Description of Business

Unless otherwise noted, (1) the term "Arrowhead" refers to Arrowhead Research Corporation, a Delaware corporation, (2) the terms the "Company," "we," "us," and "our," refer to the ongoing business operations of Arrowhead and its Subsidiaries, whether conducted through Arrowhead or a subsidiary of Arrowhead,
(3) the term "Subsidiaries" refers collectively to Arrowhead Madison Inc. ("Madison"), formerly known as "Roche Madison, Inc.", Alvos Therapeutics, Inc. ("Alvos"), Calando Pharmaceuticals, Inc. ("Calando"), Ablaris Therapeutics, Inc. ("Ablaris"), Agonn Systems, Inc. ("Agonn"), and Tego Biosciences Corporation ("Tego") as well as our former subsidiary, Unidym, Inc. ("Unidym"), which was divested in January 2011, (4) the term "Minority Investments" refers collectively to Nanotope, Inc. ("Nanotope") and Leonardo Biosystems, Inc. ("Leonardo") in which the company holds a less than majority ownership position, and (5) the term "Common Stock" refers to Arrowhead's Common Stock and the term "stockholder(s)" refers to the holders of Arrowhead Common Stock. All Arrowhead share and per share data have been adjusted to reflect a one for ten reverse stock split effected on November 17, 2011.

Arrowhead Research Corporation is a clinical stage targeted therapeutics company with development programs in oncology, obesity, and chronic hepatitis B virus infection. Arrowhead is focused on creating new therapeutics that are preferentially taken up by target tissues in order to maximize a drug's efficacy and potentially limit side effects associated with exposure to healthy cells. Arrowhead has assembled a broad set of technologies and licenses to enable targeted RNAi therapeutics capable of silencing specific gene products in specific cells. Arrowhead has also assembled a proprietary targeting library that may be used with its RNAi platforms as well as with small molecule or peptide drugs. These platforms have yielded several drug candidates under both internal and partnered development.

Critical Accounting Policies and Estimates

Management makes certain judgments and uses certain estimates and assumptions when applying accounting principles generally accepted in the United States in the preparation of our Consolidated Financial Statements. We evaluate our estimates and judgments on an ongoing basis and base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our consolidated financial statements and require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements. For further information, see Note 1, Organization and Significant Accounting Policies, to our Consolidated Financial Statements which outlines our application of significant accounting policies and new accounting standards.

Revenue Recognition

Revenue from product sales are recorded when persuasive evidence of an arrangement exists, title has passed and delivery has occurred, a price is fixed and determinable, and collection is reasonably assured.

We may generate revenue from technology licenses, collaborative research and development arrangements, research grants and product sales. Revenue under technology licenses and collaborative agreements typically consists of nonrefundable and/or guaranteed technology license fees, collaborative research funding, and various milestone and future product royalty or profit-sharing payments.

Revenue associated with research and development funding payments under collaborative agreements is recognized ratably over the relevant periods specified in the agreement, generally the research and development period. Revenue from up-front license fees, milestones and product royalties are recognized as earned based on the completion of the milestones and product sales, as defined in the respective agreements. Payments received in advance of recognition as revenue are recorded as deferred revenue.

Business Combinations

In October 2011, we acquired all of the outstanding common stock of Roche Madison, Inc. and certain related intellectual property assets for a $50,000 promissory note and 1,288,158 shares of Arrowhead Common Stock, an estimated consideration value of $5.1 million on the date of the acquisition. We assigned the value of the consideration to the tangible assets and identifiable intangible assets and the liabilities assumed on the basis of their fair values on the date of acquisition. The excess of net assets over the consideration was recorded as a nonoperating gain.

In April 2012, we acquired all of the outstanding common stock of Alvos Therapeutics, Inc. in exchange for the issuance of 315,457 shares of Arrowhead Common Stock, valued at $2.0 million at the time of acquisition. The consideration was assigned to its tangible and intangible assets, and liabilities based on estimated fair values at the time of acquisition.

The allocation of value to certain items, including property and equipment, intangible assets and certain liabilities require management judgment, and is based upon the information available at the time of acquisition.

Impairment of Long-lived Assets

We review long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of assets may not be fully recoverable or that our assumptions about the useful lives of these assets are no longer appropriate. If impairment is indicated, recoverability is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset.

Intangible assets consist of in-process research and development, patents and license agreements acquired in conjunction with a business acquisition. Intangible assets are monitored for potential impairment whenever events or circumstances indicate that the carrying amount may not be recoverable, and are also reviewed annually to determine whether any impairment is necessary. Based on early adoption of ASU 2012-02, the annual review of intangible assets is performed via a two-step process. First, a qualitative assessment is performed to determine if it is more likely than not that the intangible asset is impaired. If required, a quantitative assessment is performed and, if necessary, impairment is recorded.

Stock-Based Compensation

We recognize stock-based compensation expense based on the grant date fair value using the Black-Scholes options pricing model, which requires us to make assumptions regarding certain variables including the risk-free interest rate, expected stock price volatility, and the expected life of the award. The assumptions used in calculating stock-based compensation expense represent management's best estimates, but these estimates involve inherent uncertainties, and if factors change or the Company used different assumptions, its stock-based compensation expense could be materially different in the future.

Derivative Assets and Liabilities

We account for warrants and other derivative financial instruments as either equity or assets/liabilities based upon the characteristics and provisions of each instrument. Warrants classified as equity are recorded as additional paid-in capital on our consolidated balance sheet and no further adjustments to their valuation are made. Some of our warrants were determined to be ineligible for equity classification because of provisions that may result in an adjustment to their exercise price. Warrants classified as derivative liabilities and other derivative financial instruments that require separate accounting as assets or liabilities are recorded on our consolidated balance sheet at their fair value on the date of issuance and are revalued on each subsequent balance sheet date until such instruments are exercised or expire, with any changes in the fair value between reporting periods recorded as other income or expense. We estimate the fair value of these assets/liabilities using option pricing models that are based on the individual characteristics of the warrants or instruments on the valuation date, as well as assumptions for expected volatility, expected life and risk-free interest rate. Changes in the assumptions used could have a material impact on the resulting fair value. The primary input affecting the value of our derivatives liabilities is the Company's stock price. For example, at September 30, 2012, a 50% change in the value of the Company's stock price would affect the value of the derivative liability by approximately $0.3 million to $0.4 million, depending on other inputs.

Reverse Stock Split

As of November 17, 2011, the Company effected a 1 for 10 reverse stock split (the "reverse stock split"). As a result of the reverse stock split, each ten shares of the Company's Common Stock issued and outstanding immediately prior to the reverse split was combined into one share of Common Stock. Also, as a result of the Reverse Stock Split, the per share exercise price of, and the number of shares of Common Stock underlying outstanding Company stock options, warrants, Series A Preferred and any Common Stock based equity grants outstanding immediately prior to the reverse stock split was proportionally adjusted, based on the one-for-ten split ratio, in accordance with the terms of such options, warrants or other Common Stock based equity grants as the case may be. No fractional shares of Common Stock were issued in connection with the reverse stock split. Stockholders instead received cash payment in lieu of any fractional shares. Unless otherwise noted, all share and per share amounts in these have been retrospectively adjusted to reflect the reverse stock split.

Full Year Review

On October 21, 2011, the Company acquired Roche Madison, Inc. and other intangible assets from Roche. The acquisition included a laboratory research facility in Madison, Wisconsin comprising over 24,000 square feet. Roche Madison Inc. employed 41 employees at the time of the acquisition. Due to the significant new costs associated with the facility, its people and research programs, salary costs, general and administrative costs, and research and development costs increased significantly relative to prior periods. Going forward, we expect this increased cost structure to continue as research and development efforts are accelerated.

On April 11, 2012, the Company acquired Alvos Therapeutics, Inc., a targeted therapeutics company. Prior to the acquisition, Alvos licensed a large platform proprietary human-derived Homing Peptides and the method for their discovery from MD Anderson Cancer Center. The company hired one employee as a result of the acquisition, and the operations of Alvos are being integrated into our research facility in Madison, Wisconsin.

Results of Operations

The Company had a net loss of $22.1 million for the year ended September 30, 2012, compared to a net loss of $3.5 million for the year ended September 30, 2011, an increase of $18.6 million.

Revenues

The Company generated revenue of $147,000 during the year ended September 30, 2012, due to license agreements obtained in conjunction with the acquisition of Roche Madison, as compared to revenue of $296,000 during the year ended September 30, 2011. The revenue in 2011 was primarily related to a qualifying therapeutic discovery grant received by Calando.

Operating Expenses

The analysis below details the operating expenses and discusses the expenditures of the Company within the major expense categories. For purposes of comparison, the amounts for the years ended September 30, 2012 and 2011 are shown in the table below.

Salary & Wage Expenses-Fiscal 2012 compared to Fiscal 2011

The Company employs management, administrative, and scientific and technical staff at its corporate offices and its research facility. Salaries and wages expense consists of salary and related benefits. Salary and benefits include two major categories: general and administrative compensation expense, and research and development compensation expense, based on the primary activities of each employee. The following table provides detail of salary and related benefits expenses for the years ended September 30, 2012 and 2011.

(in thousands)

                              Twelve months           % of            Twelve months           % of
                                  Ended              Expense              Ended              Expense         Increase (Decrease)
                            September 30, 2012      Category        September 30, 2011      Category            $              %
G&A-compensation-related   $              3,107            48 %    $              1,144            81 %    $     1,963          172 %
R&D-compensation-related                  3,308            52 %                     264            19 %          3,044         1153 %

Total                      $              6,415           100 %    $              1,408           100 %    $     5,007          356 %

During the year ended September 30, 2012, G&A compensation expense increased $1,963,000. During the fiscal year, upon the acquisition of Roche Madison, the Company expanded its senior management team. Its G&A headcount also increased due to several Madison employees classified as G&A. During the year ended September 30, 2012, R&D compensation expense increased $3,044,000. This increase was due to employees hired upon the acquisition of Roche Madison.

General & Administrative Expenses-Fiscal 2012 compared to Fiscal 2011

The following table provides details of our general and administrative expenses for the fiscal years 2012 and 2011.

(in thousands)

                                              Twelve months             % of              Twelve months             % of
                                                  Ended                Expense                Ended                Expense            Increase (Decrease)
                                            September 30, 2012        Category          September 30, 2011        Category              $                %
Professional/outside services              $              1,800              28 %      $              2,383              63 %      $      (583 )         -24 %
Patent expense                                            1,024              16 %                       604              16 %              420            70 %
Facilities and related                                      120               2 %                       168               4 %              (48 )         -29 %
Travel                                                      369               6 %                       201               5 %              168            84 %
Business insurance                                          202               3 %                       194               5 %                8             4 %
Communication and Technology                                196               3 %                        96               3 %              100           104 %
Office expenses                                              91               1 %                        54               1 %               37            69 %
Other                                                     2,637              41 %                        95               3 %            2,542            NM

Total                                      $              6,439             100 %      $              3,795             100 %      $     2,644            70 %

Professional/outside services include legal, accounting and other outside services retained by Arrowhead and its subsidiaries. All periods include normally occurring legal and accounting expenses related to SEC compliance and other corporate matters. Professional/outside services expense was $1,800,000 during the year ended September 30, 2012, compared to $2,383,000 in the comparable prior period. In the prior period, the Company recorded expenses of $663,000 related to stock issued for financing commitments in association with the September 2011 financing in conjunction with the acquisition of Roche Madison, Inc.

Facilities and related expense was $120,000 during the year ended September 30, 2012, compared to $168,000 in the comparable prior period. Facilities and related expense within general and administrative expenses primarily relate to rental costs associated with the Company's headquarters in Pasadena, California. Facilities expense decreased due to reduction in the company's rental expense because its lease for its corporate headquarters expired. During most of fiscal 2012, the Company occupied smaller and less expensive office space. In August 2012, the Company moved into a new facility. Its rental costs in fiscal 2013 are expected to increase relative to the temporary space occupied in 2012.

Travel expense was $369,000 during the year ended September 30, 2012, compared to $201,000 in the comparable prior period. Travel expense increased due to travel associated with the acquisition of Roche Madison Inc., as well as additional travel costs related to Madison-based employees. During fiscal 2012, the Company hired a Chief Operating Officer and a Chief Business Officer, whose job functions require travel. Also, travel costs are expected to increase in the future due to increased travel between the Madison and Pasadena locations. Travel expense includes costs related to travel by Company personnel for operational business meetings at other company locations, business initiatives and collaborations throughout the world with other companies, marketing, investor relations, fund raising and public relations purposes. Travel expenses can fluctuate from quarter to quarter and from year to year depending on current projects and activities.

Business insurance expense was $202,000 during the year ended September 30, 2012, compared to $194,000 in the comparable prior period. The company experienced favorable rate decreases in its Directors and Officers insurance coverage, which was offset by additional insurance costs associated with Madison.

Communication and technology expense was $196,000 during the year ended September 30, 2012, compared to $96,000 in the comparable prior period. The increase was related to software maintenance costs at Madison, primarily desk top software and license renewal fees on software related to the operation of laboratory equipment.

Office expenses are administrative costs to facilitate the operations of the Company's office facilities in Pasadena and Madison, and include office supplies, copier/printing costs, postage/delivery, professional dues/memberships, books/subscriptions, staff amenities, and professional training. Office expenses were $91,000 during the year ended September 30, 2012, compared to $54,000 in the comparable prior period. The increase in office expenses was related to costs incurred at its newly acquired Madison facility.

Other expense was $2.6 million during the year ended September 30, 2012 compared to $95,000 in the comparable prior period. During the year ended September 30, 2012, the Company recorded reserves against receivable from its unconsolidated affiliates, Nanotope and Leonardo in the amount of $2.5 million.

Research and Development Expenses-Fiscal 2012 compared to Fiscal 2011

R&D expenses are related to the Company's on-going research and development efforts, primarily related to its laboratory research facility in Madison, Wisconsin, and also include outsourced R&D services. The following table provides detail of research and development expense for the years ended September 30, 2012 and 2011.

                                          Twelve months            % of             Twelve months            % of
                                              Ended               Expense               Ended               Expense           Increase (Decrease)
                                        September 30, 2012       Category         September 30, 2011       Category             $               %
Outside labs & contract services       $              1,096             20 %     $                605             19 %     $       491            81 %
In vivo studies                                         302              6 %                       29              1 %             273           941 %
Drug Manufacturing                                    1,256             23 %                       68              2 %           1,188          1747 %
Consulting                                              655             12 %                      440             13 %             215            49 %
License, royalty & milestones                           274              5 %                    2,045             63 %          (1,771 )         -87 %
Laboratory supplies & services                          793             15 %                        2              0 %             791            NM
Facilities and related                                  787             15 %                        8              0 %             779            NM
Sponsored research                                      185              3 %                       75              2 %             110           147 %
Other research expenses                                  43              1 %                        6              0 %              37           617 %

Total                                  $              5,391            100 %     $              3,278            100 %     $     2,113            64 %

Outside lab and services expense was $1,096,000 during the year ended September 30, 2012, compared to $605,000 in the comparable prior period. The increase is due to outside services contracted to complement the research performed at our Madison facility, which was acquired in October 2012, and not part of the prior period expenses.

In vivo studies expense was $302,000 during the year ended September 30, 2012, compared to 29,000 in the comparable prior period. The current period expense relates to preclinical animal studies at our Madison research facility, and we expect this increased level of expense for such studies to continue at an elevated level as the company accelerates its product development efforts. The prior period expense related to certain limited outsourced in vivo studies related to Calando.

Drug manufacturing expense was $1,256,000 during the year ended September 30, 2012, compared to $68,000 in the comparable prior period. Approximately half of the drug manufacturing expense related to raw materials, specifically, polymer components for RONDEL. Prior year costs for this program were $68,000. The other half of the drug manufacturing costs relate to our manufacturing campaign related to the Company's Hepatitis B Virus (HBV) program, which began in the fourth quarter of fiscal 2012, for use in upcoming GLP toxicity studies planned in the first half of fiscal 2013. The Company is utilizing outside manufacturers to produce these components; these costs will continue until the manufacturing campaign is completed in 2013.

Consulting expense was $655,000 during the year ended September 30, 2012, compared to $440,000 in the comparable prior period. The increase in consulting expense was primarily related to fees paid to our consultants monitoring our clinical trial at Calando, as well as clinical consulting costs for a planned clinical trial in HBV, as well as higher costs associated with the scientific advisory board at Ablaris.

License, royalty & milestone expense was $274,000 during the year ended September 30, 2012, compared to $2,045,000 in the comparable prior period. The licensing fees, royalty and milestones expenses during the prior year reflect a one-time to $2 million in licensing fees paid to University of Texas M.D. Anderson Cancer Center for the anti-obesity compound licensed by Ablaris. The current year expense also relates to Ablaris and was payable to the University of Texas M.D. Anderson Cancer Center related to a milestone achieved by dosing its first patient in an obesity/prostate cancer clinical trial.

Stock-based compensation expense

Stock-based compensation expense, a noncash expense, was $1,241,000 during the year ended September 30, 2012, compared to $1,376,000 during the comparable prior period. Stock-based compensation expense is based upon the valuation of stock options granted to employees, directors, and certain consultants. Many variables affect the amount expensed, including the Company's stock price on the date of the grant, as well as other assumptions. Based on the completion of vesting of a number of stock options during the second half of fiscal 2011, compensation expense related to those awards ended. This was mostly offset by additional options granted to new and existing employees in fiscal 2012.

Depreciation and amortization expense

Depreciation and amortization expense, a noncash expense, was $1,749,000 during . . .