8. Financial Instruments

Success Fee

In October 2011, an executive officer and member of Kadmon Holdings, LLC issued an equity instrument for which the underlying value is based on 536,065 Class A units. The intrinsic value of the instrument is redeemable for cash upon certain defined liquidity or distribution events (“Success Fee”).

Upon consummation of the Company’s IPO on August 1, 2016 with a price per share of $12.00 per share, the fair value of this equity instrument had a fair value of $0, which resulted in no Success Fee owed by the Company. As a result of marking to market this instrument, the Company recorded ($0.1) million and ($0.2) million to change in fair value of financial instruments for the years ended December 31, 2016 and 2015, respectively.

As there were no quoted prices for identical or similar instruments prior to the IPO, the Company had utilized a Black‑Scholes calculation to value this instrument at December 31, 2015, with the following assumptions: risk-free interest rate of 0.49%, expected term of 0.5 years, expected volatility of 79.2%, unit price of $32.50. strike price of $74.17 and a dividend rate of 0%.

Equity issued pursuant to Credit Agreements

In connection with the incurrence of the Senior Convertible Term Loan, the Company issued three tranches of warrants as fees to the lenders that were redeemable for Class A units. The change in fair value of the warrants was ($0.2) million and ($1.3) million for the years ended December 31, 2016 and 2015, respectively. Upon consummation of the Company’s IPO on August 1, 2016 with a price per share of common stock in the IPO of $12.00, the warrants to purchase Class A units issued to lenders in the Senior Convertible Term Loan were exchanged for 351,992 warrants with a strike price of $10.20 per share to purchase the same number of shares of the Company’s common stock. Since the strike price was determined at IPO, the aggregate fair value of these warrants totaling $1.7 million was reclassified from liability to equity upon consummation of the Company’s IPO in August 2016.

At December 31, 2015 the Company utilized a binomial model to measure all three warrant tranches. Due to the uncertainty of the strike price of the warrants, the Company performed each calculation multiple times using a weighted number of units exercisable based on the Company’s best estimate of how many units would be issuable. The inputs used in the calculations to measure all three warrant tranches at December 31, 2015 are as follows: risk-free interest rate of 0.49%, expected term of 0.5 years, expected volatility of 79.2%, unit price of $32.50. strike price of $61.75 and a dividend rate of 0%.

In connection with the 2015 Credit Agreement, the Company issued warrants as fees to the lenders to purchase an aggregate of $6.3 million of the Company’s Class A units. The strike price of the warrants was 85% of the price per unit in an IPO or, if before an IPO, 85% of the deemed per unit equity value as defined in the 2015 Credit Agreement. The warrants were exercisable as of the earlier of an IPO or July 1, 2016. Prior to the Third Amendment, these warrants were redeemable at the option of the holder after the 51st month from the issue date and were recorded as a non-current liability of $3.3 million at December 31, 2016. Since these warrants are now redeemable at the option of the holder upon the occurrence of, and during the continuance of, an event of default, they are recorded as a liability of $1.2 million at December 31, 2017. Upon entry into the agreement in August 2015, the warrants issued to an existing lender was recorded to loss on extinguishment of debt of $0.9 million and the warrants issued to the new lender was recorded as a debt discount of $5.4 million and will be amortized over the three year term (Note 7) in accordance with ASC 470. As a result of the Third Amendment, $0.9 million was recorded as a debt premium and will be amortized to interest expense over the remaining term of the agreement as the Third Amendment was deemed to be a modification in accordance with ASC 470. The Company used the Black-Scholes pricing model to value the warrant liability at December 31, 2017 with the following assumptions: risk-free interest rate of 2.20%, expected term of 4.66 years, expected volatility of 74.9% and a dividend rate of 0%.

Upon consummation of the Company’s IPO on August 1, 2016 with a price per share of common stock in the IPO of $12.00, the warrants to purchase Class A units issued to lenders under the 2015 Credit Agreement were exchanged for 617,651 warrants with a strike price of $10.20 per share to purchase the same number of shares of the Company’s common stock. The decline in fair value of the warrants was $(1.1) million and $(4.3) million for the years ended December 31, 2017 and 2016, while there was no change in fair value of financial instruments for the year ended December 31, 2015. None of these instruments have been exercised at December 31, 2017 or December 31, 2016. At December 31, 2017, the fair value of the warrant liability was approximately $1.2 million and is recorded as a short-term liability since the redemption feature of the warrant terminates upon the current maturity of the 2015 credit agreement on June 17, 2018.

Other Warrants

On April 16, 2013, the Company issued warrants with an estimated fair value of $1.4 million for the purchase of 30,000 Class A units at a strike price of $21.24 as consideration for fundraising efforts performed. Upon consummation of the Company’s IPO on August 1, 2016 and Corporate Conversion, these warrants to purchase Class A units were exchanged for 46,163 warrants to purchase the same number of shares of the Company’s common stock at a strike price of $138.06. None of these warrants have been exercised at December 31, 2017.

In connection with the sale of common stock in March 2017, warrants to purchase 2,707,138 shares of common stock were issued at an exercise price of $4.50 per share. At December 31, 2017, all of these warrants were outstanding. These warrants included a cash settlement option requiring the Company to record a liability for the fair value of the warrants at the time of issuance and at each reporting period with any change in the fair value reported as other income or expense. The Company used the Black-Scholes pricing model to value the warrant liability at December 31, 2017 with the following assumptions: risk-free interest rate of 1.39%, expected term of 0.27 years, expected volatility of 71.5% and a dividend rate of 0%. At the time of issuance, approximately $1.6 million was recorded as warrant liability. The change in the fair value of these warrants was $(0.9) million for the year ended December 31, 2017. At December 31, 2017, the fair value of the warrant liability was approximately $0.7 million and is recorded as a short-term liability as the warrants expire in April 2018.

In connection with the 2017 Public Offering, the Company issued warrants to purchase 10,710,000 shares of common stock at an initial exercise price of $3.35 per share for a term of 5 years from the date of issuance. As of December 31, 2017, warrants to purchase 10,687,200 shares of common stock were outstanding. The Company assessed the warrants under FASB ASC 480 and determined that the warrants were outside the scope of ASC 480. The Company next assessed the warrants under FASB ASC 815. Under the related guidance, a reporting entity shall not consider a contract to be a derivative instrument if the contract is both (1) indexed to the entity’s own stock and (2) classified in stockholders’ equity. The Company determined that the warrants were indexed to the Company’s stock, as the agreements do not contain any exercise contingencies and the warrants’ settlement amount equals the difference between the fair value of the Company’s common stock price and the warrant strike price. The Company also assessed the classification in stockholders’ equity and determined the warrants met all of the criteria for classification as equity under ASC 815. Based on this analysis, the Company determined that the warrant should be classified as equity and recorded $22.8 million to additional paid in capital, which represents the allocation of the 2017 Public Offering proceeds to the fair value of the warrants at issuance date.

Fair Value of Long‑term Debt

The Company had no long-term secured debt at December 31, 2017 and maintained a long‑term secured term debt balance of $28.7 million at December 31, 2016. Since the secured debt becomes due in June 2018, it has been recorded as short-term secured debt at December 31, 2017.The underlying agreements for these balances were negotiated with parties that included fully independent third parties, at an interest rate which is considered to be in line with over-arching market conditions. Based on these factors management considers the carrying value of the debt to approximate fair value at December 31, 2017.

Fair Value Classification

The Company held certain liabilities that are required to be measured at fair value on a recurring basis. Fair value guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These
tiers include:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The table below represents the values of the Company’s financial instruments at December 31, 2017 and December 31, 2016 (in thousands):



	Fair Value Measurement Using:
	December 31,		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2016		(Level 2)		(Level 3)
Warrants	$	3,305	$	3,305	$	—
Total	$	3,305	$	3,305	$	—

	December 31,		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2017		(Level 2)		(Level 3)
Warrants	$	1,952	$	1,952	$	—
Total	$	1,952	$	1,952	$	—

The table below represents a rollforward of the Level 2 and Level 3 financial instruments from January 1, 2015 to December 31, 2017 (in thousands).



	Significant Other Observable Inputs		Significant Unobservable Inputs
	(Level 2)		(Level 3)
Balance as of January 1, 2016	$	—	$	8,289
Transfer of warrants from Level 3 to Level 2		6,300		(6,300)
Change in fair value of financial instruments		(4,107)		(273)
Beneficial conversion feature recognized on warrants issued in connection with 2015 credit agreement		1,112		—
Reclassification of warrants to APIC in connection with IPO		—		(1,716)
Balance as of December 31, 2016	$	3,305	$	—
Fair value of warrants modified in the Third Amendment		(908)		—
Issuance of warrants in private placement		1,651		—
Change in fair value of financial instruments		(2,096)		—
Balance as of December 31, 2017	$	1,952	$	—

The Level 2 inputs used to value our financial instruments were determined using prices that can be directly observed or corroborated in active markets. In August 2016, the warrants issued in connection with the 2015 Credit Agreement were transferred from Level 3 to Level 2 as the Company’s securities began trading on the New York Stock Exchange. Although the fair value of this obligation is calculated using the observable market price of Kadmon Holdings Inc. common stock, an active market for this financial instrument does not exist and therefore the Company has classified the fair value of this liability as a Level 2 liability in the table above.