Note 5 — Fair Value of Financial Instruments

The valuation techniques required to determine fair value are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect internal market assumptions. The two types of inputs create the following fair value hierarchy:

Level 1 - Quoted prices for identical instruments in active markets.

Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3 - Significant inputs to the valuation model are unobservable.

The fair value of certain of our cash equivalents are based upon quoted prices for identical instruments in active markets. The fair value of our other cash equivalents is based upon a discounted cash flow model and approximate cost. Derivative financial instruments are measured at fair value, the material portions of which are based on active or inactive markets for identical or similar instruments or model-derived valuations whose inputs are observable. Where model-derived valuations are appropriate, we use the applicable credit spread as the discount rate. Credit risk related to derivative financial instruments is considered minimal and is managed by requiring high credit standards for counterparties and through periodic settlements of positions.

The fair value of our contingent consideration liabilities to the sellers of businesses that we have acquired are revalued to their fair value each period. Any increase or decrease in the fair value of the contingent consideration liabilities is recorded into selling, general and administrative expense. Changes in the assumed timing and amount of the probability of payment scenarios could impact the fair value.

At December 31, 2017, we have the following remaining contingent consideration arrangements with the sellers of companies which we acquired:

Deltenna: Payment of up to $7.3 million of contingent consideration if Deltenna meets certain sales goals from the date of acquisition through the year ending September 30, 2022.

GATR: Payment of up to $7.5 million of contingent consideration if GATR meets certain gross profit goals for the 12 month period ended February 28, 2018.

TeraLogics: Payment of up to $1.8 million if TeraLogics meets certain sales goals in fiscal year 2018; and up to $1.0 million will be paid if specific contract extensions are exercised by TeraLogics customers through fiscal 2018.

H4 Global: Payment of up to $3.4 million of contingent consideration based upon the value of contracts entered over the five-year period ended September 30, 2020.

The fair value of contingent consideration liabilities that are based upon revenue targets or gross margin targets are based upon a real option approach. The contingent consideration liabilities that are valued using this real option approach include the Deltenna contingent consideration, a portion of the TeraLogics contingent consideration, and the GATR contingent consideration. Under this real option approach, each payment was modeled using long digital options written on the underlying revenue or gross margin metric. The strike price for each option is the respective revenue or gross margin as specified in the related agreement, and the spot price is calibrated to the revenue or gross margin forecast by calculating the present value of the corresponding projected revenues or gross margins using a risk-adjusted discount rate. The volatility for the underlying revenue metrics was based upon analysis of comparable guideline public companies and the volatility factors used in the December 31, 2017 valuations were 43% for Deltenna, 15% for TeraLogics and 15% for GATR. The volatility factor used in the September 30, 2017 valuations were 40% for Deltenna, 15% for TeraLogics and 15% for GATR. The risk-free rate was selected based on the quoted yields for U.S. Treasury securities with terms matching the earn-out payment period.

The fair value of the portion of the TeraLogics contingent consideration that is based on customer execution of contract extensions was estimated using a probability weighted approach. The fair value of the contingent consideration was determined by applying probabilities of achieving the periodic payment to each period’s potential payment, and summing the present value of any estimated future payments.

The fair value of the H4 Global contingent consideration was estimated using a probability weighted approach. Subject to the terms and conditions of the H4 Global Purchase Agreement, contingent consideration will be paid over a five year term that commenced on October 1, 2015 and ends on September 30, 2020. The payments will be calculated based on the award of certain contracts during the specified period. The fair value of the contingent consideration was determined by applying probabilities to different scenarios, and summing the present value of any future payments.

The inputs to each of the contingent consideration fair value models include significant unobservable inputs and therefore represent Level 3 measurements within the fair value hierarchy. Significant judgment is employed in determining the appropriateness of these assumptions as of the acquisition dates and each subsequent period. Accordingly, changes in the assumptions described above can materially impact the amount of contingent consideration expense we record in any period.

As of December 31, 2017, the following table summarizes the change in fair value of our Level 3 contingent consideration liability (in thousands):


		H4		TeraLogics (Contract Extensions)		TeraLogics (Revenue Targets)		GATR		Deltenna		Total
Balance as of September 30, 2017	$	591	$	800	$	2,450	$	—	$	1,376	$	5,217
Cash paid to seller		—		—		(1,750)		—		—		(1,750)
Total remeasurement (gain) loss recognized in earnings		113		100		100		—		(15)		298
Balance as of December 31, 2017	$	704	$	900	$	800	$	—	$	1,361	$	3,765

The following table presents assets and liabilities measured and recorded at fair value on our balance sheets on a recurring basis (in thousands):


	December 31, 2017								September 30, 2017
	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets
Cash equivalents	$	5,001	$	—	$	—	$	5,001	$	8,501	$	—	$	—	$	8,501
Current derivative assets		—		2,416		—		2,416		—		2,591		—		2,591
Noncurrent derivative assets		—		443		—		443		—		1,128		—		1,128
Total assets measured at fair value	$	5,001	$	2,859	$	—	$	7,860	$	8,501	$	3,719	$	—	$	12,220
Liabilities
Current derivative liabilities		—		2,601		—		2,601		—		3,456		—		3,456
Noncurrent derivative liabilities		—		443		—		443		—		1,128		—		1,128
Contingent consideration to seller of Deltenna		—		—		1,361		1,361		—		—		1,376		1,376
Contingent consideration to seller of GATR		—		—		—		—		—		—		—		—
Contingent consideration to seller of TeraLogics - contract extensions		—		—		900		900		—		—		800		800
Contingent consideration to seller of TeraLogics - revenue targets		—		—		800		800		—		—		2,450		2,450
Contingent consideration to seller of H4 Global		—		—		704		704		—		—		591		591
Total liabilities measured at fair value	$	—	$	3,044	$	3,765	$	6,809	$	—	$	4,584	$	5,217	$	9,801

We carry certain financial instruments, including accounts receivable, short-term borrowings, accounts payable and accrued liabilities at cost, which we believe approximates fair value because of the short-term maturity of these instruments.

The fair value of long-term debt is calculated by discounting the value of the note based on market interest rates for similar debt instruments, which is a Level 2 technique. The following table presents the estimated fair value and carrying value of our long-term debt (in millions):


	December 31,		September 30,
	2017		2017
Fair value	$	201.1	$	202.1
Carrying value	$	200.0	$	200.0

We did not have any significant non-financial assets or liabilities measured at fair value on a non-recurring basis in the first quarter of fiscal 2018 or 2017 other than assets and liabilities acquired in business acquisitions, and the fair value of our new CMS and CGD Systems reporting units described in Note 2 above.