UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2019

OR

For the transition period from ________ to ________

Commission File Number: 001-38662

SUTRO BIOPHARMA, INC.

(Exact Name of Registrant as Specified in its Charter)

Registrant’s telephone number, including area code: (650) 392-8412

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 for 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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

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 financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

Securities registered pursuant to Section 12(b) of the Act:

As of May 10, 2019, the registrant had 22,925,441 shares of common stock, $0.001 par value per share, outstanding.

Table of Contents

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

Sutro Biopharma, Inc.

Condensed Balance Sheets

(In thousands, except share and per share amounts)

See accompanying notes to unaudited interim condensed financial statements.

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Sutro Biopharma, Inc.

Condensed Statements of Operations

(Unaudited)

(In thousands, except share and per share amounts)

See accompanying notes to unaudited interim condensed financial statements.

2

Sutro Biopharma, Inc.

Condensed Statements of Comprehensive Loss

(Unaudited)

(In thousands)

See accompanying notes to unaudited interim condensed financial statements.

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Sutro Biopharma, Inc.

Condensed Statements of Stockholders’ (Deficit) Equity

(Unaudited)

(In thousands, except share amounts)

See accompanying notes to unaudited interim condensed financial statements.

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Sutro Biopharma, Inc.

Condensed Statements of Cash Flows

(Unaudited)

(In thousands)

See accompanying notes to unaudited interim condensed financial statements.

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Sutro Biopharma, Inc.

Notes to Unaudited Interim Condensed Financial Statements

1. Organization and Principal Activities

Description of Business

Sutro Biopharma, Inc. (the “Company”) is a clinical stage drug discovery, development and manufacturing company focused on leveraging its integrated cell-free protein synthesis and site-specific conjugation platform, XpressCF+™, to create a broad variety of optimally designed, next-generation protein therapeutics for cancer and autoimmune disorders. The Company was incorporated on April 21, 2003, and was formerly known as Fundamental Applied Biology, Inc. The Company is headquartered in South San Francisco, California.

The Company operates in one business segment, the development of biopharmaceutical products.

Liquidity

The Company has incurred significant losses and has negative cash flows from operations. As of March 31, 2019, there was an accumulated deficit of $154.3 million. Management expects to continue to incur additional substantial losses in the foreseeable future as a result of the Company’s research and development activities and costs to operate as a public company.

As of March 31, 2019, the Company had unrestricted cash, cash equivalents and marketable securities of $184.3 million, which are available to fund future operations. The Company will need to raise additional capital to support the completion of its research and development activities and its operations.

The Company believes that its unrestricted cash, cash equivalents and marketable securities as of March 31, 2019 will be sufficient for the Company to continue as a going concern for at least one year from the issuance date of its unaudited interim condensed financial statements.

2. Summary of Significant Accounting Policies

Basis of Presentation and Use of Estimates

The accompanying condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The Company bases its estimates on historical experience and market-specific or other relevant assumptions that it believes are reasonable under the circumstances. The amounts of assets and liabilities reported in the Company’s balance sheets and the amount of expenses and income reported for each of the periods presented are affected by estimates and assumptions, which are used for, but are not limited to, determining research and development periods under multiple element arrangements, stock-based compensation expense, fair value of redeemable convertible preferred stock warrant liabilities (prior to closing of the Company’s IPO), income taxes and certain accrued liabilities. Actual results could differ from such estimates or assumptions.

Unaudited Interim Condensed Financial Statements

The interim condensed balance sheet as of March 31, 2019, the condensed statements of operations and comprehensive loss for the three months ended March 31, 2019 and 2018, the condensed statements of stockholders’ (deficit) equity for the three months ended March 31, 2019 and 2018 and the condensed statements of cash flows for the three months ended March 31, 2019 and 2018, are unaudited. The unaudited interim condensed financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of March 31, 2019, its results of operations and comprehensive loss for the three months ended March 31, 2019 and 2018, the changes in stockholders’ (deficit) equity for the three months ended March 31, 2019 and 2018 and cash flows for the three months ended March 31, 2019 and 2018. The financial data and the other financial information contained in these notes to the condensed financial statements related to the three-month periods are also unaudited. The results of operations for the three months ended March 31, 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 condensed balance sheet as of December 31, 2018 included herein was derived from the audited financial statements as of that date. The condensed financial statements should be read in conjunction with the Company's audited financial statements included in the Annual Report on Form 10-K pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, for the year ended December 31, 2018.

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Adoption of New Accounting Principles

Revenue Recognition

On January 1, 2019, the Company adopted Accounting Standards Update (ASU) No. 2014-09 (Topic 606), Revenue from Contracts with Customers (“ASC 606”). ASC 606 supersedes the guidance in ASC 605, Revenue Recognition. Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration that the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of ASC 606, the entity performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation.

In the adoption of ASC 606, the Company used the practical expedients to analyze only those contracts that were still active contracts as of January 1, 2019 and evaluated those contracts based on the cumulative contract modifications through that date. The Company does not believe that the use of the practical expedients has or will have a material impact on its transition adjustment or its prospective accounting. The Company adopted ASC 606 on a modified retrospective basis under which it recognized the cumulative effect of adoption of $10.3 million as a transition adjustment to reduce opening accumulated deficit; therefore, the periods prior to the adoption date of ASC 606 have not been restated. If the Company had continued to use ASC 605 during 2019, revenue would have been $7.6 million in the three months ended March 31, 2019, as compared to the $8.6 million reported.

The impact of the adoption of Topic 606 on select unaudited condensed balance sheet as of January 1, 2019 was as follows (in thousands):

The impact of the adoption of ASC 606 on select unaudited condensed balance sheet and condensed statement of operations line items as of and for the three months ended March 31, 2019 were as follows:

Nonemployee Share-Based Payment

In June 2018, the FASB issued ASU 2018-07 (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”). ASU 2018-07 simplifies the accounting for share-based payments to nonemployees by

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aligning it with the accounting for share-based payments to employees, with certain exceptions. Some of the areas of simplification apply only to nonpublic entities. The Company adopted this guidance on January 1, 2019. The adoption of this guidance did not have a material impact on the Company’s financial statements.

Recently Issued Accounting Pronouncements

In August 2018, the FASB issued ASU 2018-13 (Topic 820), Fair Value Measurement: Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, reducing certain disclosures concerning the fair value hierarchy. The guidance is effective for the Company in annual periods beginning after December 15, 2019, and interim periods within those annual periods. The Company does not expect the adoption of this guidance to have a material impact on the Company’s condensed financial statements.

In June 2016, the FASB issued ASU 2016-13 (Topic 326), Financial Instruments Credit Losses, which requires consideration of a broader range of reasonable and supportable information to developing credit loss estimates. The guidance is effective for the fiscal year beginning January 1, 2020, including interim periods within that fiscal year. The Company does not expect the adoption of this guidance to have a material impact on the Company’s condensed consolidated financial statements.

Leases

In February 2016, the FASB issued ASU 2016-02 (Topic 842), Leases (“ASC 842”). ASC 842 supersedes the lease recognition requirements in ASC 840, Leases. ASC 842 clarifies the definition of a lease and requires lessees to recognize right-of-use assets and lease liabilities for all leases, including those classified as operating leases under previous lease accounting guidance. For public entities, ASU 2016-02 is effective for fiscal years beginning after December 15, 2018. The guidance is effective for nonpublic business entities for fiscal years and interim periods beginning after December 15, 2019, with early adoption permitted. As a result of the Company having elected the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act, ASC842 will be effective for the Company from January 1, 2020. Originally, entities were required to adopt ASC 842 using a modified retrospective transition method. However, in July 2018, the FASB issued ASU 2018-11 (Topic 842), Leases: Targeted Improvements, which provides entities with an additional transition method. Under ASU 2018-11, entities have the option of initially applying ASC 842 at the adoption date, rather than at the beginning of the earliest period presented, and recognizing the cumulative effect of applying the new standard as an adjustment to beginning retained earnings in the year of adoption while continuing to present all prior periods under previous lease accounting guidance. The Company expects to elect this transition method at the adoption date of January 1, 2020. The Company is currently evaluating the impact of adopting this guidance on the Company’s financial statements. The Company currently expects that its operating lease commitments will be subject to the new standard and recognized as right-of-use assets and operating lease liabilities upon adoption of this standard, which will increase the total assets and total liabilities that it reports relative to such amounts prior to adoption.  

Cash, Cash Equivalents and Restricted Cash

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the balance sheets that sum to the total of the same amounts shown in the statements of cash flows.

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Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability, or an exit price, in the principal or most advantageous market for that asset or liability in an orderly transaction between market participants on the measurement date, and establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs, where available, and minimizes the use of unobservable inputs when measuring fair value. The Company determined the fair value of financial assets and liabilities using the fair value hierarchy that describes three levels of inputs that may be used to measure fair value, as follows:

Level 1—Quoted prices in active markets for identical assets and liabilities;

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The carrying amounts of accounts receivable, prepaid expenses, accounts payable, accrued liabilities and accrued compensation and benefits approximate fair value due to the short-term nature of these items.

The fair value of the Company’s outstanding loan (See Note 6) is estimated using the net present value of the payments, discounted at an interest rate that is consistent with market interest rate, which is a Level 2 input. The estimated fair value of the Company’s outstanding loan approximates the carrying amount, as the loan bears a floating rate that approximates the market interest rate.

Revenue Recognition

The Company recognizes revenue when its customers obtain control of the promised goods or services, in an amount that reflects the consideration that the Company expects to receive in exchange for those goods or services.

Collaboration revenue

The Company derives revenue from collaboration arrangements, under which the Company may grant licenses to its collaboration partners to further develop and commercialize its proprietary product candidates. The Company may also perform research and development activities under the collaboration agreements. Consideration under these contracts generally includes a nonrefundable upfront payment, development, regulatory and commercial milestones and other contingent payments, and royalties based on net sales of approved products. Additionally, the collaborations may provide options for the customer to acquire from the Company’s materials and reagents, clinical product supply or additional research and development services under separate agreements.

The Company assesses which activities in the collaboration agreements are considered distinct performance obligations that should be accounted for separately. The Company develops assumptions that require judgement to determine whether the license to the Company’s intellectual property is distinct from the research and development services or participation in activities under the collaboration agreements.

At the inception of each agreement, the Company determines the arrangement transaction price, which includes variable consideration, based on the assessment of the probability of achievement of future milestones and contingent payments and other potential consideration.

For arrangements that include multiple performance obligations, the Company allocates the transaction price to the identified performance obligations based on the standalone selling price (“SSP”) of each distinct performance obligation. In instances where SSP is not directly observable, the Company develops assumptions that require judgment to determine the SSP for each performance obligation identified in the contract. These key assumptions may include full-time equivalent (“FTE”) personnel effort, estimated costs, discount rates and probabilities of clinical development and regulatory success.

Upfront Payments: For collaboration arrangements that include a nonrefundable upfront payment, if the license fee and research and development services cannot be accounted for as separate performance obligations, the transaction price is deferred and recognized as revenue over the expected period of performance using a cost-based input methodology. The Company uses judgement to assess the pattern of delivery of the performance obligation.  In addition, amounts paid in advance of services being rendered may result in an associated financing component to the upfront payment.  Accordingly, the interest on such borrowing cost component will be recorded as interest expense and revenue, based on an appropriate borrowing rate applied to the value of services to be performed by the Company over the estimated service performance period.

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License Grants: For collaboration arrangements that include a grant of a license to the Company’s intellectual property, the Company considers whether the license grant is distinct from the other performance obligations included in the arrangement. For licenses that are distinct, the Company recognizes revenues from nonrefundable, upfront payments and other consideration allocated to the license when the license term has begun and the Company has provided all necessary information regarding the underlying intellectual property to the customer, which generally occurs at or near the inception of the arrangement.

Milestone and Contingent Payments: At the inception of the arrangement and at each reporting date thereafter, the Company assesses whether it should include any milestone and contingent payments or other forms of variable consideration in the transaction price using the most likely amount method. If it is probable that a significant reversal of cumulative revenue would not occur upon resolution of the uncertainty, the associated milestone value is included in the transaction price. At the end of each subsequent reporting period, the Company re-evaluates the probability of achievement of each such milestone and any related constraint and, if necessary, adjusts its estimate of the overall transaction price. Since milestone and contingent payments may become payable to the Company upon the initiation of a clinical study or filing for or receipt of regulatory approval, the Company reviews the relevant facts and circumstances to determine when the Company should update the transaction price, which may occur before the triggering event. When the Company updates the transaction price for milestone and contingent payments, the Company allocates the changes in the total transaction price to each performance obligation in the agreement on the same basis as the initial allocation. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment, which may result in recognizing revenue for previously satisfied performance obligations in such period. The Company’s collaborators generally pay milestones and contingent payments subsequent to achievement of the triggering event.

Research and development services: For amounts allocated to the Company’s research and development obligations in a collaboration arrangement, the Company recognizes revenue over time using a cost-based input methodology, representing the transfer of goods or services as activities are performed over the term of the agreement.

Materials Sales: The Company provides materials and reagents, clinical materials and services to certain of its collaborators under separate agreements. The consideration for such services is generally based on FTE personnel effort used to manufacture those materials reimbursed at an agreed upon rate in addition to agreed-upon pricing for the provided materials. The amounts billed are recognized as revenue as the performance obligations are met by the Company.  

The Company’s revenue recognition policies under ASC 605 are described in the Annual Report on Form 10-K for the year ended December 31, 2018.

3. Fair Value Measurements

The following table sets forth the fair value of the Company’s financial assets and liabilities measured on a recurring basis by level within the fair value hierarchy:

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Where applicable, the Company uses quoted market prices in active markets for identical assets to determine fair value. This pricing methodology applies to Level 1 investments, which are composed of money market funds.

If quoted prices in active markets for identical assets are not available, then the Company uses quoted prices for similar assets or inputs other than quoted prices that are observable, either directly or indirectly. These investments are included in Level 2 and consist of commercial paper, corporate debt securities, asset-backed securities and U.S. government agency securities. These assets are valued using market prices when available, adjusting for accretion of the purchase price to face value at maturity.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires management to make judgments and consider factors specific to the asset or liability.

In certain cases where there is limited activity or less transparency around inputs to valuation, securities are classified as Level 3 within the valuation hierarchy. Level 3 liabilities that were measured at estimated fair value on a recurring basis consisted of the redeemable convertible preferred stock warrant liability (prior to closing of the Company’s IPO).

Upon closing of the IPO on October 1, 2018, all of the outstanding redeemable convertible preferred stock warrants either expired or were converted into common stock warrants, which resulted in the reclassification of the redeemable convertible preferred stock warrant liability to other income and additional paid-in-capital.  

4. Cash Equivalents and Marketable Securities

Cash equivalents and marketable securities consisted of the following:

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As of March 31, 2019, $13.7 million of marketable securities had maturities of more than one year and are classified as long-term assets.  As of December 31, 2018, no marketable securities had maturities of more than one year.

5. Collaboration and License Agreements and Supply Agreements

The Company has entered into collaboration and license agreements with various pharmaceutical and biotechnology companies. As described in Note 2, on January 1, 2019, the Company adopted ASC 606, Revenue from Contracts with Customers, which supersedes the guidance in ASC 605, Revenue Recognition. The Company recognized revenue under ASC 606 for the three months ended March 31, 2019 and under ASC 605 for the three months ended March 31, 2018. In accordance with the collaboration agreements, the Company recognized revenue as follows:

The following table presents the changes in the Company’s deferred revenue balance from collaboration agreements during the three months ended March 31, 2019:

The Company’s balance of deferred revenue contains the transaction price from collaboration agreements allocated to performance obligations which are partially unsatisfied. The Company expects to recognize approximately $19.0 million of deferred revenue over the next twelve months.

There have been no material changes to the Company’s collaboration agreements in the three months ended March 31, 2019, except as described below.

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Celgene Agreement

In September 2014, the Company signed a Collaboration and License Agreement with Celgene to discover and develop bispecific antibodies and/or antibody-drug conjugates (“ADCs”), focused primarily on the field of immuno-oncology, using the Company’s proprietary integrated cell-free protein synthesis platform, XpressCF™.

Upon signing the Celgene Agreement, the Company received an upfront, nonrefundable payment totaling $83.1 million.   

In March 2015, the Company received a $15.0 million contingent payment (“March 2015 payment”) from Celgene that provided Celgene a right to access certain of the Company’s technology for use in conjunction with certain Celgene intellectual property. In June 2016, the Company received a $25.0 million milestone (“June 2016 payment”) upon completion of certain preclinical activities. Additionally, in June 2016, the Company earned a $10.0 million substantive milestone for certain manufacturing accomplishments.

In August 2017, the Company entered into an amended and restated collaboration and license agreement with Celgene to refocus the collaboration on four programs that are advancing through preclinical development, including an ADC program targeting B cell maturation antigen (“BCMA ADC”).

In August 2017, the Company received an option fee payment of $12.5 million. In September 2017, the Company earned a $10.0 million milestone for certain manufacturing accomplishments, which payment was received from Celgene in October 2017. In December 2018, the Company earned a $10.0 million milestone for certain manufacturing accomplishments, which payment was received from Celgene in the same month.

The Company has received and will be eligible to receive financial support for research and development services assigned to the Company by Celgene, based on an agreed-upon level of FTE personnel effort and related reimbursement rate, which will be recognized as revenue as the related reimbursable activities approved by Celgene and the Company are performed by the Company.

Under the terms of the Celgene Agreement, the Company is entitled to earn development and regulatory contingent payments for each of the four programs under the collaboration, and royalties on sales of any commercial products that may result from the Celgene Agreement.  For licensed products for which Celgene holds worldwide rights, the Company is eligible to receive contingent development and regulatory payments and tiered royalties. Additionally, for licensed products for which Celgene holds ex-U.S. rights, the Company will also be eligible to receive contingent development and regulatory payments and tiered royalties. The contingent payments under the Celgene Agreement are not considered to be substantive milestones because the receipt of such payments is based solely on the performance of Celgene.

Celgene may terminate the Celgene Agreement at any time with 120 days’ prior written notice. Either the Company or Celgene has the right to terminate the Celgene Agreement based on the other party’s uncured material breach, challenge of the validity and enforceability of intellectual property, or bankruptcy.

In accounting for this arrangement under ASC 606, applying the practical expedients, the Celgene Agreement was treated as a single arrangement that had been modified in 2017.  

Given the modification of the Celgene Agreement in 2017, the Company determined that the remaining deferred revenue balance of $8.2 million as of the date of the modification, related to certain prior Celgene payments to the Company, together with the $12.5 million option fee payment received in August 2017, would comprise the transaction price of $20.7 million to be allocated on a relative basis among the Company’s performance obligations based on the Company’s best estimate of each SSP or fair value. The Company identified the three  performance obligations relating to the Celgene Agreement as: (1) access by Celgene to worldwide development and commercialization rights on the first collaboration program to achieve investigational new drug (“IND”) clearance; (2) the Company’s estimated future services on the collaboration Joint Steering Committee (“JSC”); and (3) Celgene’s use of certain technology and the option to acquire worldwide development and commercialization rights to a second collaboration program.

Based on its estimated SSP, relative to the total estimated SSP values of all identified performance obligations, the portion of the transaction price allocated to the first performance obligation was $8.2 million, which performance obligation was satisfied as of the modification date of the Celgene Agreement, as the BCMA ADC program was the most advanced of the four collaboration programs and estimated by the Company to be the one for which Celgene would first achieve IND clearance and gain worldwide development and commercialization rights. The second and third performance obligations identified above were unsatisfied as of the modification date of the Celgene Agreement.  The Company determined the portion of the transaction price to be allocated to the JSC performance obligation was $0.2 million. Revenue related to such performance obligation will be recognized by the Company over the estimated period during which it will perform its JSC services.  The Company determined that the portion of the transaction price to be allocated to the third performance obligation, which provided Celgene with an option to acquire worldwide development and commercialization rights to a

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second collaboration program, was $12.3 million.  Revenue related to such performance obligation will be recognized over the period from August 2017 through September 2020, the estimated term of the use of the technology.  

Upon the adoption of ASC 606 on January 1, 2019, the Company recorded a $4.5 million adjustment to decrease its deferred revenue for performance obligations that were satisfied in prior periods, with the corresponding adjustment being a reduction to the Company’s accumulated deficit.  For the three months ended March 31, 2019, the Company recognized approximately $1.1 million of revenue under ASC 606.  

As of March 31, 2019 and December 31, 2018, there was $5.9 million and $11.4 million, respectively, of deferred revenue related to payments received by the Company under the Celgene Agreements.

2018 Celgene Master Services Agreement

In March 2018, the Company entered into a Master Development and Clinical Manufacturing Services Agreement (the “2018 Celgene Master Services Agreement”) with Celgene, wherein Celgene requested the Company to provide development, manufacturing and supply chain management services, including clinical product supply. The consideration for the services is based on an agreed-upon level of FTE personnel effort and related reimbursement rate in addition to agreed-upon pricing for the clinical product supply.   

Upon adoption of ASC 606 on January 1, 2019, this was deemed a modification of the arrangement and the consideration terms were at fair value and materials are to be provided on an as agreed upon basis.   Accordingly the Company will recognize revenue upon the performance of such services.

For the three months ended March 31, 2019 and 2018, the Company earned $0.5 million and $1.9 million, respectively, under the 2018 Celgene Master Services Agreement.

2018 Merck Agreement – Related Party

In July 2018, the Company entered into an Exclusive Patent License and Research Collaboration Agreement (the “2018 Merck Agreement”) with Merck, a related party of the Company, to jointly develop up to three research programs focusing on cytokine derivatives for cancer and autoimmune disorders.

Under the 2018 Merck Agreement, the Company received from Merck a non-refundable, non-creditable, upfront payment of $60.0 million in August 2018 for access to the Company’s technology and the identification and preclinical research and development of two target programs, with an option for Merck to engage the Company to continue these activities for a third program upon the payment of an additional amount. Under ASC 606, the Company identified the five performance obligations under the 2018 Merck Agreement as: (1) access to certain intellectual property rights;  (2) performance of services related to the first target program; (3) performance of services related to the second target program; (4)  the Company’s estimated future services on the collaboration JSC; and (5) a   material right pertaining to the performance of services related to a contingent third target program upon the payment of an additional amount. The transaction price of $60.0 million was allocated among the performance obligations using the Company’s best estimate of SSP for each of the associated performance obligations.  Based on its estimated SSP, relative to the estimated total SSP values of all identified performance obligations, the portion of the transaction price allocated to the first performance obligation was $7.3 million.  It was determined that such performance obligation was satisfied as of the effective date of the 2018 Merck Agreement, and accordingly revenue associated with this performance obligation would, pursuant to ASC 606, have been recorded on the effective date of the Merck Agreement. Revenue allocated to the first and second target programs, which totaled $47.1 million is being recognized on a proportion of performance basis, using the FTE cost as the basis of measurement, with such performance expected to occur over an estimated service period of three years for each target program.  As it pertains to the JSC performance obligation, the revenue allocated to such performance obligation was $0.7 million, which is being recognized as revenue on a proportion of performance basis using FTE cost as the basis, and such effort is expected to be incurred on a relatively consistent basis throughout the term of the 2018 Merck Agreement.  The Company allocated $4.9 million of the transaction price to the material right associated with the contingent third program.  Recognition of the $4.9 million as revenue will begin upon commencement of the third program or upon the determination that the contingent third target program is no longer a performance obligation.

Additionally, under ASC 606, the Company determined there was a financing component associated with the $60.0 million upfront payment, and has calculated total interest of $7.6 million on the unearned revenue portion beyond one year from the effective date of the agreement, which amount is expected to be recognized as revenue over the estimated service period for the first and second target programs   .

For the three months ended March 31, 2019, the Company recognized $3.0 million of revenue associated with the $60.0 million upfront payment, $0.9 million related to the interest component described above, and $0.8 million for FTE funding provided by Merck.

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Upon adoption of ASC 606 on January 1, 2019, the Company recorded a $6.3 million adjustment to decrease its deferred revenue for performance obligations that were satisfied in prior periods, with the corresponding adjustment being a reduction to the Company’s accumulated deficit.        

As of March 31, 2019 and December 31, 2018, there was $43.7 million and $53.0 million, respectively, of deferred revenue related to the transaction price under the 2018 Merck Agreement.  As of both March 31, 2019 and December 31, 2018, the Company had a $0.9 million receivable from Merck related to the 2018 Merck Agreement, which is included in accounts receivable on the balance sheet.

The Company is also eligible to receive aggregate milestone payments of up to $1.6 billion, assuming the development and sale of all therapeutic candidates and all possible indications identified under the collaboration. If one or more products from each of the target programs are developed for non-oncology or a single indication, the Company will be eligible for reduced aggregate milestone payments. In addition, the Company is eligible to receive tiered royalties ranging from mid-single digit to low teen percentages on the worldwide sales of any commercial products that may result from the collaboration.

Merck may terminate the 2018 Merck Agreement at any time with 60 days’ prior written notice. Either the Company or Merck has the right to terminate the 2018 Merck Agreement based on the other party’s uncured material breach or bankruptcy.

During 2018, Merck purchased 74,794,315 shares of the Company’s Series E redeemable convertible preferred stock at a price per share of $0.2674, resulting in gross proceeds of $20.0 million.  In a private placement concurrent with the Company’s IPO, which was completed on October 1, 2018, Merck purchased 666,666 shares of common stock at a price per share of $15.00, resulting in proceeds of approximately $10.0 million.  As a result of the investments in the Company’s equity, Merck is a related party.

EMD Serono Agreement

The Company signed a Collaboration Agreement and a License Agreement with EMD Serono in May 2014 and September 2014, respectively, which were entered into in contemplation of each other and therefore treated as a single agreement for accounting purposes. The Collaboration Agreement was subsumed into the License Agreement (the “MDA Agreement”), which agreement is to develop ADCs for multiple cancer targets.

Upon signing the Collaboration Agreement, the Company received an upfront, nonrefundable, non-creditable payment totaling $10.0 million. Upon signing the MDA Agreement, the Company received an additional upfront, nonrefundable payment totaling $10.0 million and will receive financial support for research and development services to be provided by the Company, based on an agreed-upon level of FTE personnel effort and related reimbursement rate.

The Company is eligible to receive up to $52.5 million for each product developed under the MDA Agreement, primarily from pre-commercial contingent payments. In addition, the Company is eligible to receive tiered royalties ranging from low-to-mid single digit percentages, along with certain additional one-time royalties, on worldwide sales of any commercial products that may result from the MDA Agreement. The MDA Agreement term expires on a product-by-product and country-by-country basis. Upon expiration, EMD Serono will have a fully paid-up, royalty-free, perpetual, and irrevocable non-exclusive license, with the right to grant sublicenses, under certain Company intellectual property rights. EMD Serono may terminate the MDA Agreement at any time with 90 days’ prior written notice or upon the inability of the Company to provide EMD Serono access to a specified number of cancer drug targets. Either the Company or EMD Serono has the right to terminate the MDA Agreement based on the other party’s uncured material breach or bankruptcy.

Upon adoption of ASC 606 on January 1, 2019, the Company identified a single performance obligation under the MDA Agreement, which consists of the technology license, research and development activities and JSC participation over the estimated period of the agreement, as each are interrelated and not distinct within the overall context of the agreement. The transaction price of $20.0 million is being recognized on a proportion of performance basis, using the FTE cost as the basis of measurement, with such performance expected to occur over the estimated service period of the agreement, from June 2014 through May 2019.

The Company recorded a $0.6 million adjustment to increase its deferred revenue for performance obligations that were unsatisfied in prior periods, with the corresponding adjustment being an increase to the Company’s accumulated deficit.  

As of March 31, 2019 and December 31, 2018, there was $0.9 million and $1.7 million, respectively, of deferred revenue related to payments received by the Company under the MDA Agreement. As of March 31, 2019 and December 31, 2018, the Company had $1.5 million and $0.9 million, respectively, of receivables from EMD Serono related to the MDA Agreement, which are included in accounts receivable on the balance sheet.

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SutroVax, Inc. Supply Agreement – Related Party

In May 2018, the Company entered into a Supply Agreement (the “Supply Agreement”) with SutroVax, Inc., (“SutroVax”), wherein SutroVax engaged the Company to supply extracts and custom reagents, as requested by SutroVax. The pricing is based on an agreed upon cost plus arrangement. For the three months ended March 31, 2019, the Company recognized $0.3 million under the Supply Agreement. As of March 31, 2019 and December 31, 2018, the Company had $0.3 million and $49,000 in receivables, respectively, from SutroVax related to the Supply Agreement, which is included in accounts receivable on the balance sheet.

Upon adoption of ASC 606 on January 1, 2019, as the Company has a right to consideration from SutroVax in an amount that corresponds directly with the value of the Company’s supplied extracts and custom reagents, the Company’s sales of extracts and custom reagents in discrete unit form are recognized as revenue at the time when such supplies are shipped to SutroVax, in line with the practical expedient in ASC 606-10-55-18.  

The Company has not received any returns to date and believes that returns of its products will continue to be minimal. As such, the Company does not record any reserve for the returns but will continue to evaluate the need for a reserve each reporting period.

The Leukemia & Lymphoma Society, Inc.

In August 2018, the Company entered into a Research, Development and Commercialization Agreement (the “LLS Agreement”) with The Leukemia & Lymphoma Society (“LLS”), under which LLS has agreed to contribute up to $6.0 million in clinical development funding for STRO-001, the Company’s CD74-targeting ADC to treat relapsed and/or refractory multiple myeloma and non-Hodgkin lymphoma. The funding will be provided in installments based upon the achievement of funding milestones, with any excess funding above actual expenditures refundable to LLS. The initial payment of $0.5 million was received by the Company upon execution of the LLS Agreement. As of March 31, 2019, the Company had received total payments from LLS of $1.0 million, of which this full amount was reflected as an offset against other income (expense). In consideration for the funding to the Company under the LLS Agreement, the Company may be required in the future to make payments to LLS, contingent upon reaching certain pre-specified late-stage clinical development, regulatory and commercialization milestones and should the Company enter into certain transactions relating to STRO-001 with a third party, which payments in the aggregate could total up to a maximum $19.5 million, assuming receipt by the Company from LLS of the entire $6.0 million in clinical development funding for STRO-001. As of March 31, 2019, no events have occurred that would require such payments to LLS. The LLS Agreement terminates upon the earlier of (a) fulfillment of all payment obligations by both parties or (b) 12 years after the effective date.  LLS may terminate the LLS Agreement at any time with 60 days’ prior written notice. Either the Company or LLS has the right to terminate the LLS Agreement based on the other party’s uncured material breach.

The Company concluded that the contingent payments were an embedded derivative and recorded a related liability.  As of March 31, 2019, and December 31, 2018, the Company recorded $0.1 million as other noncurrent liabilities, with the corresponding amount recorded in the statement of operations as other income (expense), net. The value of the embedded derivative was estimated, at each reporting period, based on the probability-adjusted and discounted value of future payments.

6. Loan and Security Agreement

In August 2017, the Company entered into a loan and security agreement with Oxford Finance LLC (“Oxford”) and Silicon Valley Bank (“SVB”) under which it borrowed $15.0 million (the “August 2017 Loan”). The loan is due in 30 monthly installments from March 2019 through its repayment in August 2021, with interest-only monthly payments until March 2019. The Company commenced repayment of the loan in March 2019.

The August 2017 Loan is secured by all assets of the Company, excluding intellectual property and certain other assets. The August 2017 Loan contains customary affirmative and restrictive covenants, including with respect to fundamental transactions, the incurrence of additional indebtedness, grant liens, pay any dividend or make any distributions to the Company’s holders, make investments, merge or consolidate with any other person, or engage in transactions with its affiliates, but does not include any financial covenants. The loan agreement provides that an event of default will occur if, among other triggers, any circumstances occur that could reasonably be expected to result in a material adverse effect on the Company’s business, operations or condition, or on its ability to perform its obligations under the loan. The loan agreement also includes customary representations and warranties, other events of default and termination provisions.

As of March 31, 2019, the Company has classified $5.8 million of the outstanding debt balance as current and $8.5 million as non-current, which reflects the scheduled repayment terms under the August 2017 Loan.

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The interest charges on the loan are based on a floating rate that equals the greater of 7.39% or the sum of the 30-day U.S. Dollar London Interbank Offered Rate (“LIBOR”) plus 6.40%. For the three months ended March 2019, the average interest rate was 8.90%.  In addition, the Company will make a final payment equal to 3.83% of the original principal amount of the loan, or $0.6 million, which is being accrued over the term of the loan using the effective-interest method. As of March 31, 2019, total interest expense accrued was $0.3 million.

In connection with the August 2017 Loan, the Company issued to Oxford and SVB a warrant to purchase the Company’s Series D-2 redeemable convertible preferred stock (the “2017 Warrant”). The 2017 Warrants were later converted into warrants to purchase Series E redeemable convertible preferred stock in May and July 2018, and upon the Company’s IPO on October 1, 2018, all Series E redeemable convertible preferred stock warrants were converted to warrants to purchase 46,359 shares of common stock. The estimated fair value upon issuance of the 2017 Warrant of $0.3 million was recorded as a debt discount on the associated borrowings on the Company’s balance sheet. The debt discount is being amortized to interest expense over the repayment period of the loan using the effective-interest method.

During the three months ended March 31, 2019 and 2018, the Company recorded interest expense related to this loan of $0.4 million and $0.4 million, respectively, and interest related to the accretion of debt discount of $42,000 and $38,000, respectively.

7. Related-Party Transactions

Upon the Company’s IPO, Celgene’s ownership of the Company’s outstanding equity interest decreased to less than 10%. As a result, starting October 1, 2018, the Company ceased to reflect balances and transactions associated with Celgene as a related party in its financial statements. Transactions with Celgene for the three months ended March 31, 2019 and 2018, respectively, are described in Note 5.    

Related party transactions with Merck, which owned 11.9% of the Company’s outstanding equity interest both as of March 31, 2019 and December 31, 2018, are described in Note 5.      

Three directors of the Company have performed consulting services for the Company, which consulting services were terminated prior to the Company’s IPO in September 2018.  During the three months ended March 31, 2019, the Company made no payment to these three directors relating to consulting services.  During the three months ended March 31, 2018, the Company paid $15,000, $7,500 and $7,500, respectively, to these three directors relating to their consulting services.  

Investment in SutroVax, Inc. (“SutroVax”)

In December 2013, the Company and Johnson & Johnson Innovation, through the Johnson & Johnson Development Corporation, provided initial co-funding for a new company, SutroVax. SutroVax leverages the Company’s proprietary integrated cell-free protein synthesis platform, XpressCF™, to develop novel vaccines for a broad range of disease targets. The Company had $0.3 million and $49,000 in receivables due from SutroVax as of March 31, 2019 and December 31, 2018, respectively, which were included in accounts receivable on the condensed balance sheet.

As of both March 31, 2019 and December 31, 2018, the Company held a 5.6% common stock ownership interest in SutroVax, respectively, on a fully-diluted basis, with a carrying value of $0 and was accounted for under the cost method.

SutroVax qualifies as a variable interest entity. However, the Company maintains only shared power to direct the activities that most significantly impact the performance of SutroVax. Therefore, the Company is not considered the primary beneficiary and consolidation is not required.

See Note 5, SutroVax, Inc. Supply Agreement for discussion of the supply arrangement entered into with SutroVax in May 2018 and related revenue recognized for the three months ended March 31, 2019.

8. Stockholders’ Equity (Deficit)

Common Stock

Holders of common stock are entitled to one vote per share on all matters to be voted upon by the stockholders of the Company.

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The Company had reserved common stock, on an if-converted basis, for issuance as follows:

Preferred Stock

Effective October 30, 2018, the Company had 10,000,000 shares of preferred stock authorized with a par value of $0.001. No shares of preferred stock were outstanding as of March 31, 2019.

Warrants

During the period from 2008 to 2012, the Company issued various warrants for the purchase of redeemable convertible preferred stock in connection with debt financings and the issuance of redeemable convertible preferred stock.

In August 2017, the Company issued warrants to Oxford and SVB to purchase an aggregate of 682,230 shares of Series D-2 redeemable convertible preferred stock at an exercise price of $0.6596 per share in connection with the issuance of the August 2017 Loan. If there was a subsequent convertible preferred stock or other senior equity securities financing with a per share price less than the Series D-2 redeemable convertible preferred per share price, then the warrant would automatically convert to a warrant to purchase such class of shares, based on the per share price of such equity. Given that the price per share of the Series E redeemable convertible preferred stock described above was less than the price per share of the Series D-2 redeemable convertible preferred stock, the 2017 Warrant converted into a warrant to purchase a total of 1,682,871 shares of Series E redeemable convertible preferred stock at an exercise price of $0.2674 per share. The warrant is exercisable from the original date of issuance and has a 10-year term.

The Company adjusted the warrant liability for changes in fair value until the completion of its IPO on October 1, 2018, at which time certain convertible preferred stock warrants were converted into warrants for the purchase of common stock and the related convertible preferred stock warrant liability was reclassified to additional paid-in capital and others expired.  On October 1, 2018, 1,232,220 shares of the Series C redeemable convertible preferred warrants were canceled, and the remaining 687,928 shares were converted to warrants to purchase common stock on a 1-for-0.0370 basis. All Series E redeemable convertible preferred warrants were converted to warrants to purchase common stock on a 1-for-0.0275 basis.

9. Equity Incentive Plans, Employee Stock Purchase Plan and Stock-Based Compensation

2004 Equity Incentive Plan and 2018 Equity Incentive Plan

In September 2018, the Company adopted the 2018 Equity Incentive Plan (“2018 Plan”), which became effective on September 25, 2018. As a result, the Company will not grant any additional awards under the 2004 Equity Incentive Plan (“2004 Plan”). The terms of the 2004 Plan and applicable award agreements will continue to govern any outstanding awards thereunder. In addition to the shares of common stock reserved for future issuance under the 2004 Plan that were added to the 2018 Plan upon its effective date, the Company has initially reserved 2,300,000 shares of common stock for issuance under the 2018 Plan. In addition, the number of shares of common stock reserved for issuance under the 2018 Plan will automatically increase on the first day of January for a period of up to ten years, commencing on January 1, 2019, in an amount equal to 5% of the total number of shares of the Company’s capital stock outstanding on the last day of the preceding year, or a lesser number of shares determined by the Company’s board of directors. As a result, common stock reserved for issuance under the 2018 Plan was increased by 1,142,409 shares on January 1, 2019.  As of March 31, 2019, the Company had 2,742,059 shares available for grant under the 2018 Plan.

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The following table summarizes option activity under the Company’s 2004 Plan and 2018 Plan:

The aggregate intrinsic value was calculated as the difference between the exercise prices of the underlying stock option awards and the estimated fair value of the Company’s common stock on the date of exercise. For the three months ended March 31, 2019, the aggregate intrinsic value of stock options exercised was $46,116, determined at the date of the option exercise. For the three months ended March 31, 2018, the aggregate intrinsic value of stock options exercised was $60,000, determined at the date of the option exercise.

Employee Stock Options Valuation

For determining stock-based compensation expense, the fair-value-based measurement of each employee stock option was estimated as of the date of grant using the Black-Scholes option-pricing model with assumptions as follows:

Using the Black-Scholes option-valuation model, the weighted-average estimated grant-date fair value of employee stock options granted during the three months ended March 31, 2019 was $5.86 per share and during the three months ended March 31, 2018, was $8.39 per share. The total fair value of options vested during the three months ended March 31, 2019 was $1.7 million, and for the three months ended March 31, 2018 was $0.2 million.

Restricted Stock Units

During the three months ended March 31, 2019, the Company granted 154,900 shares of restricted common stock, or RSUs, to certain employees. These RSUs will become fully vested over four years in March 2023.  As of March 31, 2019, no RSUs had vested.

A summary of the status and activity of non-vested RSUs at March 31, 2019 is as follows:

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2018 Employee Stock Purchase Plan

In September 2018, the Company adopted the 2018 Employee Stock Purchase Plan (“ESPP”), which became effective on September 26, 2018, the day that the Form S-1 related to the IPO was declared effective, in order to enable eligible employees to purchase shares of the Company’s common stock.  The Company initially reserved 230,000 shares of common stock for sale under the ESPP. The aggregate number of shares reserved for sale under the ESPP will increase automatically on January 1st of each of the first ten calendar years after the effective date by the number of shares equal to the lesser of 1% of the total outstanding shares of the Company’s common stock as of the immediately preceding December 31 (rounded to the nearest whole share) or a number of shares as may be determined by the Company’s board of directors. As a result, common stock reserved for issuance under the ESPP was increased by 228,481 shares on January 1, 2019.  The aggregate number of shares issued over the term of the Company’s ESPP, subject to stock-splits, recapitalizations or similar events, may not exceed 2,300,000 shares of the Company’s common stock.  The initial ESPP purchase date by the Company’s eligible employees was March 15, 2019.

The fair value of the ESPP shares is estimated using the Black-Scholes option pricing model. For the three months ended March 31, 2019, the fair value of ESPP shares was estimated using the following assumptions:

As of March 31, 2019, 68,910 shares purchase had been made and 389,571 shares were available for future issuance under the ESPP.

Stock-Based Compensation Expense

The Company believes that the fair value of the stock options, RSUs and ESPP shares is more reliably measurable than the fair value of services received.

For the three months ended March 31, 2019 and 2018, the Company recorded $1.7 million and $0.2 million, respectively, of stock-based compensation expense related to the stock options granted under the Company’s Equity Incentive Plans, $0.5 million and none, respectively, of stock-based compensation expense related to the RSUs and $0.1 million and none, respectively, of stock-based compensation expense related to the ESPP.

As of March 31, 2019, unrecognized stock-based compensation expense related to the unvested stock options and RSUs granted was $22.5 million and $5.5 million, respectively. The remaining unrecognized compensation cost is expected to be recognized over a weighted-average period of 3.4 years and 2.7 years, respectively. As of March 31, 2019, there is no unrecognized stock-based compensation expense related to the ESPP.

Total stock-based compensation expense recognized was as follows:

Non-Employee Stock-Based Compensation Expense

The fair value of options granted to non-employees was estimated using the Black-Scholes method. The stock-based compensation expense related to non-employees for the three months ended March 31, 2019 and 2018 was immaterial.

2017 Call Option Plan

In February 2017, the Company adopted a 2017 Call Option Plan to grant selected employees, officers, directors and consultants (collectively, the “Participants”) options to purchase shares of the common stock of SutroVax, an unconsolidated investee of the Company. The Company has reserved 450,000 shares of SutroVax common stock as of

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March 31, 2019 for issuance under the program. The call options vest 25% on each of January 1, 2017, 2018, 2019, and 2020, and expire one year from the vesting date.

Using the Black-Scholes option-valuation model, the call options are measured at fair value on grant date and at each reporting period prior to their vesting, with cost recognized over the requisite service period as compensation cost. Any changes in the fair value subsequent to the vesting date are recognized in other income (expense), net in the statement of operations.  Call options covering 420,000 shares have been granted with an exercise price of $0.76 per share.  As of March 31, 2019, 315,000 of such options had vested, 210,000 were exercised and 105,000 were outstanding and unvested.  As of December 31, 2018, 210,000 of such options had vested and were exercised and 210,000 were outstanding and unvested.  

The amounts recognized as compensation expense related to the 2017 Call Option Plan for the three months ended March 31, 2019 and 2018, respectively, were $18,000 and $15,000.

The amounts recognized as other income (expense) related to the 2017 Call Option Plan for the three months ended March 31, 2019 and 2018, respectively, were $4,000 and zero.       

10. Net Loss Per Share

The following table sets forth the computation of the Company’s basic and diluted net loss per share.

The following common stock equivalents were excluded from the computation of diluted net loss per share for the three months ended March 31, 2019 and 2018, because including them would have been antidilutive:

11. Subsequent Events

As related to the Celgene Agreement discussed in Note 5, Celgene was advancing four preclinical collaboration programs, one of which is an ADC targeting B-cell maturation antigen (“BCMA”) for the treatment of multiple myeloma.  Celgene has worldwide development and commercialization rights with respect to this BCMA ADC.  

The U.S. Food and Drug Administration recently cleared the IND application for the BCMA ADC, which was discovered and manufactured by the Company and which is the first collaboration program IND.  The Company will continue to be responsible for clinical supply manufacturing and certain development services for this BCMA ADC and is eligible to receive from Celgene aggregate development and regulatory contingent payments of up to $275.0 million, if approved in multiple indications, and tiered royalties ranging from mid to high single digit percentages on worldwide sales of any resulting commercial products.  

With respect to the remaining three collaboration programs (BCMA-CD3, PD1-LAG3 and PD1-TIM3), Celgene has decided to not retain the option to acquire U.S. clinical development and commercialization rights to a second

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collaboration program. Celgene is therefore not paying the Company the $12.5 million option maintenance fee due on IND clearance for the first collaboration program, described above.  Consequently, the U.S. clinical development and commercialization rights to the other three collaboration programs remain owned by the Company, without any further option to Celgene.  For any products resulting from these three programs, Celgene will own ex-U.S. development and commercialization rights and will be obligated to pay the Company development and regulatory contingent payments and tiered royalties ranging from mid to high single digit percentages.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion of our financial condition and results of operations in conjunction with our condensed financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2018. In addition to historical financial information, this discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as statements of our plans, objectives, expectations, intentions and belief. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in the section titled “Risk Factors” under Part II, Item 1A below.  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 preclinical and clinical development activities, efficacy and safety profile of our product candidates, use of net proceeds from our public offering, our ability to maintain and recognize the benefits of certain designations received by product candidates, the timing and results of preclinical studies and clinical trials, commercial collaborations with third parties and the receipt and timing of potential regulatory designations, approvals and commercialization of product candidates. The words “believe,” “may,” “will,” “potentially,” “estimate,” “continue,” “anticipate,” “predict,” “target,” “intend,” “could,” “would,” “should,” “project,” “plan,” “expect,” and similar expressions that convey uncertainty of future events or outcomes are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words.

These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements.

Overview

We are a clinical stage drug discovery, development and manufacturing company focused on deploying our proprietary integrated cell-free protein synthesis and site-specific conjugation platform, XpressCF™, to create a broad variety of optimally designed, next-generation protein therapeutics initially for cancer and autoimmune disorders. We aim to design therapeutics using the most relevant and potent modalities, including cytokine-based targets, immuno-oncology, or I/O, agents, antibody-drug conjugates, or ADCs, and bispecific antibodies that are directed primarily against clinically validated targets where the current standard of care is suboptimal. We believe our platform allows us to accelerate the discovery and development of potential first-in-class and best-in-class molecules by enabling the rapid and systematic evaluation of protein structure-activity relationships to create optimized homogeneous product candidates. Our mission is to transform the lives of patients by using our XpressCF™ Platform to create medicines with improved therapeutic profiles for areas of unmet need.

Once identified, production of protein drug candidates can be rapidly and predictably scaled in our current Good Manufacturing Practices compliant manufacturing facility. We have the ability to manufacture our cell-free extract that supports our production of proteins on a large scale using a semi-continuous fermentation process. Our two most advanced product candidates are wholly owned: STRO-001, an ADC directed against CD74, for patients with multiple myeloma and non-Hodgkin lymphoma, or NHL, and STRO-002, an ADC directed against folate receptor-alpha, or FolRα, for patients with ovarian and endometrial cancers. STRO-001 is currently enrolling patients in a Phase 1 trial, with initial safety data expected in mid-2019 and initial efficacy data expected by year end 2019. In October 2018, we were granted Orphan Drug Designation by the U.S. Food and Drug Administration, or FDA, for STRO-001 for the treatment of multiple myeloma. We began enrolling patients in a STRO-002 Phase 1 trial focused on ovarian and endometrial cancers in March 2019, with initial safety data expected by year end 2019. We have also entered into multi-target, product-focused collaborations with leaders in the field of oncology, including a cytokine derivatives collaboration with Merck Sharp & Dohme Corp., a subsidiary of Merck & Co., Inc., Kenilworth, NJ, USA, or Merck, an ADC targeting B-cell maturation antigen, or BCMA, and an immuno-oncology directed alliance with Celgene Corporation, or Celgene, and an oncology-focused collaboration with Merck KGaA, Darmstadt, Germany (operating in the United States and Canada under the name “EMD Serono”).

Since the commencement of our operations, we have devoted substantially all of our resources to performing research and development and manufacturing activities in support of our own product development efforts and those of our collaborators, raising capital to support and expand such activities and providing general and administrative support for these operations. We have funded our operations to date primarily from upfront, milestone and other payments under our collaboration agreements with Merck, Celgene and EMD Serono, the issuance and sale of redeemable convertible preferred stock, our initial public offering, or IPO, of common stock and debt proceeds.

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On October 1, 2018, we closed our IPO and issued and sold an aggregate of 5,667,000 shares of common stock at a price of $15.00 per share for gross proceeds of approximately $85.0 million.  We received net proceeds from the IPO of approximately $74.4 million, after underwriting discounts, commissions and offering expenses. In addition to the shares of common stock sold in the IPO, we concurrently sold in a private placement to Merck, 666,666 shares of common stock at the IPO offering price of $15.00 per share, for proceeds of approximately $10.0 million.  

We have no products approved for commercial sale and have not generated any revenue from commercial product sales. We had a net loss of $14.3 million and $12.0 million for the three months ended March 31, 2019 and 2018, respectively.  Although we had net income for the year ended December 31, 2016 of $1.7 million, we cannot assure you that we will ever have net income again or that we will generate positive cash flow from operating activities. As of March 31, 2019, we had an accumulated deficit of $154.3 million. We do not expect to generate any revenue from commercial product sales unless and until we successfully complete development and obtain regulatory approval for one or more of our product candidates, which we expect will take a number of years. If we obtain regulatory approval for any of our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. We expect our operating expenses to significantly increase as we continue to develop, and seek regulatory approvals for, our product candidates, engage in other research and development activities, expand our pipeline of product candidates, continue to develop our manufacturing facility and capabilities, maintain and expand our intellectual property portfolio, seek regulatory and marketing approval for any product candidates that we may develop, acquire or in-license other assets or technologies, ultimately establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval and operate as a public company. Our net losses may fluctuate significantly from quarter-to-quarter and year-to-year, depending on the timing of our clinical trials, our expenditures on other research and development activities and the timing of achievement, receipt and revenue recognition of upfront, milestones and other collaboration agreement payments.

Recent Developments

As previously disclosed under the amended and restated collaboration and license agreement with Celgene, or Celgene Agreement, Celgene was advancing four preclinical collaboration programs, one of which is an ADC targeting BCMA, for the treatment of multiple myeloma.  Pursuant to the Celgene Agreement, Celgene has worldwide development and commercialization rights with respect to this BCMA ADC.  

The FDA recently cleared the investigational new drug, or IND, application for the BCMA ADC, which was discovered and manufactured by us and which is the first collaboration program IND.  We will continue to be responsible for clinical supply manufacturing and certain development services for this BCMA ADC and are entitled to development and regulatory contingent payments and tiered royalties from Celgene for this BCMA ADC. 

With respect to the remaining three collaboration programs (BCMA-CD3, PD1-LAG3 and PD1-TIM3), Celgene has decided to not retain the option to acquire U.S. clinical development and commercialization rights to a second collaboration program. Celgene is therefore not paying us the $12.5 million option maintenance fee due on IND clearance for the first collaboration program, described above.  Consequently, the U.S. clinical development and commercialization rights to the other three collaboration programs remain owned by us, without any further option to Celgene.  For any products resulting from these three programs, Celgene will own ex-U.S. development and commercialization rights and will be obligated to pay us development and regulatory contingent payments and tiered royalties ranging from mid to high single digit percentage.

Financial Operations Overview

Total Revenue

We have no products approved for commercial sale and have not generated any revenue from commercial product sales. Our total revenue to date has been generated principally from our collaboration and license agreements with Celgene, Merck and EMD Serono, and to a lesser extent, from manufacturing, supply and services and products we provide to Celgene and SutroVax, Inc., or SutroVax.

As described in Note 2 to our Condensed Financial Statements, on January 1, 2019, we adopted ASC 606, Revenue from Contracts with Customers. ASC 606 supersedes the guidance in ASC 605, Revenue Recognition. We adopted ASC 606 on a modified retrospective basis under which we recognized the $10.3 million cumulative effect of adoption as a reduction to the opening accumulated deficit balance. Revenue for the three months ended March 31,2018 was recorded under ASC 605, while revenue for the three months ended March 31, 2019 was recorded under ASC 606. If we had continued to use ASC 605 during 2019, revenue would have been $7.6 million in the three months ended March 31, 2019, as compared to the $8.6 million actually recorded for the period.  

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Collaboration revenue

We derive revenue from collaboration arrangements, under which we may grant licenses to our collaboration partners to further develop and commercialize our proprietary product candidates. We may also perform research and development activities under the collaboration agreements. Consideration under these contracts generally includes a nonrefundable upfront payment, development, regulatory and commercial milestones and other contingent payments, and royalties based on net sales of approved products. Additionally, the collaborations may provide options for the customer to acquire from our materials and reagents, clinical product supply or additional research and development services under separate agreements.

We assess which activities in the collaboration agreements are considered distinct performance obligations that should be accounted for separately. We develop assumptions that require judgement to determine whether the license to our intellectual property is distinct from the research and development services or participation in activities under the collaboration agreements.

At the inception of each agreement, we determine the arrangement transaction price, which includes variable consideration, based on the assessment of the probability of achievement of future milestones and contingent payments and other potential consideration.

For arrangements that include multiple performance obligations, we allocate the transaction price to the identified performance obligations based on the standalone selling price, or SSP, of each distinct performance obligation. In instances where SSP is not directly observable, we develop assumptions that require judgment to determine the SSP for each performance obligation identified in the contract. These key assumptions may include full-time equivalent, or FTE, personnel effort, estimated costs, discount rates and probabilities of clinical development and regulatory success.

Upfront Payments: For collaboration arrangements that include a nonrefundable upfront payment, if the license fee and research and development services cannot be accounted for as separate performance obligations, the transaction price is deferred and recognized as revenue over the expected period of performance using a cost-based input methodology. We use judgement to assess the pattern of delivery of the performance obligation.  In addition, amounts paid in advance of services being rendered may result in an associated financing component to the upfront payment.  Accordingly, the interest on such borrowing cost component will be recorded as interest expense and revenue, based on an appropriate borrowing rate applied to the value of services to be performed by us over the estimated service performance period.

License Grants: For collaboration arrangements that include a grant of a license to our intellectual property, we consider whether the license grant is distinct from the other performance obligations included in the arrangement. For licenses that are distinct, we recognize revenues from nonrefundable, upfront payments and other consideration allocated to the license when the license term has begun and we have provided all necessary information regarding the underlying intellectual property to the customer, which generally occurs at or near the inception of the arrangement.

Milestone and Contingent Payments: At the inception of the arrangement and at each reporting date thereafter, we assess whether it should include any milestone and contingent payments or other forms of variable consideration in the transaction price using the most likely amount method. If it is probable that a significant reversal of cumulative revenue would not occur upon resolution of the uncertainty, the associated milestone value is included in the transaction price. At the end of each subsequent reporting period, we re-evaluate the probability of achievement of each such milestone and any related constraint and, if necessary, adjusts its estimate of the overall transaction price. Since milestone and contingent payments may become payable to us upon the initiation of a clinical study or filing for or receipt of regulatory approval, we review the relevant facts and circumstances to determine when we should update the transaction price, which may occur before the triggering event. When we update the transaction price for milestone and contingent payments, we allocate the changes in the total transaction price to each performance obligation in the agreement on the same basis as the initial allocation. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment, which may result in recognizing revenue for previously satisfied performance obligations in such period. Our collaborators generally pay milestones and contingent payments subsequent to achievement of the triggering event.

Research and development services: For amounts allocated to our research and development obligations in a collaboration arrangement, we recognize revenue over time using a cost-based input methodology, representing the transfer of goods or services as activities are performed over the term of the agreement.

Materials Sales: We provide materials and reagents, clinical materials and services to certain of our collaborators under separate agreements. The consideration for such services is generally based on FTE personnel effort used to manufacture those materials reimbursed at an agreed upon rate in addition to agreed-upon pricing for the provided materials. The amounts billed are recognized as revenue as the performance obligations are met by us.     

Our revenue recognition policies under ASC 605 are described in our Annual Report on Form 10-K for the year ended December 31, 2018.

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Operating Expenses

Research and Development

Research and development expenses represent costs incurred in performing research, development and manufacturing activities in support of our own product development efforts and those of our collaborators, and include salaries, employee benefits, stock-based compensation, laboratory supplies, outsourced research and development expenses, professional services and allocated facilities-related costs. We expense both internal and external research and development costs as they are incurred. Non-refundable advance payments for services that will be used or rendered for future research and development activities are recorded as prepaid expenses and recognized as expenses as the related services are performed.

We expect our research and development expenses to increase in the future as we advance our product candidates into and through preclinical studies and clinical trials, pursue regulatory approval of our product candidates, expand our pipeline of product candidates and continue to develop our manufacturing facility and capabilities. The process of conducting the necessary preclinical and clinical research to obtain regulatory approval is costly and time consuming. The actual probability of success for our product candidates may be affected by a variety of factors including: the safety and efficacy of our product candidates, early clinical data, investment in our clinical programs, the ability of collaborators to successfully develop our licensed product candidates, competition, manufacturing capability and commercial viability. We may never succeed in achieving regulatory approval for any of our product candidates. As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of our product candidates.

The following table summarizes our research and development expenses incurred during the periods indicated. The internal costs include personnel, facility costs and research and scientific related activities associated with our pipeline. The external program costs reflect external costs attributable to our clinical development candidates and preclinical candidates selected for further development. Such expenses include third-party costs for preclinical and clinical studies and research services, and other consulting costs.

General and Administrative

Our general and administrative expenses consist primarily of personnel costs, expenses for outside professional services, including legal, human resource, audit, accounting and tax services and allocated facilities-related costs. Personnel costs include salaries, employee benefits and stock-based compensation. We expect to incur additional expenses operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and listing standards applicable to companies listed on the Nasdaq Global Market, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to increase the size of our administrative function to support the anticipated growth of our business.

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Interest Income

Interest income consists primarily of interest received on our invested funds.

Interest Expense and Other Expense, Net

Interest expense includes interest incurred on our debt and amortization of debt issuance costs. Additionally, under ASC 606, the Company identified a financing component under the Merck 2018 Agreement and recorded interest expense associated with the upfront payment.

Other expense, net in the three months ended March 31, 2019 primarily includes increases from the remeasurement of our derivative liability. In the three months ended March 31, 2018, the remeasurement of our liabilities related to our redeemable convertible preferred stock warrants was zero. We adjusted the liability for changes in estimated fair value until the earlier of the exercise of the warrants, expiration of the warrants, or conversion of the redeemable convertible preferred stock warrants upon the completion of our IPO, into common stock warrants. With the completion of our IPO on October 1, 2018, the redeemable convertible preferred stock warrant liability was reclassified to additional paid-in-capital and we will no longer record any related periodic fair value adjustments.

Comparison of the Three Months Ended March 31, 2019 and 2018

Revenue

We have recognized revenue as follows during the periods indicated:

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Under ASC 606, total revenue increased by $2.8 million, or 49%, during the three months ended March 31, 2019 compared to the three months ended March 31, 2018, due primarily to the inception of the 2018 Merck Agreement which added revenue of $4.6 million, of which $0.5 million represents additional revenue earned under ASC 606, along with a $0.9 million increase in revenue related to the financing component to the upfront payment.  Further, supply and other revenue from SutroVax increased by $0.3 million, and due to the adoption of ASC 606, the Company recorded an additional $0.3 million in license fee and research development services from EMD Serono. This was offset by a $2.5 million decrease in option fees, research and development services, and clinical materials and services from Celgene, of which $0.7 million was due to the change from ASC 605 to ASC 606.

Research and Development Expense

Research and development expense increased by $2.1 million, or 16%, during the three months ended March 31, 2019 compared to the three months ended March 31, 2018. The increase was due primarily to increases of $1.5 million in compensation-related expenses due to higher headcount and $1.0 million in preclinical research and clinical development expenses, of which $0.5 million was related to external clinical trial services for STRO-001 and STRO-002.

General and Administrative Expense

General and administrative expense increased by $3.3 million, or 75%, during the three months ended March 31, 2019 compared to the three months ended March 31, 2018.  The increase was due primarily to increases of $2.4 million in personnel-related expenses, $0.5 million in legal, insurance and external audit fees, and $0.2 million in licenses and other fees associated with being a public company.

Interest Income

Interest income increased by $1.1 million during the three months ended March 31, 2019 compared to the three months ended March 31, 2018, due primarily to a higher cash balance resulting from the proceeds from the Series E financing, the upfront payment received under the 2018 Merck Agreement, and combined net proceeds from the completion of our IPO and the private placement of common stock to Merck.

Interest Expense and Other Expense, Net

Interest expense and other expense, net increased by $0.8 million during the three months ended March 31, 2019 compared to the three months ended March 31, 2018, due primarily to interest expense associated with a financing component under ASC 606 related to the 2018 Merck Agreement.

Liquidity and Capital Resources

Sources of Liquidity

To date, we have incurred net losses, except for 2016, and negative cash flows from operations. Prior to our IPO, our operations have been financed primarily by payments received from our collaborators, net proceeds from the sale and issuance of our preferred stock, and debt proceeds. As of March 31, 2019, we had $184.3 million in cash, cash equivalents and marketable securities, and outstanding debt of $14.3 million, which is net of $0.2 million unamortized debt discount, and an accumulated deficit of $154.3 million.  

Funding Requirements

Based upon our current operating plan, we believe that our existing capital resources will enable us to fund our operating expenses and capital expenditure requirements through at least the next twelve months after the date of this filing. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. We will continue to require additional financing to advance our current product candidates into and through clinical development, to develop, acquire or in-license other potential product candidates, pay our obligations and to fund operations for the foreseeable future.

We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations, strategic alliances, licensing arrangements, marketing and distribution arrangements, or other sources of financing. Adequate additional funding may not be available to us on acceptable terms, or at all. Any failure to raise capital as and when needed could have a negative impact on our financial condition and on our ability to pursue our business plans and strategies, and may cause us to delay, reduce the scope of or suspend one or more of our preclinical and clinical studies, research and development programs or commercialization efforts, and may necessitate us to delay, reduce or terminate planned activities in order to reduce costs. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter

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into additional collaborations with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies.

To the extent we raise additional capital through new collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we do raise additional capital through public or private equity or convertible debt offerings, the ownership interest of our existing stockholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect our stockholders’ rights. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends.  

Cash Flows

The following table summarizes our cash flows during the periods indicated: