Note 14.

Fair Value of Financial Instruments

The FASB defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous markets for the asset and liability in an orderly transaction between market participants at the measurement date. The Company estimates fair value of its financial instruments utilizing an established three-level hierarchy in accordance with U.S. GAAP. The hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date as follows:


•	Level 1 –	Valuation is based upon unadjusted quoted prices for identical assets or liabilities in active markets.

•	Level 2 –	Valuation is based upon quoted prices for similar assets and liabilities in active markets, or other inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instruments.

•	Level 3 –	Valuation is based upon other unobservable inputs that are significant to the fair value measurements.

The classification of fair value measurements within the hierarchy is based upon the lowest level of input that is significant to the measurement.

At September 30, 2018, the Company had foreign currency forward contracts recorded at fair value. The fair values of these instruments were measured using valuations based upon quoted prices for similar assets and liabilities in active markets (Level 2) and are valued by reference to similar financial instruments, adjusted for credit risk, restrictions and other terms specific to the contracts.

In February 2016, the Company entered into a contingent earnout arrangement which provides up to a maximum of $6.0 million of additional cash earnout opportunities based upon II-VI EpiWorks achieving certain agreed upon financial and operational targets for capacity, wafers output and gross margin, which if earned would be payable for the achievement of each specific annual target over the next three years. The Company paid the first year earnout amount of $2.0 million during the quarter ended June 30, 2017.

The fair values of the contingent earnout arrangements and the net put option were measured using valuations based upon other unobservable inputs that are significant to the fair value measurement (Level 3).

The Company estimated the fair value of the 0.25% convertible notes based on quoted market prices as of the last trading day prior to September 30, 2018; however, the convertible notes have only a limited trading volume and as such this fair value estimate is not necessarily the value at which the convertible notes could be retired or transferred. The Company concluded that this fair value measurement should be categorized within Level 2. The carrying value of the convertible notes is net of unamortized discount and issuance costs. See Note 9. Debt for details on the Company’s debt facilities. The fair value and carrying value of the convertible notes were as follows at September 30, 2018 ($000):

		Fair Value				Carrying Value
Convertible notes		$	406,203			$	291,700

The following table provides a summary by level of the fair value of financial instruments that are measured on a recurring basis or for which fair value is disclosed for the periods presented ($000):

	Fair Value Measurements at September 30, 2018 Using:
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2018		(Level 1)		(Level 2)		(Level 3)
Assets:
Foreign currency forward contracts	$	387	$	-	$	387	$	-
Liabilities:
Net put option		2,024	$	-	$	-		2,024
Contingent earnout arrangements		4,997	$	-	$	-		4,997

	Fair Value Measurements at June 30, 2018 Using:
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	June 30,		Assets		Inputs		Inputs
	2018		(Level 1)		(Level 2)		(Level 3)
Assets:
Foreign currency forward contracts	$	121	$	-	$	121	$	-
Liabilities:
Contingent earnout arrangements	$	5,405	$	-	$	-	$	5,405
Net put option	$	2,024	$	-	$	-	$	2,024

The Company’s policy is to report transfers into and out of Levels 1 and 2 of the fair value hierarchy at fair values as of the beginning of the period in which the transfers occur. There were no transfers in and out of Levels 1 and 2 of the fair value hierarchy during the three months ended September 30, 2018.

The following table presents a reconciliation of the beginning and ending fair value measurements of the Company’s Level 3 contingent earnout arrangements related to the Company’s acquisitions and the net put option relating to the equity investment acquired in November 2017. ($000):

	Significant
	Unobservable Inputs
	(Level 3)
Balance at July 1, 2018		7,429

Contingent earnout arrangements
Payments		(2,500	)
Changes in fair value recorded in other expense, (income)		(505	)
Other earnout arrangement		2,597

Balance at September 30, 2018		7,021

The fair values of cash and cash equivalents are considered Level 1 among the fair value hierarchy and approximate fair value because of the short-term maturity of those instruments. The Company’s borrowings including its capital lease obligation are considered Level 2 among the fair value hierarchy and their principal amounts approximate fair value.