Note 8 — 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 following table presents assets and liabilities measured and recorded at fair value on our balance sheets on a recurring basis (in thousands):


	December 31, 2018								September 30, 2018
	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets
Cash equivalents	$	—	$	—	$	—	$	—	$	9,000	$	—	$	—	$	9,000
Current derivative assets		—		5,036		—		5,036		—		1,803		—		1,803
Noncurrent derivative assets		—		581		—		581		—		314		—		314
Total assets measured at fair value	$	—	$	5,617	$	—	$	5,617	$	9,000	$	2,117	$	—	$	11,117
Liabilities
Current derivative liabilities		—		3,367		—		3,367		—		1,657		—		1,657
Noncurrent derivative liabilities		—		—		—		—		—		75		—		75
Contingent consideration to seller of Deltenna		—		—		1,343		1,343		—		—		1,081		1,081
Contingent consideration to seller of Shield		—		—		5,618		5,618		—		—		5,618		5,618
Contingent consideration to seller of TeraLogics - revenue targets		—		—		—		—		—		—		1,750		1,750
Contingent consideration to seller of H4 Global		—		—		832		832		—		—		665		665
Total liabilities measured at fair value	$	—	$	3,367	$	7,793	$	11,160	$	—	$	1,732	$	9,114	$	10,846

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

At December 31, 2018, we have the following remaining contingent consideration arrangements with the sellers of companies which we acquired:

Deltenna: Payment of up to $6.9 million of contingent consideration if Deltenna meets certain sales goals from the date of acquisition through the year ending September 30, 2022.

H4 Global: Payment of up to $3.2 million of contingent consideration based upon the value of contracts entered into over the five-year period ending September 30, 2020.

Shield: Payments of up to $10.0 million of contingent consideration if Shield meets certain sales goals from the date of acquisition through July 31, 2025.

In addition, we have a contingent consideration arrangement with the Purchaser of our CGD Services business under which we are eligible to receive a cash payment of $3.0 million if the Purchaser is awarded certain government contracts in the future.

The fair value of Deltenna contingent consideration was valued using the real option approach. Under this approach, each payment was modeled using long digital options written on the underlying revenue metric. The strike price for each option is the respective revenue as specified in the related agreement, and the spot price is calibrated to the revenue forecast by calculating the present value of the corresponding projected revenues 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 factor used in the December 31, 2018 valuations was 40% for Deltenna. The volatility factor used in the September 30, 2018 valuation was 53% for Deltenna. 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 maximum remaining payout to the sellers of H4 Global is $3.2 million at December 31, 2018, and is based upon the value of contracts entered into over the five-year period ending September 30, 2020. 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 fair value of the Shield contingent consideration was estimated based on Monte Carlo simulations. Under the purchase agreement, we will pay the sellers up to $10.0 million if Shield meets certain sales goals from the date of acquisition through July 31, 2025. The fair value of the contingent consideration was determined based upon a probability distribution of values based on 100,000 iterations. Key inputs for the simulation include projected revenues, assumed discount rates for projected revenue and cash flows, and volatility. The volatility and revenue risk adjustment factors used as of December 31, 2018 were 20% and 14%, respectively, and were determined based on analysis of publicly traded comparable companies. The discount rate used as of December 31, 2018 and September 30, 2018 was based on our expected borrowing rate under our financing arrangements, which was determined to be 5.0% at December 31, 2018 and September 30, 2018.

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, 2018, the following table summarizes the change in fair value of our Level 3 contingent consideration liabilities (in thousands):


		H4 Global		TeraLogics (Revenue Targets)		Deltenna		Shield		Total
Net balances at September 30, 2018	$	665	$	1,750	$	1,081	$	5,618	$	9,114
Cash paid to seller		—		(1,750)		—		—		(1,750)
Total remeasurement (gain) loss recognized in earnings		167		—		262		—		429
Balance as of December 31, 2018	$	832	$	—	$	1,343	$	5,618	$	7,793

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,
	2018		2018
Fair value	$	195.4	$	193.7
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 2019 or 2018 other than assets and liabilities acquired in business acquisitions described in Note 3 and the restricted stock units that were granted in the first quarter of fiscal 2019 that contain performance and market-based vesting criteria described in Note 11.