NOTE 11. FAIR VALUE MEASUREMENTS

The Company measures its 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, the Company is 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.

The following table summarizes fair value measurements at December 31, 2013 and September 30, 2013 for assets and liabilities measured at fair value on a recurring basis:

December 31, 2013:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	59,713,424	$	—	$	—	$	59,713,424
Derivative assets	$	—	$	—	$	—	$	—
Derivative liabilities	$	—	$	—	$	5,097,442	$	5,097,442
Acquisition related contingent consideration obligations	$	—	$	—	$	1,595,273	$	1,595,273

September 30, 2013:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	19,114,444	$	—	$	—	$	19,114,444
Derivative assets	$	—	$	—	$	—	$	—
Derivative liabilities	$	—	$	—	$	4,096,363	$	4,096,363
Acquisition related contingent consideration obligations	$	—	$	—	$	1,595,273	$	1,595,273

The Company invests its excess cash balances in short and long-term corporate bonds, generally with remaining maturities of less than two years. At December 31, 2013, the Company had short-term investments of $15,912,757, and long-term investments of $9,837,846, for a total of $25,750,603. The fair value of its investment at December 31, 2013 was $25,533,387. The Company expects to hold such investments until maturity, and thus unrealized gains and losses from the fluctuations in the fair value of the securities are not likely to be realized.

As part of the proceeds from the sale of Unidym in January 2011, Arrowhead received a bond from Wisepower in the face amount of $2.5 million. The bond is convertible to Wisepower common stock at a price of $2.00 per share. The conversion feature is subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the conversion feature on the date of issuance was estimated using an option pricing model and recorded on the Company’s consolidated balance sheet as a derivative asset. The fair value of the conversion feature is estimated at the end of each reporting period and the change in the fair value of the conversion feature is recorded as a nonoperating gain/loss as change in value of derivatives in Company’s Consolidated Statement of Operations. During the quarter ended March 31, 2013, the trading of Wisepower stock was halted. Trading resumed in July 2013, but the trading price is significantly below the conversion price. During fiscal 2013, the Company determined that the probability of realizing value from the conversion feature was remote, and the derivative asset value was reduced to zero.

During the three months ended December 31, 2013, there was no change in the fair value of the derivative asset.

The assumptions used in valuing the derivative asset were not applicable as the value has been determined to be zero at December 31, 2013 and September 30, 2013.

	December 31, 2013	September 30, 2013
Risk free interest rate	—	—
Expected life	—	—
Dividend yield	—	—
Volatility	—	—

The following is a reconciliation of the derivative asset:

Value at September 30, 2012	$	250,250
Receipt of instruments		—
Decrease in value		(250,250	)
Net settlements		—
Value at September 30, 2013	$	—
Receipt of instruments		—
Decrease in value		—
Net settlements		—
Value at December 31, 2013	$	—

As part of an equity financing in June 2010, Arrowhead issued warrants to acquire up to 329,649 shares of Common Stock (the “2010 Warrants”), of which 50,836 warrants were outstanding at December 31, 2013, which contain a mechanism to adjust the strike price upon the issuance of certain dilutive equity securities. If during the term of the 2010 Warrants, the Company issues Common Stock at a price lower than the exercise price of the 2010 Warrants, the exercise price of the 2010 Warrants would be reduced to the amount equal to the issuance price of the Common Stock. Similarly, as part of a financing in December 2012, Arrowhead issued warrants to acquire up to 912,543 shares of Common Stock (the “2012 Warrants”) of which 324,461 warrants were outstanding at December 31, 2013, which contain a mechanism to adjust the strike price upon the issuance of certain dilutive equity securities. If during the term of the 2012 Warrants, the Company issues Common Stock at a price lower than the exercise price of the 2012 Warrants, the exercise price of the 2012 Warrants would be reduced to the amount equal to the issuance price of the Common Stock. Further, as part of a financing in January 2013, Arrowhead issued warrants to acquire up to 833,530 shares of Common Stock (the “2013 Warrants”) of which 168,408 warrants were outstanding at December 31, 2013 which contain a mechanism to adjust the strike price upon the issuance of certain dilutive equity securities. If during the term of the 2013 Warrants, the Company issues Common Stock at a price lower than the exercise price of the 2013 Warrants, the exercise price of the 2013 Warrants would be reduced to the amount equal to the issuance price of the Common Stock. As a result of these features, the 2010 Warrants, the 2012 Warrants, and the 2013 Warrants are subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the Warrants on the date of issuance was estimated using an option pricing model and recorded on the Company’s consolidated balance sheet as a derivative liability. The fair value of the Warrants is estimated at the end of each reporting period and the change in the fair value of the Warrants is recorded as a nonoperating gain or loss in the Company’s consolidated statement of operations. During the three months ended December 31, 2013, the Company recorded a non-cash loss from the change in fair value of the derivative liability of $3,519,579.

The assumptions used in valuing the derivative liability were as follows:

2010 Warrants	December 31, 2013	September 30, 2013
Risk free interest rate	0.38%	0.33%
Expected life	2.0 Years	2.2 Years
Dividend yield	None	None
Volatility	69%	69%

2012 Warrants	December 31, 2013	September 30, 2013
Risk free interest rate	1.27%	1.39%
Expected life	4.0 Years	4.2 Years
Dividend yield	None	None
Volatility	69%	69%

2013 Warrants	December 31, 2013	September 30, 2013
Risk free interest rate	1.27%	1.39%
Expected life	4.1 Years	4.3 Years
Dividend yield	None	None
Volatility	69%	69%

The following is a reconciliation of the derivative liability related to these warrants:

Value at September 30, 2012	$	626,195
Issuance of instruments		2,153,819
Change in value		5,066,591
Net settlements		(3,754,808	)
Value at September 30, 2013	$	4,091,797
Issuance of instruments		—
Change in value		3,507,496
Net settlements		(2,518,502)
Value at December 31, 2013	$	5,080,791

In conjunction with the financing of Ablaris in fiscal 2011, Arrowhead sold exchange rights to certain investors whereby the investors have the right to exchange their shares of Ablaris for a prescribed number of Arrowhead shares based upon a predefined ratio. The exchange rights have a seven-year term. During the first year, the exchange right allows the holder to exchange one Ablaris share for 0.06 Arrowhead shares (as adjusted for a subsequent reverse stock split). This ratio declines to 0.04 in the second year, 0.03 in the third year and 0.02 in the fourth year. In the fifth year and beyond the exchange ratio is 0.01. Exchange rights for 675,000 Ablaris shares were sold in fiscal 2011, and remain outstanding at December 31, 2013. The exchange rights are subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the exchange rights on the date of issuance was estimated using an option pricing model and recorded on the Company’s consolidated balance sheet as a derivative liability. The fair value of the exchange rights is estimated at the end of each reporting period and the change in the fair value of the exchange rights is recorded as a nonoperating gain or loss in the Company’s Consolidated Statement of Operations. During the three months ended December 31, 2013, the Company recorded a non-cash loss from the change in fair value of the derivative liability of $12,082.

The assumptions used in valuing the derivative liability were as follows:

	December 31, 2013	September 30, 2013
Risk free interest rate	1.27%	1.39%
Expected life	4.0 Years	4.3 Years
Dividend yield	None	None
Volatility	69%	69%

The following is a reconciliation of the derivative liability related to these exchange rights:

Value at September 30, 2012	$	10,375
Issuance of instruments		—
Change in value		(5,806	)
Net settlements		—
Value at September 30, 2013	$	4,569
Issuance of instruments		—
Change in value		12,082
Net settlements		—
Value at December 31, 2013	$	16,651

The derivative assets/liabilities are estimated using option pricing models that are based on the individual characteristics of the warrants or instruments on the valuation date, as well as assumptions for expected volatility, expected life and risk-free interest rate. Changes in the assumptions used could have a material impact on the resulting fair value. The primary input affecting the value of our derivatives liabilities is the Company’s stock price. Other inputs have a comparatively insignificant effect.

During fiscal 2012, contingent consideration was recorded upon the acquisitions of Roche Madison Inc. and Alvos Therapeutics, Inc., totaling $173,621. The fair value measurement of the contingent consideration obligations is determined using Level 3 inputs. The fair value of contingent consideration obligations is based on a discounted cash flow model using a probability-weighted income approach. The measurement is based upon unobservable inputs supported by little or no market activity based on our own assumptions and experience. Estimating timing to complete the development, and obtain approval of products is difficult, and there are inherent uncertainties in developing a product candidate, such as obtaining U.S. Food and Drug Administration (FDA) and other regulatory approvals. In determining the probability of regulatory approval and commercial success, we utilize data regarding similar milestone events from several sources, including industry studies and our own experience. These fair value measurements represent Level 3 measurements as they are based on significant inputs not observable in the market. Significant judgment is employed in determining the appropriateness of these assumptions as of the acquisition date and for each subsequent period. Accordingly, changes in assumptions could have a material impact on the amount of contingent consideration expense we record in any given period. Changes in the fair value of the contingent consideration obligations are recorded in our consolidated statement of operations.

The following is a reconciliation of contingent consideration fair value.

Value at September 30, 2012	$	173,621
Purchase price contingent consideration		—
Contingent consideration payments		—
Change in fair value of contingent consideration		1,421,652
Value at September 30, 2013	$	1,595,273
Purchase price contingent consideration		—
Contingent consideration payments		—
Change in fair value of contingent consideration		—
Value at December 31, 2013	$	1,595,273

The fair value of contingent consideration obligations is estimated through valuation models designed to estimate the probability of such contingent payments based on various assumptions and incorporating estimated success rates. Estimated payments are discounted using present value techniques to arrive at estimated fair value at the balance sheet date. Changes in the fair value of the contingent consideration obligations can result from changes to one or multiple inputs, including adjustments to the discount rates, changes in the amount or timing of expected expenditures associated with product development, changes in the amount or timing of cash flows from products upon commercialization, changes in the assumed achievement or timing of any development milestones, changes in the probability of certain clinical events and changes in the assumed probability associated with regulatory approval. Each of these assumptions can have a significant impact on the calculation of contingent consideration.

The carrying amounts of the Company’s other financial instruments, which include accounts receivable, accounts payable, and accrued expenses approximate their respective fair values due to the relatively short-term nature of these instruments. The carrying value of the Company’s debt obligations approximates fair value based on market interest rates.