Fair Value of Financial Instruments

12 Months Ended

Sep. 30, 2020

Fair Value of Financial Instruments

Fair Value of Financial Instruments

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 following table presents assets and liabilities measured and recorded at fair value on our Consolidated Balance Sheets on a recurring basis (in thousands):

	September 30, 2020								September 30, 2019
	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets
Current derivative assets	$	—	$	1,398	$	—	$	1,398	$	—	$	2,635	$	—	$	2,635
Noncurrent derivative assets		—		222		—		222		—		859		—		859
Total assets measured at fair value	$	—	$	1,620	$	—	$	1,620	$	—	$	3,494	$	—	$	3,494
Liabilities
Current derivative liabilities		—		4,557		—		4,557		—		529		—		529
Noncurrent derivative liabilities		—		14,070		—		14,070		—		228		—		228
Contingent consideration to seller of H4 Global		—		—		1,148		1,148		—		—		1,073		1,073
Contingent consideration to seller of Deltenna		—		—		3,004		3,004		—		—		1,787		1,787
Contingent consideration to seller of Shield		—		—		5,566		5,566		—		—		3,814		3,814
Contingent consideration to seller of Nuvotronics		—		—		—		—		—		—		4,200		4,200
Contingent consideration to seller of Delerrok		—		—		900		900		—		—		—		—
Total liabilities measured at fair value	$	—	$	18,627	$	10,618	$	29,245	$	—	$	757	$	10,874	$	11,631

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 September 30, 2020, we have the following remaining contingent consideration arrangements with the sellers of companies which we acquired:

H4 Global: Payments of up to $2.8 million at September 30, 2020 based upon a percentage of the value of contracts entered into from October 1, 2015 through September 30, 2020. At September 30, 2020, the fair value of the contingent

consideration was determined based on the remaining value of contracts entered into through September 30, 2020 for which the related consideration payment had yet to be paid to the sellers.

Deltenna: Payments of up to $7.0 million if Deltenna meets certain sales goals from the date of acquisition through September 30, 2022. The fair value of the contingent consideration was estimated using a combination of a probability weighted approach and the real option approach. Under the real option 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 an analysis of comparable public companies and was 52% and 36% as of September 30, 2020 and 2019, respectively. The selected discount rate was 10.5% and 11.0% as of September 30, 2020 and 2019, respectively.

Shield: Payments of 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 estimated based on Monte Carlo simulations, which uses a probability distribution of values based on one million simulation trials. Key inputs for the simulation include projected revenues, discount rates, risk adjustment factors and volatility. The volatility and revenue risk adjustment factors were determined based on analysis of publicly traded comparable companies and as of September 30, 2020 were 31% and 16%, respectively, and as of September 30, 2019 were 18.0% and 13.1%, respectively. The selected discount rate was based primarily on an analysis of publicly traded comparable companies and was 5.7% and 3.6% at September 30, 2020 and 2019, respectively.

Nuvotronics: Payments of up to $8.0 million if Nuvotronics meets certain gross profit goals for the 12-month periods ending December 31, 2020 and December 31, 2021. The fair value of the contingent consideration was estimated based on Monte Carlo simulations, which uses a probability distribution of values based on one million simulation trials. As of September 30, 2020, the fair value of the Nuvotronics contingent consideration was determined to be zero as its forecasted gross profit amounts were below the payout thresholds.

Delerrok: Payments of up to $2.0 million if Delerrok meets certain sales goals for the 12-month period ending December 31, 2020. The fair value of the contingent consideration was estimated based on Monte Carlo simulations, which uses a probability distribution of values based on one million simulation trials. Key inputs for the simulation include projected revenues, discount rates and volatility. The volatility factor was determined based on an analysis of publicly traded comparable companies and was 14% as of September 30, 2020. The discount rate at September 30, 2020 was 3.4% and was based on our risk-free rate of return adjusted for our revenue required risk premium.

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 September 30, 2020, the following table summarizes the change in fair value of our Level 3 contingent consideration liabilities (in thousands):

	H4 Global		Deltenna		Shield		Nuvotronics		Delerrok		TeraLogics		Total
Balance as of September 30, 2018	$	665	$	1,081	$	5,618	$	—	$	—	$	1,750	$	9,114
Initial measurement recognized at acquisition		—		—		—		4,900		—		—		4,900
Cash paid to seller		(385)		—		—		—		—		(1,750)		(2,135)
Adjustment to the provisional acquisition date valuation		—		—		—		—		—		—		—
Total remeasurement (gain) loss recognized in earnings		793		706		(1,804)		(700)		—		—		(1,005)
Balance as of September 30, 2019	$	1,073	$	1,787	$	3,814	$	4,200	$	—	$	—	$	10,874
Initial measurement recognized at acquisition		—		—		—		—		1,600		—		1,600
Cash paid to seller		—		—		—		—		—		—		—
Adjustment to the provisional acquisition date valuation		—		—		—		—		—		—		—
Total remeasurement (gain) loss recognized in earnings		75		1,217		1,752		(4,200)		(700)		—		(1,856)
Balance as of September 30, 2020	$	1,148	$	3,004	$	5,566	$	—	$	900	$	—	$	10,618

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 our variable rate long-term debt approximates its carrying value at September 30, 2020.

In fiscal 2019 and 2020, we invested $5.0 million and $1.2 million, respectively, in Franklin Blackhorse, L.P., a limited partnership investment fund that invests in early stage, privately owned companies in the military, commercial, and disruptive technology sectors. We account for our investment using the equity method of accounting. Our share of the fund’s operating losses was $1.1 million and $0.3 million for the years ended September 30, 2020 and September 30, 2019, respectively, and is included in other income (expense), net in our Consolidated Statements of Operations. Our investment balance is included within other assets in our Consolidated Balance Sheet and amounted to $5.6 million and $5.3 million at September 30, 2020 and September 30, 2019.

We did not have any significant non-financial assets or liabilities measured at fair value on a non-recurring basis in 2020, 2019 or 2018 other than assets and liabilities acquired in business acquisitions described in Note 2 and the RSUs that contain performance and market-based vesting criteria described in Note 14.