XOMA Royalty Corp (XOMA) FY 2022 MD&A

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

Overview

XOMA is a biotech royalty aggregator. We have a sizable portfolio of economic rights to future potential milestone and royalty payments associated with partnered pre-commercial therapeutic candidates. Our portfolio was built through licensing our proprietary products and platforms from our legacy discovery and development business, combined with the acquisition of rights to future milestones and royalties that we have made since our royalty aggregator business model was implemented in 2017. Our drug royalty aggregator business is focused on early to mid-stage clinical assets, primarily in Phase 1 and 2, with significant commercial sales potential that are licensed to large-cap partners. We expect that most of our future revenue will be based on payments we may receive for milestones and royalties related to these programs.

The generation of future revenues related to licenses, milestones, and royalties is dependent on the achievement of milestones or product sales by our existing licensees. Although we generated net income of $15.8 million and positive cash flows from operations of $22.7 million for the year ended December 31, 2021, we generated net loss of $17.1 million and negative cash flows from operations of $12.9 million for the year ended December 31, 2022 and we had an accumulated deficit of $1.2 billion as of December 31, 2022. The payment we received from Novartis pursuant to our Anti-TGFβ Antibody License Agreement in 2021 was a one-time milestone payment that does not represent recurring revenue.

Significant Developments

Purchase of IP

ObsEva Intellectual Property Acquisition Agreement

In November 2022, we entered into the ObsEva IP Acquisition Agreement pursuant to which we acquired all of ObsEva’s intellectual property (patents and know-how) and license agreement rights related to ebopiprant, an investigational compound previously licensed by ObsEva from Merck KGaA. We also assumed ObsEva’s ongoing obligations under the Organon License Agreement and the Merck KGaA License Agreement. Pursuant to the Organon License Agreement, XOMA is eligible to receive up to $475.0 million in payments for ebopiprant development, commercialization and sales-based milestones.  If ebopiprant is successfully commercialized, we will be entitled to receive royalties that range from low to mid-teens from Organon and will be required to make mid-single-digit royalty payments to Merck KGaA.  We paid ObsEva a $15.0 million upfront payment at closing and will pay potential earn-out payments of up to $97.5 million for development, regulatory and sales-based milestones, representing a portion of what we will receive pursuant to the Organon License Agreement.

Royalty and Commercial Payment Purchase Agreements

Commercial Payment Purchase Agreement with Affitech

In January 2022, Genentech, a member of the Roche group, received approval from the FDA to commercialize VABYSMO (faricimab-svoa) for the treatment of wet, or neovascular, age-related macular degeneration and diabetic macular edema.  Pursuant to the Affitech CPPA, we paid Affitech a $5.0 million regulatory approval milestone tied to these U.S. marketing approvals. Under the terms of the Affitech CPPA, we are eligible to receive a 0.5% commercial payment stream on net sales of VABYSMO in each of certain regions where it is approved, for a ten-year period following its first commercial sale in such region.

In September 2022, in connection with Roche receiving approval from the EC to commercialize VABYSMO for the treatment of neovascular or ‘wet’ age-related macular degeneration and visual impairment due to diabetic macular edema, we made a $3.0 million milestone payment to Affitech pursuant to the terms of the Affitech CPPA. As a result of

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the EC approvals, we will be eligible to receive a 0.5% commercial payment stream for ten years from the first commercial sale of VABYSMO in Europe.

VABYSMO was previously approved by the FDA in January 2022 and by Japan’s Ministry of Health, Labour, and Welfare in March 2022. In August 2022, we received $0.5 million from Roche representing the first commercial payment for sales of VABYSMO during the first six months of 2022, and in February 2023 we received $2.4 million for sales of VABYSMO during the second half of 2022.

Kuros Royalty Purchase Agreement

In July 2022, we received $2.5 million pursuant to our Kuros RPA. This payment represents 50% of a milestone earned by Kuros upon the closing of Regeneron’s acquisition of Checkmate Pharmaceuticals on May 31, 2022.

License and Collaboration Agreements

Compugen

In November 2022, we earned a $0.8 million milestone payment under our license agreement with Compugen.

Novartis – VPM087

In March 2023, Novartis notified us that based upon a strategic review of the development program, Novartis will not initiate further studies of gevokizumab in gastrointestinal cancers.  Novartis’ study to evaluate treatment with gevokizumab with standard of care anti-cancer therapies in patients with metastatic colorectal, gastroesophageal, and renal cancers will continue to primary analysis, which is anticipated later this year.

Novartis – Anti-CD40 Antibody

In September 2021, Novartis announced its decision to discontinue its study of CFZ533 (iscalimab) in kidney transplant. In September 2022, after an interim analysis of data, Novartis also decided to discontinue its study of CFZ533 in liver transplant. Novartis is continuing iscalimab studies in other indications such as Sjögren’s Syndrome, Lupus Nephritis and Hidradenitis Suppurativa.

Sonnet Collaboration Agreement

In April 2022, Sonnet dosed the first patient in its Phase 1 clinical trial for SON-1010, and we earned a development-related milestone payment of $0.5 million from Sonnet pursuant to our Sonnet Collaboration Agreement.

Rezolute – RZ358 Antibody

In January 2022, Rezolute dosed the last patient in its Phase 2b clinical trial for RZ358, we earned a $2.0 million milestone payment pursuant to our Rezolute License Agreement.

Modification of Equity Awards

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In November 2022, we entered into the November 2022 Letter Agreement with Thomas Burns. Pursuant to the November 2022 Letter Agreement, in the event Mr. Burns remains employed by us for a twelve-month period beginning on November 1, 2022, he will be deemed “retirement eligible” for purposes of his equity awards under the terms of his equity award agreements. All other terms of his amended and restated employment agreement remain the same. Conditioned on his execution of a release in favor of us, Mr. Burns will also receive this benefit upon any involuntary termination for reasons other than cause. This modification resulted in an acceleration of the expense recognized related to Mr. Burns’ stock options. During the year ended December 31, 2022, we recognized stock-based compensation expense of $0.6 million related to the Mr. Burns’ option awards. As of December 31, 2022, there was $0.5 million total

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unrecognized compensation expense related to Mr. Burns’ stock options expected to be recognized through the earlier of the vesting date of the option or October 31, 2023.

Employee Retention Bonus

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In October 2022, we approved the Amended Retention Plan that amended the Retention Plan to provide that each of our current employees, excluding the Chief Executive Officer (“CEO”), will be eligible to receive a cash retention bonus if employed through each of two periods: (1) the three-month anniversary of November 1, 2022 (the “Initial Period”) and (2) the nine-month period immediately following the Initial Period. All other terms of the Amended Retention Plan remain consistent with the Retention Plan. As of December 31, 2022, we expect to pay $0.8 million in 2023 related to employee retention bonuses under the Amended Retention Plan, of which $0.1 million was accrued in operating expenses in the consolidated statement of operations and comprehensive loss during the year ended December 31, 2022.

James R. Neal’s Departure and Continuity Incentive

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Effective December 31, 2022, James R. Neal retired as our Chief Executive Officer and, effective as of January 1, 2023, resigned as a member of our Board and Chairman of the Board. Pursuant to Mr. Neal’s  Amended and Restated Employment Agreement, dated as of December 15, 2021, following his departure date, Mr. Neal is entitled to a cash payment of $1.2 million, which will be made in equal monthly installments starting in January 2023 through December 2023, less deductions and withholdings.  As of December 31, 2022, we accrued the full amount of Mr. Neal’s continuity incentive of $1.2 million in operating expenses in the consolidated statement of operations and comprehensive loss during the year ended December 31, 2022.

On December 30, 2022, the Board appointed Owen Hughes as our Executive Chairman of the Board and Interim Chief Executive Officer (principal executive officer), effective as of January 1, 2023. Mr. Hughes will receive an annual base salary of $125,000 and will be eligible to receive an annual discretionary cash bonus with a target amount equal to 55% of his annual base salary upon the achievement of annual performance milestones to be established by the Board.

On December 30, 2022, the Board also appointed Bradley Sitko as our Chief Investment Officer, effective as of January 3, 2023. Mr. Sitko will receive an annual base salary of $500,000, a signing bonus of $110,000 and will be eligible to receive an annual discretionary cash bonus with a target amount equal to 50% of his annual base salary upon the achievement of annual performance milestones to be established by the Board.

Mr. Hughes and Mr. Sitko were also granted non-qualified stock options subject to the terms and conditions of the Company’s Amended and Restated 2010 Long Term Incentive and Stock Award Plan. The options were granted outside the Plan as an inducement material to Mr. Hughes and Mr. Sitko entering into employment with us in accordance with Nasdaq Listing Rule 5635(c)(4).  Further details of the stock option grants can be found in our Form 8-K filed January 4, 2023.

Arbitration Proceeding

In June 2021, we initiated an arbitration proceeding against one of our licensees (the “Licensee”) with the American Arbitration Association/International Centre for Dispute Resolution.  We seek damages, plus interest, and fees and costs of the arbitration (which fees and costs are currently estimated to be in the mid-single-digit millions of U.S. dollars range).  In response, the Licensee seeks declarations that the License Agreement, under our interpretation, is unlawful, void and unenforceable, and that the License Agreement has expired.  To date, the Licensee has not filed any counterclaims against us. However, to the extent the Licensee is deemed to be the prevailing party, the arbitrators, in their discretion, may require us to pay the Licensee’s fees and costs of the arbitration (currently estimated to be in the mid-single-digit millions of U.S. dollars range). A hearing before a panel of arbitrators was held on this matter in November 2022, and the parties have submitted post-hearing briefs.

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Critical Accounting Estimates

The preparation of financial statements in accordance with generally accepted accounting principles, or GAAP, requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities and the reported amounts of revenues and expenses that are not readily apparent from other sources. Actual results may differ from those estimates under different assumptions and conditions.

Critical accounting estimates are those estimates that involve a significant level of judgment and/or estimation uncertainty and could have or are reasonably likely to have a material impact on our financial condition or results of operations. We believe the following critical accounting policies and estimates describe the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Purchase of Rights to Future Milestones, Royalties and Commercial Payments

We have purchased rights to receive a portion of certain future developmental, regulatory and commercial sales milestones, and royalties on sales of products currently in clinical development. We acquired such rights from various entities and recorded the amount paid for these rights as long-term royalty receivables. We have accounted for the purchased rights as a financial asset in accordance with ASC 310.

Receivables

We account for milestone and royalty rights related to developmental pipeline products on a non-accrual basis using the cost recovery method. Except for VABYSMO, these developmental pipeline products are non-commercialized, non-approved products that require FDA or other regulatory approval, and thus have uncertain cash flows. The related receivable balances are classified as noncurrent since no payments are probable to be received in the near term. VABYSMO received FDA approval in January 2022, was approved by Japan’s Ministry of Health, Labour, and Welfare in March 2022, and was approved by the EU’s EC in September 2022 and we do not yet have a foundation upon which to estimate receipts expected to be collected in the near term; therefore, they remain classified as noncurrent until such time an estimate can be made. Under the cost recovery method, any milestone, royalty, or other payment received is recorded as a direct reduction of the recorded receivable balance. When the recorded receivable balance has been fully collected, any additional amounts collected will be recognized as revenue.

Contingent Payments

We may be obligated to make contingent payments related to certain product development and regulatory approval milestones and sales-based milestones. If the contingent payments fall within the scope of ASC 815, the contingent payments are measured at fair value at the inception of the arrangement, subject to remeasurement to fair value at the end of each reporting period. Any changes in the estimated fair value are recorded in the consolidated statement of operations and comprehensive (loss) income.

Impairment Assessment

We review these balances for impairment on a quarterly basis using updates from our partners, press releases and public information on clinical trials.  If we determine an impairment is necessary, the impairment recorded will be based on an estimate of discounted future cash flows, which will rely on assumptions including probability of technical success and discount rate.  Changes to these assumptions could have a material impact on our financial statements.  No impairment has been recorded as of December 31, 2022.

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Stock-Based Compensation

Stock-based compensation expense for stock options and other stock awards is estimated at the grant date based on the award’s fair value-based measurement. The valuation of stock-based compensation awards is determined at the date of grant using the Black-Scholes Model. This model requires highly complex and subjective inputs, such as the expected term of the option and expected volatility. These inputs are subjective and generally require significant analysis and judgment to develop. Our current estimate of volatility is based on the historical volatility of our stock price. To the extent volatility in our stock price increases in the future, our estimates of the fair value of options granted in the future could increase, thereby increasing stock-based compensation cost recognized in future periods. To establish an estimate of expected term, we consider the vesting period and contractual period of the award and our historical experience of stock option exercises, post-vesting cancellations and volatility. The risk-free rate is based on the yield available on United States Treasury zero-coupon issues. Forfeitures are recognized as they occur.

We review our valuation assumptions quarterly and, as a result, we likely will update our valuation assumptions used to value stock-based awards granted in future periods utilizing current data. In the future, as additional empirical evidence regarding these input estimates becomes available, we may change or refine our approach of deriving these input estimates. These changes could impact our fair value-based measurement of stock options granted in the future. Changes in the fair value-based measurement of stock awards could materially impact our operating results.

Results of Operations

Revenues

Total revenues for the years ended December 31, 2022 and 2021, were as follows (in thousands):

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Revenue from Contracts with Customers

Revenue from contracts with customers includes upfront fees, annual license fees and milestone payments related to the out-licensing of our legacy product candidates and technologies. The primary components of revenue from contracts with customers in 2022 were due to milestones earned of $2.0 million pursuant to our Rezolute License Agreement, $0.8 million pursuant to the Takeda Collaboration Agreement, $0.8 million pursuant to our license agreement with Compugen and $0.5 million pursuant to our Sonnet Collaboration Agreement. The primary components of revenue from contracts with customers in 2021 were due to milestones earned of $35.0 million under our Anti-TGFβ Antibody License Agreement with Novartis, $0.5 million under our license agreement with Compugen and $0.7 million under our license agreement with Janssen.

Revenue recognized under units-of-revenue method

Revenues recognized under the units-of-revenue method include the amortization of unearned revenue from the sale of royalty interests to HCRP in 2016. The increase in 2022 compared with 2021 was due to increased sales of products underlying the agreements with HCRP.

G&A Expenses

G&A expenses include salaries and related personnel costs, professional fees, and facilities costs. In 2022, G&A expenses were $23.2 million compared with $20.5 million in 2021.

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The net increase of $2.7 million in 2022 as compared with 2021 was primarily due a $2.6 million increase in salaries and related expenses including the $1.2 million Continuity Incentive accrued in connection with the departure of Mr. Neal, a $0.7 million increase in salaries and wages due to increased headcount and general salary increases, $0.4 million related to bonus payments to Mr. Neal pursuant to his amended employment agreement, and $0.1 million accrued in connection with the employee retention bonus. A $2.3 million increase in consulting and legal costs also contributed to the overall increase. The increases in salaries and related expenses, consulting and legal costs were partially offset by a $2.6 million reduction in stock-based compensation expense for stock options.

Other Income (Expense)

Interest Expense

The $0.5 million interest expense reported for the year ended December 31, 2021 was related to our SVB Loan that was repaid in June 2021. There was no interest expense for the year ended December 31, 2022. We expect no interest expense in 2023 as we have no outstanding loan balances; however if we elect to obtain new debt financing, our interest expense may increase.

Other Income (Expense), Net

The following table shows the activity in other income (expense), net for the years ended December 31, 2022 and 2021 (in thousands):

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The change in fair value of equity securities is due to the change in market price of equity securities we own in shares of Rezolute’s common stock. Investment income increased $0.7 million compared with the same period in 2021 due to higher market interest rates.

Provision for Income Taxes

We recorded a $15,000 income tax benefit and a $0.1 million income tax expense for the years ended December 31, 2022 and 2021, respectively. We continue to maintain a full valuation allowance against our remaining net deferred tax assets. We had a total of $5.9 million of gross unrecognized tax benefits, none of which would impact our effective tax rate to the extent that we continue to maintain a full valuation allowance against our deferred tax assets. We do not expect our unrecognized tax benefits to change significantly over the next twelve months.

Liquidity and Capital Resources

The following table summarizes our unrestricted cash, our working capital and our cash flow activities as of and for each of the periods presented (in thousands):

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Net cash used in operating activities for 2022 was primarily due to our operating expenses of $23.4 million, excluding non-cash expenses of $4.4 million including stock-based compensation of $3.6 million, partially offset by a $2.0 million milestone payment received from Rezolute, a $0.8 million milestone payment received from Takeda and a $0.8 million milestone payment received from Compugen. Our primary source of cash provided by operating activities in 2021 was the $35.0 million milestone payment received from Novartis, partially offset by our operating expenses of $20.6 million excluding non-cash expenses including stock-based compensation of $6.2 million.

Net cash used in investing activities for the year ended December 31, 2022 of $20.2 million was primarily due to the $15.2 million paid for the IP acquired pursuant to the ObsEva IP Acquisition Agreement in November 2022 and the $5.0 million and $3.0 million payments for regulatory milestones pursuant to the Affitech CPPA, partially offset by the $2.5 million milestone payment received from Kuros in July 2022 and the $0.5 million commercial payment received from Roche in August 2022. Net cash used in investing activities for the year ended December 31, 2021, of $26.5 million was due to our acquisitions under RPAs and a CPPA, including a $13.5 million payment pursuant to the Viracta RPA, a $7.0 million payment pursuant to the Kuros RPA and a $6.0 million payment pursuant to the Affitech CPPA.

Net cash used in financing activities for the year ended December 31, 2022, of $4.5 million was primarily due to the payment of dividends on our Series A and Series B Preferred Stock of $5.5 million, partially offset by the receipt of net cash provided from the exercise of stock options after related tax payments of $1.0 million. Net cash provided by financing activities for the year ended December 31, 2021 of $12.8 million was primarily due to the receipt of net cash proceeds of $37.1 million from our public offering of Series B Preferred Stock, $1.1 million net cash provided from the exercise of stock options after related tax payments, partially offset by $4.3 million cash used in the principal payments of debt, $17.1 million cash used to extinguish outstanding loans and $3.5 million payment of dividends on our Series A Preferred Stock and Series B Preferred Stock.

Capital Resources

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We have incurred significant operating losses since our inception and as of December 31, 2022, we had an accumulated deficit of $1.2 billion.  As of December 31, 2022, we had $57.8 million in cash and cash equivalents. Based on our current cash balance and our ability to control discretionary spending, such as royalty acquisitions, we have evaluated and concluded our financial condition is sufficient to fund our planned operations, commitments, and contractual obligations for a period of at least one year following the filing date of this report.

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We have primarily financed our operations and acquisitions through the issuance of our common stock, Series A and Series B Preferred Stock, and amounts received as milestone payments under our license agreements.  The generation of future revenues related to licenses, milestones, and royalties is dependent on the achievement of milestones or product sales by our existing licensees. Milestone payments earned in 2021 and 2022 are not indicative of anticipated milestones in future periods. We may seek additional capital through use of our 2018 Common Stock ATM Agreement or 2021 Series B Preferred Stock ATM Agreement (see Note 11 of the Consolidated Financial Statements), or through other public or private debt or equity transactions. Our ability to raise additional capital in the equity and debt markets, should we choose to do so, is dependent on a number of factors, including, but not limited to, the market demand for our common and preferred stock, which are subject to a number of development and business risks and uncertainties, our creditworthiness and the uncertainty that we would be able to raise such additional capital at a price or on terms that are favorable to us.  If we are unable to raise additional funds when we need them, our business and operations may be adversely affected.

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Material Cash Requirements

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Our material cash requirements in the short and long term consist of the following expenditures:

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Operating expenditures: Our primary uses of cash and operating expenses relate to employee and related costs, consultants to support our administrative and business development efforts, legal and accounting services, insurance, investor relations and IT services. Our planned spending includes costs to satisfy the Continuity Incentive related to the departure of Mr. Neal as CEO in December 2022 and increased personnel-related costs starting in 2023 due to the appointment of our new Executive Chairman and Chief Investment Officer.

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In response to our prior CEO’s intention to retire as announced in December 2021, we implemented a Retention Plan to encourage our employees to remain with the Company through and beyond the new CEO transition period. Our Retention Plan includes a cash “stay” bonus, effective November 1, 2022, as well as a policy defining benefits upon any involuntary termination for reasons other than cause, which includes minimum severance, COBRA benefits, outplacement services and certain modifications to option awards. We expect our operating expenses to increase as a result of this Retention Plan.

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To support our royalty aggregator business model, we engage third parties to assist in our evaluation of potential acquisitions of milestone and royalty streams. Additional operating expenses, including consulting and legal costs, may increase in 2023 in response to an anticipated increase in the volume of acquisition targets evaluated or completed.

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Our amended headquarters lease expires in July 2023, and we are currently evaluating our office space needs, however, due to our small staff and minimal operating space requirements, we do not expect to incur material incremental costs associated with our current or future building leases.

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RPAs, CPPAs and IP Acquisitions: A significant component of our business model is to acquire rights to potential future milestone and royalty streams.  We expect to continue deploying capital toward these acquisitions in the near and long term.

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We also have potential contingent consideration of $0.1 million recorded on our consolidated balance sheets as of December 31, 2022, for development milestones due under our agreement with Bioasis. We paid Affitech a total of $8.0 million in 2022 for milestones tied to the achievement of  regulatory approvals. We have evaluated and concluded our existing capital resources are adequate to meet those needs.

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We also have potential sales-based milestones that may become due under our agreements with Aronora, Kuros and Affitech as well as non-sales-based milestones, sales-based milestones and sales-based royalty payments that may become due under our agreement with ObsEva. All of these milestones and royalty payments represent a portion of the funds we may receive in the future pursuant to these agreements, and therefore will be fully funded by the related royalty or commercial payment receipts.

Collaborative Agreements, Royalties and Milestone Payments: We have committed to make potential future milestone payments and legal fees to third parties as part of licensing and development programs. Payments under these agreements become due and payable only upon the achievement of certain developmental, regulatory and commercial milestones by our licensees. Because it is uncertain if and when these milestones will be achieved, such contingencies, aggregating up to $6.3 million (assuming one product per contract meets all milestone events) have not been recorded on our consolidated balance sheet as of December 31, 2022. We are unable to determine precisely when and if our payment obligations under the agreements will become due as these obligations are based on milestone events, the achievement of which is subject to a significant number of risks and uncertainties.  All payments due will be funded by a portion of the related milestone or royalty revenue we receive or will be reimbursed by our licensees.

Dividends: Holders of our Series A Preferred Stock are entitled to receive, when and as declared by our Board of Directors, cumulative cash dividends at the rate of 8.625% of the $25.00 liquidation preference per year (equivalent to $2.15625 per share of Series A Preferred Stock per year). Holders of Series B Depositary Shares are entitled to receive, when and as declared by our Board of Directors, cumulative cash dividends at the rate of 8.375% of the $25,000 liquidation

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preference per share of Series B Preferred Stock ($25.00 per depositary share) per year, which is equivalent to $2,093.75 per year per share of Series B Preferred Stock ($2.09375 per year per depositary share).  Dividends on the Series A and Series B Preferred Stock are payable in arrears on or about the 15th day of January, April, July and October of each year.  Since original issuance, all dividends have been paid as scheduled.  We expect to continue making these dividend payments as scheduled using our existing capital resources.

Recent Accounting Pronouncements

See Note 2 to the Consolidated Financial Statements for information regarding new accounting pronouncements.

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