3. Fair Value Measurements

FASB accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (the exit price) in an orderly transaction between market participants at the measurement date. The accounting guidance outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures. In determining fair value, we use quoted prices and observable inputs. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources.

The fair value hierarchy is broken down into three levels based on the source of inputs as follows:

Level 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 — Valuations based on observable inputs and quoted prices in active markets for similar assets and liabilities.

Level 3 — Valuations based on inputs that are unobservable and models that are significant to the overall fair value measurement.

The following fair value hierarchy table presents information about each major category of our financial assets and liabilities measured at fair value on a recurring basis:


	Level 1		Level 2		Level 3		Total
December 31, 2015
Assets
Money market funds (cash equivalents)	$	12,243,104	$	—	$	—	$	12,243,104
Short-term investments		—		5,106,627		—		5,106,627
Total assets	$	12,243,104	$	5,106,627	$	—	$	17,349,731
Liabilities
Interest make-whole derivative		—		—	$	55,000	$	55,000
Shape contingent consideration		—		—		21,080,000		21,080,000
Common stock warrant liability		—		—		64,877		64,877
Total liabilities	$	—	$	—	$	21,199,877	$	21,199,877
June 30, 2016
Assets
Money market funds (cash equivalents)	$	7,429,658	$	—	$	—	$	7,429,658
Total assets	$	7,429,658	$	—	$	—	$	7,429,658
Liabilities
Interest make-whole derivative		—		—	$	42,000	$	42,000
Shape contingent consideration		—		—		23,242,000		23,242,000
Common stock warrant liability		—		—		4,716		4,716
Total liabilities	$	—	$	—	$	23,288,716	$	23,288,716

In 2009 and 2010, we issued warrants to purchase our common stock, or the 2009/2010 Warrants, which contain a provision whereby the exercise price may be reduced upon the occurrence of certain events within our control, such as the future issuance of equity securities or rights to purchase equity securities at a price below the current exercise price of the 2009/2010 Warrants. Accordingly, the 2009/2010 Warrants are recorded as a derivative liability on our balance sheets, with subsequent changes to fair value recorded through earnings at each reporting period on our statements of operations and comprehensive loss as change in fair value of derivative liabilities. Each subsequent change in fair value is reflected in our statements of cash flows as a noncash adjustment to net loss under operating activities. Upon exercise of these warrants, the cash inflow is recorded as a financing activity on the statements of cash flows. The fair value of each 2009/2010 Warrant is estimated using an option-pricing model, which requires inputs such as the expected volatility based on comparable public companies (75%), the fair value of the common stock, and the remaining contractual term of the warrant (3.3 to 3.7 years). For this liability, we developed our own assumptions that do not have observable inputs or available market data to support the fair value.

Significant decreases in our stock price volatility will significantly decrease the overall valuation of our derivative liabilities, while significant increases in our stock price volatility will significantly increase the overall valuation. As discussed above, the strike price of our 2009/2010 Warrants may be decreased. Accordingly, a significant decrease in the strike price of the 2009/2010 Warrants will substantially increase the overall valuation. In addition, changes in the market price of our common stock will have a significant effect on the overall valuation of the warrant liabilities.

In April 2014, we acquired by merger 100% of Shape Pharmaceuticals. The acquisition of Shape Pharmaceuticals includes a contingent consideration arrangement that may require us to pay additional consideration in the form of milestone payments and tiered royalty payments upon commercialization. We account for contingent consideration in accordance with applicable guidance provided within Accounting Standards Codification (ASC) 805, Business Combinations. It is currently estimated that the Shape Pharmaceuticals milestone payments will occur between mid-2017 and 2021. The range of undiscounted milestones we could be required to pay under our agreement is between zero and $64.5 million. The current and non-current potions of the contingent consideration liability are based upon the timing of when the Company anticipates achieving the various milestones associated with the arrangement, one of which is expected to be achieved within a year. We determined the fair value of the liability for the contingent consideration based on a probability-weighted discounted cash flow analysis. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy. The fair value of the contingent consideration liability associated with future milestone payments was based on several factors including:

estimated cash flows projected from the success of unapproved product candidates in the U.S. and ROW;

the probability of success for product candidates including risks associated with uncertainty, achievement and payment of milestone events;

the time and resources needed to complete the development and approval of product candidates;

the life of the potential commercialized products and associated risks of obtaining regulatory approvals in the U.S. and ROW;

the risk adjusted discount rate for fair value measurement; and

the credit risk of TetraLogic.

In June 2014, we issued $47.0 million in aggregate principal amount of 8.00% convertible senior notes due June 15, 2019 (the “8% Notes”), of which $43.75 million are outstanding at June 30, 2016. The 8% Notes include an interest make-whole feature whereby if a note holder converts any of the Notes after December 31, 2014, they are entitled, in addition to the other consideration payable or deliverable in connection with such conversion, to an interest make-whole payment through the earlier of (i) the date that is three years after the conversion date and (ii) the maturity date if the notes had not been so converted. We have determined that this feature is an embedded derivative and have recognized the fair value of this derivative as a liability in our balance sheet, with subsequent changes to fair value recorded through earnings at each reporting period on our statements of operations and comprehensive loss as change in fair value of derivative liabilities. The fair value of this embedded derivative was determined based on a binomial lattice model.

The following tables set forth a summary of changes in the fair value of Level 3 liabilities for the six months ended June 30, 2015 and 2016:


	December 31,								Change in		June 30,
	2014		Additions		Deductions		Conversions		Fair Value		2015
Interest make-whole derivative	$	2,400,000	$	—		—		(165,957)	$	(1,484,043)	$	750,000
Shape contingent consideration		31,491,686		—	$	—		—		2,129,000		33,620,686
Common stock warrant liability		256,027		—		—	$	—		(158,180)		97,847
Total liabilities	$	34,147,713	$	—	$	—	$	—	$	486,777	$	34,468,533


	December 31,								Change in		June 30,
	2015		Additions		Deductions		Conversions		Fair Value		2016
Interest make-whole derivative	$	55,000		—		—	$	—	$	(13,000)	$	42,000
Shape contingent consideration		21,080,000		—		—		—		2,162,000		23,242,000
Common stock warrant liability		64,877		—		—		—		(60,161)		4,716
Total liabilities	$	21,199,877	$	—	$	—	$	—	$	2,088,839	$	23,288,716

As of June 30, 2016, the fair value and carrying value of our convertible debt was as follows:


	Fair Value		Carrying Value		Face Value

8.00% convertible senior notes due June 15, 2019	$	11,366,000	$	29,925,203	$	43,750,000

The fair value shown above represents the fair value of the total debt instrument, inclusive of both the liability and equity components, while the carrying value represents the carrying value of the liability. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy. The fair value of the total debt instrument was based on several factors including the terms of the instrument, our common stock price at the valuation date, the expected stock price volatility, the remaining term of the convertible notes, and the risk-free interest rate.