Note 4. Fair value of financial instruments

The Company records financial assets and liabilities at fair value. The carrying amounts of certain financial assets and liabilities including cash and cash equivalents, accounts receivable, other current assets, accounts payable, accrued liabilities and deferred revenue, approximated their fair value due to their short maturities. The remaining financial instruments were reported on the Company’s consolidated balance sheets at amounts that approximate current fair values based on market based assumptions and inputs.

As a basis for categorizing inputs, the Company uses a three tier fair value hierarchy, which prioritizes the inputs used to measure fair value from market based assumptions to entity specific assumptions as follows:

Level 1: Unadjusted quoted prices for identical assets in an active market.

Level 2: Quoted prices in markets that are not active or inputs that are observable either directly or indirectly for substantially the full-term of the asset.

Level 3: Prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. They reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset.

The following table presents the hierarchy for the Company’s financial instruments measured at fair value on a recurring basis for the indicated dates:


		Fair Value as of December 31, 2018
	Level 1		Level 2		Level 3		Total
		(in thousands)
Cash and cash equivalents	$	27,419	$	19,059	$	—	$	46,478
Total financial assets	$	27,419	$	19,059	$	—	$	46,478
Earnout liability	$	—	$	—	$	37	$	37
Derivative liability (see Note 11)		—		—		2,017		2,017
Total financial liabilities	$	—	$	—	$	2,054	$	2,054


	Fair Value as of December 31, 2017
	Level 1		Level 2		Level 3		Total
	(in thousands)
Cash and cash equivalents	$	31,969	$	—	$	—	$	31,969
Short-term investments		—		18,448		—		18,448
Total financial assets	$	31,969	$	18,448	$	—	$	50,417
Earnout liability	$	—	$	—	$	170	$	170
Derivative liability (see Note 11)		—		—		1,660		1,660
Total financial liabilities	$	—	$	—	$	1,830	$	1,830

The Company’s Level 1 assets included bank deposits, certificates of deposit and actively traded money market funds with an original maturity of 90 days or less at December 31, 2018 and 2017. Asset values were considered to approximate fair value due to their short-term nature.

The Company’s Level 2 assets included commercial paper and corporate bonds with maturities of less than one year that are not actively traded which were classified as available-for-sale securities. The level 2 cash equivalents consist of U.S. agency bonds and corporate commercial paper that mature in less than 90 days which are valued using quoted prices and other data values. The estimated fair values of these securities were determined by third parties using valuation techniques that incorporate standard observable inputs and assumptions such as quoted prices for similar assets, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, benchmark securities, bids/offers and other pertinent reference data.

The Company’s cash and cash equivalents and short-term investments had quoted prices at December 31, 2018 and 2017 as shown below:


	December 31, 2018
	Amortized		Unrealized		Market
	Cost		Loss		Value
	(in thousands)
Bank deposits and money market funds	$	27,419	$	—	$	27,419
Financial and corporate debt securities		19,059		—		19,059
	$	46,478	$	—	$	46,478


	December 31, 2017
	Amortized		Unrealized		Market
	Cost		Loss		Value
	(in thousands)
Bank deposits and money market funds	$	31,969	$	—	$	31,969
Financial and corporate debt securities		18,454		(6)		18,448
	$	50,423	$	(6)	$	50,417

The Company’s Level 3 liability included the fair value of the earnout liability and the fair value of the Deerfield Private Design Fund III, L.P. and Deerfield Special Situations Fund, L.P. derivative liability at December 31, 2018 and 2017.

The fair value of the earnout liability was determined after taking into consideration valuations using the Monte Carlo method based on assumptions at December 31, 2017 and revised at December 31, 2018. These revisions were primarily due to an updated revenue forecast for the Company’s generic Tussionex and the use of a directly-calculated revenue volatility of 42% based on data for potential comparable publicly-traded companies in the generic drug manufacturing space including the Company, whereas previously an unlevered equity volatility of 50% had been selected. Significant changes to these assumptions would result in increases/decreases to the fair value of the earnout liability. The methodologies and significant inputs used in the determination of the fair value of the earnout liability were as follows:


	December 31, 2018	December 31, 2017
	Earnout Liability	Earnout Liability
Date of Valuation	12/31/2018	12/31/2017
Valuation Method	Monte Carlo	Monte Carlo
Volatility (annual)	42%	42%
Risk‑free rate (annual)	2.53% - 3.29%	1.62% ‑ 2.88%
Time period from valuation until end of earnout	.5 ‑ 9.5	.5 ‑ 9.5
Earnout Target 1 (thousands)	$13,700	$13,700
Earnout Target 2 (thousands)	$18,200	$18,200
Discount rate	21.35% - 21.68%	14.72% ‑ 15.98%
Fair value of liability at valuation date (thousands)	$37	$170

The fair value of the derivative liability was determined after taking into consideration valuations using the Monte Carlo method based on assumptions at December 31, 2018 and 2017. There were no significant changes in the pricing assumptions during the year ended December 31, 2018. The methodologies and significant inputs used in the determination of the fair value of the debt derivative liability were as follows:


	Derivative Liability
Date of Valuation	12/31/2018	12/31/2017
Valuation Method	Monte Carlo	Monte Carlo
Volatility (annual)	N/A	N/A
Time period from valuation until maturity of debt (yrs.)	3.4	4.4
Cumulative probability of a change in control prepayment implied by model	25.1%	27%
Cumulative probability of other accelerated prepayments implied by model	13.7%	17%
Discount rate	23.12%	16.20%
Fair value of liability at valuation date (thousands)	$2,017	$1,660

Significant changes to these assumptions in the preceding valuation tables would result in increases/decreases to the fair value of the earnout liability and derivative liability.

Changes in Level 3 liabilities measured at fair value for the periods indicated were as follows:


	Level 3
	Liabilities
	(in thousands)
Balance at December 31, 2016	$	232
Addition of Deerfield derivative liability		2,107
Change in fair value		(509)
Balance at December 31, 2017		1,830
Change in fair value		224
Balance at December 31, 2018	$	2,054