NOTE 9. 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 June 30, 2017 and September 30, 2016 for assets and liabilities measured at fair value on a recurring basis:

June 30, 2017:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	38,383,135	$	—	$	—	$	38,383,135
Short-term investments	$	36,451,134	$	—	$	—	$	36,451,134
Derivative liabilities	$	—	$	—	$	83,113	$	83,113

September 30, 2016:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	85,366,448	$	—	$	—	$	85,366,448
Short-term investments	$	—	$	—	$	—	$	—
Derivative liabilities	$	—	$	—	$	1,602,626	$	1,602,626

As part of a financing in December 2012, Arrowhead issued warrants to purchase up to 912,543 shares of Common Stock (the “2012 Warrants”) of which 265,161 warrants were outstanding at June 30, 2017. Further, as part of a financing in January 2013, Arrowhead issued warrants to purchase up to 833,530 shares of Common Stock (the “2013 Warrants” and, together with the 2012 Warrants, the “Warrants”) of which 12,123 warrants were outstanding at June 30, 2017. Each of the Warrants contains a mechanism to adjust the strike price upon the issuance of certain dilutive equity securities. If during the terms of the Warrants, the Company issues Common Stock at a price lower than the exercise price for the Warrants, the exercise price would be reduced to the amount equal to the issuance price of the Common Stock. As a result of these features, the 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 non-operating gain or loss as change in value of derivatives in the Company’s Consolidated Statement of Operations and Comprehensive Loss. During the three and nine months ended June 30, 2017, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $61,915 and $1,490,863, respectively, and during the three and nine months ended June 30, 2016, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $(110,859) and $230,082, respectively.

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

2012 Warrants	June 30, 2017	September 30, 2016
Risk-free interest rate	1.14%	0.68%
Expected life	0.5 Years	1.2 Years
Dividend yield	—	—
Volatility	79%	89%

2013 Warrants	June 30, 2017	September 30, 2016
Risk-free interest rate	1.14%	0.68%
Expected life	0.6 Years	1.3 Years
Dividend yield	—	—
Volatility	79%	89%

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

Value at September 30, 2016	$	1,565,874
Issuance of instruments		—
Change in value		(1,490,863	)
Net settlements		—
Value at June 30, 2017	$	75,011

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 of Common Stock based upon a predefined ratio. The exchange rights have a seven-year term and a current exchange ratio of 0.01. Exchange rights for 675,000 Ablaris shares were sold in fiscal 2011, and 500,000 remain outstanding at June 30, 2017. 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 non-operating gain or loss in the Company’s Consolidated Statement of Operations and Comprehensive Loss. During the three and nine months ended June 30, 2017, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $1,150 and $28,650, respectively, and during the three and nine months ended June 30, 2016, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $(2,500) and $2,200, respectively.

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

	June 30, 2017	September 30, 2016
Risk-free interest rate	1.14%	0.68%
Expected life	0.7 Years	1.5 Years
Dividend yield	—	—
Volatility	79%	89%

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

Value at September 30, 2016	$	36,752
Issuance of instruments		—
Change in value		(28,650	)
Net settlements		—
Value at June 30, 2017	$	8,102

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 the Company’s derivatives liabilities is the Company’s stock price. Other inputs have a comparatively insignificant effect.

The Company’s investments at June 30, 2017 consisted of corporate bonds with maturities remaining of less than one year. The total fair value of the investments at June 30, 2017 was $36,451,134. The fair value of these investments is measured using quoted market prices, and therefore, they are classified as level 1 assets.

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 other long-term liabilities approximates fair value based on market interest rates.