1.	Organization and Description of Business

 

Diffusion Pharmaceuticals Inc. (“Diffusion” or the “Company”), a Delaware Corporation, is a clinical stage biotechnology company focused on extending the life expectancy of cancer patients by improving the effectiveness of current standard-of-care treatments, including radiation therapy and chemotherapy. The Company’s lead product candidate, trans sodium crocetinate (“TSC”), uses a novel mechanism to re-oxygenate the microenvironment of solid cancerous tumors, thereby enhancing tumor cells’ response to conventional treatment without additional side effects. TSC has received orphan drug designations for the treatment of glioblastoma multiforme (“GBM”) and metastatic brain cancer. The Company expects to enter a Phase III study in newly diagnosed GBM patients and potentially a Phase II study in patients with pancreatic cancer in the next twelve months, assuming the availability of financial resources.

 

On August 17, 2016, the Company effected a 1-for-10 reverse split of its common stock. Any references in the unaudited condensed consolidated financial statements and related notes to share or per share amounts give retroactive effect to this reverse stock split.

 

On January 8, 2016, the Company completed a merger (the “Merger”) of a wholly-owned subsidiary with Diffusion Pharmaceuticals LLC (“Diffusion LLC”) pursuant to an Agreement and Plan of Merger, dated December 15, 2015, by and among the Company, Arco Merger Sub LLC and Diffusion LLC (the “Merger Agreement”) and, as a result, Diffusion LLC became a wholly-owned subsidiary of the Company.

 

At the effective time of the Merger, each outstanding unit of membership interest of Diffusion LLC (“Diffusion Units”) was converted into the right to receive 0.3652658 shares of the Company’s common stock, as determined pursuant to the Merger Agreement (“Exchange Ratio”). Also at the effective time of the Merger, $1,125,000 of Diffusion LLC convertible notes were outstanding and  the rights of the holders of each outstanding convertible promissory note convertible into Diffusion Units (“Diffusion Convertible Notes”) were converted into the right to convert such securities into a number of shares of the Company’s common stock equal to the number of Diffusion Units into which such Diffusion Convertible Notes would have been convertible under the terms of the note in effect immediately prior to the consummation of the Merger multiplied by the Exchange Ratio. In addition, at the effective time of the Merger and as a result of the Merger, all outstanding options to purchase Diffusion Units were converted into and became options to purchase the Company’s common stock on terms substantially identical to those in effect prior to the effective time of the Merger, except for adjustments to the underlying number of shares and the exercise price based on the Exchange Ratio. As a result of the Merger, at the Effective Time, after taking into account the adjustments to the number of shares and exercise price as a result of the Merger, the Company assumed options to purchase Diffusion Units which converted into options to purchase an aggregate of 1,495,249 shares of the Company’s common stock with a weighted average exercise price of $3.91 per share. No fractional shares of the Company’s common stock were issued in connection with the Merger, and holders of Diffusion Units were eligible to receive cash in lieu thereof.

 

The Merger transaction was accounted for as a reverse acquisition under the acquisition method of accounting. Because Diffusion LLC’s pre-transaction owners held an 84.1% economic and voting interest in the combined company immediately following the closing of the Merger, Diffusion LLC is considered to be the acquirer of the Company for accounting purposes. Accordingly, the historical financial statements of Diffusion LLC became the Company’s historical financial statements including the comparative prior periods. All references in the unaudited interim condensed consolidated financial statements to the number of shares and per-share amounts of common stock have been retroactively restated to reflect the Exchange Ratio.

 

Immediately following the Merger, the holders of the Company’s common stock immediately prior to the Merger held 1,861,503 shares, or approximately 15.9% of the common stock of the combined company, in each case, on a fully-diluted basis (subject to certain exceptions and adjustments).

 

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2.

Liquidity

 

The Company has not generated any revenues from product sales and has funded operations primarily from the proceeds of private placements of its membership units and convertible notes. Substantial additional financing will be required by the Company to continue to fund its research and development activities. No assurance can be given that any such financing will be available when needed or that the Company’s research and development efforts will be successful.

 

The Company regularly explores alternative means of financing its operations and seeks funding through various sources, including public and private securities offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. However, the Company currently does not have any commitments to obtain additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. If the Company cannot obtain funding in the immediate future, it will need to delay, scale back or eliminate some or all of its research and development programs or enter into collaborations with third parties to: commercialize potential products or technologies that it might otherwise seek to develop or commercialize independently; consider various strategic alternatives, including a merger or sale of the Company; or cease operations. If the Company engages in collaborations, it may receive lower consideration upon commercialization of such products than if it had not entered into such arrangements or if it entered into such arrangements at later stages in the product development process.

 

The Company has prepared its financial statements assuming that it will continue as a going concern, which contemplates realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses since inception and it expects to generate losses from operations for the foreseeable future primarily due to research and development costs for its potential product candidates. Various internal and external factors will affect whether and when the Company’s product candidates become approved drugs and how significant their market share will be. The regulatory approval and market acceptance of the Company’s proposed future products (if any), length of time and cost of developing and commercializing these product candidates and/or failure of them at any stage of the drug approval process will materially affect the Company’s financial condition and future operations. The Company believes its cash and cash equivalents at September 30, 2016 are sufficient to fund operations and meet its research and development goals into the early first quarter of 2017.

 

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3.	Basis of Presentation and Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited interim condensed consolidated  financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information as found in the Accounting Standard Codification (“ASC”) and Accounting Standards Updates (“ASUs”) of the Financial Accounting Standards Board (“FASB”), and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (the “SEC”). In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements of the Company include all normal and recurring adjustments (which consist primarily of accruals, estimates and assumptions that impact the financial statements) considered necessary to present fairly the Company’s financial position as of  September 30, 2016, its results of operations for the three and nine months ended September 30, 2016 and 2015 and cash flows for the nine months ended September 30, 2016 and 2015. Operating results for the three and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. The unaudited interim condensed consolidated  financial statements presented herein do not contain the required disclosures under GAAP for annual financial statements. The accompanying unaudited interim condensed consolidated  financial statements should be read in conjunction with the annual audited financial statements and related notes as of and for the year ended December 31, 2015 filed with the SEC on Form 8-K/A on March 25, 2016.

 

The Company’s members’ capital at December 31, 2015 has been recast as common stock and additional paid in capital. On August 17, 2016, the Company effected a 1-for-10 reverse split of its common stock. The accompanying unaudited condensed consolidated financial statements and these notes give retroactive effect to this reverse stock split.

 

Fair Value of Financial Instruments

 

The carrying amounts of the Company’s financial instruments, including cash equivalents, accounts payable, and accrued expenses approximate fair value due to the short-term nature of those instruments. As of September 30, 2016 and December 31, 2015, the fair value of the Company’s outstanding convertible notes was approximately $5,950,000 and $4,800,000, respectively. The fair value of the convertible notes are determined using a binomial lattice model that utilizes certain unobservable inputs that fall within Level 3 of the fair value hierarchy.

 

Cash and Cash Equivalents

 

The Company considers any highly liquid investments, such as money market funds, with original maturities of three months or less to be cash and cash equivalents.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS

   

 

Property and Equipment

 

The Company records property and equipment at cost less accumulated depreciation and amortization. Costs of renewals and improvements that extend the useful lives of the assets are capitalized. Maintenance and repairs are expensed as incurred. Depreciation is recognized on a straight-line basis over the estimated useful lives of the assets, which generally range from five to fifteen years. The Company amortizes leasehold improvements over the shorter of the estimated useful life of the asset or the term of the related lease. Upon retirement or disposition of assets, the costs and related accumulated depreciation and amortization are removed from the accounts with the resulting gains or losses, if any, reflected in results of operations.

 

Long-Lived Assets

 

Long-lived assets are reviewed for potential impairment whenever events indicate that the carrying amount of such assets may not be recoverable. The Company does this by comparing the carrying value of the long-lived assets with the estimated future undiscounted cash flows expected to result from the use of the assets, including cash flows from disposition. If it is determined an impairment exists, the asset is written down to its estimated fair value. The Company has not recognized any impairment of long-lived assets during the nine months ended September 30, 2016.

 

Intangible Assets

 

Intangible assets are comprised of identifiable in-process research and development (“IPR&D”) assets and are considered indefinite-lived intangible assets and are assessed for impairment annually or more frequently if impairment indicators exist. If the associated research and development effort is abandoned, the related assets will be written-off and the Company will record a non-cash impairment loss. For those compounds that reach commercialization, the IPR&D assets will be amortized over their estimated useful lives. In August 2016, the Company abandoned the future development efforts for the IPR&D asset associated with the Company’s RES-440 product candidate, and the value of the IPR&D asset was written down to $0 (See Note 4).

 

Goodwill

 

Goodwill is the excess of the cost of an acquired entity over the net amounts assigned to tangible and intangible assets acquired and liabilities assumed. Goodwill is not amortized, but is subject to an annual impairment test. The Company has a single reporting unit and all goodwill relates to that reporting unit.

 

The Company performs its annual goodwill impairment test on October 1 of its fiscal year or more frequently if changes in circumstances or the occurrence of events suggest that an impairment exists. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the implied fair value of the reporting unit’s goodwill is less than the carrying value of the reporting unit’s goodwill. The Company has not recognized any impairment of goodwill during the nine months ended September 30, 2016.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS

   

 

Research and Development

 

Major components of research and development costs include internal research and development (such as salaries and related employee benefits, equity-based compensation, supplies and allocated facility costs) and contracted services (research and development activities performed on the Company’s behalf). Costs incurred for research and development are expensed as incurred.

 

At the end of the reporting period, the Company compares payments made to third-party service providers to the estimated progress toward completion of the research or development objectives. Such estimates are subject to change as additional information becomes available. Depending on the timing of payments to the service providers and the progress that the Company estimates has been made as a result of the services provided, the Company may record net prepaid or accrued expenses relating to these costs.

 

Upfront milestone payments made to third parties who perform research and development services on the Company’s behalf are expensed as services are rendered.

 

Patent Costs

 

Patent costs, including related legal costs, are expensed as incurred and are recorded within general and administrative expenses in the statements of operations.

 

Income Taxes

 

Prior to the Merger, Diffusion LLC was treated as a partnership for federal and state income tax purposes. Diffusion LLC’s taxable income or loss, as well as certain other tax attributes, were passed through directly to its members and were reported in each member’s individual income tax return.

 

Upon completion of the Merger as discussed in Note 1, the Company converted from a partnership to a corporation for accounting purposes. As a corporation, the Company uses the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. The Company recognizes the benefit of an uncertain tax position that it has taken or expects to take on its income tax return it files, if such a position is more likely than not to be sustained.

 

Debt

 

The current and noncurrent portions of accrued interest related to the Company’s Convertible Notes and 2016 Convertible Notes are included within other accrued expenses and liabilities and other liabilities, respectively, on the accompanying consolidated balance sheets. Debt issuance costs incurred in connection with debt financing arrangements are amortized to interest expense over the life of the respective financing arrangement using the effective interest method.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS

   

 

Stock-Based Compensation

 

The Company measures employee and nonemployee stock-based awards at grant-date fair value and records compensation expense on a straight-line basis over the vesting period of the award. Stock-based awards issued to non-employees are revalued until the award vests. The Company uses the Black-Scholes option pricing model to value its stock option awards. Estimating the fair value of stock option awards requires management to apply judgment and make estimates, including the volatility of the Company’s common stock, the expected term of the Company’s stock options, the expected dividend yield and the fair value of the Company’s common stock on the measurement date. As a result, if factors change and management uses different assumptions, stock-based compensation expense could be materially different for future awards.

 

The expected life of stock options was estimated using the “simplified method” for employee options as the Company has no historical information to develop reasonable expectations about future exercise patterns and post vesting employment termination behavior for its stock option grants. The simplified method is based on the average of the vesting tranches and the contractual life of each grant. For options granted to non-employees, the Company uses the remaining contractual life. For stock price volatility, the Company uses comparable public companies as a basis for its expected volatility to calculate the fair value of option grants. The Company assumes no dividend yield because dividends are not expected to be paid in the near future, which is consistent with the Company’s history of not paying dividends. The risk-free interest rate is based on U.S. Treasury notes with a term approximating the expected life of the option.

 

Net Loss Per Share

 

Basic loss per share is computed by dividing net loss applicable to common stockholders by the weighted average number of shares of common stock outstanding during each period. Diluted loss per share includes the effect, if any, from the potential exercise or conversion of securities, such as convertible debt, warrants, stock options and unvested restricted stock that would result in the issuance of incremental shares of common stock. In computing the basic and diluted net loss per share applicable to common stockholders, the weighted average number of shares remains the same for both calculations due to the fact that when a net loss exists, dilutive shares are not included in the calculation as the impact is anti-dilutive.

 

The following potentially dilutive securities outstanding as of September 30, 2016 and 2015 have been excluded from the computation of diluted weighted average shares outstanding, as they would be anti-dilutive:

 

		September 30,
		2016				2015
Convertible debt			749,280				5,847,645
Common stock warrants			460,721				—
Stock options			2,010,409				1,109,605
Unvested restricted stock awards			10,738				18,410
			3,231,148				6,975,660

 

Amounts in the table reflect the common stock equivalents of the noted instruments.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS

   

 

Recent Accounting Pronouncements

 

In March 2016, the FASB issued ASU 2016-09, Compensation – Improvements to Employee Share-Based Payment Accounting , which simplifies several aspects of the accounting for employee share-based payment transactions including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2016 and interim periods within those years. The Company is evaluating the effect that ASU 2016-09 will have on its condensed consolidated financial statements and related disclosures.

 

In March 2016, the FASB issued ASU 2016-06, Contingent Put and Call Options in Debt Instruments . The FASB issued final guidance clarifying that the assessment of whether an embedded contingent put or call option is clearly and closely related to the debt host only requires an analysis of the four-step decision sequence outlined in ASC 815-15-25-42. Entities are required to apply the guidance to existing debt instruments (or hybrid financial instruments that are determined to have a debt host) using a modified retrospective transition method as of the period of adoption. The guidance is effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted. The Company is evaluating the effect that ASU 2016-06 will have on its condensed consolidated financial statements and related disclosures.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) . The FASB issued the update to require the recognition of lease assets and liabilities on the balance sheet of lessees. The standard will be effective for fiscal years beginning after December 15, 2018, including interim periods within such fiscal years. The ASU requires a modified retrospective transition method with the option to elect a package of practical expedients. Early adoption is permitted. The Company is currently evaluating the potential impact of the adoption of this standard on its consolidated results of operations, financial position and cash flows and related disclosures.

 

In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern . The amendments in this update will explicitly require a company’s management to assess an entity’s ability to continue as a going concern, and to provide related footnote disclosures in certain circumstances. The new standard will be effective in the first annual period ending after December 15, 2016. Early application is permitted. The Company is currently evaluating the potential impact of the adoption of this standard, but believes its adoption will have no impact on its consolidated results of operations, financial position or cash flows.

 

Reclassification

 

Certain prior period balances have been reclassified to conform with the current period presentation.

 

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4.	Acquisition

 

Merger of RestorGenex Corporation and Diffusion Pharmaceuticals LLC

 

On December 15, 2015, the Company, formerly known as RestorGenex Corporation (“RestorGenex”), entered into the Merger Agreement with Diffusion LLC. On January 8, 2016, the Company completed the Merger, with Diffusion LLC surviving as a wholly-owned subsidiary of the Company. Subsequent to the Merger, the Company was renamed “Diffusion Pharmaceuticals Inc.” and the Company’s ticker symbol on the OTC Bulletin Board was changed from “RESX” to “DFFN.” In November 2016, the Company's common stock was approved for listing on the NASDAQ Capital Market and will continue to trade under the ticker symbol "DFFN". Diffusion LLC and RestorGenex entered into the merger agreement in an effort to provide improved access to the capital markets in order to obtain the resources necessary to accelerate development of TSC in multiple clinical programs and continue to build an oncology-focused company.

 

The Merger transaction was accounted for as a reverse acquisition under the acquisition method of accounting. Because Diffusion LLC’s pre-transaction owners held an 84.1% economic and voting interest in the combined company immediately following the completion of the Merger, Diffusion LLC is considered to be the acquirer of RestorGenex for accounting purposes.

 

Each Diffusion Unit was converted into the right to receive 0.3652658 shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”), as determined pursuant to the Exchange Ratio. Additionally, the right of holders of Diffusion Convertible Notes to convert such notes into Diffusion Units was converted into the right to convert such notes into a number of shares of Common Stock equal to the number of Diffusion Units into which such note would have been convertible under the terms of the note in effect immediately prior to the consummation of the Merger multiplied by the Exchange Ratio. In addition, all outstanding options to purchase Diffusion Units were assumed by the Company and the right to exercise converted into stock options to purchase Common Stock on terms substantially identical to those in effect prior to the Merger transaction, except for adjustments to the underlying number of shares and the exercise price based on the Exchange Ratio.

 

In connection with the Merger, the Company’s Board of Directors authorized, declared and effected a distribution of contingent value rights (“CVRs”) to shareholders of the Company as of the close of business on January 7, 2016. Each CVR is a non-transferable right to potentially receive certain cash payments in the event the Company receives net cash payments during the five-year period after the Merger as a result of the sale, transfer, license or similar transaction or any other agreement to the extent relating to the development of the Company’s product currently known as RES-440, a “soft” anti-androgen. See below and Note 11 for additional fair value information.

 

The purchase consideration in a reverse acquisition is determined with reference to the value of equity that the accounting acquirer, Diffusion LLC, would have had to issue to the owners of the accounting acquiree, RestorGenex, to give the pre-acquisition RestorGenex equity holders the same percentage interest in Diffusion LLC that such pre-acquisition RestorGenex equity holders held in the Company immediately following the reverse acquisition. The purchase price was calculated as follows:

 

 

Fair value of RestorGenex shares outstanding		$	19,546,000
Estimated fair value of RestorGenex stock options outstanding			1,321,000
Estimated fair value of RestorGenex warrants outstanding			384,000
CVRs – RES-440 product candidate			10,000
Total preliminary purchase price		$	21,261,000

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS

   

 

The Merger transaction has been accounted for using the acquisition method of accounting, which requires that assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The valuation technique utilized to value the IPR&D was the cost approach.

 

The following table summarizes the preliminary allocation of the purchase price to the assets acquired and liabilities assumed as of the acquisition date:

 

Cash and cash equivalents		$	8,500,602
Prepaid expenses and other assets			195,200
Property and equipment			57,531
Intangible assets			9,600,000
Goodwill			6,929,258
Accrued liabilities			(377,432	)
Deferred tax liability			(3,644,159	)
Net assets acquired		$	21,261,000

 

The above allocation of the purchase price is based on certain preliminary valuations and other analyses that have not been completed as of the date of the filing. Any changes in the estimated fair values of the net assets recorded for the Merger upon the finalization of more detailed analyses of the facts and circumstances that existed at the date of the transaction may change the allocation of the purchase price. As such, the purchase price allocations for this transaction are preliminary estimates, which are subject to change within the measurement period. During the three months ended September 30, 2016, the Company corrected the valuation of the acquired intangible assets and recorded an additional $283,000 and $107,226 to the estimated fair value of acquired intangible assets and deferred tax liability, respectively. As a result, goodwill decreased by $175,773.

 

Qualitative factors supporting the recognition of goodwill due to the Merger include the Company’s anticipated enhanced ability to secure additional capital and gain access to capital market opportunities as a public company and the potential value created by having a more well-rounded clinical development portfolio by adding the earlier stage RestorGenex products to the Company’s later state product portfolio.

 

Intangible assets acquired were as follows:

 

 

 

		Acquisition Date Fair Value				Accumulated Amortization				Impairment Upon Abandonment				Carrying Value at September 30, 2016
RES 529		$	8,639,000			$	-			$	-			$	8,639,000
RES 440			961,000				-				(961,000	)			-
Total in-process research and development costs (IPR&D)		$	9,600,000			$	-			$	(961,000	)		$	8,639,000

 

The Company’s novel PI3K/Akt/mTOR pathway inhibitor, RES-529, is in preclinical development for oncology. Through a series of in vitro and in vivo animal models, RES-529 has been shown to have activity in several cancer types due to its ability to target and inhibit the PI3K/Akt/mTOR signal transduction pathway. RES-529 is a first-in-class inhibitor of both TORC1 and TORC2 that is mechanistically differentiated from other PI3K/Akt/mTOR pathway inhibitors currently in development. RES-529 has shown activity in both in vitro and in vivo glioblastoma animal models and has been demonstrated to be orally bioavailable and can cross the blood brain barrier.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS

   

 

In August 2016, the Board of Directors determined that RES-440, a “soft” anti-androgen compound for the treatment of acne vulgaris, was outside the Company’s core product focus, and was not a priority. Therefore, future development efforts were abandoned in the third quarter of 2016. In connection with its review of such abandonment, the Company concluded RES-440 was impaired in its entirety and the CVRs were remeasured and determined to have no value as of September 30, 2016. The abandonment resulted in a net impairment charge of $951,000 and was recorded as a component of research and development expenses within the Company’s unaudited condensed consolidated statements of operations for the three and nine months ended September 30, 2016. The abandonment also resulted in an income tax benefit of $364,796.

 

Pro Forma Financial Information (Unaudited)

 

The following pro forma financial information reflects the condensed consolidated results of operations of the Company as if the acquisition of RestorGenex had taken place on January 1, 2015. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed date.

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
Net revenues		$	N/A			$	—			$	—			$	—
Net loss		$	N/A			$	(3,576,120	)		$	(13,900,691	)		$	(13,636,471	)
Basic and diluted loss per share		$	N/A			$	(0.87	)		$	(1.36	)		$	(3.31	)

 

Non-recurring pro forma transaction costs directly attributable to the Merger were $1,644,768 for the nine month period ended September 30, 2016 and have been deducted from the net loss presented above. The costs deducted from the nine months ended September 30, 2016 periods included a success fee of $1,000,000 and approximately 46,000 shares of common stock with a fair market value of $487,500 paid to a financial advisor upon the closing of the Merger on January 8, 2016. The three months ended September 30, 2016 are not presented as those results include RestorGenex results. Additionally, the Company incurred approximately $3,000,000 in severance costs as a result of resignations of executive officers immediately prior to the Merger. These costs are excluded from the pro forma financial information for the three and nine months ended September 30, 2016. The Company excluded an $11,100,000 goodwill impairment charge incurred by RestorGenex from the pro forma financial information for the three and nine month periods ended September 30, 2015.

 

5.	Other Accrued Expenses and Liabilities

 

Other accrued expenses and liabilities consisted of the following:

 

		September 30, 2016				December 31, 2015
Accrued interest payable		$	927			$	14,009
Accrued payroll and payroll related expenses			491,678				56,947
Accrued professional fees			142,056				327,950
Accrued clinical studies expenses			326,410				184,737
Other accrued expenses			82,768				38,026
Total		$	1,043,839			$	621,669

 

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6.	Convertible Debt

 

The following table provides the details of the Convertible Notes outstanding at September 30, 2016:

 

Note		Issue Date		Maturity Date		Conversion Price				Interest Rate				Total Principal
2016 Convertible Notes		9/27/2016		9/27/2017		$	3.50				6.00	%		$	1,880,000
Series B Note		3/15/2011		6/30/2018		$	2.74				1.00	%			550,000
Total principal amount														$	2,430,000

 

On September 27, 2016, the Company issued and sold convertible promissory notes (“2016 Convertible Notes”) in an aggregate principal amount of $1,880,000. The 2016 Convertible Notes were issued to an investor and certain other parties in connection with the settlement of a litigation matter (see Note 9). The 2016 Convertible Notes have a term of one year and bear interest at a rate of 6.0% per annum with the principal and accrued interest due upon the earlier of the maturity date or conversion date. At any time prior to the maturity date, the holders may elect to convert, in whole or in part, the 2016 Convertible Notes (including any accrued but unpaid interest) into shares of the Company’s common stock, par value $0.001 per share, at a conversion price of $3.50 per share. In the event of a Change of Control (as defined in the 2016 Convertible Notes), the holders of the 2016 Convertible Notes may declare the aggregate outstanding amount of the 2016 Convertible Notes to be immediately due and payable or may elect to convert the 2016 Convertible Notes and any accrued but unpaid interest as if such conversion took place on the maturity date.

 

The Company accounted for the issuance of the convertible promissory notes in accordance with ASC 470-10-25 and, at the time of issuance, recorded a litigation settlement expense of $2,500,000 which represents the difference between the estimated fair value of the 2016 Convertible Notes issued and the cash received from the noteholders.

 

From December 2009 through December 2015, Diffusion LLC issued unsecured convertible promissory notes (the “Convertible Notes”) for gross proceeds of $22,384,320. The Convertible Notes bear interest at either 1% or 1.5% per annum. The Convertible Notes accrue interest beginning on the date of issuance, with the principal and accrued interest due upon the earlier of the maturity date or conversion date. At any time prior to the maturity date, the holders may elect to convert, in whole or in part, the Convertible Notes and any related accrued but unpaid interest into common stock of the Company at a price per share equal to the conversion price.

 

In the event of a Change of Control or a Qualified Financing (each as defined below), the holders of the Convertible Notes may declare the aggregate outstanding amount of the Convertible Notes to be immediately due and payable or may elect to convert the Convertible Notes and any accrued but unpaid interest as if such conversion took place on the maturity date. A Change of Control is defined as: (i) a merger or consolidation in which the members immediately prior to the transaction do not own, directly or indirectly, more than 50% of the membership interest of the surviving company; (ii) the acquisition of more than 50% of the Company’s outstanding membership interest by a single person, entity or group or persons or entities acting in concert or (iii) the sale or transfer of all or substantially all of the assets of the Company. A Qualified Financing is defined as a sale of units or other transaction that results in gross proceeds to the Company of at least $15,000,000, including the conversion of the Convertible Notes. Through the date the financial statements were available to be issued, there have been no Change of Control or Qualified Financing events.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS  

 

 

The Company may prepay the Convertible Notes, in full or in part, at any time on a pari passu basis. Upon receipt of notice that the Company intends to prepay the Convertible Notes, holders will have the option to convert their notes in lieu of payment.

 

At the effective time of the Merger, $1,125,000 in aggregate principal amount of Convertible Notes were outstanding and  the rights of the holders of each such outstanding Convertible Note convertible into Diffusion Units were converted into the right to convert such securities into a number of shares of the Company’s common stock equal to the number of Diffusion Units such Convertible Note would be convertible into pursuant to its terms multiplied by the Exchange Ratio.

 

During the nine months ended September 30, 2016, the following Convertible Notes and the related accrued interest were converted into 217,122 shares of common stock:

 

Convertible Note Series		Principal				Accrued Interest				Total Principal and Accrued Interest
B		$	20,000			$	962			$	20,962
C			425,000				14,538				439,538
E			50,000				770				50,770
F			200,000				225				200,225
Total		$	695,000			$	16,495			$	711,495

 

During the three and nine months ended September 30, 2015, $54,500 and $1,361 of Series C principal and accrued interest, respectively, were converted into equity.

 

7.	Stockholder’s Equity

 

Common Stock

 

In connection with the reverse merger, as discussed in Note 4, the Company ascribed non-cash consideration of $384,000 to 478,200 warrants outstanding prior to the reverse merger. During the nine months ended September 30, 2016, the Company is deemed to have issued 2,226,698 shares of its common stock of which 1,861,503 are shares held by the former shareholders of RestorGenex immediately prior to the completion of the Merger, 45,643 shares were issued for advisory services provided to Diffusion LLC in connection with the Merger, 102,430 shares were issued for general financial advisory services provided to Diffusion Pharmaceuticals Inc. and 217,122 shares were issued pursuant to conversions of convertible debt as discussed in Note 6. The Company did not purchase or retire any shares of its common stock.

 

Legacy RestorGenex Warrants

 

During the nine months ended September 30, 2016, the Company did not grant any warrants to purchase shares of its common stock and no warrants were exercised. During the nine months ended September 30, 2016, warrants to purchase an aggregate of 17,479 shares of common stock expired unexercised.

 

Warrants to purchase an aggregate of 460,721 shares of the Company’s common stock were outstanding and exercisable as of September 30, 2016, with per share exercise prices ranging from $20.00 to $750.00 and a weighted average exercise price of $54.27 per share.

 

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8.	Stock-Based Compensation

 

Stock-based Compensation

 

Upon consummation of the Merger, all outstanding options to purchase Diffusion LLC units were converted into stock options to purchase the Company’s common stock on terms substantially identical to those in effect prior to the reverse merger, except for adjustments to the underlying number of shares and the exercise price based on the Exchange Ratio. At the time of the Merger, there were 301,156 RestorGenex stock options that were exercisable for shares of the Company’s common stock at a weighted average exercise price of $40.13 per share.

 

The Company recorded stock-based compensation expense in the following expense categories of its unaudited interim condensed consolidated statements of operations for the periods indicated:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
Research and development		$	174,932			$	78,289			$	601,260			$	197,871
General and administrative			215,425				63,119				520,730				176,118
Total stock-based compensation expense		$	390,357			$	141,408			$	1,121,990			$	373,989

 

The following table summarizes the activity related to all stock option grants to employees and non-employees for the nine months ended September 30, 2016:

 

		Number of Options				Weighted average exercise price per share				Weighted average remaining contractual life (in years)
Balance at January 1, 2016			1,495,615			$	3.92
RestorGenex options outstanding			301,156				40.13
Cancelled			(48,190	)			61.30
Granted			261,828				8.89
Outstanding at September 30, 2016			2,010,409			$	8.62				7.6
Exercisable at September 30, 2016			1,357,109			$	9.64				7.1
Vested and expected to vest at September 30, 2016			2,006,156			$	8.62				7.6

 

At September 30, 2016, there was $3,076,088 of unrecognized compensation cost related to non-vested options of which $402,910 is attributable to 67,597 options issued to non-employees and subject to re-measurement until vested. The total unrecognized compensation expense will be recognized as expense over a weighted-average period of 5.9 years.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS  

 

 

Generally, the options have a ten-year term and vest in equal monthly installments over three years. In August 2016, the Company granted an option to purchase 204,907 shares of Common Stock to a new director in connection with his appointment to the board of directors. The options will vest in equal quarterly installments over ten years and any options exercised are restricted from being sold until August 2021. All options granted were valued using the Black-Scholes model and assumptions used to value the options granted during the first nine months of 2016 were as follows:

 

Grant date fair value		$7.30	-	$8.01
Exercise price		$8.75	-	$9.60
Expected term (in years)		5.77	-	7.48
Risk-free interest rate		1.2%	-	1.5%
Expected volatility		106.8%	-	124.0%
Dividend yield			0%

 

 

Restricted Stock Awards

 

As of September 30, 2016, and December 31, 2015, there were 10,738 and 15,341, respectively, unvested shares of restricted stock. During the three and nine months ended September 30, 2016, 1,534 and 4,603 shares vested, respectively, and the Company recognized stock-based compensation expense of $3,024 and $9,057 during the three and nine months ended September 30, 2016, respectively. At September 30, 2016, there was $20,538 of unrecognized compensation cost related to unvested restricted stock that will be recognized as expense over a weighted average period of 1.7 years.

 

2015 Equity Plan

 

The 2015 Equity Plan, as amended in July 2016, currently allows for the issuance of up to a maximum of 500,000 shares of common stock in connection with the grant of stock-based awards, including stock options, restricted stock, restricted stock units, stock appreciation rights and other types of awards as deemed appropriate, not including shares subject to awards assumed in connection with certain transactions, including the Merger. As of September 30, 2016, there were 237,507 shares of common stock available for future issuance under the 2015 Equity Plan. In addition, beginning on January 1, 2017, on each January 1 ^st through the term of the plan, up to 4.0% of the total shares of the Company’s common stock outstanding as of December 31 ^st may be added to the plan reserve upon Board approval.

 

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9.	Commitments and Contingencies

 

Office Space Rental

 

The Company leases office and laboratory facilities in Charlottesville, Virginia under a month-to-month cancelable operating lease. Rent expense related to the operating lease was $18,200 and $16,500 for the three months ended September 30, 2016 and 2015, respectively and $53,500 and $49,500 for the nine months ended September 30, 2016 and 2015, respectively.

 

In connection with the acquisition of RestorGenex in January 2016 (see Note 4), the Company assumed leased office space totaling approximately 2,900 square feet in Buffalo Grove, Illinois. The term of the lease commenced on September 15, 2014 and will continue through February 28, 2018. Rent expense related to the operating lease was $15,300 and $61,000 for the three and nine months ended September 30, 2016, respectively. During the nine months ended September 30, 2016, the Company vacated these leased premises and recorded an associated rent liability pursuant to Accounting Standard Codification Topic 420, Exit or Disposal Cost Obligations (ASC 420) . At September 30, 2016, the rent liability was $19,403 and is included in other liabilities.

 

The Company’s contractual obligations with respect to rental commitment in Illinois as of September 30, 2016 was as follows:

 

 

Legal Proceedings

 

From time to time, the Company is subject to various pending or threatened legal actions and proceedings, including those that arise in the ordinary course of its business, which may include employment matters, breach of contract disputes and stockholder litigation. Such actions and proceedings are subject to many uncertainties and to outcomes that are not predictable with assurance and that may not be known for extended periods of time. The Company records a liability in its unaudited interim condensed consolidated financial statements for costs related to claims, including future legal costs, settlements and judgments, when the Company has assessed that a loss is probable and an amount can be reasonably estimated. If the reasonable estimate of a probable loss is a range, the Company records the most probable estimate of the loss or the minimum amount when no amount within the range is a better estimate than any other amount. The Company discloses a contingent liability even if the liability is not probable or the amount is not estimable, or both, if there is a reasonable possibility that a material loss may have been incurred. In the opinion of management, as of September 30, 2016, the amount of liability, if any, with respect to these matters, individually or in the aggregate, will not materially affect the Company’s unaudited interim condensed consolidated results of operations, financial position or cash flows.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS  

 

 

On August 7, 2014, a complaint was filed in the Superior Court of Los Angeles County, California by Paul Feller, the Company’s former Chief Executive Officer under the caption Paul Feller v. RestorGenex Corporation, Pro Sports & Entertainment, Inc., ProElite, Inc. and Stratus Media Group, GmbH (Case No. BC553996). The complaint asserts various causes of action, including, among other things, promissory fraud, negligent misrepresentation, breach of contract, breach of employment agreement, breach of the covenant of good faith and fair dealing, violations of the California Labor Code and common counts. The plaintiff is seeking, among other things, compensatory damages in an undetermined amount, punitive damages, accrued interest and an award of attorneys’ fees and costs. On December 30, 2014, the Company filed a petition to compel arbitration and a motion to stay the action. On April 1, 2015, the plaintiff filed a petition in opposition to the Company’s petition to compel arbitration and a motion to stay the action. After a hearing for the petition and motion on April 14, 2015, the Court granted the Company’s petition to compel arbitration and a motion to stay the action. On January 8, 2016, the plaintiff filed an arbitration demand with the American Arbitration Association. No arbitration hearing has yet been scheduled. The Company believes this matter is without merit and intends to defend the arbitration vigorously. Because this matter is in an early stage, the Company is unable to predict its outcome and the possible loss or range of loss, if any, associated with its resolution or any potential effect the matter may have on the Company’s financial position. Depending on the outcome or resolution of this matter, it could have a material effect on the Company’s financial position.

 

On September 21, 2015, David Schmidt, a former member of Diffusion LLC and current stockholder of the Company, filed suit (the “Original Complaint”) in the Circuit Court for Albemarle County, Virginia (Case. No. CL15-791, David G. Schmidt v. Diffusion Pharmaceuticals LLC), which Complaint was amended on April 14, 2016 (the “Amended Complaint”).  In December 2009, Mr. Schmidt purchased a $1.5 million convertible promissory note from Diffusion LLC which he elected to immediately convert in full into membership units at the contractual per-unit conversion price of $3.50. In 2012, Diffusion LLC negotiated a reduction of the conversion price, from $3.50 to $1.00, with respect to the notes in such series that remained outstanding at such time. The Original Complaint alleged that this renegotiation represented a breach of contract with respect to Mr. Schmidt’s previously converted convertible note, and requested relief of specific performance requiring Diffusion LLC to issue him an additional 1,071,432.50 units, representing the additional number of units he would have received had he converted at the renegotiated conversion price. The claim was dismissed on March 14, 2016 for failure to state a viable cause of action, but Mr. Schmidt was given 21 days to file an amended complaint. The Amended Complaint alleged that Mr. Schmidt was denied the opportunity to exercise preemptive rights under Diffusion LLC’s Operating Agreement to purchase the additional 1,071,432.50 units for $1 per unit.  The sole relief sought by Mr. Schmidt was an order of specific performance requiring the Company to issue him 391,358 shares of the Common Stock (the equivalent of 1,071,432.50 Diffusion Units multiplied by the Exchange Ratio) in exchange for his payment of $1,071,432.50. 

 

On September 27, 2016, the Company, Diffusion LLC, Mr. Schmidt and the other parties thereto entered into a Settlement Agreement (the “Settlement Agreement”) pursuant to which, among other things, (i) Mr. Schmidt and Diffusion each agreed to submit a consent order to the Court dismissing all claims set forth in the Amended Complaint with prejudice and without an admission of liability by any party, (ii) Mr. Schmidt and Diffusion each released, on behalf of such party and its heirs, assigns, representatives, affiliates and agents, all claims and causes of action of any nature against the other party existing as of the date of the Settlement Agreement and (iii) as consideration therefor, the Company agreed to issue and sell, to Mr. Schmidt and the other parties to the Settlement Agreement, the 2016 Convertible Notes in an aggregate principal amount of $1,880,000.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS  

 

 

The Company recognized a litigation settlement charge of $2,500,000 which represents the difference between the fair value of the 2016 Convertible Notes issued and the cash received from Mr. Schmidt and other parties. The settlement charge was recorded as a component of general and administrative expenses within the Company’s unaudited condensed consolidated statements of operations for the three and nine months ended September 30, 2016.

 

10.	Income Taxes

 

Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect for years in which differences are expected to reverse.  A deferred tax liability of $3,644,159 was recorded for the basis differences associated with indefinite-lived in-process R&D assets.  Due to their indefinite-lived treatment, the related deferred tax liabilities are not expected to reverse in a period that would support the realization of the Company’s deferred tax assets.  The Company maintains a valuation allowance against its deferred tax assets.  In August 2016, the Company abandoned future development efforts for the IPR&D asset associated with RES-440 and recorded an impairment charge of $961,000 which is equal to its acquired value. Upon recognizing the impairment, the Company recognized an income tax benefit of $364,796 and reduced the carrying value of the related deferred tax liability as of September 30, 2016 (Note 4).

 

The Company has incurred net operating losses for federal and state income tax purposes since inception.  The Tax Reform Act of 1986 (the “Act”) provides for limitation on the use of net operating loss and research and development tax credit carryforwards following certain ownership changes (as defined in the Act) that could limit the Company’s ability to utilize these carryforwards.  The Company may have experienced various ownership changes as a result of past financings and acquisitions. Accordingly, the Company’s ability to utilize the aforementioned carryforwards may be limited.  Additionally, U.S. tax laws limit the time during which these carryforwards may be applied against future taxes; therefore, the Company has determined it is more likely than not that these net operating losses will not be realized.

 

11.	Fair Value Measurements

 

Certain assets and liabilities are carried at fair value under GAAP. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. Financial assets and liabilities carried at fair value are to be classified and disclosed in one of the following three levels of the fair value hierarchy, of which the first two are considered observable and the last is considered unobservable:

 

●

Level 1—Quoted prices in active markets for identical assets or liabilities.

 

●

Level 2—Observable inputs (other than Level 1 quoted prices), such as quoted prices in active markets for similar assets or liabilities, quoted prices in markets that are not active for identical or similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data.

 

●

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to determining the fair value of the assets or liabilities, including pricing models, discounted cash flow methodologies and similar techniques.

 

 

DIFFUSION PHARMACEUTICALS INC.  

 

NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS  

 

 

The asset’s or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.

 

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis:

 

		September 30, 2016
		(Level 1)				(Level 2)				(Level 3)
Assets
Cash and cash equivalents		$	3,021,388			$	—			$	—

 

 

		December 31, 2015
		(Level 1)				(Level 2)				(Level 3)
Assets
Cash and cash equivalents		$	1,997,192			$	—			$	—

 

 

Contingent Value Rights Distribution

 

In December 2015, the Company’s Board of Directors authorized, declared and effected a distribution of the CVRs to shareholders of the Company as of the close of business on January 7, 2016 (the “CVR Record Date”) at a rate of one CVR for each share of Common Stock. The CVRs, which are not certificated and not attached to the shares of Common Stock, were payable immediately prior to the effective time. Each CVR represents a non-transferable right (subject to certain limited exceptions) to potentially receive certain cash payments in the event the Company receives net cash payments during the five-year period after the Merger as a result of the sale, transfer, license or similar transaction relating to the Company’s product currently known as RES-440, which is a “soft” anti-androgen, upon the terms and subject to the conditions set forth in a contingent value rights agreement, dated January 8, 2016, between the Company and Computershare, Inc., as rights agent (the “CVR Agreement”). The aggregate cash payments to be distributed to the holders of the CVRs, if any, will be equal to the amount of net cash payments received by the Company as a result of the sale, transfer, license or similar transaction relating to RES-440, as determined pursuant to the CVR Agreement, but will not exceed $50,000,000 in the aggregate. Any option or warrant holder of the Company as of the record date for the CVRs would, at the time of exercise, be entitled to receive one CVR for each share of the Company’s common stock issued upon the future exercise of the option or warrant, which would entitle the holder to a pro rata portion of any CVR payments made after the date of exercise.

 

In connection with the abandonment of the RES-440 IPR&D asset (see Note 4), the Company remeasured the value of each CVR and as of September 30, 2016, determined the CVRs have no value.

 

The reconciliation of the contingent consideration liability measured at fair value on a recurring basis using significant unobservable inputs (Level 3) is as follows:

 

		Contingent Consideration
Issued in connection with the Merger transaction		$	10,000
Change in fair value upon abandonment of RES-440			(10,000	)
Balance at September 30, 2016		$	—

 

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