UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2019
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 001-37897 
OBALON THERAPEUTICS, INC.
(Exact Name of Registrant as Specified in Its Charter)

Delaware
26-1828101
(State of Incorporation)
(I.R.S. Employer
Identification No.)
 
 
5421 Avenida Encinas, Suite F
 
Carlsbad, California
92008
(Address of Principal Executive Offices)
(Zip Code)
 (844) 362-2566
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Securities Exchange Act of 1934. 
Large accelerated filer
¨
 
Accelerated filer
¨
Non-accelerated filer
x
 
Smaller reporting company
x
 
 
 
Emerging growth company
x
     If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financing accounting standards provided pursuant to Section 13(a) of the Exchange Act.  x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨  No x
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common stock, par value $0.001 per share
OBLN
The NASDAQ Stock Market LLC
(NASDAQ Global Market)
Total shares of common stock outstanding as of the close of business on November 6, 2019 was 7,694,576.




TABLE OF CONTENTS
 
PART I. FINANCIAL INFORMATION
 
 
 
 
Item 1.
2
 
2
 
3
 
4
 
6
 
7
Item 2.
22
Item 3.
32
Item 4.
32
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
Item 1.
33
Item 1A.
33
Item 2.
73
Item 3.
73
Item 4.
74
Item 5.
74
Item 6.
75
 
 
 
76



1




PART I. FINANCIAL INFORMATION
ITEM 1. Condensed Consolidated Financial Statements


OBALON THERAPEUTICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except shares and par value data)
 
September 30, 2019
 
December 31, 2018
Assets
(Unaudited)
 
 
Current assets:
 

 
 

Cash and cash equivalents
$
19,380

 
$
21,187

Short-term investments

 
2,548

Accounts receivable, net of allowance of $508 and $665, respectively
238

 
870

Inventory
2,048

 
1,580

Other current assets
683

 
2,462

Total current assets
22,349

 
28,647

Property and equipment, net
1,117

 
1,739

Lease right-of-use assets
1,191

 

Total assets
$
24,657

 
$
30,386

Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
732

 
$
1,159

Accrued compensation
724

 
3,805

Deferred revenue
283

 
352

Other current liabilities
1,609

 
1,985

Current portion of lease liabilities
557

 

Current portion of long-term loan

 
9,930

Total current liabilities
3,905

 
17,231

Lease liabilities long-term
687

 

Other long-term liabilities

 
48

Total long-term liabilities
687


48

Total liabilities
4,592

 
17,279

Commitments and contingencies (See Note 10)


 


Stockholders’ equity:
 

 
 

Common stock, $0.001 par value; 100,000,000 shares authorized as of September 30, 2019 and December 31, 2018; 7,724,100 and 2,351,333 shares issued and outstanding as of September 30, 2019 and December 31, 2018, respectively
8

 
2

Additional paid-in capital
187,574

 
161,859

Accumulated deficit
(167,517
)
 
(148,754
)
Total stockholders’ equity
20,065

 
13,107

Total liabilities and stockholders’ equity
$
24,657

 
$
30,386


See accompanying notes to unaudited interim condensed consolidated financial statements.


2





OBALON THERAPEUTICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except shares and per share data)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019
 
2018
 
2019

2018
 
(Unaudited)
Revenue
$
333

 
$
2,987

 
$
2,494

 
$
7,065

Cost of revenue
412

 
1,418

 
2,323

 
3,919

Gross (deficit) profit
(79
)
 
1,569

 
171

 
3,146

Operating expenses:
 
 
 

 


 


Research and development
1,174

 
2,368

 
5,401

 
8,359

Selling, general and administrative
2,489

 
5,836

 
13,025

 
23,092

Total operating expenses
3,663

 
8,204

 
18,426

 
31,451

Loss from operations
(3,742
)
 
(6,635
)
 
(18,255
)
 
(28,305
)
Interest income (expense), net
37

 
(70
)
 
(448
)
 
(164
)
Other expense, net
(1
)
 
(40
)
 
(60
)
 
(155
)
      Net loss
(3,706
)
 
(6,745
)
 
(18,763
)
 
(28,624
)
Other comprehensive income (loss)

 
(3
)
 

 
3

Net loss and comprehensive loss
$
(3,706
)
 
$
(6,748
)
 
$
(18,763
)
 
$
(28,621
)
Net loss per share, basic and diluted
$
(0.61
)
 
$
(3.47
)
 
$
(5.07
)
 
$
(16.05
)
Weighted-average common shares outstanding, basic and diluted
6,061,248

 
1,945,864

 
3,700,538

 
1,783,793

 
See accompanying notes to unaudited interim condensed consolidated financial statements.


3




OBALON THERAPEUTICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except shares and per share data)

 
Common stock 
 
Additional
paid-in
capital
 
Accumulated
deficit
 
Total
stockholders’
equity
 
Shares
Amount
 
 
(Unaudited)
Balance at December 31, 2018
2,351,333

$
2

 
$
161,859

 
$
(148,754
)
 
$
13,107

Stock-based compensation


 
1,105

 

 
1,105

Issuance of common stock for cash upon exercise of stock options
119


 
1

 

 
1

Vesting of early exercised stock options


 
14

 

 
14

Issuance of common stock, net of issuance costs
75,551

1

 
580

 

 
581

Cancellation of restricted stock awards
(2,051
)

 

 

 

Net loss


 

 
(8,290
)
 
(8,290
)
Balance at March 31, 2019
2,424,952

3

 
163,559

 
(157,044
)
 
6,518

Stock-based compensation


 
536

 

 
536

Issuance of common stock for cash upon exercise of stock options


 

 

 

Vesting of early exercised stock options


 
15

 

 
15

Issuance of common stock, net of issuance costs
1,158,187

1

 
8,073

 

 
8,074

Cancellation of restricted stock awards
(24,859
)

 

 

 

Net loss


 

 
(6,767
)
 
(6,767
)
Balance at June 30, 2019
3,558,280

$
4

 
$
172,183

 
$
(163,811
)
 
$
8,376

Stock-based compensation


 
659

 
 
 
659

Costs associated with issuance of common stock


 
(7
)
 

 
(7
)
Vesting of early exercised stock options


 
14

 

 
14

Issuance of common stock and warrants, net of issuance costs
2,427,500

2

 
14,716

 
 
 
14,718

Exercise of warrants for the purchase of common stock
1,735,000

2

 
 
 
 
 
2

Issuance of round up common stock for reverse stock split
3,320


 
9

 
 
 
9

Net loss


 

 
(3,706
)
 
(3,706
)
Balance at September 30, 2019
7,724,100

$
8

 
$
187,574

 
$
(167,517
)
 
$
20,065


See accompanying notes to consolidated financial statements.



4




OBALON THERAPEUTICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except shares and per share data)
 
Common stock 
 
Additional
paid-in
capital
 
Accumulated
other
comprehensive
(loss) income
 
Accumulated
deficit
 
Total
stockholders’
equity
 
Shares
Amount
 
 
(unaudited)
Balance at December 31, 2017
1,750,061

$
2

 
$
146,490

 
$
(5
)
 
$
(111,374
)
 
$
35,113

Stock-based compensation


 
1,389

 

 

 
1,389

Issuance of common stock for cash upon exercise of stock options
2,068


 
28

 

 

 
28

Vesting of early exercised stock options


 
14

 

 

 
14

Issuance of restricted stock awards, net of cancellations
7,500


 

 

 

 

Unrealized gain on short-term investments


 

 
6

 

 
6

Net loss


 

 

 
(12,126
)
 
(12,126
)
Balance at March 31, 2018
1,759,629

2

 
147,921

 
1

 
(123,500
)
 
24,424

Stock-based compensation


 
1,214

 

 

 
1,214

Issuance of common stock for cash upon exercise of stock options
223


 
3

 

 

 
3

Vesting of early exercised stock options


 
15

 

 

 
15

Issuance of common stock under ESPP
4,526


 
148

 

 

 
148

Issuance of restricted stock awards, net of cancellations
21,495


 

 

 

 

Net loss


 

 

 
(9,753
)
 
(9,753
)
Balance at June 30, 2018
1,785,873

$
2

 
$
149,301

 
$
1

 
$
(133,253
)
 
$
16,051

Stock-based compensation
 

 
1,007

 

 

 
1,007

Issuance of common stock for cash upon exercise of stock options
310


 
7

 

 

 
7

Vesting of early exercised stock options


 
14

 

 

 
14

Issuance of common stock, net of issuance costs
549,451

5

 
9,817

 

 

 
9,822

Cancellation of restricted stock awards
(7,600
)

 

 

 

 
0

Unrealized gain on short-term investments



 

 
(3
)
 

 
(3
)
Net loss


 

 

 
(6,745
)
 
(6,745
)
Balance at September 30, 2018
2,328,034

$
7

 
$
160,146

 
$
(2
)
 
$
(139,998
)
 
$
20,153


See accompanying notes to consolidated financial statements.



5





OBALON THERAPEUTICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Nine Months Ended September 30,
 
2019
 
2018
 
(Unaudited)
Operating activities:
 

 
 

Net loss
$
(18,763
)
 
$
(28,624
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 

Depreciation
361

 
428

Stock-based compensation
2,300

 
3,610

Loss on disposal of fixed assets
128

 
107

Amortization of right-of-use asset
301

 

Accretion of investment discount, net
(2
)
 
(20
)
Amortization of debt discount
70

 
29

Change in operating assets and liabilities:
 
 
 

Accounts receivable, net
632

 
1,448

Inventory
(117
)
 
(537
)
Other current assets
1,604

 
805

Accounts payable
(724
)
 
135

Accrued compensation
(3,097
)
 
(1,823
)
Deferred revenue
(69
)
 
(209
)
Lease liabilities, net
(248
)
 

Other current and long-term liabilities
(363
)
 
634

Net cash used in operating activities
(17,987
)
 
(24,017
)
Investing activities:
 

 
 

Purchases of short-term investments

 
(9,103
)
Maturities of short-term investments
2,550

 
24,302

Purchases of property and equipment
(44
)
 
(867
)
Net cash provided by investing activities
2,506

 
14,332

Financing activities:
 

 
 

Proceeds from long-term loan
10,000

 

Payment on long-term loan
(20,000
)
 

Proceeds from issuance of common stock and warrants, net of paid issuance costs
15,014

 

Proceeds from issuance of common stock, net of issuance costs
8,659

 
9,973

Proceeds from stock issued under employee stock purchase plan

 
148

Proceeds from sale of common stock upon exercise of stock options
1

 
38

Fees paid in connection with loan amendment

 
(30
)
Net cash provided by financing activities
13,674

 
10,129

Net (decrease) increase in cash and cash equivalents
(1,807
)
 
444

Cash and cash equivalents at beginning of period
21,187

 
21,108

Cash and cash equivalents at end of period
$
19,380

 
$
21,552

Supplemental cash flow information:
 

 
 

Interest paid
$
700

 
$
473

Unpaid issuance costs
$
295

 
$
160

Property and equipment in accounts payable
$

 
$
106


See accompanying notes to unaudited interim condensed consolidated financial statements.


6




OBALON THERAPEUTICS, INC.
NOTES TO UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1.
Organization and Basis of Presentation
Obalon Therapeutics, Inc., or the Company, was incorporated in the state of Delaware on January 2, 2008. The Company is a vertically-integrated medical device company focused on developing and commercializing innovative medical devices to treat obese and overweight people. Using its patented technology, the Company has developed the Obalon® balloon system, the first and only U.S. Food and Drug Administration, or FDA, approved swallowable, gas-filled intragastric balloon designed to provide progressive and sustained weight loss in obese patients.
The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP, and include the Company's accounts and accounts of its wholly-owned subsidiaries. The Company also consolidates variable interest entities (“VIE”) for which it is the primary beneficiary. The primary beneficiary has both (a) the power to direct the activities of the VIE that most significantly affect the entity’s economic performance and (b) either the obligation to absorb losses or the right to receive benefits. Refer to Note 11, “Variable Interest Entities” for further details. All intercompany transactions and balances have been eliminated in consolidation.
The Company’s principal operations are located in Carlsbad, California, and it operates in one business segment.

Reverse Stock Split
On July 24, 2019, the Company filed a certificate of amendment to its certificate of incorporation with the Secretary of State of the State of Delaware to effect a one-for-ten reverse split of its issued and outstanding common stock. The accompanying consolidated financial statements and notes thereto give retrospective effect to the reverse stock split for all periods presented. All issued and outstanding common stock, options exercisable for common stock, restricted stock units, performance restricted stock units, and per share amounts contained in the consolidated financial statements have been retrospectively adjusted to reflect this reverse stock split for all periods presented. The number of authorized shares of common stock will not be changed by virtue of the reverse stock split and will remain at 100.0 million shares.
Liquidity
As of September 30, 2019, the Company has devoted a substantial portion of its efforts to product development, raising capital, and building infrastructure, and, since January 2017, U.S. commercialization. The Company has incurred operating losses and has experienced negative cash flows from operations since its inception. In July 2012, the Company realized initial revenue from its planned principal operations. The Company recognized total revenue of $0.3 million and $3.0 million for the three months ended September 30, 2019 and 2018, respectively, and $2.5 million and $7.1 million for the nine months ended September 30, 2019 and 2018, respectively. However, the Company has not yet established an ongoing source of revenue sufficient to cover its operating costs and has funded its activities to date almost exclusively from debt and equity financings.
As reflected in the accompanying condensed consolidated financial statements, the Company has a limited operating history and the sales and income potential of the Company’s business are unproven. The Company has not been profitable since inception, and as of September 30, 2019, its accumulated deficit was $167.5 million. Since inception, the Company has financed its operations primarily through private placements of preferred securities, the sale of common stock through its initial public offering (IPO), and a subsequent public and private placements, and, to a lesser extent, debt financing arrangements.

In August 2019, the Company issued and sold an aggregate of (i) 2,427,500 shares of its common stock (including 412,500 shares of common stock pursuant to the partial exercise of the underwriters’ over-allotment option to purchase 562,500 additional shares), (ii) pre-funded warrants to purchase up to 1,735,000 shares of common stock, (iii) accompanying warrants to purchase up to 3,234,375 shares of common stock (including the exercise in full of the underwriters’ over-allotment option to purchase additional warrants to purchase 421,875 shares of common stock) and (iv) an additional warrant to the underwriters for the purchase 37,500 shares of common stock, for net proceeds from the offering of approximately $14.7 million after deducting underwriting discounts and commissions and offering expenses payable by the Company. As of September 30, 2019, the Company had cash and cash equivalents of $19.4 million. Additionally, during the second quarter of 2019, the Company paid down $15.0 million of the principal balance due under the loan and security agreement with Pacific Western Bank (as successor-in-interest to Square 1 Bank) and during the third quarter of 2019, the Company paid down the remaining $5.0 million of principal balance due under the loan and security agreement with Pacific Western Bank, thereby removing the risks and restrictions of carrying long-term debt. See Note 8 for further detail regarding the equity financing transactions.
In an effort to address the Company's liquidity concerns, and pay expenses relating to its operating activities, including selling, general and administrative expenses and research and development expenses, on April 2, 2019, the Company commenced an


7




internal restructuring and notified approximately 49 employees, or approximately 50% of the Company's workforce, that their employment would be terminated. This restructuring included the elimination of the Company's field sales force and a transition to more centralized customer support and marketing program strategy. Going forward, rather than focusing on selling to physicians, the Company intends to focus its commercialization efforts on the establishment and operation of company-owned or managed Obalon-branded retail treatment centers.
The consolidated financial statements as of and for the nine months ended September 30, 2019 have been prepared on the basis that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. Based on the Company's cash balances and recurring losses since inception, there is substantial doubt about its ability to continue as a going concern and if the Company is not able to continue to raise sufficient capital, it will not be able to support ongoing operations.
2. Summary of Significant Accounting Policies

Except for the operating lease policy described below, there were no significant changes to the accounting policies during the nine months ended September 30, 2019, from the significant accounting policies described in Note 2 of the “Notes to Consolidated Financial Statements” in the Company's Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 22, 2019.
Leases
Effective January 1, 2019, the Company adopted ASC No. 2016‑02, Leases (Topic 842) (“ASU 2016‑02” or “ASC 842”), which supersedes the current accounting for leases, using the modified retrospective transition method. The Company has elected to apply the practical expedients allowed by the standard for existing leases. The new standard, while retaining two distinct types of leases, finance and operating, (i) requires lessees to record a right-of-use (“ROU”) asset and a related liability for the rights and obligations associated with a lease, regardless of lease classification, and recognize lease expense in a manner similar to current accounting, (ii) eliminates current real estate specific lease provisions, (iii) modifies the lease classification criteria and (iv) aligns many of the underlying lessor model principles with those in the new revenue standard. The Company determines the initial classification and measurement of its ROU asset and lease liabilities at the lease commencement date and thereafter, if modified. The Company recognizes a ROU asset for its operating leases with lease terms greater than 12 months.  The lease term includes any renewal options and termination options that the Company is reasonably assured to exercise. The present value of lease payments is determined by using the incremental borrowing rate for operating leases determined by using the incremental borrowing rate of interest that the Company would pay to borrow on a collateralized basis an amount equal to the lease payments in a similar economic environment and term. The Company applied the new guidance to its existing facility lease at the time of adoption and recognized a ROU asset and lease liability of $1.2 million and $1.3 million, respectively, during the first quarter of 2019.

Rent expense for operating leases is recognized on a straight-line basis over the reasonably assured lease term based on the total lease payments and is included in research and development and general and administrative expenses in the statements of operations.
Variable Interest Entities
The Company evaluates its ownership, contractual and other interests in entities that are not wholly-owned to determine if these entities are VIEs, and, if so, whether the Company is the primary beneficiary of the VIE. In determining whether the Company is the primary beneficiary of a VIE and therefore required to consolidate the VIE, the Company applies a qualitative approach that determines whether the Company has both (1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (2) the obligation to absorb losses of, or the rights to receive benefits from, the VIE that could potentially be significant to that VIE. The Company continuously assesses whether it is the primary beneficiary of a VIE, as changes to existing relationships or future transactions may result in the consolidation or deconsolidation of such VIE.
Revenue Recognition
The Company recognizes revenue, in accordance with ASC 606, when control of its products is transferred to its customers in an amount that reflects the consideration it expects to receive in exchange for those products. The Company's revenue recognition process involves identifying the contract with a customer, determining the performance obligations in the contract, determining the transaction price, allocating the transaction price to the distinct performance obligations in the contract, and recognizing revenue as performance obligations are satisfied. A performance obligation is considered distinct from other obligations in a contract when it provides a benefit to the customer either on its own or together with other resources that are readily available to the customer and is separately identified in the contract. The Company considers a performance obligation


8




satisfied once it has transferred control of a good or service to the customer, meaning the customer has the ability to use and obtain the benefit of the good or service. The Company recognizes revenue for satisfied performance obligations only when it determines there are no uncertainties regarding payment terms or transfer of control.
Revenue is generated from sales of the Obalon Balloon System to physicians and institutions in the United States and to a distributor in the Middle East. The Company recognizes revenue upon shipment of its product as the Company's standard contract terms dictate that control transfers to the customer upon shipment of its product. Invoicing typically occurs upon shipment and the time period between invoicing and when payment is due is not significant. Sales taxes collected are excluded from revenues. Shipping charges billed to customers are included in revenue and related shipping cost is included in cost of revenue. The Company's revenue contracts do not provide for maintenance. Commissions are considered incremental costs to obtain a contract with a customer and paid to salespeople when contracts are executed. Commissions are recognized as a selling expense when incurred as the amortization period is one year or less.

The components of the Obalon Balloon System are typically packaged in a kit and shipped to the customer at the same time, satisfying the majority of performance obligations in the contract. The Company recognizes revenue for any unsatisfied, distinct performance obligations, such as undelivered components, as they are satisfied based on the standalone selling price of each performance obligation. The Company estimates the standalone selling price of each performance obligation by estimating the expected cost of satisfying that performance obligation plus an appropriate margin.

When the Company enters into contracts with multiple performance obligations, such obligations are generally satisfied within a short time frame of approximately three to six months after the contract execution date. The Company does not disclose the value of the unsatisfied performance obligations within its contracts.

The Company offers a swallow guarantee program in the United States where it may provide replacement balloons to customers when their patients are unsuccessful in swallowing an Obalon balloon, subject to certain requirements and restrictions. The Company considers the replacement balloons provided under this program as an additional performance obligation in the contract and defers revenue relating to the replacement balloons based on an expected swallow failure rate and then recognizes revenue when replacement balloons are provided.

The Company recognizes revenue at the net sales price, which reflects the consideration the Company believes it is most likely to receive. The net sales price includes estimates of variable consideration for customer incentives and returns.  The Company reserves for product returns as a reduction to revenue in the period when the related revenue is recognized. The Company estimates its product returns based on historical return rates and specifically known events. Estimated costs of customer incentive programs are recorded at the time the incentives are offered, based on the specific terms and conditions of the program. Customer incentives that provide discounts to the customer on purchases of current or future product are recorded as a reduction of revenue in the period the related product revenue is recognized.  Any consideration payable to a customer is presumed as a reduction to revenue unless the Company can demonstrate that the consideration provided to the customer is in exchange for a distinct good or service.

Actual amounts of consideration ultimately received may differ from the Company’s estimates.  If actual results vary from the Company’s estimates, the Company would adjust these estimates, which would impact net product revenue and results of operations in the period such variances become known.
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 and the disclosure of assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period.
Reported amounts and note disclosures reflect the overall economic conditions that are most likely to occur and anticipated measures management intends to take. Actual results could differ materially from those estimates. All revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected.
Unaudited Interim Condensed Consolidated Financial Statements
The interim condensed consolidated financial statements as of September 30, 2019 and for the three and nine months ended September 30, 2019 and 2018 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and reflect, in the opinion of management, all adjustments of a normal and recurring nature that are necessary for the fair presentation of the Company’s condensed consolidated financial position as of September 30, 2019 and its condensed consolidated results of operations for the three and nine months ended


9




September 30, 2019 and 2018, statements of stockholders' equity for the three and nine months ended September 30, 2019 and 2018, and cash flows for the nine months ended September 30, 2019 and 2018. The results of operations for the three and nine months ended September 30, 2019 are not necessarily indicative of the results to be expected for the year ending December 31, 2019 or for any other future annual or interim period. The balance sheet as of December 31, 2018 included herein was derived from the audited financial statements as of that date. These financial statements should be read in conjunction with the Company’s audited financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 22, 2019.
Fair Value Measurements
The carrying values of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximate their fair values due to the short maturity of these instruments. The carrying value of the term loan approximates its fair value as the interest rate and other terms are that which are currently available to the Company.
The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible. The Company determines fair value based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market. When considering market participant assumptions in fair value measurements, the following fair value hierarchy distinguishes between observable and unobservable inputs, which are categorized in one of the following levels in accordance with authoritative accounting guidance:
Level 1 inputs: Observable inputs such as unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

Level 2 inputs: Other than quoted prices included in Level 1, inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability.

Level 3 inputs: Unobservable inputs for the asset or liability used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at measurement date.
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash equivalents and trade accounts receivable, which are generally not collateralized. The Company limits its exposure to credit loss by placing its cash equivalents with high credit quality financial institutions and investing in high quality short-term debt instruments. The Company’s customers consist of physicians and institutions in the United States and one international distributor. The Company establishes customer credit policies related to its accounts receivable based on historical collection experiences within the various markets in which the Company operates, historical past-due amounts, and any specific information that the Company becomes aware of such as bankruptcy or liquidity issues of customers.
 
 
The following table summarizes certain financial data for the customers who accounted for 10.0% or more of revenue and accounts receivable.

 
Three Months Ended
September 30,
Nine Months Ended
September 30,
Revenue
2019
 
2018
 
2019
 
2018
 
Customer A
%
 
39.4
%
 
23.6
%
 
45.4
%
 
Customer B
25.1
%
 
0.5
%
 
4.3
%
 
0.8
%
 
Customer C
22.4
%
 
4.7
%
 
21.4
%
 
3.9
%
 
Customer D
11.4
%
 
%
 
2.0
%
 
0.2
%
 

Accounts Receivable
September 30, 2019
 
December 31, 2018
Customer B
21.2
%
 
0.9
%
Customer D
10.8
%
 
1.5
%



10




The Company's largest customer for the nine months ended September 30, 2019 and the largest customer for the three and nine months ended September 30, 2018 was its Middle East distributor. There were no other international sales aside for the nine months ended September 30, 2019, aside from sales to this distributor during the three months ended March 31, 2019.
Net Loss per Share
Basic net loss per share is calculated by dividing the net loss by the weighted-average number of shares of common stock outstanding during the period without consideration for common stock equivalents. Diluted net loss per share is the same as basic net loss per common share, since the effects of potentially dilutive securities are anti-dilutive due to the net loss position of all periods presented.
Potentially dilutive common stock equivalents are comprised of warrants, if material, unvested restricted stock awards (RSAs), and unexercised stock options outstanding under the Company’s equity plan.
Recently Issued and Adopted Accounting Pronouncements
Recently Adopted Accounting Pronouncements
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). Under this new guidance, at the commencement date, lessees will be required to recognize (i) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis and (ii) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. This guidance is not applicable for leases with a term of 12 months or less. In July 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842 (Leases), which provides narrow amendments to clarify how to apply certain aspects of the new lease standard. The new standard is effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2018, with early adoption permitted. In July 2018, the FASB issued ASU No. 2018-11, Leases Topic (842): Targeted Improvements. This ASU provides companies an option to apply the transition provisions of the new lease standard at its adoption date instead of at the earliest comparative period presented in its financial statements. The Company elected the optional method to account for the impact of the adoption with a cumulative-effect adjustment in the period of adoption, if needed, and did not restate prior periods. The Company elected certain practical expedients permitted under the transition guidance. As part of the adoption, the Company recorded a ROU asset and liability upon adoption of the guidance pertaining to its long-term real estate lease for its corporate facilities. No cumulative-effect adjustment was needed.
Recently Issued Accounting Pronouncements not yet adopted

In June 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-13, Financial Instruments - Credit Losses, which changes the accounting for recognizing impairments of financial assets. Under the new guidance, credit losses for certain types of financial instruments will be estimated based on expected losses. The new guidance also modifies the impairment models for available-for-sale debt securities and for purchased financial assets with credit deterioration since their origination. This update is effective for annual periods beginning after December 15, 2019, and interim periods within those periods, and early adoption is permitted. The Company believes the adoption will modify the way the Company analyzes financial instruments, but it does not anticipate a material impact on results of operations. The Company is in the process of determining the effects the adoption will have on its condensed consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820); Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This guidance removes certain disclosure requirements related to the fair value hierarchy, modifies existing disclosure requirements related to measurement uncertainty and adds new disclosure requirements. The new disclosure requirements include disclosing the changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and the range and weighted-average of significant unobservable inputs used to develop Level 3 fair value measurements. Certain disclosures required by this guidance must be applied on a retrospective basis and others on a prospective basis. The guidance will be effective for fiscal years beginning after December 15, 2019, although early adoption is permitted. The Company is currently evaluating this guidance to determine the impact, if any, it may have on its condensed consolidated financial statements.

3. Fair Value Measurements
Instruments Recorded at Fair Value on a Recurring Basis


11




The Company has segregated all financial assets and liabilities that are measured at fair value on a recurring basis (at least annually) into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date in the table below.
Assets and liabilities measured at fair value on a recurring basis as of September 30, 2019 and December 31, 2018 are as follows (in thousands):
 
 
 
Fair value measurements at reporting date using
 
Balance as of September 30, 2019
 
Quoted prices
in active
markets for
identical assets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Assets:
 

 
 

 
 

 
 

Cash equivalents:
 

 
 

 
 

 
 

Money market funds
$
19,380

 
$
19,380

 
$

 
$

Total assets
$
19,380

 
$
19,380

 
$

 
$

 
 
 
 
Fair value measurements at reporting date using
 
Balance as of December 31, 2018
 
Quoted prices
in active
markets for
identical assets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Assets:
 

 
 

 
 
 
 

Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
21,187

 
$
21,187

 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
U.S. Treasury bonds
2,548

 
2,548

 
$

 
$

Total assets
$
23,735

 
$
23,735

 
$

 
$

The Company’s investments in Level 1 assets are valued based on publicly available quoted market prices for identical securities as of September 30, 2019 and December 31, 2018.

Instruments Not Recorded at Fair Value on a Recurring Basis
The estimated fair value of the Company's short-term loan as of December 31, 2018 is determined by Level 2 inputs and is based primarily on quoted market prices for the same or similar issues. The recorded value of the Company's short-term loan approximates the current fair value as the interest rate and other terms are that which are currently available to the Company. 

4. Net Loss per Share
The following table sets forth the computation of basic and diluted net loss per share of common stock (in thousands, except shares and per share data): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019

2018
 
2019
 
2018
Net loss
$
(3,706
)
 
$
(6,745
)
 
$
(18,763
)
 
$
(28,624
)
Weighted-average common shares outstanding, basic and diluted
6,061,248

 
1,945,864

 
3,700,538

 
1,783,793

Net loss per share, basic and diluted
$
(0.61
)
 
$
(3.47
)
 
$
(5.07
)
 
$
(16.05
)

The following table sets forth the outstanding potentially dilutive securities determined using the treasury stock method that have been excluded in the calculation of diluted net loss per share because to do so would be anti-dilutive (in common stock equivalent shares):


12




 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019

2018
 
2019
 
2018
Stock options to purchase common stock
8

 
25,968

 
5,328

 
42,473

Total
8

 
25,968

 
5,328

 
42,473

 
 
5. Balance Sheet Details

Inventory consist of the following (in thousands):
 
 
September 30, 2019
 
December 31, 2018
Raw materials
$
1,885

 
$
1,090

Work in process
78

 
288

Finished goods
85

 
202

Total
$
2,048

 
$
1,580

 
Other current assets consist of the following (in thousands):
 
 
September 30, 2019
 
December 31, 2018
Prepaid expenses
$
656

 
$
2,329

Interest receivable

 
12

Other assets
27

 
121

Total
683

 
$
2,462


Property and equipment, net consist of the following (in thousands):
 
 
September 30, 2019
 
December 31, 2018
Computer hardware
$
259

 
$
410

Computer software
291

 
274

Leasehold improvements
422

 
405

Furniture and fixtures
179

 
178

Scientific equipment
1,993

 
1,921

Construction in progress, or CIP
180

 
530

 
3,324

 
3,718

Less: accumulated depreciation
(2,207
)
 
(1,979
)
Total
$
1,117

 
$
1,739

 
Depreciation expense was $0.1 million for each of the three months ended September 30, 2019 and 2018, respectively, and $0.4 million for both the nine months ended September 30, 2019 and 2018.
Other current liabilities consist of the following (in thousands):
 


13




 
September 30, 2019
 
December 31, 2018
Accrued legal and professional fees
$
637

 
$
624

Accrued customer incentives
178

 
467

Accrued sales and other taxes
118

 
132

Other accrued expenses
676

 
762

Total
$
1,609

 
$
1,985



6. Term Loan

In June 2013, the Company entered into a $3.0 million loan and security agreement (the "Loan Agreement") with Pacific Western Bank (successor-in-interest to Square 1 Bank), which it subsequently amended in October 2014, September 2016, December 2016, June 2017 and July 2018.

In July 2018, the Company executed the Fifth Amendment to the Loan and Security Agreement (the "Loan Amendment") with Pacific Western Bank, which increased the loan capacity to $20 million from $10 million. The loan capacity of $20 million consists of two tranches as follows: a first tranche consisting of $10.0 million funded on July 10, 2018, of which the full $10.0 million was required to settle the existing debt with Pacific Western Bank on a net settlement basis (pursuant to its original terms); and a second tranche consisting of an additional $10.0 million which may be drawn at any time prior to July 9, 2019. During the first quarter of 2019, the Company drew down on the remaining $10.0 million tranche. During the second quarter of 2019, the Company paid down $15.0 million of the principal balance due under the Loan Agreement. During the third quarter of 2019, the Company paid down the remaining $5.0 million of principal balance due under the term loan, thereby removing the risks and restrictions of carrying long-term debt. As of September 30, 2019, the Company had no outstanding borrowings under the Loan Agreement.

The debt that was repaid in the third quarter of 2019 had a variable annual interest rate equal to the greater of the prime rate plus 1.5% per annum, or 5%, and would have matured in July 2022. While the debt was outstanding in 2019, the prime rate was 5.5%, resulting in an interest rate on the debt of 7.0% at the time that the Company paid down the remaining debt. The Loan Amendment provided for an interest-only period through July 9, 2019 followed by 36 equal monthly installments of principal and interest with the first principal payment due on August 9, 2019. Under the terms of the Loan Agreement, the Company could prepay the debt in full at any time with no additional cost, which occurred in August 2019.
Upon repayment of the outstanding debt in full, the Loan Agreement was terminated and the Company is no longer subject to the covenants and restrictions set forth in the Loan Agreement.
 
The loan fee paid and the remaining balance of debt issuance costs and debt discount on the previous loan agreement held with Pacific Western Bank were amortized to interest expense during the third quarter of 2019. As of September 30, 2019, there were no unamortized debt issuance costs due to the $15.0 million and $5.0 million payments on the Company's term loan in the second and third quarters of 2019, respectively.

7. Stock-Based Compensation

Equity Incentive Plan
As of September 30, 2019, 78,771 stock options and awards remained available for future grant under the 2016 Equity Incentive Plan. No other plans had options or awards available for grant.
 
The Company recorded total non-cash compensation, including non-cash compensation to employees and nonemployees in the condensed consolidated statements of operations and comprehensive loss as follows (in thousands):
 


14




 
Three Months Ended September 30,
 
Nine Months Ended
September 30,
 
2019
 
2018
 
2019
 
2018
Cost of revenue
$
5

 
$
28

 
$
(21
)
 
$
68

Research and development
158

 
307

 
568

 
859

Selling, general and administrative
496

 
672

 
1,753

 
2,683

Total
$
659

 
$
1,007

 
$
2,300

 
$
3,610

 
Unrecognized stock-based compensation expense at September 30, 2019 was approximately $2.2 million, which is expected to be recognized over a weighted-average term of 2.25 years.

Incentive Stock Options
The following table summarizes stock option transactions for the 2016 Equity Incentive Plan for the nine months ended September 30, 2019 (in thousands, except shares and per share data):
 
 
Number of
shares
 
Weighted-
average
exercise
price per share
 
Weighted-
average
remaining
contractual
life (in
years)
 
Aggregate
intrinsic
value (in
thousands)
Outstanding at December 31, 2018
336,008

 
$
58.29

 
 
 
 

Options granted
159,765

 
17.16

 
 
 
 

Options exercised
(118
)
 
8.72

 
 
 
 

Options canceled
(50,621
)
 
45.45

 
 
 
 

Outstanding at September 30, 2019
445,034

 
$
45.00

 
6.55
 
$

Vested and expected to vest at September 30, 2019
409,978

 
$
46.33

 
6.52
 
$

Vested and exercisable at September 30, 2019
254,911

 
$
52.52

 
6.29
 
$

 
Restricted Stock Awards
The following table summarizes restricted stock award transactions for the 2016 Equity Incentive Plan for the nine months ended September 30, 2019:
 
Number of
awards
 
Weighted-
average
grant date fair value
Outstanding at December 31, 2018
61,198

 
$
58.85

Awards granted

 

Awards released
(4,750
)
 
71.50

Awards canceled
(26,924
)
 
77.70

Outstanding at September 30, 2019
29,524

 
$
39.64


Restricted Stock Units
The following table summarizes restricted stock unit transactions for the 2016 Equity Incentive Plan for the nine months ended September 30, 2019:


15




 
Number of
shares
 
Weighted-average grant date fair value
 
Aggregate
intrinsic
value (in
thousands)
Outstanding at December 31, 2018

 
$

 
 

Awards granted
55,574

 
11.70

 
 

Awards released

 

 
 

Awards canceled

 

 
 

Outstanding at September 30, 2019
55,574

 
$
11.70

 
$
108

Vested and expected to vest at September 30, 2019
49,114

 
$
11.87

 
$
95



8. Stockholder's Equity

Public Offering and related warrants

On August 1, 2019, the Company entered into an underwriting agreement with A/G.P./Alliance Global Partners, as underwriter, in connection with a public offering of the Company's securities, pursuant to which the Company issued and sold (i) 2,427,500 shares of common stock (including 412,500 shares of common stock pursuant to the partial exercise of the underwriters’ over-allotment option to purchase 562,500 additional shares), (ii) pre-funded warrants to purchase up to 1,735,000 shares of common stock (“Pre-funded Warrants”), (iii) accompanying warrants to purchase up to 3,234,375 shares of common stock (including the exercise in full of the underwriters’ over-allotment option to purchase additional warrants to purchase 421,875 shares of common stock) (“Purchase Warrants”) and (iv) an additional warrant to the underwriters for the purchase 37,500 shares of common stock (“Representative Warrant”). The offering was made pursuant to a registration statement on Form S-1. The offering closed on August 6, 2019 resulting in net proceeds of approximately $14.7 million after deducting underwriting discounts and commissions and offering expenses payable by the Company. The shares of common stock and accompanying Purchase Warrants were sold at a public offering price of $4.00 per share, the Pre-funded Warrants and accompanying Purchase Warrants were sold at a public offering of $3.999. The Purchase Warrants were immediately exercisable upon issuance, will expire on August 6, 2024 and have an exercise price of $4.40 and the Representative Warrant has an exercise price of $5.00, in each case subject to adjustment in the event of stock dividends, stock splits, stock combinations, reclassifications, reorganizations or similar events. The Representative Warrant is exercisable in February 2020 and expires on August 6, 2024. All of the Pre-funded warrants were exercised during the third quarter of 2019. None of the Purchase or Representative Warrants have been exercised as of September 30, 2019. All of the warrants are recorded within equity in accordance with authoritative accounting guidance.

Securities Purchase Agreement

On May 23, 2019, the Company entered into a Securities Purchase Agreement with certain investors for the sale by the Company of 500,000 shares of the Company's common stock, par value $0.001 per share, at a purchase price of $6.00 per share. The closing of the sale of the shares under the Securities Purchase Agreement occurred on May 28, 2019. The Company incurred $0.4 million of legal, accounting and other professional fees related to the Securities Purchase Agreement. The aggregate gross proceeds for the sale of the shares was $3.0 million.

Equity Distribution Agreement

On December 27, 2018, the Company entered into the Equity Distribution Agreement (the "Equity Distribution Agreement") with Canaccord Genuity LLC ("Canaccord"), pursuant to which the Company may, from time to time, sell shares of its common stock, having an aggregate offering price of up to $10.0 million through Canaccord, as the Company's sales agent.



16




The Company pays Canaccord a commission of 3.0% of the gross proceeds from the sales of common stock sold pursuant to the terms of the Equity Distribution Agreement. The Equity Distribution Agreement also contains, among other things, customary representations, warranties and covenants by the Company and indemnification obligations of the Company and Canaccord as well as certain termination rights for both the Company and Canaccord. The Company has no obligation to sell any at-the-market ("ATM") shares under the Equity Distribution Agreement, and may at any time suspend solicitation and offers under the Equity Distribution Agreement. Until the aggregate market value of the Company's common stock held by non-affiliates, or public float, is greater than $75.0 million, the amount the Company can raise through primary public offerings of securities in any twelve-month period using shelf registration statements, including sales under the Company's ATM program, is limited to an aggregate of one-third of its public float.

The Company incurred $0.2 million of legal, accounting and other professional fees related to the Equity Distribution Agreement. These amounts are included as deferred charges within other current assets on the Company's condensed consolidated balance sheet as of September 30, 2019 and all were charged against paid-in capital upon receipt of proceeds from the sale of common stock under the Equity Distribution Agreement. As of September 30, 2019, the Company has sold 377,615 shares under the Equity Distribution Agreement for aggregate gross proceeds of $2.8 million.

Lincoln Park Purchase Agreement

On December 27, 2018, the Company entered into a purchase agreement (the "Lincoln Park Purchase Agreement") with the Lincoln Park Capital Fund, LLC ("Lincoln Park") and a registration rights agreement, or the Registration Rights Agreement, with Lincoln Park, pursuant to which the Company has the right, but not the obligation, to sell to Lincoln Park, and Lincoln Park is obligated to purchase up to $20.0 million of the Company's common stock, over the 36-month period that commenced in February 2019.

Under the Lincoln Park Purchase Agreement, and excluding the impact of any adjustments resulting form the Company's reverse stock split, on any business day selected by the Company on which the closing price of its common stock is not less than $0.50 per share (subject to standard anti-dilution adjustments), the Company may direct Lincoln Park to purchase up to 50,000 shares of common stock on such business day (each, a “Regular Purchase”), provided, however, that (i) the Regular Purchase may be increased to up to 100,000 shares, provided that the closing sale price of the common stock is not below $2.00 on the purchase date (subject to standard anti-dilution adjustments) (ii) the Regular Purchase may be increased to up to 125,000 shares, provided that the closing sale price of the common stock is not below $3.00 on the purchase date (subject to standard anti-dilution adjustments) and (iii) the Regular Purchase may be increased to up to 150,000 shares, provided that the closing sale price of the common stock is not below $4.00 on the purchase date (subject to standard anti-dilution adjustments). In each case, Lincoln Park’s maximum commitment in any single Regular Purchase may not exceed $1,000,000. The purchase price per share for each such Regular Purchase will be based off of prevailing market prices of the Company's common stock immediately preceding the time of sale without any fixed discount. In addition to Regular Purchases, the Company may also direct Lincoln Park to purchase other amounts as accelerated purchases or as additional accelerated purchases if the closing sale price of the common stock exceeds certain threshold prices as set forth in the Lincoln Park Purchase Agreement.

Depending on the prevailing market price of our common stock, the Company may not be able to sell shares to Lincoln Park for the maximum $20.0 million over the term of the Lincoln Park Purchase Agreement. For example, under the rules of the Nasdaq Capital Market, in no event may the Company issue more than 19.99% of its shares outstanding (which is approximately 465,470 shares based on 2,328,512 shares outstanding prior to the signing of the Lincoln Park Purchase Agreement) under the Lincoln Park Purchase Agreement unless the Company obtains stockholder approval or an exception pursuant to the rules of the Nasdaq Capital Market is obtained to issue more than 19.99%. This limitation will not apply if, at any time the exchange cap is reached and at all times thereafter, the average price paid for all shares issued and sold under the Lincoln Park Purchase Agreement is equal to or greater than the specified minimum amount set forth in the Lincoln Park Purchase Agreement. The Company is not required or permitted to issue any shares of common stock under the Purchase Agreement if such issuance would breach the its obligations under the rules or regulations of the Nasdaq Capital Market. In addition, Lincoln Park will not be required to purchase any shares of the Company's common stock if such sale would result in Lincoln Park’s beneficial ownership exceeding 9.99% of the then outstanding shares of the Company's common stock. The Company's inability to access a portion or the full amount available under the Lincoln Park Purchase Agreement, in the absence of any other financing sources, could have a material adverse effect on its business.

The Company incurred $0.8 million of commitment shares issued, legal, accounting, registration and other professional fees related to the Lincoln Park Purchase Agreement. These amounts are included as deferred charges within other current assets on the Company's balance sheet as of September 30, 2019 and all were charged against paid-in capital upon receipt of proceeds from the sale of common stock under the Lincoln Park Purchase Agreement. As of September 30, 2019, the Company has sold


17




356,122 shares under the Lincoln Park Purchase Agreement for aggregate gross proceeds of $4.2 million. No future issuances are anticipated under this agreement.

Common Stock Reserved for Future Issuance
Common stock reserved for future issuance consists of the following as of September 30, 2019:
Stock options issued and outstanding
445,034

Restricted stock units issued and outstanding
55,574

Warrants for the purchase of common stock
3,271,875

Authorized for future option and ongoing vesting of award grants
78,771

Authorized for future issuance under ESPP
74,520

Total
3,925,774

 

9. Income Taxes
For the three and nine months September 30, 2019 and 2018, the Company did not record an income tax provision. The U.S. federal and California deferred tax assets generated from the Company’s net operating losses have been fully reserved, as the Company believes it is more likely than not the benefit will not be realized. 
 

10. Commitments and Contingencies
Operating Leases
The Company leases its facilities and retail treatment center under noncancelable operating leases which expire on various dates between 2021 and 2022. In July 2019, the Company entered into an office lease agreement to launch an Obalon-branded retail treatment center in San Diego, California, which expires on August 5, 2021. Under the terms of the facilities and retail center leases, the Company is required to pay its proportionate share of property taxes, insurance and normal maintenance costs. Upon the Company’s adoption of ASC 842 as of January 1, 2019, the Company recognized a ROU asset and lease liability for its building lease, assuming a 7.0% discount rate. Any short-term leases defined as 12 months or less or month-to-month leases were excluded and continue to be expensed each month. Total costs associated with short-term leases for the three and nine months ended September 30, 2019 were immaterial.

The Company determines if an arrangement is a lease at inception. The exercise of lease renewal options is at the Company’s sole discretion and were not included in the calculation of the Company’s lease liability as the Company is not able to determine without uncertainty if the renewal option will be exercised. The depreciable life of assets and leasehold improvements are limited to the expected term, unless there is a transfer of title or purchase option reasonably certain of exercise. The Company’s lease agreements do not contain any variable lease payments, residual value guarantees or any restrictive covenants.

The Company’s ROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date of the lease or the ASC 842 adoption date, whichever is later, based on the present value of lease payments over the lease term. When readily determinable, the Company uses the implicit rate in determining the present value of lease payments, or 7.0%, as of the adoption date. When leases do not provide an implicit rate, the Company uses its incremental borrowing rate based on the information available at the lease commencement date or adoption date, including the lease term. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Lease expense for lease payments is recognized on a straight-line basis over the lease term.



18




Future minimum annual lease payments under such leases are as follows as of September 30, 2019 (in thousands):
 
Undiscounted lease payments:
 
Remainder of 2019
$
137

2020
569

2021
533

2022
117

Total undiscounted lease payments
1,356

Less: imputed interest
(112
)
Lease liability
1,244

Less: current portion of lease liability
(557
)
Lease liability, less current portion
$
687


As of September 30, 2019, the Company’s remaining lease terms range from 1.9 to 2.5 years. Rent expense totaled $0.2 million and $0.1 million for the three months ended September 30, 2019 and 2018, respectively, and $0.4 million and $0.2 million for the nine months ended September 30, 2019 and 2018, respectively. The Company paid $0.1 million and $0.2 million of cash payments related to its operating lease agreement for the three and nine months ended September 30, 2019, respectively.

The Company enters into contracts in the normal course of business with clinical trial sites and clinical supply manufacturing organizations and with vendors for preclinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts.

Pursuant to the Company's supplier agreement entered into in December 2018, the Company is obligated to purchase certain minimum quantities. These costs scale up as the Company's projected manufacturing volume increases. Under the terms of the agreement, the Company can reduce the forecasted minimum quantities and is required to incur a holding fee for items manufactured by the supplier. This represents the one year minimum commitment of approximately $1.5 million as of September 30, 2019.

Termination of Stock Offering
On January 23, 2018, the Company issued a press release announcing the termination of its previously announced offering of common stock due to a purported whistleblower compliant, which was later found to be without merit. As of September 30, 2019, the Company did not record any liability associated with termination of the offering, and management believed that the likelihood is remote that the Company will incur material fees in the future.

Shareholder Lawsuit
On February 14 and 22, 2018, plaintiff stockholders filed class action lawsuits against the Company and certain of its executive officers in the United States District Court for the Southern District of California (Hustig v. Obalon Therapeutics, Inc., et al., Case No. 3:18-cv-00352-AJB-WVG, and Cook v. Obalon Therapeutics, Inc. et al., Case No. 3:18-cv-00407-CAB-RBB). On July 24, 2018, the court appointed Inter-Local Pension Fund GCC/IBT as lead plaintiff. On October 5, 2018, plaintiffs filed an amended complaint. The amended complaint alleges that the Company and certain of its executive officers made false and misleading statements and failed to disclose material adverse facts about its business, operations, and prospects in violation of Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Exchange Act. The amended complaint also alleges violations of Section 11 of the Exchange Act arising out of the Company’s initial public offering. The plaintiffs seek damages, interest, costs, attorneys' fees, and other unspecified equitable relief. The underwriters from our initial public offering have also been named as defendants in this case and we have certain obligations under the underwriting agreement to indemnify them for their costs and expenses incurred in connection with this litigation.

On September 25, 2019, the court granted in part and denied in part the defendants’ motion to dismiss. The court dismissed the Section 11 claims entirely, without leave to amend, and accordingly dismissed the underwriters and certain directors from the case. The Court also dismissed certain statements from the Section 10 claims. The Company believes the remaining claims in the complaint are without merit and intends to defend vigorously against them.

11. Variable Interest Entity


19




In conjunction with the Company’s strategic focus to open weight loss treatment centers to provide medical services to patients who wish to lose weight through the Obalon balloon system, the Company entered into a consulting agreement with a lead doctor to open the first treatment center and oversee the treatment center’s activities. The treatment center was opened in September 2019 as a professional corporation (“PC”) in the State of California and, as a result of state regulatory requirements, may not be owned by a corporation. The Company will fully fund all the activities of the treatment center and no financial contribution will be made by the lead doctor. In addition, the Company is authorized and expected to provide daily oversight of the activities of the center, with the exception of directly providing medical services.
As the PC’s equity investment at risk is not sufficient to permit the entity to finance its activities without subordinated financial support, the PC is considered a variable interest entity. Although the Company does not own any equity interest in the PC, the Company holds the controlling financial interest as the sold funding source for the entity and through the ability to provide daily oversight. Therefore, the Company was determined to be the primary beneficiary of the PC and consolidated the PC’s balances and activity within its condensed consolidated financial statements.

For the three months ended September 30, 2019, the PC recognized an immaterial amount of deferred revenue associated with prepaid services at the treatment center, which is fully presented in the condensed consolidated balance sheet of the Company at September 30, 2019.


12. Restructuring Charges
2019 Restructuring Activities
In the second quarter of 2019, the Company recorded restructuring charges of $1.1 million, which are comprised of the following components (in thousands):
 
Nine Months Ended September 30,
 
2019
Employee separation costs
$
1,008

Asset disposals
91

Total
$
1,099

In April 2019, the Company notified approximately 49 employees whose employment will be terminated, or approximately 50% of its workforce, with the intent to refocus activities, streamline operations and make more efficient use of cash. As a result of the workforce reduction, the Company recorded a restructuring charge in April 2019 for termination benefits of $0.5 million which has been paid as of September 30, 2019. Additionally, as a result of the workforce reduction, the Company recognized a reversal of stock-based compensation expense of $0.8 million in April of 2019 and a $0.1 million restructuring charge in connection with the disposal of assets related to the terminated employees.
In May and June 2019, the Company accepted the voluntary resignations of its President and Chief Executive Officer and its Vice President of Research and Development. As part of the resignations, each former officer entered into a consulting agreement for a term of 12 months, which allows for the continuous vesting of stock awards held over the consulting term and a monthly, fixed consulting fee. No severance amounts were granted. The Company recorded a restructuring charge in June 2019 for the full consulting benefits of $0.6 million and an immaterial amount of this charge has been paid as of September 30, 2019. Additionally, the Company recognized the full stock-based compensation expense of $0.7 million.
No further restructuring charges were recorded in the third quarter of 2019. For the nine months ended September 30, 2019, the following restructuring charges were included in the condensed consolidated statements of operations and comprehensive loss as follows (in thousands):


20




 
Nine Months Ended September 30,
 
2019
Cost of revenue
$
53

Research and development
370

Selling, general and administrative
676

Total
$
1,099


Activity and restructuring charge reserve balance as of September 30, 2019 were as follows:
 
Employee separation costs
Reserve balance at December 31, 2018
$

2019:
 
Restructuring charges
1,105

Cash payments
(537
)
Reserve balance at June 30, 2019
$
568

Cash payments
(144
)
Reserve balance at September 30, 2019
$
424



13. Subsequent Event
On October 19, 2019, the Company’s Board of Directors approved the promotion of William Plovanic to Chief Executive Officer from his prior role of Chief Financial Officer.  Mr. Plovanic will retain the title of President and continue to serve as a Class II director on the Board. In addition, the Company promoted Nooshin Hussainy to Chief Financial Officer from her prior role of Vice President Finance and Controller.  Concurrent with these promotions, the Company's Board of Directors approved stock option awards covering 74,682 shares of common stock to certain of the Company's executive officers and employees.





21




ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements. All statements other than statements of historical fact are “forward-looking statements” for purposes of this Quarterly Report on Form 10-Q. These forward-looking statements may include, but are not limited to, statements regarding our future results of operations and financial position, business strategy, market size, potential growth opportunities, timing and results of preclinical and clinical development activities, selection of specific financial and strategic alternatives, and potential regulatory approval and commercialization of products and product candidates. In some cases, forward looking-statements may be identified by terminology such as “believe,” “may,” “will,” “should,” “predict,” “goal,” “strategy,” “potentially,” “estimate,” “continue,” “anticipate,” “intend,” “could,” “would,” “project,” “plan,” “expect,” “seek” and similar expressions and variations thereof. These words are intended to identify forward-looking statements.
We have based these forward-looking statements largely on our current expectations and projections about future events and trends that we believe may affect our financial condition, results of operations, business strategy, research and development, short-term and long-term business operations and objectives and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in the “Risk Factors” section and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment, and new risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.
You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this report to conform these statements to actual results or to changes in our expectations, except as required by law.
As used in this Quarterly Report on Form 10-Q, the terms “Obalon,” “the Company,” “we,” “us,” and “our” refer to Obalon Therapeutics, Inc. and, where appropriate, its consolidated subsidiary, unless the context indicates otherwise.
You should read the following discussion and analysis of our financial condition and results of operations together with our unaudited condensed consolidated financial statements and related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and related notes thereto for the year ended December 31, 2018, included in our Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 22, 2019.
OVERVIEW
We are a vertically integrated medical device company focused on developing and commercializing innovative medical devices to treat people with obesity. Our initial product offering is the Obalon Balloon System, the first and only U.S. Food and Drug Administration, or FDA, approved swallowable, gas-filled intragastric balloon designed to provide progressive and sustained weight loss in patients with obesity. We believe the Obalon Balloon System offers patients and physicians benefits over prior weight loss devices including, but not limited to: a favorable safety profile, improved patient tolerability and comfort, progressive weight loss with durable results, simple and convenient placement, and potentially attractive economics for patients and physicians.
The Obalon Balloon System is FDA approved for temporary use to facilitate weight loss in adults with obesity having a body mass index, or BMI, of 30 to 40, or approximately 30 to 100 pounds overweight, who have failed to lose weight through diet and exercise alone. The system is intended to be used as an adjunct to a moderate intensity diet and behavior modification program. All balloons must be removed in six months after the first balloon is placed. We believe the Obalon Balloon System may provide patients and physicians with a cost-effective, reversible and repeatable weight loss solution that can be delivered in an outpatient setting, without altering patient anatomy or requiring surgery.
The current generation of our Obalon Balloon System consists of a swallowable capsule that contains an inflatable balloon attached to a microcatheter; the Navigation System console, which is a combination of hardware and software used to track and display the location of the balloon during placement; the Obalon Touch Inflation Dispenser, which is a semi-automated, hand-held inflation device used to inflate the balloon once it is placed; and a disposable canister filled with our proprietary mixture of gas. Placement of a balloon typically occurs in less than 10 minutes and can be accomplished in an outpatient setting. Patients


22




receive a total of three balloons over the course of eight to 12 weeks and all balloons are removed six months after the first balloon is placed.
The Obalon Balloon System has demonstrated progressive weight loss with durable results. In our SMART trial, patients in the Obalon treatment group lost, on average, approximately twice as much body weight as patients in the sham-control group. In addition, patients in the Obalon treatment group showed, on average, progressive weight loss over the entire six-month balloon treatment period, and maintained, on average, 89.5% of the weight loss six months after balloon removal. In December 2018, we analyzed data from our commercial registry on more than 1,300 patients at 108 treatment sites. For those patients who received three balloons and at least 20 weeks of therapy, the average weight loss was 21.7 pounds, resulting in 9.9% reduction in total body weight and a 3.5 point decrease in BMI compared to baseline values. Of note, the top quartile of those patients lost an average of 39 pounds, resulting in a 16.8% reduction in total body weight and a 6.2 point decrease in BMI compared to baseline values. Furthermore, in May 2019, additional data was presented, which included additional data analysis from our commercial registry of 1,411 total patients from 143 treatment sites in the United States. In this larger data set, for those patients receiving three balloons and at least 20 weeks of therapy, the average weight loss was 21.7 pounds, resulting in a 10.2% reduction in total body weight. Of note, 50.7% of patients lost 10% or more total body weight and 77.9% lost 5% or more total body weight. Weight loss in the first months of therapy was the largest predictor of success.
We commenced U.S. commercialization of our prior generation Obalon balloon system in January 2017. In February 2019, we commercialized our Obalon Touch Inflation Dispenser and our Obalon Navigation System, which together are designed to make balloon placement more reliable, safer, easier and less expensive. The Obalon Navigation System is designed to eliminate the need to use x-ray technology when placing the Obalon balloon.
Historically we have sold our products directly to physicians, who would then sell weight loss treatment packages to their patients that included our balloon therapy, dietary counseling and balloon removal on a non-reimbursed, self-pay basis. Beginning in April 2019, we began to fundamentally change our commercialization efforts, and eliminated our direct sales force in connection with an overall workforce reduction in April 2019. Concurrent with our workforce reduction, we transitioned to a centralized customer support model through which we sell to existing physicians that are using our balloons or new physicians that contact us directly to acquire our system and balloons, and provide marketing and clinical support to those physicians. Marketing support may include media assets and media purchasing support and leads generated from our Find-A-Doc locator. In addition, rather than focusing on selling directly to physicians, we intend to establish company-owned or managed Obalon-branded retail treatment centers, the first of which began operations in late September 2019. Under this new model, we plan to either directly employ physicians or manage the practices where the treatments are prescribed by physicians, and we will be directly responsible for practice marketing and promotion efforts. We expect to provide the physician office support staff, equipment and services necessary for patients to receive the Obalon balloon therapy from licensed physicians. We began operating of our first Obalon-branded retail treatment center in September 2019. We are in the early stages of this transition and cannot predict whether it will be an effective means of selling the Obalon Balloon System. We believe this model will contribute to standardization of both quality of care and patient pricing and provide us greater operational and financial control of our business.
We intend to continue to drive patient awareness and interest in part through multiple efforts that may vary over time and may include digital, offline and social marketing. We estimate that there were more than 49 million views of our digital advertisements and more than 6 million views of our digital videos in 2018. We also estimate that visits to our website were 1.7 million in 2018 and searches of our website for physicians capable of placing our Obalon Balloon System were over 580,000 in 2018. We also generated over 71,000 patient leads to our physician partners in the United States during 2018. During the nine months ended September 30, 2019, we estimate there were approximately 9.3 million views of our digital advertisements, more than 3.3 million views of our digital videos, over 285,000 visits to our website, over 38,000 searches of our website for physicians capable of placing our Obalon Balloon System and generated approximately 21,000 patient leads to our physician partners in the United States. There was a significant reduction in spending for digital, offline and social marketing in the second quarter of 2019 due to the change in commercialization efforts. In the third quarter of 2019 we initiated digital marketing programs in support of the Obalon-branded retail treatment center, whixh we refer to as the Obalon Center for Weight Loss.
We generated total revenue of $0.3 million and $3.0 million for the three months ended September 30, 2019 and 2018, respectively, and $2.5 million and $7.1 million for the nine months ended September 30, 2019 and 2018, respectively. We have incurred significant losses in each period since our inception in 2008, with net losses of $3.7 million and $6.7 million during the three months ended September 30, 2019 and 2018, respectively, and $18.8 million and $28.6 million during the nine months ended September 30, 2019 and 2018, respectively. We have not been profitable since inception, and as of September 30, 2019, our accumulated deficit was $167.5 million. From inception through September 30, 2019, we have


23




financed our operations primarily through private placements of our preferred stock, the sale of common stock in our IPO and in subsequent public and private placements, and, to a lesser extent, debt financing arrangements.
In August 2019, we issued and sold an aggregate of (i) 2,427,500 shares of our common stock (including 412,500 shares of common stock pursuant to the partial exercise of the underwriters’ over-allotment option to purchase 562,500 additional shares), (ii) pre-funded warrants to purchase up to 1,735,000 shares of common stock ("Pre-funded Warrants"), (iii) accompanying warrants to purchase up to 3,234,375 shares of common stock (including the exercise in full of the underwriters’ over-allotment option to purchase additional warrants to purchase 421,875 shares of common stock) ("Purchase Warrants") and (iv) an additional warrant to the underwriters for the purchase 37,500 shares of common stock ("Representative Warrant") resulting in net proceeds from the offering of approximately $14.7 million after deducting underwriting discounts and commissions and offering expenses payable by the Company. The offering was made pursuant to a registration statement on Form S-1. As of September 30, 2019, we had cash and cash equivalents of $19.4 million. During the second quarter of 2019, we paid down $15.0 million of the principal balance due under the loan and security agreement with Pacific Western Bank (as successor-in-interest to Square 1 Bank) and during the third quarter of 2019, the Company paid down the remaining $5.0 million of principal balance due under the loan and security agreement with Pacific Western Bank, thereby removing the risks and restrictions of carrying long-term debt.
In an effort to address our liquidity concerns, on April 2, 2019, we commenced an internal restructuring and notified approximately 49 employees, or approximately 50% of our workforce, that their employment would be terminated. This restructuring included the elimination of our field sales force and a transition to more centralized customer support and marketing program strategy. Going forward, rather than focusing on selling to physicians, we intend to focus our commercialization efforts on the establishment and operation of company-owned or managed Obalon-branded retail treatment centers.
Our consolidated financial statements as of and for the nine months ended September 30, 2019 have been prepared on the basis that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. Based on our cash balances and recurring losses since inception, there is substantial doubt about our ability to continue as a going concern and if we are not able to continue to raise sufficient capital, we will not be able to support ongoing operations.


24




COMPONENTS OF OUR RESULTS OF OPERATIONS
Revenue
For the three and nine months ended September 30, 2019 and 2018, revenue reflects sales of our Obalon Balloon System directly to physicians and institutions in the United States. For the nine months ended September 30, 2019, and the three and nine months ended September 30, 2018, revenue also reflects sales of our Obalon Balloon System to our Middle East distributor.
Prior to December 31, 2016, all of our sales were outside the United States. In January 2017, we shifted our focus to commercialization efforts in the United States and recognized our initial U.S. revenue. We will continue to focus on selling our Obalon Balloon System in the United States, which we anticipate to be our primary market. However, in the fourth quarter of 2019, we anticipate revenue from the discreet sale of product to an international distributor. In April 2019, we restructured operations and eliminated the field sales force, and transitioned to a centralized customer support model to support our physician customers. However, to date we have experienced limited penetration of the U.S. market, and the degree to which our revenue will increase depends on many factors, including our ability to develop the Company-owned or managed retail treatment center model, our ability to develop the intragastric balloon market (which is currently small and immature), acceptance of our current Obalon Balloon System and its future iterations by doctors and patients, our ability to scale production in a cost effective manner, the emergence of competing products, actions by regulatory bodies and general economic trends. The amount of revenue and timing of revenue recognition may also be impacted by the customer incentive programs we decide to offer and the channels through which the revenue is derived.
In January 2017, we began offering a swallow guarantee program to our physician customers in the United States through which we may provide replacement balloons to physicians and institutions when patients are unsuccessful in swallowing an Obalon balloon, subject to certain requirements and restrictions. We defer revenue relating to this swallow guarantee program based on expected failure rate and then recognize the revenue when replacement balloons are provided. As a result of this program our financial results or gross profit may be adversely impacted.
Cost of revenue and gross margin
Cost of revenue consists primarily of costs related to the direct materials and direct labor that are used to manufacture our products and the overhead costs that directly support manufacturing. Currently, a significant portion of our cost of revenue consists of manufacturing overhead, which is mostly fixed in nature. These overhead costs include the costs of compensation for operations management, engineering support, material procurement and inventory control personnel, outside consultants, production related supplies, allocated quality assurance and facilities costs, and depreciation on production equipment. We expect cost of revenue to increase at a higher rate with U.S. commercialization of the Obalon Navigation System due to higher costs associated with capital equipment, including the Obalon Navigation System Console and Obalon Touch Inflation Dispenser, and inefficiencies associated with manufacturing scale up for our new Obalon Navigation balloon and related components. Longer term, we expect cost of revenue to increase in absolute dollars to the extent our revenue grows but decrease as a percentage of revenue over time as the fixed portion of our overhead costs is allocated over a greater number of units produced.
We calculate gross margin as gross profit divided by revenue. Our gross margin has been and will continue to be affected by a variety of factors, primarily production volumes, geographic mix, product mix, manufacturing costs, product yields, headcount and cost-reduction strategies. We expect our gross margin to increase over the long term as our production volume increases, and as we allocate the fixed portion of our manufacturing overhead costs over a larger number of units produced, thereby reducing our per unit manufacturing costs. We intend to use our design, engineering and manufacturing capabilities to further advance and improve the efficiency of our manufacturing processes, which we believe will reduce costs per unit and increase our gross margin. While we expect gross margin to increase over the long term, it will likely fluctuate from quarter to quarter as we adopt new manufacturing processes and technologies, continue to introduce new products, expand manufacturing capacity when required, discontinue obsolete products and enter international markets. We have experienced challenges in our ability to produce finished goods and we may not be able to meet commercial demand. While we have taken steps to address these challenges, we cannot assure you those steps will be sufficient or that additional challenges will not arise as we continue with the commercialization of our Obalon Balloon System including the Obalon Navigation System and Obalon Navigation balloon.
Research and development expenses
Research and development, or R&D, expenses consist of the cost of engineering, clinical affairs, regulatory affairs and quality assurance associated with developing our Obalon Balloon System. R&D expenses consist primarily of:
employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense;


25




cost of outside consultants who assist with technology development, regulatory affairs, clinical affairs and quality assurance;
cost of clinical trial activities performed by third-party medical partners; and
cost of facilities, depreciation on R&D equipment and supplies used for internal research and development and clinical activities.
We expense R&D costs as incurred. We expect R&D expenses as a percentage of total revenue to vary over time depending on the level of revenue, the timing of our new product development efforts, as well as our clinical development, clinical trial, FDA required post approval studies and other related activities.
Selling, general and administrative expenses
Selling, general and administrative, or SG&A, expenses consist of employee-related expenses, including salaries, commissions, benefits, travel expense and stock-based compensation expense. Other SG&A expenses include promotional and advertising activities, marketing, conferences and trade shows, professional services fees, including legal fees, accounting fees, insurance costs, general corporate expenses, and allocated facilities-related expenses. SG&A expenses decreased in the third quarter of 2019 due to overall headcount reductions and elimination of significant one-time charges executed in the second quarter of 2019, but could increase in absolute dollars in subsequent quarters. SG&A expenses are expected to vary as a percentage of total revenue for the foreseeable future.
RESULTS OF OPERATIONS
 
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2019
 
2018
 
2019
 
2018
 
 
 
 
 
 
 
 
 
(in thousands)
Condensed consolidated statements of operations data:
 

 
 

 
 
 
 
Revenue
$
333

 
$
2,987

 
$
2,494

 
$
7,065

Cost of revenue
412

 
1,418

 
2,323

 
3,919

Gross (deficit) profit
(79
)
 
1,569

 
171

 
3,146

Operating expenses:
 

 
 

 


 


Research and development
1,174

 
2,368

 
5,401

 
8,359

Selling, general and administrative
2,489

 
5,836

 
13,025

 
23,092

Total operating expenses
3,663

 
8,204

 
18,426

 
31,451

Loss from operations
(3,742
)
 
(6,635
)
 
(18,255
)
 
(28,305
)
Interest income (expense), net
37

 
(70
)
 
(448
)
 
(164
)
Other expense, net
(1
)
 
(40
)
 
(60
)
 
(155
)
Net loss
(3,706
)
 
(6,745
)
 
(18,763
)
 
(28,624
)
Other comprehensive income (loss)

 
(3
)
 

 
3

Net loss and comprehensive loss
$
(3,706
)
 
$
(6,748
)
 
$
(18,763
)
 
$
(28,621
)
Comparison of three months ended September 30, 2019 and 2018
Revenue.    Revenue decreased $2.7 million to $0.3 million during the three months ended September 30, 2019, compared to $3.0 million during the three months ended September 30, 2018. The revenue decrease was primarily due to a decrease of $1.2 million in sales to our Middle East distributor and a decrease of $1.5 million in U.S. sales, due to the decrease in total balloon units sold worldwide. The decrease in U.S. sales was largely attributable to the elimination of our direct field sales force in the second quarter of 2019 and our transition to a centralized customer support model.
Cost of revenue and gross profit.    Cost of revenue decreased $1.0 million to $0.4 million during the three months ended September 30, 2019, compared to $1.4 million during the three months ended September 30, 2018. This was primarily attributable to the decrease in revenue compared to the prior year period. Gross deficit increased $1.6 million to $0.1 million during the three months ended September 30, 2019, compared to a gross profit of $1.5 million during the three months ended September 30, 2018. The increase in gross deficit was primarily attributable to the decrease in revenue compared to the prior year period, coupled with continued fixed operational expenses, such as indirect charges and facilities.


26




Research and development expenses.    R&D expenses decreased $1.2 million to $1.2 million during the three months ended September 30, 2019, compared to $2.4 million during the three months ended September 30, 2018. This decrease was due primarily to decreases in payroll related expenses of $0.8 million, supplies expense of $0.2 million and stock-based compensation expense of $0.2 million resulting from a reduction in headcount associated with internal restructuring activities initiated in the second quarter and completed in the third quarter of 2019.
Selling, general and administrative expenses.    SG&A expenses decreased $3.3 million to $2.5 million during the three months ended September 30, 2019, compared to $5.8 million during the three months ended September 30, 2018. The decrease from the prior period was primarily driven by a decrease of $1.8 million in payroll related expenses, travel expenses and stock-based compensation expense resulting from a reduction in headcount, a decrease of $1.2 million in spending on marketing and advertising programs and a decrease of $0.3 million in sales commissions.
Interest income (expense), net.    Interest income, net changed from $70,000 of interest expense, net during the three months ended September 30, 2018, to $37,000 of interest income, net during the three months ended September 30, 2019. The change was attributable to our repayment of $5.0 million in long term debt under our loan and security agreement with Pacific Western Bank coupled with interest income earned on $14.7 million of net proceeds from equity financing during the three months ended September 30, 2019.
Comparison of nine months ended September 30, 2019 and 2018
Revenue.    Revenue decreased $4.6 million to $2.5 million during the nine months ended September 30, 2019, compared to $7.1 million during the nine months ended September 30, 2018. The revenue decrease was primarily due to a decrease of $2.6 million in sales to our Middle East distributor and a decrease of $2.0 million in U.S. sales, due to a decrease in total balloon units sold worldwide.
Cost of revenue and gross profit.    Cost of revenue decreased $1.6 million to $2.3 million during the nine months ended September 30, 2019, compared to $3.9 million during the nine months ended September 30, 2018. This was primarily attributable to a decrease in revenue compared to the prior year period. Gross profit decreased $3.0 million to $0.2 million during the nine months ended September 30, 2019, compared with the nine months ended September 30, 2018. Gross profit as a percentage of revenue decreased to 7% during the nine months ended September 30, 2019, compared to 44% during the nine months ended September 30, 2018. This was primarily attributable to the decrease in revenue compared to the prior year period, coupled with the inventory write down in connection with the discontinuance of the prior generation Obalon Balloon System and the continued fixed operational expenses, such as indirect charges and facilities.
Research and development expenses.    R&D expenses decreased $3.0 million to $5.4 million during the nine months ended September 30, 2019, compared to $8.4 million during the nine months ended September 30, 2018. This decrease was due primarily to decreases in payroll and travel related expenses of $1.7 million, supplies expense of $0.6 million, clinical trial expense of $0.4 million and stock-based compensation expense of $0.2 million. One-time restructuring charges of approximately $0.4 million reported in the second quarter are included in R&D expenses for the nine months ended September 30, 2019.
Selling, general and administrative expenses.    SG&A expenses decreased $10.1 million to $13.0 million during the nine months ended September 30, 2019, compared to $23.1 million during the nine months ended September 30, 2018. The change from the prior period was primarily driven by a decrease of $5.3 million in payroll related expenses, travel expenses and stock-based compensation expense due to a reduction in headcount, a decrease of $3.9 million in spending on marketing and advertising programs and a decrease of $0.8 million in sales commissions. One-time restructuring charges of approximately $0.7 million reported in the second quarter are included in SG&A expenses for the nine months ended September 30, 2019.
Interest expense, net.    Interest expense, net increased $0.3 million to $0.4 million during the nine months ended September 30, 2019, compared to $0.2 million during the nine months ended September 30, 2018. This increase was attributable to the $10.0 million draw down on the second tranche under our loan and security agreement with Pacific Western Bank for a total outstanding amount of $20.0 million in the first quarter of 2019, coupled with increase in the prime rate during the nine months ended September 30, 2019 compared to the prior year period. During the second and third quarters of 2019, we repaid the outstanding debt balance, thereby reducing overall interest expense. Interest income associated with $14.7 million in equity financing in August 2019 further reduced overall interest expense for the nine months ended September 30, 2019.
LIQUIDITY AND CAPITAL RESOURCES


27




As of September 30, 2019, we had cash and cash equivalents of $19.4 million and an accumulated deficit of $167.5 million. Our primary sources of capital have been private placements of preferred stock, the sale of common stock in our IPO and in subsequent public and private placements, and, to a lesser extent, the incurrence of debt.
In August 2019, we issued and sold an aggregate of (i) 2,427,500 shares of our common stock (including 412,500 shares of common stock pursuant to the partial exercise of the underwriters’ over-allotment option to purchase 562,500 additional shares), (ii) pre-funded warrants to purchase up to 1,735,000 shares of common stock ("Pre-funded Warrants"), (iii) accompanying warrants to purchase up to 3,234,375 shares of common stock (including the exercise in full of the underwriters’ over-allotment option to purchase additional warrants to purchase 421,875 shares of common stock) ("Purchase Warrants") and (iv) an additional warrant to the underwriters for the purchase 37,500 shares of common stock ("Representative Warrant") resulting in net proceeds from the offering of approximately $14.7 million after deducting underwriting discounts and commissions and offering expenses payable by the Company. The offering was made pursuant to a registration statement on Form S-1. During the second quarter of 2019, we paid down $15.0 million of the principal balance due under the loan and security agreement with Pacific Western Bank (as successor-in-interest to Square 1 Bank). During the third quarter of 2019, we paid the remaining $5.0 million of principal balance due under the loan and security agreement with Pacific Western Bank, thereby removing the risks and restrictions of carrying long-term debt.

Notwithstanding our recent financings, our current cash level raises substantial doubt about our ability to continue as a going concern and if we are not able to continue to raise sufficient capital, we will not be able to support ongoing operations.

Public Offering
As noted above, on August 1, 2019, we entered into an underwriting agreement with A.G.P./Alliance Global Partners, as underwriter, in connection with a public offering of our securities, pursuant to which we issued and sold (i) 2,427,500 shares of our common stock (including 412,500 shares of common stock pursuant to the partial exercise of the underwriters’ over-allotment option to purchase 562,500 additional shares), (ii) pre-funded warrants to purchase up to 1,735,000 shares of our common stock ("Pre-funded Warrants"), (iii) accompanying warrants to purchase up to 3,234,375 shares of our common stock (including the exercise in full of the underwriters’ over-allotment option to purchase additional warrants to purchase 421,875 shares of common stock) ("Purchase Warrants") and (iv) an additional warrant to the underwriters for the purchase of 37,500 shares of our common stock ("Representative Warrant") resulting in net proceeds from the offering of approximately $14.7 million after deducting underwriting discounts and commissions and offering expenses payable by the Company. The shares of common stock and accompanying Purchase Warrants were sold at a public offering price of $4.00, and the Pre-funded Warrants and accompanying Purchase Warrants were sold at a public offering price of $3.999. The Purchase Warrants were immediately exercisable upon issuance, will expire on August 6, 2024 and have an exercise price of $4.40 and the Representative Warrant has an exercise price of $5.00 per share, in each case subject to adjustment in the event of stock dividends, stock splits, stock combinations, reclassifications, reorganizations or similar events. The Representative Warrant is exercisable in February 2020 and expire on August 6, 2014. All of the Pre-funded warrants were exercised during the third quarter of 2019. None of the Purchase or Representative Warrant have been exercised as of September 30, 2019.

Securities Purchase Agreement
On May 23, 2019, we entered into a Securities Purchase Agreement with certain investors for the sale of 500,000 shares of our common stock, par value $0.001 per share, at a purchase price of $6.00 per share. The closing of the sale of the shares under the Securities Purchase Agreement occurred on May 28, 2019. The aggregate gross proceeds for the sale of the shares was $3.0 million.
Equity Distribution Agreement
On December 27, 2018, we entered into the Equity Distribution Agreement, with Canaccord, pursuant to which we may, from time to time, sell shares of our common stock, having an aggregate offering price of up to $10 million through Canaccord, as our sales agent. Any shares sold pursuant to the Equity Distribution Agreement will be freely tradeable unless purchased by one of our affiliates.
We will pay Canaccord a commission of 3.0% of the gross proceeds from the sales of common stock sold pursuant to the terms of the Equity Distribution Agreement. The Equity Distribution Agreement also contains, among other things, customary representations, warranties and covenants by us and indemnification obligations of us and Canaccord as well as certain termination rights for both us and Canaccord. We have no obligation to sell any shares under the Equity Distribution Agreement, and may at any time suspend solicitation and offers under the Equity Distribution Agreement. Until the aggregate market value of our common stock held by non-affiliates, or public float, is greater than $75.0 million, the amount we can raise through primary public offerings of securities in any twelve-month period using shelf registration statements, including sales


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under our ATM program, is limited to an aggregate of one-third of our public float. As of September 30, 2019, the Company sold 377,615 shares under the Equity Distribution Agreement for aggregate gross proceeds of $2.8 million.
Lincoln Park Purchase Agreement
On December 27, 2018, we entered into a Purchase Agreement and Registration Rights Agreement, with Lincoln Park Capital Fund LLC, or Lincoln Park, pursuant to which we have the right, but not the obligation, to sell Lincoln Park, and Lincoln Park is obligated to purchase up to $20.0 million of our common stock, over the 36-month period that commenced in February 2019.
Under purchase agreement, and excluding the impact of any adjustments resulting from the Company’s reverse stock split, on any business day selected by us on which the closing price of our common stock is not less than $0.50 per share (subject to standard anti-dilution adjustments), we may direct Lincoln Park to purchase up to 50,000 shares of common stock on such business day (each, a “Regular Purchase”), provided, however, that (i) the Regular Purchase may be increased to up to 100,000 shares, provided that the closing sale price of the common stock is not below $2.00 on the purchase date (subject to standard anti-dilution adjustments) (ii) the Regular Purchase may be increased to up to 125,000 shares, provided that the closing sale price of the common stock is not below $3.00 on the purchase date (subject to standard anti-dilution adjustments) and (iii) the Regular Purchase may be increased to up to 150,000 shares, provided that the closing sale price of the common stock is not below $4.00 on the purchase date (subject to standard anti-dilution adjustments). In each case, Lincoln Park’s maximum commitment in any single Regular Purchase may not exceed $1,000,000. The purchase price per share for each such Regular Purchase will be based off of prevailing market prices of our common stock immediately preceding the time of sale without any fixed discount. In addition to Regular Purchases, we may also direct Lincoln Park to purchase other amounts as accelerated purchases or as additional accelerated purchases if the closing sale price of the common stock exceeds certain threshold prices as set forth in the purchase agreement.
Depending on the prevailing market price of our common stock, we may not be able to sell shares to Lincoln Park for the maximum $20.0 million over the term of the Lincoln Park Purchase Agreement. For example, we cannot sell shares to Lincoln Park on any day in which the closing price of our common stock is below $0.50 per share. Our closing price has been below $0.50 per share for 11 of the last 30 trading days. Additionally, under the rules of the Nasdaq Capital Market, in no event may we issue more than 19.99% of our shares outstanding (which is approximately 465,470 shares based on 2,328,512 shares outstanding prior to the signing of the Lincoln Park Purchase Agreement) under the Lincoln Park Purchase Agreement unless we obtain stockholder approval or an exception pursuant to the rules of the Nasdaq Capital Market is obtained to issue more than 19.99%. This limitation will not apply if, at any time the exchange cap is reached and at all times thereafter, the average price paid for all shares issued and sold under the Lincoln Park Purchase Agreement is equal to or greater than the specified minimum amount set forth in the Lincoln Park Purchase Agreement. We are not required or permitted to issue any shares of common stock under the Purchase Agreement if such issuance would breach our obligations under the rules or regulations of the Nasdaq Capital Market. In addition, Lincoln Park will not be required to purchase any shares of our common stock if such sale would result in Lincoln Park’s beneficial ownership exceeding 9.99% of the then outstanding shares of our common stock. Our inability to access a portion or the full amount available under the Lincoln Park Purchase Agreement, in the absence of any other financing sources, could have a material adverse effect on our business.
We issued to Lincoln Park 22,818 shares of common stock as commitment shares in consideration for entering into the purchase agreement. As of September 30, 2019, the Company has sold 356,122 shares under the Lincoln Park Purchase Agreement for aggregate gross proceeds of $4.2 million.
Loan and security agreement
In June 2013, we entered into a $3.0 million loan and security agreement with Square 1 Bank (predecessor in interest to Pacific Western Bank), which we subsequently amended in October 2014, September 2016, December 2016, June 2017 and July 2018.
In July 2018, we executed the fifth amendment to the loan and security agreement (the "Loan Amendment") with Pacific Western Bank, which increased the loan capacity to $20 million from $10 million. The loan capacity of $20 million consists of two tranches as follows: a first tranche of $10.0 million funded on July 10, 2018, of which the full $10.0 million was required to be used to settle the existing debt with Pacific Western Bank on a net settlement basis (pursuant to its original terms); and a second tranche of an additional $10.0 million which could be drawn at any time prior to July 9, 2019. During the first quarter of 2019, we drew down on the remaining $10.0 million tranche and in the second quarter of 2019, we repaid $15.0 million of the principal balance due under the loan and security agreement with Pacific Western Bank (as successor-in-interest to Square 1 Bank). In the third quarter of 2019, we paid the remaining $5.0 million of principal balance due under the loan and security agreement with Pacific Western Bank, removing the risks and restrictions of carrying long-term debt.


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Additional Capital Requirements
We expect to incur substantial expenditures in the next twelve months to continue developing the immature intragastric balloon market, support the U.S. commercialization of our product and to support continued research and development. In particular, we expect our costs and expenses could increase in the future as we continue (i) U.S. commercialization of our product, including our efforts to expand the number of Obalon-branded retail treatment centers, incur costs associated with a centralized customer support strategy, and other efforts to develop the immature intragastric balloon market and (ii) research and development, including conducting clinical trials of our products in development. Additionally, we expect to continue to incur substantial costs as a result of operating as a public company. We believe there is substantial doubt about our ability to continue as a going concern and if we are not able to continue to raise sufficient capital, we will not be able to support ongoing operations. The accompanying consolidated financial statements have been prepared assuming we will continue to operate as a going concern, which contemplates the realization of assets and settlement of liabilities in the normal course of business, and do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result from uncertainty related to our ability to continue as a going concern.
In an effort to address these liquidity concerns, on April 2, 2019, we commenced an internal restructuring and notified approximately 49 employees, or approximately 50% of our workforce, that their employment would be terminated. This restructuring included the elimination of our field sales force and a transition to a more centralized customer support model for our existing physician customers. Going forward, rather than focusing on selling to physicians, we intend to focus our commercialization efforts on the establishment and operation of company-owned or managed Obalon-branded retail treatment centers. We are in the early stages of this transition and cannot predict whether it will be an effective means of selling the Obalon Balloon System.
Our ability to continue as a going concern, and correspondingly to execute on our business plan and strategy, is dependent upon our ability to accomplish one or more of the following: raise additional capital in the very near term to fund our ongoing operations or engage in a strategic alternative.

CASH FLOWS
 
The following table provides a summary of the net cash flow activity for each of the periods set forth below (in thousands):
 
Nine Months Ended
September 30,
 
2019
 
2018
Net cash (used in) provided by:
 

 
 

Operating activities
$
(17,987
)
 
$
(24,017
)
Investing activities
2,506

 
14,332

Financing activities
13,674

 
10,129

Net (decrease) increase in cash and cash equivalents
$
(1,807
)
 
$
444

Net cash used in operating activities
During the nine months ended September 30, 2019, net cash used in operating activities was $18.0 million, consisting primarily of a net loss of $18.8 million, a decrease in net operating assets of $2.4 million primarily related to a decrease in accrued compensation, partially offset by a decrease in other current assets. These items were partially offset by non-cash charges of $3.2 million, consisting primarily of stock-based compensation expense and depreciation expense.
During the nine months ended September 30, 2018, net cash used in operating activities was $24.0 million, consisting primarily of a net loss of $28.6 million, offset by a decrease in net operating assets of $0.5 million primarily related to a decrease in accounts receivable and prepaid other current assets, offset by the decrease in accrued compensation. These items were further offset by non-cash charges of $4.2 million, consisting primarily of stock-based compensation expense and depreciation expense.
Net cash provided by investing activities
During the nine months ended September 30, 2019, net cash provided by investing activities was $2.5 million, consisting primarily of maturities of short-term investments.


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During the nine months ended September 30, 2018, net cash used in investing activities was $14.3 million, consisting primarily of maturities of short-term investments, slightly offset by purchases of short-term investments and capital expenditures.
Net cash provided by financing activities
During the nine months ended September 30, 2019, net cash provided by financing activities was $13.7 million, consisting primarily of $23.7 million in proceeds from issuance of equity securities, net of issuance costs, the draw down on the second tranche under our loan and security agreement with Pacific Western Bank of $10.0 million, partially offset by the subsequent pay down on the loan with Pacific Western Bank of $20.0 million.
During the nine months ended September 30, 2018, net cash provided by financing activities was $10.1 million, consisting primarily of proceeds from issuance of common stock, net of issuance costs of $10.0 million and proceeds from purchases of common stock pursuant to the our Employee Stock Purchase Plan.

OFF-BALANCE SHEET ARRANGEMENTS

We currently have no off-balance sheet arrangements, such as structured finance, special purpose entities or unconsolidated variable interest entities.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the accounting policies related to revenue recognition, accrued research and development costs, stock-based compensation expense and income taxes are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates.
Aside from newly implemented accounting policies relating to the implementation of ASC 842, under the heading “Leases,” and "Recently Adopted Accounting Pronouncements," and "Variable Interest Entities", as discussed in Note 2 to our Unaudited Interim Condensed Consolidated Financial Statements, there have been no significant changes in our critical accounting policies and estimates as compared to the critical accounting policies and estimates disclosed in Management’s Discussion and Analysis of Financial Condition and Operations included in the Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 22, 2019.

RECENT ACCOUNTING PRONOUNCEMENTS
Except as described in Note 2 to our Unaudited Interim Condensed Consolidated Financial Statements under the heading “Recent Accounting Pronouncements” and the recent adoption of the lease accounting guidance found in ASC 842, there have been no new accounting pronouncements or changes to accounting pronouncements during the nine months ended September 30, 2019, as compared to the recent accounting pronouncements described in the Company's Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 22, 2019.
JOBS ACT ACCOUNTING ELECTION
In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth


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company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
Not applicable.


ITEM 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our principal executive officer and our principal financial officer, evaluated, as of the end of the period covered by this Quarterly Report on Form 10-Q, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act). Based on that evaluation, our principal executive officer and principal financial officer has concluded that as of September 30, 2019, our disclosure controls and procedures were effective at the reasonable assurance level. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


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PART II-OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

From time to time, we are involved in legal proceedings in the ordinary course of business.
On February 14 and 22, 2018, plaintiff stockholders filed class action lawsuits against us and certain of our executive officers in the United States District Court for the Southern District of California (Hustig v. Obalon Therapeutics, Inc., et al., Case No. 3:18-cv-00352-AJB-WVG, and Cook v. Obalon Therapeutics, Inc. et al., Case No. 3:18-cv-00407-CAB-RBB). On July 24, 2018, the court appointed Inter-Local Pension Fund GCC/IBT as lead plaintiff. On October 5, 2018, plaintiffs filed an amended complaint. The amended complaint alleges that we and certain of our executive officers made false and misleading statements and failed to disclose material adverse facts about our business, operations, and prospects in violation of Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Exchange Act. The amended complaint also alleges violations of Section 11 of the Exchange Act arising out of the Company’s initial public offering. The plaintiffs seek damages, interest, costs, attorneys' fees, and other unspecified equitable relief. The underwriters from our initial public offering have also been named as defendants in this case and we have certain obligations under the underwriting agreement to indemnify them for their costs and expenses incurred in connection with this litigation.

On September 25, 2019, the court granted in part and denied in part the defendants’ motion to dismiss. The court dismissed the Section 11 claims entirely, without leave to amend, and accordingly dismissed the underwriters and certain directors from the case. The Court also dismissed certain statements from the Section 10 claims. We believe the remaining claims in the complaint are without merit and intend to defend vigorously against them.

ITEM 1A. Risk Factors
Investing in our common stock involves a high degree of risk. Before making your decision to invest in shares of our common stock, you should carefully consider the risks described below, together with the other information contained in this Quarterly Report on Form 10-Q, including our unaudited interim condensed consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect us. If any of the following risks actually occurs, our business, financial condition, results of operations and future growth prospects could be materially and adversely affected. The market price of our common stock would likely decline, and you could lose all or part of your investment.
RISKS RELATED TO OUR BUSINESS
The report of our independent registered public accounting firm contains an explanatory paragraph indicating substantial doubt about our ability to continue as a going concern.
Our operations have consumed substantial amounts of cash since inception. We expect to continue to invest in a centralized customer support model, marketing programs, the expansion of our manufacturing facilities and as we continue to spend on research and development, including conducting clinical trials of our products in development and completing development and commercialization of advancements to our existing Obalon Balloon System as well as our additional products under development. Additionally, we will continue to incur general and administrative costs as a result of supporting growth and operating as a public company. The audit report of our independent registered public accounting firm covering the December 31, 2018 consolidated financial statements contains an explanatory paragraph that states that our recurring losses from operations and liquidity position raises substantial doubt about our ability to continue as a going concern. This going concern opinion could materially limit our ability to raise additional funds through the issuance of new debt or equity securities or otherwise. Future reports on our financial statements may also include an explanatory paragraph with respect to our ability to continue as a going concern. To date, our operating losses have been funded primarily from outside sources of invested capital and gross profits. We currently need to raise additional cash from outside sources to fund our ongoing operations.
Execution of our new commercial strategy may not be successful and will subject us to new risks, some of which we may not yet have identified.
Historically we have sold our products directly to physicians, who then sold their patients treatment packages that include our balloon therapy, dietary counseling and removal on a non-reimbursed, self-pay basis. Beginning in April 2019, we eliminated approximately 50% of our workforce. As part of the workforce restructuring, we eliminated our field sales force and


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transitioned to a more centralized customer support model. Going forward, rather than focusing on selling to physicians, we intend to focus our commercialization efforts on the establishment and operation of company-owned or managed Obalon-branded retail treatment centers. In the third quarter of 2019, we opened our first Obalon-branded retail treatment center in California, engaged a medical director, hired non-medical staff to support operations and initiated digital marketing programs to drive patient interest. Under this model, subject to state law and any federal requirements, we plan to either directly employ the physicians or contract for their services, and we will be directly responsible for marketing and patient acquisition. We would also provide the facilities, staff, equipment and support services necessary for patients to receive Obalon balloon therapy. Our intent with this strategic shift is to standardize both quality of care and patient pricing, and provide us greater operational and financial control of our business. While we have historically provided marketing services intended to drive patients to physician offices, we have no prior experience marketing our products to drive patients to our own centers and we cannot assure you that this new strategic model will be successful.
Our ability to execute this strategy successfully is subject to numerous risks, including:
difficulty or inability to successfully engage physicians to provide medical services for Obalon-owned treatment centers in states that limit the corporate practice of medicine;
difficulty or inability to successfully recruit and retain qualified physicians and other employees for our Obalon-branded or managed retail treatment centers;
difficulty or inability to build brand awareness among patients for our products and therapy, or to convert brand awareness into patient visits to our centers;
difficulty or inability to convince patients of the benefits of treatment with our Obalon Balloon System;
difficulty or inability in identifying suitable properties for our centers and obtaining leases with acceptable terms;
timely securing, and for an acceptable cost, all applicable federal, state and local licenses, permits and regulatory approvals;
timely delivery of leased premises to us from our landlords and punctual commencement and completion of construction;
the possibility that execution of this strategy will require greater expenditures and investments than we have planned;
changes in federal, state and local law and regulations that adversely affect our ability to open our centers as well as how we conduct our business;
changes in economic and other conditions in geographic areas where we open an Obalon-branded retail treatment center that may impact patient demand to receive Obalon balloon therapy; and
unforeseen engineering or environmental problems with leased premises.
Additionally, there is no assurance that our current physician customers will be willing to accept the decreased amount of direct field support. Should physicians reject a centralized customer support model, we may experience a negative impact on our results of operations, including a decrease in future sales to existing customers, an increase in our rate of product returns and a decrease in our ability to collect our outstanding accounts receivable. Moreover, without a direct sales force, we expect a very limited amount, if any, of new accounts.
If we are unable to secure additional financing on favorable terms, or at all, to meet our current capital needs, we could be forced to sell portions of our business or seek bankruptcy protection to protect stakeholder value.
We recently initiated the transition of our commercialization efforts to focus on Obalon-branded or managed retail treatment centers. We have opened one such facility and expect that we will need significant additional capital to execute on this strategy. We may seek additional debt or equity financing in order to support our new operating plan. However, adequate funding may not be available to us on acceptable terms, or at all. The failure to obtain sufficient funds on acceptable terms or in a timely manner could force us to take actions that could materially and adversely affect our business, including further reductions in our operations (including our employee base), possible surrender or other disposition of our rights to some technologies or product opportunities, delaying the opening of any planned company-owned or managed Obalon-branded retail treatment center, delaying of our clinical trials or curtailing or ceasing operations and could result in us seeking bankruptcy protection. We also cannot give assurance that we will achieve sufficient revenues in the future to achieve profitability and cash flow positive operations to allow us to continue as a going concern. The perception that we may not be able to continue as a going concern may cause third parties including suppliers, customers, and employees to terminate their respective relationship with us due to concerns about our ability to meet our contractual obligations, which could have a material adverse effect on our business.


34




Our future capital requirements will depend on many factors, including:

the rate at which the currently small and immature intragastric balloon market develops;
the degree of success we experience in commercializing our Obalon Balloon System with both the centralized customer support model and Obalon-branded or managed retail treatment centers;
our ability to scale manufacturing in a cost-effective manner to meet demand;
costs associated with opening and operating company-owned or managed Obalon-branded retail treatment centers;
the costs and expenses of our U.S. sales and marketing infrastructure, operational expenses associated with Obalon-branded or managed retail treatment centers, and our manufacturing operations;
the revenue and gross profit generated by sales of our Obalon Balloon System, Obalon Navigation System, and any other products that may be approved in the United States;
the costs, timing and outcomes of clinical trials and regulatory reviews associated with our products under development;
the costs and timing of developing enhancements of our Obalon Balloon System and Obalon Navigation System and obtaining FDA clearance or approval of such enhancements;
the emergence of competing or complementary technological developments;
the extent to which our Obalon Balloon System and Obalon Navigation System are adopted by the physician community and patients;
the number and types of future generation products we develop and commercialize and their success and adoption in the marketplace;
the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending intellectual property-related claims;
costs of operating as a public company and compliance with existing and future regulations;
the extent and scope of our general and administrative expenses;
the legal costs associated with defending against shareholder litigation; and
the degree of success we experience in international sales of our Obalon Balloon System.
Additional financing may not be available on a timely basis on terms acceptable to us, or at all. We may raise funds in equity or debt financings or enter into additional credit facilities in order to access funds for our capital needs. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. Any debt financing obtained by us in the future would cause us to incur additional debt service expenses and could include restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and pursue business opportunities. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, we may terminate or delay the development of the company-owned or managed Obalon-branded retail treatment centers, negatively impact services associated with our centralized customer support model, delay the development of one or more of our products, delay clinical trials necessary to market our products, or delay other activities necessary to commercialize our products. If this were to occur, our ability to continue to grow and support our business and to respond to business challenges could be significantly limited.
We have implemented alternative financing arrangements including an "at-the-market" offering program and a purchase agreement with Lincoln Park Capital Fund, LLC, or Lincoln Park. Pursuant to the purchase agreement with Lincoln Park, or the Lincoln Park Purchase Agreement, Lincoln Park has committed to purchase up to $20.0 million of our common stock from time to time over a 36-month period that commenced on February 13, 2019. Depending on the prevailing market price of our common stock, we may not be able to sell shares to Lincoln Park for the maximum $20.0 million over the term of the Lincoln Park Purchase Agreement. Per terms of the agreement, we are not able to sell shares to Lincoln Park under the existing agreement if the closing price of our stock is below a specific minimum price. In addition, under the rules of the Nasdaq Capital Market, in no event may we issue more than 19.99% of our shares outstanding under the Lincoln Park Purchase Agreement unless we obtain stockholder approval or an exception pursuant to the rules of the Nasdaq Capital Market is obtained to issue more than 19.99%. This limitation will not apply in certain limited circumstances as set out in the Lincoln


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Park Purchase Agreement. As of September 30, 2019, we have sold 356,122 shares to Lincoln Park. We are not required or permitted to issue any shares of common stock under the Purchase Agreement if such issuance would breach our obligations under the rules or regulations of the Nasdaq Global Market. In addition, Lincoln Park will not be required to purchase any shares of our common stock if such sale would result in Lincoln Park’s beneficial ownership exceeding 9.99% of the then outstanding shares of our common stock. Our inability to access a portion or the full amount available under the Lincoln Park Purchase Agreement, in the absence of any other financing sources, could have a material adverse effect on our business.
We have limited operating experience and a history of net losses, and we may not be able to achieve or sustain profitability.
We have a limited operating history and have focused primarily on research and development, clinical trials, product engineering and building our manufacturing capabilities. Before launching our prior generation Obalon Balloon System in the United States in January 2017, we sold an earlier generation of our product in certain international markets. Our commercial sales experience has been limited. We have incurred significant losses in each period since our inception in 2008, with net losses of $3.7 million and $6.7 million during the three months ended September 30, 2019 and 2018, respectively, and $18.8 million and $28.6 million during the nine months ended September 30, 2019 and 2018, respectively. As of September 30, 2019, we had an accumulated deficit of approximately $167.5 million and had cash and cash equivalents of $19.4 million. These losses and our accumulated deficit reflect the substantial investments we have made to develop, seek and obtain regulatory approval for our current and future generation Obalon Balloon System, sell our Obalon Balloon System in international markets, and commercialize our Obalon Balloon System in the United States. Our consolidated financial statements as of and for the six month period ended September 30, 2019 have been prepared on the basis that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. Based on our cash balances and recurring losses since inception, there is substantial doubt about our ability to continue as a going concern and if we are not able to raise additional capital in a timely manner, we will not be able to support our ongoing operations.
We expect our costs and expenses to increase in the future as we continue U.S. commercialization of our product, including the cost associated with our new centralized customer support model, cost associated with the Obalon-branded or managed retail treatment centers, investment to develop the immature intragastric balloon market, and the expansion of our manufacturing capacity. In the centralized customer support model, we sell the Obalon Navigation System Console to physicians at a price that approximates our cost and will negatively impact future gross profit dollars and gross margin percentage. Furthermore, we have limited experience manufacturing the Obalon Navigation Balloon, and as a result expect lower gross profits. We will also continue to invest in research and development of new product candidates, including conducting clinical trials of our products currently in development. In addition, as a public company, we incur significant insurance, legal, accounting, compliance and other expenses that we would not incur as a private company. As a result, we expect our losses to continue for the foreseeable future. Accordingly, we cannot assure you that we will achieve profitability in the future or that, if we do become profitable, we will sustain profitability. Our failure to achieve and sustain profitability would negatively impact the market price of our common stock.
We are currently a single product company with limited commercial sales experience, which makes it difficult to evaluate our current business, predict our future prospects and forecast our financial performance and growth.
We were incorporated in 2008, and prior to January 2017 our business activities were focused on the development and regulatory approval of our Obalon Balloon System and building the commercial infrastructure to sell our product in the United States. We commenced commercial launch of our prior generation Obalon balloon system in the United States in January 2017 and commenced commercial shipments of our most recent iteration of our Obalon Balloon System, Obalon Navigation System and Obalon Touch Inflation Dispenser in the United States in the first quarter of 2019. All of our revenue to date is attributable to sales of our Obalon Balloon System including its component parts and accessories. In the future, we expect to continue to generate sales of our products to physicians through a centralized customer support model and intend to establish a separate company-owned or managed Obalon-branded retail treatment center model. Through 2016, our primary commercial sales experience was limited to sales to distributors in a limited number of countries outside the United States. We expect that sales through our centralized customer support model to physicians in the United States will account for a majority of our revenue for the foreseeable future as we establish the company-owned or managed Obalon-branded retail treatment center business. However, we eliminated our direct sales force early in the second quarter of 2019 and anticipate that will significantly reduce revenue until we are able to grow our Obalon-branded or managed retail treatment centers. Our limited operating and commercialization experience in what we expect will be our primary market makes it difficult to evaluate our current business and predict our future prospects. Throughout 2019, we plan to phase out our prior generation Obalon balloon system that uses x-ray technology to place balloons, and eventually only sell versions of the Obalon Balloon System that use the Obalon Navigation System to place balloons. In the centralized customer support model for physicians, use of the Obalon Navigation System requires the physician to make a capital purchase of the Navigation console, Obalon Touch Dispenser, Obalon Navigation Balloon Kits and consumables and physicians are responsible for driving patient interest. We cannot assure you that


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our current physician customers will be willing to make that purchase, and if we cannot transition physicians who currently use the prior generation Obalon balloon system to the Obalon Navigation System, we may experience a decline in sales. A number of factors that are outside our control may contribute to fluctuations in our financial results, including:
patient and physician demand for our Obalon Balloon System, including the rate at which physicians recommend our Obalon Balloon System to their patients and the rate at which patients seek treatment from physicians, whether at company-owned or managed Obalon-branded retail treatment centers or otherwise;
the degree of success we experience in commercializing our Obalon Balloon System with both the centralized customer support model and company-owned or managed Obalon-branded retail treatment centers;
positive or negative media coverage, or public, patient and/or physician perception, of our Obalon Balloon System, the procedures or products of our competitors, or our industry;
any safety or efficacy concerns that arise through physician and patient experience with our Obalon Balloon System;
willingness of physicians to purchase the capital equipment required to place balloons using the Obalon Navigation System;
any safety or efficacy concerns for the category of intragastric balloons, including liquid-filled balloons, as the FDA has issued three Letters to Health Care Providers warning them about the use of liquid-filled intragastric balloons citing potential risks, including death;
changes in the composition of our customer base caused by acquisition of private medical practices by large hospitals could extend our selling cycle;
our ability to develop, finance, obtain regulatory approval for, and successfully launch our next generation products and the success of our next generation products in the marketplace;
our ability to develop, obtain regulatory approval for, and successfully manage the company-owned or managed Obalon-branded retail treatment center;
our ability to service and maintain equipment such as the Obalon Navigation System;
our ability to maintain our current or obtain further regulatory clearances, licenses or approvals;
delays in, or failure of, product and component deliveries by our third-party suppliers and single-source suppliers;
difficulties in producing a sufficient quantity of our product to meet commercial demand due to shortages of component parts or due to issues in the manufacturing process;
introduction of new procedures or products for treating patients who are obese or overweight that compete with our product;
adverse changes in the economy that reduce patient demand for elective procedures;
performance of our international distributors; and
favorable or unfavorable positions developed on intragastric balloons, or the Obalon Balloon System by professional medical associations, such as the American Society for Metabolic and Bariatric Surgery (ASMBS), the American Society for Gastrointestinal Endoscopy (ASGE), or other organizations with influence on physicians.
It is therefore difficult to predict our future financial performance and growth, and such forecasts are inherently limited and subject to a number of uncertainties. If our assumptions regarding the risks and uncertainties we face, which we use to plan our business, are incorrect or change due to circumstances in our business or our markets, or if we do not address these risks successfully, our operating and financial results could differ materially from our expectations and our business could suffer.
Because we devote substantially all of our resources to our Obalon Balloon System and rely on our Obalon Balloon System as our sole source of revenue, any factors that negatively impact our product, or result in decreasing product sales, would materially and adversely affect our business, financial condition and results of operations.

We are required to maintain high levels of inventory, which could consume a significant amount of our resources, reduce our cash flows and lead to inventory impairment charges.

As a result of the need to maintain substantial levels of inventory due to single third-party sourcing and long lead-times to develop alternate third-party sources, we carry a high level of inventory for strategic materials and products and are subject to the risk of inventory obsolescence. In the event that a substantial portion of our inventory becomes obsolete, it could have a material adverse effect on our earnings and cash flows due to the resulting costs associated with the inventory impairment


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charges and costs required to replace such inventory. In addition, because we are a vertically integrated manufacturer, insufficient demand for our products may subject us to the risk of high inventory carrying costs and increased inventory obsolescence.
Opening Obalon-branded retail treatment centers in existing markets where we have historically sold direct to physicians may negatively affect revenue with our current physician customers.
The target area of our centers varies by location and depends on a number of factors, including population density, other available retail and medical services, area demographics and geography. As a result, the opening of an Obalon-branded retail treatment center in or near markets in which we already have physician customers could adversely affect the revenues of those existing physician customers. Existing physician customers could also make it more difficult to build our patient base for a center in the same market. Our business strategy does not entail opening Obalon-branded retail treatment centers that we believe will materially affect revenue at our existing physician customers, but we may selectively open centers in and around areas of existing physicians customers to effectively serve our patients. Revenue “cannibalization” between our centers and physician customers may become significant in the future as we continue to expand our operations and could affect our revenue growth, which could, in turn, adversely affect our business, financial condition and results of operations.
We will be subject to all of the risks associated with leasing space subject to long-term non-cancelable leases for Obalon-branded retail treatment centers that we intend to operate.
We do not own and we do not intend to own any of the real property where our company-owned or managed centers will operate. We expect to lease the spaces for the company-owned or managed centers we intend to open in the future. We may not be able to locate appropriate properties and obtain leases on favorable terms or at all. If a future company-owned center is not profitable, resulting in its closure, we may nonetheless be committed to perform our obligations under the applicable lease including, among other things, paying the base rent for the balance of the lease term. In addition, we may fail to negotiate renewals as each of our leases expires, either on commercially acceptable terms or at all, which could cause us to pay increased occupancy costs or to close centers in desirable locations. These potential increases in occupancy costs and the cost of closing company-owned or managed centers could materially adversely affect our business, financial condition or results of operations.
Physicians and patients may be slow to adopt and use intragastric balloons, and adverse events or other negative developments involving other companies’ intragastric balloons or other obesity treatments may further slow physician and patient adoption. If any of these events were to occur, our business and prospects would be negatively affected.
Intragastric balloons represent a relatively new category of treatment for obese and overweight patients that is small and immature. Currently, we are aware of only one other intragastric balloon available for sale in the United States, which was available starting in 2015. As a result, physician and patient awareness of intragastric balloons as a treatment option for obesity and weight management, and experience with intragastric balloons, is minimal. To date, we have experienced limited penetration of this market, and our success depends in large part on our ability to further develop the currently small and immature intragastric balloon market, educate patients and physicians, and successfully demonstrate the safety, tolerability, ease of use, efficacy, cost effectiveness and other merits of our Obalon Balloon System. In April 2019, as part of a restructuring, we eliminated our direct field sales force and transitioned to a centralized customer support model for our existing physician customers and focused our efforts on establishing our first company-owned or managed Obalon-branded retail treatment center. We expect to continue investing in the various activities to develop the intragastric balloon market for the foreseeable future. Since we received PMA approval for the Obalon Balloon System in September 2016, we have engaged in various marketing campaigns to raise awareness of our Obalon Balloon System and its benefits among physicians and patients, but we cannot assure you that these efforts will be successful or that they will not prove to be cost-prohibitive.
Physicians play a significant role in determining the course of a patient’s weight management or obesity treatments and as a result, the type of treatment that will be recommended or provided to a patient. Though we recently eliminated our direct sales force, using our centralized customer support model, we continue to target our sales efforts towards bariatric surgeons and gastroenterologists, because they are either the physicians treating obese and overweight patients, have experience with endoscopic procedures and/or have experience with cash pay medical treatments. If we experience physician disruption due to our shift to a centralized customer support model, we may experience a decrease in sales. Also, the initial point of contact for many patients who are obese and overweight may be general practitioners, bariatricians, endocrinologists, obstetricians and gynecologists, each of whom commonly manage and regularly see patients that are obese and overweight. If these physicians are not made aware of our Obalon Balloon System, they may not refer patients to bariatric surgeons, gastroenterologists or Obalon-owned or managed retail treatment centers for treatment using our product, and those patients may instead not seek treatment at all or be treated with pharmaceuticals or an alternative device or surgical procedure.


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Additionally, because the market for intragastric balloons is new and developing and contains a limited number of market participants, our products could be negatively impacted by unfavorable market reactions to these other devices. If the use of these or future intragastric balloons results in serious adverse device events, or SADEs, or such products are subject to malfunctions or misuse, patients and physicians may attribute such negative events to intragastric balloons generally, which may adversely affect market adoption of our Obalon Balloon System. Since February 2017, the FDA has issued three separate letters to health care providers warning of serious adverse events, including deaths, which are specific to liquid-filled intragastric balloons. We are aware of the filing of additional reports of serious adverse events, including deaths, associated with liquid-filled balloons since the issuance of the FDA safety alert letters. While the alerts were specific to liquid-filled intragastric balloons and not gas-filled intragastric balloons, these alerts could create negative perceptions of the entire category and slow down the acceptance of the Obalon Balloon System. Medical professional associations, such as ASMBS, have or may publish positions to their memberships which may be favorable or unfavorable toward the use of intragastric balloons, or the Obalon Balloon specifically. Additionally, if patients undergoing treatment with our Obalon Balloon System perceive the weight loss inadequate or adverse events too numerous or severe as compared with the treatment rates of alternative balloons or procedures, it will be difficult to demonstrate the value of our Obalon Balloon System to patients and physicians. As a result, demand for our Obalon balloon system may decline or may not increase at the pace or to the levels we expect.
If physicians do not choose to recommend the Obalon Balloon System to their patients, we may be unable to sell our products, grow our business or achieve profitability.
Our ability to sell our Obalon Balloon System depends heavily on the willingness of physicians to recommend it to their patients. Physicians may not prescribe our Obalon Balloon System unless they are able to determine long-term ability of Obalon to continue operations, and based on experience, long-term clinical data, recommendations from other physicians and published peer-reviewed journal articles, that it provides a safe and effective treatment alternative for obesity. Even if we are able to raise awareness among physicians, physicians tend to be slow in changing their medical treatment practices and may be hesitant to select our Obalon Balloon System for recommendation to patients for a variety of reasons, including:
lack of access or reluctance to acquire access to ancillary equipment such as endoscopy which is necessary to remove the Obalon Balloon System;
reluctance to invest in ancillary equipment, such as the Obalon Navigation System, which is necessary to place an Obalon balloon;
long-standing relationships with competitors and distributors that sell other products and their competitive response and negative selling efforts;
lack of experience with our products and concerns that we are relatively new to the obesity market, or concerns that our competitors offer greater support or have larger amounts of resources than our company;
lack of confidence in Obalon continuation of operations or ability to effectively shift to a centralized support model;
perceived liability risk generally associated with the use of new products and procedures;
lack or perceived lack of sufficient clinical evidence supporting clinical benefits;
reluctance to change to or use new products;
perceptions that our products are unproven or experimental;
time and skill commitment that may be required to gain familiarity with a new system; and
difficulty convincing physicians of the economic benefit of our product to their practice.
We are also aware of certain characteristics and features of our Obalon Balloon System that may prevent widespread market adoption. For example, for the Obalon Navigation System, a physician is required to purchase the capital component of the system, which is the console, to treat patients. Furthermore, our Obalon Balloon System is approved as an adjunct to a moderate intensity diet and behavior modification program. As a result, physicians will need to develop the appropriate practice management programs, which include treatment protocols, nutritional counseling and patient management, to treat patients in a manner consistent with our treatment protocol. If physicians are unable or unwilling to make the necessary financial and regulatory commitments and implement the appropriate practice management programs to successfully treat patients with the Obalon balloon, they may not adopt our balloon system.
If we fail to grow our sales and marketing capabilities and develop widespread brand awareness cost effectively, our financial performance and business may suffer.


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We have limited experience as a company in the sales and marketing of our products. Prior to 2017, the majority of our product sales had been to a single international distributor in the Middle East. We first sold our products to physicians and institutions in the United States in 2017, and we commenced commercial shipments of our Obalon Navigation System in the first quarter of 2019. We anticipate the United States to be our primary market focus going forward. We recently eliminated our direct sales force and now sell to physicians through a centralized customer support model. In the centralized customer support model, marketing and clinical support is provided from our corporate office. Marketing support may include media assets and media purchasing support and leads generated from our Find-A-Doc locater. Training our applicable employees in use of our Obalon Balloon System and Obalon Navigation System to achieve the level of clinical competency expected by physicians, and to comply with applicable federal and state laws and regulations and our policies and procedures requires significant time, expense and attention. It can take several months to recruit and fully train employees. Our business may be harmed if there is excessive turnover in our employees that support our physician customers, or our efforts to train and retain our employees do not generate a corresponding increase in revenues. In particular, there is significant competition for qualified and experienced personnel. If we are unable to hire, develop and retain talented personnel or if new personnel are unable to achieve desired productivity levels in a reasonable period of time, we may not be able to realize the expected benefits of this investment or increase our revenues sufficiently to offset the cost incurred.
In addition, factors that may inhibit our efforts to commercialize our Obalon Balloon System, Obalon Navigation System and any other products that may receive FDA approval include:
the inability of our employees to perform their duties and conduct business in a manner that is compliant with our internal policies and procedures and FDA law and regulations;
the inability of our employees to obtain access to an adequate numbers of physicians to recommend any current and future products;
the lack of complementary products to be offered by our personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines;
unforeseen costs and expenses associated with our centralized customer support model, including the marketing organization;
efforts by our competitors to commercialize products or procedures that address a similar patient population; and
the existence of negative publicity about us or our products.
Our ability to develop broader market acceptance of our Obalon Balloon System will depend to a significant extent on our ability to efficiently expand our marketing programs which create physician and patient demand for our product. We have in the past and plan to in the future, dedicate significant financial and other resources to our marketing programs. Our investments in marketing have varied over time and were significantly reduced as we transition to our new business strategies of centralized customer support and the Obalon-branded retail treatment centers. In September 2019, we reinitiated marketing programs to increase patient interest for the Obalon Center for Weight Loss. Our business will be harmed if our marketing efforts and expenditures do not generate a sufficient increase in revenue to offset their cost.
In addition, we believe that developing and maintaining awareness of our brand in a cost-effective manner is critical to achieving acceptance of our product and attracting new customers. Brand promotion activities may not generate customer awareness or increase revenue, and even if they do, any increase in revenue may not offset the costs and expenses we incur in building our brand. If we fail to successfully promote, maintain and protect our brand, we may fail to attract or retain the customers necessary to realize a sufficient return on our brand-building efforts, or to achieve brand awareness that is critical for broad customer adoption of our Obalon Balloon System.
The effectiveness and safety of our Obalon Balloon System depends critically on our ability, and our international distributor’s ability, to educate and train physicians on its safe and proper use. If we or our international distributor are unable to do so, we may not achieve our expected growth and may be subject to risks and liabilities.
In addition to educating physicians on the clinical benefits of our Obalon Balloon System, we and our international distributor must also train physicians on its safe and appropriate use. In particular, our FDA approved labeling requires physicians to complete an Obalon training program before they can place the device and for us to provide clinical support as needed. If we or our international distributor are unable to provide an adequate training program, product misuse can occur and lead to serious injury requiring reporting to the FDA. Many physicians may be unfamiliar with such treatments or find it more complex than competitive products or alternative treatments. As such, there is a learning process involved for physicians to become proficient in the use of our products. In addition, it is also critical for physicians to be educated and trained on best practices in order to achieve optimal results, including patient selection and eligibility criteria as well as complementary methods of use such as diet or behavioral modification programs. Convincing physicians to dedicate the time and resources necessary for adequate training


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is challenging, and we cannot assure that we will be successful in these efforts. This training process may also take longer than we expect. In the event that physicians are not properly trained in the use of our Obalon Balloon System, they may have misused and ineffectively used our products for the treatment of patients. As a result, patients have experienced adverse events and have not been able to enjoy the benefits of our system or achieve the weight loss outcomes they expected, leading to dissatisfaction and could lead to market rejection of our products. Physicians may not follow our instructions for use when treating patients with our products. A physician's failure to follow our instructions for use or other misuse of our products in any stage of the treatment may result in, among other things, patient injury, adverse side effects, negative publicity or lawsuits against us. Any of these events could have an adverse effect on our business and reputation.
The efficacy of our Obalon Balloon System depends on patient compliance with a moderate intensity diet and behavior modification program. If patients are unwilling to make dietary and behavioral changes, patient outcomes may suffer which could negatively impact perception of our product in the marketplace.
Our Obalon Balloon System is approved as an adjunct to a moderate intensity diet and behavior modification program. As a result, in addition to undergoing the Obalon balloon procedure, patients will also need to modify their existing diet and level of physical activity in order to achieve their desired weight loss. If patients are unwilling to implement the appropriate dietary and behavioral changes, the amount of weight loss may be less than desired, leading to a negative perception of our product in the marketplace.
If patients are unable to successfully swallow the capsule, our device malfunctions during delivery or physicians cannot deploy the Obalon balloon, physicians may be unwilling to continue to recommend our products and perception among patients may be negatively impacted.
Patients may be unable to successfully swallow the capsule that contains the Obalon balloon, potentially creating an economic disincentive for physicians to prescribe the Obalon Balloon System. In our SMART pivotal trial, 7.6% of the combined treatment and control group patients failed to swallow a capsule with the microcatheter attached despite success swallowing a placebo that did not have a catheter attached. We are experiencing similar rates in U.S. commercial usage. There have also been instances where balloon deployment was negatively impacted due to a leak in the microcatheter caused by the patient biting the catheter during placement and requiring endoscopic removal. There may be other reasons for unsuccessful placements of which we are not yet aware. If the balloon is not successfully placed for any reason, the patient may attempt to seek a refund or monetary damages for the treatment. Alternatively, physicians and institutions that have paid us for a balloon, but have not been paid by their patient because of a treatment failure, may seek a refund or monetary damages from us. Either scenario could cause a negative financial impact for us and could also create ill will with patients and physicians.
Patients may experience serious injury related to the device or procedures as the result of the misuse or malfunction of, or design flaws in, our products, that could expose us to expensive litigation, divert management’s attention and harm our reputation and business.
Our business is subject to significant risks associated with manufacture, distribution and use of medical devices that are placed inside the human body, including the risk that patients may be severely injured by or even die from the misuse or malfunction of our products caused by design flaws or manufacturing defects. In addition, our business may suffer adverse consequences even in circumstances where a patient injury is caused by the actions of others, such as where a patient is injured due to the improper or negligent use of our products by a physician.
For instance, if the Obalon capsule does not reach a patient’s stomach and is inflated in another portion of the body, such as the esophagus, the patient could experience a serious injury. A patient who experiences an esophageal inflation of the balloon would most likely require surgical intervention, and could die as a result of an esophageal inflation or as a result of complications from the subsequent intervention. Physicians may use the Obalon Navigation System to track the location of the balloon prior to inflation. Failure of the sensor to function or the Obalon Navigation System to dynamically track the capsule could result in serious injury if the Obalon balloon is inflated in another portion of the body, such as the esophagus. Perforation of the esophagus at any time, including during removal, is also possible. Esophageal perforation leading to sepsis and death associated with the sepsis has been reported with use of our product. Serious injury could also occur if one or more of the balloons deflates and migrates into the lower intestine causing an obstruction. This can also lead to surgical removal of the device and associated complications including death. Failure of the Obalon Touch Inflation Dispenser to function could result in need for immediate endoscopic removal or patient injury. Balloon deflation and migration into the lower intestine requiring surgical removal has also been reported with use of our product. Perforation of the stomach is also possible and can lead to surgical removal of the device and associated complications including death. Perforation of the stomach requiring surgical repair has also been reported with use of our product. One or more balloons may get lodged in the pyloric channel which could lead to severe dehydration and be life threatening and/or require surgical procedures to remove. Failure to transit has been


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reported with use of our product and unscheduled endoscopy has been performed to remove the uninflated balloon. Aspiration during placement or removal is also a risk with intragastric balloons which could lead to pneumonia or other serious injury. Acute pancreatitis has been reported that may or may not be associated with the use of our product. While we have designed our products, and established instructions and protocols for physicians, to attempt to mitigate such risks, we cannot guarantee that adverse events will not occur again in the future. For example, physicians and/or patients have in the past failed, and may again in the future fail, to follow our instructions and protocols, and the safety systems we design into our products may not prevent all possible adverse events and injuries and/or our products may fail to function properly.
Our quality assurance testing programs may not be adequate to detect all defects, which may result in patient adverse events, interfere with customer satisfaction, reduce sales opportunities, harm our marketplace reputation, increase warranty repairs and/or harm our revenue and results of operations. Our inability to remedy a product defect could result in a product recall, temporary or permanent withdrawal of a product from a market, product liability suits, damage to our reputation or our brand, inventory replacement costs or product reengineering expenses, any of which could have a material impact on our business, results of operations and financial condition.
We actively employ social media and call center activities as part of our marketing strategy, which could give rise to regulatory violations, liability, breaches of data security or reputational damage.
Despite our efforts to monitor evolving social media communication guidelines and comply with applicable laws and regulations, there is risk that the use of social media by us, our employees or our customers to communicate about our products or business may cause us to be found in violation of applicable requirements, including requirements of regulatory bodies such as the FDA, CMS and Federal Trade Commission. For example, adverse events, product complaints, off-label usage by physicians, unapproved marketing or other unintended messages could require an active response from us, which may not be completed in a timely manner and could result in regulatory action by a governing body. In addition, our employees may knowingly or inadvertently make use of social media in ways that may not comply with our social media policy or other legal or contractual requirements, which may give rise to liability, lead to the loss of trade secrets or other intellectual property, or result in public exposure of personal information of our employees, clinical trial patients, customers and others. Furthermore, negative posts or comments about us or our products in social media could seriously damage our reputation, brand image and goodwill.
We do not expect that physicians or patients will receive third-party reimbursement for treatment using our products. As a result, we expect that our success will depend on the ability and willingness of physicians to adopt self-pay practice management infrastructure and of patients to pay out-of-pocket for treatment with our products.
Certain elective treatments, such as an intragastric balloon, are typically not covered by insurance. Accordingly, we do not expect that any third-party payors will cover or reimburse physicians or patients for the Obalon Balloon System. As a result, we expect that our success will depend on the ability and willingness of physicians that may not have historically operated a self-pay practice to adopt the policies and procedures needed to successfully operate such a practice. Additionally, we will need to demonstrate the ability to operate company-owned or managed Obalon-branded retail treatment centers successfully. Our centralized customer support efforts in the United States are targeted at bariatric surgeons, gastroenterologists and plastic surgeons. Bariatric surgeons and gastroenterologists are accustomed to providing services that are reimbursed by third-party payors. As a result, these physicians may need to augment their administrative staff and billing procedures to address the logistics of a self-pay practice. If physicians are unable or unwilling to make such changes, adoption of our products may be slower than anticipated.
Our success will also depend on the ability and willingness of patients to pay out-of-pocket for treatment with our products. Adverse changes in the economy may cause consumers to reassess their spending choices and reduce the demand for elective treatments and could have an adverse effect on consumer spending. This shift could have an adverse effect on our net sales. Furthermore, consumer preferences and trends may shift due to a variety of factors, including changes in demographic and social trends, public health initiatives and product innovations, which may reduce consumer demand for our products. The decision by a patient to elect to undergo treatment with the Obalon Balloon System may be influenced by a number of additional factors, such as:
the success of any sales and marketing programs, including direct-to-consumer marketing efforts, that we, or any third parties we engage, undertake, and as to which we have limited experience;
the extent to which physicians offer the Obalon Balloon System to their patients;
the extent to which the Obalon Balloon System satisfies patient expectations;
the general perception of the Obalon Balloon System in the consumer market;


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the cost, safety, comfort, tolerability, ease of use, and effectiveness of the Obalon Balloon System as compared to other treatments; and
general consumer confidence, which may be impacted by economic and political conditions.
Our financial performance will be materially harmed if we cannot generate significant physician or patient demand for the Obalon Balloon System.
We have limited experience manufacturing our Obalon Balloon System and Obalon Navigation System in commercial quantities and may experience production delays or issues in our manufacturing organization and be unable to meet current or future demand.
Prior to 2017, the majority of our product sales had been to a single international distributor in the Middle East. We first sold our products to physicians and institutions in the United States in 2017, and we anticipate the United States to be our primary market focus going forward. We have limited experience in manufacturing the current Obalon Balloon System, the Obalon Navigation System, and the Obalon Touch Inflation Dispenser in commercial quantities, and we will need to adjust our manufacturing capabilities in order to satisfy expected demand. We may find that we are unable to successfully manufacture these new products in sufficient quantities and expect manufacturing of the Obalon Navigation Balloon kit to be at a much higher per unit cost initially. We may need to adjust our manufacturing capabilities in order to satisfy expected demand for our Obalon Navigation balloon. In addition, the Obalon Navigation balloon with the Obalon Touch Inflation Dispenser utilizes a different catheter and dispenser configuration from our prior U.S. product, which we have limited experience manufacturing in commercial quantities.
Furthermore, in June 2019 we initiated a facility reduction plan that included consolidating certain functions of manufacturing. There were certain quality system requirements we needed to satisfy in order to restart our manufacturing operations. The quality system requirements were satisfied in July 2019 and manufacturing operations resumed.
We have and may continue to encounter production delays or shortfalls caused by many factors, including the following:
the reduction in workforce in April 2019 could negatively impact our ability to meet an increase in demand;
the timing and process needed to assimilate the changes necessary to enable our production processes to accommodate anticipated demand;
shortages that we may experience in any of the key components or sub-assemblies that we obtain from third-party suppliers;
production delays or stoppages caused by receiving components or supplies which do not meet our quality specifications;
delays that we may experience in completing validation and verification testing for new controlled-environment rooms at our manufacturing facilities;
delays that we may experience in seeking FDA review and approval of PMA supplements required for certain changes in manufacturing facilities, methods or quality control procedures;
our limited experience in complying with the FDA’s Quality System Regulation, or the QSR, which sets forth good manufacturing practice requirements for medical devices and applies to the manufacture of the components of our Obalon Balloon System;
our ability to attract, train, and retain qualified employees, who are in short supply, in order to increase our manufacturing output;
our ability to design and validate processes to allow us to manufacture future generations of the Obalon Balloon System that meets or exceeds our quality specifications in an efficient, cost-effective manner;
our ability to produce commercial product that meets or exceeds our manufacturing specifications and release criteria;
production delays or stoppages caused by malfunction of production equipment and/or malfunction of the electrical, plumbing, ventilation, or cooling systems supporting our manufacturing facility; and
production stoppages and/or product scrap caused by positive tests for objectionable organisms on our products.
As we have scaled manufacturing, we have experienced challenges in our ability to meet commercial demand. While we have taken steps to address these challenges, we cannot assure you those steps will be sufficient or that additional challenges will not arise as we continue with the commercialization of our Obalon Balloon System and the recently commercialized Obalon Navigation System. If we continue to experience these challenges, our revenue could be impaired, our costs could increase,


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market acceptance for our product could be harmed and our customers might instead purchase our competitors’ products. Our inability to successfully manufacture components of our Obalon Balloon System in quantities sufficient to meet expected demand would materially harm our business.
We depend on third-party suppliers, including single source suppliers, to manufacture some of our components and sub-assemblies, which could make us vulnerable to supply shortages, interruptions in production and price fluctuations that could harm our business.
We currently manufacture our Obalon Balloon System and some of its components and sub-assemblies at our Carlsbad facility and we rely on third-party suppliers for other components and sub-assemblies used in production. In some cases, these suppliers are single source suppliers. For example, we rely on single suppliers for the extruded film, swallowable capsule, molded silicone valve used to manufacture our Obalon balloons and the hydrophilic coating for our catheters. We also rely on additional single source suppliers for components of our Obalon Navigation balloons and console. These components are critical to our current and future products and there are relatively few alternative sources of supply. We do not carry a significant inventory of these components and obtaining additional components may require significant lead-time. We have experienced and may continue to experience production challenges due to shortages of key components from suppliers. Any concern regarding our current financial position or delay in our payments to suppliers, especially our key suppliers for the Obalon Navigation Console and balloon components, could negatively impact suppliers' perception of Obalon and result in delayed or canceled delivery of components, which could result in production challenges. Suppliers could also modify payment terms, including upfront cash payments. Identifying and qualifying additional or replacement suppliers for any of the components or sub-assemblies used in our products could involve significant time and cost and could delay production and adversely affect our ability to fill product orders, service and maintain equipment with customers. For example, given that our Obalon Balloon System is a PMA approved product, any replacement supplier will have to be assessed by us through audits and other verification and assessment tools and found capable of producing quality components that meet our approved specifications, and we may be required to notify or obtain approval from the FDA for a change in a supplier prior to our ability to use the components it provides. If we were unable to find a replacement supplier, it could result in significant delays as we would be unable to produce additional product until such replacement supplier had been identified and qualified. If an existing or replacement supplier proposes to change any component specifications or quality requirements, the change may require FDA approval of a PMA supplement. If a supplier changes a component without notifying us, that change could result in an undetected change being incorporated into the finished product. Once detected and investigated, if the change is found to potentially affect the safety or effectiveness of the product, we would have to take corrective and preventive action, including possibly recalling the product, which could be time-consuming and expensive, and could impair our ability to meet the demand of our customers and harm our business and reputation.
In addition, our reliance on third-party suppliers for current and future products subjects us to a number of risks that could impact our ability to manufacture our products, service and maintain equipment with customers and harm our business, including:
inability to obtain adequate supply in a timely manner or on commercially reasonable terms;
change in payment terms, requiring upfront payment;
difficulty identifying and qualifying alternative suppliers for components in a timely manner;
interruption of supply resulting from modifications to, or discontinuation of, a supplier’s operations;
damage to suppliers' facilities could interrupt supply;
delays in product shipments resulting from uncorrected defects, reliability issues or a supplier’s failure to produce components that consistently meet our quality specifications;
price fluctuations due to a lack of long-term supply arrangements with our suppliers for key components;
inability of suppliers to comply with applicable provisions of the QSR or other applicable laws or regulations enforced by the FDA and state regulatory authorities;
inability to ensure the quality of products manufactured by third parties;
production delays related to the evaluation and testing of products from alternative suppliers and corresponding regulatory qualifications;
delays in delivery by our suppliers due to changes in demand from us or their other customers;