3. Fair Value Measurements

Fair value is defined 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 market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. The three levels of input are:

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 following table represents the Company’s fair value hierarchy for its financial assets (cash, cash equivalents, and investments) and liability measured at fair value on a recurring basis (in thousands):



	Fair Value Measurements at September 30, 2012 Using
		Quoted Prices in		Significant
		Active Markets		Other		Significant
		for		Observable		Unobservable		Balance
		Identical Assets		Inputs		Inputs		as of
Description		(Level 1)		(Level 2)		(Level 3)		September 30, 2012
Assets:
Money market funds	$	53,506	$	—	$	—	$	53,506
Restricted Italian state
bonds		374		—		—		374
Total	$	53,880	$	—	$	—	$	53,880

Liability:
Contingent
consideration	$	—	$	—	$	562	$	562
Total	$	—	$	—	$	562	$	562



	Fair Value Measurements at December 31, 2011 Using
		Quoted Prices in		Significant
		Active Markets		Other		Significant
		for		Observable		Unobservable		Balance
		Identical Assets		Inputs		Inputs		as of
Description		(Level 1)		(Level 2)		(Level 3)		December 31, 2011
Assets:
Money market funds	$	31,849	$	—	$	—	$	31,849
Restricted Italian state
bonds		364		—		—		364
Total	$	32,213	$	—	$	—	$	32,213

Liability:
Contingent
consideration	$	—	$	—	$	15,400	$	15,400
Total	$	—	$	—	$	15,400	$	15,400

Contingent Consideration

As part of the acquisition of NovaMed, the Company may be required to pay up to an additional $43.0 million in earn-out payments upon the successful achievement of revenue and earnings targets for the 2011 and 2012 fiscal years (the “earn-out” or “contingent consideration”). Under the Agreement, the earn-out is based upon certain financial performance metrics, including a revenue-based formula and an adjusted EBITDA (earnings before interest, depreciation and taxes) based formula. The earn-out provisions provide that: (i) if cumulative revenue in China for legacy NovaMed products for the two fiscal years ending December 31, 2012 exceed $94.2 million, a cash payment ranging from $9.2 million to $11.5 million will be paid, with the full amount payable if such revenue is $117.8 million or more; and (ii) if adjusted EBITDA for the two year period ending December 31, 2012 exceeds $91.8 million, a cash payment from $17.2 million to $21.5 million will be paid with the full amount payable if such adjusted EBITDA is $137.8 million or more. Adjusted EBITDA is defined in the Agreement to exclude certain expenses which are not generally related to operating results in China, including SciClone’s US research and development expense, certain share-based compensation, license fees paid by SciClone for new products, certain legal and advisory fees related to the Agreement or to change-in-control transactions, and certain fees and expenses, including legal fees and governmental fines or settlements paid with respect to the pending formal, non-public investigation being conducted by the US Securities and Exchange Commission (“SEC”).

The earn-out provisions are subject to a number of adjustments and acceleration provisions. The total earn-out payments described above may be increased by $10.0 million (a total maximum contingent cash consideration of $43.0 million) or reduced by $10.0 million, depending upon whether the Company is able to achieve targets relating to the renewal of the Depakine services agreement with Sanofi. The earn-out payments are due 20 business days after completion of the Company’s audit for the fiscal year ending December 31, 2012. However, the earn-out payments may be accelerated in certain conditions. If there is a change-in-control of the Company before December 31, 2012, then the earn-out payment would become due and the payment would range between $11.5 million and $23.0 million depending upon achievement against the adjusted EBITDA and revenue targets through the date of the change-in-control. In addition, if either (i) Mark Lotter is terminated without cause (as defined in the Agreement) prior to December 31, 2012, or (ii) if the Company fails to meet certain obligations to appoint and retain Mark Lotter and Peter Barrett (or their replacements) on the Company’s Board through December 31, 2012, the earn-out payment would be deemed to be $23.0 million and would be due 20 business days after completion of the Company’s audit for the fiscal year ending December 31, 2012. If the earn-out obligations are accelerated, the payment of the specified earn-out amount satisfies all of the Company’s obligations under the earn-out and no further payment is due. The earn-out and acceleration provisions are subject to various limitations and conditions specified in the Agreement.

The Company uses the assistance of a third-party valuation expert to estimate the fair value of the contingent consideration using a Monte Carlo simulation model. The estimated fair value of the contingent consideration is subject to fluctuations as a result of adjustments to certain performance metric projections used to estimate the fair value. The significant unobservable inputs used in the fair value measurement of the contingent consideration are revenue volatility of 40%; revenue discount rate of 20%; risk free rate of 0.13%; earn-out discount rate, including counterparty risk of 5%; estimates of projected revenues and earnings before taxes; and other assumptions regarding customer conditions, and probability of change of control and employment termination considerations. Significant increases (decreases) in the estimated revenues, earnings before taxes, customer conditions, and revenue volatility would result in a significantly higher (lower) fair value measurement. Generally, an increase (decrease) in the assumption used for revenue discount rate is accompanied by a decrease (increase) in the fair value of the contingent consideration.

The Company initially recorded $18.9 million as the estimated fair value of the contingent consideration. The fair value of the contingent consideration is remeasured each quarter, and changes to the fair value are recorded to contingent consideration expense or gain. As of September 30, 2012, the Company estimated the fair value of the contingent consideration to be $0.6 million, resulting in a non-cash gain of $12.8 million and $14.9 million for the three- and nine-month periods ended September 30, 2012, respectively. The significant reduction in the valuation of the contingent consideration expense during the three months ended September 30, 2012 was primarily related to the decrease in the estimated probability of achieving targets relating to NovaMed’s product distribution agreements, including the renewal of the Depakine services agreement with Sanofi for a five-year term. The Depakine services agreement expires June 30, 2013. The Company is currently negotiating an extension of that agreement, but believes that any initial extension will be for less than a five-year term.

The following represents the change in the estimated fair value of the contingent consideration (in thousands):



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
Contingent Consideration:
Balance at beginning of period	$	13,325	$	19,663	$	15,400	$	—
Fair value at acquisition date		—		—		—		18,870
Foreign currency translation		10		1		22		(14)
Change in the estimated fair value of the
contingent consideration liability		(12,773)		(2,231)		(14,860)		(1,423)
Balance at end of period	$	562	$	17,433	$	562	$	17,433