considered distinct from every other license for a designated target and related services performance obligation as each research plan is pursued independent of every other research plans for other designated targets. 

As of the date of initial application of Topic 606, the total transaction price for the Merck KGaA Agreement was $22,875, which included approximately $7,875 fees for research and development activities which have been or were expected to be received and $3,000 of milestone payments previously earned.  The Company utilizes the expected value approach to estimate the amount of consideration related to the payment of fees associated with development and research services.  The Company utilizes the most likely amount approach to estimate any development and regulatory milestone payments to be received.  As of the date of initial application of Topic 606, there were no milestones payments that had not already been received, included in the estimated transaction price.  The Company considered the stage of development and the remaining risks associated with the remaining development required to achieve the milestone, as well as whether the achievement of the milestone is outside the control of the Company or Merck KGaA.  The milestone payment amounts were fully constrained, as a result of the uncertainty whether any of the associated milestones would be achieved.  The Company has determined that any commercial milestones and sales based royalties will be recognized when the related sales occur as they were determined to relate predominantly to the license granted and therefore have also been excluded from the transaction price.  The Company will re-evaluate the transaction price in each reporting period and as uncertain events are resolved or other changes in circumstances occur.  For each of the three and nine months ended September 30, 2018, the transaction price decreased $805 to $22,070 due to a decrease in fees for research and development activities expected to be received, as the Company revised its estimate for fees associated with research and development activities under the Merck KGaA Agreement in the third quarter of 2018 to $7,070. The revised total transaction price for the Merck KGaA Agreement is $22,070.

The transaction price was allocated to the performance obligations based on the relative estimated standalone selling prices of each performance obligation or in the case of certain variable consideration to one or more performance obligations.  The estimated standalone selling prices for performance obligations, that include a license and research services, were developed using the estimated selling price of the license and an estimate of the overall effort to perform the research service and an estimated market rate for research services. The estimated standalone selling price of the licenses was established based on comparable transactions.  The estimated standalone selling price for the rights to future technological improvements was developed based on the estimated selling prices of a license or rights received, as well as considering the probability that additional technology would be made available or the probability the counterpart would utilize the technology. The estimated standalone selling price for the joint research committee services was developed using an estimate of the time and costs incurred to participate in the committees.

The transaction price of $22,875 was allocated to the performance obligations as follows: approximately $4,226 for each of the license and corresponding research and development services units of account for the first and second designated targets; $3,439 for each of the license and corresponding research and development services units of account for the third, fourth,  fifth and sixth designated target; $425 for rights to future technological improvements; and $242 for joint research committee services.

The Company is recognizing revenue related to the exclusive license and research and development services performance obligation over the estimated period of the research and development services using a proportional performance model.  The Company measures proportional performance based on the costs incurred relative to the total costs expected to be incurred.  To the extent that the Company receives fees for the research services as they are preformed, these amounts are recorded as deferred revenue. Revenue related to future technological improvements and joint research committee services will be recognized ratably over the performance period (which in the case of the joint research committee services approximate the time and cost incurred each period), which are 10 and 5 years, respectively.  The Company is continuing to reassess the estimated remaining term at each subsequent reporting period.

During the three months ended September 30, 2018 and 2017 and the nine months ended September 30, 2018 and 2017, the Company recorded revenue of $1,482,  $499,  $2,426 and $2,107, respectively, related to its efforts under the collaboration agreement. Included in accounts receivable as of September 30, 2018 and December 31, 2017 was $163 and $330, respectively, related to the Merck KGaA Agreement.

As of September 30, 2018, the Company had recorded $5,480 in deferred revenue related to the Merck KGaA Agreement that will be recognized over the remaining performance period.

Summary of Contract Assets and Liabilities

The following table presents changes in the balances of our contract assets and liabilities during the three and nine months ended September 30, 2018:

 

 

The impact of the adoption of the new revenue recognition guidance is reflected within the beginning of period balance.

During the three months and nine months ended September 30, 2018, the Company recognized the following revenues as a result of changes in the contract asset and the contract liability balances in the respective periods:

Other Revenue

The Company has provided limited services for a collaboration partner, Asana BioSciences. For the three months ended September 30, 2018 and 2017 and the nine months ended September 30, 2018 and 2017, the Company recorded revenue of $587,  $0,  $782 and $125, respectively, related to these services. In addition, during the nine months ended September 30, 2018, the Company recognized revenue of $1,500 related to a milestone achieved upon the completion of a GLP toxicology study by Asana BioSciences. The next potential milestone the Company is eligible to receive is $2,500 upon dosing the fifth patient in a Phase 1 clinical study by Asana BioSciences. Included in accounts receivable as of September 30, 2018 was $391 related to the Asana agreement.

4. Fair value measurements

The following table presents information about the Company's assets and liabilities regularly measured and carried at a fair value and indicates the level within fair value hierarchy of the valuation techniques utilized to determine such value as of September 30, 2018 and December 31, 2017:

 

There were no changes in valuation techniques or transfers between fair value measurement levels during the nine months ended September 30, 2018 and 2017. As of September 30, 2018 and December 31, 2017, cash and cash equivalents were comprised of cash and money market funds.