6. Fair Value of Financial Instruments

The tables below present information about the Company’s assets that are measured at fair value on a recurring basis as of June 30, 2017 and December 31, 2016 and indicate the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize observable inputs such as quoted prices in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are either directly or indirectly observable, such as quoted prices for similar instruments in active markets, interest rates and yield curves. Fair values determined by Level 3 inputs utilize unobservable data points in which there is little or no market data, which require the Company to develop its own assumptions for the asset or liability.

The Company’s investment portfolio includes mainly fixed income securities that do not always trade on a daily basis. As a result, the pricing services used by the Company apply other available information as applicable through processes such as benchmark yields, benchmarking of like securities, sector groupings and matrix pricing to prepare valuations. In addition, model processes are used to assess interest rate impact and develop prepayment scenarios. These models take into consideration relevant credit information, perceived market movements, sector news and economic events. The inputs into these models may include benchmark yields, reported trades, broker-dealer quotes, issuer spreads and other relevant data. The Company validates the prices provided by its third-party pricing services by obtaining market values from other pricing sources and analyzing pricing data in certain instances.

The following tables present the assets and liabilities the Company has measured at fair value on a recurring basis (in thousands):


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	June 30, 2017		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and cash equivalents:
Money market funds	$	90,745	$	90,745	$	—	$	—
U.S. Treasury securities		16,743		16,743		—		—
U.S. government-sponsored securities		62,846		—		62,846		—
Available-for-sale securities:
U.S. Treasury securities		20,490		20,490		—		—
U.S. government-sponsored securities		70,273		—		70,273		—
Convertible Note Hedges		171,880		—		—		171,880
Total assets measured at fair value	$	432,977	$	127,978	$	133,119	$	171,880
Liabilities:
Note Hedge Warrants	$	149,458	$	—	$	—	$	149,458
Contingent Consideration		86,198		—		—		86,198
Total liabilities measured at fair value	$	235,656	$	—	$	—	$	235,656


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	December 31, 2016		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and cash equivalents:
Money market funds	$	32,486	$	32,486	$	—	$	—
Available-for-sale securities:
U.S. Treasury securities		115,021		115,021		—		—
U.S. government-sponsored securities		136,191		—		136,191		—
Convertible Note Hedges		132,521		—		—		132,521
Total assets measured at fair value	$	416,219	$	147,507	$	136,191	$	132,521
Liabilities:
Note Hedge Warrants	$	113,237	$	—	$	—	$	113,237
Contingent Consideration		77,660		—		—		77,660
Total liabilities measured at fair value	$	190,897	$	—	$	—	$	190,897

There were no transfers between fair value measurement levels during the three and six months ended June 30, 2017 or 2016.

Cash equivalents, accounts receivable, related party accounts receivable, prepaid expenses and other current assets, accounts payable, related party accounts payable, accrued expenses and the current portion of capital lease obligations at June 30, 2017 and December 31, 2016 are carried at amounts that approximate fair value due to their short-term maturities.

The non-current portion of the capital lease obligations at December 31, 2016 approximates fair value as it bears interest at a rate approximating a market interest rate.

Convertible Note Hedges and Note Hedge Warrants

The Company’s Convertible Note Hedges and the Note Hedge Warrants are recorded as derivative assets and liabilities, and are classified as Level 3 under the fair value hierarchy. These derivatives are not actively traded and are valued using the Black-Scholes option-pricing model which requires the use of subjective assumptions. Significant inputs used to determine the fair value as of June 30, 2017 included the price per share of the Company’s Class A common stock, time to maturity of the derivative instruments, the strike prices of the derivative instruments, the risk-free interest rate, and the volatility of the Company’s Class A common stock. The Company has not paid and does not anticipate paying cash dividends on its shares of common stock in the foreseeable future; therefore, the expected dividend yield is assumed to be zero. Changes to these inputs could materially affect the valuation of the Convertible Note Hedges and Note Hedge Warrants.

The following inputs were used in the fair market valuation of the Convertible Note Hedges and Note Hedge Warrants as of June 30, 2017 and December 31, 2016:


	Six Months Ended						Year Ended
	June 30,						December 31,
	2017						2016
	Convertible			Note Hedge			Convertible			Note Hedge
	Note Hedges			Warrants			Note Hedges			Warrants
Risk-free interest rate (1)		1.9	%		2.0	%		2.0	%		2.1	%
Time to maturity		5.0			5.5			5.5			6.0
Stock price (2)	$	18.88		$	18.88		$	15.29		$	15.29
Strike price (3)	$	16.58		$	21.50		$	16.58		$	21.50
Common stock volatility (4)		44.5	%		44.2	%		47.4	%		45.8	%
Dividend yield		—	%		—	%		—	%		—	%

(1)

Based on U.S. Treasury yield curve, with terms commensurate with the terms of the Convertible Note Hedges and the Note Hedge Warrants.

(2)

The closing price of the Company’s Class A common stock on the last trading day of the quarter ended June 30, 2017 and December 31, 2016.

(3)

As per the respective agreements for the Convertible Note Hedges and Note Hedge Warrants.

(4)

Selected volatility based on historical volatility of the Company’s Class A common stock.

The Convertible Note Hedges and the Note Hedge Warrants are recorded at fair value at each reporting period and changes in fair value are recorded in other expense, net within the Company’s condensed consolidated statements of operations. Gains and losses for these derivative financial instruments are presented separately in the Company’s condensed consolidated statements of cash flows.

The following table reflects the change in the Company’s Level 3 convertible note derivatives from December 31, 2016 through June 30, 2017 (in thousands):


	Convertible		Note Hedge
	Note Hedges		Warrants
Balance at December 31, 2016	$	132,521	$	(113,237)
Change in fair value, recorded as a component of gain (loss) on derivatives		39,359		(36,221)
Balance at June 30, 2017	$	171,880	$	(149,458)

Contingent Consideration

In connection with the Lesinurad Transaction, the Company recorded a liability of $67.9 million as of the Acquisition Date. This valuation was based on a Monte-Carlo simulation, which includes significant estimates related to probability weighted net cash outflow projections, discounted using a yield curve equivalent to the Company’s credit risk, which was the estimated cost of debt financing for market participants. This estimate represents the probability weighted analysis of expected future milestone and royalty payments based on net sales to be made to AstraZeneca. Changes to these inputs are re-evaluated each reporting period and could materially affect the valuation of the contingent consideration. The estimated fair value of contingent consideration was approximately $86.2 million as of June 30, 2017.

The following table reflects the change in the Company’s Level 3 contingent consideration payable from December 31, 2016 through June 30, 2017 (in thousands):


	Contingent
	Consideration
Fair value at December 31, 2016	$	77,660
Changes in fair value		8,547
Payments/transfers to accrued expenses and other current liabilities		(9)
Fair value at June 30, 2017	$	86,198

11% PhaRMA Notes

In January 2013, the Company closed a private placement of $175.0 million in aggregate principal amount of the PhaRMA Notes. The outstanding principal balance of the PhaRMA Notes was redeemed in January 2017. The estimated fair value of the PhaRMA Notes was approximately $134.9 million as of December 31, 2016 and was determined using Level 3 inputs, including a quoted rate.

2.25% Convertible Senior Notes

In June 2015, the Company issued approximately $335.7 million of its 2022 Notes. The Company separately accounted for the liability and equity components of the 2022 Notes by allocating the proceeds between the liability component and equity component (Note 10). The fair value of the 2022 Notes, which differs from their carrying value, is influenced by interest rates, the price of the Company’s Class A common stock and the volatility thereof, and the prices for the 2022 Notes observed in market trading, which are Level 2 inputs. The estimated fair value of the 2022 Notes was approximately $450.5 million and approximately $384.2 million as of June 30, 2017 and December 31, 2016, respectively.

8.375% Notes Due 2026

In September 2016, the Company closed a direct private placement pursuant to which the Company issued $150.0 million in aggregate principal amount of the 2026 Notes in January 2017. The estimated fair value of the 2026 Notes was approximately $155.8 million as of June 30, 2017. This valuation was calculated using a discounted cash flow estimate of expected interest and principal payments and was determined using Level 3 inputs, including significant estimates related to expected LINZESS sales and a discount rate equivalent to market participant interest rates.