Fair value of financial instruments

6 Months Ended

Jun. 30, 2015

Note 5. Fair value of financial instruments

Financial instruments are categorized into a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the categorization of the financial instrument is based on the lowest priority level input that is significant to the fair value measurement of the instrument.

Financial assets recorded at fair value on the Company’s consolidated balance sheets are categorized 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 2 inputs include the following:

Quoted prices for similar assets in active markets.

Quoted prices for identical or similar assets in nonactive markets.

Inputs other than quoted market prices that are observable.

Inputs that are derived principally from or corroborated by observable market data through correlation or other means.

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, 2014
	Level 1		Level 2		Level 3		Total
	(in thousands)

Cash and cash equivalents	$	13,343	$	—	$	—	$	13,343
Short term investments	3,000		—		—		3,000
Earnout liability	—		—		756		756
Series C Redeemable Preferred Stock Warrants	—		—		1,789		1,789

	$	16,343	$	—	$	2,545	$	18,888

	Fair Value as of June 30, 2015
	Level 1		Level 2		Level 3		Total
	(in thousands)

Cash and cash equivalents	$	25,631	$	—	$	—	$	25,631
Short term investments	—		—		—		—
Earnout liability	—		—		356		356
Series C Redeemable Preferred Stock Warrants	—		—		3,934		3,934

	$	25,631	$	—	$	4,290	$	29,921

The Company’s Level 1 assets include bank deposits, U.S. Treasury bills and money market funds with quoted prices in active markets.

Level 3 liabilities include the fair values of the earnout liability and the outstanding warrants to purchase Series C Redeemable Convertible Preferred Stock. Various methodologies were utilized to value the Level 3 liabilities including Black-Scholes, Probability-Weighted Expected Return (“PWERM”), Option Pricing and Monte Carlo. The methodologies and significant inputs used in the determination of the fair value of the Series C Redeemable Convertible Preferred Stock Warrants issued with the senior debt were as follows:

	Revalue Series C		Revalue Series C		Revalue Series C
	Warrants Issued with		Warrants Issued with		Warrants Issued with
	Senior Debt at		Senior Debt at		Senior Debt at
	December 31, 2014		March 31, 2015		June 30, 2015
	(Dollars in thousands, except $5 Exercise Price)

Date of Valuation	12/31/2014		3/31/2015		6/30/2015
Valuation Method	PWERM and Option Pricing		PWERM and Option Pricing		PWERM and Option Pricing
Dividend yield (per share)	0		0		0
Exercise price	$ 5		$ 5		$ 5
Volatility (annual)	60%		60%		60%
Risk-free rate (annual)	.25% - 2.47%		.19% - 2.31%		.14% - 2.83%
Contractual term (years)	1 - 5		.75 - 5		.5 - 5
Number of warrants	170,000		170,000		170,000


Fair value of liability at valuation date	$	454	$	486	$	573

The methodologies and significant inputs used in the determination of the fair value of the Series C Redeemable Convertible Preferred Stock Warrants issued with the Series C Redeemable Preferred Stock were as follows:

	Initial Valuation of
	December 31, 2014	Initial Valuation	Initial Valuation	Revalue All Warrants	Revalue All Warrants
	Warrants Issued	of January 2015	of February 2015	Issued With Series C	Issued With Series C
	With Series C	Warrants Issued With	Warrants Issued With	Redeemable Preferred	Redeemable Preferred
	Redeemable	Series C Redeemable	Series C Redeemable	Stock at	Stock at
	Preferred Stock	Preferred Stock	Preferred Stock	March 31, 2015	June 30, 2015
	(Dollars in thousands, except $5 Exercise Price)

Date of Valuation	12/31/2014	1/31/2015	2/28/2015	3/31/2015	6/30/2015
Valuation Method	PWERM and Option Pricing	PWERM and Option Pricing	PWERM and Option Pricing	PWERM and Option Pricing	PWERM and Option Pricing
Dividend yield (per share)	0	0	0	0	0
Exercise price	$ 5	$ 5	$ 5	$ 5	$ 5
Volatility (annual)	60%	60%	60%	60%	60%
Risk-free rate (annual)	.25% - 2.47%	.25% - 2.47%	.25% - 2.47%	.19% - 2.31%	.14% - 2.83%
Contractual term (years)	1 - 5	1 - 5	1 - 5	.75 - 5	.5 - 5
Number of warrants	749,967	590,906	606,312	1,947,185	1,797,185

Fair value of liability at valuation date	$ 1,335	$ 1,052	$ 1,079	$ 3,233	$ 3,361

The methodologies and significant inputs used in the determination of the fair value of the earnout liability were as follows:

	December 31, 2014		March 31, 2015		June 30, 2015
	Earnout Liability		Earnout Liability		Earnout Liability
	(Dollars in thousands)

Date of Valuation	12/31/2014		3/31/2015		6/30/2015
Valuation Method	Monte Carlo		Monte Carlo		Monte Carlo
Volatility (annual)	50%		50%		50%
Risk-free rate (annual)	.15% - 3.21%		.14% - 3.00%		.09% - 3.51%
Time period from valuation until end of earnout	.5 - 9.5		.375 - 9.375		.25 - 9.0
Earnout Target 1	$	13,700	$	13,700	$	13,700
Earnout Target 2	$	18,200	$	18,200	$	18,200
Discount rate	7.96% - 11.03%		8.18% - 11.04%		7.96% - 11.39%

Fair value of liability at valuation date	$	756	$	314	$	356

Significant changes to these assumptions would result in increases/decreases to the fair value of the outstanding warrants to purchase Series C Redeemable Convertible Preferred Stock and the earnout liability.

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

				Series C Warrants		Series C Warrants Issued
	Earnout			Issued With		With Series C Redeemable
	Liability			Senior Debt		Preferred Stock Financing
	(in thousands)

Balance at December 31, 2014	$	756		$	454	$	1,335
Additions during the period	—			—		2,131
Changes in fair value	(400		)	119		176
Warrants exercised	—			—		(281		)


Balance at June 30, 2015	$	356		$	573	$	3,361

The reductions in fair value of the earnout liability shown above resulted from new information regarding the projected impact of the U.S. DEA’s reclassification of Tussionex from a Schedule III controlled substance to a Schedule II controlled substance and a review of the launch dates of the Company’s three ADHD product candidates. The increases in the fair value of the Series C warrants were due to the increased PWERM weighting of the IPO scenario.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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