Adaptive Biotechnologies Corp (ADPT) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes and the other financial information appearing elsewhere in this Annual Report on Form 10-K, as well as the other financial information we file with the SEC from time to time. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties relating to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

This section generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 may be found in Part II, Item 7 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC on February 24, 2021.

Overview

We are advancing the field of immune medicine by harnessing the inherent biology of the adaptive immune system to transform the diagnosis and treatment of disease. We believe the adaptive immune system is nature’s most finely tuned diagnostic and therapeutic for most diseases, but the inability to decode it has prevented the medical community from fully leveraging its capabilities. Our immune medicine platform applies our proprietary technologies to read the diverse genetic code of a patient’s immune system and aims to understand precisely how the immune system detects and treats disease in that patient. We capture these insights in our dynamic clinical immunomics database, which is underpinned by computational biology and machine learning, and use them to develop and commercialize clinical products and services that we are tailoring to each individual patient. We have commercial products and services and a robust pipeline of clinical products and services that we are designing to diagnose, monitor and enable the treatment of diseases, such as cancer, autoimmune disorders and infectious diseases.

Our immune medicine platform is the foundation for our expanding suite of products and services. The cornerstone of our platform and core immunosequencing product, immunoSEQ, serves as our underlying research and development engine and generates revenue from biopharmaceutical and academic customers. Our first clinical diagnostic product, clonoSEQ, is the first test authorized by the FDA for the detection and monitoring of MRD in patients with MM, ALL and CLL and is also available as a CLIA-validated LDT for patients with other lymphoid cancers. Leveraging our collaboration with Microsoft, we are creating the TCR-Antigen Map. We are using this map to develop research solutions by disease called immunoSEQ T-MAP and a diagnostic product for many diseases from a single blood test called T-Detect.

T-Detect COVID, for which we have received EUA, is designed to confirm past SARS-CoV-2 infection, the virus that causes COVID-19, and is also the first indication for the T-Detect product line. We expect to launch a second indication, T-Detect Lyme, during the 2022 Lyme season. In addition, we have confirmed signals in Crohn’s disease, celiac disease, and multiple sclerosis, as well as identified new signals in ulcerative colitis and rheumatoid arthritis.

Our therapeutic product candidates, being developed under the Genentech Agreement, leverage our platform to identify specific receptors on immune cells to develop into cellular therapies in oncology. We also extended our platform to identify highly potent neutralizing antibodies against SARS-CoV-2 and we believe this differentiated approach may be leveraged across multiple disease states.

For our life sciences research customers, we provide two categories of products and services using immunoSEQ. First, we provide immunosequencing services, the revenue from which we record as sequencing revenue. Second, we provide certain research customers professional support, for which we receive nonrefundable upfront or recurring payments. We may receive additional payments upon those customers achieving specified milestones. Revenue related to these activities are recorded as development revenue.

For our clinical diagnostics customers, we sell our clonoSEQ diagnostic test and T-Detect COVID test, which include our immunosequencing services and are thus recorded as sequencing revenue. In the future, we intend to sell other diagnostic products and services, including other indications for T-Detect, which we also expect to record as sequencing revenue.

For our current drug discovery collaborator, Genentech, we screen, identify and characterize TCRs in support of our collaboration. We record revenue from this collaboration as development revenue.

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Historically, we have sold immunoSEQ as a fee-for-service offering. These research offerings have comprised the majority of our revenue to date, although our business is pursuing broader opportunities. As we continue to expand the use of our clonoSEQ diagnostic tests, develop and commercialize T-Detect and develop and commercialize therapeutic product candidates with our drug discovery collaborator, we expect our mix of revenue to shift to clinical products and services, which we believe will become our largest sources of revenue.

We are actively pursuing opportunities to deepen our relationships with current customers and initiate relationships with new customers. We have an experienced, specialty salesforce that is targeting department heads, laboratory directors, principal investigators, core facility directors, clinicians, payors, research scientists and pathologists at leading academic institutions, biopharmaceutical companies, research institutions and contract research organizations. As MRD assessment becomes standard practice for patient management across a range of blood cancers, we believe it will be essential for clinicians and patients to have access to a highly accurate, sensitive and standardized MRD assessment tool. We are focused on establishing and maintaining collaborative relationships with payors, developing health economic evidence and building billing and patient access infrastructure to expand reimbursement coverage for our clinical diagnostics. We continue to seek expanded coverage of our clonoSEQ diagnostic test and have successfully expanded coverage through contractual agreements or positive medical policies with Medicare and several of the largest national private health insurers in the United States.

We recognized revenue of $154.3 million and $98.4 million for the year ended December 31, 2021 and 2020, respectively. Net loss attributable to Adaptive Biotechnologies Corporation was $207.3 million and $146.2 million for the year ended December 31, 2021 and 2020, respectively. We have funded our operations to date principally from the sale of convertible preferred stock and common stock and, to a lesser extent, sequencing and development revenue. As of December 31, 2021 and 2020, we had cash, cash equivalents and marketable securities of $570.2 million and $806.8 million, respectively.

Follow-On Offering

In July 2020, we completed an underwritten public offering of our common stock in which we issued and sold 7,200,000 shares of common stock at a public offering price of $40.00 per share. We received $271.8 million in net proceeds, after deducting underwriting discounts and net offering expenses paid by us.

Components of Results of Operations

Revenue

We derive our revenue from two sources: (1) sequencing revenue and (2) development revenue.

Sequencing revenue. Sequencing revenue reflects the amounts generated from providing testing services through clonoSEQ to clinical and research customers, from providing our T-Detect COVID test to clinical customers and from providing sequencing services through immunoSEQ to research customers.

For our clinical customers, we primarily derive revenue from providing our clonoSEQ report to ordering physicians. We bill medical institutions and commercial and government payors based on tests delivered to ordering physicians. Amounts paid for clonoSEQ diagnostic tests by medical institutions and commercial and government payors vary based on respective reimbursement rates and patient responsibilities, which may differ from our targeted list price. We recognize clinical revenue by evaluating customer payment history, contracted reimbursement rates, if applicable, and other adjustments to estimate the amount of revenue that is collectible.

For our clonoSEQ coverage under Medicare, we bill an episode of treatment when we deliver the first eligible test results. This billing contemplates all necessary tests required during a patient’s treatment cycle, which is currently estimated at approximately four tests per patient, including the initial sequence identification test. Revenue recognition commences at the time the initial billable test result is delivered and is based upon cumulative tests delivered to date. Any unrecognized revenue from the initial billable test is recorded as deferred revenue and recognized either as we deliver our estimate of the remaining tests in a patient’s treatment cycle or when the likelihood becomes remote that a patient will receive additional testing.

For our research customers, which include biopharmaceutical customers and academic institutions, delivery of the sequencing results may include some level of professional support and analysis. Terms with biopharmaceutical customers generally include non-refundable upfront payments, which we record as deferred revenue. For all research customers, we recognize revenue as we deliver sequencing results. From time to time, we offer discounts in order to gain rights and access to certain datasets. Revenue is recognized net of these discounts and costs associated with these services are reflected in cost of revenue. In periods where our sample estimates are reduced or a customer project is cancelled and, in either case, we have remaining related deferred revenue, we recognize revenue using a cumulative catch-up approach based on the proportion of samples delivered to date relative to the remaining samples expected to be delivered.

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Development revenue. Development revenue primarily represents regulatory or development support services that we provide to biopharmaceutical customers who seek access to our platform to support their therapeutic development activities. We enter into collaboration and similar agreements with these customers. These agreements may include substantial non-refundable upfront payments, which we recognize as development revenue over time as we perform the respective services. When the agreements include sequencing activities, we separately classify those activities as sequencing revenue. Additionally, we generate development revenue from the achievement of regulatory milestones.

During the year ended December 31, 2021, we executed an intellectual property license agreement that includes variable consideration related to sales-based royalties. Any consideration related to such royalties will be recognized as development revenue at the later of when (i) the related sales occur or (ii) the performance obligation to which some or all of the sales-based royalty has been allocated has been satisfied (or partially satisfied).

We expect revenue to increase over the long term, particularly as the mix of revenue migrates to clinical diagnostics and drug discovery. The pace by which this mix migrates will be determined by the level of customer adoption and frequency of use of our products and services. Our revenue may fluctuate from period to period due to the uncertain nature of delivery of our products and services, the achievement of milestones by us or our customers, timing of expenses incurred, changes in estimates of total anticipated costs related to our Genentech Agreement and other events not within our control, such as the delivery of customer samples or customer decisions to no longer pursue their development initiatives.

Due to the ongoing uncertainties related to the COVID-19 pandemic, we may experience variability in revenue in the near term as our customers’ abilities to procure samples for their research initiatives change, as customer initiatives evolve and as clinical testing is impacted by the pandemic.

Cost of Revenue

Cost of revenue includes the cost of materials, personnel-related expenses (including salaries, benefits and share-based compensation), shipping and handling expenses, equipment costs and allocated facility costs associated with processing samples and professional support for our sequencing revenue activities. Allocated facility costs include depreciation of laboratory equipment, as well as allocated facility occupancy and information technology costs. Costs associated with processing samples are recorded as expense, regardless of the timing of revenue recognition. As such, cost of revenue and related volume does not always trend in the same direction as revenue recognition and related volume. Additionally, costs to support our Genentech Agreement are a component of our research and development expenses.

We expect cost of revenue to increase in absolute dollars as we grow our sequencing volume and make increased investments in laboratory automation and facilities, but the cost per sample to decrease over the long term due to the efficiencies we may gain as sequencing volume increases from improved utilization of our laboratory capacity, automation and other value engineering initiatives. If our sample volume throughput is reduced as a result of the COVID-19 pandemic or otherwise, cost of revenue as a percentage of total revenue may be adversely impacted due to fixed overhead costs.

Research and Development Expenses

Research and development expenses consist of laboratory materials costs, personnel-related expenses, equipment costs, allocated facility costs, information technology expenses and contract service expenses. Research and development activities support further development and refinement of existing assays and products, discovery of new technologies and investments in our immune medicine platform. We also include in research and development expenses the costs associated with software development of applications to support future commercial opportunities, as well as development activities to support laboratory scaling and workflow. We are currently conducting research and development activities for several products and services and we typically use our laboratory materials, personnel, facilities, information technology and other development resources across multiple development programs. Additionally, certain of these research and development activities benefit more than one of our product opportunities. We do not track research and development expenses by specific product candidates.

A component of our research and development expenses are costs supporting clinical and analytical validations to obtain regulatory approval for future clinical products and services. Additionally, the costs to support our Genentech Agreement are a component of our research and development expenses. Some of these activities have generated and may in the future generate development revenue.

We expect our research and development expenses to continue to increase in absolute dollars as we innovate and expand the application of our platform. However, we expect research and development expenses to decrease as a percentage of revenue in the long term, although the percentage may fluctuate from period to period due to the timing and extent of our development and commercialization efforts.

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Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel-related expenses for commercial sales, product and account management, marketing, reimbursement, medical education and business development personnel that support commercialization of our platform products. In addition, these expenses include external costs, such as advertising expenses, customer education and promotional expenses, market analysis expenses, conference fees, travel expenses and allocated facility costs.

We expect our sales and marketing expenses to increase in absolute dollars as we expand our commercial sales, marketing and business development teams and increase marketing activities to drive awareness and adoption of our products and services. However, we expect sales and marketing expenses to decrease as a percentage of revenue in the long term, subject to fluctuations from period to period due to the timing and magnitude of these expenses.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel-related expenses (including salaries, benefits and share-based compensation) for our personnel in executive, legal, finance and accounting, human resources and other administrative functions, including third-party billing services. In addition, these expenses include insurance costs, external legal costs, accounting and tax service expenses, consulting fees and allocated facility costs.

We expect our general and administrative expenses to continue to increase in absolute dollars as we increase headcount. Though expected to increase in absolute dollars, we expect these expenses to decrease as a percentage of revenue in the long term as revenue increases.

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Statements of Operations Data and Other Financial and Operating Data

The following table sets forth our statements of operations data and other financial and operating data for the periods presented:

(1) Adjusted EBITDA is a non-GAAP financial measure that we define as net loss attributable to Adaptive Biotechnologies Corporation adjusted for interest and other income, net, income tax (expense) benefit, depreciation and amortization and share-based compensation expenses. Please refer to “Adjusted EBITDA” below for a reconciliation between Adjusted EBITDA and net loss attributable to Adaptive Biotechnologies Corporation, the most directly comparable GAAP financial measure, and a discussion about the limitations of Adjusted EBITDA.

Comparison of the Years Ended December 31, 2021 and 2020

Revenue

The $37.5 million increase in sequencing revenue was primarily attributable to a $24.3 million increase in revenue generated from biopharmaceutical and academic customers, inclusive of a $2.9 million increase due to changes in estimates of total samples to be provided under certain of our MRD development agreements. Additionally, there was a $13.2 million increase in revenue generated from clinical customers, inclusive of a $1.9 million increase related to Medicare reimbursements resulting from our determination that the likelihood of additional testing for specific patients was remote and a change in our estimate of expected cumulative tests per patient for one of our covered indications.

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Research sequencing volume increased by 42% to 32,146 sequences delivered in the year ended December 31, 2021 from 22,663 sequences delivered in the year ended December 31, 2020. Clinical sequencing volume, excluding T-Detect COVID volume, increased by 48% to 22,516 clinical tests delivered in the year ended December 31, 2021 from 15,186 clinical tests delivered in the year ended December 31, 2020.

The $18.5 million increase in development revenue was primarily attributable to a $9.2 million increase in revenue generated from the Genentech Agreement and an $8.4 million increase in revenue recognized from MRD development agreements, inclusive of a $7.5 million increase in revenue recognized upon the achievement of certain regulatory milestones by us and our customers' therapeutics.

Cost of Revenue

The $26.8 million increase in cost of revenue was primarily attributable to a $13.5 million increase in labor, overhead and facility costs and a $9.7 million increase in materials costs resulting from increased revenue sample volume. Additionally, there was a $1.6 million increase in sample collection costs and a $1.5 million increase in shipping costs. These increases were partially offset by a $0.9 million decrease related to higher usage of our production laboratory to process research and development samples versus revenue samples.

Research and Development

The following table presents disaggregated research and development expenses by cost classification for the periods presented:

The $26.3 million increase in research and development expenses was primarily attributable to a $17.9 million increase in personnel costs and a $6.4 million increase in depreciation and other expenses, which included a $2.3 million increase in consultant costs.

Sales and Marketing

The $34.1 million increase in sales and marketing expenses was primarily attributable to $23.7 million in additional personnel costs, $6.0 million in additional marketing expenses, a $2.2 million increase in travel and customer event related expenses and a $1.2 million increase in consultant costs. Our clonoSEQ and T-Detect marketing efforts were the largest drivers of the $6.0 million increase in marketing expenses.

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General and Administrative

The $25.0 million increase in general and administrative expenses was primarily attributable to a $13.3 million increase in personnel costs, as well as a $7.8 million increase in building, facility and depreciation related expenses. Additionally, there was a $2.3 million increase in consultant costs and a $2.2 million increase in computer and software expenses, which were partially offset by a $2.1 million decrease in legal, accounting and tax fees.

Interest and Other Income, Net

The $4.9 million decrease in interest and other income, net was primarily attributable to a $4.8 million decrease in net interest income and investment amortization resulting from reductions in interest rates and related yields of a smaller portfolio.

Adjusted EBITDA

Adjusted EBITDA is a non-GAAP financial measure that we define as net loss attributable to Adaptive Biotechnologies Corporation adjusted for interest and other income, net, income tax (expense) benefit, depreciation and amortization and share-based compensation expenses.

Management uses Adjusted EBITDA to evaluate the financial performance of our business and the effectiveness of our business strategies. We present Adjusted EBITDA because we believe it is frequently used by analysts, investors and other interested parties to evaluate companies in our industry and it facilitates comparisons on a consistent basis across reporting periods. Further, we believe it is helpful in highlighting trends in our operating results because it excludes items that are not indicative of our core operating performance.

Adjusted EBITDA has limitations as an analytical tool and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. We may in the future incur expenses similar to the adjustments in the presentation of Adjusted EBITDA. In particular, we expect to incur meaningful share-based compensation expense in the future. Other limitations include that Adjusted EBITDA does not reflect:

In addition, Adjusted EBITDA may not be comparable to similarly titled measures used by other companies in our industry or across different industries.

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The following is a reconciliation of net loss attributable to Adaptive Biotechnologies Corporation to Adjusted EBITDA for the periods presented (in thousands):

(1) Represents share-based compensation expense related to option and restricted stock unit awards. See Note 13 of the accompanying notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for details on our share-based compensation expense.

Liquidity and Capital Resources

We have incurred losses since inception and have incurred negative cash flows from operations since inception through December 31, 2018, and again in the years ended December 31, 2020 and 2021. As of December 31, 2021, we had an accumulated deficit of $718.9 million.

We have funded our operations to date principally from the sale of convertible preferred stock and common stock and, to a lesser extent, sequencing and development revenue. As of December 31, 2021, we had cash, cash equivalents and marketable securities of $570.2 million.

We believe our existing cash, cash equivalents and marketable securities will be sufficient to fund our operating expenses and capital expenditure requirements through at least the next 12 months. We may consider raising additional capital to expand our business, to pursue strategic investments, to take advantage of financing opportunities or for other reasons. If our available cash, cash equivalents and marketable securities balances and anticipated cash flows from operations are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or convertible debt securities, enter into a credit facility or another form of third-party funding or seek other debt financing. The sale of equity and convertible debt securities may result in dilution to our shareholders and, in the case of preferred equity securities or convertible debt, those securities could provide for rights, preferences or privileges senior to those of our common stock. The terms of debt securities issued or borrowings pursuant to a credit agreement could impose significant restrictions on our operations. This additional capital may not be available on reasonable terms, or at all.

We plan to utilize the existing cash, cash equivalents and marketable securities on hand primarily to fund our commercial and marketing activities associated with our clinical products and services, continued research and development initiatives for our pipeline candidates and drug discovery initiatives and ongoing investments in our immune medicine platform. We also expect to make capital expenditures in the near term related to the expansion of our laboratory space and expect to continue investing in laboratory equipment and operations to support our anticipated growth. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to capital preservation and liquidity. Currently, our funds are held in money market funds and marketable securities consisting of U.S. government debt securities and corporate bonds.

Our contractual obligations as of December 31, 2021 include operating lease obligations of $149.5 million, reflecting the minimum commitments for our office and laboratory spaces in Seattle, Washington and South San Francisco, California, our warehouse lease in Bothell, Washington and our office lease in New York City, New York, as well as a commitment for server space in Seattle, Washington. See Note 10 of the accompanying notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information, including the timing of cash payments related to these lease obligations. Additionally, we have minimum commitments for laboratory material suppliers, which are generally fulfilled within one year, software and service license commitments, which are generally fulfilled within one to three years, purchase commitments for cloud data storage through our collaboration with Microsoft and royalty commitments. Furthermore, in connection with one of our lease agreements, we have an existing letter of credit of $2.1 million with one of our existing financial institutions.

While we may experience variability in revenue in the near term, as long-term revenue from sales of our current and future products and services is expected to grow, we expect our accounts receivable and inventory balances to increase. Any increase in accounts receivable and inventory may not be completely offset by increases in accounts payable and accrued expenses, which could result in greater working capital requirements.

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Cash Flows

The following table summarizes our uses and sources of cash for the years ended December 31, 2021 and 2020 (in thousands):

Operating Activities

Cash used in operating activities during the year ended December 31, 2021 was $192.7 million, which was primarily attributable to a net loss of $207.3 million and a net change in operating assets and liabilities of $56.8 million, partially offset by noncash share-based compensation of $43.3 million, noncash depreciation and amortization of $21.2 million and noncash lease expense of $7.0 million. The net change in operating assets and liabilities was primarily due to a $57.7 million reduction in deferred revenue primarily related to revenue recognized from the Genentech Agreement, a $7.4 million increase in accounts receivable, net and a $5.2 million increase in inventory, which were partially offset by an $8.5 million increase in operating lease liabilities, a $3.9 million increase in accounts payable and accrued liabilities primarily related to our corporate bonus to be paid in 2022, and a $1.3 million decrease in prepaid expenses and other assets.

Cash used in operating activities during the year ended December 31, 2020 was $149.7 million, which was primarily attributable to a net loss of $146.2 million and a net change in our operating assets and liabilities of $40.8 million, partially offset by noncash share-based compensation of $24.8 million, noncash depreciation and amortization of $9.2 million and noncash lease expense of $3.3 million. The net change in our operating assets and liabilities was primarily due to a $43.4 million reduction in deferred revenue primarily related to revenue recognized from the Genentech Agreement, a $5.0 million increase in inventory, a $1.4 million increase in prepaid expenses and other current assets and a $0.9 million decrease in operating lease liabilities. These changes were partially offset by an increase in accounts payable and accrued liabilities of $7.5 million and a reduction in accounts receivable, net of $2.6 million.

Investing Activities

Cash provided by investing activities during the year ended December 31, 2021 was $181.2 million, which was primarily attributable to proceeds from maturities of marketable securities of $559.5 million, partially offset by purchases of marketable securities of $316.5 million and purchases of property and equipment of $61.7 million.

Cash used in investing activities during the year ended December 31, 2020 was $117.0 million, which was primarily attributable to purchases of marketable securities of $695.0 million and purchases of property and equipment of $18.8 million, partially offset by proceeds from sales and maturities of marketable securities of $596.7 million.

Financing Activities

Cash provided by financing activities during the year ended December 31, 2021 was $27.1 million, which was primarily attributable to proceeds from the exercise of stock options.

Cash provided by financing activities during the year ended December 31, 2020 was $293.6 million, which was primarily attributable to $271.8 million in proceeds, after deducting underwriting discounts and net offering expenses paid by us, received from our underwritten public offering completed in July 2020, as well as $21.7 million in proceeds from the exercise of stock options.

Net Operating Loss Carryforwards

Utilization of our NOL carryforwards and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by Section 382 of the Internal Revenue Code of 1986 (“Section 382”) and similar state provisions. The annual limitation may result in the expiration of NOL carryforwards and credits before utilization. If there should be an ownership change, our ability to utilize our NOL carryforwards and credits could be limited. We have completed a Section 382 analysis for changes in ownership through December 31, 2020 and continue to monitor for changes that could trigger a limitation. Based on this analysis, we do not expect to have any permanent limitations on the utilization of our federal NOLs. Under the TCJA, federal NOLs incurred in 2018 and future years may be carried forward indefinitely, but the deductibility of such federal NOLs is subject to an annual limitation. NOLs generated prior to 2018 are eligible to be carried forward up to 20 years. Based on the available objective evidence, management determined that it was more likely than not that the net deferred tax assets would not be realizable as of December 31, 2021. Accordingly, management applied a full valuation allowance against net deferred tax assets as of December 31, 2021.

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Critical Accounting Policies and Estimates

We have prepared our consolidated financial statements in accordance with GAAP. Our preparation of these consolidated financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities and related disclosures at the date of the consolidated financial statements, as well as revenue and expense recorded during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and or other relevant assumptions that we believe to be reasonable under the circumstances. Estimates are used in several areas, including, but not limited to, estimates of progress to date for certain performance obligations and the transaction price for certain contracts with customers, the provision for income taxes, including related reserves, and goodwill, among others. These estimates generally involve complex issues and require judgments, involve the analysis of historical results and prediction of future trends, can require extended periods of time to resolve and are subject to change from period to period. Actual results may differ materially from management’s estimates.

While our significant accounting policies are described in more detail in Note 2 of the accompanying notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies are critical to the judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

Our development and sequencing revenue arrangements may include upfront payments for the performance of services in the future, which have both fixed and variable consideration. Non-refundable upfront fees and funding for related development services are generally considered fixed consideration, while milestone payments are identified as variable consideration.

In determining the appropriate amount of revenue to recognize as we fulfill our obligations under these agreements, we perform the following steps to determine the amount of revenue to be recognized: (1) identify the contract or contracts; (2) determine whether the promised goods or services are performance obligations, including whether they are distinct in the context of the contract; (3) measure the transaction price, including the constraint on variable consideration; (4) allocate the transaction price to the performance obligations based on estimated selling prices; and (5) recognize revenue when (or as) we satisfy each performance obligation.

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account in Accounting Standard Codification (“ASC”) Topic 606, Revenue from Contracts with Customers. Our performance obligations include sequencing services and services associated with regulatory submission and approval processes. Significant management judgment is applied to determine (1) the measurement of the transaction price, including the constraint on variable consideration, (2) the allocation of the transaction price to the performance obligations and (3) the appropriate input or output based method to recognize revenue and the extent of progress to date.

We include the unconstrained amount of estimated variable consideration in the transaction price. The amount included in the transaction price is constrained to the amount for which it is probable that a significant reversal of cumulative revenue recognized will not occur. At the end of each subsequent reporting period, we re-evaluate the estimated variable consideration included in the transaction price and any related constraint and, if necessary, adjust our estimate of the overall transaction price.

To determine the allocation of the transaction price to the performance obligations, we apply the adjusted market assessment approach. Using this approach, we evaluate the market in which we sell the services and estimate the price that a customer in that market would be willing to pay for those services.

To select the measure of progress, we consider the expectations of the performance period which may be based on customer-dependent estimates of samples or internal estimates of the performance period based on both the customer and our expected development timeframes. For our collaboration with Genentech, we estimate the extent of progress using a proportional performance model that uses an input method based on costs incurred relative to the total estimated costs of research and development efforts to pursue both the Shared Products and Personalized Product pathways. These estimates are based on our internal estimates and development timeframes, which are subject to revision based on the potential outcomes for both product pathways, decisions made by Genentech, regulatory feedback or other factors not currently known. We regularly review our expectations of the extent of progress, including whether any variable consideration is no longer constrained, and, if any changes in estimates are made, we recognize revenue using the cumulative catch-up method.

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Goodwill

Goodwill represents the excess of the purchase price over the net amount of identifiable assets acquired and liabilities assumed in a business combination measured at fair value. We assess goodwill for impairment annually on October 1 and upon any occurrence of triggering events or substantive changes in circumstances that could indicate a potential impairment.

We evaluate goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount. We evaluate certain qualitative factors such as macroeconomic conditions, the market and industry in which we operate, cost factors, overall financial performance and other relevant entity-specific events to determine if there are any negative trends or events that could indicate impairment. Key assumptions in this analysis include anticipated demand for our products and services, including industry and regulatory changes, future revenue growth and cash flow trends. These assumptions are determined based on our historical performance and management’s forecasted results. Management’s estimates of forecasted results are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. If we determine that it is more likely than not that the fair value of our reporting unit is less than its carrying amount, or if we choose to bypass the qualitative assessment, we perform a quantitative goodwill impairment test. Goodwill impairment exists when the estimated fair value of our one reporting unit is less than its carrying value. If impairment exists, the carrying value of the goodwill is reduced to fair value through an impairment charge recorded in our consolidated statements of operations. To date, we have not recognized any impairment of goodwill.