Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2012

Fair Value of Financial Instruments

Fair Value of Financial Instruments

NOTE 6: Fair Value of Financial Instruments

Fair Value Measurements

The Company categorizes the fair value measurements of its financial assets and liabilities into a three level fair value hierarchy, based on the inputs used in determining fair value. The categories in the fair value hierarchy are as follows:

Level 1—Financial assets and liabilities whose values are based on unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2—Financial assets and liabilities whose values are based on quoted market prices for similar assets and liabilities, quoted market prices for identical assets and liabilities in markets that are not active or other inputs that can be corroborated by observable market data.

Level 3—Financial assets and liabilities whose values are based on inputs that are both significant to the fair value measurement and unobservable. Internally developed valuations reflect the Company’s judgment about assumptions market participants would use in pricing the asset or liability estimated impact to quoted market prices.

The Company records derivative liabilities on its balance sheet related to the 2008 and the 2010 Warrants and the conversion feature embedded in the Series B-1 Preferred Stock in the Level 3 category.

The Company’s liabilities measured and recorded at fair value on a recurring basis are as follows (in thousands):

	September 30, 2012
	(Unaudited)
	Total		(Level 1)		(Level 2)		(Level 3)
Conversion feature embedded in the Series B-1 Preferred Stock	$	118	$	—	$	—	$	118
2008 Warrants	—		—		—		—
2010 Warrants	419		—		—		419
Total derivative liabilities	$	537	$	—	$	—	$	537

	December 31, 2011
	Total		(Level 1)		(Level 2)		(Level 3)
Conversion feature embedded in the Series B-1 Preferred Stock	$	1,835	$	—	$	—	$	1,835
2008 Warrants	29		—		—		29
2010 Warrants	3,914		—		—		3,914
Total derivative liabilities	$	5,778	$	—	$	—	$	5,778

A reconciliation of the Company’s derivative liabilities measured and recorded at fair value on a recurring basis using significant unobservable inputs (Level 3) is as follows (in thousands):

Balance, December 31, 2011	$	5,778
Total unrealized gains
Included in earnings	(5,270		)
Included in other comprehensive income	—
Issuances	29
Transfers in and/or out of Level 3	—
Balance, September 30, 2012	$	537

The assumptions used in the valuation models to determine the fair value of the Company’s derivative liabilities are as follows:

			Input
Financial Instrument	Valuation Technique	Unobservable Input	September 30, 2012			December 31, 2011
Conversion feature embedded in Series B-1 Preferred Stock	Binomial tree	Exercise price	$	15.95		$	15.95
		Volatility	103.67		%	78.43		%
		Stock Price	$	0.37		$	2.15
		Option Adjusted Spread	58.46		%	30.60		%
		Risk-free discount rate(1)	0.34		%	0.59		%
		Preferred adjustment	1.51		%	0.82		%
2008 Warrants	Binomial tree	Exercise price	$	9.05		$	9.05
		Volatility	103.67		%	78.43		%
		Stock Price	$	0.37		$	2.15
		Risk-free discount rate(1)	0.16		%	0.19		%
2010 Warrants	Binomial tree	Exercise price	$	3.84		$	3.84
		Volatility	103.67		%	78.43		%
		Stock Price	$	0.37		$	2.15
		Risk-free discount rate(1)	0.50		%	0.83		%

(1)Based on the remaining life of the instruments.

A binomial tree valuation model uses a “discrete-time” (lattice based) model of the varying price over time of the underlying financial instrument. Each node in the lattice represents a possible price of the underlying (stock price) at a given point in time. Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). When valuing the above instruments, a lattice representing all possible paths the stock price could take during the life of the conversion and a lattice representing variations in the strike price if certain conditions are met are developed and used in concert.

Changes in fair value of the Company’s derivative liabilities are recorded in other income (expense) as unrealized gains and losses in the Company’s interim condensed consolidated statement of operations. The fair values of these instruments are subject to material changes primarily associated with fluctuations in the market value of the Company’s common stock. Generally, as the market value of the common stock increases/decreases, the fair values of these derivative liabilities increase/decrease and a corresponding loss/gain is recorded. In addition, the estimate of the fair value of these instruments includes other key inputs and assumptions such as option-adjusted spread, volatility and a risk-free discount rate. As the option-adjusted spread increases/decreases, the fair values of these derivative liabilities decrease/increase and a corresponding gain/loss is recorded. As the volatility and risk-free discount rate increase/decrease, the fair values of these derivative liabilities increase/decrease and a corresponding loss/gain is recorded.

The Company is not a party to any hedging arrangements, commodity swap agreements or any other derivative financial instruments.

Estimated Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, restricted cash, accounts receivable and accounts payable approximate their fair value due to the short maturity of those instruments, and therefore, have been excluded from the table below. The fair value of debt was determined using quoted market prices, if available, or the discounted cash flow (“DCF”) method of the income approach, as applicable. The fair value of the mandatorily redeemable preferred stock is calculated by using the DCF method of the income approach.

The following table sets forth the fair value of the Company’s remaining financial assets and liabilities (in thousands):

		September 30, 2012				December 31, 2011
	Fair Value Hierarchy	Carrying Amount		Fair Value		Carrying Amount		Fair Value
		(Unaudited)
Financial liabilities:
Long-term debt—Notes	Level 2	$	297,473	$	129,528	$	296,615	$	185,250
Long-term debt—Whitebox Revolving Credit Facility	Level 3	50,000		21,788		50,000		33,277
Other(1)	Level 2	––		––		2,072		2,072
Mandatorily redeemable preferred stock:
Series C-1	Level 3	45,498		11,346		41,477		20,353
Series D	Level 3	14,990		5,174		11,733		12,636

(1)Includes short-term debt with maturities of less than one year in markets that are not active.

The assumptions used in the valuation models to determine the fair value of the Whitebox Revolving Credit Facility and the mandatorily redeemable preferred stock at September 30, 2012, are as follows:

Financial Instrument	Valuation Technique	Unobservable Input	Input
Whitebox Revolving Credit Facility	DCF	Option Adjusted Spread	58.46	%
		Preferred adjustment	1.51	%
		Risk-free discount rate(1)	0.34	%
Series C-1 Preferred Stock	DCF	Option Adjusted Spread	58.46	%
		Preferred adjustment	1.51	%
		Risk-free discount rate(1)	0.34	%
Series D Preferred Stock	Binomial tree	Option Adjusted Spread	58.46	%
	(Black Derman Toy Method)	Preferred adjustment	1.21	%

(1)Based on the remaining life of the instruments.

Under a DCF model, all future cash flows are estimated and discounted to give their present values. The sum of all discounted future cash flows, both incoming and outgoing, is the net present value, which is taken as the value or price of the related cash flows. The discount rate incorporates the credit risk of the Company as well as the subordinated nature of Series C-1 Preferred Stock. As mentioned above, the binomial tree valuation model uses a “discrete-time” (lattice based) model of the varying price over time of the underlying financial instrument. When valuing the Series D Preferred Stock, the lattice represents all possible paths the short term treasury interest rate (six months) could take during the life of the instrument.

The estimates of the fair values of the Whitebox Revolving Credit Facility and the mandatorily redeemable preferred stock are subject to material changes primarily associated with the option-adjusted spread. As the option-adjusted spread increases/decreases, the fair values of these instruments decrease/increase. Additionally, as the risk-free discount rate and the preferred adjustment increase/decrease, the fair values of these instruments increase/decrease.