ARQT US Equity☆

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 together with our “Selected Financial Data” and our audited financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans, objectives, expectations, projections and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors identified below and those set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results and the timing of selected events could differ materially from the forward-looking statements contained in the following discussion and analysis. Please also see the section entitled “Special Note Regarding Forward-Looking Statements.”

Overview

We are a late-stage biopharmaceutical company focused on developing and commercializing treatments for dermatological diseases with high unmet medical needs. Our current portfolio is comprised of highly differentiated topical treatments with significant potential to treat immune-mediated dermatological diseases and conditions. We believe we have built the industry's leading platform for dermatologic product development. Our strategy is to focus on validated biological targets, and to use our platform and deep dermatology expertise to develop differentiated products that have the potential to address the major shortcomings of existing therapies in our targeted indications. We believe this strategy uniquely positions us to rapidly progress towards our goal of bridging the treatment innovation gap in dermatology, while maximizing our probability of technical success and financial resources.

Our lead product candidate, roflumilast cream, has successfully completed pivotal Phase 3 clinical trials in plaque psoriasis. We are currently preparing an NDA, with a submission to the FDA expected in the second half of 2021. Roflumilast cream is a highly potent and selective PDE4 inhibitor, an established biological target in dermatology, with multiple PDE4 inhibitors approved by the FDA for dermatological conditions. We are developing roflumilast cream for the treatment of plaque psoriasis, including psoriasis in intertriginous regions such as the groin, axillae, and inframammary areas, as well as atopic dermatitis. We have also successfully completed a long-term safety study of roflumilast cream in plaque psoriasis patients.

Additionally, we have completed a Phase 2 proof of concept study of roflumilast cream in atopic dermatitis and recently initiated Phase 3 clinical trials, with topline data expected in the second half of 2022.

We are also developing a topical foam formulation of roflumilast, and have successfully completed Phase 2 studies in both seborrheic dermatitis and scalp psoriasis. In seborrheic dermatitis, we had a successful End of Phase 2 meeting with the FDA and plan to initiate a single pivotal Phase 3 clinical trial in the second or third quarter of 2021, with topline data expected in the second or third quarter of 2022. Pending discussions with regulators, we expect to initiate our Phase 3 program in scalp psoriasis in the second half of 2021, with topline data anticipated in the second half of 2022.

Beyond this, we have completed enrollment in a Phase 2b clinical study of ARQ-252, a potent and highly selective topical JAK1 inhibitor for the treatment of chronic hand eczema, and expect topline data by mid-2021. We also plan to initiate a Phase 2 proof of concept study of ARQ-252 for the treatment of vitiligo in the first quarter of 2021. Additionally, we have formulation and preclinical efforts underway for ARQ-255, an alternative topical formulation of ARQ-252 designed to reach deeper into the skin in order to potentially treat alopecia areata.

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Since our inception in 2016, we have invested a significant portion of our efforts and financial resources in clinical development activities. We have not generated any revenue from product sales and have funded our operations primarily with the net proceeds from our IPO completed in January and with the net proceeds from our follow-on equity offerings in October 2020 and February 2021 respectively, as well as with $162.5 million in net cash proceeds from private placements of our convertible preferred stock prior to IPO. On February 4, 2020, we closed our IPO of 10,781,250 shares of common stock at an offering price of $17.00 per share, which included the exercise in full by the underwriters of their option to purchase up to 1,406,250 additional shares of common stock. Our net proceeds, after deducting underwriting discounts, commissions and offering related transaction costs, were $167.2 million. In addition, on October 6, 2020, we closed our public offering of 4,000,000 shares of common stock and concurrent private placement of 1,400,000 shares of common stock, both at a price of $25.00 per share, receiving an aggregate of $128.4 million in net proceeds after deducting the underwriting discounts, commissions and offering related transaction costs. Also, on February 5, 2021, we closed our public offering of 6,325,000 shares of common stock at a price of $35.00 per share, including 825,000 shares sold pursuant to the underwriters' full exercise of their option to purchase additional shares, receiving approximately $207.4 million in aggregate net proceeds, after deducting underwriting discounts, commissions and estimated offering expenses. See Note 13 to the financial statements for additional information.

We have incurred net losses in each year since inception, including net losses of $135.7 million, $42.0 million and $19.3 million for the years ended December 31, 2020, 2019 and 2018, respectively. As of December 31, 2020, we had an accumulated deficit of $202.0 million and cash, cash equivalents, restricted cash and marketable securities of$286.0 million.

We expect to continue to incur losses for the foreseeable future and expect to incur increased expenses as we advance our product candidates through clinical trials and regulatory submissions. We do not expect to generate revenue from product sales unless, and until, we obtain regulatory approval or clearance from the FDA or other foreign regulatory authorities for our product candidates. If we obtain regulatory approval or clearance for our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. In addition, we expect that our expenses will increase substantially as we continue preclinical studies and clinical trials for, and research and development of, our product candidates and maintain, expand and protect our intellectual property portfolio.As a result, we will need substantial additional funding to support our operating activities. Adequate funding may not be available to us on acceptable terms, or at all. We currently anticipate that we will seek to fund our operations through equity or debt financings or other sources, such as future potential collaboration agreements. Our failure to obtain sufficient funds on acceptable terms as and when needed could have a material adverse effect on our business, results of operations and financial condition. See “—Liquidity, Capital Resources and Requirements” below and Note 1 to the financial statements for additional information. Based on our current planned operations, we expect that our current cash, cash equivalents and marketable securities, along with the cash proceeds received in February 2021 related to our financing, will be sufficient to fund our operations into 2023.

We rely on third parties in the conduct of our preclinical studies and clinical trials and for manufacturing and supply of our product candidates. We have no internal manufacturing capabilities, and we will continue to rely on third parties, many of whom are single source suppliers, for our preclinical and clinical trial materials, as well as the commercial supply of our products. In addition, we do not yet have a sales organization or fully developed commercial infrastructure. Accordingly, we expect to incur significant expenses to fully develop a sales organization or commercial infrastructure in advance of generating any product sales.

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COVID-19 Update

In March 2020, the World Health Organization declared a pandemic related to the COVID-19 outbreak. COVID-19 has placed strains on the providers of healthcare services, including the sites where we conduct our clinical trials. These strains have resulted in some clinical sites slowing or halting enrollment in clinical trials and restricting the on-site monitoring of clinical trials. We follow FDA guidance on clinical trial conduct during the COVID-19 pandemic, including the remote monitoring of clinical data. We are monitoring the impact COVID-19 may have on the clinical development of our product candidates, including potential delays or modifications to ongoing and planned trials. Thus far, we have seen limited impact on our clinical trials including some disruptions in screening, enrollment and monitoring, however at this time, we do not expect delays to previously disclosed clinical timelines, including those for roflumilast cream, roflumilast foam and ARQ-252. We cannot, at this time, predict the specific extent, duration, or full impact that the COVID-19 outbreak will have on our ongoing and planned clinical trials and other business operations.

There have been no disruptions in our supply chain of drug manufacturers necessary to conduct our clinical trials and, given our drug inventories, we believe that we will be able to supply the drug needs of our ongoing clinical studies.

In alignment with public health guidance designed to slow the spread of COVID-19, we implemented a remote work plan for all employees as of mid-March 2020. We may need to undertake additional actions that could impact our operations as required by applicable laws or regulations, or which we determine to be in the best interests of our employees.

License Agreements

AstraZeneca License Agreement

In July 2018, we entered into the AstraZeneca License Agreement with AstraZeneca, granting us a worldwide exclusive license, with the right to sublicense through multiple tiers, under certain AstraZeneca-controlled patent rights, know-how and regulatory documentation, to research, develop, manufacture, commercialize and otherwise exploit products containing roflumilast in topical forms, as well as delivery systems sold with or for the administration of roflumilast, or collectively, the AZ-Licensed Products, for all diagnostic, prophylactic and therapeutic uses for human dermatological indications, or the Dermatology Field. Under this agreement, we have sole responsibility for development, regulatory, and commercialization activities for the AZ-Licensed Products in the Dermatology Field, at our expense, and we shall use commercially reasonable efforts to develop, obtain and maintain regulatory approvals for, and commercialize the AZ-Licensed Products in the Dermatology Field in each of the United States, Italy, Spain, Germany, the United Kingdom, France, China, and Japan.

We paid AstraZeneca an upfront non-refundable cash payment of $1.0 million and issued 484,388 shares of our Series B convertible preferred stock, valued at $3.0 million on the date of the AstraZeneca License Agreement. We subsequently paid AstraZeneca the first milestone cash payment of $2.0 million upon the completion of a Phase 2b study of roflumilast cream in plaque psoriasis in August 2019 for the achievement of positive Phase 2 data for an AZ-Licensed Product. We have agreed to make additional cash payments to AstraZeneca of up to an aggregate of $12.5 million upon the achievement of specific regulatory approval milestones with respect to the AZ-Licensed Products and payments up to an additional aggregate amount of $15.0 million upon the achievement of certain aggregate worldwide net sales milestones. With respect to any AZ-Licensed Products we commercialize under the AstraZeneca License Agreement, we will pay AstraZeneca a low to high single-digit percentage royalty rate on our, our affiliates’ and our sublicensees' net sales of such AZ-Licensed Products, until, as determined on an AZ-Licensed Product-by-AZ-Licensed Product and country-by-country basis, the later of the date of the expiration of the last-to-expire AstraZeneca-licensed patent right containing a valid claim in such country and ten years from the first commercial sale of such AZ-Licensed Product in such country. See Note 6 to the financial statements for additional information.

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Hengrui Exclusive Option and License Agreement

In January 2018, we entered into the Hengrui License Agreement, with Hengrui, whereby Hengrui granted us an exclusive option to obtain certain exclusive rights to research, develop and commercialize products containing the compound designated by Hengrui as SHR0302, a JAK 1 inhibitor, in topical formulations for the treatment of skin diseases, disorders, and conditions in the United States, Canada, Japan, and the EU (including for clarity the United Kingdom). We made a $0.4 million upfront non-refundable cash payment to Hengrui upon execution of the Hengrui Option and License Agreement. In December 2019, we exercised our exclusive option under the agreement, for which we made a $1.5 million cash payment, and also contemporaneously amended the agreement to expand the territory to additionally include Canada. In addition, we have agreed to make cash payments of up to an aggregate of $20.5 million upon our achievement of specified clinical development and regulatory approval milestones with respect to the licensed products and cash payments of up to an additional aggregate of $200.0 million in sales-based milestones based on achieving certain aggregate annual net sales volumes with respect to a licensed product. With respect to any products we commercialize under the Hengrui License Agreement, we will pay tiered royalties to Hengrui on net sales of each licensed product by us, or our affiliates, or our sublicensees, ranging from mid single-digit to sub-teen percentage rates based on tiered annual net sales bands subject to specified reductions. We are obligated to pay royalties until the later of (1) expiration of the last valid claim of the licensed patent rights covering such licensed product in such country and (2) the expiration of regulatory exclusivity for the relevant licensed product in the relevant country, on a licensed product-by-licensed product and country-by-country basis. Additionally, we are obligated to pay Hengrui a specified percentage, ranging from the low-thirties to the sub-teens, of certain non-royalty sublicensing income we receive from sublicensees of our rights to the licensed products, such percentage decreasing as the development stage of the licensed products advance.

The agreement continues in effect until the expiration of our obligation to pay royalties as described above, unless earlier terminated in accordance with the following: (1) by either party upon written notice for the other party’s material breach or insolvency event if such party fails to cure such breach or the insolvency event is not dismissed within specified time periods; and (2) by us for convenience upon 90 days prior written notice to Hengrui and having discussed and consulted any potential cause or concern with Hengrui in good faith. See Note 6 to the financial statements for additional information.

Components of Our Results of Operations

Operating Expenses

Research and Development Expenses

Since our inception, we have focused significant resources on our research and development activities, including conducting preclinical studies and clinical trials, manufacturing development efforts and activities related to regulatory filings for our product candidates. Research and development costs are expensed as incurred. These costs include direct program expenses, which are payments made to third parties that specifically relate to our research and development, such as payments to clinical research organizations, clinical investigators, manufacturing of clinical material, preclinical testing and consultants. In addition, employee costs, including salaries, payroll taxes, benefits, stock-based compensation and travel, for employees contributing to research and development activities are classified as research and development costs. We allocate direct external costs to our product candidates; internal costs are not allocated to specific product candidates.

We expect to continue to incur substantial research and development expenses in the future as we develop our product candidates. In particular, we expect to incur substantial research and development expenses for the Phase 3 trials of roflumilast cream for atopic dermatitis and roflumilast foam for seborrheic dermatitis and scalp psoriasis, the preclinical studies and clinical trials for the continued development of ARQ-252 for hand eczema and vitiligo, and ARQ-255 for alopecia areata.

We have entered, and may continue to enter, into license agreements to access and utilize certain molecules for the treatment of dermatological diseases and disorders. We evaluate if the license agreement is an acquisition of an asset or a business. To date, none of our license agreements have been considered to be an acquisition of a business. For asset acquisitions, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects.

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The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate the nature, timing or costs required to complete the remaining development of roflumilast cream, roflumilast foam, ARQ-252 and ARQ-255 or any future product candidates. This is due to the numerous risks and uncertainties associated with the development of product candidates. See “Risk Factors” for a discussion of the risks and uncertainties associated with the development of our product candidates.

General and Administrative Expenses

Our general and administrative expenses consist primarily of salaries and related costs, including payroll taxes, benefits, stock-based compensation and travel. Other general and administrative expenses include legal costs of pursuing patent protection of our intellectual property, insurance, and professional services fees for auditing, tax and general legal services. We expect our general and administrative expenses to continue to increase in the future as we expand our operating activities and prepare for potential commercialization of our product candidates, increase our headcount and support our operations as a public company, including increased expenses related to legal, accounting, insurance, regulatory and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, directors and officers liability insurance premiums and investor relations activities.

Other Income, Net

Other income, net primarily consists of interest income earned on our cash, cash equivalents, restricted cash and marketable securities.

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Results of Operations

Comparison of the Years Ended December 31, 2020 and 2019

The following table sets forth our results of operations for the periods indicated:

Year Ended December 31, Change

(in thousands)

Operating expenses:

Research and Development Expenses

Year Ended December 31, Change

(unaudited)

(in thousands)

Direct Costs:

Indirect Costs:

Research and development expenses increased by $78.8 million, or 216%, for the year ended December 31, 2020 compared to the year ended December 31, 2019. The increase was due to an increase in clinical trial costs of $59.4 million, an increase in manufacturing costs of $9.9 million, an increase in compensation and personnel-related expenses of $9.2 million, and an increase of $3.8 million in other costs, including regulatory, research and clinical consulting costs, partially offset by a decrease in licensing milestones of $3.5 million. The increases in clinical trial and manufacturing costs relate primarily to new and ongoing studies, including Phase 3 studies of roflumilast cream for plaque psoriasis, Phase 2 studies of roflumilast foam in scalp psoriasis and seborrheic dermatitis, and the ARQ-252 Phase 2 study for hand eczema. The increase in compensation and personnel-related expenses, which includes stock compensation, was primarily due to an increase in headcount. Licensing milestones consisted of a $2.0 million cash milestone payment made to AstraZeneca in August 2019 and a $1.5 million cash option payment to Hengrui in December 2019.

General and Administrative Expenses

General and administrative expenses increased by $14.7 million, or 223%, for the year ended December 31, 2020 compared to the year ended December 31, 2019. The increase was primarily due to an increase in compensation and personnel-related expenses of $7.6 million, an increase in professional services of $3.8 million, and an increase in insurance costs of $2.6 million. The increase in compensation and personnel-related expenses, which includes stock compensation, was primarily due to an increase in headcount. The increases in professional services and insurance costs were mainly due to overall Company growth and the costs associated with being a public company.

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Other Income, Net

Other income, net decreased by $0.2 million, or 15%, for the year ended December 31, 2020 compared to the year ended December 31, 2019. The decrease was primarily due to a lower yield on our investment portfolio, partially offset by higher balances.

Comparison of the Year Ended December 31, 2019 and 2018

The following table sets forth our results of operations for the periods indicated:

Year Ended December 31, Change

(in thousands)

Operating expenses:

Research and Development Expenses

Year Ended December 31, Change

(unaudited)

(in thousands)

Direct Costs:

Indirect Costs:

Research and development expenses increased by $18.6 million, or 104%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was due to an increase in clinical trial costs of $14.6 million, an increase in compensation and personnel-related expenses of $3.0 million, and an increase in manufacturing costs of $1.0 million. The increases in clinical trial and manufacturing costs relate to the initiation of the Phase 2b and open label extension studies in roflumilast cream for plaque psoriasis in the second half of 2018 and the initiation of the Phase 2 study in roflumilast cream in atopic dermatitis in early 2019. The increase in compensation and personnel-related expenses, which includes stock compensation, was primarily due to an increase in headcount.

General and Administrative Expenses

General and administrative expenses increased by $4.8 million, or 268%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to an increase in professional services associate with the general growth of the business of $2.3 million, which includes legal, tax, audit, market research studies and various other administrative functions, as well as an increase of $2.1 million in compensation and personnel-related expenses, which includes stock compensation, due to an increase in headcount.

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Other Income, Net

Other income, net increased by $0.7 million, or 137%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to interest earned on marketable securities, in which we had larger balances in 2019 than in 2018 due to the timing of issuances of our Series B and C convertible preferred stock.

Liquidity, Capital Resources and Requirements

Sources of Liquidity

We have incurred operating losses since our inception and have an accumulated deficit as a result of ongoing efforts to develop our product candidates, including conducting preclinical and clinical trials and providing general and administrative support for these operations. As of December 31, 2020 and 2019, we had cash, cash equivalents, restricted cash and marketable securities of $286.0 million and $101.3 million, respectively, and an accumulated deficit of $202.0 million and $66.3 million, respectively. In addition, on February 5, 2021, we completed an equity offering and received approximately $207.4 million in aggregate net proceeds, after deducting underwriting discounts, commissions and estimated offering expenses. We anticipate that operating losses and net cash used in operating activities will increase over the next several years as we further develop roflumilast cream, roflumilast foam, ARQ-252 and ARQ-255, move into later and more costly stages of product development, develop new product candidates, hire personnel and prepare for regulatory submissions and the commercialization of our product candidates.

We have historically financed our operations primarily through private placements of preferred stock, as well as our IPO completed in January 2020 and our follow-on equity offerings in October 2020 and February 2021, and will continue to be dependent upon equity, debt financing, collaborations or other forms of capital at least until we are able to generate positive cash flows from our operations.

Cash Flows

The following table sets forth our cash flows for the periods indicated:

Year Ended December 31,

(in thousands)

Net Cash Used in Operating Activities

During the year ended December 31, 2020, net cash used in operating activities was $113.0 million, which consisted of a net loss of $135.7 million, offset by a change in net operating assets and liabilities of $14.1 million and net non-cash charges of $8.5 million. The change in net operating assets and liabilities was primarily due to an increase of $17.6 million in accounts payable and accrued liabilities due to our operating expense growth and timing of payments. The net non-cash charges were primarily related to stock-based compensation expense of $7.9 million.

During the year ended December 31, 2019, net cash used in operating activities was $42.8 million, which consisted of a net loss of $42.0 million, a change in net operating assets and liabilities of $1.5 million, partially offset by net non-cash charges of $0.7 million. The change in net operating assets and liabilities was due to an increase of $3.3 million in prepaid expenses and other current assets for advances made for clinical trial costs, partially offset by an increase of $1.9 million in accounts payable and accrued liabilities due to our overall growth, increased research and development spending and timing of payments. The net non-cash charges were primarily related to stock-based compensation expense of $0.8 million, and depreciation and right-of-use asset amortization of $0.2 million, partially offset by net amortization/accretion on marketable securities of $0.4 million.

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During the year ended December 31, 2018, net cash used in operating activities was $14.1 million and consisted primarily of a net loss of $19.3 million adjusted by non-cash charges of $3.1 million and a change of $2.1 million in our net operating assets and liabilities. The non-cash charges were primarily related to the issuance of convertible preferred stock in connection with the AstraZeneca License Agreement, which was expensed to research and development. The change in net operating assets and liabilities was primarily due to a net increase of $1.9 million in accounts payable and accrued liabilities due to our overall growth, increased research and development spending and timing of payments.

Net Cash Used in Investing Activities

During the year ended December 31, 2020, net cash used in investing activities was $181.8 million, which was comprised primarily of purchases of marketable securities of $279.1 million, partially offset by proceeds from the maturities of marketable securities of $97.6 million.

During the year ended December 31, 2019, net cash used in investing activities was $26.3 million, which was comprised of purchases of marketable securities of $60.8 million and property and equipment of $0.3 million, partially offset by proceeds from the maturities of marketable securities of $34.8 million.

During the year ended December 31, 2018, net cash used in investing activities was $11.5 million, which represented the purchase of marketable securities.

Net Cash Provided by Financing Activities

During the year ended December 31, 2020, net cash provided by financing activities was $298.1 million, which was comprised primarily of the net cash proceeds received from the IPO of $168.6 million and follow-on financing in October 2020 of $128.4 million.

During the year ended December 31, 2019, net cash provided by financing activities was $93.1 million, which was comprised of the net proceeds received from the issuance of Series C convertible preferred stock of $94.2 million as well as the proceeds from the exercise of stock options of $0.3 million, offset by deferred financing costs of $1.4 million paid in connection with the IPO.

During the year ended December 31, 2018, net cash provided by financing activities was $61.6 million, which was comprised of $61.2 million in proceeds from the issuance of our Series A and Series B convertible preferred stock and $0.4 million from proceeds received from the exercise of stock options.

Funding Requirements

We have historically incurred significant losses and negative cash flows from operations since our inception and had an accumulated deficit of $202.0 million and $66.3 million as of December 31, 2020 and 2019, respectively. We had cash, cash equivalents and marketable securities of $284.4 million and $101.3 million as of December 31, 2020 and 2019, respectively. In addition, on February 5, 2021, we received approximately $207.4 million in net proceeds from an equity offering, after deducting underwriting discounts, commissions and estimated offering expenses. Based on our current planned operations, we expect that our current cash, cash equivalents and marketable securities, along with the cash proceeds from our financing in February 2021, will be sufficient to fund our operations into 2023. Our ability to continue as a going concern is dependent upon our ability to successfully secure sources of financing and ultimately achieve profitable operations.

We will need to raise substantial additional capital to fund our operations through the sale of our equity securities, incurring debt, entering into licensing or collaboration agreements with partners, grants or other sources of financing. There can be no assurance that sufficient funds will be available to us at all or on attractive terms when needed from these sources. If we are unable to obtain additional funding from these or other sources when needed it may be necessary to significantly reduce our current rate of spending through reductions in staff and delaying, scaling back, or stopping certain research and development programs. Insufficient liquidity may also require us to relinquish rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose.

We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical products, we are unable to estimate the exact amount of our operating capital requirements. Our future funding requirements will depend on many factors, including, but not limited to:

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•the scope, progress, results and costs of researching and developing our lead product candidates or any future product candidates, and conducting preclinical studies and clinical trials, in particular our planned or ongoing clinical studies of roflumilast cream in plaque psoriasis and atopic dermatitis, roflumilast foam in seborrheic dermatitis and scalp psoriasis, ARQ-252 in hand eczema and vitiligo, and our formulation and preclinical efforts for ARQ-255 in alopecia areata.

•suspensions or delays in the enrollment or changes to the number of patients we decide to enroll in our ongoing clinical trials as a result of the COVID-19 pandemic;

•the timing of, and the costs involved in, obtaining regulatory approvals for our lead product candidate or our other product candidates;

•the number and characteristics of any additional product candidates we develop or acquire;

•the cost of manufacturing our lead product candidates or any future product candidates and any products we successfully commercialize, including costs associated with building out our supply chain;

•the cost of commercialization activities if our lead product candidates or any future product candidates are approved for sale, including marketing, sales and distribution costs;

•the cost of building a sales force in anticipation of product commercialization;

•our ability to establish and maintain strategic collaborations, licensing or other arrangements and the financial terms of any such agreements that we may enter into;

•the costs related to milestone payments to AstraZeneca or Hengrui, upon the achievement of predetermined milestones;

•any product liability or other lawsuits related to our products;

•the expenses needed to attract and retain skilled personnel;

•the costs associated with being a public company;

•the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing patent claims, and the outcome of this and any other future patent litigation we may be involved in; and

•the timing, receipt and amount of sales of any future approved products, if any.

Contractual Obligations and Contingent Liabilities

The following summarizes our significant contractual obligations as of December 31, 2020:

Total Less than 1 Year 1-3 Years 3-5 Years More than 5 Years

(in thousands)

In April 2020, we amended our lease agreement for our facility in Westlake Village, California to relocate to a new expanded space including 22,643 square feet. The lease payment term for the new space began on December 30, 2020 and will terminate 91 months thereafter, with a renewal option for a term of five years. We have a one-time option to cancel the lease after month 67.

The lease is subject to fixed rate escalation increases with an initial base rent of $76,000 per month and includes rent free periods aggregating approximately one year. The amended lease agreement provides for a leasehold improvement allowance up to $1.25 million. It also required that we deliver a letter of credit to the landlord of $1.5 million upon occupying the space, which is allowed to be reduced throughout the lease period as rent obligations are met. Accordingly, in November 2020, we entered into a letter of credit for $1.5 million, which is secured with a restricted cash account in the same amount.

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Indemnification

In the normal course of business, we enter into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. Our exposure under these agreements is unknown because it involves claims that may be made against us in the future, but have not yet been made. To date, we have not paid any claims or been required to defend any action related to our indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations.

In accordance with our certificate of incorporation and bylaws, we have indemnification obligations to our officers and directors for specified events or occurrences, subject to some limits, while they are serving at our request in such capacities. There have been no claims to date, and we have director and officer insurance that may enable us to recover a portion of any amounts paid for future potential claims.

Off-Balance Sheet Arrangements

We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under SEC rules.

Critical Accounting Policies and Use of Estimates

Our management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported expenses during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on 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. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our financial statements and understanding and evaluating our reported financial results.

Preclinical and Clinical Accruals and Costs

We record accrued liabilities for estimated costs of research and development activities conducted by third-party service providers, which include the conduct of preclinical studies, clinical studies, clinical trials and contract manufacturing activities. These costs are a significant component of our research and development expenses. Research and development costs are expensed as incurred unless there is an alternative future use in other research and development projects. We accrue for these costs based on factors such as estimates of the work completed and in accordance with agreements established with third-party service providers under the service agreements. As it relates to clinical trials, the financial terms of these contracts are subject to negotiations which vary from contract to contract and may result in payment flows that do not match the periods over which materials or services are provided under such contracts. Payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. Such payments are evaluated for current or long-term classification based on when they will be realized. Additionally, if expectations change such that we do not expect goods to be delivered or services to be rendered, such prepayments are charged to expense. Our objective is to reflect the appropriate expense in our financial statements by matching those expenses with the period in which the services and efforts are expended. We account for these expenses according to the progress of the trial as measured by patient progression and the timing of various aspects of the trial utilizing financial models taking into consideration discussions with applicable personnel and outside service providers. In this manner, our clinical trial accrual is dependent in part upon the timely and accurate reporting of progress and efforts incurred from CROs, contract manufacturers and other third-party vendors. Although we expect our estimates to be materially consistent with actual amounts incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in our reporting changes in estimates in any particular period. We make significant judgments and estimates in determining the accrued liabilities balance in each reporting period. As actual costs become known, we adjust our accrued liabilities. We have not experienced any material differences between accrued costs as of December 31, 2020 and 2019 and actual costs incurred.

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Stock-Based Compensation

We account for share-based payments at fair value. For share-based awards that vest subject to the satisfaction of a service requirement, the fair value measurement date for such awards is the date of grant and the expense is recognized on a straight-line basis, over the expected vesting period. For share-based awards that vest subject to a performance condition, we recognize compensation cost for awards if and when we conclude that it is probable that the awards with a performance condition will be achieved on an accelerated attribution method. We account for forfeitures as they occur.

We calculate the fair value measurement of stock options using the Black-Scholes option pricing model and assumptions discussed below. Each of these inputs is subjective and generally requires significant judgement.

Fair value of common stock—see the subsection titled “Common Stock Valuation” below.

Expected Term—The expected term represents the period that we expect our stock-based awards to be outstanding. We used the simplified method (based on the mid-point between the vesting date and the end of the contractual term) to determine the expected term.

Expected Volatility—Since we do not have sufficient trading history for our common stock, the expected volatility was estimated based on the average historical volatilities for comparable publicly traded pharmaceutical companies over a period equal to the expected term of the stock option grants. The comparable companies were chosen based on their similar size, stage in the life cycle and area of specialty. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our stock price becomes available.

Risk-Free Interest Rate—The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of option.

Dividend Yield—We have never paid dividends on common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero.

See Note 9 to our audited financial statements included elsewhere in this Annual Report on Form 10-K for more information concerning certain of the specific assumptions we used in applying the Black-Scholes option pricing model to determine the estimated fair value of our stock options. Certain of such assumptions involve inherent uncertainties and the application of significant judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our stock-based compensation could be materially different.

We recorded stock-based compensation expense of $7.9 million, $0.8 million, and $0.2 million for the years ended December 31, 2020, 2019 and 2018, respectively. As of December 31, 2020, there was $23.2 million of unrecognized compensation expense related to unvested options, which are expected to be recognized over a weighted-average period of approximately 3.4 years. As of December 31, 2020, there was $3.6 million of unrecognized compensation expense related to restricted stock, which are expected to be recognized over a weighted-average period of approximately 3.6 years. We expect to continue to grant stock options, restricted stock, and other equity-based awards in the future, and to the extent that we do, our stock-based compensation expense recognized in future periods will likely increase.

Common Stock Valuation

Prior to the completion of our public offering, there were significant assumptions and estimates required in determining the fair value of our common stock. Due to the absence of an active market for our common stock prior to our IPO, the fair value of our common stock for grants during that time period was determined in good faith by our board of directors, with the assistance and upon the recommendation of management and valuations of our common stock prepared by an unrelated third-party valuation firm, based on a number of objective and subjective factors consistent with the methodologies outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, referred to as the AICPA Practice Aid, including:

• contemporaneous valuations of our shares of common stock;

• the prices of each of our series of preferred stock sold by us to outside investors in arm’s length transactions, and the rights, preferences and privileges of each of these series of preferred stock relative to our common stock;

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• our results of operations, financial position and the status of our research and development efforts;

• the composition of our management team and board of directors;

• the material risks related to our business;

• the market performance of publicly traded companies in the life sciences and biotechnology sectors;

• the likelihood of achieving a liquidity event for the holders of our shares of common stock, such as a sale of the company or an IPO, given prevailing market conditions;

• the lack of marketability of our common stock; and

• external market conditions affecting the life sciences and biotechnology industry sectors.

If we had made different assumptions than those described below, the fair value of the underlying common stock and amount of our stock-based compensation expense, net loss and net loss per share amounts would have differed. Following the closing of our IPO, the fair value per share of our common stock for purposes of determining stock-based compensation will be the closing price of our common stock as reported on the applicable grant date.

Historically, prior to our IPO, fair values of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. Our board of directors considered, among other things, valuations of our common stock which were prepared by an unrelated third-party valuation firm in accordance with the guidance provided by the AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.

In 2019, we reassessed the determination of the fair value of the common shares underlying the grants made prior to August 2018 in connection with a valuation of the convertible preferred stock liability. This analysis revised our implied equity value, which was then allocated to each equity class using an option pricing method and the implied value of common stock was then reduced by a discount for lack of marketability. As a result of this reassessment, we determined that fair value of common stock increased to $0.46, $1.12 and $1.18 per share as of April 2017, December 2017 and March 2018, respectively. The increase to both recognized and unrecognized share-based compensation expense due to these higher share prices was approximately $0.1 million and $0.4 million, respectively, as of December 31, 2018.

Income Taxes

As of December 31, 2020, we had net deferred tax assets of $45.6 million. The deferred tax assets have been offset by a valuation allowance due to uncertainties surrounding our ability to realize these tax benefits. The deferred tax assets are primarily composed of NOL, tax carryforwards. As of December 31, 2020, we had federal, California and other state NOL carryforwards of $180.7 million, $180.8 million and $3.2 million, respectively, available to potentially offset future taxable income. As of December 31, 2020, we also had federal and California research and development tax credit carryforwards of approximately $6.4 million and $1.4 million, respectively, available to potentially offset future federal income taxes. The federal research and development tax carryforwards, if not utilized, will expire beginning in 2036. The California research and development tax credit carryforwards are available indefinitely. Federal and California tax law impose significant restrictions on the utilization of NOL carryforwards in the event of a change in ownership, as defined by Internal Revenue Code Section 382 and 383. We have not completed a formal study to determine any limitations on our tax attributes due to changes in ownership and may have limitations on the utilization of NOL carryforwards, credit carryforwards, or other tax attributes due to ownership changes.

Recent Accounting Pronouncements

See Note 2 to our financial statements.

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Emerging Growth Company Status

We are an emerging growth company as defined in the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date that we are (i) no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, these financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. We early adopted ASU No. 016-01, Financial Instruments—Overall (Topic 825)—Recognition and Measurement of Financial Assets and Financial Liabilities, ASU 2016-09, Compensation—Stock Compensation (Topic 718)—Improvements to Employee Share Based Payment Accounting, ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, ASU No. 2016-02, Leases, ASU No. 2016-13, Financial Instruments—Credit Losses(Topic 326): Measurement of Credit Losses on Financial Instruments, ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement, and ASU No. 2019-12, Income Taxes (Topic 740), as the JOBS Act does not preclude an emerging growth company from early adopting a new or revised accounting standard earlier than the time such standard applies to private companies. We expect to use the extended transition period for any other new or revised accounting standards during the period in which we remain an emerging growth company.

We will remain an emerging growth company until the last day of our fiscal year following the fifth anniversary of the completion of our IPO. However, if certain events occur prior to the end of such five-year period, including if we become a “large accelerated filer,” our annual gross revenues exceed $1.07 billion or we issue more than $1.0 billion of non-convertible debt in any three year period, we will cease to be an emerging growth company prior to the end of such five year period.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate sensitivities. As of December 31, 2020, we had cash and cash equivalents of $65.1 million, restricted cash of $1.5 million and marketable securities of $219.4 million, which consist of bank deposits, money market funds, commercial paper and government securities. The primary objective of our investment activities is to preserve capital to fund our operations. We also seek to maximize income from our investments without assuming significant risk. Because our investments are primarily short-term in duration, we believe that our exposure to interest rate risk is not significant, and a 1% movement in market interest rates would not have a significant impact on the total value of our portfolio. We had no debt outstanding as of December 31, 2020.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Our financial statements, together with the independent registered public accounting firm report thereon, are set forth in Part IV Item 15, “Exhibits, Financial Statement Schedules” of this Annual Report on Form 10-K.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

Item 9A. CONTROLS AND PROCEDURES

Inherent Limitations on Effectiveness of Controls and Procedures

In designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their control objectives.

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Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of December 31, 2020.

Management’s Annual Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over our financial reporting, as such term is defined in Rule 13a-15(f) under the Exchange Act. Our management conducted an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2020, the end of the period covered by this Annual Report on Form 10-K. Management based its assessment on the criteria set forth in "Internal Control - Integrated Framework (2013)" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, our management concluded that, as of December 31, 2020, our internal control over financial reporting was effective.

Changes in Internal Control over Financial Reporting

There was no change in our internal controls over financial reporting during the most recent fiscal quarter covered by this Annual Report on Form 10-K that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Attestation Report of the Registered Public Accounting Firm

This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm due to an exemption established by the JOBS Act for “emerging growth companies.”

Item 9B. OTHER INFORMATION

None.

Part III

Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this item is incorporated by reference from the applicable information set forth in “Executive Officers,” “Election of Directors,” “Corporate Governance,” and Section 16(a) Beneficial Ownership Reporting Compliance” which will be included in our Proxy Statement for our 2021 Annual Meeting of Stockholders, or the Proxy Statement, to be filed with the SEC.

Item 11. EXECUTIVE COMPENSATION

The information required by this item is incorporated by reference from the applicable information set forth in “Executive Compensation,” and “Director Compensation” and “Corporate Governance” which will be included in our definitive Proxy Statement.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item is incorporated by reference from the applicable information set forth in “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” which will be included in our definitive Proxy Statement.

Item 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS AND DIRECTOR INDEPENDENCE

The information required by this item is incorporated by reference from the applicable information set forth in “Certain Relationships and Related Party Transactions” and “Corporate Governance” which will be included in our definitive Proxy Statement.

Item 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

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The information required by this item is incorporated by reference from the applicable information set forth in “Ratification of Selection of Independent Registered Public Accounting Firm” which will be included in our definitive Proxy Statement.

Part IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

(a) Financial Statement Schedules.

The following financial statements are included herein:

Page

Audited Financial Statements

Report of Independent Registered Public Accounting Firm F-1

Balance Sheets F-2

Statements of Operations and Comprehensive Loss F-3

Statements of Convertible Preferred Stock and Stockholders’ Equity (Deficit) F-4

Statements of Cash Flows F-5

Notes to Financial Statements F-6

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(b) Exhibits.

3.1 Restated Certificate of Incorporation. S-1/A 1/21/20 3.2

4.1 Form of Common Stock Certificate. S-1/A 1/21/20 4.1

10.2# 2017 Stock Incentive Plan and forms of award agreements. S-1 1/6/20 10.2

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23.1 Consent of Independent Registered Public Accounting Firm. X

101.SCH Inline XBRL Taxonomy Extension Schema Document. X

101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase Document. X

101.DEF Inline XBRL Taxonomy Extension Definition Linkbase Document. X

101.LAB Inline XBRL Taxonomy Extension Label Linkbase Document. X

101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase Document. X

______________

† Registrant has omitted portions of the exhibit as permitted under Item 601(b)(10) of Regulation S-K.

^ Registrant has omitted schedules and exhibits pursuant to Item 601(b)(2) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of the omitted schedules and exhibits to the SEC upon request.

# Indicates management contract or compensatory plan.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the stockholders and the Board of Directors of Arcutis Biotherapeutics, Inc.

Opinion on the Financial Statements

We have audited the accompanying balance sheets of Arcutis Biotherapeutics, Inc. (the Company) as of December 31, 2020 and 2019, the related statements of operations and comprehensive loss, statements of convertible preferred stock and stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.

Our audits include performing procedures to assess the risks of material misstatement on the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ Ernst & Young LLP

We have served as the Company’s auditor since 2019.

Los Angeles, California

February 16, 2021

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ARCUTIS BIOTHERAPEUTICS, INC.

Balance Sheets

(In thousands, except share and par value)

December 31,

ASSETS

Current assets:

Restricted cash 1,542 —

Prepaid expenses and other current assets 6,843 5,209

Property and equipment, net 2,016 227

Operating lease right-of-use asset 3,349 264

LIABILITIES, CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)

Current liabilities:

Operating lease liability — 178

Operating lease liability, noncurrent 4,964 129

Other long-term liabilities 82 184

Commitments and contingencies (Note 7)

Stockholders’ equity (deficit):

Accumulated other comprehensive loss (2) (1)

The accompanying notes are an integral part of these financial statements.

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ARCUTIS BIOTHERAPEUTICS, INC.

Statements of Operations and Comprehensive Loss

(In thousands, except share and per share data)

Year Ended December 31,

Operating expenses:

Other comprehensive loss:

Unrealized loss on marketable securities (1) (1) —

Per share information:

Net loss per share, basic and diluted $ (3.80) $ (22.78) $ (15.53)

The accompanying notes are an integral part of these financial statements.

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ARCUTIS BIOTHERAPEUTICS, INC.

Statements of Convertible Preferred Stock and Stockholders’ Equity (Deficit)

(In thousands, except share data)

Shares Amount Shares Amount

Vesting of founder shares subject to repurchase — — 360,560 — — — — —

Stock-based compensation expense — — — — 151 — — 151

Issuance of common stock upon the exercise of stock options — — 15,885 — 9 — — 9

Issuance of restricted stock units — — 13,245 — 8 — — 8

Vesting of founder shares subject to repurchase — — 275,726 — — — — —

Stock-based compensation expense — — — — 824 — — 824

Unrealized loss on marketable securities — — — — — (1) — (1)

Vesting of founder shares subject to repurchase — — 137,863 — — — — —

Stock-based compensation expense — — — — 7,943 — — 7,943

Unrealized loss on marketable securities — — — — — (1) — (1)

The accompanying notes are an integral part of these financial statements.

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ARCUTIS BIOTHERAPEUTICS, INC.

Statements of Cash Flows

(In thousands)

Year Ended December 31,

CASH FLOWS FROM OPERATING ACTIVITIES:

Adjustments to reconcile net loss to net cash used in operating activities:

Non-cash lease expense 333 127 —

Net amortization/accretion on marketable securities 72 (354) (14)

Loss on disposal of property and equipment 42 — —

Change in fair value of convertible preferred stock liability — — (75)

Changes in operating assets and liabilities:

Prepaid expenses and other current assets (3,412) (3,304) 243

Other assets — (47) —

Operating lease liabilities (6) (84) —

CASH FLOWS FROM INVESTING ACTIVITIES:

Proceeds from maturities of marketable securities 97,600 34,800 —

Purchases of property and equipment (321) (295) —

CASH FLOWS FROM FINANCING ACTIVITIES:

Proceeds from initial public offering, net of issuance costs 168,642 — —

Proceeds from issuance of common stock, net of issuance costs 128,360 — —

Proceeds from issuance of common stock for ESPP purchase 617 — —

Payment of financing costs — (1,401) —

Net increase in cash, cash equivalents and restricted cash 3,288 23,942 35,976

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING INFORMATION:

Conversion of preferred stock to common stock and APIC $ 166,491 $ — $ —

Right-of-use asset obtained in exchange for lease liability $ 3,617 $ 391 $ —

Reduction in right-of-use asset upon reassessment of lease term $ 123 $ — $ —

The accompanying notes are an integral part of these financial statements.

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ARCUTIS BIOTHERAPEUTICS, INC.

Notes to Financial Statements

1. Organization and Description of Business

Arcutis Biotherapeutics, Inc., or the Company, is a late-stage biopharmaceutical company focused on developing and commercializing treatments for dermatological diseases with high unmet medical needs. The Company’s current portfolio is comprised of highly differentiated topical treatments with significant promise to treat immune-mediated dermatological diseases and conditions. The Company believes it has built the industry's leading platform for dermatologic product development.The Company’s strategy is to focus on validated biological targets and to use our platform and deep dermatology expertise to develop differentiated products that have the potential to address the major shortcomings of existing therapies in its targeted indications. The Company believes this strategy uniquely positions it to rapidly advance its goal of bridging the treatment innovation gap in dermatology while maximizing its probability of technical success.

On January 17, 2020, the Company's board of directors approved a 1-for-2.0007 reverse stock split of the Company’s capital stock and the Company filed a certificate of amendment to its restated certificate of incorporation to effect the split. The par value and authorized shares of common stock and convertible preferred stock were not adjusted as a result of the reverse split. All share and per share information included in the accompanying financial statements has been adjusted to reflect this reverse stock split.

Initial Public Offering and Follow-On Financings

On February 4, 2020, the Company closed an initial public offering (IPO) issuing and selling 10,781,250 shares of common stock at a public offering price of $17.00 per share, including 1,406,250 shares sold pursuant to the underwriters’ full exercise of their option to purchase additional shares. The aggregate net proceeds received by the Company from the offering were approximately $167.2 million, after deducting underwriting discounts, commissions and offering related transaction costs. Upon the closing of the IPO, all of the outstanding shares of convertible preferred stock automatically converted into shares of common stock. Subsequent to the closing of the IPO, there were no shares of convertible preferred stock outstanding.

On October 6, 2020, the Company completed a public offering of 4,000,000 shares of common stock at an offering price of $25.00 per share, receiving aggregate net proceeds of approximately $93.4 million after deducting the underwriting discounts, commissions and offering related transaction costs. In addition, the Company concurrently sold 1,400,000 shares of common stock in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended, at a price per share equal to the public offering price, receiving net proceeds of $35.0 million.

On February 5, 2021, the Company completed a public offering of 6,325,000 shares of stock at an offering price of $35.00 per share, including 825,000 shares sold pursuant to the underwriters full exercise of their option to purchase additional shares. The aggregate net proceeds received by the Company were approximately $207.4 million, after deducting underwriting discounts, commissions and estimated offering expenses. See Note 13.

Liquidity

The Company has incurred significant losses and negative cash flows from operations since its inception and had an accumulated deficit of $202.0 million and $66.3 million as of December 31, 2020 and 2019, respectively. The Company had cash, cash equivalents, restricted cash and marketable securities of $286.0 million and $101.3 million as of December 31, 2020 and 2019, respectively. In addition, on February 5, 2021, the Company received $180.3 million in net proceeds from an equity offering. See Note 13. Prior to selling common stock in its IPO and follow-on financings, the Company had historically financed its operations primarily through the sale of its convertible preferred stock. Management expects operating losses to continue for the foreseeable future.

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ARCUTIS BIOTHERAPEUTICS, INC.

Notes to Financial Statements

The Company believes that its existing capital resources will be sufficient to meet the projected operating requirements for at least 12 months from the date of issuance of its financial statements. The Company will be required to raise additional capital to fund future operations. However, no assurance can be given as to whether additional needed financing will be available on terms acceptable to the Company, if at all. If sufficient funds on acceptable terms are not available when needed, the Company may be required to curtail planned activities to significantly reduce its operating expenses. Failure to manage discretionary spending or raise additional financing, as needed, may adversely impact the Company’s ability to achieve its intended business objectives and have an adverse effect on its results of operations and future prospects.

Coronavirus Outbreak

In March 2020, the World Health Organization declared a pandemic related to the global novel coronavirus disease 2019 (COVID-19) outbreak. As of February 16, 2021, the Company’s operations have not been significantly impacted by the COVID-19 pandemic. The Company is monitoring the impact COVID-19 may have on the clinical development of its product candidates, including potential delays or modifications to its ongoing and planned trials. However, the Company cannot at this time predict the specific extent, duration, or full impact that the COVID-19 outbreak will have on its financial condition and operations, including ongoing and planned clinical trials.

2. Summary of Significant Accounting Policies

Basis of Presentation

The Company’s financial statements have been prepared in accordance with United States generally accepted accounting principles (U.S. GAAP).

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates such estimates and assumptions for continued reasonableness. In particular, management makes estimates with respect to accruals for research and development activities, fair value of common stock and convertible preferred stock (prior to the IPO completed in January 2020), stock-based compensation expense and income taxes. Appropriate adjustments, if any, to the estimates used are made prospectively based upon such periodic evaluation. Actual results could differ from those estimates.

Segments

To date, the Company has viewed its financial information on an aggregate basis for the purposes of evaluating financial performance and allocating the Company’s resources. Accordingly, the Company has determined that it operates in one segment.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with original maturities of three months or less from the purchase date to be cash equivalents. Cash equivalents consist primarily of money market funds, commercial paper, and U.S. Treasury securities.

Restricted Cash

As of December 31, 2020, the Company held $1.5 million of restricted cash as collateral for a letter of credit related to our amended office space lease. As of December 31, 2019, the Company did not hold any restricted cash. See Note 7.

Marketable Securities

Marketable securities consist of investment grade short to intermediate-term fixed income investments that have been classified as available-for-sale and are carried at estimated fair value as determined based upon quoted market prices or pricing models for similar securities. Management determines the appropriate classification of its investments in fixed income securities at the time of purchase. Available-for-sale securities with original maturities beyond three months at the date of purchase are classified as current based on their availability for use in current operations.

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ARCUTIS BIOTHERAPEUTICS, INC.

Notes to Financial Statements

Unrealized gains and losses are excluded from earnings and are reported as a component of other comprehensive loss. Realized gains and losses as well as credit losses, if any, on marketable securities are included in other income, net. The Company evaluated the underlying credit quality and credit ratings of the issuers during the period. To date, no such credit losses have occurred or have been recorded. The cost of investments sold is based on the specific-identification method. As of December 31, 2020, there were net unrealized losses on marketable securities of $2,000, and as of December 31, 2019, there were net unrealized losses on marketable securities of $1,000. Unrealized gains and losses on marketable securities are reported as a component of accumulated other comprehensive loss on the balance sheets. Realized gains or losses on investments for the year ended December 31, 2020 were not material. There were no realized gains or losses on investments for the year ended December 31, 2019. Interest on marketable securities is included in other income, net.

Concentration of Credit Risk and Other Risks and Uncertainties

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalents and marketable securities. The Company maintains deposits in federally insured financial institutions in excess of federally insured limits. The Company is exposed to credit risk in the event of a default by the financial institutions holding its cash to the extent recorded on the balance sheets.

Management believes the Company is not exposed to significant credit risk due to the financial position of the depository institutions in which those deposits are held.

Fair Value Measurement

The Company’s financial instruments, in addition to those presented in Note 3, include cash equivalents, accounts payable and accrued liabilities. The carrying amount of cash equivalents, accounts payable and accrued liabilities approximate their fair values due to their short maturities.

Assets and liabilities recorded at fair value on a recurring basis on the balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair values. Fair value is defined as the exchange price that would be received for an asset or an exit price that would be 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. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The authoritative guidance on fair value measurements establishes a three-tier fair value hierarchy for disclosure of fair value measurements as follows:

Level 1—Observable inputs such as unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;

Level 2—Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active;

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation on property and equipment is calculated using the straight-line method over the estimated useful lives of the assets which range from three to five years. Leasehold improvements are depreciated on a straight-line basis over the shorter of their estimated useful lives or lease terms. Maintenance and repairs are expensed as incurred. The Company reviews the carrying values of its property and equipment for possible impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. There were no impairments recognized during the years ended December 31, 2020 and 2019.

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Notes to Financial Statements

Leases

The Company determines if an arrangement is or contains a lease at inception. Right-of-use (ROU) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. The classification of the Company’s leases as operating or finance leases along with the initial measurement and recognition of the associated ROU assets and lease liabilities is performed at the lease commencement date. The measurement of lease liabilities is based on the present value of lease payments over the lease term. The Company uses its incremental borrowing rate, based on the information available at commencement date, to determine the present value of lease payments when its leases do not provide an implicit rate. The Company uses the implicit rate when readily determinable. The ROU asset is based on the measurement of the lease liability, includes any lease payments made prior to or on lease commencement and is adjusted for lease incentives and initial direct costs incurred, as applicable. Lease expense for the Company’s operating leases is recognized on a straight-line basis over the lease term. The Company considers a lease term to be the non-cancelable period that it has the right to use the underlying asset, including any periods where it is reasonably assured the Company will exercise the option to extend the contract. Periods covered by an option to extend are included in the lease term if the lessor controls the exercise of that option.

The Company’s lease agreements includes lease and non-lease components and the Company has elected to not separate such components for all classes of assets. Further, the Company elected the short-term lease exception policy, permitting it to not apply the recognition requirements of this standard to leases with terms of 12 months or less (short-term leases) for all classes of assets.

Preclinical and Clinical Accruals and Costs

The Company records accrued liabilities for estimated costs of research and development activities conducted by third-party service providers, which include the conduct of preclinical studies, clinical trials and contract manufacturing activities. These costs are a significant component of the Company’s research and development expenses. The Company accrues for these costs based on factors such as estimates of the work completed and in accordance with agreements established with its third-party service providers under the service agreements. The Company makes significant judgments and estimates in determining the accrued liabilities balance in each reporting period. As actual costs become known, the Company adjusts its accrued liabilities. For the years ended December 31, 2020, 2019 and 2018, the Company has not experienced any material differences between accrued costs and actual costs incurred.

Convertible Preferred Stock

Prior to its IPO, the Company classified its outstanding convertible preferred stock outside of stockholders’ equity (deficit) on its balance sheets as the requirements of triggering a deemed liquidation event, as defined within its amended and restated certificate of incorporation, were not entirely within the Company’s control. In the event of such a deemed liquidation event, the proceeds from the event were to be distributed in accordance with the liquidation preferences, provided that the holders of convertible preferred stock had not converted their shares into common stock. The Company recorded the issuance of convertible preferred stock at the issuance price less related issuance costs. The Company did not adjust the carrying values of the convertible preferred stock to the liquidation preferences of such shares because of the uncertainty as to whether or when a deemed liquidation event may have occurred.In connection with the IPO in February 2020, the Company’s outstanding shares of convertible preferred stock were automatically converted into 24,385,388 shares of common stock.

Research and Development

Research and development expenses include costs directly attributable to the conduct of research and development programs, including the cost of salaries, payroll taxes, employee benefits, license fees, stock-based compensation expense, materials, supplies, and the cost of services provided by outside contractors. All costs associated with research and development are expensed as incurred. Payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods are received or services are rendered. Such payments are evaluated for current or long-term classification based on when they will be realized.

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Notes to Financial Statements

The Company has entered into and may continue to enter into, license agreements to access and utilize certain technology. In each case, the Company evaluates if the license agreement results in the acquisition of an asset or a business. To date, none of the Company’s license agreements have been considered an acquisition of a business. For asset acquisitions, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval that do not meet the definition of a derivative, are immediately recognized as research and development expense when paid or become payable, provided there is no alternative future use of the rights in other research and development projects.

Stock-Based Compensation

The Company accounts for share-based payments at fair value. The fair value of stock options is measured using the Black-Scholes option-pricing model. For share-based awards that vest subject to the satisfaction of a service requirement, the fair value measurement date for such awards is the date of grant and the expense is recognized on a straight-line basis, over the expected vesting period. For share-based awards that vest subject to a performance condition, the Company will recognize compensation cost for awards if and when the Company concludes that it is probable that the awards with a performance condition will be achieved on an accelerated attribution method. The Company accounts for forfeitures as they occur.

Income Taxes

Income taxes are accounted for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period of enactment. The Company records a valuation allowance to reduce deferred tax assets to an amount for which realization is more likely than not. Due to the Company’s historical operating performance and the recorded cumulative net losses in prior fiscal periods, the net deferred tax assets have been fully offset by a valuation allowance.

The Company recognizes the tax benefit from an uncertain tax position if it is more likely than not that the tax position will be sustained upon examination by the tax authorities, based on the merits of the position. The Company’s policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense or benefit. To date, there have been no interest or penalties incurred in relation to the unrecognized tax benefits.

The United States Congress enacted the Families First Coronavirus Response Act (FFCR Act) on March 18, 2020 and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) on March 27, 2020. The CARES Act is an emergency economic stimulus package that includes spending and tax breaks to strengthen the U.S. economy and fund a nationwide effort to curtail the effect of COVID-19. The FFCR Act and CARES Act include numerous tax-related provisions including modifications to the limitations on business interest expense and net operating losses (NOLs), certain refundable employee retention credits, as well as a payment delay of employer payroll taxes in 2020 after the date of enactment. On June 29, 2020, the California State Assembly Bill 85 (Trailer Bill) was enacted which suspends the use of California NOL deductions and certain tax credits, including research and development credits, for the 2020, 2021, and 2022 tax years. The Company does not expect the FFCR Act, CARES Act or Trailer Bill to have a material impact on the Company’s financial statements.

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Notes to Financial Statements

Variable Interest Entities

The Company reviews agreements it enters into with third-party entities, pursuant to which the Company may have a variable interest in the entity, in order to determine if the entity is a variable interest entity (VIE). If the entity is a VIE, the Company assesses whether or not it is the primary beneficiary of that entity. In determining whether the Company is the primary beneficiary of an entity, the Company applies a qualitative approach that determines whether it has both (i) the power to direct the economically significant activities of the entity and (ii) the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to that entity. If the Company determines it is the primary beneficiary of a VIE, it consolidates that VIE into the Company’s financial statements. The Company’s determination about whether it should consolidate such VIEs is made continuously as changes to existing relationships or future transactions may result in a consolidation or deconsolidation event. The Company currently does not consolidate any VIEs.

Net Loss Per Share

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of shares of common stock outstanding for the period, without consideration for potential dilutive shares of common stock. Diluted net loss per share is computed by dividing the net loss by the weighted-average number of common share equivalents outstanding for the period determined using the treasury-stock method. Since the Company was in a loss position for all periods presented, basic net loss per share is the same as diluted net loss per share since the effects of potentially dilutive securities are antidilutive. Shares of common stock subject to repurchase are excluded from the weighted-average shares.

Emerging Growth Company Status

The Company is an emerging growth company, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. The Company has elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date that it is (i) no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, these financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates.

Recently Adopted Accounting Pronouncements

In August 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement, or ASU No. 2018-13, which removes, modifies, and adds various disclosure requirements on fair value measurements in Topic 820. ASU No. 2018-13 is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted-average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. The Company early adopted this standard as of January 1, 2020, and it did not have a material impact on its financial statements.

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Notes to Financial Statements

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses(Topic 326): Measurement of Credit Losses on Financial Instruments, or ASU No. 2016-13. This update requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations now include forward-looking information in the determination of their credit loss estimates. Many of the previous loss estimation techniques are still permitted, although the inputs to those techniques have changed to reflect the full amount of expected credit losses. In addition, this update amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The Company early adopted this standard as of January 1, 2020, and it did not have a material impact on its financial statements. There was no impact on the Company's financial statements from credit losses for the year ended December 31, 2020.

In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740), or ASU No. 2019-12, which amends the existing guidance relating to the accounting for income taxes. This standard is intended to simplify the accounting for income taxes by removing certain exceptions to the general principles of accounting for income taxes and to improve the consistent application of GAAP for other areas of accounting for income taxes by clarifying and amending existing guidance. The standard is effective for public business entities for fiscal years beginning after December 15, 2020, and interim periods therein. Early adoption is permitted. An entity that elects early adoption in an interim period should reflect any adjustments as of the beginning of the annual period that includes that interim period. Additionally, an entity that elects early adoption should adopt all the amendments in the same period. The Company early adopted this guidance as of January 1, 2020, and it did not have a material impact on its financial statements.

3. Fair Value Measurements

The following table sets forth the Company’s financial instruments that were measured at fair value on a recurring basis by level within the fair value hierarchy (in thousands):

Level 1 Level 2 Level 3 Total

Assets:

Level 1 Level 2 Level 3 Total

Assets:

______________

(1)This balance includes cash requirements settled on a nightly basis.

Commercial paper, money market funds and U.S. Treasury securities are valued taking into consideration valuations obtained from third-party pricing services. The pricing services utilize industry standard valuation models, including both income and market-based approaches, for which all significant inputs are observable, either directly or indirectly, to estimate fair value. These inputs include reported trades of and broker/dealer quotes on the same or similar securities, issuer credit spreads; benchmark securities; prepayment/default projections based on historical data; and other observable inputs.

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Notes to Financial Statements

The following table summarizes the estimated value of the Company’s cash, cash equivalents and marketable securities and the gross unrealized holding gains and losses (in thousands):

Amortizedcost Unrealizedgains Unrealizedlosses Estimatedfair value

Cash and cash equivalents:

Total cash and cash equivalents $ 65,082 $ — $ — $ 65,082

Marketable securities:

______________

(1)This balance includes cash requirements settled on a nightly basis.

Amortizedcost Unrealizedgains Unrealizedlosses Estimatedfair value

Cash and cash equivalents:

Total cash and cash equivalents $ 63,336 $ — $ — $ 63,336

Marketable securities:

______________

(1)This balance includes cash requirements settled on a nightly basis.

Realized gains or losses on investments for the year ended December 31, 2020 were not material. There were no realized gains or losses on investments for the year ended December 31, 2019. As of December 31, 2020 and 2019, unrealized losses on marketable securities were not material, and accordingly, no allowance for credit losses were recorded. As of December 31, 2020 and 2019, all securities have a maturity of one year or less and all securities with gross unrealized losses have been in a continuous loss position for less than one year.

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Notes to Financial Statements

4. Balance Sheet Components

Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consist of the following (in thousands):

Prepaid clinical trial costs $ 4,865 $ 2,998

Deferred financing costs — 1,747

Other prepaid expenses and current assets 1,219 257

Total prepaid expenses and other current assets $ 6,843 $ 5,209

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

Early exercise liability, current 176 225

Accrued expenses and other current liabilities 1,098 553

5. Property and Equipment, net

Property and equipment, net consists of the following (in thousands):

December 31,

Furniture and fixtures 5 230 60

Construction in process 298 —

Property and equipment, gross 2,094 295

Less accumulated depreciation (78) (68)

Property and equipment, net $ 2,016 $ 227

Leasehold improvements are depreciated over the term of the lease. Depreciation expense was $122,000 and $68,000 for the years ended December 31, 2020 and 2019, respectively. There was no depreciation expense for the year ended December 31, 2018.

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Notes to Financial Statements

6. License Agreements

AstraZeneca License Agreement

In July 2018, the Company entered into an exclusive license agreement, or the AstraZeneca License Agreement, with AstraZeneca AB (AstraZeneca), granting the Company a worldwide exclusive license, with the right to sublicense through multiple tiers, under certain AstraZeneca-controlled patent rights, know-how and regulatory documentation, to research, develop, manufacture, commercialize and otherwise exploit products containing roflumilast in topical forms, as well as delivery systems sold with or for the administration of roflumilast, or collectively, the AZ-Licensed Products, for all diagnostic, prophylactic and therapeutic uses for human dermatological indications, or the Dermatology Field. Under this agreement, the Company has sole responsibility for development, regulatory, and commercialization activities for the AZ-Licensed Products in the Dermatology Field, at its expense, and it shall use commercially reasonable efforts to develop, obtain and maintain regulatory approvals for, and commercialize the AZ-Licensed Products in the Dermatology Field in each of the United States, Italy, Spain, Germany, the United Kingdom, France, China, and Japan.

The Company paid AstraZeneca an upfront non-refundable cash payment of $1.0 million and issued 484,388 shares of Series B convertible preferred stock, valued at $3.0 million on the date of the AstraZeneca License Agreement. The Company subsequently paid AstraZeneca the first milestone cash payment of $2.0 million upon the completion of a Phase 2b study of roflumilast cream in plaque psoriasis in August 2019 for the achievement of positive Phase 2 data for an AZ-Licensed Product, which was recorded in research and development expense. The Company has agreed to make additional cash payments to AstraZeneca of up to an aggregate of $12.5 million upon the achievement of specified regulatory approval milestones with respect to the AZ-Licensed Products and payments up to an additional aggregate amount of $15.0 million upon the achievement of certain aggregate worldwide net sales milestones. With respect to any AZ-Licensed Products the Company commercializes under the AstraZeneca License Agreement, it will pay AstraZeneca a low to high single-digit percentage royalty rate on the Company’s, its affiliates’ and its sublicensees’ net sales of such AZ-Licensed Products, subject to specified reductions, until, as determined on an AZ-Licensed Product-by-AZ-Licensed Product and country-by-country basis, the later of the date of the expiration of the last-to-expire AstraZeneca-licensed patent right containing a valid claim in such country and ten years from the first commercial sale of such AZ-Licensed Product in such country.

There were no payments made or due in connection with AZ-Licensed Products for the year ended December 31, 2020. For the year ended December 31, 2019, the Company recorded research and development expense of $2.0 million related to the milestone payment made upon the completion of a Phase 2B study of ARQ-151 in plaque psoriasis for the achievement of positive Phase 2 data for an AZ-Licensed Product For the year ended December 31, 2018, the Company recorded research and development expense of $4.0 million related to the upfront fee payment and the issuance of Series B convertible preferred stock.

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Notes to Financial Statements

Hengrui Exclusive Option and License Agreement

In January 2018, the Company entered into an exclusive option and license agreement, or the Hengrui License Agreement, with Jiangsu Hengrui Medicine Co., Ltd. (Hengrui), whereby Hengrui granted the Company an exclusive option to obtain certain exclusive rights to research, develop and commercialize products containing the compound designated by Hengrui as SHR0302, a Janus kinase type 1 inhibitor, in topical formulations for the treatment of skin diseases, disorders, and conditions in the United States, Japan, Canada and the European Union (including for clarity the United Kingdom). The Company made a $0.4 million upfront non-refundable cash payment to Hengrui upon execution of the Hengrui Option and License Agreement, which was recorded as research and development expense. In December 2019, the Company exercised its exclusive option under the agreement, for which it made a $1.5 million cash payment, which was recorded in research and development expense, and also contemporaneously amended the agreement to expand the territory to additionally include Canada. In addition, the Company has agreed to make cash payments of up to an aggregate of $20.5 million upon achievement of specified clinical development and regulatory approval milestones with respect to the licensed products and cash payments of up to an additional aggregate of $200.0 million in sales-based milestones based on certain aggregate annual net sales volumes with respect to a licensed product.

With respect to any products the Company commercializes under the Hengrui License Agreement, it will pay tiered royalties to Hengrui on net sales of each licensed product by the Company, or its affiliates, or its sublicensees, ranging from mid single-digit to sub-teen percentage rates based on tiered annual net sales bands subject to specified reductions. The Company is obligated to pay royalties until the later of (1) expiration of the last valid claim of the licensed patent rights covering such licensed product in such country and (2) expiration of regulatory exclusivity for the relevant licensed product in the relevant country, on a licensed product-by-licensed product and country-by-country basis. Additionally, the Company is obligated to pay Hengrui a specified percentage, ranging from the low-thirties to the sub-teens, of certain non-royalty sublicensing income it receives from sublicensees of its rights to the licensed products, such percentage decreasing as the development stage of the licensed products advance.

There were no payments made or due in connection with Hengrui for the year ended December 31, 2020.

Hawkeye Collaboration Agreement

In June 2019, the Company entered into a collaboration agreement, or Hawkeye Agreement, with Hawkeye Therapeutics, Inc. (Hawkeye), a related party with common ownership, for the development of one or more new applications of roflumilast. The Hawkeye Agreement grants Hawkeye an exclusive license to certain intellectual property developed under the agreement as it relates to the applications.

Contemporaneously with the execution of the Hawkeye Agreement, the Company entered into a stock purchase agreement, purchasing 995,000 shares of Hawkeye’s common stock at $0.0001 per share, representing 19.9% of the outstanding common stock of Hawkeye. In the event that Hawkeye issues shares of Series A preferred stock with proceeds over $5.0 million, Hawkeye is required to issue to the Company a number of fully-paid fully-vested shares of common stock determined by dividing (i) $2,000,000 by (ii) an amount equal to the cash price per share for Series A preferred stock. Other than the potential issuance of this common stock, there are no upfront payments, milestones or royalties pursuant to the Hawkeye Agreement. The Company determined that Hawkeye is a VIE for which consolidation is not required as it is not the primary beneficiary.

7. Commitments and Contingencies

Operating Lease

The Company leases a facility in Westlake Village, California under an operating lease that commenced in February 2019. This lease was amended in April 2020 in order to relocate to a new expanded space comprising 22,643 square feet. At the time of the amendment, the Company reassessed the lease term of the original space in accordance with the option to terminate if leasing additional space in the same property. In connection with the reduction of the lease term for the original space, the Company reduced the ROU asset and lease liability balance by $123,000.

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Notes to Financial Statements

The Company recognized the ROU asset and lease liability for the new space on May 1, 2020, which was determined to be the lease commencement date, or the date on which the new space was made available to the Company for purposes of planning and constructing the leasehold improvements. The lease payment term for the new space began on December 30, 2020, which was 15 days after the leasehold improvements were substantially complete. The lease payments terminate 91 months thereafter, with a renewal option for a term of five years. The Company will have a one-time option to cancel the lease after month 67. The renewal and one-time cancellation options have not been considered in the determination of the ROU asset or lease liability, as the Company did not consider it reasonably certain it would exercise these options.

The lease is subject to fixed rate escalation increases with an initial base rent of $76,000 per month, and includes rent free periods aggregating approximately one year. As a result, the Company recognizes rent expense on a straight-line basis for the full amount of the commitment including the minimum rent increases over the life of the lease and the free rent period. The amended lease agreement provided for a leasehold improvement allowance up to $1.25 million. It also required the Company to have an available letter of credit of $1.5 million upon occupying the space, which is allowed to be reduced throughout the lease period as rent obligations are met. Accordingly, in November 2020, the Company entered into a letter of credit for $1.5 million, which it secured with a restricted cash account in the same amount. The restricted cash will be reduced by $308,000 on the first, second, third, and fourth anniversary and by $45,000 on the fifth anniversary from when the lease payment term began on December 30, 2020, with no further reductions thereafter.

In association with commencement of this new lease, the Company recorded lease liabilities and off-setting ROU assets of $3.6 million on its balance sheet as of June 30, 2020. Since the Company was reasonably certain to incur costs equal to or exceeding the leasehold improvement allowance of $1.25 million, the allowance was treated as a lease incentive that was payable to the Company at the lease commencement date. Accordingly, the leasehold improvement allowance was included in the measurement of the consideration in the contract at commencement, and was recognized as a reduction in the ROU asset and lease liability. Upon completion in December 2020, the leasehold improvements were reclassified from the lease liability to property and equipment and will be depreciated over the term of the lease.

The minimum annual rental payments of the Company’s operating lease liability as of December 31, 2020 are as follows (in thousands):

Amounts

Total minimum lease payments $ 6,673

Less: Amounts representing interest (1,709)

Present value of lease payments $ 4,964

Operating lease liability, noncurrent 4,964

Total operating lease liability $ 4,964

Straight-line rent expense recognized for operating leases was $602,000 and $151,000 for the years ended December 31, 2020 and 2019, respectively. Rent expense for the year ended December 31, 2018 was not material. There were no significant variable lease payments, including non-lease components such as common area maintenance fees, recognized as rent expense for operating leases for the year ended December 31, 2020.

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Notes to Financial Statements

The following information represents supplemental disclosure for the statement of cash flows related to the Company’s operating lease (in thousands):

Cash flows from operating activities

Cash paid for amounts included in the measurement of lease liabilities $ 192

The following summarizes additional information related to the operating lease:

Weighted-average remaining lease term (in years) 7.6

Weighted-average discount rate 7.0 %

Indemnification

In the ordinary course of business, the Company enters into agreements that may include indemnification provisions. Pursuant to such agreements, the Company may indemnify, hold harmless and defend an indemnified party for losses suffered or incurred by the indemnified party. Some of the provisions will limit losses to those arising from third-party actions. In some cases, the indemnification will continue after the termination of the agreement. The maximum potential amount of future payments the Company could be required to make under these provisions is not determinable. The Company has never incurred material costs to defend lawsuits or settle claims related to these indemnification provisions. The Company has also entered into indemnification agreements with its directors and officers that may require the Company to indemnify its directors and officers against liabilities that may arise by reason of their status or service as directors or officers to the fullest extent permitted by California corporate law. The Company currently has directors’ and officers’ insurance coverage that reduces its exposure and enables the Company to recover a portion of any future amounts paid. The Company believes any potential loss exposure under these indemnification agreements in excess of applicable insurance coverage is minimal.

8. Convertible Preferred Stock and Stockholders’ Equity (Deficit)

Convertible Preferred Stock

Convertible preferred stock as of December 31, 2019 consisted of the following (in thousands, except share amounts):

In connection with the Company's IPO in February 2020, all of the Company’s outstanding shares of convertible preferred stock were automatically converted into 24,385,388 shares of common stock.

In October 2019, the Company issued 8,122,963 shares of Series C convertible preferred stock at a purchase price of $11.63 per share for total net proceeds of $94.2 million, some of which were to related parties.

In September 2018, the Company issued 9,364,850 shares of Series B convertible preferred stock at a purchase price of $6.19 per share for total net proceeds of $54.9 million, some of which were to related parties.

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Notes to Financial Statements

In April 2017 and March 2018, the Company issued 3,590,845 and 3,156,784 shares, respectively, of Series A convertible preferred stock at a purchase price of $2.00 per share for net proceeds of $13.4 million.Additionally, in April 2017, the Company issued 149,946 shares of Series A convertible preferred stock as a result of the conversion of convertible promissory notes.

Common Stock

The holders of the Company’s common stock have one vote for each share of common stock. Common stockholders are entitled to dividends when, as, and if declared by the board of directors. The holders have no preemptive or other subscription rights and there are no redemption or sinking fund provisions with respect to such shares. As of December 31, 2020, no dividends had been declared by the board of directors.

The Company reserved the following shares of common stock for issuance as follows:

December 31,

Convertible preferred stock outstanding — 24,385,388

Restricted stock units outstanding 162,930 —

Authorized Share Capital

On February 4, 2020, the Company’s certificate of incorporation was amended and restated to provide for 300,000,000 authorized shares of common stock with a par value of $0.0001 per share and 10,000,000 authorized shares of preferred stock with a par value of $0.0001 per share. There were no shares of preferred stock outstanding as of December 31, 2020 and 2019.

9. Stock-Based Compensation

In January 2020, the Company’s board of directors approved the 2020 Equity Incentive Plan (2020 Plan), which became effective January 30, 2020 in connection with the IPO. The 2020 Plan serves as the successor incentive award plan to the Company’s 2017 Equity Incentive Plan, (2017 Plan), and has 2,134,000 shares of common stock available for issuance pursuant to a variety of stock-based compensation awards, including stock options, stock appreciation rights, restricted stock awards, restricted stock unit (RSU) awards and other stock-based awards, plus 1,550,150 shares of common stock that were reserved for issuance pursuant to future awards under the 2017 Plan at the time the 2020 Plan became effective, plus shares represented by awards outstanding under the 2017 Plan that are forfeited, lapsed or unexercised, and which following the effective date of the 2020 Plan are not issued under the 2017 Plan. In addition, the 2020 Plan reserve will increase on January 1, 2021 and each subsequent anniversary through 2030, by an amount equal to the lesser of (a) four percent of the shares of stock outstanding (on an as-converted basis) on the day immediately prior to the date of increase and (b) such smaller number of shares of stock as determined by our board of directors; provided, however, that no more than 11,000,000 shares of stock may be issued upon the exercise of incentive stock options. Accordingly, on January 1, 2021, the plan reserve increased by 1,747,112 shares. As of December 31, 2020, the Company had 2,184,517 shares available for future grant under the 2020 Plan.

The 2020 Plan provides for the Company to sell or issue common stock or restricted common stock, or to grant incentive stock options or nonqualified stock options for the purchase of common stock, to employees, members of the board of directors and consultants of the Company under terms and provisions established by the board of directors. Under the terms of the 2020 Plan, options may be granted at an exercise price not less than fair market value. The Company generally grants stock-based awards with service conditions. Options granted typically vest over a four-year period but may be granted with different vesting terms.

Following the Company’s IPO and in connection with the effectiveness of the Company’s 2020 Plan, the 2017 Plan terminated and no further awards will be granted under that plan. However, all outstanding awards under the 2017 Plan will continue to be governed by their existing terms.

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Notes to Financial Statements

Stock Option Activity

The following summarizes option activity (in thousands, except share amounts):

______________

(1)Options exercisable includes early exercisable options.

The aggregate intrinsic value is calculated as the difference between the exercise price of the options and the fair value of the Company’s common stock as of December 31, 2020. As of December 31, 2019, prior to the Company's IPO, the estimated fair value of the Company's common stock was determined by the board of directors.

The intrinsic value of options exercised for the year ended December 31, 2020 was $3.6 million.

The total grant-date fair value of the options vested during the year ended December 31, 2020 was $2.8 million. The weighted-average grant-date fair value of employee options granted during the year ended December 31, 2020 was $18.16.

Restricted Stock Unit Activity

The following table summarizes information regarding our RSUs:

Number of Units Weighted-AverageGrant Date Fair Value

Vested — —

The grant date fair value of an RSU equals the closing price of our common stock on the grant date. RSUs generally vest equally over four years. There were no RSU grants prior to January 1, 2020.

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ARCUTIS BIOTHERAPEUTICS, INC.

Notes to Financial Statements

Stock-Based Compensation Expense

Stock-based compensation expense included in the statements of operations and comprehensive loss was as follows (in thousands):

Year Ended December 31,

Total stock-based compensation expense $ 7,943 $ 824 $ 151

As of December 31, 2020, there was $23.2 million of total unrecognized compensation cost related to unvested options that are expected to vest, which is expected to be recognized over a weighted-average period of 3.2 years. As of December 31, 2020, there was $3.6 million of total unrecognized compensation cost related to RSUs that is expected to vest, which is expected to be recognized over a weighted-average period of 3.6 years.

In determining the fair value of the stock options granted, the Company uses the Black-Scholes option-pricing model and assumptions discussed below. Each of these inputs is subjective and generally requires significant judgment.

Fair value of common stock—For options granted prior to IPO in the year ended December 31, 2019, given the absence of a public trading market, the Company’s board of directors with input from management considered numerous objective and subjective factors to determine the fair value of common stock. The factors included, but were not limited to: (i) third-party valuations of the Company’s common stock; (ii) the Company’s stage of development; (iii) the status of research and development efforts; (iv) the rights, preferences and privileges of the Company’s convertible preferred stock relative to those of the Company’s common stock; (v) the Company’s operating results and financial condition, including the Company’s levels of available capital resources; and (vi) equity market conditions affecting comparable public companies; (vii) general U.S. market conditions; and (viii) the lack of marketability of the Company’s common stock. For options granted after IPO, the Company uses its closing stock price as reported on Nasdaq on the grant date for the fair value of its stock.