9. Fair Value of Financial Instruments

The carrying amounts of financial instruments, which include cash equivalents and accounts payable, approximate their fair values due to their relatively short maturities. The fair value of the note payable to our principal stockholder cannot be reasonably estimated as the Company would not be able to obtain a similar credit arrangement in the current economic environment.

Cash equivalents consist of highly liquid investments with original or remaining maturities of 90 days or less at the time of purchase that are readily convertible into cash. As of December 31, 2012 and 2013, the Company held $61.8 million and $70.8 million, respectively of cash and cash equivalents, consisting of money market funds of $60.8 million and $67.7 million, respectively, and the remaining funds in non-interest bearing checking accounts. The fair value of these money market funds was determined by using quoted prices for identical investments in an active market (Level 1 in the fair value hierarchy).

The following is a summary of the carrying values and estimated fair values of the Company’s senior convertible notes due in 2013 and 2015 and the facility financing obligation due in 2019 (in millions).


	December 31, 2012				December 31, 2013
	Carrying value		Estimated fair value		Carrying value		Estimated fair value
2013 notes	$	114.4	$	81.9	$	—	$	—
2015 notes	$	97.6	$	63.2	$	98.4	$	102.2
2019 notes	$	—	$	—	$	102.3	$	107.0

Senior convertible notes

The senior convertible notes due 2013 were paid in full in December, consequently, they had a balance of $0. The estimated fair value of the 2013 notes was calculated based on quoted prices in an active market (Level 1 in the fair value hierarchy). The estimated fair value of the senior convertible notes due 2015 was calculated based on model derived valuations whose inputs were observable, such as the Company’s stock price, and non-observable, such as the Company’s long-term historical volatility, which was estimated to be 65% (Level 3 in the fair value hierarchy). As there is no current observable market for the senior convertible notes due 2015, the Company determined the estimated fair value using a convertible bond valuation model within a lattice framework. The convertible bond valuation model combined expected cash outflows with market-based assumptions regarding risk-adjusted yields, stock price volatility and recent price quotes and trading information regarding Company issued debt instruments and shares of common stock into which the notes are convertible.

Facility financing agreement

As discussed in Note 16 — Facility financing agreement, in connection with the Facility Agreement, the Company issued 2019 notes and Milestone Rights and recorded the Commitment Asset on July 1, 2013. As there is no current observable market for the 2019 notes, the Company determined the estimated fair value using a bond valuation model based on a discounted cash flow methodology. The bond valuation model combined expected cash flows associated with principal repayment and interest based on the contractual terms of the debt agreement discounted to present value using a selected market discount rate of 12.4% (Level 3 in the fair value hierarchy). On December 31, 2013, the market discount rate was 12.7%. The estimated fair value of the Milestone Rights was calculated using the income approach in which the cash flows associated with the specified contractual payments were adjusted for both the expected timing and the probability of achieving the milestones discounted to present value using a selected market discount rate (Level 3 in the fair value hierarchy). The expected timing and probability of achieving the milestones, starting in 2014, was developed with consideration given to both internal data, such as progress made to date and assessment of criteria required for achievement, and external data, such as market research studies. The discount rate (17.5%) was selected based on an estimation of required rate of returns for similar investment opportunities using available market data. The fair value of the Commitment Asset was estimated using the income approach by estimating the fair value of the future tranches using a market debt rate (12%) commensurate with the risk of the future tranches and the fair value of the cash expected to be received by the Company and assessing the probability of the commitments being funded in the future based on the operational hurdles required for funding being met (Level 3 in the fair value hierarchy). At December 31, 2013, the carrying value of the Milestone Rights and Commitment Asset approximates their respective estimated fair values.

Derivatives

Four embedded features that required bifurcation and separate accounting were identified in the facility financing obligation and the Company determined should be bundled together as a single, compound embedded derivative, bifurcated from the host contract, and accounted for at fair value, with changes in fair value being recorded in the Statement of Operations. The four embedded derivatives contained in the facility financing obligation were the Conversion Option, Major Transaction Put Option, Acceleration upon a Legal Judgment Against the Company in Excess of $100,000, and Tax Gross-Up. The four embedded features were evaluated together as a single compound derivative to determine the fair value of the derivative. The estimated fair value of the embedded derivative was calculated using Level 3 inputs and by applying a cumulative probability percentage to the values derived from a Black-Karasinski lattice model for the major transaction put option (0.8%), the conversion option feature (0.0%), and the acceleration upon a legal judgment against the Company in excess of $100,000 feature (0.1%). The Tax Gross-Up feature was evaluated using a Level 2 analysis based on the withholding requirements (i.e., the tax laws) on interest payments between the US and the British Virgin Islands and was determined to be de-minimus. As of December 9, 2013 and December 31, 2013, management determined the impact of the valuation of the embedded derivative was immaterial (see Note 16).

The fair value of foreign exchange hedging contracts equals the carrying value at each balance sheet date. The fair value of these contracts was determined using methodologies based on market observable inputs (Level 2 in the fair value hierarchy), including foreign currency spot rates. The Company used derivative financial instruments to manage its exposure to foreign currency exchange risks related to quarterly purchases on insulin. The Company does not use derivative financial instruments for trading or speculative purposes, nor does it use leveraged financial instruments. Credit risk related to derivative financial instruments was considered minimal and was managed by requiring high credit standards for counterparties and through periodic settlements of positions.

The Company entered into foreign exchange hedging contracts with notional amounts totaling $25.5 million and zero at December 31, 2010 and 2011, respectively. The Company recorded an unrealized loss on the foreign exchange hedging contracts of $0.2 million at December 31, 2010. The Company recorded a realized loss of $1.6 million and a realized gain of $1.3 million for the years ended December 31, 2010 and 2011, respectively, on the execution of quarterly foreign exchange hedging contracts. The Company terminated these contracts during the quarter ended March 31, 2011.

The Company’s derivative financial instruments are not designated as hedging instruments, and gains or losses resulting from changes in the fair value are reported in other income (expense), in the consolidated statements of operations. Derivative financial instruments are recognized as other assets or other current liabilities in the financial statements and measured at fair value.

The estimated fair values in connection with the February 2012 The Mann Group Common Stock Purchase Agreement (“The February 2012 Forward Purchase Contract”) and the October 2012 The Mann Group Common Stock and Warrant Purchase Agreement (“The October 2012 Forward Purchase Contract”) was based on forward purchase contract valuations (Level 3 in the fair value hierarchy) (see Note 10).

The following roll-forward provides a summary of the changes in fair value of the Company’s Level 3 forward purchase contracts during the year ended December 31, 2012 (in thousands) :


	The February 2012 Forward Purchase Contract			The October 2012 Forward Purchase Contract			Total
Beginning Balance	$	—		$	—		$	—
Issuance		1,080			28,237			29,317
Adjustments to fair value included in other income (expense)		12,011			(13,248	)		(1,237	)
Transfers to additional paid-in-capital		(13,091	)		(14,989	)		(28,080	)

Ending Balance	$	—		$	—		$	—