FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

6 Months Ended

Jun. 30, 2014

FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

NOTE 8—FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

We measure our financial assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Additionally, we are required to provide disclosure and categorize assets and liabilities measured at fair value into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Level 1 provides the most reliable measure of fair value while Level 3 generally requires significant management judgment. Financial assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows:

Level 1—Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2—Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly.

Level 3—Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date.

Our common stock purchase warrants issued in conjunction with debt and consulting services are detachable, or free standing, instruments. In addition, we have recorded a derivative liability associated with the conversion feature in our Senior Convertible Note. We estimate fair values of these warrants and derivative liabilities utilizing Level 3 inputs for all classes of warrants and derivative liabilities issued. Other than the Financing Warrant and Senior Convertible Note derivative liability, we use the Black-Scholes option valuation technique as it embodies all of the requisite assumptions (including trading volatility, remaining term to maturity, market price, strike price, and risk free rates) necessary to fair value these instruments. To determine the value of the Financing Warrant and Senior Convertible Note derivative liability, we used a Monte Carlo option-pricing model, which takes into consideration the market values of comparable public companies, considering among other factors, the use of multiples of earnings, and adjusted to reflect the restrictions on the ability of our shares to trade in an active market. We determined that as the Financing Warrant and debt conversion can only be exercised upon the probability of satisfying a performance condition such as a Qualifying IPO or Fundamental Transaction, as provided for in the applicable instrument, and thus a closed-form model such as the Black-Scholes option valuation model would not be appropriate (see Note 4).

The following assumptions were used in the Monte Carlo option-valuation model to determine the fair value of the Financing Warrant and Senior Convertible Note derivative liability during the period from June 17, 2013 to June 30, 2013:

	Expected Life (Years)	Risk Free Rate	Volatility	Probability of a Capital Raise
Financing Warrant	6.5 - 7	1.57 - 2.28%	65.3 - 68.6%	—
Senior Convertible Note Derivative Liability	0.75 - 1.75	0.19 - 0.24%	81.0 - 102.1%	75 - 90%

The following assumptions were used in the Black-Scholes option-pricing model to determine the fair value of the warrant liabilities:

	December 31, 2013	June 30, 2014
Assumptions:
Risk-free interest rate	0.8% - 2.45%	1.25% - 2.31%
Expected dividend yield	0%	0%
Expected volatility	60.0% - 65.6%	64.0% - 69.7%
Expected term (in years)	4.08 - 7.0	3.58 – 5.95

We used a fair value per share of our common stock of $5.54 and $7.72 as of December 31, 2013 and June 30, 2014, respectively, to determine the fair value of derivative and warrant liabilities.

Liabilities measured at fair value on a recurring basis as of December 31, 2013, are as follows:

			Fair Value Measurements Using
	Balance as of December 31, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Liabilities:
Senior convertible note derivative	$	5,056,502	$	—	$	—	$	5,056,502
Bridge loan warrants	1,338,071		—		—		1,338,071
Consulting warrant	1,228,616		—		—		1,228,616
Financing warrant	709,397		—		—		709,397
Total	$	8,332,586	$	—	$	—	$	8,332,586

Liabilities measured at fair value on a recurring basis as of June 30, 2014 are as follows:

			Fair Value Measurements Using
	Balance as of June 30, 2014		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Liabilities:
Bridge loan warrants	$	1,882,353	$	—	$	—	$	1,882,353
Consulting warrant	1,713,567		—		—		1,713,567
Financing warrant	1,242,279		—		—		1,242,279
Total	$	4,838,199	$	—	$	—	$	4,838,199

We estimated the fair value of our warrants and Senior Convertible Note derivative at the time of issuance and subsequently re-measure using the Black-Scholes option valuation model or Monte Carlo option-pricing model as discussed above, at each reporting date, using the following inputs: the risk-free interest rates; the expected dividend rates; the remaining expected life of the warrants; and the expected volatility of the price of the underlying common stock. Under the Monte Carlo option-pricing model we estimate the fair value of the Senior Convertible Note derivative liability and Financing Warrant liability at the time of issuance and subsequently re-measurement dates considering the probability of achieving a milestone, the cost of capital, and the estimated time period the right would be outstanding. The estimates were based, in part, on subjective assumptions and could differ materially in the future (see Note 4). Changes to these assumptions as well as our stock price on the reporting date can have a significant impact on the fair value of the warrant liabilities in the future.

The following table provides a reconciliation of all liabilities measured at fair value using Level 3 significant unobservable inputs:

	Warrant Liabilities(1)		Senior Convertible Note Derivative Liability(2)
Balance at December 31, 2013	$	3,276,084	$	5,056,502
Issuance of warrant and derivative liabilities	—		—
Change in fair value	1,562,115		1,633,272
Write-off due to conversion	—		(6,689,774		)
Balance at June 30, 2014	$	4,838,199	$	—

(1) The change in the fair value of the warrants was recorded as a reduction of $928,021 and $1.6 million to other income in the condensed consolidated statement of operations for the three and six months ended June 30, 2014, respectively.

(2) The extinguishment of the senior convertible note derivative liability was recorded as an increase of $5.5 million to additional paid-in capital and a gain of $1.2 million to other income in the condensed consolidated statement of operations for both the three and six months ended June 30, 2014, respectively.