Personalis, Inc. (PSNL) FY 2022 MD&A

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and accompanying notes and other financial information included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. You should review the sections titled “Note Regarding Forward-Looking Statements” for a discussion of forward-looking statements and in Part I, Item 1A, “Risk Factors” for a discussion of factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and elsewhere in this Annual Report on Form 10-K.

Overview

We strive to develop some of the most comprehensive and actionable cancer genomic tests in the world to help patients live better and longer lives. We believe we have one of the most discerning technologies to both characterize and monitor cancer – with the aim of driving a new paradigm for cancer management and guiding care from biopsy through the life of the patient. Our assays combine tumor-and-normal profiling with proprietary algorithms to deliver advanced insights even as cancer evolves over time. Our products are designed to detect recurrence at the earliest timepoints, enable selection of targeted therapies based on ultra-comprehensive genomic profiling, and enhance biomarker strategy for drug development.

Today, our platforms are routinely used by many of the largest oncology-focused pharmaceutical companies for analysis of patient samples in their clinical trials and drug development programs. Our advanced genomic sequencing and analytics also support the development of personalized cancer vaccines and other next-generation cancer immunotherapies. For example, we are providing genomic testing to Moderna in its ongoing clinical trials evaluating a personalized cancer vaccine. In addition, we partner with diagnostics companies by providing our advanced tumor profiling and analysis capabilities as an input to their products. More recently, we launched new diagnostic offerings for the clinical setting and are preparing for future expansion in the clinical diagnostics market. Finally, we have also pursued non-cancer related business opportunities, specifically within the population sequencing market, by providing whole genome sequencing ("WGS") services under contract with the U.S. Department of Veterans Affairs Million Veteran Program ("VA MVP").

As part of one of our new strategies for 2023 and beyond, we are working with a growing number of leading cancer centers and world-class academic research institutions to build and publish the clinical evidence-base to support our products and our key indications. Specifically, because of the high sensitivity of our technology, we aim to focus on three indications in the next 2-3 years: immunotherapy (IO) monitoring, breast cancer, and lung cancer. We have announced collaborations with BC Cancer, Duke University, UCSF, Criterium, and Academic Breast Cancer Consortium that will focus on building the evidence-base for our technology and these indications. If the key opinion leaders ("KOLs") we are collaborating with have a positive experience using our platform, we are optimistic this will support broader use of our platform by other KOLS, as well as clinicians in the future.

Our work in oncology is underpinned by our experience and capacity for next-generation sequencing at scale. We have the capacity to sequence and analyze approximately 200 trillion bases of DNA per week in our facility. We believe that our capacity is already larger than most cancer genomics companies, and we continue to build automation and other infrastructure to scale further as demand increases. To date, we have sequenced more than 300,000 human samples, of which more than 160,000 were whole human genomes.

In October 2022, we relocated our corporate headquarters from Menlo Park, California to a new facility in Fremont, California. We signed a 13.5-year lease that extends to 2036 for the 100,000 square foot facility, which is approximately triple the amount of space than our Menlo Park location. The new facility allows for expansion of our laboratory for testing to support pharmaceutical customers and clinical diagnostic testing. In addition, the new space is intended to support the expansion of research and development efforts to bring leading edge products and services to the marketplace. Our Menlo Park office currently continues to house our Clinical Laboratory Improvement Amendments of 1988 (“CLIA”)-certified and College of American Pathologists (“CAP”)-accredited laboratory and we expect to move our laboratory operations from Menlo Park to the new facility in 2023.

2022 Highlights

Total revenue decreased 24%, or $20.4 million, during 2022 compared to 2021, due primarily to expected lower population sequencing revenue from the VA MVP. Revenue from pharma tests, enterprise, and other customers was $56.6 million in 2022 compared to $39.8 million in 2021, an increase of 42%, driven by higher sales to Natera under our partnership to provide advanced tumor analysis for use in Natera's MRD testing offerings. Revenue from population sequencing was $8.4 million in 2022 compared to $45.7 million in 2021, due to a reduction in the value of annual task orders received from the VA MVP in the past two years.

We announce new product offerings, business developments, and research collaborations at various times during the year. Significant announcements during 2022 included the following:

First Quarter 2022:

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Received our first customer order for NeXT Personal from a large global pharmaceutical customer and processed samples for initial order.

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Announced a collaboration with the Moores Cancer Center at UC San Diego Health, a National Cancer Institute-designated Comprehensive Cancer Center, to support clinical diagnostic testing in patients with advanced solid tumors and hematological malignancies.

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Second Quarter 2022:

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Received a new US patent relating to NeXT Personal, signifying its unique place among MRD assays as it combines a highly sensitive measurement of tumor burden with the ability to simultaneously track thousands of tumor variants, both tumor-informed and prespecified, in a single panel.

Third Quarter 2022:

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Launched a research collaboration with BC Cancer using NeXT Personal to determine the optimal time for ctDNA sampling for MRD detection in colorectal and pancreatic cancers, with the aim of identifying cancer progression before current standard of care tests.

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Announced a research collaboration with Duke University, deploying NeXT Personal to profile and accurately track MRD in patients with advanced gastroesophageal cancer over the course of therapy with the aim of better predicting a patient’s immune response to therapy.

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Added two additional patents to our MRD-related IP portfolio, both with priority to January 2013; the new patents describe the detection of cancer and its recurrence by using WGS of a patient’s tumor to identify variants for a subsequently used personalized liquid biopsy assay as well as the design of the liquid biopsy assay.

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Appointed Christopher Hall as SVP (subsequently promoted to President) who will lead the company’s diagnostic business, bringing 20 years of experience including leading the commercial organization at Veracyte and growing its business to nearly $100M in diagnostic revenue.

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Launched marketing and sales outreach to oncologists to begin generating demand for NeXT Dx, the company’s tissue-based clinical test that covers the whole exome and transcriptome and assesses genomic alterations in matched tumor and normal specimens to report variants and help oncologists with decision-making for therapy selection.

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Won an exclusive five-year contract and received the initial order from the VA MVP.

Fourth Quarter 2022:

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Initiated a research collaboration with University Medical Center Hamburg-Eppendorf ("UKE") and its new Fleur-Hiege Center for Skin Cancer Research, where Dr. Klaus Pantel, Dr. Christoffer Gebhardt, and team are using NeXT Personal to track tumor response to immunotherapy ("IO") in patients with melanoma, with the aim of gathering evidence to advance the use of ultra-sensitive MRD detection in routine clinical practice for IO therapy monitoring.

Recent Events

In January 2023, we announced a headcount reduction of up to 30% to reduce expenses and extend our cash runway. The reduction in workforce is expected to be completed in March 2023.

In January 2023, partnered with Criterium and the Academic Breast Cancer Consortium (ABRCC) to conduct a prospective clinical trial to validate the clinical performance of the NeXT Personal assay to evaluate minimal residual disease (MRD) and subsequent recurrence in patients with early-stage, resectable triple negative breast cancer (TNBC).

In February 2023, we announced a partnership with Moderna to provide genomic testing for its upcoming clinical studies evaluating mRNA-4157/V940, an investigational personalized cancer vaccine, jointly developed by Moderna and Merck.

In February 2023, we made a decision to streamline our international operations by closing our operations in China as expeditiously as possible in 2023. We expect to incur one-time charges in connection with the closure, including noncash impairments of property and equipment and a lease asset. Such charges cannot be estimated at this time, but we do not expect such charges to exceed $1.5 million.

Factors Affecting Our Performance

We believe there are several important factors that have impacted, and that we expect will continue to impact, our operating performance and results of operations, including:

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The continued development of the market for genomic-based tests. Our performance depends on the willingness of pharmaceutical companies, enterprise customers, and oncologists to continue to seek more comprehensive molecular information to develop more efficacious cancer therapies.

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Increasing adoption of our products and solutions by existing customers. Our performance depends on our ability to retain and broaden adoption with existing customers. Because our technology is novel, some customers begin using our platform by initiating pilot studies involving a small number of samples to gain experience with our service. As a result, historically a significant portion of our revenue has come from existing customers. We believe that our ability to convert initial pilots into larger orders from existing customers has the potential to drive substantial long-term revenue. We expect there may be some variation in the number of samples they choose to test each quarter.

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Adoption of our products and solutions by new customers. While new customers initially may not account for significant revenue, we believe that they have the potential to grow substantially over the long term as they gain confidence in our service. Our ability to engage new customers is critical to our long-term success. Our publications, posters and presentations at scientific conferences lead to engagement at the scientific level with potential customers who often make the initial decision to gain experience with our platform. Accessing these new customers through scientific engagement and marketing to gain initial buy-in is critical to our success and gives us the opportunity to demonstrate the utility of our platform.

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Our revenue and cost are affected by the volume of samples we receive from customers from period to period. The timing and size of sample shipments received after orders have been placed is variable. Since sample shipments can be large, and are often received from a third party, the timing of arrival can be difficult to predict over the short term. Although our long-term performance is not affected, we see quarter-to-quarter volatility due to these factors. Samples arriving later than expected may not be processed in the quarter proposed and result in revenue the following quarter. Since many of our customers request defined turnaround times, we employ project managers to coordinate and manage the complex process from sample receipt to sequencing and delivery of results.

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Investment in product innovation to support growth. Investment in research and development, including the development of new products and capabilities is critical to establish and maintain our leading position. We have invested significantly in our NeXT Platform, introducing new products and additional capabilities. We are also collaborating with key opinion leaders from cancer centers, such as Mayo Clinic and UC San Diego Moores Cancer Center, to support the clinical utility of our platform. We believe this work is critical to gaining customer adoption and expect our investments in these efforts to increase.

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Leverage our operational infrastructure. We have invested significantly in our sample processing capabilities and commercial infrastructure. With our current operating model and infrastructure, we can increase our production and commercialize new generations of our platform. We expect to grow our revenue and spread our costs over a larger volume of services.

Components of Operating Results

Revenue

We derive our revenue primarily from sales of advanced sequencing and analytics to the following four groups of customers:

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Pharma tests and services includes sales of testing services and data analytics for clinical trials and research to pharmaceutical companies in support of their drug development programs.

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Enterprise sales includes sales of tumor profiling and diagnostic tests directly to other businesses as an input to their products. Revenue from our partnership with Natera to provide advanced tumor analysis for use in Natera's MRD testing offerings currently makes up substantially all of the revenue in this category.

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Population sequencing includes sales of genomic sequencing services and data analytics to support large-scale genetic research programs. Revenue from our partnership with the VA MVP to provide population sequencing accounts for all of the revenue in this category.

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Other includes sales of genomic tests and analytics to universities and non-profits. This category also includes sales of diagnostics tests ordered by healthcare providers for cancer patients, which was insignificant in 2022.

Our ability to increase revenue will depend on our ability to further increase sales to these groups of customers and expand our customer base within each group. To do this, we are developing a growing set of state-of-the-art services and products, advancing our operational infrastructure, building our regulatory credentials, focusing our marketing efforts on large pharmaceutical companies, and seeking additional partnerships such as ours with Natera. We sell through a small direct sales force. We also anticipate increasing our revenue in the future through entrance into the clinical diagnostics market and have begun building our regulatory, clinical, and reimbursement capabilities, including hiring a national clinical sales force.

We have one reportable segment from the sale of sequencing and data analysis services. Most of our revenue to date has been derived from sales in the United States.

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Costs and Expenses

Cost of Revenue

Cost of revenue consists of raw materials costs, personnel costs (salaries, bonuses, stock-based compensation, payroll taxes, and benefits), laboratory supplies and consumables, depreciation and maintenance on equipment, and allocated facilities and information technology (“IT”) costs. We expect cost of revenue to increase as our revenue grows. We expect variability in our gross margins over the medium term due to fluctuating population sequencing revenue, investments in new capabilities such as automation of laboratory workflows, processing of diagnostic tests for the clinical market while we work to secure reimbursement, and costs related to our new Fremont facility. Over the long-term, we anticipate higher gross margins as growing revenue leads to economies of scale.

Research and Development Expenses

Research and development expenses consist of costs incurred for the research and development of our services and products and costs related to conducting studies and collaborations with partners to validate the clinical utility of our offerings. The expenses primarily consist of personnel costs (salaries, bonuses, stock-based compensation, payroll taxes, and benefits); laboratory supplies and consumables; costs of processing samples for research, product development, collaborations, and studies; depreciation and maintenance on equipment; and allocated facilities and IT costs. We include in research and development expenses the costs to further develop software we use to operate our laboratory, analyze the data it generates, and automate our operations.

We expense our research and development costs in the period in which they are incurred. We expect to increase our research and development expenses overall as we expand collaborations for clinical validation to secure reimbursement and develop our NeXT Personal test as an LDT for the clinical market, partially offset by cost reductions from our first quarter 2023 reduction in workforce and anticipated savings from our planned discontinuation of operations in China.

Selling, General and Administrative Expenses

Selling expenses consist of personnel costs (salaries, commissions, bonuses, stock-based compensation, payroll taxes, and benefits), customer support expenses, direct marketing expenses, and market research. Our general and administrative expenses include costs for our executive, accounting, finance, legal, and human resources functions. These expenses consist of personnel costs (salaries, bonuses, stock-based compensation, payroll taxes, and benefits), corporate insurance, audit and legal expenses, consulting costs, and allocated facilities and IT costs. We expense all selling, general and administrative costs as incurred.

We expect our selling, general and administrative expenses to decrease significantly in the medium term as a result of the 2023 reduction in workforce, partially offset by investments in our diagnostic sales outreach efforts.

Interest Income and Interest Expense

Interest income consists primarily of interest earned on our cash and cash equivalents and short-term investments. Our interest income increased significantly during 2022 as a result of the higher interest rate environment after the Federal Reserve began taking measures to curb inflation in 2022.

Interest expense in 2022 and 2021 is the recognition of imputed interest on noninterest bearing loans.

Other Income (Expense), Net

Other income (expense), net consists primarily of foreign currency exchange gains and losses, and realized gains or losses associated with sales of marketable securities.

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Trend Financial Information

The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes thereto in Item 8 of Part II, “Financial Statements and Supplementary Data”. Historical results are not necessarily indicative of future results.

Results of Operations

This section generally discusses 2022 and 2021 items and year-to-year comparisons between 2022 and 2021. Discussions of 2020 items and year-to-year comparisons between 2021 and 2020 that are not included in this Annual Report on Form 10-K can be found in “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, 2021, which is incorporated by reference herein.

Revenue

The following table shows revenue by customer type (in thousands):

The following table shows customers that made up at least 10% of total revenue in each year presented:

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Pharma tests and services

Revenue from pharma tests and services decreased 2%, or $0.7 million, in 2022. This was the result of decreases in certain customer projects, notably declines in ImmunoID NeXT samples processed for research and clinical trial projects for two large pharmaceutical customers; partially offset by increased revenue from other customer projects, notably fulfillment of an ImmunoID NeXT project with a different large pharmaceutical customer, a NeXT Liquid Biopsy project with another large pharmaceutical customer, and an ACE cancer sequencing project for a new customer.

Enterprise sales

Revenue from enterprise sales increased 204%, or $17.9 million, in 2022 primarily due to an increase in the volume of samples we tested for Natera for use in Natera's MRD testing offerings, partially offset by lower selling prices as a result of volume-based tiered pricing. The number of samples processed increased over 300% in 2022 as compared to 2021.

Population sequencing

Population sequencing revenue is made up entirely of sales to the VA MVP. The decrease of 82%, or $37.2 million, in revenue from the VA MVP in 2022 was due to a reduction in the value of annual task orders received from the VA MVP in the past two years. Specifically, we received task orders with values exceeding $36.0 million each year from 2017 to 2019. In 2020, the annual task order received from the VA MVP was $30.9 million, and in 2021 the annual task order received from the VA MVP was $9.7 million. The 2021 task order was the last task order received under our prior contract with the VA MVP, which is now expired. Our conversion of orders into revenue necessarily declined beginning in the fourth quarter of 2021 through the second quarter of 2022, which is when we completed the fulfillment of all outstanding task orders under the prior contract.

In September 2022, we entered into a new contract with the VA MVP to continue providing them WGS services. The performance period under the new contract includes a base period of one year, with four one-year renewal option periods that may be exercised upon discretion of the VA MVP. We concurrently received an initial task order with a value of up to $10.0 million, of which we fulfilled $0.9 million during the fourth quarter of 2022. We expect to recognize the remaining $9.1 million unfulfilled portion of the order in 2023.

Other

Other revenue decreased 46%, or $0.4 million, in 2022 due to lower revenue from university research projects.

Costs and Expenses

Cost of revenue

The decrease in cost of revenue of 4%, or $2.1 million, in 2022 was primarily due to lower revenue levels but also improved contribution margins due to customer mix (non-population sequencing sales generally have higher contribution margins), partially offset by higher fixed laboratory costs and indirect supplies costs (enterprise and pharma customer orders require more supplies to process as compared to population sequencing orders).

Specific components of the decrease were a $12.2 million decrease in raw materials costs due to lower revenue levels plus higher contribution margins, partially offset by a $4.4 million increase in facilities costs and maintenance on lab equipment, a $3.5 million increase in labor costs due to increased headcount, and a $2.2 million increase in laboratory supplies and consumables.

Research and development

The increase in research and development expenses of 32%, or $15.6 million, in 2022 was primarily due to new product and service development, increased hiring to build our clinical offerings, and the cost of testing samples for clinical validation work.

Specific components of the increase were a $7.5 million increase in personnel-related costs primarily related to increased headcount, a $4.1 million increase in sample processing costs incurred in our laboratory for new product development, a $3.0 million increase in IT and fixed facilities costs, and a $1.0 million increase in depreciation and maintenance on research and development equipment.

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Selling, general and administrative

The increase in selling, general and administrative expenses of 34%, or $16.3 million, in 2022 was primarily due to expansion of our commercial and clinical diagnostics teams in addition to one-time charges in connection with our former chief executive officer's retirement at the end of 2022.

Specific components of the increase were a $9.6 million increase in personnel-related costs (primarily related to increased headcount but also a $2.0 million one-time charge for severance and equity modifications in connection with our former chief executive officer's retirement at the end of 2022), a $2.6 million increase in professional services (including audit fees and legal expenses), a $2.5 million increase in sales-related and travel expenses, and a $1.6 million increase in facilities costs driven by our new Fremont facility.

Interest Income, Interest Expense and Other Expense, Net

Interest income and interest expense

The increase in interest income in 2022 was due to increased yields on our investments. Interest expense in 2022 and 2021 is the recognition of imputed interest on noninterest bearing loans.

Other income (expense), net

Other income (expense), net consisted mainly of foreign currency remeasurements.

Liquidity and Capital Resources

The following tables present selected financial information and cash flow information (in thousands):

From our inception through December 31, 2022, we have funded our operations primarily from $279.0 million in net proceeds from our follow-on equity offerings in August 2020 and January 2021, $144.0 million in net proceeds from our IPO in June 2019, and $89.6 million from issuance of redeemable convertible preferred stock, as well as cash from operations and debt financings. As of December 31, 2022, we had cash and cash equivalents in the amount of $89.1 million and short-term investments in the amount of $78.5 million.

We have incurred net losses since our inception. We anticipate that our current cash and cash equivalents and short-term investments, together with cash provided by operating activities, are sufficient to fund our near-term capital and operating needs for at least the next 12 months.

We have based these future funding requirements on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. If our available cash balances and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements, including because of lower demand for our services or other risks described in this Annual Report on Form 10-K, we may seek to sell additional common or preferred equity or convertible debt securities, enter into an additional credit facility or another form of third-party funding or seek other debt financing. We filed a prospectus supplement in January 2022 pursuant to which we could offer and sell additional shares of our common stock up to an aggregate amount of $100.0 million through an at-the-market offering program. The sale of equity and convertible debt securities may result in dilution to our stockholders 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. Additional capital may not be available on reasonable terms, or at all.

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Our short-term investments portfolio is primarily invested in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. Our investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer.

As of December 31, 2022, cash and cash equivalents held by foreign subsidiaries was $0.7 million. Our intent is to indefinitely reinvest funds held outside the United States and our current plans do not demonstrate a need to repatriate them to fund our domestic operations. However, if in the future, we encounter a significant need for liquidity domestically or at a particular location that we cannot fulfill through borrowings, equity offerings, or other internal or external sources, or the cost to bring back the money is not significant from a tax perspective, we may determine that cash repatriations are necessary or desirable. Repatriation could result in additional material taxes. These factors may cause us to have an overall tax rate higher than other companies or higher than our tax rates have been in the past.

During 2022, cash used in operating activities of $70.2 million was a result of $113.3 million of net loss, partially reduced by non-cash expenses of $32.5 million (the most significant non-cash expenses were $19.4 million of stock-based compensation and $8.4 million of depreciation and amortization) and a net positive change in working capital of $10.6 million (primarily due to $13.2 million cash receipts in connection with our Fremont facility lease incentives and a $3.1 million increase in accounts payable, partially offset by a $3.0 million increase in inventory and a $2.7 million reduction in outstanding customer prepayments as we fulfilled the related revenue contracts).

During 2022, cash provided by investing activities was $52.5 million due to $102.4 million of net proceeds from short-term investments partially offset by $49.9 million in property and equipment purchases. Cash provided by financing activities of $1.4 million during the same period consisted of $2.5 million proceeds from stock option exercises and purchases under our ESPP and $1.2 million proceeds from noninterest bearing loans, partially offset by $2.3 million repayments of noninterest bearing loans.

Material Cash Requirements

Our material cash requirements in the short- and long-term consist primarily of variable costs of revenue, operating expenditures, capital expenditures, property leases, and other. We plan to fund our material cash requirements with our existing cash and cash equivalents and short-term investments, which amounted to $167.7 million as of December 31, 2022, as well as anticipated cash receipts from customers. To fund our material cash requirements in the short- and long-term, we may also seek to sell additional common or preferred equity or convertible debt securities, enter into an additional credit facility or another form of third-party funding or seek other debt financing.

Variable costs of revenue. From time to time in the ordinary course of business, we enter into agreements with vendors for the purchase of raw materials, laboratory supplies and consumables to be used in the sequencing of customer samples. However, we generally do not have binding and enforceable purchase orders beyond the short term, and the timing and magnitude of purchase orders beyond such period is difficult to accurately project. We currently expect spend in this area to increase in 2023 to support expected higher levels of revenue.

Operating expenditures. Our primary use of cash relates to paying employees, spend on professional services, spend related to research and development projects, and other costs related to our research and development, selling, general and administrative functions. We currently expect to decrease our spend in these areas as a result of our first quarter 2023 workforce reduction. On a long-term basis, we manage future cash requirements relative to our long-term business plans.

Capital expenditures. Capital expenditures are expected to decrease significantly after 2022 as we have substantially completed the one-time build-out of our new headquarters and laboratory facility in Fremont, California as of the end of 2022. Going forward, our capital expenditures are expected to consist primarily of laboratory equipment and computer equipment. We currently expect capital expenditures to be between $4 million to $6 million in each of the years 2023, 2024, and 2025.

Property leases. Our noncancelable operating lease payments were $83.8 million as of December 31, 2022. The timing of these future payments, by year, can be found in Part II, Item 8 of this Annual Report on Form 10-K in the Notes to Consolidated Financial Statements in Note 7, Leases.

Other. As of December, 2022, we had three noninterest bearing loans to finance the purchase of $6.9 million of computer hardware, internal use software licenses, and related ongoing support. In connection with the loans, we made payments of $2.3 million in 2022. Remaining payments of $2.3 million and $0.4 million due in 2023 and 2024, respectively. Further discussion of these transactions can be found in Part I, Item 1 of this Annual Report on Form 10-K in the Notes to Consolidated Financial Statements in Note 6, Loans.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. We believe that the assumptions and estimates associated with revenue recognition, stock-based compensation, and leases have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates.

Revenue Recognition

We generate our revenue from selling sequencing and data analysis services. We agree to provide services to our customers through a contract, which may be in the form of a combination of a signed agreement, statement of work and/or a purchase order.

We have evaluated the performance obligations contained in contracts with customers to determine whether any of the performance obligations are distinct, such that the customers can benefit from the obligations on their own, and whether the obligations can be separately identifiable from other obligations in the contract. For the significant majority of our contracts to date, the customer orders a specified quantity of a sequencing; therefore, the delivery of the ordered quantity per the purchase order is accounted for as one performance obligation. Our contracts include only one performance obligation—the delivery of the sequencing and data analysis services to the customer.

Fees for our sequencing and data analysis services are predominantly based on a fixed price per sample. The fixed prices identified in the arrangements only change if a pricing amendment is agreed with a customer. In limited cases we provide our customers a discount if samples received above a certain volume are purchased. In such cases, the discount applies prospectively. We have analyzed such discounts if they represent a material right provided to a customer. We have concluded that such discounts generally do not represent a material right provided to a customer since they are not deemed to be incremental to the pricing offered to the customer or are not enforceable options to acquire additional goods. As a result, these discounts do not constitute a material right and do not meet the definition of a separate performance obligation, except in limited instances. We do not offer retrospective discounts or rebates. Accordingly, all of the transaction price, net of any discounts, is allocated to one performance obligation. Therefore, upon delivery of the services, there are no remaining performance obligations.

Contracts that contain multiple distinct performance obligations would require an allocation of the transaction price to each performance obligation based on a relative stand-alone selling price basis. Sometimes we deliver sequencing results in two or more batches; however, since the quantity delivered per batch of each individual test per sales order in these instances is in the same ratio as in the original sales order, allocating the transaction price on a relative stand-alone selling price basis would have no impact on the revenue recognized in any period presented.

We recognize revenue when control of the promised services is transferred to our customers. Management has determined that customers obtain control when the sequencing and data analysis service results are delivered to customers. Revenue is recorded net of sales or other transaction taxes collected from clients and remitted to taxing authorities.

A customer contract liability will arise when we receive payments from a customer related to an executed contract in advance of our provision of sequencing and data analysis services to such customer. We record a customer contract liability for performance obligations outstanding related to payments received in advance for customer deposits. We expect to satisfy these remaining performance obligations and recognize the related revenue upon providing sequencing and data analysis services.

All of our revenue and trade receivables are generated from contracts with customers.

Payment Terms

Payment terms and conditions vary by contract and customer. Our standard payment terms are typically 90 days or less from the invoice date. In instances where the timing of our revenue recognition differs from the timing of its invoicing, we have determined that our contracts do not include a significant financing component. The primary purposes of our invoicing terms are to provide customers with simplified and predictable ways of purchasing our services and provide payment protection for us.

Stock-Based Compensation

For options granted to employees, non-employees, and directors, stock-based compensation is measured at grant date based on the fair value of the award. We determine the grant-date fair value of options using the Black-Scholes option-pricing model, except for certain performance-based awards for which an alternative valuation method may be used. We determine the fair value of restricted stock unit awards using the closing market price of the Company’s common stock on the date of grant. The grant-date fair value of awards is amortized over the employees’ requisite service period on a straight-line basis, or the non-employees’ vesting period as the goods are received or services rendered. Forfeitures are accounted for as they occur. Additionally, our ESPP is deemed to be a compensatory plan and therefore is included in stock-based compensation expense.

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Estimating the fair value of equity-settled awards as of the grant date using valuation models, such as the Black-Scholes option-pricing model, is affected by assumptions regarding a number of complex variables. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. These inputs are subjective and generally require significant analysis and judgment to develop.

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Expected Term—The expected term assumption represents the weighted-average period that the stock-based awards are expected to be outstanding. We have elected to use the “simplified method” for estimating the expected term of the options, which is an available method if there is insufficient historical data about exercise patterns and post-vesting employment termination behavior. The simplified method is based on the vesting period and the contractual term for each grant, or for each vesting tranche for awards with graded vesting. The midpoint of the vesting date and the contractual expiration date is used as the expected term under this method. For awards with multiple vesting tranches, the assumed period for each tranche is computed separately and then averaged together to determine the expected term for the award.

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Expected Volatility—For all stock options granted to date, expected volatility was estimated based on an average historical stock price volatility of a peer group of publicly traded companies as we did not have sufficient trading history for our own common stock. For purposes of identifying these peer companies, we considered the industry, stage of development, size, and financial leverage of potential comparable companies.

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Expected Dividend Yield—The Black-Scholes option-pricing valuation model calls for a single expected dividend yield as an input. We currently have no history or expectation of paying cash dividends on our common stock.

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Risk-Free Interest Rate—The risk-free interest rate is based on the yield available on U.S. Treasury zero-coupon issues similar in duration to the expected term of the award.

Incremental Borrowing Rate

Lease liabilities are recognized at the present value of the fixed lease payments, reduced by landlord incentives, using a discount rate based on the Company’s current borrowing rate at the lease commencement date (the incremental borrowing rate), unless the rate implicit in the lease is readily determinable.

In August 2021, we entered into a 13.5-year lease for our new corporate headquarters in Fremont, California. We estimated our incremental borrowing rate as the rate implicit in the lease was not readily determinable. To determine the incremental borrowing rate, we estimated our credit rating by comparing certain financial ratios and metrics of the Company to those of other issuers with publicly-available credit ratings from Standard & Poor’s (S&P). We then adjusted yields from publicly traded corporate bonds of companies of similar size and credit rating over a term approximating the term of our lease for the nature of the collateral. Our concluded incremental borrowing rate for this lease was 5.8%, which resulted in a lease liability and right-of-use asset of $44.7 million.

In September 2022, the lease commencement date for our new facility in Fremont, California was delayed from the original intended date due to delays in the completion of the work necessary for the Company to move into the facility, which resulted in a reassessment of the lease term and consequently a remeasurement of the lease liability and corresponding adjustment to the carrying amount of the right-of-use asset based on the updated incremental borrowing rate. We estimated our incremental borrowing rate by using the same method described above and concluded that the incremental borrowing rate for the remeasured lease was 10.5%. The lease reassessment resulted in a $12.9 million reduction to right-of-use assets in 2022. The increase in our estimated borrowing rate between August 2021 and September 2022 mostly reflects the higher interest rate environment in 2022 as compared to 2021.

Recent Accounting Pronouncements

See the sections titled “Summary of Significant Accounting Policies—Recent Accounting Pronouncements” and “—Recent Accounting Pronouncements Not Yet Adopted” in Note 2 to our consolidated financial statements for additional information.