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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 ________________________________ 

FORM 10-Q
  ________________________________ 
 
(Mark One)
ý 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2019 
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to            
 
Commission file number 001-36156
 ________________________________ 

VERACYTE, INC.
(Exact name of registrant as specified in its charter)
________________________________ 
 
Delaware
 
20-5455398
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
 
6000 Shoreline Court, Suite 300
South San Francisco, California 94080
(Address of principal executive offices, zip code)
 
(650) 243-6300
(Registrant’s telephone number, including area code)
  ________________________________ 


Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Trading Symbol(s)
 
Name of each exchange on which registered
Common Stock, par value, $0.001 per share
 
VCYT
 
The Nasdaq Stock Market LLC

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ý No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.



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Large accelerated filer o
 
Accelerated filer x
 
 
 
Non-accelerated filer o
 
Smaller reporting company x
 
 
 
 
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes o No ý

As of July 26, 2019, there were 48,445,700 shares of common stock, par value $0.001 per share, outstanding.



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VERACYTE, INC.
INDEX
 
 
Page
No.
 
 


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PART I. — FINANCIAL INFORMATION
 
Item 1. Condensed Financial Statements
 
VERACYTE, INC. 
Condensed Balance Sheets 
(In thousands, except share and per share amounts)
 
June 30,
2019
 
December 31, 2018
 
(Unaudited)
 
(See Note 1)
Assets
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
192,647

 
$
77,995

Accounts receivable
19,626

 
13,168

Supplies
5,104

 
3,402

Prepaid expenses and other current assets
2,573

 
2,387

Total current assets
219,950

 
96,952

Property and equipment, net
8,150

 
8,940

Right-of-use assets - finance lease, net
677

 

Right-of-use assets - operating lease
9,412

 

Finite-lived intangible assets, net
11,467

 
12,000

Goodwill
1,057

 
1,057

Restricted cash
603

 
603

Other assets
1,061

 
1,086

Total assets
$
252,377

 
$
120,638

Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
4,061

 
$
2,516

Accrued liabilities
9,820

 
9,186

Current portion of long-term debt

 
1,357

Current portion of finance lease liability
156

 

Current portion of operating lease liability
1,284

 

Total current liabilities
15,321

 
13,059

Long-term debt
585

 
23,925

Deferred rent, net of current portion

 
3,899

Operating lease liability, net of current portion
12,231

 

Total liabilities
28,137

 
40,883

Commitments and contingencies


 


Stockholders’ equity:
 

 
 

Preferred stock, $0.001 par value; 5,000,000 shares authorized, no shares issued and outstanding as of June 30, 2019 and December 31, 2018

 

Common stock, $0.001 par value; 125,000,000 shares authorized, 48,255,225 and 40,863,202 shares issued and outstanding as of June 30, 2019 and December 31, 2018, respectively
48

 
41

Additional paid-in capital
462,689

 
313,800

Accumulated deficit
(238,497
)
 
(234,086
)
Total stockholders’ equity
224,240

 
79,755

Total liabilities and stockholders’ equity
$
252,377

 
$
120,638

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

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VERACYTE, INC.
 
Condensed Statements of Operations and Comprehensive Loss
 
(Unaudited)
 
(In thousands, except share and per share amounts)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
2019
 
2018
Revenue
$
30,136

 
$
22,751

 
$
59,665

 
$
42,792

Operating expenses:
 

 
 

 
 
 
 
Cost of revenue
8,777

 
8,246

 
17,290

 
16,113

Research and development
3,330

 
4,601

 
6,765

 
8,276

Selling and marketing
13,943

 
9,623

 
26,420

 
21,166

General and administrative
6,920

 
5,932

 
13,824

 
11,576

Intangible asset amortization
266

 
266

 
533

 
533

Total operating expenses
33,236

 
28,668

 
64,832

 
57,664

Loss from operations
(3,100
)
 
(5,917
)
 
(5,167
)
 
(14,872
)
Interest expense
(235
)
 
(481
)
 
(538
)
 
(929
)
Other income, net
841

 
150

 
1,294

 
376

Net loss and comprehensive loss
$
(2,494
)
 
$
(6,248
)
 
$
(4,411
)
 
$
(15,425
)
Net loss per common share, basic and diluted
$
(0.05
)
 
$
(0.18
)
 
$
(0.10
)
 
$
(0.45
)
Shares used to compute net loss per common share, basic and diluted
45,586,081

 
34,314,234

 
43,389,540

 
34,320,793

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


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VERACYTE, INC.
Condensed Statements of Stockholders' Equity
(Unaudited)
(In thousands)

 
 
 
 
 
Additional
Paid-in
Capital
 
Accumulated
Deficit
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
Shares
 
Amount
 
 
 
Balance at March 31, 2019
41,509

 
$
42

 
$
319,733

 
$
(236,003
)
 
$
83,772

Sale of common stock in a public offering, net of issuance costs of $9,208
6,325

 
6

 
137,842

 

 
137,848

Issuance of common stock on exercise of stock options and vesting of restricted stock units
421

 

 
2,668

 

 
2,668

Tax portion of vested restricted stock units

 

 
(120
)
 

 
(120
)
Stock-based compensation expense (employee)

 

 
2,334

 

 
2,334

Stock-based compensation expense (non-employee)

 

 
55

 

 
55

Stock-based compensation expense (ESPP)

 

 
177

 

 
177

Net loss and comprehensive loss

 

 

 
(2,494
)
 
(2,494
)
Balance at June 30, 2019
48,255

 
$
48

 
$
462,689

 
$
(238,497
)
 
$
224,240

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2018
40,863

 
$
41

 
$
313,800

 
$
(234,086
)
 
$
79,755

Sale of common stock in a public offering, net of issuance costs of $9,208
6,325

 
6

 
137,842

 

 
137,848

Issuance of common stock on exercise of stock options and vesting of restricted stock units
987

 
1

 
6,907

 

 
6,908

Issuance of common stock under employee stock purchase plan (ESPP)
80

 

 
491

 

 
491

Tax portion of vested restricted stock units

 

 
(676
)
 
 
 
(676
)
Stock-based compensation expense (employee)

 

 
3,932

 

 
3,932

Stock-based compensation expense (non-employee)

 

 
75

 

 
75

Stock-based compensation expense (ESPP)

 

 
318

 

 
318

Net loss and comprehensive loss

 

 

 
(4,411
)
 
(4,411
)
Balance at June 30, 2019
48,255

 
$
48

 
$
462,689

 
$
(238,497
)
 
$
224,240



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Additional
Paid-in
Capital
 
Accumulated
Deficit
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
Shares
 
Amount
 
 
 
Balance at March 31, 2018
34,327

 
$
34

 
$
250,238

 
$
(220,264
)
 
$
30,008

Issuance of common stock on exercise of stock options and vesting of restricted stock units
115

 

 
315

 

 
315

Issuance of common stock under employee stock purchase plan (ESPP)

 

 

 
 
 

Tax portion of vested restricted stock units

 

 

 

 

Stock-based compensation expense (employee)

 

 
1,646

 

 
1,646

Stock-based compensation expense (non-employee)

 

 
(5
)
 

 
(5
)
Stock-based compensation expense (ESPP)

 

 
90

 

 
90

Legal settlement from short-swing profits, net of tax

 

 

 

 

Net loss and comprehensive loss

 

 

 
(6,248
)
 
(6,248
)
Balance at June 30, 2018
34,442

 
$
34

 
$
252,284

 
$
(226,512
)
 
$
25,806

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017
34,210

 
34

 
248,278

 
(211,087
)
 
37,225

Issuance of common stock on exercise of stock options and vesting of restricted stock units
159

 

 
423

 

 
423

Issuance of common stock under employee stock purchase plan (ESPP)
73

 

 
397

 

 
397

Tax portion of vested restricted stock units

 

 
(30
)
 

 
(30
)
Stock-based compensation expense (employee)

 

 
2,729

 

 
2,729

Stock-based compensation expense (non-employee)

 

 
(4
)
 

 
(4
)
Stock-based compensation expense (ESPP)

 

 
181

 

 
181

Legal settlement from short-swing profits, net of tax

 

 
310

 

 
310

Net loss and comprehensive loss

 

 

 
(15,425
)
 
(15,425
)
Balance at June 30, 2018
34,442

 
$
34

 
$
252,284

 
$
(226,512
)
 
$
25,806

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


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VERACYTE, INC.  

Condensed Statements of Cash Flows 

(Unaudited) 

(In thousands)
 
Six Months Ended June 30,
 
2019
 
2018
Operating activities
 

 
 

Net loss
$
(4,411
)
 
$
(15,425
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
1,869

 
1,969

Gain on disposal of property and equipment
(17
)
 

Stock-based compensation
4,325

 
2,906

Other income

 
(93
)
Amortization of debt issuance costs
83

 
16

Interest on end-of-term debt obligation
120

 
149

Changes in operating assets and liabilities:
 

 
 

Accounts receivable
(6,458
)
 
(290
)
Supplies
(1,702
)
 
2,275

Prepaid expenses and other current assets
(192
)
 
98

Right-of-use assets - operating lease and operating lease liability
(173
)
 

Other assets
25

 
(272
)
Accounts payable
1,746

 
(1,912
)
Accrued liabilities and deferred rent
1,319

 
67

Net cash used in operating activities
(3,466
)
 
(10,512
)
Investing activities
 

 
 

Purchases of property and equipment
(1,424
)
 
(761
)
Proceeds from disposal of property and equipment
17

 

Net cash used in investing activities
(1,407
)
 
(761
)
Financing activities
 

 
 

Proceeds from the issuance of common stock in a public offering, net of costs
137,848

 

Payment of long-term debt
(24,900
)
 

Proceeds from legal settlement regarding short-swing profits

 
403

Payment of finance lease liability
(152
)
 
(144
)
Proceeds from the exercise of common stock options and employee stock purchases
6,729

 
881

Net cash provided by financing activities
119,525

 
1,140

Net increase (decrease) in cash, cash equivalents and restricted cash
114,652

 
(10,133
)
Cash, cash equivalents and restricted cash at beginning of period
78,598

 
34,494

Cash, cash equivalents and restricted cash at end of period
$
193,250

 
$
24,361

Supplementary cash flow information of non-cash investing and financing activities:
 

 
 

Operating lease liability arising from obtaining right-of-use assets - operating lease
$
14,118

 
$

Purchases of property and equipment included in accounts payable
$
72

 
$
63

Interest paid on debt
$
319

 
$
741




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Cash, Cash Equivalents and Restricted Cash:
 
June 30, 2019
 
December 31, 2018
Cash and cash equivalents
$
192,647

 
$
77,995

Restricted cash
603

 
603

Total cash, cash equivalents and restricted cash
$
193,250

 
$
78,598



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

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VERACYTE, INC.
 
Notes to Financial Statements
 
1. Organization and Description of Business
 
Veracyte, Inc. (“Veracyte” or the “Company”) is a leading genomic diagnostics company that is creating value through innovation. The Company was founded in 2008 with a mission to improve diagnostic accuracy. Today, through its innovative scientific platform, Veracyte is serving this critical medical need and expanding its offerings further along the clinical continuum of care to advance early detection of disease and inform treatment decisions. The Company utilizes its scientific platform, which uses RNA whole-transcriptome sequencing combined with machine learning, to discover and develop its products.

Veracyte was incorporated in the state of Delaware on August 15, 2006 as Calderome, Inc. Calderome operated as an incubator until early 2008. On March 4, 2008, the Company changed its name to Veracyte, Inc. The Company’s operations are based in South San Francisco, California and Austin, Texas, and it operates in one segment.
 
The Company currently offers the following products in three clinical indications:

Afirma Genomic Sequencing Classifier ("Afirma GSC") and Xpression Atlas - The Company’s Afirma offering, consisting of the Afirma GSC and the Afirma Xpression Atlas, provides a comprehensive solution in thyroid nodule diagnosis and is intended to provide physicians with clinically actionable results from a single fine needle aspiration ("FNA") biopsy. The Afirma GSC is used to identify patients with benign thyroid nodules among those with indeterminate cytopathology results so that these patients can avoid unnecessary thyroid surgery. The Afirma Xpression Atlas provides genomic alteration content from the same sample to help physicians decide with greater confidence on surgery strategy and treatment options for their patients.

Percepta Genomic Sequencing Classifier ("Percepta GSC") - The Percepta GSC, which is the second generation of the original Percepta test, improves lung cancer diagnosis by enhancing the performance of diagnostic bronchoscopies and determines the risk of lung cancer to guide next steps in the evaluation of patients with lung nodules. The test may help patients avoid unnecessary invasive procedures by identifying those with a low risk of having cancer, while helping to guide next intervention steps for patients it identifies as high risk. The Percepta GSC uses novel "field of injury" science - through which genomic changes associated with lung cancer in current and former smokers can be identified with a simple brushing of a person's airway - without the need to sample the often hard-to-reach nodule directly.

Envisia Genomic Classifier - The Envisia classifier improves diagnosis of idiopathic pulmonary fibrosis ("IPF") by helping physicians better differentiate IPF from other interstitial lung diseases without the need for surgery. The test identifies the genomic pattern of usual interstitial pneumonia, a hallmark of IPF, with high accuracy on patient samples that are obtained through transbronchial biopsy, a nonsurgical procedure that is commonly used in lung evaluation.

The Company’s approach also provides multiple opportunities for partnerships with biopharmaceutical companies. In developing its products, the Company has built or gained access to unique biorepositories that include extensive clinical cohorts and whole genome RNA sequencing data that it believes are important to the development of new targeted therapies, determining clinical trial eligibility and guiding treatment selection.

All of the Company's testing services are made available through its clinical reference laboratories located in South San Francisco, California and Austin, Texas.
 
Basis of Presentation
 
The Company’s financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. The condensed balance sheet as of June 30, 2019, the condensed statements of operations and comprehensive loss for the three and six months ended June 30, 2019 and 2018, the condensed statements of stockholders' equity for the three and six months ended June 30, 2019 and 2018, and the condensed statements of cash flows for the six months ended June 30, 2019 and 2018 are unaudited, but include all adjustments, consisting only of normal recurring adjustments, which the Company considers necessary for a fair presentation of its financial position, operating results and cash flows for the periods presented. The condensed balance sheet at December 31, 2018 has been

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derived from audited financial statements. The results for the three and six months ended June 30, 2019 are not necessarily indicative of the results expected for the full year or any other period.
 
The accompanying interim period condensed financial statements and related financial information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.
 
Use of Estimates
 
The preparation of unaudited interim financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Items subject to such estimates include: revenue recognition; the useful lives of property and equipment; the recoverability of long-lived assets; the incremental borrowing rate for leases; the estimation of the fair value of intangible assets; stock options; income tax uncertainties, including a valuation allowance for deferred tax assets; and contingencies. The Company bases these estimates on historical and anticipated results, trends, and various other assumptions that the Company believes are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities and recorded revenue and expenses that are not readily apparent from other sources. Actual results could differ from those estimates and assumptions.
 
Issuance of Common Stock in a Public Offering

On May 7, 2019, the Company issued and sold 6,325,000 shares of common stock in a registered public offering, including 825,000 shares issued and sold upon the underwriters’ exercise in full of their option to purchase additional shares, at a price to the public of $23.25 per share. The Company's net proceeds from the offering were approximately $137.8 million, after deducting underwriting discounts and commissions and offering expenses of $9.2 million.

On July 30, 2018, the Company issued and sold 5,750,000 shares of common stock in a registered public offering, including shares issued and sold upon the underwriters' exercise in full of their option to purchase an additional 750,000 shares, at a price to the public of $10.25 per share. The Company's net proceeds from the offering were approximately $55.0 million, after deducting underwriting commissions and offering expenses of $3.9 million.

Concentrations of Credit Risk and Other Risks and Uncertainties
 
The majority of the Company’s cash and cash equivalents are deposited with one major financial institution in the United States. Deposits in this institution may exceed the amount of insurance provided on such deposits. The Company has not experienced any losses on its deposits of cash and cash equivalents.
 
Several of the components of the Company’s sample collection kit and test reagents are obtained from single-source suppliers. If these single-source suppliers fail to satisfy the Company’s requirements on a timely basis, it could suffer delays in being able to deliver its diagnostic solutions, a possible loss of revenue, or incur higher costs, any of which could adversely affect its operating results.
 
The Company is also subject to credit risk from its accounts receivable related to its sales. The Company generally does not perform evaluations of customers’ financial condition and generally does not require collateral.
 
Through June 30, 2019, most of the Company’s revenue has been derived from the sale of Afirma. To date, Afirma has been delivered primarily to physicians in the United States. The Company’s third-party payers in excess of 10% of total revenue and their related revenue as a percentage of total revenue were as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
2019
 
2018
Medicare
26
%
 
28
%
 
24
%
 
28
%
UnitedHealthcare
11
%
 
12
%
 
11
%
 
12
%
 
37
%
 
40
%
 
35
%
 
40
%
 

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On December 28, 2018, the Company entered into a diagnostics development agreement with Johnson & Johnson Services, Inc. ("JJSI") for which the Company recognized $3.2 million and $7.0 million of revenue for the provision of data and fulfillment of milestone obligations, which represents 10.6% and 11.7% of total revenue for the three and six months ended June 30, 2019, respectively.


The Company’s third-party payers in excess of 10% of accounts receivable and their related accounts receivable balance as a percentage of total accounts receivable were as follows at the following dates:
 
June 30,
2019
 
December 31, 2018
Medicare
13
%
 
20
%
UnitedHealthcare
9
%
 
11
%
 
As at June 30, 2019, accounts receivable from JJSI was $2.0 million for the fulfillment of milestone obligations, which represents 10.2% of total accounts receivable.

Restricted Cash
 
The Company had deposits of $603,000 included in long-term assets as of June 30, 2019 and December 31, 2018, restricted from withdrawal and held by a bank in the form of collateral for an irrevocable standby letter of credit held as security for the lease of the Company’s South San Francisco facility.
 
Revenue Recognition
 
The Company commenced recognizing revenue in accordance with the provisions of ASC 606, Revenue from Contracts with Customers, or ASC 606, starting January 1, 2018.

Revenue from Diagnostic Services

Most of the Company’s revenue is generated from the provision of diagnostic services. These services are completed upon the delivery of test results to the prescribing physician, at which time the Company bills for the services. The Company recognizes revenue related to billings based on estimates of the amount that will ultimately be realized. In determining the amount to accrue for a delivered test, the Company considers factors such as payment history, payer coverage, whether there is a reimbursement contract between the payer and the Company, payment as a percentage of agreed upon rate (if applicable), amount paid per test and any current developments or changes that could impact reimbursement. These estimates require significant judgment by management.
 
The Company adopted ASC 606 on January 1, 2018 using the modified retrospective method, which requires a cumulative catch-up adjustment as if the Company had recognized revenue under ASC 606 from January 1, 2016. Prior to January 1, 2018, the Company recognized revenue in accordance with ASC 954 and recognized revenue for tests delivered on an accrual basis when amounts that will ultimately be realized could be reasonably estimated, and on the cash basis when there was insufficient information to estimate revenue accruals. The adoption of ASC 606 did not have a material impact on the Company's statement of operations or financial position.
 
During the first half of 2019, the Company changed its revenue estimates due to actual and anticipated cash collections for tests delivered in prior quarters and recognized additional revenue of $0.1 million and $0.8 million for the three and six months ended June 30, 2019, respectively. As of June 30, 2019, $0.6 million of these adjustments have been collected. These adjustments resulted in decreases in the Company's loss from operations of $0.1 million and $0.8 million and a decrease in basic and diluted net loss per share of $0.01 and $0.02 for the three and six months ended June 30, 2019, respectively.

During the first half of 2018, the Company changed its revenue estimates due to actual and anticipated cash collections for tests delivered in prior quarters and recognized additional revenue of $0.5 million and $1.2 million of revenue for the three and six months ended June 30, 2018, respectively. These adjustments resulted in decreases in basic and diluted net loss from operations of $0.5 million and $1.2 million and decreases in loss per share of approximately $0.02 and $0.04 for the three and six months ended June 30, 2018, respectively.

Arrangements with Multiple-Performance Obligations

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From time to time, the Company enters into arrangements for research and development and/or commercialization services. Such arrangements may require the Company to deliver various rights, services and/or samples, including intellectual property rights/licenses, R&D services, and/or commercialization services. The underlying terms of these arrangements generally provide for consideration to the Company in the form of nonrefundable upfront license fees, development and commercial performance milestone payments, royalty payments, and/or profit sharing.

In arrangements involving more than one performance obligation, each required performance obligation is evaluated to determine whether it qualifies as a distinct performance obligation based on whether (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available and (ii) the good or service is separately identifiable from other promises in the contract. The consideration under the arrangement is then allocated to each separate distinct performance obligation based on its respective relative stand-alone selling price. The estimated selling price of each deliverable reflects the Company's best estimate of what the selling price would be if the deliverable was regularly sold by the Company on a stand-alone basis or using an adjusted market assessment approach if selling price on a stand-alone basis is not available.

The consideration allocated to each distinct performance obligation is recognized as revenue when control of the related goods or services is transferred. Consideration associated with at-risk substantive performance milestones is recognized as revenue when it is probable that a significant reversal of the cumulative revenue recognized will not occur. Should there be royalties, the Company utilizes the sales and usage-based royalty exception in arrangements that resulted from the license of intellectual property, recognizing revenues generated from royalties or profit sharing as the underlying sales occur.

Collaborative Arrangements

The Company enters into collaborative arrangements with partners that fall under the scope of ASC Topic 808,
Collaborative Arrangements, or ASC 808. While these arrangements are in the scope of ASC 808, the Company may analogize to ASC 606 for some aspects of the arrangements. The Company analogizes to ASC 606 for certain activities
within the collaborative arrangement for the delivery of a good or service (i.e., a unit of account) that is part of its ongoing
major or central operations.

The terms of the Company’s collaborative arrangements typically include one or more of the following: (i) up-front fees; (ii) milestone payments related to the achievement of development, regulatory, or commercial goals; and (iii) royalties on net sales of licensed products. Each of these payments may result in collaboration revenues or an offset against research and development expense.

As part of the accounting for these arrangements, the Company must develop estimates and assumptions that require judgment to determine the underlying stand-alone selling price for each performance obligation which determines how the transaction price is allocated among the performance obligations. Generally, the estimation of the stand-alone selling price may include such estimates as, independent evidence of market price, forecasted revenues or costs, development timelines, discount rates, and probabilities of technical and regulatory success. The Company evaluates each performance obligation to determine if they can be satisfied at a point in time or over time, and it measures the services delivered to the collaborative partner which are periodically reviewed based on the progress of the related program. The effect of any change made to an estimated input component and, therefore revenue or expense recognized, would be recorded as a change in estimate. In addition, variable consideration (e.g., milestone payments) must be evaluated to determine if it is constrained and, therefore, excluded from the transaction price.

Up-front Fees: If a license to the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company recognizes revenues from the transaction price allocated to the license when the license is transferred to the licensee and the licensee is able to use and benefit from the license. For licenses that are bundled with other promises, the Company utilizes judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time.

Milestone Payments: At the inception of each arrangement that includes milestone payments (variable consideration), the Company evaluates whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within the Company’s or the collaborative partner’s control, such as non-operational developmental and

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regulatory approvals, are generally not considered probable of being achieved until those approvals are received. At the end of each reporting period, the Company re-evaluates the probability of achievement of milestones that are within its or the collaborative partner’s control, such as operational developmental milestones and any related constraint, and if necessary, adjusts its estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenues and earnings in the period of adjustment. Revisions to the Company’s estimate of the transaction price may also result in negative collaboration revenues and earnings in the period of adjustment.

Services Agreement with Loxo Oncology

On April 9, 2018, the Company entered into an agreement with Loxo Oncology, Inc. ("Loxo") whereby the Company agreed to provide certain tissue samples and other services in exchange for agreed-upon fees. The agreement has a term of one year with an automatic renewal of one year and Loxo may terminate the agreement at any time with at least 90 days' notice. As of June 30, 2019, the agreement has not been terminated. The Company evaluated the accounting for this agreement under ASC 606 and concluded the performance obligations thereunder are the delivery of tissue samples and performance of services, both of which are distinct. For the three months ended March 31, 2019, the Company recognized revenue of $90,000 for the delivery of tissue samples. There were no deliveries of tissue samples for the three months ended June 30, 2019. The Company recognized revenue of $250,000 for the performance of services for each of the three months ended March 31, 2019 and June 30, 2019. The cost of revenue associated with revenue recognized under the agreement with Loxo is not significant. There was no deferred revenue related to this agreement at either June 30, 2019 or December 31, 2018.
 
Diagnostic Development Agreement with Johnson & Johnson

On December 28, 2018, the Company entered into a diagnostics development agreement with JJSI (i) to cooperate on a program to enable the Company to use JJSI samples and clinical data to develop a next generation bronchial genomic classifier diagnostic for lung cancer diagnosis (“Percepta v.2") and a nasal genomic classifier diagnostic for lung cancer (“NasaRISK”) and (ii) for JJSI to use Veracyte data generated in two Veracyte development programs for therapeutic purposes and for purposes of developing a companion diagnostic product used in conjunction with a JJSI therapeutic. The Company granted a license to JJSI with the right to use data and under the Company's intellectual property rights for JJSI's therapeutic purposes, including the development and commercialization of a companion diagnostic for its products, from the Percepta v.2 and NasaRISK programs. The license granted to JJSI is not distinct from other performance obligations as JJSI receives benefit only when other performance obligations are met.
  
The Company will provide data from its RNA whole-transcriptome sequencing platform to JJSI in exchange for $7.0 million in payments from JJSI. The Company is also entitled to additional payments from JJSI of up to $13.0 million, conditioned upon the achievement of certain milestones relating to the development and reimbursement of Percepta v.2 and NasaRISK. For a period of ten years commencing with the first commercial sale of Percepta v.2 and NasaRISK, respectively, the Company will make payments to JJSI of one percent of net cash collections for Percepta v.2 and in the low-single digits of net cash collections for NasaRISK, depending on the number and timing of JJSI samples and associated clinical data the Company receives from JJSI.

The JJSI agreement is considered to be within the scope of ASC 808, as the parties are active participants and exposed to the risks and rewards of the collaborative activity. The Company evaluated the terms of the JJSI agreement and has analogized to ASC 606 for the delivery of data from its RNA whole-transcriptome sequencing platform to JJSI under the collaborative arrangement, which the Company believes is a distinct service for which JJSI meets the definition of a customer. Using the concepts of ASC 606, the Company has identified the delivery of data as its only performance obligation. The Company further determined that the transaction price under the arrangement was the $7.0 million in payments which was allocated to the obligation to deliver data. The $13.0 million in future potential payments is considered variable consideration because the Company determined that the potential payments are contingent upon regulatory and commercialization milestones that are uncertain to occur and, as such, were not included in the transaction price, and will be recognized accordingly as each potential payment becomes probable.

During the three months ended March 31, 2019, the Company received $5.0 million from JJSI. The Company recognized revenue of $3.8 million and $1.2 million for the provision of data for the three months ended March 31, 2019 and June 30, 2019, respectively. In addition, the Company recognized revenue of $2.0 million for fulfillment of obligations relating to Percepta v.2 development milestones during the three months ended June 30, 2019 and the related accounts receivable was $2.0 million at June 30, 2019. The cost of revenue associated with revenue recognized under the agreement with JJSI is not significant. There was no deferred revenue related to this agreement at either June 30, 2019 or December 31, 2018.

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Legal Settlement

In March 2018, the Company received $0.4 million as a settlement with an institutional investor that was a beneficial owner of the Company's common stock related to the disgorgement of short-swing profits pursuant to Section 16(b) of the Securities Exchange Act of 1934, as amended. The settlement of $0.4 million was recognized as additional paid-in capital.

Recent Accounting Pronouncements
 
In February 2016, the FASB issued ASU No. 2016-2, Leases (Topic 842). This ASU is aimed at making leasing activities more transparent and comparable, and requires substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases currently accounted for as operating leases. The ASU is effective for interim and annual periods beginning after December 15, 2018. Additionally, the FASB issued ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which offers an additional transition method whereby entities may apply the new leases standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings rather than application of the new leases standard at the beginning of the earliest period presented in the financial statements. The Company elected this transition method and adopted ASC 842 on January 1, 2019 and as a result, recorded operating lease right-of-use ("ROU") assets of $9.8 million, including offsetting deferred rent of $4.3 million, along with the associated operating lease liabilities of $14.1 million. On January 1, 2019, the Company had a finance lease ROU of $0.8 million and associated finance lease liabilities of $0.3 million for leases classified as finance leases prior to the adoption of ASC 842. The adoption of ASC 842 had an immaterial impact on the Company's condensed statement of operations and comprehensive loss, condensed statement of stockholders' equity and condensed statement of cash flows for the three-month period ended March 31, 2019 and the six-month period ended June 30, 2019. In addition, the Company elected the package of practical expedients permitted under the transition guidance within the new standard which allowed it to carry forward the historical lease classification. Additional information and disclosures required by this new standard are contained in Note 5, Commitments and Contingencies.

In November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (Topic 808). Under this ASU, transactions in collaborative arrangements are to be accounted for under ASC 606 if the counterparty is a customer for a good or service (or bundle of goods and services) that is a distinct unit of account. Also, entities are precluded from presenting consideration from transactions with a counterparty that is not a customer together with revenue recognized from ASC 606. This ASU is effective for all interim and annual reporting periods beginning on or after December 15, 2019, with early adoption permitted. The Company is currently evaluating the potential effect of this standard on its financial statements.

2. Net Loss Per Common Share
 
Basic net loss per common share is calculated by dividing net loss attributable to common stockholders by the weighted-average number of common shares outstanding during the period, without consideration of common stock equivalents. Diluted net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted-average number of common share equivalents outstanding for the period determined using the treasury stock method. The following outstanding common stock equivalents have been excluded from diluted net loss per common share because their inclusion would be anti-dilutive:
  
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
2019
 
2018
Shares of common stock subject to outstanding options
5,721,801

 
6,209,143

 
5,696,450

 
6,100,753

Employee stock purchase plan
29,471

 
42,531

 
27,582

 
34,137

Restricted stock units
752,607

 
450,505

 
646,274

 
322,367

Total common stock equivalents
6,503,879

 
6,702,179

 
6,370,306

 
6,457,257



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3. Accrued Liabilities
 
Accrued liabilities consisted of the following (in thousands of dollars):
 
 
June 30,
2019
 
December 31,
2018
Accrued compensation expenses
$
7,056

 
$
6,412

Accrued other
2,764

 
2,774

Total accrued liabilities
$
9,820

 
$
9,186


4. Fair Value Measurements
 
The Company records its financial assets and liabilities at fair value. The carrying amounts of certain financial instruments of the Company, including cash and cash equivalents, prepaid expenses and other current assets, accounts payable and accrued liabilities, approximate fair value due to their relatively short maturities. The carrying value of the Company’s debt approximates its fair value because the interest rate approximates market rates that the Company could obtain for debt with similar terms. The fair value of the Company’s debt is estimated using the net present value of the payments, discounted at an interest rate that is consistent with market interest rates, which is a Level II input.  The accounting guidance for fair value provides a framework for measuring fair value, clarifies the definition of fair value, and expands disclosures regarding fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance establishes a three-tiered hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value as follows:
 
Level I: Inputs which include quoted prices in active markets for identical assets and liabilities;

Level II: Inputs other than Level I that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and

Level III: Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
 
The fair value of the Company’s financial assets includes money market funds and a deposit for the lease of the Company's South San Francisco facility. Money market funds, included in cash and cash equivalents in the accompanying condensed balance sheets, were $192.0 million and $76.6 million as of June 30, 2019 and December 31, 2018, respectively, and are Level I assets as described above. The deposit for the lease, included in restricted cash in the accompanying condensed balance sheets, was $603,000 as of June 30, 2019 and December 31, 2018, and is a Level I asset as described above.
 
5. Commitments and Contingencies
 
Operating Leases
 
The Company leases its headquarters and laboratory facilities in South San Francisco, California under a non-cancelable lease agreement for approximately 59,000 square feet. The lease began in June 2015 and ends in March 2026 and contains extension of lease term and expansion options. The Company had deposits of $603,000 included in long-term assets as of June 30, 2019 and December 31, 2018, restricted from withdrawal and held by a bank in the form of collateral for an irrevocable standby letter of credit held as security for the lease of the South San Francisco facility.
 
The Company also leases laboratory and office space in Austin, Texas under a lease that expires in January 2029 and includes options for expansion and early termination in 2025. The Company provided a cash security deposit for this lease of $139,000, included in other assets in the Company’s condensed balance sheets as of June 30, 2019 and December 31, 2018.

The Company determined its operating lease liabilities for the two operating leases mentioned above using a discount rate of 7.53% based on the rate that the Company would have to pay to borrow on a collateralized basis for a similar lease an amount equal to the lease payments in a similar economic environment. Operating lease liabilities along with the associated right-of-use assets as of June 30, 2019 are disclosed in the accompanying condensed balance sheets. After the adoption of ASC 842,

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the Company classified its deferred rent for tenant improvements with its operating lease right-of-use assets on the condensed balance sheets.

Future minimum lease payments under non-cancelable operating leases as of June 30, 2019 are as follows (in thousands of dollars):
 
Year Ending December 31,
 
Remainder of 2019
$
1,101

2020
2,332

2021
2,401

2022
2,472

2023
2,543

Thereafter
6,841

Total minimum lease payments
$
17,690

 
The Company recognizes operating lease expense on a straight-line basis over the non-cancelable lease period. Operating lease expense was $476,000 for the three months ended June 30, 2019 and 2018, and $953,000 for the six months ended June 30, 2019 and 2018.

Finance Lease

The Company entered into a finance lease in December 2016 for $1.2 million of laboratory equipment which ends in December 2019. The Company paid an upfront amount of $330,000 and the present value of the total future minimum lease payments at the inception of the lease was $874,000. As of June 30, 2019, the remaining future minimum lease payments of $159,000 are due in the last half of 2019. The interest expense and related amortization of laboratory equipment are recorded in the statements of operations for nominal amounts. After the adoption of ASC 842, this finance lease remained a finance lease and the Company did not change the discount rate to determine the lease liability nor the amortization life of the related right-of-use assets.
 
Contingencies
 
From time to time, the Company may be involved in legal proceedings arising in the ordinary course of business. The Company assesses contingencies to determine the degree of probability and range of possible loss for potential accrual in its financial statements. An estimated loss contingency is accrued in the financial statements if it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The Company believes there is no litigation pending that could have, either individually or in the aggregate, a material adverse effect on the Company’s financial statements.
 
6. Debt
 
Loan and Security Agreement

On November 3, 2017, the Company entered into a loan and security agreement (the "Loan and Security Agreement"), with Silicon Valley Bank. The Loan and Security Agreement allows the Company to borrow up to $35.0 million, with a $25.0 million advance term loan (the "Term Loan Advance"), and a revolving line of credit of up to $10.0 million (the "Revolving Line of Credit"). The Term Loan Advance was advanced upon the closing of the Loan and Security Agreement and was used to pay the outstanding balance of the Company’s existing long-term debt, which was canceled at that date. The Company had not drawn on the Revolving Line of Credit as of June 30, 2019. Borrowings under the Loan and Security Agreement mature on October 1, 2022. Amounts may be borrowed and repaid under the Revolving Line of Credit up until the earliest of full repayment or maturity of the Loan and Security Agreement, termination of the Loan and Security Agreement, or October 1, 2022.

The Term Loan Advance bears interest at a variable rate equal to (i) the thirty-day U.S. London Interbank Offer Rate ("LIBOR") plus (ii) 4.20%, with a minimum rate of 5.43% per annum. Principal amounts outstanding under the Revolving Line of Credit bear interest at a variable rate equal to (i) LIBOR plus (ii) 3.50%, with a minimum rate of 4.70% per annum. The average Term Loan Advance rate for the six months ended June 30, 2019 was 7.23%.

The Company may prepay the outstanding principal amount under the Term Loan Advance plus accrued and unpaid interest and, if the Term Loan Advance is repaid in full, a prepayment premium. The prepayment premium will be (i) $750,000 if

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prepayment is made prior to November 3, 2018, (ii) $500,000 if the prepayment is made after November 3, 2018 but on or before November 3, 2019, or (iii) $250,000 if the prepayment is made after November 3, 2019. In January 2019 and May 2019, the Company prepaid $12.5 million and $12.4 million, respectively, of the principal amount of the Term Loan Advance. These prepayments did not trigger any prepayment premium because they were partial, not full, repayments of the principal amount.

In addition, a final payment on the Term Loan Advance in the amount of $1.2 million is due upon the earlier of the maturity date of the Term Loan Advance or its payment in full. The Loan and Security Agreement contains customary representations, warranties, and events of default such as a material adverse change in the Company's business, operations or financial condition, as well as affirmative and negative covenants. The negative covenants include, among other provisions, covenants that limit or restrict the Company's ability to incur liens, make investments, incur indebtedness, merge with or acquire other entities, dispose of assets, make dividends or other distributions to holders of its equity interests, engage in any new line of business, or enter into certain transactions with affiliates, in each case subject to certain exceptions. The Company’s obligations under the Loan and Security Agreement are secured by substantially all of its assets (excluding intellectual property), subject to certain customary exceptions. The Loan and Security Agreement also requires the Company to achieve certain revenue levels tested quarterly on a trailing twelve-month basis. However, failure to maintain the revenue levels will not be considered a default if the sum of the Company’s unrestricted cash and cash equivalents maintained with Silicon Valley Bank and amount available under the Revolving Line of Credit is at least $40.0 million. As of June 30, 2019, the Company was in compliance with the loan covenants.

The net debt obligation for borrowings made under the Loan and Security Agreement was as follows (in thousands of dollars):
 
 
June 30, 2019
 
December 31, 2018
Debt principal
$
100

 
$
25,000

End-of-term debt obligation
485

 
365

Unamortized debt issuance costs

 
(83
)
Net debt obligation
$
585

 
$
25,282


Future principal and end-of-term debt obligation payments due under the Loan and Security Agreement are $1.3 million in 2022.  

The end-of-term debt obligation accretes over the term of the Loan and Security Agreement until maturity and is included in interest expense in the Company's condensed statements of operations and comprehensive loss.
 
7. Stockholders’ Equity
 
Common Stock
 
The Company had reserved shares of common stock for issuance as follows:
 
 
June 30,
2019
 
December 31, 2018
Stock options and restricted stock units issued and outstanding
6,567,833

 
6,235,258

Stock options and restricted stock units available for grant under stock option plans
1,886,789

 
1,571,658

Common stock available for the Employee Stock Purchase Plan
229,218

 
309,419

Total
8,683,840

 
8,116,335


8. Thyroid Cytopathology Partners
 
The Company has an agreement with a specialized pathology practice, Thyroid Cytopathology Partners, ("TCP"), to provide testing services to the Company (the "TCP Agreement").  The TCP Agreement is effective through October 31, 2022, and thereafter automatically renews every year unless either party provides notice of intent not to renew at least 12 months prior to the end of the then-current term. Under the TCP Agreement, the Company pays TCP based on a fixed price per test schedule which is reviewed periodically for changes in market pricing, and the TCP Agreement included a clause allowing TCP to sublease

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a portion of the Company's facility in Austin, Texas.  The Company does not have an ownership interest in or provide any form of financial or other support to TCP.  The Company previously concluded that TCP represents a variable interest entity as a result of the facility arrangement clause, but that the Company is not the primary beneficiary as it does not have the ability to direct the activities that most significantly impact TCP's economic performance, and therefore does not consolidate TCP.  On February 14, 2019, the TCP Agreement was amended to remove the facility clause.  Accordingly, the Company believes TCP was no longer a variable interest entity as of that date.
 
TCP's portion of rent and related operating expenses reimbursed to the Company for the shared space at the Austin, Texas facility was $32,000 for the three months ended June 30, 2018 and $11,000 and $64,000 for the six months ended June 30, 2019 and 2018, respectively, and is included in other income, net in the Company’s condensed statements of operations and comprehensive loss.

9. Income Taxes
 
The Company did not record a provision or benefit for income taxes during the three and six months ended June 30, 2019 and 2018. The Company continues to maintain a full valuation allowance against its net deferred tax assets.
 
As of June 30, 2019, the Company had unrecognized tax benefits of $2.8 million, none of which would currently affect the Company’s effective tax rate if recognized due to the Company’s net deferred tax assets being fully offset by a valuation allowance. The Company does not anticipate that the amount of unrecognized tax benefits relating to tax positions existing at June 30, 2019 will significantly increase or decrease within the next 12 months. There was no interest expense or penalties related to unrecognized tax benefits recorded through June 30, 2019.

A number of years may elapse before an uncertain tax position is audited and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, the Company believes that its reserves for income taxes reflect the most likely outcome. The Company adjusts these reserves, as well as the related interest, with consideration of changing facts and circumstances. Settlement of any particular position could require the use of cash.

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis of financial condition and results of operations should be read together with the condensed financial statements and the related notes included in Item 1 of Part I of this Quarterly Report on Form 10-Q, and with our audited financial statements and the related notes included in our Annual Report on Form 10-K for the year ended December 31, 2018.
 
This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. When used in this report, the words "expects," "anticipates," "intends," "estimates," "plans," "believes," "continuing," "ongoing," and similar expressions are intended to identify forward-looking statements. These are statements that relate to future events and include, but are not limited to, the factors that may impact our financial results; our expectations regarding revenue; our expectations with respect to our future research and development, general and administrative and selling and marketing expenses and our anticipated uses of our funds; our beliefs with respect to the optimization of our processes for the analysis of ribonucleic acid, or RNA, samples; our collaboration with Johnson & Johnson Services, Inc.; our belief in the importance of maintaining libraries of clinical evidence; our expectations regarding capital expenditures; our anticipated cash needs and our estimates regarding our capital requirements; the timing and success of our transition to a single platform for all of our classifiers and tests; our ability to maintain Medicare coverage for each of our tests; our estimates of the number of people covered under the TRICARE program, our belief that published clinical validation and utility study finding for the Envisia classifier can improve diagnosis and decrease the need for surgery, study results demonstrating that the Afirma GSC test has an enhanced ability to distinguish benign from cancerous Hürthle cells, our belief that variant and fusion information from the Afirma Xpression Atlas data may help guide physicians in preoperative evaluation, surgical planning and targeted therapy selections; our need for additional financing; potential future sources of cash; our business strategy and our ability to execute our strategy; our ability to achieve and maintain reimbursement from third-party payers at acceptable levels and our expectations regarding the timing of reimbursement; the estimated size of the global markets for our tests; the estimated number of patients who receive uncertain diagnoses who are candidates for our test; the attributes and potential benefits of our tests and any future tests we may develop to patients, physicians and payers; the factors we believe drive demand for and reimbursement of our tests; our ability to sustain or increase demand for our tests; our intent to expand into other clinical areas; our ability to develop new tests, and the timeframes for development or commercialization; our ability to get our data and clinical studies accepted in peer-reviewed publications; our dependence on and the terms of our agreement with TCP, and on other strategic relationships, and the success of those relationships; our beliefs regarding our laboratory capacity; the potential for future clinical studies to contradict or undermine

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previously published clinical study results; the applicability of clinical results to actual outcomes; our expectations regarding our international expansion; the occurrence, timing, outcome or success of clinical trials or studies; the ability of our tests to impact treatment decisions; our beliefs regarding our competitive position; our compliance with federal, state and international regulations; the potential impact of regulation of our tests by the Food and Drug Administration, or FDA, or other regulatory bodies; the impact of new or changing policies, regulation or legislation, or of judicial decisions, on our business; the impact of seasonal fluctuations and economic conditions on our business; our belief that we have taken reasonable steps to protect our intellectual property; our belief that our intellectual property will develop and maintain our competitive position; the impact of accounting pronouncements and our critical accounting policies, judgments, estimates, models and assumptions on our financial results; and anticipated trends and challenges in our business and the markets in which we operate. We caution you that the foregoing list does not contain all of the forward-looking statements made in this report.
 
Forward-looking statements are based on our current plans and expectations and involve risks and uncertainties which could cause actual results to differ materially. These risks and uncertainties include, but are not limited to, those risks discussed in Part II, Item 1A of this report. These forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation or undertaking to update any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

When used in this report, all references to "Veracyte," the "company," "we," "our" and "us" refer to Veracyte, Inc.

Veracyte, Afirma, Percepta, Envisia, Know by Design, the Veracyte logo and the Afirma logo are our trademarks. We also refer to trademarks of other corporations or organizations in this report.

This report contains statistical data and estimates that we obtained from industry publications and reports. These publications typically indicate that they have obtained their information from sources they believe to be reliable, but do not guarantee the accuracy and completeness of their information. Some data contained in this report is also based on our internal estimates.
 
Overview
 
We are a leading genomic diagnostics company that is creating value through innovation. We were founded in 2008 with a mission to improve diagnostic accuracy. Today, through our innovative scientific platform which utilizes RNA whole-transcriptome sequencing combined with machine learning, we are serving this critical medical need and expanding our offerings further along the clinical continuum of care so that we can advance early detection of disease and inform treatment decisions at the same time as diagnosis.

We have commercialized seven leading, first-to-market tests that are transforming care in large, untapped clinical areas - thyroid cancer, lung cancer and IPF. We develop tests that answer specific clinical questions, providing patients and physicians with a clear path forward without the need for risky or costly procedures that are often unnecessary. Our RNA whole-transcriptome sequencing platform enables us to maximize the amount of genomic content that we extract from each nonsurgical patient sample. We utilize our machine learning expertise to develop genomic classifiers that provide actionable information at the time of diagnosis. At the same time, our approach enables us to provide information that can guide treatment decisions such as surgery strategy and therapy selection.

We position our tests in each clinical indication at the point where they improve diagnostic clarity for cancer and other diseases. In its 2015 report, “Improving Diagnostic Errors in Medicine,” the Institute of Medicine concluded that most people will experience at least one diagnostic error in their lifetime, sometimes with devastating consequences. Annually, of the hundreds of thousands of patients who are evaluated for suspected disease in our thyroid and lung indications, diagnosis can be ambiguous in 15% to 70% of cases.

To date, we have commercialized seven genomic tests that are changing disease diagnosis:

In endocrinology:
the Afirma Genomic Sequencing Classifier, or Afirma GSC, for thyroid cancer;
the Afirma Gene Expression Classifier, or GEC, which was the Afirma GSC’s predecessor;
the Malignancy Classifiers which test for the BRAF v600E mutation and medullary thyroid cancer; and
the Afirma Xpression Atlas, which provides genomic alteration information to inform surgery and treatment decisions.

In pulmonology:

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the Percepta Genomic Sequencing Classifier, or Percepta GSC, for lung cancer; and
the Percepta Bronchial Genomic Classifier, which was the Percepta GSC’s predecessor.

In interstitial lung disease:
the Envisia Genomic Classifier for IPF.

Collectively, we believe the tests we are currently offering address a $2 billion global market opportunity.

The published evidence supporting our tests demonstrates the robustness of our science and clinical studies, and we believe is key to driving adoption and reimbursement. Patients and physicians can access our full list of publications on our website. Over 38 clinical studies covering our products have been published, including two landmark clinical validation papers published in The New England Journal of Medicine for the Afirma and Percepta classifiers, respectively. We continue to build upon our extensive library of clinical evidence.

We believe our focus on developing clinically useful tests that change patient care is enabling us to set new standards in genomic test reimbursement. Our Afirma genomic classifier is now covered by every major health plan in the United States, which collectively insure more than 275 million people for use in thyroid cancer diagnosis. Veracyte is now contracted as an in-network service provider to health plans representing over 220 million people in the United States. Our Percepta classifier is the first genomic test to gain Medicare coverage for improved lung cancer screening and diagnosis, making it a covered benefit for more than 60 million people. Our Envisia Genomic Classifier is the first commercial test to improve the diagnosis of IPF among patients with a suspected interstitial lung disease and gained Medicare coverage effective April 1, 2019, making it a covered benefit for more than 60 million people.

Second Quarter 2019 Financial Results

For the second quarter of 2019 as compared to the second quarter of 2018:

Revenue was $30.1 million, an increase of 32%; excluding $3.5 million of biopharmaceutical services revenue, revenue was $26.7 million, an increase of 20%.
Gross Margin was 71%, an increase of seven percentage points; excluding biopharmaceutical services revenue, gross margin was 67%, an increase of four percentage points.
Operating Expenses, Excluding Cost of Revenue were $24.5 million, an increase of 20%.
Net Loss was $2.5 million, an improvement of 60%.
Net Loss Per Share was $0.05, an improvement of 72%.
Net Cash Used in Operating Activities was $2.5 million, an improvement of 21%.
Cash and Cash Equivalents was $192.6 million at June 30, 2019.

For the six-month period ended June 30, 2019, as compared with the prior year period of 2018:

Revenue was $59.7 million, an increase of 39%; excluding $7.6 million of biopharmaceutical services revenue, revenue was $52.1 million, an increase of 23%.
Gross Margin was 71%, an increase of nine percentage points; excluding biopharmaceutical services revenue, gross margin was 67%, an increase of five percentage points.
Operating Expenses, Excluding Cost of Revenue were $47.5 million, an increase of 14%.
Net Loss was $4.4 million, an improvement of 71%.
Net Loss Per Share was $0.10, an improvement of 78%.
Net Cash Used in Operating Activities was $3.5 million, an improvement of 67%.

Second Quarter 2019 and Recent Business Highlights

Commercial Growth and Reimbursement Expansion:

Launched the “next-generation” Percepta Genomic Sequencing Classifier (GSC) in June 2019, ahead of the company’s expectations, completing the transition of all of the company’s classifiers to its RNA whole-transcriptome sequencing platform.
Grew total genomic test volume in the second quarter of 2019 to 9,663, an increase of 26% over the second quarter of 2018.
Increased Percepta classifier test volume to 744 tests and revenue to more than $1.0 million, representing a 142% and 159% increase, respectively, compared with the second quarter of 2018.

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Ramped Envisia® Genomic Classifier test volume as well as the number of institutions ordering the test by more than 100% sequentially from the first quarter of 2019 to 130 tests and 76 sites, respectively.
Grew Afirma® classifier test volume to 8,789 tests, an increase of 19% over the second quarter of 2018.
Achieved in-network status with four Blue Cross Blue Shield plans in New Jersey, North Carolina, South Carolina and Vermont, covering nearly 8.5 million medical members.

Strengthened Library of Clinical Evidence:

Unveiled clinical validation data for the Percepta GSC during ATS 2019, demonstrating the test’s ability to down-classify lung nodule patients to “low risk” for cancer so they may avoid unnecessary invasive procedures (NPV of 91%), while also up-classifying patients to “high risk” to help guide next steps (PPV of 65%).
Published clinical validation and utility study findings for the Envisia classifier in The Lancet Respiratory Medicine, showing that the test helps physicians distinguish idiopathic pulmonary fibrosis (IPF) from other interstitial lung diseases without the need for surgery, and that when paired with HRCT results and patient clinical history, the test provided physicians with a higher level of confidence in making an IPF diagnosis.
Positive data were presented at the 2019 ASCO Annual Meeting demonstrating the ability of the Afirma Xpression Atlas (XA) to identify gene mutations in medullary thyroid cancer that may guide targeted treatment decisions for patients concurrent with diagnosis by the Afirma GSC.
Independent clinical utility study for the Afirma GSC was published in Thyroid showing that use of the test enabled Ohio State University researchers to identify significantly more benign thyroid nodules and therefore meaningfully decrease surgeries compared to the original test.
Publication in Cancer Cytopathology detailed how new RNA sequencing-based genomic testing, the technology behind the Afirma GSC and Afirma XA, is helping to reduce unnecessary surgeries in thyroid cancer diagnosis and inform on surgery and treatment decision-making using the same minimally invasive patient sample.

Financing and Debt Facility

Issued and sold 6,325,000 shares of common stock in May 2019 in a registered public offering, including the underwriters’ exercise in full of their option to purchase an additional 825,000 shares, at a price to the public of $23.25 per share. Net proceeds from the offering were approximately $137.8 million.
Used $12.4 million of offering proceeds to reduce the company’s principal debt balance from $12.5 million at the end of first quarter of 2019 to $0.1 million at the end of the second quarter of 2019.

Factors Affecting Our Performance
 
Reported Genomic Test Volume
 
Our performance depends on the number of genomic tests that we perform and report as completed in our CLIA laboratories. Factors impacting the number of tests that we report as completed include, but are not limited to:

the number of samples that we receive that meet the medical indication for each test performed;
the quantity and quality of the sample received;
receipt of the necessary documentation, such as physician order and patient consent, required to perform, bill and collect for our tests;
the patient's ability to pay or provide necessary insurance coverage for the tests performed;
the time it takes us to perform our tests and report the results;
the seasonality inherent in our business, such as the impact of work days per period, timing of industry conferences and the timing of when patient deductibles are exceeded, which also impacts the reimbursement we receive from insurers; and
our ability to obtain prior authorization or meet other requirements instituted by payers, benefit managers, or regulators necessary to be paid for our tests.

We generate substantially all our revenue from genomic testing services, including the rendering of a cytopathology diagnosis as part of the Afirma solution. For the Afirma classifier, we do not accrue revenue for approximately 5% - 10% of the tests that we perform and report as complete due principally to insufficient RNA from which to render a result and tests performed for which we do not reasonably expect to be paid.


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Continued Adoption of and Reimbursement for our Products
 
     Revenue growth depends on our ability to secure coverage decisions, achieve broader reimbursement at increased levels from third-party payers, expand our base of prescribing physicians and increase our penetration in existing accounts. Because some payers consider our products experimental and investigational, we may not receive payment for tests and payments we receive may not be at acceptable levels. We expect our revenue growth to increase if more payers make a positive coverage decision and as payers enter into contracts with us, which should enhance our revenue and cash collections. To drive increased adoption of our products, we increased our sales force and marketing efforts over the last several years. Our sales team is structured to sell all of our products; we do not maintain a separate sales force for each product. If we are unable to expand the base of prescribing physicians and penetration within these accounts at an acceptable rate, or if we are not able to execute our strategy for increasing reimbursement, we may not be able to effectively increase our revenue. We expect to continue to see pressure from payers to limit the utilization of tests, generally, and we believe more payers are deploying cost containment tactics, such as pre-authorization, reduction of the payer portion of reimbursement and employing laboratory benefit managers to reduce utilization rates.

How We Recognize Revenue
 
We commenced recognizing revenue in accordance with the provisions of ASC 606, Revenue from Contracts with Customers starting January 1, 2018. Prior to January 1, 2018, we recognized revenue in accordance with the provisions of ASC 954-605, Health Care Entities - Revenue Recognition.

Most of our revenue is generated from the provision of diagnostic services. These services are completed upon the delivery of test results to the prescribing physician, at which time we bill for the services. We recognize revenue related to billings on an accrual basis based on estimates of the amount that will ultimately be realized. In determining the amount to accrue for a delivered test, we consider factors such as payment history, payer coverage, whether there is a reimbursement contract between the payer and us, payment as a percentage of agreed upon rate (if applicable), amount paid per test and any current developments or changes that could impact reimbursement. These estimates require significant judgment by management.

As of December 31, 2018, cumulative amounts billed at list price for tests processed which were not recognized as revenue upon delivery of a patient report because our accrual revenue recognition criteria were not met and for which we have not collected cash or written off as uncollectible, totaled approximately $159.3 million. Of this amount, we did not collect any amounts in the six months ended June 30, 2019 and we have no expectation of future collection because we began accruing for substantially all revenue upon delivery of a patient report in the third quarter of 2016.

Generally, cash we receive is collected within 12 months of the date the test is billed. We cannot provide any assurance as to when, if ever, or to what extent any of these amounts will be collected. Notwithstanding our efforts to obtain payment for these tests, payers may deny our claims, in whole or in part, and we may never receive payment for these tests.

We bill list price regardless of contract rate, but only recognize revenue from amounts that we estimate are collectible and meet our revenue recognition criteria. Revenue may not be equal to the list price or billed amount due to a number of factors that we consider when determining revenue accrual rates, including differences in reimbursement rates, the amounts of patient co-payments and co-insurance, the existence of secondary payers, claims denials and the amount we expect to ultimately collect. Finally, when we increase our list price, it will increase the cumulative amounts billed but may not positively impact accrued revenue. In addition, payer contracts generally include the right of offset and payers may offset payments prior to resolving disputes over tests performed.

Generally, we calculate the average reimbursement from our products from all payers, for tests that are on average a year old, since it can take a significant period of time to collect from some payers. Except in situations where we believe the rate we reasonably expect to collect to vary due to a coverage decision, contract, more recent reimbursement data or evidence to the contrary, we use an average of reimbursement for tests provided over four quarters as it reduces the effects of temporary volatility and seasonal effects. Thus, the average reimbursement per product represents the total cash collected to date against genomic classifier tests, including variants, performed during the relevant period divided by the number of these tests performed during that same period.

The average Afirma genomic classifier reimbursement rate will change over time due to a number of factors, including medical coverage decisions by payers, the effects of contracts signed with payers, changes in allowed amounts by payers, our ability to successfully win appeals for payment, and our ability to collect cash payments from third-party payers and individual patients. Historical average reimbursement is not necessarily indicative of future average reimbursement. For the three months ended June 30, 2019, we accrued, on average, between $2,800 and $2,900 for the Afirma genomic classifier tests, including variants, that met our revenue recognition standard, which was between 90% - 95% of the reported Afirma classifier test volume.

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From the second quarter of 2018 to the second quarter of 2019, we accrued between $1.0 million and $2.6 million in revenue per quarter from providing cytopathology services associated with our Afirma solution.

We incur expense for tests in the period in which the test is conducted and recognize revenue for tests in the period in which our revenue recognition criteria are met.
 
Development of Additional Products
 
We continue to advance our product portfolio with diagnostic tests that leverage innovations in genomic science, sequencing technology and machine learning methodologies to further improve patient care. In May 2017, we introduced the Afirma GSC, supported by rigorous clinical validation data showing that the RNA sequencing-based test can help significantly more patients avoid unnecessary surgery in thyroid cancer diagnosis, compared to the original Afirma Classifier. In March 2018, we unveiled our Afirma Xpression Atlas, which uses the same RNA sequencing data from the platform as the Afirma GSC and enables us to extract rich genomic content - including gene expression, DNA variants and RNA fusions in over 500 genes that are associated with thyroid cancer - from thyroid FNA samples. We believe that this offering will provide clinicians with valuable genomic information that may inform surgery strategy and treatment options for patients with suspected thyroid cancer.

Together with our Afirma GSC and our tests for the BRAF v600E mutation and medullary thyroid cancer, or Malignancy Classifiers, the Afirma Xpression Atlas rounds out a comprehensive solution for physicians evaluating thyroid nodules. This innovation also enables us to enter into research collaborations with biopharmaceutical companies, which is intended to support their development of targeted therapies for genetically defined cancers, including thyroid cancer.

We have also expanded our ability to provide important clinical answers - without the need for surgery - into pulmonology. Our Percepta Bronchial Genomic Classifier, introduced in April 2015, is the first genomic test to receive Medicare coverage for use in lung cancer diagnosis, where it improves the performance of diagnostic bronchoscopy. In June 2019, we began making our “next-generation” Percepta Genomic Sequencing Classifier available to physicians, providing them with expanded lung cancer risk information that can further guide next steps for patients with suspicious lung nodules, as compared to the Percepta Bronchial Genomic Classifier.

Additionally, our Envisia Genomic Classifier, launched in October 2016, is the first commercial test to improve the diagnosis of IPF among patients with a suspected interstitial lung disease. In March 2019, we received final Medicare coverage for the Envisia classifier through the MolDX program, with an effective date of April 1, 2019.

We are currently exploring opportunities to utilize the same “field of injury” technology that powers our Percepta classifier to develop a nasal swab test that can enable earlier lung cancer detection - and ultimately help reduce lung cancer deaths. Additionally, we believe our Xpression Atlas platform can be transferred to our pulmonology indications, to further improve patient care and advance precision medicine in lung cancer and IPF.
 
Timing of Our Research and Development Expenses
 
We deploy state-of-the-art and costly genomic technologies in our biomarker discovery experiments, and our spending on these technologies may vary substantially from quarter to quarter. We also spend a significant amount to secure clinical samples that can be used in discovery and product development as well as clinical validation studies. The timing of these research and development activities is difficult to predict, as is the timing of sample acquisitions. If a substantial number of clinical samples are acquired in a given quarter or if a high-cost experiment is conducted in one quarter versus the next, the timing of these expenses can affect our financial results. We conduct clinical studies to validate our new products as well as on-going clinical studies to further the published evidence to support our commercialized tests. As these studies are initiated, start-up costs for each site can be significant and concentrated in a specific quarter. Spending on research and development, for both experiments and studies, may vary significantly by quarter depending on the timing of these various expenses.


Financial Overview
 
Revenue
 
Through June 30, 2019, we had derived most of our revenue from the sale of Afirma, delivered primarily to physicians in the United States. We generally invoice third-party payers upon delivery of a patient report to the prescribing physician. As

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such, we take the assignment of benefits and the risk of cash collection from the third-party payer and individual patients. Third-party payers in excess of 10% of total revenue and their related revenue as a percentage of total revenue were as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
2019
 
2018
Medicare
26
%
 
28
%
 
24
%
 
28
%
UnitedHealthcare
11
%
 
12
%
 
11
%
 
12
%
 
37
%
 
40
%
 
35
%
 
40
%
 
On December 28, 2018, we entered into a diagnostics development agreement with Johnson & Johnson Services, Inc. ("JJSI") for which we recognized $3.2 million and $7.0 million of revenue for the provision of data and fulfillment of milestone obligations, which represents 10.6% and 11.7% of total revenue for the three and six months ended June 30, 2019, respectively.

For tests performed, we recognize the related revenue upon delivery of a patient report to the prescribing physician based on the amount that we expect to ultimately receive. In determining the amount to accrue for a delivered test, we consider factors such as payment history, payer coverage, whether there is a reimbursement contract between the payer and us, payment as a percentage of agreed upon reimbursement rate (if applicable), amount paid per test and any current development or changes that could impact reimbursement. Upon ultimate collection, the amount received is compared to previous estimates and the amount accrued is adjusted accordingly. Our ability to increase our revenue will depend on our ability to penetrate the market, obtain positive coverage policies from additional third-party payers, obtain reimbursement and/or enter into contracts with additional third-party payers for our current and new tests, and increase reimbursement rates for tests performed. Finally, should the judgments underlying our estimated reimbursement change, our accrued revenue and financial results could be negatively impacted in future quarters.
 
Cost of Revenue
 
The components of our cost of revenue are laboratory expenses, sample collection expenses, compensation expense, license fees and royalties, depreciation and amortization, other expenses such as equipment and laboratory supplies, and allocations of facility and information technology expenses. Costs associated with performing tests are recorded as the test is processed regardless of whether and when revenue is recognized with respect to that test. As a result, our cost of revenue as a percentage of revenue may vary significantly from period to period because we may not recognize all revenue in the period in which the associated costs are incurred. We expect cost of revenue in absolute dollars to increase as the number of tests we perform increases. However, we expect that the cost per test will decrease over time due to leveraging fixed costs, efficiencies we may gain as test volume increases and from automation, process efficiencies and other cost reductions. As we introduce new tests, initially our cost of revenue will be high as we expect to run suboptimal batch sizes, run quality control batches, test batches, registry samples and generally incur costs that may suppress or reduce gross margins. This will disproportionately increase our aggregate cost of revenue until we achieve efficiencies in processing these new tests.

Research and Development
 
Research and development expenses include expenses incurred to develop our technology, collect clinical samples and conduct clinical studies to develop and support our products and pipeline. These expenses consist of compensation expenses, direct research and development expenses such as prototype materials, laboratory supplies and costs associated with setting up and conducting clinical studies at domestic and international sites, professional fees, depreciation and amortization, other miscellaneous expenses and allocation of facility and information technology expenses. We expense all research and development costs in the periods in which they are incurred. We expect to incur significant research and development expenses as we continue to invest in research and development activities related to developing additional products and evaluating various platforms. We incurred research and development expenses on ongoing evidence development for our Afirma, Percepta and Envisia classifiers in 2018 and the first and second quarters of 2019, and expect to continue doing so in the remainder of 2019. We believe a majority of our research and development expenses in and after 2019 will be predominantly in support of our pipeline products.
 
Selling and Marketing
 
Selling and marketing expenses consist of compensation expenses, direct marketing expenses, professional fees, other expenses such as travel and communications costs and allocation of facility and information technology expenses. We have expanded our internal sales force as we invest in our multi-product sales strategy to assign a single point of contact to successfully develop and implement relationships with our customers and increased our marketing spending. We have also incurred increased

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selling and marketing expense as a result of investments in our lung product portfolio and believe total selling and marketing expenses will continue to increase as we launch and promote our new tests.
 
General and Administrative
 
General and administrative expenses include compensation expenses for executive officers and administrative, billing and client service personnel, professional fees for legal and audit services, occupancy costs, depreciation and amortization, and other expenses such as information technology and miscellaneous expenses offset by allocation of facility and information technology expenses to other functions. For the six months ended June 30, 2019, approximately 66% of the average headcount classified as general and administrative encompass our billing and customer care teams. We expect general and administrative expenses to continue to increase as we build our general and administration infrastructure and to stabilize thereafter.
 
Intangible Asset Amortization
 
Intangible asset amortization began in April 2015 when we launched the Percepta test. The related finite-lived intangible asset with a cost of $16.0 million, and a net book value of $11.5 million at June 30, 2019, is being amortized over 15 years, using the straight-line method.
 
Interest Expense
 
Interest expense is attributable to our borrowings under debt agreements and capital leases as well as costs associated with the pre-payment of debt.
 
Other Income, Net
 
Other income, net consists primarily of sublease rental income and interest income from our cash held in interest bearing accounts.
 
Results of Operations
 
Comparison of the three and six months ended June 30, 2019 and 2018 (in thousands of dollars, except percentages and genomic classifiers reported):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
Change
 
%
 
2019
 
2018
 
Change
 
%
Revenue
$
30,136

 
$
22,751

 
$
7,385

 
32%
 
$
59,665

 
$
42,792

 
$
16,873

 
39%
Operating expense:
 

 
 

 
 

 
 
 
 
 
 
 
 

 
 
Cost of revenue
8,777

 
8,246

 
531

 
6%
 
17,290

 
16,113

 
1,177

 
7%
Research and development
3,330

 
4,601

 
(1,271
)
 
(28)%
 
6,765

 
8,276

 
(1,511
)
 
(18)%
Selling and marketing
13,943

 
9,623

 
4,320

 
45%
 
26,420

 
21,166

 
5,254

 
25%
General and administrative
6,920

 
5,932

 
988

 
17%
 
13,824

 
11,576

 
2,248

 
19%
Intangible asset amortization
266

 
266

 

 
—%
 
533

 
533

 

 
—%
Total operating expenses
33,236

 
28,668

 
4,568

 
16%
 
64,832

 
57,664

 
7,168

 
12%
Loss from operations
(3,100
)
 
(5,917
)
 
2,817

 
(48)%
 
(5,167
)
 
(14,872
)
 
9,705

 
(65)%
Interest expense
(235
)
 
(481
)
 
246

 
(51)%
 
(538
)
 
(929
)
 
391

 
(42)%
Other income, net
841

 
150

 
691

 
461%
 
1,294

 
376

 
918

 
244%
Net loss and comprehensive loss
$
(2,494
)
 
$
(6,248
)
 
$
3,754

 
(60)%
 
$
(4,411
)
 
$
(15,425
)
 
$
11,014

 
(71)%
Other Operating Data:
 

 
 

 
 

 
 
 
 

 
 

 
 

 
 
Genomic classifiers reported
9,663

 
7,686

 
1,977

 
26%
 
18,825

 
14,550

 
4,275

 
29%
Depreciation and amortization expense
924

 
989

 
(65
)
 
(7)%
 
1,869

 
1,969

 
(100
)
 
(5)%
Stock-based compensation expense
2,566

 
1,731

 
835

 
48%
 
4,325

 
2,906

 
1,419

 
49%
 
Revenue

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Revenue increased $7.4 million, or 32%, for the three months ended June 30, 2019 compared to the same period in 2018 primarily due to a 26% volume increase in genomic classifiers and an increase in the accrual rate for our Afirma genomic classifiers. In the three months ended June 30, 2019, we also recognized $3.5 million of biopharmaceutical service revenue and $1.1 million of revenue for Percepta, the volume for which is included in the number of genomic classifiers reported, compared to $0.5 million and $0.4 million in the same period in 2018, respectively. We also make adjustments, as necessary, for tests accrued in prior quarters as collections are made if the amount we expect to ultimately collect changes. The adjustment for tests accrued in prior quarters increased revenue by $0.1 million and $0.5 million for the three months ended June 30, 2019 and 2018, respectively, a net decrease of $0.4 million between the periods.

Revenue increased $16.9 million, or 39%, for the six months ended June 30, 2019 compared to the same period in 2018 primarily due to a 29% volume increase in genomic classifiers and an increase in the accrual rate for our Afirma genomic classifiers. In the six months ended June 30, 2019, we also recognized $7.6 million of biopharmaceutical service revenue and $2.0 million of revenue for Percepta, the volume for which is included in the number of genomic classifiers reported, compared to $0.5 million and $0.6 million in the same period in 2018, respectively. We also make adjustments, as necessary, for tests accrued in prior quarters as collections are made if the amount we expect to collect changes. The adjustment for tests accrued in prior quarters increased revenue by $0.8 million and $1.2 million for the six months ended June 30, 2019 and 2018, respectively, a net decrease of $0.4 million between the periods.

Cost of revenue
 
Comparison of the three and six months ended June 30, 2019 and 2018 is as follows (in thousands of dollars, except percentages):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
Change
 
%
 
2019
 
2018
 
Change
 
%
Cost of revenue:
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Laboratory costs
$
4,871

 
$
4,817

 
$
54

 
1%
 
$
9,536

 
$
8,984

 
$
552

 
6
 %
Sample collection costs
1,201

 
1,070

 
131

 
12%
 
2,297

 
2,084

 
213

 
10
 %
Compensation expense
1,440

 
1,035

 
405

 
39%
 
2,900

 
2,184

 
716

 
33
 %
License fees and royalties
3

 
282

 
(279
)
 
(99)%
 
5

 
740

 
(735
)
 
(99
)%
Depreciation and amortization
271

 
190

 
81

 
43%
 
521

 
390

 
131

 
34
 %
Other expenses
440

 
383

 
57

 
15%
 
909

 
755

 
154

 
20
 %
Allocations
551

 
469

 
82

 
17%
 
1,122

 
976

 
146

 
15
 %
Total
$
8,777

 
$
8,246

 
$
531

 
6%
 
$
17,290

 
$
16,113

 
$
1,177

 
7
 %
 
Cost of revenue increased $0.5 million, or 6%, for the three months ended June 30, 2019 compared to the same period in 2018. Reported genomic classifiers volume increased 26% and cytopathology volume was flat    for the three months ended June 30, 2019 compared to the same period in 2018. Laboratory costs were essentially flat for the three months ended June 30, 2019 as compared to the same period in 2018 despite the increase in reported genomic classifiers volume due to better pricing on supplies and improved efficiencies following the completion of the transition from the Afirma GEC to Afirma GSC in the third quarter of 2018. The increase in sample collection costs was primarily related to the increase in the overall volume of samples received, partially offset by shipping cost savings from improvements to our collection kits. The increase in compensation expense was primarily due to an average laboratory headcount increase of 14% and an increase in average salaries. The decrease in license fees and royalties was due to the completed transition to the Afirma GSC in the third quarter of 2018, for which we do not pay license fees as we did in connection with the Afirma GEC.

Cost of revenue increased $1.2 million, or 7%, for the six months ended June 30, 2019 compared to the same period in 2018. Reported genomic classifiers volume increased 29% and cytopathology volume was flat for the six months ended June 30, 2019 compared to the same period in 2018. The increase in laboratory costs was due primarily to the increase in reported genomic classifiers volume, partially offset by better pricing on supplies and improved efficiencies following the completion of the transition from the Afirma GEC to Afirma GSC in the third quarter of 2018. The increase in sample collection costs was primarily related to the increase in the overall volume of samples received, partially offset by shipping cost savings from improvements to our collection kits. The increase in compensation expense was primarily due to an average laboratory headcount increase of 12%. The decrease in license fees and royalties was due to the completed transition to the Afirma GSC in the third quarter of 2018, for

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which we do not pay license fees as we did in connection with the Afirma GEC. The increase in depreciation and amortization is from more equipment being placed into service. The increase in other expenses was due to higher maintenance and laboratory supply costs. The increase in allocations was due to higher allocated costs from increased headcount.

Research and development
 
Comparison of the three and six months ended June 30, 2019 and 2018 is as follows (in thousands of dollars, except percentages):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
Change
 
%
 
2019
 
2018
 
Change
 
%
Research and development expense:
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Compensation expense
$
2,350

 
$
2,013

 
$
337

 
17%
 
$
4,480

 
$
4,317

 
$
163

 
4
 %
Direct research and development expense
415

 
1,780

 
(1,365
)
 
(77)%
 
991

 
2,391

 
(1,400
)
 
(59
)%
Professional fees
122

 
264

 
(142
)
 
(54)%
 
323

 
471

 
(148
)
 
(31
)%
Depreciation and amortization
69

 
111

 
(42
)
 
(38)%
 
137

 
217

 
(80
)
 
(37
)%
Other expenses
86

 
130

 
(44
)
 
(34)%
 
244

 
244

 

 
 %
Allocations
288

 
303

 
(15
)
 
(5)%
 
590

 
636

 
(46
)
 
(7
)%
Total
$
3,330

 
$
4,601

 
$
(1,271
)
 
(28)%
 
$
6,765

 
$
8,276

 
$
(1,511
)
 
(18
)%
 
Research and development expense decreased $1.3 million, or 28%, for the three months ended June 30, 2019 compared to the same period in 2018. The increase in compensation expense was primarily due to higher stock-based compensation expense from the increase in our stock price and incentive compensation. The decrease in direct research and development primarily relates to one-time sequencing costs in the second quarter of 2018 associated with research and development projects. The decrease in professional fees was primarily due to lower consulting expenses.

Research and development expense decreased $1.5 million, or 18%, for the six months ended June 30, 2019 compared to the same period in 2018. The increase in compensation expense was primarily due to higher stock-based compensation expense from the increase in our stock price and incentive compensation, partially offset by severance costs incurred in the three months ended March 31, 2018 that were not incurred in the three months ended March 31, 2019. The decrease in professional fees was primarily due to lower consulting expenses.

Selling and marketing
 
Comparison of the three and six months ended June 30, 2019 and 2018 is as follows (in thousands of dollars, except percentages):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
Change
 
%
 
2019
 
2018
 
Change
 
%
Selling and marketing expense:
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Compensation expense
$
8,410

 
$
5,517

 
$
2,893

 
52%
 
$
16,123

 
$
13,378

 
$
2,745

 
21
%
Direct marketing expense
1,776

 
1,512

 
264

 
17%
 
3,365

 
2,651

 
714

 
27
%
Professional fees
728

 
314

 
414

 
132%
 
1,091

 
640

 
451

 
70
%
Other expenses
2,277

 
1,707

 
570

 
33%
 
4,327

 
3,323

 
1,004

 
30
%
Allocations
752

 
573

 
179

 
31%
 
1,514

 
1,174

 
340

 
29
%
Total
$
13,943

 
$
9,623

 
$
4,320

 
45%
 
$
26,420

 
$
21,166

 
$
5,254

 
25
%
 
Selling and marketing expense increased $4.3 million, or 45%, for the three months ended June 30, 2019 compared to the same period in 2018. The increase in compensation expense was primarily due to an average headcount increase of 44%, higher incentive compensation and higher stock-based compensation expense. The increase in direct marketing expense was due to higher general marketing expeditures. The increase in professional fees was due to higher consulting expenses. The increase

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in other expenses was primarily due to travel and entertainment expenses related to the increase in headcount, as was the increase in allocations.

Selling and marketing expense increased $5.3 million, or 25%, for the six months ended June 30, 2019 compared to the same period in 2018. The increase in compensation expense was primarily due to an average headcount increase of 43% and higher stock-based compensation expense, partially offset by higher incentive compensation expense in the prior year period. The increase in direct marketing expense was due to higher general marketing expenditures. The increase in professional fees was due to higher consulting expenses. The increase in other expenses was primarily due to travel and entertainment expenses related to the increase in headcount, as was the increase in allocations.

General and administrative
 
Comparison of the three and six months ended June 30, 2019 and 2018 is as follows (in thousands of dollars, except percentages):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2019
 
2018
 
Change
 
%
 
2019
 
2018
 
Change
 
%
General and administrative expense:
 

 
 

 
 

 
 
 
 

 
 

 
 

 
 

Compensation expense
$
4,594

 
$
3,879

 
$
715

 
18%
 
$
8,794

 
$
7,659

 
$
1,135

 
15
 %
Professional fees
1,928

 
1,564

 
364

 
23%
 
4,210

 
2,964

 
1,246

 
42
 %
Occupancy expenses
623

 
596

 
27

 
5%
 
1,246

 
1,215

 
31

 
3
 %
Depreciation and amortization
318

 
420

 
(102
)
 
(24)%
 
678

 
826

 
(148
)
 
(18
)%
Other expenses
1,048

 
819

 
229

 
28%
 
2,122

 
1,697

 
425

 
25
 %
Allocations
(1,591
)
 
(1,346
)
 
(245
)
 
18%
 
(3,226
)
 
(2,785
)
 
(441
)
 
16
 %
Total
$
6,920


$
5,932


$
988

 
17%
 
$
13,824

 
$
11,576

 
$
2,248

 
19
 %
 
General and administrative expense increased $1.0 million, or 17%, for the three months ended June 30, 2019 compared to the same period in 2018. The increase in compensation expense was primarily due to higher stock-based compensation expense from the increase in our stock price. The increase in professional fees was primarily due to higher legal expenses. The increase in other expenses was primarily due to information technology costs incurred to support the increase in our headcount.
 
General and administrative expense increased $2.2 million, or 19%, for the six months ended June 30, 2019 compared to the same period in 2018. The increase in compensation expense was primarily due to higher stock-based compensation expense from the increase in our stock price. The increase in professional fees was primarily due to higher legal expenses. The increase in other expenses was primarily due to information technology costs incurred to support the increase in our headcount.

 Interest expense
 
Interest expense decreased $246,000, or 51%, for the three months ended June 30, 2019 compared to the same period in 2018, mainly due to the prepayments of $12.5 million and $12.4 million of the principal amount of our Term Loan in January 2019 and May 2019, respectively. The average Term Loan Advance interest rate was 7.76% and 6.03% for the three months ended June 30, 2019 and 2018, respectively.

Interest expense decreased $391,000, or 42%, for the six months ended June 30, 2019 compared to the same period in 2018, mainly due to the prepayments of $12.5 million and $12.4 million of the principal amount of our Term Loan in January 2019 and May 2019, respectively. The average Term Loan Advance interest rate was 7.23% and 5.86% for the six months ended June 30, 2019 and 2018, respectively.

Other income, net

Other income, net, increased $691,000 for the three months ended June 30, 2019 compared to the same period in 2018 primarily due to higher interest income from our money market investments from higher invested cash balances.

Other income, net, increased $918,000 for the six months ended June 30, 2019 compared to the same period in 2018 primarily due to higher interest income from our money market investments from higher invested cash balances.

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Liquidity and Capital Resources
 
From inception through June 30, 2019, we have been financed primarily through net proceeds from the sale of our equity securities and borrowings under our credit facilities. We have incurred net losses since our inception. For the six months ended June 30, 2019, we had a net loss of $4.4 million, and as of June 30, 2019, we had an accumulated deficit of $238.5 million. We expect to incur additional losses in 2019 and potentially in future years.

We believe our existing cash and cash equivalents of $192.6 million as of June 30, 2019, our available revolving line of credit, and our revenue during the next 12 months will be sufficient to meet our anticipated cash requirements for at least the next 12 months. We expect that our near- and longer-term liquidity requirements will continue to consist of costs to run our laboratories, research and development expenses, selling and marketing expenses, general and administrative expenses, working capital, costs to service our Loan and Security Agreement (See Note 6 to our unaudited condensed financial statements included in the Form 10-Q for more information about our Loan and Security Agreement), capital expenditures and general corporate expenses associated with the growth of our business. However, we may also use cash to acquire or invest in complementary businesses, technologies, services or products that would change our cash requirements. If we are not able to secure additional funding when needed, we may have to delay, reduce the scope of or eliminate one or more research and development programs or selling and marketing initiatives, or forgo potential acquisitions or investments.

Public Offering of Common Stock

On May 7, 2019, we issued and sold 6,325,000 shares of common stock in a registered public offering, including 825,000 shares issued and sold upon the underwriters’ exercise in full of their option to purchase additional shares, at a price to the public of $23.25 per share. Our net proceeds from the offering were approximately $137.8 million, after deducting underwriting discounts and commissions and offering expenses of $9.2 million.

On July 30, 2018, we issued and sold 5,750,000 shares of common stock in a registered public offering, including shares issued and sold upon the underwriters’ exercise in full of their option to purchase an additional 750,000 shares, at a price to the public of $10.25 per share. Our net proceeds from the offering were approximately $55.0 million, after deducting underwriting discounts and commissions and offering expenses of $3.9 million.

Loan and Security Agreement
On November 3, 2017, we entered into the Loan and Security Agreement with Silicon Valley Bank. The Loan and Security Agreement allows us to borrow up to $35.0 million, with a $25.0 million term loan, or Term Loan, and a revolving line of credit of up to $10.0 million, or the Revolving Line of Credit, subject to, with respect to the Revolving Line of Credit, a borrowing base of 85% of eligible accounts receivable. The Term Loan was advanced upon the closing of the Loan and Security Agreement. Borrowings under the Loan and Security Agreement mature in October 2022. The Term Loan bears interest at a variable rate equal to (i) the thirty-day U.S. London Interbank Offer Rate, or LIBOR, plus (ii) 4.20%, with a minimum rate of 5.43% per annum. Principal amounts outstanding under the Revolving Line of Credit bear interest at a variable rate equal to (i) LIBOR plus (ii) 3.50%, with a minimum rate of 4.70% per annum. We are also required to pay an annual facility fee on the Revolving Line of Credit of $25,000. The average Term Loan Advance rate for the six months ended June 30, 2019 was 7.23%.
We may prepay the outstanding principal amount under the Term Loan plus accrued and unpaid interest and, if the Term Loan is repaid in full, a prepayment premium. The prepayment premium will equal (i) $750,000, if the prepayment is made on or before November 3, 2018, (ii) $500,000, if the prepayment is made after November 3, 2018 and on or prior to November 3, 2019 and (iii) $250,000, if the prepayment is made after November 3, 2019. In addition, a final payment on the Term Loan in the amount of $1.2 million is due upon the earlier of the maturity date of the Term Loan or its payment in full. In January 2019 and May 2019, we prepaid $12.5 million and $12.4 million of the principal amount of the Term Loan, respectively, and did not incur any prepayment premium as we did not repay the Term Loan in full. These prepayments cover scheduled principal payments from November 2019 to September 2022.

The Loan and Security Agreement contains customary representations, warranties, and events of default such as a material adverse change in our business, operations or financial conditions, as well as affirmative and negative covenants. The negative covenants include, among other provisions, covenants that limit or restrict our ability to incur liens, make investments, incur indebtedness, merge with or acquire other entities, dispose of assets, make dividends or other distributions to holders of our equity interests, engage in any new line of business, or enter into certain transactions with affiliates, in each case subject to certain exceptions. As of June 30, 2019, the principal balance outstanding was $0.1 million and we were in compliance with debt covenants.

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The Loan and Security Agreement also requires us to comply with certain financial covenants, including achieving certain revenue levels tested quarterly on a trailing twelve-month basis. However, failure to maintain the revenue levels will not be considered a default if the sum of our unrestricted cash and cash equivalents maintained with Silicon Valley Bank and amount available under the Revolving Line of Credit is at least $40.0 million.
Our obligations under the Loan and Security Agreement are secured by substantially all of our assets (excluding intellectual property), subject to certain customary exceptions.

Cash Flows

The following table summarizes our cash flows for the six months ended June 30, 2019 and 2018 (in thousands of dollars): 
 
Six Months Ended June 30,
 
2019
 
2018
Cash used in operating activities
$
(3,466
)
 
$
(10,512
)
Cash used in investing activities
(1,407
)
 
(761
)
Cash provided by financing activities
119,525

 
1,140

 
Cash Flows from Operating Activities
 
Cash used in operating activities for the six months ended June 30, 2019 was $3.5 million. The net loss of $4.4 million includes non-cash charges of $4.3 million of stock-based compensation expense and $1.9 million of depreciation and amortization, which includes $0.5 million of intangible asset amortization. Cash used as a result of changes in operating assets and liabilities was $5.4 million, primarily comprised of an increase in accounts receivable of $6.5 million and increase in supplies of $1.7 million, partially offset by increases in accounts payable and accrued liabilities of $1.7 million and $1.3 million, respectively.

Cash used in operating activities for the six months ended June 30, 2018 was $10.5 million. The net loss of $15.4 million includes non-cash charges of $2.9 million of stock-based compensation expense and $2.0 million of depreciation and amortization, which includes $0.5 million of intangible asset amortization. Cash used as a result of changes in operating assets and liabilities was flat, comprised of a decrease in supplies of $2.3 million, a decrease in prepaid expenses and other current assets of $0.1 million and an increase in accrued liabilities and deferred rent of $0.1 million, offset by a decrease in accounts payable of $1.9 million, an increase in accounts receivable of $0.3 million and an increase in other assets of $0.3 million.


Cash Flows from Investing Activities
 
Cash used in investing activities for the six months ended June 30, 2019 was $1.4 million for the acquisition of property and equipment, net of proceeds from the disposal of property and equipment.

Cash used in investing activities for the six months ended June 30, 2018 was $0.8 million for the acquisition of property and equipment.

Cash Flows from Financing Activities
 
Cash provided by financing activities for the six months ended June 30, 2019 was $119.5 million, consisting of $137.8 million in net proceeds from the issuance of common stock in a public offering in May 2019 and $6.7 million in proceeds from the exercise of options to purchase our common stock and purchase of stock under our Employee Stock Purchase Plan, or ESPP, during the period, partially offset by $24.9 million of loan principal repayments and finance lease payments of $0.2 million.

Cash provided by financing activities for the six months ended June 30, 2018 was $1.1 million, consisting of $0.9 million in proceeds from the exercise of options to purchase our common stock and purchase of stock under our ESPP, and $0.4 million in proceeds from a legal settlement, partially offset by finance lease payments of $0.1 million.

 
Contractual Obligations
 
In January 2019 and May 2019, we prepaid $12.5 million and $12.4 million of the principal amount of the Term Loan Advance, respectively, under our Loan and Security Agreement. As of June 30, 2019, future principal and end-of-term debt

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obligation payments due under the Loan and Security Agreement are limited to $1.3 million in 2022. There were no other material changes during the interim period in the contractual obligations presented in our Form 10-K for the year ended December 31, 2018 filed with the Securities and Exchange Commission on February 25, 2019.
 
Off-balance Sheet Arrangements
 
We have not entered into any off-balance sheet arrangements.
 
Recent Accounting Pronouncements
 
In February 2016, the FASB issued ASU No. 2016-2, Leases (Topic 842). This ASU is aimed at making leasing activities more transparent and comparable, and requires substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases currently accounted for as operating leases. The ASU is effective for interim and annual periods beginning after December 15, 2018. Additionally, the FASB issued ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which offers an additional transition method whereby entities may apply the new leases standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings rather than application of the new leases standard at the beginning of the earliest period presented in the financial statements. We elected this transition method and adopted ASC 842 on January 1, 2019 and as a result, we recorded operating lease right-of-use ("ROU") assets of $9.8 million, including offsetting deferred rent of $4.3 million, along with the associated operating lease liabilities of $14.1 million. On January 1, 2019, we had a finance lease ROU of $0.8 million and associated finance lease liabilities of $0.3 million for leases we classified as finance leases prior to the adoption of ASC 842. The adoption of ASC 842 had an immaterial impact on our condensed statement of operations and comprehensive loss, condensed statement of stockholders' equity and condensed statement of cash flows for the three-month period ended March 31, 2019 and six-month period ended June 30, 2019. In addition, we elected the package of practical expedients permitted under the transition guidance within the new standard which allowed us to carry forward the historical lease classification. Additional information and disclosures required by this new standard are contained in Note 5, Commitments and Contingencies, in Part I of this Quarterly Report on Form 10-Q.

In November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (Topic 808). Under this ASU, transactions in collaborative arrangements are to be accounted for under ASC 606 if the counterparty is a customer for a good or service (or bundle of goods and services) that is a distinct unit of account. Also, entities are precluded from presenting consideration from transactions with a counterparty that is not a customer together with revenue recognized from ASC 606. This ASU is effective for all interim and annual reporting periods beginning on or after December 15, 2019, with early adoption permitted. We are currently evaluating the potential effect of this standard on our financial statements.


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We are exposed to market risks in the ordinary course of our business. These risks primarily relate to interest rates. We had cash and cash equivalents of $192.6 million as of June 30, 2019 which include bank deposits and money market funds. Such interest-bearing instruments carry a degree of risk; however, a hypothetical 10% change in interest rates during any of the periods presented would not have had a material impact on our unaudited interim condensed financial statements. Under our Loan and Security Agreement, we pay interest on any outstanding balances under this agreement based on a variable market rate. A significant change in these market rates may adversely affect our operating results.
 

ITEM 4.  CONTROLS AND PROCEDURES
 
(a)
Evaluation of Disclosure Controls and Procedures
 
We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, or Exchange Act, that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any

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disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
 
Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
 
(b)
Changes in Internal Control over Financial Reporting
 
There were no changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation identified above that occurred during the three months ended June 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


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PART II. — OTHER INFORMATION
 
ITEM 1A.  RISK FACTORS
 
Risks Related to Our Business
 
We have a history of losses, and we expect to incur net losses for the foreseeable future and may never achieve or sustain profitability.
 
We have incurred net losses since our inception. For the six months ended June 30, 2019, we had a net loss of $4.4 million and as of June 30, 2019, we had an accumulated deficit of $238.5 million. We expect to incur additional losses in the future, and we may never achieve revenue sufficient to offset our expenses. Over the next couple of years, we expect to continue to devote substantially all of our resources to increase adoption of, and reimbursement for our Afirma, Percepta and Envisia Classifiers and the development of additional tests. We may never achieve or sustain profitability, and our failure to achieve and sustain profitability in the future could cause the market price of our common stock to decline.
 
Our financial results currently depend mainly on sales of our Afirma tests, and we will need to generate sufficient revenue from this and other diagnostic solutions to grow our business.
 
Most of our revenue to date has been derived from the sale of our Afirma tests, which are used in the diagnosis of thyroid cancer. Over the next few years, we expect to continue to derive a substantial portion of our revenue from sales of our Afirma tests. In the third quarter of 2017, we began recognizing revenue from the sale of our Percepta test, used in the diagnosis of lung cancer. We also launched our Envisia test to help improve the diagnosis of interstitial lung disease, specifically IPF, and began recognizing revenue from Envisia in the second quarter of 2019. Once genomic tests are clinically validated and commercially available for patient testing, we must continue to develop and publish evidence that our tests are informing clinical decisions in order for them to receive positive coverage decisions by payers. Without coverage policies, our tests may not be reimbursed and we will not be able to recognize revenue. We cannot guarantee that tests we commercialize will gain and maintain positive coverage decisions and therefore, we may never realize revenue from tests we commercialize. In addition, we are in various stages of research and development for other diagnostic solutions that we may offer, but there can be no assurance that we will be able to identify other diseases that can be effectively addressed or, if we are able to identify such diseases, whether or when we will be able to successfully commercialize solutions for these diseases and obtain the evidence and coverage decisions from payers. If we are unable to increase sales and expand reimbursement for our Afirma, Percepta and Envisia tests, or develop and commercialize other solutions, our revenue and our ability to achieve and sustain profitability would be impaired, and the market price of our common stock could decline.

We depend on a few payers for a significant portion of our revenue and if one or more significant payers stops providing reimbursement or decreases the amount of reimbursement for our tests, our revenue could decline.
 
Revenue for tests performed on patients covered by Medicare and UnitedHealthcare was 24% and 11%, respectively, of our revenue for the six months ended June 30, 2019, compared with 28% and 12%, respectively, for the six months ended June 30, 2018. The percentage of our revenue derived from significant payers is expected to fluctuate from period to period as our revenue fluctuates, as additional payers provide reimbursement for our tests or if one or more payers were to stop reimbursing for our tests or change their reimbursed amounts. Effective January 2012, Palmetto GBA, the regional Medicare Administrative Contractor, or MAC, that handled claims processing for Medicare services over our jurisdiction at that time, issued coverage and payment determinations for our Afirma Classifiers now covered by Noridian Healthcare Solutions, the current MAC for our jurisdiction, through the Molecular Diagnostics Services Program, or MolDX program, administered by Palmetto GBA, under a Local Coverage Determination, or LCD.

Noridian Healthcare Solutions issued an LCD for Percepta effective for services performed on or after May 2017. This coverage policy requires us to establish and maintain a Certification and Training Registry program and make Percepta available only to certain Medicare patients through physicians who participate in this program. Failure by us or physicians to comply with the requirements of the Certification and Training Registry program could lead to loss of Medicare coverage for Percepta, which could have an adverse effect on our revenue.

We submitted the dossier of clinical evidence needed to obtain Medicare coverage for the Envisia Genomic Classifier through the MolDX technical assessment process in 2018, and received final Medicare coverage for the classifier in the first quarter of 2019, with an effective date of April 1, 2019.


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On a five-year rotational basis, Medicare requests bids for its regional MAC services. Any future changes in the MAC processing or coding for Medicare claims for the Afirma, Percepta or Envisia classifiers could result in a change in the coverage or reimbursement rates for such products, or the loss of coverage, and could also result in increased difficulties in obtaining and maintaining coverage for future products.

On March 1, 2015, an American Medical Association Current Procedural Terminology code, or CPT code, 81545 for the Afirma GEC was issued. On January 1, 2018, the Medicare Clinical Laboratory Fee Schedule payment rate for the Afirma classifier increased from $3,220 to $3,600. This rate is based on the volume-weighted median of private payer rates based on final payments made between January 1 and June 30, 2016, which we reported to the Centers for Medicare & Medicaid Services, or CMS, in 2017 as required under the Protecting Access to Medicare Act of 2014, or PAMA. This payment rate will be effective through December 31, 2020. The next data reporting period will be in 2020 for final payments made between January 1 and June 30, 2019. The volume-weighted median of these private payer rates will set the Medicare payment rate for the Afirma classifier from January 1, 2021 through December 31, 2023. There can be no assurance that the rate will not decrease from $3,600 during this or a subsequent reporting cycle under PAMA.

We submit claims to Medicare for Percepta using an unlisted code and were paid at the rate of $3,220 in 2018 under the MolDX program. A specific CPT code assigned to Percepta may be required to go through the national payment determination process, and there can be no assurance that the Medicare payment rate the test receives through this process will not be lower than the current payment rate for Percepta. There can also be no assurance that the Medicare payment rate for Percepta will not be reduced when it is set based on volume-weighted median of private payer rates when we are required to report those rates under PAMA.

We submit claims to Medicare for Envisia using an unlisted code under the MolDX program. A specific CPT code assigned to Percepta may be required to go through the national payment determination process, and there can be no assurance that the Medicare payment rate the test receives through this process will not be lower than the current payment rate for Envisia. There can also be no assurance that the Medicare payment rate for Envisia will not be reduced when it is set based on volume-weighted median of private payer rates when we are required to report those rates under PAMA.

If there is a decrease in the Medicare payment rate for our tests, our revenue from Medicare will decrease and the payment rates for some of our commercial payers may also decrease if they tie their allowable rates to the Medicare rate. These changes could have an adverse effect on our business, financial condition and results of operations.
 
Although we have entered into contracts with certain third-party payers that establish in-network allowable rates of reimbursement for our Afirma tests, payers may suspend or discontinue reimbursement at any time, may require or increase co-payments from patients, or may reduce the reimbursement rates paid to us. Reductions in private payer amounts could decrease the Medicare payment rates for our tests under PAMA. In addition, private payers have begun requiring prior authorization for molecular diagnostic tests. Potential reductions in reimbursement rate or increases in the difficulty of achieving payment could have a negative effect on our revenue.

If payers do not provide reimbursement, rescind or modify their reimbursement policies, delay payments for our tests, recoup past payments, or if we are unable to successfully negotiate additional reimbursement contracts, our commercial success could be compromised.

Physicians might not order our tests unless payers reimburse a substantial portion of the test price. There is significant uncertainty concerning third-party reimbursement of any test incorporating new technology, including our tests. Reimbursement by a payer may depend on a number of factors, including a payer’s determination that these tests are:

not experimental or investigational;

pre-authorized and appropriate for the specific patient;

cost-effective;

supported by peer-reviewed publications; and

included in clinical practice guidelines.

Since each payer makes its own decision as to whether to establish a coverage policy or enter into a contract to reimburse our tests, seeking these approvals is a time-consuming and costly process.

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We do not have a contracted rate of reimbursement with some payers for our tests. Without a contracted rate for reimbursement, our claims are often denied upon submission, and we must appeal the claims. The appeals process is time consuming and expensive, and may not result in payment. In cases where there is no contracted rate for reimbursement, there is typically a greater patient co-insurance or co-payment requirement which may result in further delay or decreased likelihood of collection. Payers may attempt to recoup prior payments after review, sometimes after significant time has passed, which would impact future revenue.
 
We expect to continue to focus substantial resources on increasing adoption, coverage and reimbursement for the Afirma, Percepta, and Envisia classifiers as well as any other future tests we may develop. We believe it will take several years to achieve coverage and contracted reimbursement with a majority of third-party payers. However, we cannot predict whether, under what circumstances, or at what payment levels payers will reimburse for our tests. Also, payer consolidation is underway and creates uncertainty as to whether coverage and contracts with existing payers will remain in effect. Finally, if there is a decrease in the Medicare payment rate for our tests, the payment rates for some of our commercial payers may also decrease if they tie their allowable rates to the Medicare rate. Reductions in private payer amounts could decrease the Medicare payment rates for our tests under PAMA. Our failure to establish broad adoption of and reimbursement for our tests, or our inability to maintain existing reimbursement from payers, will negatively impact our ability to generate revenue and achieve profitability, as well as our future prospects and our business.
 
We may experience limits on our revenue if physicians decide not to order our tests.
 
If we are unable to create or maintain demand for our tests in sufficient volume, we may not become profitable. To generate demand, we will need to continue to educate physicians about the benefits and cost-effectiveness of our tests through published papers, presentations at scientific conferences, marketing campaigns and one-on-one education by our sales force. In addition, our ability to obtain and maintain adequate reimbursement from third-party payers will be critical to generating revenue.

The Afirma genomic classifier is included in most physician practice guidelines in the United States for the assessment of patients with thyroid nodules. However, historical practice recommended a full or partial thyroidectomy in cases where cytopathology results were indeterminate to confirm a diagnosis. Our lung products are not yet integrated into practice guidelines and physicians may be reluctant to order tests that are not recommended in these guidelines. Because our diagnostic services are performed by our certified laboratory under the Clinical Laboratory Improvement Amendments of 1988, or CLIA, rather than by the local laboratory or pathology practice, pathologists may be reluctant to support our testing services as well. Guidelines that include our classifiers currently may subsequently be revised to recommend another testing protocol, and these changes may result in physicians deciding not to use our tests. Lack of guideline inclusion could limit the adoption of our tests and our ability to generate revenue and achieve profitability. To the extent international markets have existing practices and standards of care that are different than those in the United States, we may face challenges with the adoption of our tests in international markets.

We may experience limits on our revenue if patients decide not to use our tests.

Some patients may decide not to use our tests because of price, all or part of which may be payable directly by the patient if the patient’s insurer denies reimbursement in full or in part. There is a growing trend among insurers to shift more of the cost of healthcare to patients in the form of higher co-payments or premiums, and this trend is accelerating which puts patients in the position of having to pay more for our tests. We expect to continue to see pressure from payers to limit the utilization of tests, generally, and we believe more payers are deploying costs containment tactics, such as pre-authorization and employing laboratory benefit managers to reduce utilization rates. Implementation of provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act, collectively the ACA, has also resulted in increases in premiums and reductions in coverage for some patients. In addition, Congressional efforts to repeal the ACA could result in an increase in uninsured patients. These events may result in patients delaying or forgoing medical checkups or treatment due to their inability to pay for our tests, which could have an adverse effect on our revenue.
 
If we fail to comply with federal and state licensing requirements, we could lose the ability to perform our tests or experience disruptions to our business.

We are subject to CLIA, a federal law that regulates clinical laboratories that perform testing on specimens derived from humans for the purpose of providing information for the diagnosis, prevention or treatment of disease. CLIA regulations mandate specific personnel qualifications, facilities administration, quality systems, inspections, and proficiency testing. CLIA certification is also required for us to be eligible to bill state and federal healthcare programs, as well as many private third-party payers. To renew these certifications, we are subject to survey and inspection every two years. Moreover, CLIA inspectors may make random

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inspections of our clinical reference laboratories. As discussed in our Annual Report on Form 10-K for the year ended December 31, 2018 in the section titled “Business-Regulation-Clinical Laboratory Improvement Act of 1988, or CLIA,” following a routine July 2018 survey of our Austin laboratory location, in September 2018, CMS determined that because we only collected and processed patient specimens and TCP, rather than us, performed the patient testing from the Austin laboratory, we did not require a CLIA certificate for the laboratory. As a result, CMS inactivated our Austin laboratory’s CLIA number effective July 2018. While CMS recently reinstated our CLIA number effective as of February 2019, we reversed $0.6 million in previously recognized revenue associated with claims for cytopathology diagnostic services furnished after the date of the July 2018 survey and prior to the reinstatement date. If we in the future fail to maintain CLIA certificates in our South San Francisco or Austin, Texas laboratory locations we would be unable to bill for services provided by state and federal healthcare programs, as well as many private third-party payers, which may have an adverse effect on our business, financial condition and results of operations.

We are also required to maintain state licenses to conduct testing in our laboratories. California, New York, Texas, among other states’ laws, require that we maintain a license and comply with state regulation as a clinical laboratory. Other states may have similar requirements or may adopt similar requirements in the future. In addition, both of our clinical laboratories are required to be licensed on a test-specific basis by New York State. We have received approval for the Afirma and Percepta tests. We will be required to obtain approval for other tests we may offer in the future. If we were to lose our CLIA certificate or California license for our South San Francisco laboratory, whether as a result of revocation, suspension or limitation, we would no longer be able to perform our molecular tests, which would eliminate our primary source of revenue and harm our business. If we fail to meet the state licensing requirements for our Austin laboratory, we would need to move the receipt and storage of FNAs, as well as the slide preparation for cytopathology, to South San Francisco, which could result in a delay in processing tests during that transition and increased costs. If we were to lose our licenses issued by New York or by other states where we are required to hold licenses, we would not be able to test specimens from those states. New tests we may develop may be subject to new approvals by regulatory bodies such as New York State, and we may not be able to offer our new tests until such approvals are received.

We rely on sole suppliers for some of the reagents, equipment, chips and other materials used to perform our tests, and we may not be able to find replacements or transition to alternative suppliers.
 
We rely on sole suppliers for critical supply of reagents, equipment, chips and other materials that we use to perform our tests. We also purchase components used in our collection kits from sole-source suppliers. Some of these items are unique to these suppliers and vendors. In addition, we utilize a sole source to assemble and distribute our sample collection kits. While we have developed alternate sourcing strategies for these materials and vendors, we cannot be certain whether these strategies will be effective or the alternative sources will be available when we need them. If these suppliers can no longer provide us with the materials we need to perform the tests and for our collection kits, if the materials do not meet our quality specifications or are otherwise unusable, if we cannot obtain acceptable substitute materials, or if we elect to change suppliers, an interruption in test processing could occur, we may not be able to deliver patient reports and we may incur higher one-time switching costs. Any such interruption may significantly affect our future revenue, cause us to incur higher costs, and harm our customer relationships and reputation. In addition, in order to mitigate these risks, we maintain inventories of these supplies at higher levels than would be the case if multiple sources of supplies were available. If our test volume decreases or we switch suppliers, we may hold excess supplies with expiration dates that occur before use which would adversely affect our losses and cash flow position. As we introduce any new test, we may experience supply issues as we ramp test volume.
 
We depend on a specialized cytopathology practice to perform the cytopathology component of our Afirma test, and our ability to perform our diagnostic solution would be harmed if we were required to secure a replacement.
 
We rely on Thyroid Cytopathology Partners, or TCP, to provide cytopathology professional diagnoses on thyroid FNA samples pursuant to a pathology services agreement. Pursuant to this agreement, as amended, TCP has the exclusive right to provide our cytopathology diagnoses on FNA samples at a fixed price per test. Until February 2019, TCP also previously subleased a portion of our facility in Austin, Texas. Our agreement with TCP is effective through October 31, 2022, and thereafter automatically renews every year unless either party provides notice of intent not to renew at least 12 months prior to the end of the then-current term.
 
If TCP were not able to support our current test volume or future increases in test volume or to provide the quality of services we require, or if we were unable to agree on commercial terms and our relationship with TCP were to terminate, our business would be harmed until we were able to secure the services of another cytopathology provider. There can be no assurance that we would be successful in finding a replacement that would be able to conduct cytopathology diagnoses at the same volume or with the same high-quality results as TCP. Locating another suitable cytopathology provider could be time consuming and would result in delays in processing Afirma tests until a replacement was fully integrated with our test processing operations.

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Due to how we recognize revenue, our quarterly operating results are likely to fluctuate.
 
We recognize test revenue upon delivery of the patient report to the prescribing physician based on the amount we expect to ultimately realize. We determine the amount we expect to ultimately realize based on payer reimbursement history, contracts, and coverage. Upon ultimate collection, the amount received is compared to the estimates and the amount accrued is adjusted accordingly. We cannot be certain as to when we will receive payment for our diagnostic tests, and we must appeal negative payment decisions, which delays collections. Should judgments underlying estimated reimbursement change or were incorrect at the time we accrued such revenue, our financial results could be negatively impacted in future quarters. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our past results as an indication of our future performance. In addition, these fluctuations in revenue may make it difficult for us, for research analysts and for investors to accurately forecast our revenue and operating results. If our revenue or operating results fall below expectations, the price of our common stock would likely decline.

We may be unable to manage our future growth effectively, which could make it difficult to execute our business strategy.

In addition to the need to scale our testing capacity, future growth, including our transition to a multi-product company with international operations, will impose significant added responsibilities on management, including the need to identify, recruit, train and integrate additional employees with the necessary skills to support the growing complexities of our business. Rapid and significant growth may place strain on our administrative, financial and operational infrastructure. Our ability to manage our business and growth will require us to continue to improve our operational, financial and management controls, reporting systems and procedures. We have implemented an internally-developed data warehouse, which is critical to our ability to track our diagnostic services and patient reports delivered to physicians, as well as to support our financial reporting systems. The time and resources required to optimize these systems is uncertain, and failure to complete optimization in a timely and efficient manner could adversely affect our operations. If we are unable to manage our growth effectively, it may be difficult for us to execute our business strategy and our business could be harmed.
 
If we are unable to support demand for our commercial tests, our business could suffer.
 
As demand for our tests grows, we will need to continue to scale our testing capacity and processing technology, expand customer service, billing and systems processes and enhance our internal quality assurance program. We will also need additional certified laboratory scientists and other scientific and technical personnel to process higher volumes of our tests. We cannot assure you that any increases in scale, related improvements and quality assurance will be successfully implemented or that appropriate personnel will be available. Failure to implement necessary procedures, transition to new processes or hire the necessary personnel could result in higher costs of processing tests, quality control issues or inability to meet demand. There can be no assurance that we will be able to perform our testing on a timely basis at a level consistent with demand, or that our efforts to scale our operations will not negatively affect the quality of test results. If we encounter difficulty meeting market demand or quality standards, our reputation could be harmed and our future prospects and our business could suffer.
 
Changes in healthcare policy, including legislation reforming the U.S. healthcare system, may have a material adverse effect on our financial condition and operations.
 
The ACA, enacted in March 2010, made changes that significantly affected the pharmaceutical and medical device industries and clinical laboratories. Effective January 1, 2013, the ACA included a 2.3% excise tax on the sale of certain medical devices sold outside of the retail setting. Although a moratorium has been imposed on this excise tax for 2016 through 2019, the excise tax is scheduled to be restored in 2020.

Other significant measures contained in the ACA include, for example, coordination and promotion of research on comparative clinical effectiveness of different technologies and procedures, initiatives to revise Medicare payment methodologies, such as bundling of payments across the continuum of care by providers and physicians, and initiatives to promote quality indicators in payment methodologies. The ACA also includes significant new fraud and abuse measures, including required disclosures of financial arrangements with physician customers, lower thresholds for violations and increasing potential penalties for such violations.
 
In the beginning of 2017, the U.S. Congress and the Administration took actions to repeal the ACA and indicated an intent to replace it with another act and efforts to repeal or amend the ACA are ongoing. We cannot predict if, or when, the ACA will be repealed or amended, and cannot predict the impact that an amendment or repeal of the ACA will have on our business.


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In addition to the ACA, various healthcare reform proposals have also periodically emerged from federal and state governments. For example, in February 2012, Congress passed the Middle Class Tax Relief and Job Creation Act of 2012, which in part reset the clinical laboratory payment rates on the Medicare Clinical Laboratory Fee Schedule, or CLFS, by 2% in 2013. In addition, under the Budget Control Act of 2011, which is effective for dates of service on or after April 1, 2013, Medicare payments, including payments to clinical laboratories, are subject to a reduction of 2% due to the automatic expense reductions (sequester) until fiscal year 2024. Reductions resulting from the Congressional sequester are applied to total claims payment made; however, they do not currently result in a rebasing of the negotiated or established Medicare or Medicaid reimbursement rates.
 
State legislation on reimbursement applies to Medicaid reimbursement and managed Medicaid reimbursement rates within that state. Some states have passed or proposed legislation that would revise reimbursement methodology for clinical laboratory payment rates under those Medicaid programs. For example, effective July 2015, California’s Department of Health Care Services implemented a new rate methodology for clinical laboratories and laboratory services. This methodology involves the use of a range of rates that fell between zero and 80% of the calculated California-specific Medicare rate and the calculation of a weighted average (based on units billed) of such rates.

We cannot predict whether future healthcare initiatives will be implemented at the federal or state level or in countries outside of the United States in which we may do business, or the effect any future legislation or regulation will have on us. The taxes imposed by the new federal legislation, cost reduction measures and the expansion in the role of the U.S. government in the healthcare industry may result in decreased revenue, lower reimbursement by payers for our tests or reduced medical procedure volumes, all of which may adversely affect our business, financial condition and results of operations. In addition, sales of our tests outside the United States subject our business to foreign regulatory requirements and cost-reduction measures, which may also change over time.
 
Ongoing calls for deficit reduction at the federal government level and reforms to programs such as the Medicare program to pay for such reductions may affect the pharmaceutical, medical device and clinical laboratory industries. Currently, clinical laboratory services are excluded from the Medicare Part B co-insurance and co-payment as preventative services. Any requirement for clinical laboratories to collect co-payments from patients may increase our costs and reduce the amount ultimately collected.
 
CMS bundles payments for clinical laboratory diagnostic tests together with other services performed during hospital outpatient visits under the Hospital Outpatient Prospective Payment System. CMS currently maintains an exemption for molecular pathology tests from this bundling provision. It is possible that this exemption could be removed by CMS in future rule making, which might result in lower reimbursement for tests performed in this setting.
 
PAMA includes a substantial new payment system for clinical laboratory tests under the CLFS. Under PAMA, laboratories that receive the majority of their Medicare revenues from payments made under the CLFS and the Physician Fee Schedule would report on triennial bases (or annually for advanced diagnostic laboratory tests, or ADLTs), private payer rates and volumes for their tests with specific CPT codes based on final payments made during a set data collection period (the first of which was January 1 through June 30, 2016). We believe that PAMA and its implementing regulations are generally favorable to us. We reported to CMS the data required under PAMA before the March 31, 2017 deadline. The new payment rate for the Afirma genomic classifier based on the volume-weighted median of private payer rates took effect January 1, 2018, increasing from $3,220 to $3,600 through December 31, 2020. The next data reporting period will be in 2020 for final payments made between January 1 and June 30, 2019. The volume weighted median of these private payer rates will set the Medicare payment rate for the Afirma classifier from January 1, 2021 through December 31, 2023. There can be no assurance that the payment rate for Afirma will not decrease in the future or that the payment rates for Percepta or Envisia will not be adversely affected by the PAMA law and regulations.
  
We believe our Afirma genomic classifier as well as our Percepta and Envisia classifiers would be considered ADLTs under PAMA. The initial payment rate (for a period not to exceed nine months) under PAMA for a new ADLT (an ADLT for which payment has not been made under the CLFS prior to January 1, 2018) will be set at the “actual list charge” for the test as reported by the laboratory. Insofar as the actual list charge substantially exceeds private payer rates (by more than 30%), CMS will have the ability to recoup excess payments made during the initial nine-month payment period.  We can determine whether to seek ADLT status for our tests, but there can be no assurance that our tests will be designated ADLTs or that the payment rates for our tests will not be adversely affected by such designation.   

There have also been recent and substantial changes to the payment structure for physicians, including those passed as part of the Medicare Access and CHIP Reauthorization Act of 2015, or MACRA, which was signed into law on April 16, 2015. MACRA created the Merit-Based Incentive Payment System which, beginning in 2019, more closely aligns physician payments with composite performance on performance metrics similar to three existing incentive programs (i.e., the Physician Quality Reporting System, the Value-based modifier program and the Electronic Health Record Meaningful Use program) and incentivizes

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physicians to enroll in alternative payment methods. At this time, we do not know whether these changes to the physician payment systems will have any impact on orders or payments for our tests.

In December 2016, Congress passed the 21st Century Cures Act, which, among other things, revised the process for LCDs. Additionally, effective June 11, 2017, a MAC is required to, among other things, publish a summary of the evidence that it considered when developing an LCD, including a list of sources, and an explanation of the rationale that supports the MAC’s determinations. In October 2018, CMS issued additional guidance revising the requirements for the development of LCDs. We cannot predict whether these revisions will delay future LCDs and result in impeded coverage for our test products, which could have a material negative impact on revenue.

Congress is considering legislation to limit balance billing of patients who receive services from out-of-network providers (including laboratories) at in-network facilities and to set a methodology for payment of the out-of-network provider in such circumstances. This legislation, if enacted, could limit our ability to achieve payment in full for our testing services.
 
Because of Medicare billing rules, we may not receive reimbursement for all tests provided to Medicare patients.
 
Under previous Medicare billing rules, hospitals were required to bill for our tests when performed on Medicare beneficiaries who were hospital outpatients at the time of tissue specimen collection when these tests were ordered less than 14 days following the date of the patient's discharge.

Effective January 1, 2018, CMS revised its billing rules to allow the performing laboratory to bill Medicare directly for molecular pathology tests performed on specimens collected from hospital outpatients, even when those tests are ordered less than 14 days after the date of discharge, if certain conditions are met. We believe that our Afirma, Percepta, and Envisia classifiers should be covered by this policy. Accordingly, we bill Medicare for these tests when we perform them on specimens collected from hospital outpatients and meet the conditions set forth in CMS's revised billing rules.

This change does not apply to tests performed on specimens collected from hospital inpatients. We will continue to bill hospitals for tests performed on specimens collected from hospital inpatients when the test was ordered less than 14 days after the date of discharge. While we believe the impact of these revisions are favorable to us, we cannot predict with certainty the impact on our business. CMS may change this regulatory policy in the future, which could negatively impact our business.

In addition, we must maintain CLIA compliance and certification to sell our tests and be eligible to bill for diagnostic services provided to Medicare beneficiaries.
  
If the FDA were to begin regulating our tests, we could incur substantial costs and delays associated with trying to obtain premarket clearance or approval.
 
Clinical laboratory tests have long been subject to comprehensive regulations under CLIA, as well as by applicable state laws. Most laboratory developed tests, or LDTs, are not currently subject to regulation under the FDA's enforcement discretion policy, although reagents, instruments, software or components provided by third parties and used to perform LDTs may be subject to regulation. While the FDA maintains its authority to regulate LDTs, it has chosen to exercise its enforcement discretion not to enforce the premarket review and other applicable medical device requirements for LDTs. We believe that the Afirma, Percepta and Envisia classifiers are LDTs that fall under the FDA's enforcement discretion policy. In October 2014, the FDA issued draft guidance, entitled "Framework for Regulatory Oversight of LDTs," proposing a risk-based framework of oversight and a phased-in enforcement of premarket review requirements for most LDTs. In 2016, the FDA announced that it would not be finalizing the guidance.
 
In January 2017, the FDA issued a "Discussion Paper on Laboratory Developed Tests" following input it received from multiple stakeholders who had commented on its 2014 draft guidance. The FDA specifically states in its Discussion Paper that the proposals contained in the document do not represent a final version of the LDT draft guidance documents and are only designed to provide a possible approach to spark further dialogue. The suggested LDT framework could grandfather many types of LDTs without requiring new premarket review or quality management requirements. It also suggests a four-year phased implementation of the premarket review requirements for some types of tests. In a December 2018 statement, FDA said that there is a need for “a unified approach to the regulation of in vitro clinical tests to protect patient safety, support innovation, and keep pace with the rapidly evolving technology that’s helping us find new treatments for disease.” FDA listed key principles of an approach it would support.

In March 2017, a draft bill on the regulation of LDTs, entitled "The Diagnostics Accuracy and Innovation Act", or DAIA, was released for discussion. In December 2018, the sponsors of DAIA released a new version of the legislation called the “Verifying

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Accurate, Leading-edge IVCT Development Act, or VALID Act. The VALID Act proposes a risk-based approach to regulate LDTs and creates a new in vitro clinical test category, which includes LDTs, and a regulatory structure under the FDA. As proposed, the bill would create a precertification program for lower risk tests not otherwise required to go through premarket review. It would grandfather existing tests but would allow FDA to subject otherwise grandfathered tests to premarket review under certain conditions. We cannot predict whether this draft bill will become legislation and cannot quantify the effect of this draft bill on our business.

If the FDA were to require us to seek clearance or approval for our existing tests or any of our future products for clinical use, we may not be able to obtain such approvals on a timely basis, or at all. While we believe our current tests would likely qualify for the “grandfathered” tests treatment, there can be no assurance of what the FDA might ultimately require if it issued final guidance. If premarket reviews were required, our business could be negatively impacted if we were required to stop selling our products pending their clearance or approval. In addition, the launch of any new products that we develop could be delayed by the implementation of future FDA guidance. The cost of complying with premarket review requirements, including obtaining clinical data, could be significant. In addition, future regulation by the FDA could subject our business to further regulatory risks and costs. Failure to comply with applicable regulatory requirements of the FDA could result in enforcement action, including receiving untitled or warning letters, fines, injunctions, or civil or criminal penalties. Any such enforcement action would have a material adverse effect on our business, financial condition and operations. In addition, our sample collection containers are listed as Class I devices with the FDA. If the FDA were to determine that they are not Class I devices, we would be required to file 510(k) applications and obtain FDA clearance to use the containers, which could be time consuming and expensive.
 
Some of the materials we use for our tests and that we may use for future tests are labeled for research use-only, or RUO, or investigational-use only, or IUO. In November 2013, the FDA finalized guidance regarding the sale and use of products labeled RUO or IUO. Among other things, the guidance advises that the FDA continues to be concerned about distribution of research or investigational-use only products intended for clinical diagnostic use and that the manufacturer’s objective intent for the product’s intended use will be determined by examining the totality of circumstances, including advertising, instructions for clinical interpretation, presentations that describe clinical use, and specialized technical support, surrounding the distribution of the product in question. The FDA has advised that if evidence demonstrates that a product is inappropriately labeled for research or investigational-use only, the device would be considered misbranded and adulterated within the meaning of the Federal Food, Drug and Cosmetic Act. Some of the reagents, instruments, software or components obtained by us from suppliers for use in our products are currently labeled as RUO or IUO. If the FDA were to determine that any of these reagents, instruments, software or components are improperly labeled RUO or IUO and undertake enforcement actions, some of our suppliers might cease selling these reagents, instruments, software or components to us, and any failure to obtain an acceptable substitute could significantly and adversely affect our business, financial condition and results of operations, including increasing the cost of testing or delaying, limiting or prohibiting the purchase of reagents, instruments, software or components necessary to perform testing.
 
If we are unable to compete successfully, we may be unable to increase or sustain our revenue or achieve profitability.
 
Our principal competition for our tests comes from traditional methods used by physicians to diagnose and manage patient care decisions. For example, with our Afirma genomic classifier, practice guidelines in the United States have historically recommended that patients with indeterminate diagnoses from cytopathology results be considered for surgery to remove all or part of the thyroid to rule out cancer. This practice has been the standard of care in the United States for many years, and we need to continue to educate physicians about the benefits of the Afirma genomic classifier to change clinical practice.
 
We also face competition from companies and academic institutions that use next generation sequencing technology or other methods to measure mutational markers such as BRAF and KRAS, along with numerous other mutations. These organizations include Interpace Diagnostics Group, Inc., CBLPath, Inc./University of Pittsburgh Medical Center and others who are developing new products or technologies that may compete with our tests. In the future, we may also face competition from companies developing new products or technologies.
 
We believe our primary competition in pulmonology with our Percepta and Envisia classifiers will similarly come from traditional methods used by physicians to diagnose the related diseases. For the Percepta test, we expect competition from companies focused on lung cancer such as Oncocyte Corporation and Biodesix, Inc. As we expand our portfolio of tests to address clinical questions across the clinical care continuum, we may also face competition from companies focused on screening at-risk patients for cancer or companies informing treatment decisions such as Guardant Health or GRAIL. Competition could also emerge using alternative samples, such as blood, urine or sputum. However, such “liquid biopsies” are currently being used to gauge risk of recurrence or response to treatment in patients already diagnosed with lung cancer.
 
In general, we also face competition from commercial laboratories, such as Laboratory Corporation of America Holdings and Sonic Healthcare USA, with strong infrastructure to support the commercialization of diagnostic services. We face potential

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competition from companies such as Illumina, Inc. and Thermo Fisher Scientific Inc., both of which have entered the clinical diagnostics market. Other potential competitors include companies that develop diagnostic products, such as Roche Diagnostics, a division of Roche Holding Ltd, Siemens AG and Qiagen N.V.
 
In addition, competitors may develop their own versions of our solutions in countries we may seek to enter where we do not have patents or where our intellectual property rights are not recognized and compete with us in those countries, including encouraging the use of their solutions by physicians in other countries.
 
To compete successfully, we must be able to demonstrate, among other things, that our diagnostic test results are accurate and cost effective, and we must secure a meaningful level of reimbursement for our products.
 
Many of our potential competitors have widespread brand recognition and substantially greater financial, technical and research and development resources, and selling and marketing capabilities than we do. Others may develop products with prices lower than ours that could be viewed by physicians and payers as functionally equivalent to our solutions, or offer solutions at prices designed to promote market penetration, which could force us to lower the list price of our solutions and affect our ability to achieve profitability. If we are unable to change clinical practice in a meaningful way or compete successfully against current and future competitors, we may be unable to increase market acceptance and sales of our products, which could prevent us from increasing our revenue or achieving profitability and could cause the market price of our common stock to decline. As we add new tests and services, we will face many of these same competitive risks for these new tests.
 
The loss of members of our senior management team or our inability to attract and retain key personnel could adversely affect our business.
 
Our success depends largely on the skills, experience and performance of key members of our executive management team and others in key management positions. The efforts of each of these persons together will be critical to us as we continue to develop our technologies and test processes and focus on our growth. If we were to lose one or more of these key employees, we may experience difficulties in competing effectively, developing our technologies and implementing our business strategy.
 
In addition, our research and development programs and commercial laboratory operations depend on our ability to attract and retain highly skilled scientists. We may not be able to attract or retain qualified scientists and technicians in the future due to the intense competition for qualified personnel among life science businesses, particularly in the San Francisco Bay Area. Our success in the development and commercialization of advanced diagnostics requires a significant medical and clinical staff to conduct studies and educate physicians and payers on the merits of our tests in order to achieve adoption and reimbursement. We are in a highly competitive industry to attract and retain this talent. Additionally, our success depends on our ability to attract and retain qualified sales people. We recently significantly expanded our sales force as we invest in our multi-product sales strategy, which includes assignment of a single contact to successfully develop and implement relationships with our customers. There can be no assurance that we will be successful in maintaining and growing our business. Additionally, as we increase our sales channels for new tests we commercialize, including the Percepta and Envisia tests, we may have difficulties recruiting and training additional sales personnel or retaining qualified salespeople, which could cause a delay or decline in the rate of adoption of our tests. As a public company located in the San Francisco Bay Area, we also face intense competition for highly skilled finance and accounting personnel. If we are unable to attract and retain finance and accounting personnel experienced in public company financial reporting, we risk being unable to close our books and file our public documents on a timely basis. Finally, our business requires specialized capabilities in reimbursement, billing, and other areas and there may be a shortage of qualified individuals. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that could adversely affect our ability to support our research and development, clinical laboratory, sales and reimbursement, billing and finance efforts. All of our employees are at will, which means that either we or the employee may terminate their employment at any time. We do not carry key man insurance for any of our employees.

Billing for our diagnostic tests is complex, and we must dedicate substantial time and resources to the billing process to be paid.
 
Billing for clinical laboratory testing services is complex, time-consuming and expensive. Depending on the billing arrangement and applicable law, we bill various payers, including Medicare, insurance companies and patients, all of which have different billing requirements. We generally bill third-party payers for our diagnostic tests and pursue reimbursement on a case-by-case basis where pricing contracts are not in place. To the extent laws or contracts require us to bill patient co-payments or co-insurance, we must also comply with these requirements. We may also face increased risk in our collection efforts, including potential write-offs of accounts receivable and long collection cycles, which could adversely affect our business, results of operations and financial condition.
 

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Several factors make the billing process complex, including:
 
differences between the list price for our tests and the reimbursement rates of payers;

  compliance with complex federal and state regulations related to billing government payers, such as Medicare and Medicaid, including requirements to have an active CLIA certificate;

 
risk of government audits related to billing Medicare and other government payers;

disputes among payers as to which party is responsible for payment;

differences in coverage and in information and billing requirements among payers, including the need for prior authorization and/or advanced notification;

the effect of patient co-payments or co-insurance;

changes to billing codes used for our tests;

incorrect or missing billing information; and

the resources required to manage the billing and claims appeals process.
 
We use standard industry billing codes, known as CPT codes, to bill for cytopathology. In addition, we use the CPT code 81545 to bill for our Afirma classifier. CPT codes do not exist for our other proprietary molecular diagnostic tests. Therefore, until such time that we are assigned and are able to use a designated CPT code specific to Percepta and Envisia, we use “unlisted” codes for claim submissions, which can lead to delays in payers adjudicating our claims or denying payment altogether. Moreover, these codes can change over time. When codes change, there is a risk of an error being made in the claim adjudication process. These errors can occur with claims submission, third-party transmission or in the processing of the claim by the payer. Claim adjudication errors may result in a delay in payment processing or a reduction in the amount of the payment received. Coding changes, therefore, may have an adverse effect on our revenues. Even when we receive a designated CPT code specific to our tests, such as the 81545 code for the Afirma GEC that became effective January 1, 2016, there can be no assurance that payers will recognize these codes in a timely manner or that the process of transitioning to such a code and updating their billing systems and ours will not result in errors, delays in payments and a related increase in accounts receivable balances.
 
As we introduce new tests, we will need to add new codes to our billing process as well as our financial reporting systems. Failure or delays in effecting these changes in external billing and internal systems and processes could negatively affect our collection rates, revenue and cost of collecting.

Correct coding is subject to the coding policies of the American Medical Association CPT Editorial Panel, or AMA CPT. With respect to claims submitted to Medicare and Medicaid, it is also subject to coding policies developed through the National Correct Coding Initiative, or NCCI. Other payers may develop their own payer-specific coding policies. The broader coding policies of the AMA CPT, NCCI, and other payers are subject to change. For instance, the NCCI recently adopted an update to its Coding Policy Manual effective January 1, 2019, to limit instances when multiple codes may be billed for molecular pathology testing. Such coding policy changes may negativel