NOTE 8. FAIR VALUE MEASUREMENTS

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 June 30, 2016 and September 30, 2015 for assets and liabilities measured at fair value on a recurring basis:

June 30, 2016:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	43,616,543	$	—	$	—	$	43,616,543
Derivative liabilities	$	—	$	—	$	1,068,552	$	1,068,552
Acquisition-related contingent consideration obligations	$	—	$	—	$	5,862,464	$	5,862,464

September 30, 2015:

	Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	81,214,354	$	—	$	—	$	81,214,354
Derivative liabilities	$	—	$	—	$	1,301,604	$	1,301,604
Acquisition-related contingent consideration obligations	$	—	$	—	$	5,862,464	$	5,862,464

The Company invests its excess cash balances in short- and long-term corporate bonds, generally with remaining maturities of less than one year. At June 30, 2016, the Company had short-term investments of $1,030,556. The fair value of its investments at June 30, 2016 was $1,003,840. The Company expects to hold such investments until maturity, and thus unrealized gains and losses from the fluctuations in the fair value of the securities are not likely to be realized.

As part of a financing in December 2012, Arrowhead issued warrants to purchase up to 912,543 shares of Common Stock (the “2012 Warrants”) of which 265,161 warrants were outstanding at June 30, 2016. Further, as part of a financing in January 2013, Arrowhead issued warrants to purchase up to 833,530 shares of Common Stock (the “2013 Warrants” and, together with the 2012 Warrants, the “Warrants”) of which 12,123 warrants were outstanding at June 30, 2016. Each of the Warrants contains a mechanism to adjust the strike price upon the issuance of certain dilutive equity securities. If during the terms of the Warrants, the Company issues Common Stock at a price lower than the exercise price for the Warrants, the exercise price would be reduced to the amount equal to the issuance price of the Common Stock. As a result of these features, 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 non-operating gain or loss as change in value of derivatives in the Company’s Consolidated Statement of Operations and Comprehensive Loss. During the three and nine months ended June 30, 2016, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $(110,859) and $230,082, respectively. During the three and nine months ended June 30, 2015, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $(102,763) and $2,268,798, respectively. Additionally, as part of an equity financing in June 2010, Arrowhead issued warrants to purchase up to 329,649 shares of Common Stock (the “2010 Warrants”), of which warrants to exercise 24,324 shares remained unexercised and were cancelled at their expiration during fiscal 2016.

The assumptions used in valuing the derivative liability were as follows:

2012 Warrants	June 30, 2016	September 30, 2015
Risk-free interest rate	0.52%	0.6%
Expected life	1.5 Years	2.2 Years
Dividend yield	—	—
Volatility	89%	75%

2013 Warrants	June 30, 2016	September 30, 2015
Risk-free interest rate	0.52%	0.6%
Expected life	1.6 Years	2.3 Years
Dividend yield	—	—
Volatility	89%	75%

The following is a reconciliation of the derivative liability related to these warrants:

Value at September 30, 2015	$	1,272,802
Issuance of instruments		—
Change in value		(230,852	)
Net settlements		—
Value at June 30, 2016	$	1,041,950

In conjunction with the financing of Ablaris in fiscal 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 of Common Stock based upon a predefined ratio. The exchange rights have a seven-year term and a current exchange ratio of 0.01. Exchange rights for 675,000 Ablaris shares were sold in fiscal 2011, and 500,000 remain outstanding at June 30, 2016. 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 non-operating gain or loss in the Company’s Consolidated Statement of Operations and Comprehensive Loss. During the three and nine months ended June 30, 2016, the Company recorded a non-cash gain/(loss) from the change in fair value of the derivative liability of $(2,500) and $2,200, respectively. During the three and nine months ended June 30, 2015, the Company recorded a non-cash loss and gain from the change in fair value of the derivative liability of $(1,950) and $177,605, respectively.

The assumptions used in valuing the derivative liability were as follows:

	June 30, 2016	September 30, 2015
Risk-free interest rate	0.52%	1.00%
Expected life	1.6 Years	2.5 Years
Dividend yield	—	—
Volatility	89%	75%

The following is a reconciliation of the derivative liability related to these exchange rights:

Value at September 30, 2015	$	28,802
Issuance of instruments		—
Change in value		(2,200	)
Net settlements		—
Value at June 30, 2016	$	26,602

The derivative assets/liabilities are estimated using option pricing models that are based on the individual characteristics of the warrants or instruments on the valuation date, as well as assumptions for expected volatility, expected life and risk-free interest rate. Changes in the assumptions used could have a material impact on the resulting fair value. The primary input affecting the value of the Company’s derivatives liabilities is the Company’s stock price. Other inputs have a comparatively insignificant effect.

As of June 30, 2016, the Company has liabilities for contingent consideration related to its acquisition of the Roche RNAi business completed in 2011. 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 the Company’s 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, the Company utilizes data regarding similar milestone events from several sources, including industry studies and its 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 the Company records in any given period. Changes in the fair value of the contingent consideration obligations are recorded in the Company’s Consolidated Statement of Operations and Comprehensive Loss.

The following is a reconciliation of contingent consideration fair value.

Value at September 30, 2015	$	5,862,464
Purchase price contingent consideration		—
Contingent consideration payments		—
Change in fair value of contingent consideration		—
Value at June 30, 2016	$	5,862,464

The fair value of contingent consideration obligations is estimated through valuation models designed to estimate the probability of such contingent payments based on various assumptions and incorporating estimated success rates. Estimated payments are discounted using present value techniques to arrive at estimated fair value at the balance sheet date. Changes in the fair value of the contingent consideration obligations can result from changes to one or multiple inputs, including adjustments to the discount rates, changes in the amount or timing of expected expenditures associated with product development, changes in the amount or timing of cash flows from products upon commercialization, changes in the assumed achievement or timing of any development milestones, changes in the probability of certain clinical events and changes in the assumed probability associated with regulatory approval. Each of these assumptions can have a significant impact on the calculation of contingent consideration.

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 other long-term liabilities approximates fair value based on market interest rates.