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Fair Value Measurements & Derivative Instruments
 9 Months Ended
Jun. 30, 2013
Fair Value Measurements & Derivative Instruments

NOTE 10. FAIR VALUE MEASUREMENTS & DERIVATIVE INSTRUMENTS

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, 2013 and September 30, 2012 for assets and liabilities measured at fair value on a recurring basis:

June 30, 2013:

 

 

Level 1

 

Level 2

  

Level 3

 

  

Total

Cash and cash equivalents

$

  29,025,930

  

$

—

  

$

—

 

  

$

  29,025,930

Marketable securities (1)

$

  4,040,795

  

$

—

  

$

—

 

  

$

  4,040,795

Derivative assets

$

—

 

$

—

  

$

—

  

  

$

—

Derivative liabilities

$

—

 

$

—

  

$

  2,335,163

  

  

$

  2,335,163

Contingent consideration

$

—

 

$

—

  

$

  173,621

  

  

$

  173,621

September 30, 2012:

 

 

Level 1

 

Level 2

  

Level 3

 

  

Total

Cash and cash equivalents

$

  3,377,288

  

$

—

  

$

—

 

  

$

  3,377,288

Marketable securities

$

  106,500

  

$

—

  

$

—

 

  

$

  106,500

Derivative assets

$

—

 

$

—

  

$

  250,250

  

  

$

  250,250

Derivative liabilities

$

—

 

$

—

  

$

  647,213

  

  

$

  647,213

Contingent consideration

$

—

 

$

—

  

$

  173,621

  

  

$

  173,621

(1)    Marketable securities at June 30, 2013 were comprised of investments classified as “held-to-maturity”, and are recorded at amortized cost on the Company’s Consolidated Balance Sheet.

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.  The Company determined that the probability of realizing value from the conversion feature was remote, and the derivative asset value has been reduced to zero.

During the nine months ended June 30, 2013, the Company recorded a loss from the change in fair value of the derivative asset of $250,250.

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

 

 

June 30, 2013

 

September 30, 2012

Risk free interest rate

NA

 

  0.23

%

Expected life

0 Years

 

1.3 Years

Dividend yield

none

 

none

Volatility

  72

%

 

  72

%

The following is a reconciliation of the derivative asset:

 

Value at September 30, 2011

$

  161,125

  

Receipt of instruments

 

—

  

Increase in value

 

  89,125

  

Net settlements

 

—

  

Value at September 30, 2012

$

  250,250

  

Receipt of instruments

 

—

  

Change in value

 

(250,250

) 

Net settlements

 

—

  

Value at June 30, 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 322,150 warrants were outstanding at June 30, 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”) 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”) 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 nine months ended June 30, 2013, the Company recorded a non-cash gain from the change in fair value of the derivative liability of $465,869.

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

 

2010 Warrants

 

June 30, 2013

  

 

September 30, 2012

Risk free interest rate

 

  0.51

%

 

 

  0.31

%

Expected life

 

2.5 Years

 

 

3.2 Years

Dividend yield

 

none

 

 

none

Volatility

 

  69

%

 

 

  100

%

 

 

 

 

 

 

2012 Warrants

 

June 30, 2013

  

 

September 30, 2012

Risk free interest rate

 

  1.41

%

 

 

N/A

Expected life

 

4.5 Years

 

 

N/A

Dividend yield

 

none

 

 

N/A

Volatility

 

  69

%

 

 

N/A

 

 

 

 

 

 

2013 Warrants

 

June 30, 2013

 

 

September 30, 2012

Risk free interest rate

 

  1.41

%

 

 

N/A

Expected life

 

4.6 Years

 

 

N/A

Dividend yield

 

none

 

 

N/A

Volatility

 

  69

%

 

 

N/A

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

 

Value at September 30, 2011

$

  944,980

  

Issuance of instruments

 

—

 

Change in value

 

(297,767

) 

Net settlements

 

—

 

Value at September 30, 2012

$

  647,213

  

Issuance of instruments

 

  1,137,896

  

Issuance of instruments

 

  1,015,923

  

Change in value

 

(465,869

) 

Net settlements

 

—

 

Value at June 30, 2013

$

  2,335,163

  

In conjunction with the financing of Ablaris during the year ended September 30, 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 shares of Arrowhead Common Stock 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. 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 during the year ended September 30, 2011, and remain outstanding. 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 nine months ended June 30, 2013, the Company recorded a non-cash gain from the change in fair value of the derivative liability of $9,877.

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

 

 

  

June 30, 2013

 

September 30, 2012

Risk free interest rate

  

  1.41

%

 

  0.62

%

Expected life

  

4.5 Years

 

5.3 Years

Dividend yield

  

none

 

none

Volatility

  

  69

%

 

  100

%

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

 

Value at September 30, 2010

$

—

  

Issuance of instruments

 

  100,650

  

Change in value

 

(69,758

) 

Value at September 30, 2011

$

  30,892

  

Issuance of instruments

 

—

 

Change in value

 

(20,520

) 

Net settlements

 

—

 

Value at September 30, 2012

$

  10,372

  

Issuance of instruments

 

—

 

Change in value

 

(9,877

) 

Net settlements

 

—

 

Value at June 30, 2013

$

  495

  

During the year ended September 30, 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.

There were no changes in contingent consideration fair value.

 

Value at September 30, 2011

$

—

 

Purchase price contingent consideration

 

  173,621

 

Contingent consideration payments

 

—

 

Change in fair value of contingent consideration

 

—

 

Value at September 30, 2012

$

  173,621

 

Purchase price contingent consideration

 

—

 

Contingent consideration payments

 

—

 

Change in fair value of contingent consideration

 

—

 

Value at June 30, 2013

$

  173,621

 

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.