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 and accrued liabilities, approximated their fair value due to their short-term 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, 2019
	Level 1		Level 2		Level 3		Total
	(in thousands)
Cash and cash equivalents	$	12,338	$	4,492	$	—	$	16,830
Short-term investments		1,261		6,803		—		8,064
Total financial assets	$	13,599	$	11,295	$	—	$	24,894
Earnout liability	$	—	$	—	$	30	$	30
Derivative liabilities (see Note 11)		—		—		1,135		1,135
Total financial liabilities	$	—	$	—	$	1,165	$	1,165


	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

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, 2019 and 2018. 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, 2019 and 2018 as shown below:


	December 31, 2019
	Amortized		Unrealized		Market
	Cost		Gain / (Loss)		Value
		(in thousands)
Bank deposits and money market funds	$	13,599	$	—	$	13,599
Financial and corporate debt securities		11,294		1		11,295
	$	24,893	$	1	$	24,894


	December 31, 2018
	Amortized		Unrealized		Market
	Cost		Gain / (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

The Company’s Level 3 liabilities included the fair value of the earnout liability and the fair values of the Encina and Deerfield derivative liabilities at December 31, 2019. As of December 31, 2018, the Company’s Level-3 liabilities included the fair value of the earnout liability and the fair value of the Deerfield derivative liability.

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, 2018 and revised at December 31, 2019. 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 36% based on data for potential comparable publicly-traded companies in the generic drug manufacturing space including the Company at December 31, 2019, versus a similarly directly-calculated revenue volatility of 42% at December 31, 2018. 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:



	Earnout Liability
Date of Valuation		12/31/2019		12/31/2018
Valuation Method		Monte Carlo		Monte Carlo
Volatility (annual)		36%		42%
Risk‑free rate (annual)		1.53% - 2.58%		2.53% - 3.29%
Time period from valuation until end of earnout		0.5 ‑ 9.5		0.5 ‑ 9.5
Earnout Target 1 (thousands)	$	13,700	$	13,700
Earnout Target 2 (thousands)	$	18,200	$	18,200
Discount rate		22.88% - 23.35%		21.35% - 21.68%
Fair value of liability at valuation date (thousands)	$	30	$	37

The fair value of the Encina derivative liability was determined after taking into consideration valuations using the Probability Weighted Discounted Cash Flow method based on assumptions at the initial valuation date of October 2, 2019 and at December 31, 2019. The fair value of the Deerfield derivative liability was determined after taking into consideration valuations using the Monte Carlo method based on assumptions at December 31, 2019 and 2018. The methodologies and significant inputs used in the determination of the fair value of the debt derivative liabilities were as follows:


	Encina Derivative Liability						Deerfield Derivative Liability
Date of Valuation		12/31/2019			10/02/2019			12/31/2019			12/31/2018
Valuation Method		Discounted Cash Flow			Discounted Cash Flow			Monte Carlo			Monte Carlo
Volatility (annual)		N/A			N/A			N/A			N/A
Time period from valuation until maturity of debt (yrs.)		2.4			2.6			2.4			3.4
Cumulative probability of a change in control prepayment implied by model		23.9	%		24.7	%		23	%		25.1	%
Cumulative probability of other accelerated prepayments implied by model		N/A			N/A			10	%		13.7	%
Discount rate		6.0	%		6.0	%		25.34	%		23.12	%
Fair value of liability at valuation date (thousands)	$	66		$	69		$	1,069		$	2,017

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

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, 2017		1,830
Change in fair value		224
Balance at December 31, 2018		2,054
Addition of Encina derivative liability		69
Change in fair value		(958)
Balance at December 31, 2019	$	1,165