FAIR VALUE MEASUREMENTS & DERIVATIVE INSTRUMENTS

12 Months Ended

Sep. 30, 2012

FAIR VALUE MEASUREMENTS & DERIVATIVE INSTRUMENTS

NOTE 10. FAIR VALUE MEASUREMENTS & DERIVATIVE INSTRUMENTS

The Company measures its financial assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Additionally, the Company is required to provide disclosure and categorize assets and liabilities measured at fair value into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Level 1 provides the most reliable measure of fair value while Level 3 generally requires significant management judgment. Financial assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows:

Level 1—Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2—Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly.

Level 3—Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date.

The following table summarizes fair value measurements at September 30, 2012 and September 30, 2011 for assets and liabilities measured at fair value on a recurring basis:

September 30, 2012:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	3,377,288	$	—	$	—	$	3,377,288
Marketable securities	$	106,500	$	—	$	—	$	106,500
Derivative assets	$	—	$	—	$	250,250	$	250,250
Derivative liabilities	$	—	$	—	$	647,213	$	647,213
Contingent consideration	$	—	$	—	$	173,621	$	173,621
September 30, 2011:
	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	7,507,389	$	—	$	—	$	7,507,389
Marketable securities	$	634,585	$	—	$	—	$	634,585
Derivative assets	$	—	$	—	$	161,125	$	161,125
Derivative liabilities	$	—	$	—	$	944,980	$	944,980
Contingent consideration	$	—	$	—	$	—	$	—

As part of the sale of proceeds from the sale of Unidym in January 2011, Arrowhead received a bond from Wisepower in the face amount of $2.5 million. The bond is convertible to Wisepower common stock at a price of $2.00 per share. The conversion feature is subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the conversion feature on the date of issuance was estimated using an option pricing model and recorded on the Company’s consolidated balance sheet as a derivative asset. The fair value of the conversion feature is estimated at the end of each reporting period and the change in the fair value of the conversion feature is recorded as a nonoperating gain/loss as change in value of derivatives in Company’s Consolidated Statement of Operations. A portion of the bond is owed to a third party, as such the company records a derivative asset for the entire conversion feature and records a derivative liability for the portion related to the third party. The original fair value of the derivative relating to the third party was $26,310; the fair value at September 30, 2011 was $6,854, and the fair value at September 30, 2012 was $10,645. The gain from the change in value of the derivative asset, net of the derivative liability, for the year ended September 30, 2012 was $85,334, and is reflected in the change in value of derivatives in the Company’s consolidated statement of operations.

During the year ended September 30, 2012, the Company recorded a gain from the change in fair value of the derivative asset of $89,125. The assumptions used in valuing the derivative asset as of September 30, 2012 and 2011 were as follows:

	September 30, 2012	September 30, 2011
Risk free interest rate	0.23%	0.4%
Expected life	1.3 Years	2.3 Years
Dividend yield	none	none
Volatility	72%	72%

The following is a reconciliation of the derivative asset for the years ended September 30, 2012 and 2011:

Value at September 30, 2010	$	—
Receipt of instruments		618,500
Change in value		(457,375	)
Value at October 1, 2011		161,125
Receipt of instruments		—
Increase in value		89,125
Net settlements		—
Value at September 30, 2012	$	250,250

As part of the equity financing on June 17, 2010, Arrowhead issued warrants to acquire up to 329,649 shares of Common Stock (the “Warrants”) which contain a mechanism to adjust the strike price upon the issuance of certain dilutive equity securities. If during the term of the Warrants, the Company issues Common Stock at a price lower than the exercise price of the Warrants, the exercise price of the Warrants would be reduced to the amount equal to the issuance price of the Common Stock. As a result of this feature, the Warrants are subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the Warrants on the date of issuance was estimated using an option pricing model and recorded on the Company’s consolidated balance sheet as a derivative liability. The fair value of the Warrants is estimated at the end of each reporting period and the change in the fair value of the Warrants is recorded as a nonoperating gain or loss in the Company’s consolidated statement of operations. During the year ended September 30, 2012, the Company recorded a non-cash loss from the change in fair value of the derivative liability of $281,038. The assumptions used in valuing the derivative liability as of September 30, 2012 and 2011 were as follows:

	September 30, 2012	September 30, 2011
Risk free interest rate	0.31%	0.9%
Expected life	3.2 Years	4.2 Years
Dividend yield	none	none
Volatility	100%	100%

The following is a reconciliation of the derivative liability related to these warrants for the years ended September 30, 2012 and 2011:

Value at September 30, 2010	$	2,408,522
Receipt of instruments		—
Change in value		(1,501,289	)
Value at September 30, 2011	$	907,233
Receipt of instruments		—
Change in value		(281,038	)
Net settlements		—
Value at September 30, 2012	$	626,195

In conjunction with the financing of Ablaris during the year ended September 30, 2011, Arrowhead sold exchange rights to certain investors whereby the investors have the right to exchange their shares of Ablaris for a prescribed number of Arrowhead shares based upon a predefined ratio. The exchange rights have a seven-year term. During the first year, the exchange right allows the holder to exchange one Ablaris share for 0.06 Arrowhead shares (as adjusted for a subsequent reverse stock split). This ratio declines to 0.04 in the second year, 0.03 in the third year and 0.02 in the fourth year. In the fifth year and beyond the exchange ratio is 0.01. Exchange rights for 675,000 Ablaris shares were sold during the year ended September 30, 2011, and remain outstanding at September 30, 2012. The exchange rights are subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the exchange rights on the date of issuance was estimated using an option pricing model and recorded on the Company’s consolidated balance sheet as a derivative liability. The fair value of the exchange rights is estimated at the end of each reporting period and the change in the fair value of the exchange rights is recorded as a nonoperating gain or loss in the Company’s Consolidated Statement of Operations. During the year ended September 30, 2012, the Company recorded a non-cash loss from the change in fair value of the derivative liability of $20,520. The assumptions used in valuing the derivative liability as of September 30, 2012 and 2011 were as follows:

	September 30, 2012	September 30, 2011
Risk free interest rate	0.62%	1.3%
Expected life	5.3 Years	6.3 Years
Dividend yield	none	none
Volatility	100%	100%

The following is a reconciliation of the derivative liability related to these exchange rights for the years ended September 30, 2012 and 2011:

Value at September 30, 2010	$	—
Issuance of instruments		100,650
Change in value		(69,758	)
Value at September 30, 2011	$	30,892
Issuance of instruments		—
Change in value		(20,520	)
Net settlements		—
Value at September 30, 2012	$	10,372

During the year ended September 30, 2012, contingent consideration was recorded upon the acquisitions of Roche Madison, Inc. and Alvos Therapeutics, Inc., totaling $173,621. The fair value measurement of the contingent consideration obligations is determined using Level 3 inputs. The fair value of contingent consideration obligations is based on a discounted cash flow model using a probability-weighted income approach. The measurement is based upon unobservable inputs supported by little or no market activity based on our own assumptions and experience. Estimating timing to complete the development, and obtain approval of products is difficult, and there are inherent uncertainties in developing a product candidate, such as obtaining U.S. Food and Drug Administration (FDA) and other regulatory approvals. In determining the probability of regulatory approval and commercial success, we utilize data regarding similar milestone events from several sources, including industry studies and our own experience. These fair value measurements represent Level 3 measurements as they are based on significant inputs not observable in the market. Significant judgment is employed in determining the appropriateness of these assumptions as of the acquisition date and for each subsequent period. Accordingly, changes in assumptions could have a material impact on the amount of contingent consideration expense we record in any given period. Changes in the fair value of the contingent consideration obligations are recorded in our consolidated statement of operations. There were no changes in contingent consideration fair value as of September 30, 2012.

Value at September 30, 2011	$	—
Purchase price contingent consideration		173,621
Contingent consideration payments		—
Change in fair value of contingent consideration		—
Value at September 30, 2012	$	173,621

The carrying amounts of the Company’s other financial instruments, which include accounts receivable, accounts payable, and accrued expenses approximate their respective fair values due to the relatively short-term nature of these instruments. The carrying value of the Company’s debt obligations approximates fair value based on market interest rates.