Digital Turbine, Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

Fair Value Measurements

Fair Value Measurements

12 Months Ended

Mar. 31, 2018

The Company applies the provisions of ASC 820-10, “Fair Value Measurements and Disclosures.” ASC 820-10 defines fair value, and establishes a three-level valuation hierarchy for disclosures of fair value measurement that enhances disclosure requirements for fair value measures. The carrying amounts reported in the consolidated balance sheets for receivables and current liabilities each qualify as financial instruments and are a reasonable estimate of their fair values because of the short period of time between the origination of such instruments and their expected realization and their current market rate of interest. The three levels of valuation hierarchy are defined as follows:


•	Level 1 inputs to the valuation methodology are quoted prices for identical assets or liabilities in active markets.


•	Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.


•	Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The Company analyzes all financial instruments with features of both liabilities and equity under ASC 480, “Distinguishing Liabilities From Equity” and ASC 815, “Derivatives and Hedging.” Derivative liabilities are adjusted to reflect fair value at each period end, with any increase or decrease in the fair value being recorded in results of operations as adjustments to fair value of derivatives. The effects of interactions between embedded derivatives are calculated and accounted for in arriving at the overall fair value of the financial instruments. In addition, the fair values of freestanding derivative instruments such as warrant and option derivatives are valued using the Black-Scholes model.

The Company’s financial liabilities as of the issuance date of the convertible notes on the initial measurement date of September 28, 2016 are presented below at fair value and were classified within the fair value hierarchy as follows:



	Level 1		Level 2		Level 3		Balance as of September 28, 2016
Financial Liabilities
Convertible note embedded derivative liability	$	—	$	—	$	3,693	$	3,693
Warrant liability	$	—	$	—	$	1,223	$	1,223
Total	$	—	$	—	$	4,916	$	4,916

The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires management to make judgments and consider factors specific to the liability. Fair value of the Notes is determined using the residual method of accounting whereby, first, a portion of the proceeds from the issuance of the Notes is allocated to derivatives embedded in the Notes and the warrants issued in connection with the issuance of the Notes, and the proceeds so allocated are accounted for as a convertible note embedded derivative liability and warrant liability, respectively, and second, the remainder of the proceeds from the issuance of the Notes is allocated to the convertible notes, resulting in an original debt discount amounting to $4,916. The convertible notes will remain on the consolidated balance sheet at historical cost, accreted up for the amount of cumulative amortization of the debt discount over the life of the debt. The method of determining the fair value of the convertible note embedded derivative liability and warrant liability are described subsequently in this note. Market risk associated with the convertible note embedded derivative liability and warrant liability relates to the potential reduction in fair value and negative impact to future earnings from an increase in price of the Company's common stock. Please refer to Note 9 "Debt" for more information.

The carrying amounts of certain financial instruments, such as cash, accounts receivable, accounts payable and accrued liabilities, approximate fair value due to their relatively short maturities.

As of March 31, 2018, the Company’s financial assets and financial liabilities are presented below at fair value and were classified within the fair value hierarchy as follows (in thousands):



	Level 1		Level 2		Level 3		Balance as of March 31, 2018
Financial Liabilities
Convertible note embedded derivative liability	$	—	$	—	$	4,676	$	4,676
Warrant liability	$	—	$	—	$	3,980	$	3,980
Total	$	—	$	—	$	8,656	$	8,656



	Level 1		Level 2		Level 3		Balance as of March 31, 2017
Financial Liabilities
Convertible note embedded derivative liability	$	—	$	—	$	3,218	$	3,218
Warrant liability	$	—	$	—	$	1,076	$	1,076
Total	$	—	$	—	$	4,294	$	4,294

Convertible Note Embedded Derivative Liability

On September 28, 2016, the Company sold to an investment bank (the "Initial Purchaser"), 16,000 principal amount of 8.75% convertible notes maturing on September 23, 2020 (the “Notes”), unless converted, repurchased, or redeemed in accordance with their terms prior to such date. We evaluated the terms and features of our convertible notes and identified embedded derivatives (conversion options that contain “make-whole interest” provisions, fundamental change provisions, or down round conversion price adjustment provisions; collectively called the "convertible note embedded derivative liability") requiring bifurcation and accounting at fair value because the economic and contractual characteristics of the embedded derivatives met the criteria for bifurcation and separate accounting. ASC 815-10-15-83 (c) states that if terms implicitly or explicitly require or permit net settlement, then it can readily be settled net by means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. The conversion features related to the convertible notes consists of a “make-whole interest” provision, fundamental change provision, and down round conversion price adjustment provisions, which if the convertible notes were to be converted, would put the convertible note holder in a position not substantially different from net settlement. Given this fact pattern, the conversion features meet the definition of embedded derivatives and require bifurcation and accounting at fair value.

During fiscal year 2018, holders of $10,300 of the Notes, respectively, elected to convert such Notes. At March 31, 2018, aggregate principal amount of $5,700 remained outstanding and is reflected on the balance sheet, net of debt issuance costs and discounts of $1,827, in the amount of $3,873. Refer to Note 9 "Debt - Convertible Notes" and Note 12 "Capital Stock Transactions" for more details.

The convertible note embedded derivative liability represent the fair value of the conversion option, fundamental change provision, and "make-whole" provisions, as well as the down round conversion price adjustment or conversion rate adjustment provisions of the convertible notes. There is no current observable market for these types of derivatives and, as such, the Company determined the fair value of the derivative liability using a lattice approach that incorporates a Monte Carlo simulation valuation model. A Monte Carlo simulation valuation model considers the Company's future stock price, stock price volatility, probability of a change of control and the trading information of the Company's common stock into which the notes are or may become convertible. The Company marks the derivative liability to market at the end of each reporting period due to the conversion price not being indexed to the Company's own stock.

Changes in the fair value of the convertible note embedded derivative liability is reflected in our consolidated statements of operations as “Change in fair value of convertible note embedded derivative liability.”

The following table provides a reconciliation of the beginning and ending balances for the convertible note embedded derivative liability measured at fair value using significant unobservable inputs (Level 3):



	Level 3
Balance at March 31, 2017	$	3,218
Change in fair value of convertible note embedded derivative liability	7,559
Derecognition on extinguishment or conversion	(6,101		)
Balance at March 31, 2018	$	4,676

Due to the valuation of the derivative liability being highly sensitive to the trading price of the Company's stock, the increase and decrease in the trading price of the Company's stock has the impact of increasing the (loss) and gain, respectively.

Due to the Company's closing stock price increasing from March 31, 2017 to March 31, 2018 from $0.94 to $2.01, the Company recorded a loss of $7,559 during the year ended March 31, 2018.

Due to the Company's closing stock price decreasing from the inception of the Notes on September 28, 2016 to March 31, 2017 from $0.99 to $0.94, the Company recorded a gain of $475 during the year ended March 31, 2017.

The market-based assumptions and estimates used in valuing the convertible note embedded derivative liability include amounts in the following amounts:



	March 31, 2018
Stock price volatility	70	%
Probability of change in control	1.75	%
Stock price (per share)	$2.01
Expected term	2.50 years
Risk-free rate (1)	2.30	%
Assumed early conversion/exercise price (per share)	$2.73

^{(1) The Monte Carlo simulation assumes the continuously compounded equivalent (CCE) interest rate of}^1.0%^{based on the average of the 3-year and 5-year U.S. Treasury securities as of the valuation date.}

Changes in valuation assumptions can have a significant impact on the valuation of the convertible note embedded derivative liability. For example, all other things being equal, a decrease/ increase in our stock price, probability of change of control, or stock price volatility decreases/increases the valuation of the liabilities, whereas a decrease/increase in risk-free interest rates increases/decreases the valuation of the liabilities.

Warrant Liability

The Company issued detachable warrants with the convertible notes issued on September 28, 2016. The Company accounts for its warrants issued in accordance with US GAAP accounting guidance under ASC 815 applicable to derivative instruments, which requires every derivative instrument within its scope to be recorded on the balance sheet as either an asset or liability measured at its fair value, with changes in fair value recognized in earnings. Based on this guidance, the Company determined that these warrants did not meet the criteria for classification as equity. Accordingly, the Company classified the warrants as long-term liabilities. The warrants are subject to re-measurement at each balance sheet date, with any change in fair value recognized as a component of other income (expense), net in the statements of operations. We estimated the fair value of these warrants at the respective balance sheet dates using a lattice approach that incorporates a Monte Carlo simulation that considers the Company's future stock price. Option pricing models employ subjective factors to estimate warrant liability; and, therefore, the assumptions used in the model are judgmental.

Changes in the fair value of the warrant liability is primarily related to the change in price of the underlying common stock of the Company and is reflected in our consolidated statements of operations as “Change in fair value of warrant liability.”

The following table provides a reconciliation of the beginning and ending balances for the warrant liability measured at fair value using significant unobservable inputs (Level 3):



	Level 3
Balance at March 31, 2017	$	1,076
Change in fair value of warrant liability	$	3,208
Derecognition on exercise	$	(304	)
Balance at March 31, 2018	$	3,980

Due to the Company's closing stock price increasing from March 31, 2017 to March 31, 2018 from $0.94 to $2.01, the Company recorded a loss of $3,208 during the year ended March 31, 2018.

Due to the Company's closing stock price decreasing from the inception of the Notes on September 28, 2016 to March 31, 2017 from $0.99 to $0.94, the Company recorded a gain of $147 during the year ended March 31, 2017.

The market-based assumptions and estimates used in valuing the warrant liability include amounts in the following amounts:



	March 31, 2018
Stock price volatility	70	%
Probability of change in control	1.75	%
Stock price (per share)	$2.01
Expected term	2.50 years
Risk-free rate (1)	2.30	%
Assumed early conversion/exercise price (per share)	$2.73

Changes in valuation assumptions can have a significant impact on the valuation of the warrant liability. For example, all other things being equal, a decrease/increase in our stock price, probability of change of control, or stock price volatility decreases/increases the valuation of the liabilities, whereas a decrease/increase in risk-free interest rates increases/decreases the valuation of the liabilities.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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