FALCONSTOR SOFTWARE INC - 10-K filing on 2017-03-10

Fair Value Measurements

12 Months Ended

Dec. 31, 2016

The Company measures its cash equivalents, marketable securities and derivative instruments at fair value. Fair value is an exit price, representing the amount that would be received on the sale of an asset or that would be paid to transfer a liability in an orderly transaction between market participants. As a basis for considering such assumptions, the Company utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value.

Fair Value Hierarchy

The methodology for measuring fair value specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the Company’s own assumptions of market participant valuation (unobservable inputs). As a result, observable and unobservable inputs have created the following fair value hierarchy:


•	Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities. At December 31, 2016 and 2015, the Level 1 category included money market funds and commercial paper, which are included within “cash and cash equivalents” in the consolidated balance sheets.

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Level 2 – Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly. The Company had no Level 2 securities at December 31, 2016. At December 31, 2015, the Level 2 category included government securities and corporate debt securities, which are included within “marketable securities” in the consolidated balance sheets.

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Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. At December 31, 2016 and 2015, the Level 3 category included derivatives, which are included in "other long-term liabilities" in the consolidated balance sheets with the change in fair value from the period included in "interest and other loss, net" in the consolidated statement of operations. The Company did not hold any cash, cash equivalents or marketable securities categorized as Level 3 as of December 31, 2016 or 2015.

Measurement of Fair Value

The Company measures fair value as an exit price using the procedures described below for all assets and liabilities measured at fair value. When available, the Company uses unadjusted quoted market prices to measure fair value and classifies such items within Level 1. If quoted market prices are not available, fair value is based upon financial models that use, when possible, current market-based or independently-sourced market parameters such as interest rates and currency rates. Items valued using financial generated models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be inputs that are readily observable. If quoted market prices are not available, the valuation model used generally depends on the specific asset or liability being valued. The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments.

The fair value of the Company’s investments in corporate debt and government securities have been determined utilizing third party pricing services and reviewed by management. The pricing services use inputs to determine fair value which are derived from observable market sources including reportable trades, benchmark curves, credit spreads, broker/dealer quotes, bids, offers, and other industry and economic events. These investments are included in Level 2 of the fair value hierarchy.

The fair value of the Company’s derivatives were valued using the Black-Scholes pricing model adjusted for probability assumptions, with all significant inputs, except for the probability and volatility assumptions, derived from or corroborated by observable market data such as stock price and interest rates. The probability and volatility assumptions are both significant to the fair value measurement and unobservable. These embedded derivatives are included in Level 3 of the fair value hierarchy.

Items Measured at Fair Value on a Recurring Basis

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2016:



			Fair Value Measurements at Reporting Date Using
	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant other Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Cash equivalents:
Money market funds	$	1,133,280	$	1,133,280	$	—	$	—
Total cash equivalents	1,133,280		1,133,280		—		—
Marketable securities:
Corporate debt and government securities	—		—		—		—
Total marketable securities	—		—		—		—
Derivative liabilities:
Derivative Instruments	336,862		—		—		336,862
Total derivative liabilities	336,862		—		—		336,862

Total assets and liabilities measured at fair value	$	1,470,142	$	1,133,280	$	—	$	336,862

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2015:



			Fair Value Measurements at Reporting Date Using
	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant other Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Cash equivalents:
Money market funds and commercial paper	$	2,725,094	$	2,725,094	$	—	$	—
Total cash equivalents	2,725,094		2,725,094		—		—
Marketable securities:
Corporate debt and government securities	7,420,042		—		7,420,042		—
Total marketable securities	7,420,042		—		7,420,042		—
Derivative liabilities:
Derivative Instruments	82,024		—		—		82,024
Total derivative liabilities	82,024		—		—		82,024

Total assets and liabilities measured at fair value	$	10,227,160	$	2,725,094	$	7,420,042	$	82,024

The following table presents the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of each of the years ended December 31, 2016 and 2015:



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
	December 31, 2016		December 31, 2015
Beginning Balance	$	82,024	$	137,171
Issuance of Derivative Instruments	—		—
Total loss (gain) recognized in earnings	254,838		(55,147		)
Ending Balance	$	336,862	$	82,024