Quarterly report pursuant to Section 13 or 15(d)

Fair Value Measurements

Fair Value Measurements

9 Months Ended

Sep. 30, 2019

6. Fair Value Measurements

ASC No. 820, Fair Value Measurements and Disclosures (“ASC 820”), defines fair value as the price that would be received to sell an asset, or paid to transfer a liability, in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. The fair value standard also establishes a three‑level hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability on the measurement date. The three levels are defined as follows:


•	Level 1—inputs to the valuation methodology are quoted prices (unadjusted) for an identical asset or liability in an active market.


•	Level 2—inputs to the valuation methodology include quoted prices for a similar asset or liability in an active market or model‑derived valuations in which all significant inputs are observable for substantially the full term of the asset or liability.


•	Level 3—inputs to the valuation methodology are unobservable and significant to the fair value measurement of the asset or liability.

The following table presents, for each of the fair value hierarchy levels required under ASC 820, the Company’s assets and liabilities that are measured at fair value on a recurring basis:



	September 30, 2019
	Fair Value Measurements Using
	Quoted prices in		Significant other		Significant
	active markets for		observable		unobservable
	identical assets		inputs		inputs
	(Level 1)		(Level 2)		(Level 3)
Assets
Investments in money market funds*	$	3,221,364	$	—	$	—
Liabilities
Contingent consideration	$	—	$	—	$	7,473,485
Warrant liability**	$	—	$	—	$	850
Unit purchase option liability**	$	—	$	—	$	2,493



	December 31, 2018
	Fair Value Measurements Using
	Quoted prices in		Significant other		Significant
	active markets for		observable		unobservable
	identical assets		inputs		inputs
	(Level 1)		(Level 2)		(Level 3)
Assets
Investments in money market funds*	$	7,324,932	$	—	$	—
Liabilities
Contingent consideration	$	—	$	—	$	9,050,564
Warrant liability**	$	—	$	—	$	2,950
Unit purchase option liability**	$	—	$	—	$	7,216

*Investments in money market funds are reflected in cash and cash equivalents on the accompanying condensed consolidated balance sheets.

**Warrant liability and UPO liability are reflected in accrued expenses and other current liabilities on the accompanying condensed consolidated balance sheets.

As of September 30, 2019 and December 31, 2018, the Company’s financial instruments included cash and cash equivalents, restricted cash, accounts receivable, accounts payable, accrued expenses and other current liabilities, short term and long-term debt, warrant liability, the underwriters' UPO liability, and contingent consideration. The carrying amounts reported in the accompanying condensed consolidated financial statements for cash and cash equivalents, restricted cash, accounts receivable, accounts payable, accrued expenses, and other current liabilities approximate their respective fair values because of the short-term nature of these accounts. The estimated fair value of the Company’s long-term debt of $15.0 million as of September 30, 2019 was based on current interest rates for similar types of borrowings and is in Level 2 of the fair value hierarchy.

Level 3 Valuation

The tables presented below are a summary of changes in the fair value of the Company’s Level 3 valuations for the warrant liability, UPO liability and contingent consideration for the nine months ended September 30, 2019 and 2018:



	Warrant			Unit purchase			Contingent
	liability			option liability			consideration			Total
Balance at December 31, 2018	$	2,950		$	7,216		$	9,050,564		$	9,060,730
Payment of contingent consideration	—			—			(567,911		)	(567,911		)
Change in fair value due to Lachlan Settlement	—			—			(1,277,150		)	(1,277,150		)
Other changes in fair value	(2,100		)	(4,723		)	267,982			261,159
Balance at September 30, 2019	$	850		$	2,493		$	7,473,485		$	7,476,828



	Warrant		Unit purchase		Contingent
	liability		option liability		consideration			Total
Balance at December 31, 2017	$	8,185	$	26,991	$	2,576,633		$	2,611,809
Issuance of contingent consideration	—		—		7,920,000			7,920,000
Payment of contingent consideration	—		—		(137,008		)	(137,008		)
Purchase price allocation measurement period adjustment of contingent consideration	—		—		(1,210,000		)	(1,210,000		)
Change in fair value	6,145		16,183		360,850			383,178
Balance at September 30, 2018	$	14,330	$	43,174	$	9,510,475		$	9,567,979

In 2014, the Company issued warrants to purchase 625,208 shares of convertible preferred stock. Upon the closing of our initial public offering ("IPO") in October 2015 these warrants became warrants to purchase 22,328 shares of common stock, in accordance with their terms. The warrants expire in October 2020. The warrants represent a freestanding financial instrument that is indexed to an obligation, which the Company refers to as the warrant liability. The warrant liability is marked-to-market each reporting period with the change in fair value recorded to other income, net in the accompanying statements of operations until the warrants are exercised, expire or other facts and circumstances lead the warrant liability to be reclassified to stockholders’ equity. The fair value of the warrant liability is estimated using a Black-Scholes option-pricing model. The significant assumptions used in preparing the option pricing model for valuing the warrant liability as of September 30, 2019, include (i) volatility of 50%, (ii) risk free interest rate of 1.74%, (iii) strike price of $8.40, (iv) fair value of common stock of $3.29, and (v) expected life of 1.0 years.

The underwriters’ UPO was issued to the underwriters of the Company's IPO in 2015 and provides the underwriters the option to purchase up to a total of 40,000 units. The units underlying the UPO will be, immediately upon exercise, separated into shares of common stock, underwriters’ Class A warrants and underwriters’ Class B warrants (such warrants together referred to as the Underwriters’ Warrants). The Underwriters’ Warrants were warrants to purchase shares of common stock. The Class B warrants expired in April 2017 and the Class A warrants expired in October 2018, while the UPO expires in October 2020. The Company classifies the UPO as a liability, as it is a freestanding marked-to-market derivative instrument that is precluded from being classified in stockholders’ equity. The UPO liability is marked-to-market each reporting period with the change in fair value recorded to other income, net in the accompanying statements of operations until the UPO is exercised, expires or other facts and circumstances lead the UPO to be reclassified to stockholders’ equity. The fair value of the UPO liability is estimated using a Black-Scholes option-pricing model. The significant assumptions used in preparing the simulation model for valuing the UPO as of September 30, 2019, include (i) volatility of 50%, (ii) risk free interest rate of 1.74% , (iii) unit strike price of $7.47, (iv) fair value of underlying equity of $3.29, and (v) expected life of 1.0 years.

The Company's business acquisitions of Avadel's pediatric products and TRx (see Note 5) involve the potential for future payment of consideration that is contingent upon the achievement of operation and commercial milestones and royalty payments on future product sales. The fair value of contingent consideration was determined at the acquisition date utilizing unobservable inputs such as the estimated amount and timing of projected cash flows, the probability of success (achievement of the contingent event), and the risk-adjusted discount rate used to present value the probability-weighted cash flows. Subsequent to the acquisition date, at each reporting period, the contingent consideration liabilities are remeasured at the current fair value with changes recorded in the condensed consolidated statement of operations.

As part of the acquisition of Avadel's pediatric products, the Company became obligated to pay a 15% annual royalty on net sales of the acquired Avadel pediatric products through February 2026, up to an aggregate amount of $12.5 million. The fair value of the future royalty was the expected future value of the contingent payments discounted to a present value. The estimated fair value of the royalty payments as of September 30, 2019 was $7.5 million. The significant assumptions used in estimating the fair value of the royalty payment as of September 30, 2019 include (i) the expected net sales of the acquired Avadel pediatric products for that are subject to the 15% royalty based on the Company's net sales forecast and, (ii) the risk-adjusted discount rate of 7.86%, which is comprised of the risk-free interest rate of 1.60% and a counterparty risk of 6.26% utilized to discount the expected royalty payments. The liability is reduced by periodic payments. As detailed in Note 14, in connection with the Company entering into the Aytu transaction in October 2019, the contingent consideration related to Avadel's pediatric products was transferred to Aytu upon closing of the transaction on November 1, 2019. However, the liability as of September 30, 2019 does not factor in the transfer of the liability because the transaction occurred subsequent to quarter end.

The consideration for the TRx acquisition included certain potential contingent payments. First, pursuant to the TRx Purchase Agreement, the Company would have been required to pay $3.0 million to the Sellers if the gross profit related to TRx products equaled or exceeded $12.6 million in 2018. The Company did not achieve this contingent event in 2018 and therefore no value was assigned to the contingent payout as of December 31, 2018. Additionally, the Company may have been required to pay the following: (1) $2.0 million upon the transfer of the Ulesfia NDA to the Company ("NDA Transfer Milestone"), and (2) $2.0 million upon FDA approval of a new dosage of Ulesfia ("FDA Approval Milestone"). However, as part of the settlement the Company entered into during the second quarter of 2019 with Lachlan Pharmaceuticals, an Irish company controlled by the previous owners of TRx, among additional terms discussed in Note 13, the Company gave up its right to sell Ulesfia, except for a limited amount of inventory on hand until that inventory is sold or expired. As a result, the Settlement released the Company from the potential contingent payments related to the NDA Transfer Milestone and FDA Approval Milestone and therefore no value was assigned to the two milestones as of September 30, 2019 resulting in the Company recognizing a gain on the change of fair value of contingent consideration of $1.3 million for the nine months ended September 30, 2019.

No other changes in valuation techniques or inputs occurred during the nine months ended September 30, 2019 and 2018. No transfers of assets between Level 1 and Level 2 of the fair value measurement hierarchy occurred during the nine months ended September 30, 2019 and 2018.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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