NOTE 3 — COLLABORATION ARRANGEMENTS

On February 2, 2012, the Company entered into a global license and co-development agreement with Merck KGaA, of Darmstadt, Germany, to co-develop and commercialize TH-302, the Company’s small molecule hypoxia-targeted drug. Under the terms of the agreement, Merck will receive co-development rights, exclusive global commercialization rights and will provide the Company an option to co-commercialize TH-302 in the United States. The Company received an upfront payment of $25 million. The Company has also earned another $42.5 million in milestone payments, including a $10 million milestone payment earned subsequent to the quarter ended September 30, 2012. The $20 million milestone payment based on positive results from its randomized Phase 2 trial in pancreatic cancer was received during the quarter ended June 30, 2012 and the remaining $22.5 million is expected during the fourth quarter of 2012. The milestones earned to date were not deemed to be substantive milestones because the work related to the achievement of these items was predominately completed prior to the inception of the arrangement. The Company is eligible to earn additional potential milestone payments of up to $142.5 million in regulatory and development milestones and $340 million in commercialization milestones. The Company could receive an additional $42.5 million of the regulatory and development milestones in the near term.

In the United States, the Company will have primary responsibility for development of TH-302 in the soft tissue sarcoma indication. The Company and Merck KGaA will jointly develop TH-302 in all other cancer indications being pursued. Merck KGaA will pay 70% of worldwide development expenses for TH-302. Subject to FDA approval in the United States, Merck KGaA will initially be responsible for commercialization of TH-302 with the Company receiving a tiered, double-digit royalty on sales. Under the royalty-bearing portion of the agreement, Threshold retains the option to co-promote TH-302 in the United States. Additionally, the Company retains the option to co-commercialize TH-302, upon the achievement of certain sales and regulatory milestones, allowing the Company to participate in up to 50% of the profits in the United States depending on total sales. Outside of the United States, Merck KGaA will be solely responsible for the commercialization of TH-302 with the Company receiving a tiered, double-digit royalty on sales in these territories. The agreement became effective on March 12, 2012, upon termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. The agreement will continue on a country-by-country basis until the later of the last to expire patent covering TH-302 in such country or ten years following the commercial launch of a product containing TH-302 in such country, unless terminated earlier. Merck has the right to terminate the agreement after the achievement of certain milestones, and each party has the right to terminate the agreement following an uncured material breach by the other party.

The Company’s deliverables under the Merck agreement, which include delivery of the rights and license for TH-302 and performance of research and development activities, have been determined to be a single unit of accounting. The delivered license does not have standalone value at the inception of the arrangement due to the Company’s proprietary expertise with respect to the licensed compound and related ongoing developmental participation under the global license and co-development agreement, which is required for Merck to fully realize the value from the delivered license. Therefore, the revenue relating to this unit of accounting will be recorded as deferred revenue and recognized over the estimated performance period under the agreement, which is the product development period. The Company recorded the upfront payment and milestones earned as deferred revenue and is amortizing them ratably over its estimated period of performance. As a result, the Company recognized $1.8 million and $3.8 million of revenue for the three months and nine months ended September 30, 2012, respectively. The Company will periodically review and, if necessary, revise the estimated periods of performance of our collaboration. The Company also earned a $5.0 million and $10.0 million reimbursement for eligible worldwide development expenses for TH-302 from Merck during the three and nine months ended September 30, 2012, respectively. Such earned reimbursement has been reflected as a reduction of operating expenses.

Of the remaining potential future milestones, $142.5 million are related to development and regulatory milestones and $340 million are related to commercialization milestones that may be received under the Merck Agreement. Development milestones in the agreement include primarily the initiation of various phases of clinical trials. Regulatory milestones include the filing and acceptance of regulatory applications for marketing approval in major markets. Commercialization milestones include the achievement of first commercial sales in a particular market or annual product sales in excess of a pre-specified threshold. At the inception of the collaboration agreement the Company assessed development and regulatory milestones to be substantive where there was substantive scientific and regulatory uncertainty of achievement, the amounts of payments assigned were considered to be commensurate with the enhancement of the value of the delivered rights and license of TH-302 and the Company’s performance is necessary to the achievement of the milestone. Accordingly, the Company will recognize payments related to the achievement of such milestones, if any, when such milestone is achieved. Development and regulatory milestones that do not meet these conditions were considered non-substantive and payments related to the achievement of such milestones, if any, will be recorded as deferred revenue and amortized ratably over the estimated period of performance. Final determination of whether a development or regulatory milestone is substantive will depend upon the Company’s role in achieving the milestone. The specific role and responsibilities related to the development and regulatory activities for certain of these milestones have yet to be determined and may change during the development period. Under the Merck agreement, Merck will initially be responsible for commercialization activities and the Company initially may not be involved in the achievement of these commercialization milestones. These commercialization milestones would typically be achieved after the completion of the Company’s development and regulatory activities. The Company would account for the commercialization milestones in the same manner as royalties, with revenue recognized upon achievement of the milestone.