Summary of Significant Accounting Policies (Policies)

6 Months Ended

Jun. 30, 2019

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that impact the reported amounts of assets, liabilities, revenues, and expenses and the disclosure of contingent assets and liabilities in the Company’s financial statements and accompanying notes. The most significant assumptions used in the financial statements are the underlying assumptions used in valuing share-based compensation including the fair value of the common stock, allowance for bad debts, the net realizable value of inventories, the valuation of variable transaction price in its contracts with customers, the determination of standalone selling price for contracts with customers, the value of the warrant liability, the value of embedded derivatives and the estimated useful lives of equipment and furniture. The Company bases estimates and assumptions on historical experience when available and on various factors that it determined to be reasonable under the circumstances. The Company evaluates its estimates and assumptions on an ongoing basis. The Company’s actual results may differ from these estimates under different assumptions or conditions.

Fair Value Measurements

The carrying amounts reported in the Company’s financial statements for cash and cash equivalents, accounts receivable, net of allowance, prepaid expenses and other current assets, accounts payable, accrued expenses and other current liabilities approximate their respective fair values because of the short-term nature of these accounts. The fair value of the Company’s long-term debt (see Note 7, “Long-Term Debt”) is determined using Level 3 inputs using current applicable rates for similar instruments as of the balance sheet dates and assessment of the credit rating of the Company. The carrying value of the Company’s long-term debt approximates fair value because the Company’s interest rate yield is near current market rates. The Company’s warrant liability, derivative liability and long-term debt are considered Level 3 liabilities within the fair value hierarchy described below.

Fair value is defined as the price that would be received if selling an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value measurements for assets and liabilities where there exists limited or no observable market data are based primarily upon estimates, and often are calculated based on the economic and competitive environment, the characteristics of the asset and liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any valuation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could significantly affect the results of current or future values.

The Company’s financial assets are classified within the fair value hierarchy based on the lowest level of inputs that is significant to the fair value measurement. The three levels of the fair value hierarchy, and its applicability to the Company’s financial assets, are described as follows:

Level 1: Unadjusted quoted prices of identical, unrestricted assets in active markets that are accessible at the measurement date.

Level 2: Quoted prices for similar assets, or inputs that are observable, either directly or indirectly, for substantially the full term through corroboration with observable market data.

Level 3: Pricing inputs are unobservable for the assets, that is, inputs that reflect the Company’s own assumptions about the assumptions market participants would use in pricing the assets.

There were no transfers between Levels 1, 2, and 3 during the six months ended June 30, 2019 and 2018.

The Company has liabilities classified as Level 3 that are measured by management at fair value on a quarterly basis as described in Note 7, “Long-Term Debt,” and Note 9, “Warrants,” respectively. See Note 5, “Fair Value Measurements,” for additional information.

Restricted Cash

The Company had restricted cash of $551 at June 30, 2019 and December 31, 2018. $351 of the balance at June 30, 2019 and December 31, 2018 related to two irrevocable standby letters of credit in relation to the Company’s office lease agreements. Each letter of credit names the lessor as the beneficiary and is required to fulfill lease requirements in the event the Company should default on office lease obligations. $200 of the balance at June 30, 2019 and December 31, 2018 was held to collateralize the Company’s credit card.

Concentration of Credit Risk and Significant Customers

Cash, cash equivalents and accounts receivable are financial instruments that potentially subject the Company to concentrations of credit risk.

At June 30, 2019 and December 31, 2018, the Company invested its excess cash in money market funds through a United States bank with high credit ratings. The Company is exposed to credit risk in the event of a default by the financial institution holding its cash and cash equivalents to the extent recorded on the balance sheet. The Company has no financial instruments with off-balance sheet risk of loss. The Company has not experienced any significant losses in such accounts and management believes that the Company is not exposed to significant credit risk due to the financial position of the depository institutions in which those deposits are held.

The Company is also subject to credit risk from its accounts receivable. The Company sells its products through its direct sales organization in the United States and primarily through established distributors outside of the United States. To minimize credit risk, ongoing credit evaluations of customers’ financial condition are performed and upfront customer deposits are received prior to shipment whenever deemed necessary. The Company has not experienced any material losses related to receivables from individual customers, or groups of customers.

During the six months ended June 30, 2019 and 2018, the Company did not recognize revenue from any single customer over 10% of total revenues. At December 31, 2018, the Company had one customer with an accounts receivable balance greater than 10% of total accounts receivable. No such customer existed at June 30, 2019.

Convertible Preferred Stock

The Company recorded its convertible preferred stock at fair value on the dates of issuance, net of issuance costs. A deemed liquidation event will only occur upon a greater than 50% change in control or a sale of substantially all of the assets of the Company and will be a redemption event subject to election by the holders of at least 70% of the then outstanding shares of convertible preferred stock, voting together as a single class on an as-converted basis. As the redemption event is outside the control of the Company, all shares of convertible preferred stock have been presented outside of permanent equity. As of December 31 2018, it was not probable that such redemption would occur. Upon closing of the Company’s IPO on February 19, 2019, each share of convertible preferred stock automatically converted into shares of common stock at a conversion rate of one preferred share to one common share for each series of convertible preferred stock.

Revenue Recognition

The Company adopted ASC 606 on January 1, 2019 using the modified retrospective method for all contracts not completed as of the date of adoption. Under this method, the new guidance was applied to contracts that were not yet completed as of January 1, 2019 with the cumulative effect of initially applying the guidance recognized through accumulated deficit as the date of initial application. The reported results for 2019 reflect the application of ASC 606 guidance while the reported results for 2018 were prepared under the guidance of ASC 605, Revenue Recognition (“ASC 605”), which is also referred to herein as the "previous guidance.” The adoption of ASC 606 represents a change in accounting principle that will primarily impact how revenue is recognized for single dose pharmaceuticals sold in the United States and how the Company accounts for contract acquisition costs, such as commissions. See the “Financial Statement Impact of Adopting ASC 606” in Note 3 for further details. Revenue is recognized when, or as, obligations under the terms of a contract are satisfied, which occurs when control of the promised products or services is transferred to customers. Revenue is measured as the amount of consideration the Company expects to receive in exchange for transferring products or services to a customer (the “transaction price”). To the extent the transaction price includes variable consideration, the Company estimates the amount of variable consideration that should be included in the transaction price utilizing the expected value method or the most likely amount method, depending on the facts and circumstances relative to the contract. Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of the Company’s anticipated performance and all information (historical, current and forecasted) that is reasonably available. Sales, value add, and other taxes collected on behalf of third parties are excluded from revenue.

When determining the transaction price of a contract, an adjustment is made if payment from a customer occurs either significantly before or significantly after performance, resulting in a significant financing component. The Company does not assess whether a significant financing component exists if the period between when the Company performs its obligations under the contract and when the customer pays is one year or less. None of the Company’s contracts contained a significant financing component as of January 1, 2019 or June 30, 2019.

Contracts with customers may contain multiple performance obligations. For such arrangements, the transaction price is allocated to each performance obligation based on the estimated relative standalone selling prices of the promised products or services underlying each performance obligation. The Company determines standalone selling prices based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, the Company estimates the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations.

The Company has elected to account for the shipping and handling as an activity to fulfill the promise to transfer the product, and therefore will not evaluate whether shipping and handling activities are promised services to its customers.

The Company recognizes product revenue under the terms of each customer agreement upon transfer of control to the customer, which occurs at a point in time. Service warranty revenue is recognized over the service warranty period, which is typically one to two years.

The timing of revenue recognition, billings and cash collections results in accounts receivables and deferred revenue on the Company’s condensed balance sheets. All contract assets are presented as accounts receivable since the Company has an unconditional right to receive consideration when performance obligations are satisfied. Contract liabilities are presented as deferred revenue and represent consideration received or unconditionally due from customers prior to transferring goods or services to the customer under the terms of a contract.

U.S. Product Revenue

Through its direct sales force, the Company sells medical devices and related single dose pharmaceuticals directly to customers, which are typically physicians, clinics or hospitals. A contract is deemed to exist on an initial device and related single dose pharmaceuticals sale when a sales agreement and order form for the device and single dose pharmaceuticals is executed. A contract for purchases of subsequent single dose pharmaceuticals exists when a reorder form is received and accepted by the Company.

The performance obligations in the contracts for the delivery of these products may include medical devices, single dose pharmaceuticals, extended warranty service contracts and a customer option to purchase a single dose pharmaceutical in the future at a discount. The Company has, for a limited time, a program that offers a future discount on purchases subject to the customer meeting certain requirements, including one specifically related to the application for insurance reimbursement. The Company concluded the option to purchase a future dose at a discount is a material right and therefore constitutes a performance obligation. The Company provides a twelve month warranty on medical devices sold in the United States and warrants to the customer that such devices will be free from defects in materials and workmanship under normal use and conditions. The Company also warrants that single dose pharmaceuticals will be free from defects in materials and workmanship, for one use, during the period up to, but not beyond, the sterility expiration for such product. These standard warranty provisions are assurance warranties accounted for as a cost accrual and not a separate performance obligation.

The Company does not provide a right of return for any of its products; however, it may offer extended payment terms to its customers. For customers with extended payment terms, the Company determines if any of those amounts are variable and reduces the stated transaction price for the variable consideration.

The Company allocates the transaction price to each performance obligation based on its relative standalone selling price. The stand-alone selling price of single dose pharmaceuticals and extended warranty service contracts is determined based on the price at which the Company typically sells the performance obligation separately, and the standalone selling price of medical devices is estimated based on a cost plus a reasonable profit margin.

Revenue related to medical devices, single dose pharmaceuticals and the customers’ option to acquire additional single dose pharmaceuticals at a discount is generally recognized at a point in time upon transfer of control to the customer, which is generally at the time of shipment. Revenue related to extended warranty service contracts is recognized over the service warranty period, which is typically one to two years.

Outside the U.S. Product Revenue

The Company has established distributor agreements with various distributors throughout the world to sell the Company’s medical devices, related single dose pharmaceuticals and spare parts. The term of the distributor agreements is typically two years, with each option of renewal not exceeding one year. A contract is deemed to exist with a distributor when a purchase order is received and accepted by the Company.

The performance obligations in these contracts may include medical devices or single dose pharmaceuticals. The medical devices are generally covered by a warranty of fifteen months following shipment or twelve months following installation at the end-customer site, and single dose pharmaceuticals are shipped with a minimum shelf life remaining until their sterility expiration, which is generally six to twelve months. These standard warranty provisions are assurance warranties accounted for as a cost accrual and not a separate performance obligation. The Company does not offer extended warranty service contracts to its distributors as all devices are serviced directly by the distributor.

Distributors have no right of return or inventory swap-out provisions, and payments due under the contracts are not contingent upon the distributor’s sale of products to its customers and are invoiced upon shipment.

The Company allocates the transaction price to each performance obligation based on its relative standalone selling price. The standalone selling price of medical devices, single dose pharmaceuticals and spare parts sold outside of the United States is determined based on the price at which the Company typically sells the performance obligation separately.

Revenue related to medical devices and single dose pharmaceuticals is recognized at a point in time upon transfer of control to the customer, which is generally at the time of shipment.

Costs to Obtain or Fulfill a Customer Contract

The Company’s sales commission structure is based on achieving revenue targets. Outside the United States, commissions are driven by revenue derived from customer purchase orders. In the United States, commissions are driven by revenue from device sales agreements in addition to revenue from single dose pharmaceuticals reorders. All commissions costs are costs to obtain a contract since they are incremental and would not have occurred absent a customer contract.

Both the revenue derived from the single dose pharmaceuticals reorders and the revenue derived from purchase orders outside the United States are short term in nature. The renewal commissions are commensurate and therefore the amortization period is the contract duration; as such, the Company recognizes the incremental costs of obtaining these contracts as an expense when incurred.

The Company capitalizes commission costs related to device sales in the United States. These costs are deferred in other assets on the Company's condensed balance sheet, net of the short-term portion included in prepaid expenses and other current assets. Costs to obtain these contracts are amortized as sales and marketing expense on a straight-line basis over the expected period of benefit and are also periodically reviewed for impairment.

Product Warranty

Internationally, medical devices sold are covered by a standard warranty for the shorter of fifteen months following shipment or twelve months following installation. Medical devices sold within the United States are covered by a standard warranty for twelve months following installation. The Company records its estimated contractual obligations at the time of shipment since installations are generally within thirty days of shipment and returns are not accepted. The Company considers the twelve-month rolling average of actual warranty claims associated with its medical devices and related single dose pharmaceuticals when determining the warranty accrual estimate. The estimates and assumptions used in developing the accrual estimate as of June 30, 2019 were consistent with prior periods.

Changes in the product warranty accrual, included as part of accrued expenses, during the six months ended June 30, 2019 consisted of the following:

Balance at December 31, 2018	$	158
Accruals for warranties issued during the period		18
Settlements		(49	)
Balance at June 30, 2019	$	127

Share-Based Compensation

The Company has a stock-based compensation plan which is more fully described in Note 10. The Company records stock-based compensation for share based awards granted to employees and to members of the board of directors for their services on the board of directors, based on the grant date fair value of awards issued, and the expense is recorded on a straight-line basis over the applicable service period, which is generally four years. For share based awards granted to employees with performance conditions, the Company utilizes the accelerated attribution method and does not recognize expense until the event is probable. The Company accounts for non-employee stock-based compensation arrangements based upon the fair value of the consideration received or the equity instruments issued, whichever is more reliably measurable. Prior to January 1, 2019, the measurement date for non-employee awards was generally the date that the performance of services required for the non-employee award is complete. Effective January 1, 2019, the Company adopted ASU 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting” and now measures share-based payments to nonemployees at the grant date fair value. Stock-based compensation costs for non-employee awards is recognized as services are provided, which is generally the vesting period, on a straight-line basis.

The Company expenses performance based options and restricted stock awards based on the fair value of the award on the date of issuance, on an accelerated attribution basis over the associated service period of the award once it is probable that the performance condition will be met.

The Company uses the Black-Scholes option pricing model to determine the fair value of stock options. The use of the Black-Scholes option-pricing model requires management to make assumptions with respect to the expected term of the option, the expected volatility of the common stock consistent with the expected life of the option, risk-free interest rates and expected dividend yields of the common stock. The expected term was determined according to the simplified method, which is the average of the vesting tranche dates and the contractual term. Due to the lack of company specific historical and implied volatility data resulting from being a private company, the Company has based its estimate of expected volatility primarily on the historical volatility of a group of similar companies that are publicly traded. For these analyses, companies with comparable characteristics are selected, including enterprise value and position within the industry, and with historical share price information sufficient to meet the expected term of the stock-based awards. The Company computes the historical volatility data using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of its stock-based awards. The risk-free interest rate is determined by reference to U.S. Treasury zero-coupon issues with remaining maturities similar to the expected term of the options. The Company has not paid, and does not anticipate paying, cash dividends on shares of preferred and common stock; therefore, the expected dividend yield is assumed to be zero.

Prior to the Company’s IPO, the fair value of the underlying common stock was determined by the Company’s board of directors, with input from its management and the assistance of a third-party valuation specialist, by determining the equity value of the Company and then allocating this value among the different classes of equity securities based on their respective rights and individual characteristics. The equity value was determined using three different methods, which includes back-solving overall equity value to the price paid by recent financing transactions, using a combination of the market-based approach and the income approach, and also utilizing a hybrid method, as discussed below. The fair value of the Company’s equity was then allocated to various securities within the Company’s capital structure by applying an option pricing method. The option pricing method estimates the fair value of each class of security based on the potential to profit from the upside of the business, while taking into account the unique characteristics of each class of security.

For the valuation of the Company’s common stock on December 31, 2018, the Company utilized the probability-weighted expected return method (“PWERM”), in combination with the option pricing method (“OPM”), as a hybrid method (“Hybrid Method”), which is an accepted valuation method under the AICPA Practice Guide, for determining the fair value of the Company’s common stock. The PWERM is a scenario-based analysis that estimates the value per share of common stock based on the probability-weighted present value of expected future equity values for the common stock, under various possible future liquidity event scenarios, in light of the rights and preferences of each class and series of stock, discounted for a lack of marketability.

Deferred Offering Costs

Deferred offering costs consist of fees and expenses directly attributable to equity offerings. Upon completion of an offering, these amounts are offset against the proceeds of the offering. During 2018, the Company deferred offering costs related to its IPO totaling $2,829, which were capitalized and classified within noncurrent assets on the balance sheet as of December 31, 2018. Unpaid amounts as of December 31, 2018 totaled $1,601. Upon consummation of the Company’s IPO in February 2019, $4,075 of deferred offering costs were offset against the IPO proceeds and reclassified into equity.

Net Loss Per Share

Basic net loss per share attributable to common stockholders is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period, without consideration for potentially dilutive securities. Diluted net loss per share is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock and potentially dilutive securities outstanding during the period determined using the treasury-stock and if-converted methods. For purposes of the diluted net loss per share calculation, convertible preferred stock, stock options and warrants considered to be potentially dilutive securities, but were excluded from the calculation of diluted net loss per share because their effect would be anti-dilutive and therefore basic and diluted net loss per share were the same for all periods presented.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606),” (“ASC 606”) which supersedes the revenue recognition requirements in Accounting Standards Codification Topic 605, Revenue Recognition, and creates a new Topic 606, Revenue from Contracts with Customers. Two adoption methods are permitted: retrospectively to all prior reporting periods presented, with certain practical expedients permitted; or retrospectively with the cumulative effect of initially adopting the ASU recognized at the date of initial application. The adoption of this ASU included updates as provided under ASU 2015-14, “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date;” ASU 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net);” ASU 2016-10, “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing;” and ASU 2016-12, “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients.” The Company adopted the provisions of ASC 606 using the modified retrospective method effective January 1, 2019. See Notes 2 and 3 for further discussion of the effects of this standard on the Company’s financial statements.

In June 2018, the FASB issued ASU 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting.” The new standard simplifies the accounting for share-based payments to nonemployees by aligning it with the accounting for share-based payments to employees, with certain exceptions. The Company adopted this standard as of January 1, 2019, and the adoption of this standard did not have a material impact on the Company’s financial statements.

In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows: Restricted Cash.” The amendments in this update require that amounts generally described as restricted cash and restricted cash equivalents be included within cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The Company adopted this standard on a retrospective basis on January 1, 2018. The adoption resulted in an increase to cash, cash equivalents and restricted cash of $551 in the statement of cash flows for the six months ended June 30, 2019 and 2018.

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842),” which requires an entity to recognize assets and liabilities arising from a lease for both financing and operating leases. The ASU will also require new qualitative and quantitative disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases. ASU 2016-02 is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. The Company is currently evaluating the effect ASU 2016-02 will have on its financial statements.

AVEDRO INC 10-Q