UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

For the quarterly period ended June 30, 2018

 

OR

 

 

For the transition period from            to

 

Commission file number: 1-33818

 

 

RESHAPE LIFESCIENCES INC.

(Exact name of registrant as specified in its charter)

 

 

 

1001 Calle Amanecer, San Clemente, California 92673
(Address of principal executive offices, including zip code)

 

(949) 429-6680
(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or 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 and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted 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 and post such files).    Yes  ☒    No  ☐ 

 

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

 

 

If an emerging growth company, indicate by check mark whether the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards 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  ☒

As of August 10, 2018, 9,013,421 shares of the registrant’s Common Stock were outstanding.

 

 

 

 

 

 

INDEX

 

 

Registered Trademarks and Trademark Applications: In the United States we have registered trademarks for vBLOC®, ENTEROMEDICS®, MAESTRO®,  RESHAPE®, RESHAPE DUO®, and RESHAPE MEDICAL®,  each registered with the United States Patent and Trademark Office, and trademark applications for RESHAPE vBLOC, RESHAPE VEST, RESHAPE LIFESCIENCES AND DESIGN, and RESHAPE BALLOON & COLOR DESIGN. In addition, some or all of the marks vBLOC, ENTEROMEDICS, MAESTRO, MAESTRO SYSTEM ORCHESTRATING OBESITY SOLUTIONS, vBLOC POWER TO CHOOSE, vBLOC POWER TO CHOOSE AND DESIGN, RESHAPE, RESHAPE DUO, and RESHAPE MEDICAL are the subject of either a trademark registration or application for registration in Australia, Brazil, Canada, China, the European Community, India, Kuwait, Mexico, Saudi Arabia, Switzerland and the United Arab Emirates. We believe that we have common law trademark rights to RESHAPE VEST. This Quarterly Report on Form 10-Q may contain other trade names and trademarks and service marks of ReShape Lifesciences and of other companies.

 

 

 

 

PART I – FINANCIAL INFORMATION

 

ITEM 1.        CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

RESHAPE LIFESCIENCES INC.

Condensed Consolidated Balance Sheets

(Unaudited)

 

 

See accompanying notes to condensed consolidated financial statements.

 

RESHAPE LIFESCIENCES INC.

Condensed Consolidated Statements of Operations

(Unaudited)

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

 

 

RESHAPE LIFESCIENCES INC.

Condensed Consolidated Statements of Cash Flows 

(Unaudited)

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

 

 

ReShape Lifesciences Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

(1)  Summary of Significant Accounting Policies

 

Description of Business

ReShape Lifesciences Inc. (the Company) is focused on the design, development and commercialization of transformative technology to treat obesity and metabolic diseases. The Company was incorporated in the state of Minnesota on December 19, 2002, originally as two separate legal entities, Alpha Medical, Inc. and Beta Medical, Inc., both of which were owned 100% by a common stockholder. Effective October 1, 2003, the two entities were combined and the combined entity changed its name to EnteroMedics Inc. The Company reincorporated in Delaware on July 22, 2004. The Company has devoted substantially all of its resources to recruiting personnel, developing its product technology, obtaining patents to protect its intellectual property, commercialization activities and raising capital and has commenced commercial operations in the United States deriving revenues from its primary business activity in 2015 with the vBloc System (ReShape vBloc). On May 22, 2017, the Company acquired BarioSurg, Inc. (BarioSurg), a company developing the Gastric Vest System (ReShape Vest) and on October 2, 2017 it acquired ReShape Medical, Inc. (ReShape Medical), a company that develops, manufactures and markets a minimally invasive intragastric balloon (ReShape Balloon) designed to treat certain obesity patients. ReShape Medical LLC became a wholly-owned subsidiary of the Company on October 2, 2017 and its balance sheet and statement operations for the period October 2, 2017 through December 31, 2017 are included with the Company's 2017 consolidated financial statements.  Subsequent to the acquisition of ReShape Medical, the Company changed its name to ReShape Lifesciences Inc. and relocated its headquarters from St. Paul, Minnesota to San Clemente, California.

 

Risks and Uncertainties  

The Company is focused on the design, development and commercialization of transformative technology to treat obesity and metabolic diseases and its growing and differentiated product portfolio is utilized by bariatric surgeons, general surgeons, and gastroenterologists.  We believe obesity is a global epidemic and that the majority of patients need treatment options that are anatomy friendly and provide for weight loss and comorbidity improvements along with long-term, ongoing obesity support and prevention. 

We have a limited operating history and the Company's products require approval from the U.S. Food and Drug Administration (FDA) or corresponding foreign regulatory agencies prior to commercial sales. On January 14, 2015, the vBloc® System, our initial product, which we now refer to as ReShape vBloc, received U.S. Food and Drug Administration (FDA) approval for vBloc Therapy, delivered via the ReShape vBloc.  vBloc Therapy is delivered via a pacemaker-like device that helps patients feel full and eat less by intermittently blocking hunger signals on the vagus nerve.  Our therapy limits the expansion of the stomach, helps control hunger sensations between meals, reduces the frequency and intensity of stomach contractions and produces a feeling of early and prolonged fullness.

On May 22, 2017 the Company acquired the Gastric Vest System (ReShape Vest) through the acquisition of BarioSurg, Inc. The ReShape Vest is an investigational, minimally invasive, laparoscopically implanted medical device being studied for weight loss in obese and morbidly obese patients. The ReShape Vest wraps around the stomach after it has been rearranged into a banana-like shape using sutures, emulating the effect of conventional weight-loss surgery, and is intended to enable gastric volume reduction without permanently changing patient anatomy.

On October 2, 2017 the Company acquired ReShape Medical, a privately-held medical technology company that develops, manufactures and markets the ReShape® Dual Weight Loss Balloon (the ReShape Balloon), an FDA-approved, minimally invasive intragastric balloon designed to treat obesity patients with a body mass index (BMI) between 30 and 40, with one or more related comorbid conditions.  

 

The medical device industry is characterized by frequent and extensive litigation and administrative proceedings over patent and other intellectual property rights. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often difficult to predict, and the outcome may be uncertain until the court has entered final judgment and all appeals are exhausted. The Company’s competitors may assert that its products or the use of the Company’s products are covered by U.S. or foreign patents held by them.

 

The Company’s activities are subject to significant risks and uncertainties, including the ability to obtain additional financing, and there can be no assurance that the Company will be successful in obtaining additional financing on favorable terms, or at all. If adequate funds are not available, the Company may have to further reduce its cost structure until financing is obtained and/or delay development or commercialization of products or license to third parties the rights to commercialize products or technologies that the Company would otherwise seek to commercialize.

 

After the close of market on June 1, 2018, the Company effected a 1-for-15 reverse split of the Company’s outstanding common stock (the “Reverse Stock Split”). As a result of the Reverse Stock Split, each 15 shares of issued and outstanding common stock and equivalents was converted into one share of common stock. Any fractional shares of common stock resulting from the Reverse Stock Split were rounded up to the nearest whole share. As a result of the Reverse Stock Split, proportional adjustments were made to the number of shares of common stock issuable upon exercise or conversion, and the per share exercise or conversion price, of the Company’s outstanding warrants, stock options and convertible preferred stock, in each case in accordance with their terms. The Reverse Stock Split did not reduce the number of authorized shares of common stock and preferred stock of the Company. Therefore, the effect of the Reverse Stock Split was to increase the number of shares of common stock and preferred stock available for issuance relative to the number of shares issued and outstanding. The Reverse Stock Split did not alter the par value of the common stock or preferred stock or modify any voting rights or other terms of the common stock or any series of preferred stock.

 

All share and per-share amounts have been retroactively adjusted to reflect the Reverse Stock Split for all periods presented herein.

 

Basis of Presentation

 

The Company has prepared the accompanying condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. The Company’s fiscal year ends on December 31.

 

The accompanying condensed consolidated financial statements and notes thereto are unaudited. In the opinion of the Company’s management, these statements include all adjustments, which are of a normal recurring nature, necessary to present a fair presentation. Interim results are not necessarily indicative of results for a full year. The condensed consolidated balance sheet as of December 31, 2017 was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The information included in this Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

 

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

Principles of Consolidation

 

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and accounts have been eliminated in consolidation.

 

Fair Value of Financial Instruments

 

Carrying amounts of certain of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable and accrued liabilities approximate fair value due to their short maturities.  Certain of the Company’s common stock warrants are required to be reported at fair value. The fair values of common stock warrants and investments in debt and equity securities, if any, are disclosed in Note 5 – Fair Value Measurements. 

 

Common Stock Warrant Liability

 

Common stock warrants that were issued in connection with the July 8, 2015 public offering (the Series A Warrants) are classified as a liability in the condensed consolidated balance sheets. The fair value of these common stock warrants is re-measured at each financial reporting period and immediately before exercise, with any changes in fair value being recognized as a component of other income (expense) in the condensed consolidated statements of operations.

 

Cash and Cash Equivalents

 

The Company considers highly liquid investments generally with maturities of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. The Company’s cash equivalents are primarily in money market funds and certificates of deposit. The Company deposits its cash and cash equivalents in high-quality credit institutions.

 

Inventory

 

The Company accounts for inventory at the lower of cost or market and records any long-term inventory as other assets in the condensed consolidated balance sheets. The Company establishes inventory reserves for obsolescence based upon projected sales and for defect based upon specific identification of defective or unsalable units.

 

 

 

Property and Equipment, Net

 

Property and equipment are stated at cost less accumulated depreciation. Depreciation of property and equipment is computed using the straight-line method over their estimated useful lives of five to seven years for furniture and equipment and three to five years for computer hardware and software. Leasehold improvements are amortized on a straight-line basis over the lesser of their useful life or the term of the lease. Upon retirement or sale, the cost and related accumulated depreciation or amortization are removed from the condensed consolidated balance sheets and the resulting gain or loss is reflected in the condensed consolidated statements of operations. Repairs and maintenance are expensed as incurred.

 

Impairment of Long-Lived Assets, Intangible Assets and Goodwill

The Company evaluates its long-lived assets, including its finite-lived intangible assets, for impairment by comparison of the carrying amounts to future net undiscounted cash flows expected to be generated by such assets when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Should an impairment exist, the impairment loss would be measured based on the excess carrying value of the asset over the asset's fair value or estimates of future discounted cash flows.

For goodwill and indefinite-lived intangible assets, in-process research and development, the Company reviews for impairment annually and upon the occurrence of certain events as required by Accounting Standards Codification ("ASC") Topic 350, "Intangibles - Goodwill and Other." Goodwill and indefinite-lived intangible assets are tested at least annually for impairment and more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company reviews goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the Company is able to determine that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, the Company would conclude that goodwill is not impaired.  If the carrying amount of the reporting unit exceeds the estimated fair value of the reporting unit, a non-cash goodwill impairment loss is recognized as an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized will not exceed the total amount of goodwill allocated to that reporting unit.

The Company recorded $27.2 million for goodwill impairment losses for the three and six months ended June 30, 2018.  See Note 4 for additional information.

 

Income Taxes

 

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the 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 tax credit carry-forwards. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance for deferred income tax assets is recorded when it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The Company has provided a full valuation allowance against the net deferred tax assets, excluding indefinite-lived deferred tax assets and liabilities, as of June 30, 2018 and December 31, 2017. The Company’s policy is to classify interest and penalties related to income taxes as income tax expense in the condensed consolidated statements of operations.

 

Comprehensive Loss

 

Comprehensive loss is defined as the change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investment owners and distributions to owners. There was no difference from reported net loss for the three and six months ended June 30, 2018 and 2017.

 

Research and Development Expenses

 

Research and development expenses are charged to expense as incurred. Research and development expenses include, but are not limited to, product development, clinical trial expenses, including supplies, devices, explants and revisions, quality assurance, regulatory expenses, payroll and other personnel expenses, materials and consulting costs.

 

Patent Costs

Costs associated with the submission of a patent application are expensed as incurred given the uncertainty of the patents resulting in probable future economic benefits to the Company. 

Stock-Based Compensation

 

The Company recognized stock-based compensation expense associated with stock options and other stock-based awards in accordance with the authoritative guidance for stock-based compensation. The cost of a stock-based award is measured at the grant date based on the estimated fair value of the award, and is recognized as expense on a straight-line basis over the requisite service period of the award. The fair value of stock options is estimated using the Black-Scholes option valuation model, which requires the input of subjective assumptions, including price volatility of the underlying stock, risk-free interest rate, dividend yield, and expected life of the option.

 

 

 

Net Loss Per Share

 

Basic net loss per share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period. Diluted net loss per share is based on the weighted-average common shares outstanding during the period plus dilutive potential common shares calculated using the treasury stock method. Such potentially dilutive shares are excluded when the effect would be to reduce a net loss per share. The Company’s potential dilutive shares, which include outstanding common stock options and warrants, have not been included in the computation of diluted net loss per share for all periods as the result would be anti-dilutive. In addition, earnings per share calculations include the effects of anti-dilution adjustments to warrant exercise prices and convertible preferred stock conversion prices on the net loss attributable to common shareholders.

 

The following table sets forth the computation of basic and diluted net loss per share for the three and six months ended June 30, 2018 and 2017:

 

The following table sets forth the potential shares of common stock that are not included in the calculation of diluted net loss per share because to do so would be anti-dilutive as of the end of each period presented:

 

 

Segment Reporting

Operating segments are defined as components of an enterprise for which discrete financial information is available that is evaluated regularly by the chief operating decision maker ("CODM") in deciding how to allocate resources and in assessing performance. Our CODM is the Chief Executive Officer.

Under the provisions of Accounting Standards Codification (“ASC”) 280, Segment Reporting, we have determined that we have one operating segment related to the design, development and commercialization of transformative technology to treat obesity and metabolic diseases. The CODM evaluates operating performance and allocates resources on a total portfolio basis.  

 

Recently Issued or Adopted Accounting Standards

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The standard’s core principle is that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The Company adopted the standard on January 1, 2018 using the modified retrospective method applied to those contracts which were not completed as of December 31, 2017. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior-period amounts have not been retrospectively adjusted and continue to be reported in accordance with Topic 605, Revenue Recognition. Based upon the Company’s contracts which were not completed as of December 31, 2017, the Company was not required to make an adjustment to the opening balance of retained earnings as of January 1, 2018. See Note 8 – Revenue Recognition for further discussion.

In February 2016 FASB issued ASU No. 2016-02 Leases (Topic 842) that changes the recognition of lease assets and lease liabilities by lessees for those leases classified as operating lease. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for a public business entity. Early adoption is permitted. Management is evaluating the standard's impact on the consolidated financial statements.

In January 2017 FASB issued ASU No. 2017-04 Intangibles-Goodwill and Other (Topic 350) Simplifying the Test for Goodwill Impairment. Under the amendments in this update an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss

recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The amendments in this Update are required for public business entities in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company adopted the standard during the second quarter of 2018. Please refer to Note 4 – Goodwill and Other Intangible Assets for further discussion.

In March 2018, FASB issued ASU No. 2018-05, Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118.  The ASU updates the income tax accounting in U.S. GAAP to reflect the SEC interpretive guidance released on December 22, 2017, when the legislation referred to as the Tax Cuts and Jobs Act (the "2017 Tax Act") was signed into law.  We have adopted this ASU, as further discussed in Note 12 – Income Taxes.

There have been no other significant changes in recent accounting pronouncements during the six months ended June 30, 2018 as compared to the recent accounting pronouncements described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

(2)  Liquidity and Management’s Plans

 

The accompanying condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern. The Company currently is not generating revenue from operations that is sufficient relative to its level of operating expenses for at least the next several years. The Company has financed its operations to date principally through the sale of equity securities and debt financing. The Company’s history of operating losses, limited cash resources and lack of certainty regarding obtaining significant third-party reimbursement for its product portfolio, raise substantial doubt about its ability to continue as a going concern absent a strengthening of its cash position.

 

On April 3, 2018, the Company completed a registered direct offering of 6,000 shares of series D convertible preferred stock and a warrant to purchase shares of common stock for gross proceeds of $6.0 million, prior to deducting underwriting discounts and commissions and offering expenses of $750,000. 

 

On May 24, 2018, the Company entered into an agreement with an institutional investor pursuant to which the investor exercised all of its outstanding warrants to purchase common stock of the Company that were issued by the Company in January 2017 and some of its warrants to purchase common stock of the Company that were issued in April 2018 in exchange for Company’s agreement to reduce the exercise price of the warrants to the closing price of the Company’s common stock on the date of the agreement. This resulted in gross proceeds to the Company of $488,250, prior to deducting placement agent fees and other offering expenses of $39,000.

 

On June 8, 2018, the Company completed a registered direct offering priced at-the-market of 374,572 shares of its common stock, at a purchase price per share of $3.92, for gross proceeds of approximately $1.47 million. Additionally, the Company issued to the investors unregistered warrants to purchase up to 280,929 shares of common stock, at a purchase price per warrant of $0.125, for gross proceeds of approximately $0.03 million. The placement agent fees and other offering expenses were approximately $200,000.

 

On June 21, 2018 the Company completed a registered direct offering priced at-the-market of 469,490 shares of its common stock, at a purchase price per share of $3.07, for gross proceeds of approximately $1.44 million. Additionally, the Company issued to the investors unregistered warrants to purchase up to 469,490 shares of common stock, at a purchase price per warrant of $0.125, for gross proceeds of approximately $0.06 million. The placement agent fees and other offering expenses were approximately $200,000. We used $500,000 of the proceeds to redeem a portion of the outstanding shares of our series D convertible preferred stock.

 

On July 12, 2018, the Company completed a registered direct offering priced at-the-market of 1,241,382 shares of its common stock, at a purchase price per share of $2.05, for gross proceeds of approximately $2.55 million. Additionally, the Company issued to the investors unregistered warrants to purchase up to 1,241,382 shares of common stock, at a purchase price per warrant of $0.125, for gross proceeds of approximately $0.15 million. The placement agent fees and other offering expenses were approximately $205,000. For additional details, see Note 13-Subsequent Events.

 

On August 3, 2018, the Company completed a registered direct offering of 1,000,000 shares of its common stock, at a purchase price per share of $0.60, for gross proceeds of approximately $0.6 million. Additionally, the Company issued to the investors unregistered warrants to purchase up to 1,000,000 shares of common stock. The placement agent fees and other offering expenses were approximately $350,000.  For additional details, see Note 13-Subsequent Events.

 

As of June 30, 2018, the Company had $1.9 million of cash and cash equivalents available to fund its operations.

 

The Company’s anticipated operations include plans to (i) expand the controlled commercial launch of vBloc Therapy, delivered via the vBloc System, (ii) continue development of the ReShape Vest, (iii) seek opportunities to leverage the Company’s intellectual property portfolio and custom development services to provide third party sales and licensing opportunities, and (iv) explore and capitalize on synergistic opportunities to expand our portfolio and offer future minimally invasive treatments and therapies in the obesity continuum of care. The Company believes that it has the flexibility to manage the growth of its expenditures and operations depending on the amount of available cash flows, which could include reducing expenditures for marketing, clinical and product development activities.   The Company has additionally committed to reducing its operating spending to conserve resources. However, the Company will ultimately need to achieve sufficient revenues from product sales and obtain additional debt or equity financing to support its operations.

 

Management is currently pursuing various funding options, including seeking additional equity financing as well as a strategic merger or other transaction to obtain additional funding. As of August 10, 2018, the Company’s public float exceeded $75 million, based on the number of shares of our common stock held by non-affiliates outstanding on August 10, 2018 and the highest closing price of our common stock within the 60 days prior to August 10, 2018. Therefore, the Company is no longer subject to General Instruction I.B.6 of Form S-3, which limits the aggregate market value of the securities sold by or on behalf of the registrant during the 12-month period immediately prior to and including the date of the sale to no more than one-third of all common voting and nonvoting equity held by non-affiliates of the registrant. The Company will reevaluate its public float at the time it files its annual report on Form 10-K for the fiscal year ending December 31, 2018 to determine if it will become subject to General Instruction I.B.6 at that time. While there can be no assurance that the Company will be successful in its efforts, the Company has a long history of raising equity financing to fund its development activities. Should the Company be unable to obtain adequate financing in the near term, the Company’s business, result of operations, liquidity and financial condition would be materially and negatively affected, and the Company would be unable to continue as a going concern. Additionally, there can be no assurance that, assuming the Company is able to strengthen its cash position, it will achieve sufficient revenue or profitable operations to continue as a going concern.

 

 

(3)  Acquisitions

BarioSurg, Inc.

On May 22, 2017, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") to acquire all of the ownership interests of BarioSurg, Inc. ("BarioSurg"), a company developing the Gastric Vest System (which we now refer to as the “ReShape Vest”), an investigational, minimally invasive, laparoscopically implanted medical device being studied for weight loss in obese and morbidly obese patients. 

The consideration paid by the Company for all of the outstanding shares of capital stock and outstanding options of BarioSurg consisted of: (i) 92,000 shares of common stock, par value $0.01 per share, of the Company ("Company Common Stock"), (ii) 1.0 million shares of newly created conditional convertible preferred stock, par value $0.01 per share, of the Company ("Company Preferred Stock"), which shares were converted into 333,334 shares of Company Common Stock on October 25, 2017 upon the post-closing approval of the Company's stockholders in accordance with the Nasdaq Stock Market Rules, and (iii) $2.0 million in cash.  The total consideration paid by the Company, preliminarily valued at $28.3 million, includes: (a) $2.0 million in cash paid from our existing cash balances and (b) $26.3 million from the issuance of Company Common Stock and Company Preferred Stock.  The preliminary valuation of the Company Common Stock and Company Preferred Stock took into account (i) the conversion ratio of the Company Preferred Stock, (ii) the closing prices of our common stock on the Nasdaq Stock Market on the date the transaction was announced and the three trading days following the announcement, and (iii) a 19% discount for lack of marketability related to the shares issued in the transaction.

The purchase price consideration of $28.3 million does not include expenses for legal, accounting, audit, valuation and other services that were incurred after the May 22, 2017 acquisition date and were expensed as incurred.

The following table summarizes the fair values of the assets acquired and liabilities assumed as a result of the BarioSurg acquisition.  The excess of the cost of the acquisition over the fair value of assets acquired was recorded as goodwill.  During the second quarter of 2018, the Company finalized the fair value adjustments associated with the BarioSurg transaction. There were no adjustments made to the recorded fair values as a result of completing our accounting for the transaction.

We believe that the amount of goodwill relative to identifiable intangible assets relates to several factors, including (i) potential synergies related to market opportunities for multiple product offerings, (ii) future technology, and (iii) initial relationships and awareness of the ReShape Vest.

In-process research and development (“IPR&D”) consists of the ReShape Vest, which has not yet been clinically tested in the United States and has not yet been approved by the FDA.  Acquired IPR&D assets are initially recognized at fair value and are classified as indefinite-lived assets until the successful completion or abandonment of the associated research and development efforts.  The value assigned to IPR&D was determined by estimating the net cash flows from the ReShape Vest development project and discounting the net cash flows to their present value.  During the development period, this asset will not be amortized as charges to earnings; instead, this asset will be subject to periodic impairment testing.  Upon successful completion of the development process for the acquired IPR&D, the asset would then be considered a finite-lived intangible asset and amortization will commence.  Trademarks/tradenames were valued using the relief from royalty method and are being amortized over a 10-year period.  The covenant not to compete is being amortized over a three-year period.  The values of these intangible assets are considered Level 3 measurements.

ReShape Medical, Inc.

On October 2, 2017 the Company acquired ReShape Medical, Inc., a privately-held medical technology company that develops, manufactures and markets the ReShape® Dual Weight Loss Balloon, an FDA and CE marked approved, minimally invasive intragastric balloon designed to treat obesity patients with a body mass index (BMI) between 30 and 40, with one or more related comorbid conditions.

The consideration paid by the Company for ReShape Medical consisted of: (i)  157,116 shares of Company Common Stock, par value $0.01 per share, (ii) 187,772 shares of series C convertible preferred stock (which became convertible into 1,251,814 shares of common stock upon the December 19, 2017 approval of the Company's stockholders under Nasdaq rules, of which 553,334 shares of common stock were automatically converted on that date), and (iii) approximately $5.0 million in cash, which amount was immediately used to pay ReShape Medical's outstanding senior secured indebtedness and certain transaction expenses of ReShape Medical.

The total consideration paid by the Company, preliminarily valued at $39.0 million, includes: (a) $5.0 million in cash paid from our existing cash balances and (b) $34.0 million from the issuance of the common stock and the series C convertible preferred stock.  The preliminary valuation of the common stock and series C convertible preferred stock took into account (i) the conversion ratio of the series C convertible preferred stock, (ii) the closing price of our common stock on the Nasdaq Stock Market on the date the transaction was announced, and (iii) a 20% discount for lack of marketability related to the shares issued in the transaction. 

The purchase price consideration of $39.0 million does not include expenses for legal, accounting, audit, valuation and other services that were incurred after the October 2, 2017 acquisition date and were expensed as incurred.

The transaction was accounted for as a business combination and the following table summarizes the estimated fair values of the assets acquired and liabilities assumed as a result of the ReShape Medical acquisition.  The excess of the cost of the acquisition over the fair value of assets acquired was recorded as goodwill.  The assessment of fair value and the

determination of deferred tax assets acquired is preliminary and is based on information that was available at the time the consolidated condensed financial statements were prepared.  Accordingly, the allocation of purchase price related to the acquired intangible assets is preliminary and, therefore, subject to adjustment in future periods.

 

 

We believe that the amount of goodwill relative to identifiable intangible assets relates to several factors including (i) potential synergies related to market opportunities for multiple product offerings, (ii) future technology, and (iii) intact workforce.

Developed technology consists of the ReShape® Dual Weight Loss Balloon (the ReShape Balloon), an FDA-approved, minimally invasive intragastric balloon designed to treat obesity patients with a body mass index (BMI) between 30 and 40, with one or more related comorbid conditions.  The acquired developed technology assets are valued by estimating cash flows using an income approach and they are amortized over a 12-year period, consistent with the remaining lives of the technology's key patents.  Trademarks/tradenames are valued using the relief from royalty method and are being amortized over a 10-year period.  Customer relationships are valued using the with-and-without method under the income approach and are being amortized over 5 years.  The values of these intangible assets are considered Level 3 measurements.

 

(4)     Goodwill and Other Intangible Assets

Allocations of purchase prices related to the acquisitions of BarioSurg and ReShape Medical during the year ended December 31, 2017 resulted in the recording of $27.2 million of goodwill and $46.9 million of other intangible assets.

The following table summarizes the activity of intangible assets, excluding goodwill, for the quarter ended June 30, 2018:

 

 

The following table summarizes the expected future amortization of intangible assets as of June 30, 2018:

  

 

Evaluation of Goodwill for Impairment

The Company conducts its annual goodwill impairment analysis for its business during the fourth quarter of each year or when circumstances suggest that an indicator for impairment may be present.  Subsequent to the Company’s registered direct securities offering on April 3, 2018, the price of the Company’s common stock declined significantly. Management determined that this event was an indicator of potential impairment as the magnitude of the decline indicated that the net equity of the Company may be in excess of its fair market value.  As a result of the identification of this impairment indicator, the Company performed an impairment analysis that included valuing the business.  

The analysis of potential impairment of goodwill requires the Company to compare the estimated fair value at each of its reporting units to its carrying amount, including goodwill. The carrying amount of the reporting units must be adjusted first for any impairments of other definite or indefinite lived assets; accordingly the first step in performing the goodwill impairment analysis is to determine if other assets are impaired. The Company performed a qualitative impairment analysis on indefinite lived intangible assets, and assessed the recoverability of definite lived assets. The Company did not identify any impairments of indefinite or definite lived assets, other than goodwill, as a result the performance of these analyses.

If the carrying amount of the reporting unit exceeds the estimated fair value of the reporting unit, a non-cash goodwill impairment loss is recognized as an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.

 

The determination of the fair value of the reporting units and the allocation of that value to individual assets and liabilities within those reporting units requires the Company to make significant estimates and assumptions. These estimates and assumptions primarily include, but are not limited to, the selection of appropriate peer group companies, control premiums appropriate for acquisitions in the industries in which the Company competes, the discount rate, terminal growth rates, and forecasts of revenue, operating income, and capital expenditures.

The Company has one reporting unit and is operating in one segment. Additionally, for the purpose of assessing the recovery of definite lived assets, the Company has one asset group which includes all assets of the Company. The Company conducted its goodwill impairment analysis during the second quarter of 2018 and determined that the carrying value of the reporting unit exceeded the fair value.  Accordingly, the Company recorded a goodwill impairment charge of $27.2 million, reducing goodwill balances to zero, which was recorded within Goodwill impairment in the Consolidated Statements of Operations during the quarter ended June 30, 2018. The fair market value of the reporting unit was determined under an income approach using discounted cash flows. Fair value calculated using a discounted cash flow analysis is classified within level 3 of the fair value hierarchy and requires several assumptions including risk adjusted discount rates and financial forecasts. 

If our future operating results decline significantly, we may be exposed to additional impairment losses that could be material (for additional discussion of this risk, see “Item 1A. Risk Factors – During the second quarter of 2018 we were required to record a non-cash goodwill impairment loss.”)

 

(5)  Fair Value Measurements

Fair value of financial assets and liabilities is defined as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy has been

established that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

 

 

 

 

The Company’s assets that are measured at fair value on a recurring basis are classified within Level 1 or Level 2 of the fair value hierarchy. The Company does not hold any recurring assets that are measured at fair value using Level 3 inputs.

 

The Company did not hold any short-term investments classified as available for sale or held to maturity as of June 30, 2018 and December 31, 2017.

 

The fair value of the Company’s common stock warrant liability is calculated using a Black-Scholes valuation model and is classified as Level 2 in the fair value hierarchy. The fair values are presented below along with the valuation assumptions:

 

 

 

 

 

(6)  Inventory

 

The Company accounts for inventory at the lower of cost or market and records any long-term inventory as other assets in the condensed consolidated balance sheets. There was $1.0 million and $674,000 of long-term inventory, primarily consisting of raw materials, as of June 30, 2018 and December 31, 2017, respectively.  The Company has an inventory reserve of $1.9 million at June 30, 2018 related to excess quantities of ReShape vBloc inventory components, resulting in a zero net book value in long-term inventory as of that date.

 

Current inventory consists of the following as of:

 

 

 

(7)  Commitments and Contingencies

 

Operating Leases

 

The Company rents office, warehouse and laboratory facilities in St. Paul, Minnesota, under an operating lease, which was originally set to expire on September 30, 2015. On August 25, 2015, the Company entered into an amendment extending the term of the operating lease for three years until September 30, 2018, with monthly base rent ranging from $18,925 to $20,345.

 

With the acquisition of BarioSurg, the Company also leases space in Lake Forest, California under an operating lease with monthly base rent of approximately $2,200 per month through September 30, 2018.

 

With the October 2, 2017 acquisition of ReShape Medical, the Company leases separate office and manufacturing/warehouse space in San Clemente, California.  The operating lease for office space has a term that runs through June 30, 2022 with base rent of approximately $24,600 per month and with annual rent escalations of approximately 3%.  The operating lease for manufacturing/warehouse space has a term that runs through October 31, 2019 with base rent of approximately $10,900 per month.

 

Total rent expense recognized for the three months ended June 30, 2018 and 2017 was $195,000 and $62,000, and for the six months ended June 30, 2018 was $391,000 and $121,000, respectively. At June 30, 2018, future minimum payments for the Company are as follows:

 

 

Clinical Trials

The Company continues to evaluate the vBloc System in human clinical trials, including the EMPOWER trial and ReCharge trial. Both of these clinical trials require patients to be followed out to 60 months. The Company is required to pay for patient follow up visits only to the extent they occur. In the event a patient does not attend a follow up visit, the Company has no financial obligation. The Company is also required to pay for explants or revisions, including potential conversions of ReCharge control devices to active devices, should a patient request or be required to have one during the course of the clinical trials. The Company has no financial obligation unless an explant, revision or conversion is requested or required. Clinical trial costs are expensed as incurred.

Product Liability Claims

 

The Company is exposed to product liability claims that are inherent in the testing, production, marketing and sale of medical devices. Management believes any losses that may occur from these matters are adequately covered by insurance, and the ultimate outcome of these matters will not have a material effect on the Company’s financial position or results of operations. The Company is not currently a party to any product liability litigation and is not aware of any pending or threatened product liability litigation that could have a material adverse effect on the Company’s business, operating results or financial condition.

 

Litigation

On February 28, 2017, the Company received a class action and derivative complaint filed on February 24, 2017 in U. S. District Court for the District of Delaware by Vinh Du, one of the Company’s shareholders. The complaint names as defendants ReShape Lifesciences, the board of directors and four members of our senior management, namely, Scott Youngstrom, Nick Ansari, Peter DeLange and Paul Hickey, and contains a purported class action claim for breach of fiduciary duty against the board of directors and derivative claims for breach of fiduciary duty against the board of directors and unjust enrichment against our senior management.  The allegations in the complaint relate to the increase in the number

of shares authorized for grant under our Second Amended and Restated 2003 Stock Incentive Plan (the “Plan”), which was approved by our shareholders at the Special Meeting of Shareholders held on December 12, 2016 (the “Special Meeting”), and to our subsequent grant of stock options on February 8, 2017, to the Company’s Directors and senior management to purchase an aggregate of 1,093,450 shares of our common stock (the “Option Grants”).  In the complaint, the plaintiff contends that (i) the number of shares authorized for grant under the Plan, as adjusted by the board of directors after the Special Meeting for the subsequent recapitalization of the Company, resulted from an alleged breach of fiduciary duties by the board of directors, and (ii) our senior management was allegedly unjustly enriched by the subsequent Option Grants.  The plaintiff seeks relief in the form of an order rescinding the Plan as approved by the shareholders at the Special Meeting, an order cancelling the Option Grants, and an award to plaintiff for his costs, including fees and disbursements of attorneys, experts and accountants.  On April 17, 2017, we filed a motion to dismiss the complaint based on the plaintiff’s failure to satisfy Delaware’s demand requirement for a derivative action and failure to state a valid claim.  The court denied the motion to dismiss on November 30, 2017.  While the Company continues to believe that the allegations in the complaint are without merit, the parties are currently negotiating the terms of a settlement of this matter.  During the quarter ended June 30, 2018, the Company has recorded an accrued liability and legal expense for $190,000 representing a probable and currently estimable settlement amount for this matter.

On April 20, 2017, Fulfillium, Inc. filed a Complaint against ReShape Medical, Inc. (which the Company acquired in October 2017 and is now a wholly-owned subsidiary of the Company) in the United States District Court for the District of Delaware, which alleged misappropriation of trade secrets and infringement of two United States Patents.  On July 28, 2017, ReShape Medical moved to dismiss both the misappropriation of trade secret claim and the claims of patent infringement, and to transfer the litigation to the United States District Court for the Central District of California.  On October 16, 2017, the Court granted ReShape Medical’s motion to dismiss the trade secret and willful infringement claims, and ordered the case transferred to the United States District Court for the Central District of California.  Fulfillium  twice amended its Complaint, and ReShape Medical filed amended Answers. On June 4, 2018, ReShape Medical filed a motion to dismiss the patent infringement claims for lack of standing, which the Court granted on July 5, 2018.  On August 10, 2018, the Court dismissed without prejudice the trade secret claims for lack of subject matter jurisdiction and terminated the case. On July 20, 2018, Fulfillium filed a new Complaint against ReShape Medical LLC and ReShape Lifesciences, Inc. in the Central District of California asserting infringement of three U.S. patents; a response is due on August 15, 2018.  On April 20, 2018, ReShape Medical filed Inter Partes Review (“IPR”) petitions with the Patent Trial and Appeal Board of the U.S. Patent and Trademark Office to have all claims of both of the originally asserted Fulfillium patents canceled as unpatentable over various combinations of prior art. The Company intends to vigorously defend itself against Fulfillium, Inc.’s claims.  We currently are unable to estimate a loss or range of loss for this matter.

On July 12, 2018, Alpha Capital Anstalt (“Alpha”) filed a lawsuit against the Company in the United States District Court for the Southern District of New York.  In August 2017, Alpha acquired shares of the Company’s series B convertible preferred stock and warrants to purchase shares of the Company’s common stock in an underwritten public offering. Pursuant to the terms of the series B convertible preferred stock and warrants, the conversion price of the series B convertible preferred stock and exercise price of the warrants was subject to adjustment in the case of, among other things, dilutive issuances of securities by the Company. The Complaint alleges breach of contract and seeks declaratory relief, damages of not less than approximately $3.6 million (less the proceeds of actual sales of the Company’s common stock made by Alpha) and attorneys’ fees, claiming that the Company should have adjusted the conversion price of the series B convertible preferred stock and exercise price of the warrants to not less than $3.00 per share, rather than the $11.25 per share to which the Company actually adjusted such conversion price and exercise price, in connection with its registered direct offering of series D convertible preferred stock and warrants to purchase common stock that it completed and announced in April 2018. The Company believes the claims alleged are without merit and intends to vigorously protect and defend itself. However, we are currently unable to estimate a loss or range of loss for this matter. 

 On July 26, 2018, Iroquois Capital Investment Group, LLC and Iroquois Master Fund, Ltd. filed a lawsuit against the Company in the United States District Court for the Southern District of New York, which Complaint makes substantially the same claims and seeks substantially the same relief as Alpha’s Complaint described above, except that Iroquois claims that the conversion price of the series D convertible preferred stock and exercise price of the warrants should have been adjusted to $1.35 per share, and Iroquois is claiming damages estimated to exceed $5 million. The Company believes the claims alleged are without merit and intends to vigorously protect and defend itself. However, we are currently unable to estimate a loss or range of loss for this matter. 

Except as disclosed in the foregoing paragraphs, the Company is not currently a party to any litigation and the Company is not aware of any pending or threatened litigation against it that could have a material adverse effect on the Company’s business, operating results or financial condition. The medical device industry in which the Company operates is characterized by frequent claims and litigation, including claims regarding patent and other intellectual property rights as well as improper hiring practices. As a result, the Company may be involved in various legal proceedings from time to time.

 

(8) Revenue Recognition

 

Revenue from Product Sales

 

The following table presents the Company’s revenue disaggregated by product and geography, based on management’s assessment of available data:

 

 

 

 

*Outside the United States

 

The Company’s revenue consists primarily of sales of products designed to treat obesity and metabolic diseases. The Company sells its products directly to physicians and medical device distributors using employed sales representatives. Contract terms for unit price, quantity, shipping and payment are governed by sales agreements or invoices which the Company considers to be a customer’s contract in all cases. The unit price is considered the observable stand-alone selling price for the arrangements. Any volume sales discounts are applied evenly to the units sold for purposes of calculating standalone selling price.

 

Under Topic 606, the Company recognizes revenue when it satisfies a performance obligation by transferring control of the promised goods or services to its customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services.  The Company has elected the accounting policy to exclude sales taxes from revenue.

 

Product sales consist of a single performance obligation that the Company satisfies at a point in time.  The Company recognizes product revenue when the following events have occurred: (a) the Company has transferred physical possession of the products, (b) the Company has a present right to payment, (c) the customer has legal title to the products, and (d) the customer bears significant risks and rewards of ownership of the products.   Based on the Company’s historical practices and shipping terms specified in the sales agreements and invoices, these criteria are generally met when the products are:

 

 

The Company’s standard payment terms for its customers are generally 30 to 60 days after the Company satisfies the performance obligations. 

 

All amounts billed to a customer in a sales transaction related to shipping and handling, if any, represent revenues earned for the goods provided, and these amounts have been included in other revenue. Costs related to such shipping and handling billing are classified as cost of sales.

 

Variable Consideration

 

The Company records revenue from customers in an amount that reflects the transaction price it expects to be entitled to after transferring control of those goods or services. From time to time, the Company offers rebate incentives to patients in which the ultimate transaction price is tied to a patient’s weight loss measured over a period of time. The Company estimates the price adjustments using the expected value method, which takes into account historical weight loss metrics for similar patients, based upon clinical and commercial data. Variable consideration is estimated at contract inception only to the extent that it is probable that a significant reversal of revenue will not occur, and updated at the end of each reporting period as additional information becomes available.

 

Warranty

 

The Company generally provides one-year warranties against defects in materials and workmanship and will either repair the products or provide replacements at no charge to customers. As they are considered assurance-type warranties, the Company does not account for them as separate performance obligations.  Warranty reserve requirements are based on a specific assessment of the products sold with warranties where a customer asserts a claim for warranty or a product defect. 

 

Contract Balances

 

The Company records a receivable when it has an unconditional right to receive consideration after the performance obligations are satisfied.  As of June 30, 2018, and December 31, 2017, accounts receivable totaled $466,027 and $488,613, respectively.  For the three months ended June 30, 2018, the Company did not incur material impairment losses with respect to its receivables.

 

The Company defers revenue from product sales subject to the rebate incentives described under Variable Consideration unless it is probable the rebate will not be earned by the patient, which is based upon historical weight loss metrics gathered in clinical and commercial settings. As of June 30, 2018 and December 31, 2017, the Company deferred $191,400 and $0, respectively, of revenue related to rebate incentives, which is reported in accrued expenses.

 

Practical Expedients

 

The Company has elected the practical expedient not to determine whether contacts with customers contain significant financing components.

 

(9)  Stock-based Compensation

 

The fair value method of accounting for share-based payments is applied to all share-based payment awards issued to employees and where appropriate, nonemployees, unless another source of literature applies.

 

 

 

Based on the application of these standards, stock-based compensation expense for stock-based awards for nonemployees for the three and six months ended June 30, 2018 was $0 and $3,000 and for the three and six months ended June 30, 2017, was $0 and $142,000, respectively. These amounts were allocated to operating expenses follows:

 

 

As of June 30, 2018 there was approximately $8.5 million of total unrecognized compensation costs, related to employee unvested stock option awards, which are expected to be recognized over a weighted-average period of 2.95 years.

 

The estimated grant-date fair values of the stock options were calculated using the Black-Scholes valuation model, based on the following assumptions for the three and six months ended June 30, 2018 and 2017:

 

 

Option activity under the Plan for the six months ended June 30, 2018 was as follows:

 

In addition to the stock options granted pursuant to the Plan, the Company from time to time grants options to individuals as an inducement to accepting positions as employees (Inducement Grants).  These Inducement Grants are made at the discretion of the board of directors and are issued outside of the Plan.  Inducement Grant activity is summarized below: