UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2017

or

For the transition period from                      to                     

Commission file number: 000-50633

CYTOKINETICS, INCORPORATED

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (650) 624-3000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

Number of shares of common stock, $0.001 par value, outstanding as of October 27, 2017: 53,884,669

CYTOKINETICS, INCORPORATED

TABLE OF CONTENTS FOR FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2017

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 PART I. FINANCIAL INFORMATION

CYTOKINETICS, INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data) (Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CYTOKINETICS, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

(In thousands, except per share data) (Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CYTOKINETICS, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands) (Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CYTOKINETICS, INCORPORATED

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Organization and Significant Accounting Policies

Cytokinetics, Incorporated (the “Company”, “we” or “our”) was incorporated under the laws of the state of Delaware on August 5, 1997. The Company is a late stage biopharmaceutical company focused on the discovery and development of novel small molecule therapeutics that modulate muscle function for the potential treatment of serious diseases and medical conditions.

The Company’s financial statements contemplate the conduct of the Company’s operations in the normal course of business. The Company has incurred an accumulated deficit of $605.6 million since inception and there can be no assurance that the Company will attain profitability. The Company had a net loss of $87.3 million and net cash used in operations of $77.7 million for the nine months ended September 30, 2017. Cash, cash equivalents and investments increased to $308.2 million at September 30, 2017 from $163.9 million at December 31, 2016. The Company anticipates that it will have operating losses and net cash outflows in future periods.

The Company is subject to risks common to late stage biopharmaceutical companies including, but not limited to, development of new drug candidates, dependence on key personnel, and the ability to obtain additional capital as needed to fund its future plans. The Company’s liquidity will be impaired if sufficient additional capital is not available on terms acceptable to the Company. To date, the Company has funded its operations primarily through sales of its common stock, contract payments under its collaboration agreements, sale of future royalties, debt financing arrangements, sales of its convertible preferred stock, government grants and interest income. Until it achieves profitable operations, the Company intends to continue to fund operations through payments from strategic collaborations, additional sales of equity securities, grants and debt financings. The Company has never generated revenues from commercial sales of its drugs and may not have drugs to market for at least several years, if ever. The Company’s success is dependent on its ability to enter into new strategic collaborations and/or raise additional capital and to successfully develop and market one or more of its drug candidates. As a result, the Company may choose to raise additional capital through equity or debt financings to continue to fund its operations in the future. The Company cannot be certain that sufficient funds will be available from such a financing or through a collaborator when required or on satisfactory terms. Additionally, there can be no assurance that the Company’s drug candidates will be accepted in the marketplace or that any future products can be developed or manufactured at an acceptable cost. These factors could have a material adverse effect on the Company’s future financial results, financial position and cash flows.

Based on the current status of its research and development plans, the Company believes that its existing cash, cash equivalents and investments will be sufficient to fund its cash requirements for at least the next 12 months, from the filing date of this Quarterly Report on Form 10-Q. If, at any time, the Company’s prospects for financing its research and development programs decline, the Company may decide to reduce research and development expenses by delaying, discontinuing or reducing its funding of one or more of its research or development programs. Alternatively, the Company might raise funds through strategic collaborations, public or private financings or other arrangements. Such funding, if needed, may not be available on favorable terms, or at all. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Basis of Presentation

The condensed consolidated financial statements include the accounts of Cytokinetics and its wholly owned subsidiary. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. The financial statements include all adjustments (consisting only of normal recurring adjustments) that management believes are necessary for the fair statement of the Company’s position at September 30, 2017, and the results of operations for the three and nine months ended September 30, 2017 and the cash flows for the nine months ended September 30, 2017. These interim financial statement results are not necessarily indicative of results to be expected for the full fiscal year or any future interim period. The balance sheet at December 31, 2016 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete financial statements. The financial statements and related disclosures have been prepared with the presumption that users of the interim financial statements have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction

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with the audited financial statements and notes thereto contained in the Company’s Form 10-K for the year ended December 31, 2016, as filed with the SEC on March 6, 2017.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Stock-Based Compensation

The Company accounts for stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases by measuring the stock-based compensation cost at the grant date based on the calculated fair value of the award, and recognizing expense on a straight-line basis over the employee’s requisite service period, generally the vesting period of the award. Stock compensation for non-employees is measured at the fair value of the award for each period until the award is fully vested. Compensation cost for restricted stock awards that contain performance conditions is based on the grant date fair value of the award and compensation expense is recorded over the implicit or explicit requisite service period based on management’s best estimate as to whether it is probable that the shares awarded are expected to vest.

The Company reviews the valuation assumptions at each grant date and, as a result, from time to time it will likely change the valuation assumptions it uses to value stock based awards granted in future periods. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates at the time, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if conditions change and the management uses different assumptions, the Company’s stock-based compensation expense could be materially different in the future. In addition, the Company will continue to maintain the current forfeiture policy to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If the actual forfeiture rate is materially different from management’s estimate, stock-based compensation expense could be significantly different from what has been recorded in the current period.

Non-Cash Interest Expense on Liability Related to Sale of Future Royalties

The Company accounted for the Liability related to sale of future royalties as a debt financing for accounting purposes, to be amortized under the effective interest rate method over the life of the related royalty stream when the Company has a significant continuing involvement in the generation of royalty streams.

          Liability related to sale of future royalties and the debt amortization are based on the Company’s current estimates of future royalties expected to be paid over the life of the arrangement. The Company will periodically assess the expected royalty payments using a combination of internal projections and forecasts from external sources. To the extent the Company’s future estimates of future royalty payments are greater or less than its previous estimates or the estimated timing of such payments is materially different than its previous estimates, the Company will adjust the Liability related to sale of future royalties and prospectively recognize related non-cash interest expense.

Prior Year’s Presentations

Certain amounts in the prior year’s presentations have been reclassified to conform to the current presentation. These reclassifications had no effect on previously reported net income.

Recent Accounting Pronouncements

In May 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (“ASU”) 2017-09, Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. Under this new guidance, modification accounting is required if the fair value, vesting conditions, or classification of the award changes as a result of the change in terms or conditions. ASU 2017-09 is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within each annual reporting period. The Company does not expect the adoption of this guidance to have a material impact on its financial statements or disclosures.

In August 2016, the FASB issued ASU 2016-15, ‘Statement of cash flows (Topic 230): Classification of certain cash receipts and cash payments’. ASU 2016-15 issued guidance to clarify how certain cash receipts and payments should be presented in the statement of cash flows. ASU 2016-15 is effective for annual and interim reporting periods beginning after December 15, 2017 and early adoption is permitted. The Company does not expect the adoption of this standard to have a material effect on its financial statements or disclosures.

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In June 2016, the FASB issued ASU 2016-13, ‘Financial Instruments — Credit Losses — Measurement of Credit Losses on Financial Instruments. ASU 2016-13 changes the impairment model for most financial assets and certain other instruments. ASU 2016-13 is effective for annual and interim reporting periods beginning after December 15, 2019. The Company is in the process of evaluating the impact the adoption of this standard would have on its financial statements and disclosures.

In March 2016, the FASB issued ASU No. 2016-09 — Improvements to Employee Share-Based Payment Accounting which simplifies various aspects of accounting for share-based payments and presentation in the financial statements. ASU 2016-09 is effective for annual and interim reporting periods beginning after December 15, 2016 and early adoption is permitted. During the three months ended March 31, 2017, the Company adopted ASU No. 2016-09 on a modified retrospective approach. The guidance requires us to recognize all excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement and recognize previously unrecognized excess tax benefits upon adoption as a cumulative-effect adjustment in retained earnings, which eliminates the need to track unrecognized excess tax benefits for both new and existing awards. As of January 1, 2017, the Company recognized excess tax benefit of $0.7 million as an increase to deferred tax assets related to tax loss carryover. However, the entire amount was offset by a full valuation allowance. Accordingly, no cumulative-effect adjustment to retained earnings was recorded as of September 30, 2017. The Company will maintain its current forfeiture policy to estimate forfeitures expected to occur to determine stock-based compensation expense. The adoption of this aspect of the guidance did not have a material impact on our financial statements and disclosures.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 requires management to record right-to-use asset and lease liability on the statement of financial position for operating leases. ASU 2016-02 is effective for annual and interim reporting periods beginning on or after December 15, 2018 and the modified retrospective approach is required. The Company is in the process of evaluating the impact the adoption of this standard would have on its financial statements and disclosures.

In January 2016, the FASB issued ASU 2016-01, Financial instruments (Subtopic 825-10). ASU 2016-01 requires management to measure equity investments at fair value with changes in fair value recognized in net income. ASU 2016-01 is effective for annual and interim reporting periods beginning on or after December 15, 2017 and early adoption is not permitted. The Company does not expect the adoption of ASU 2016-01 to have a material effect upon its financial statements or disclosures.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In March 2016, the FASB amended the principal-versus-agent implementation guidance and illustrations in the new standard. In April 2016, the FASB amended the guidance on identifying performance obligations and the implementation guidance on licensing in the new standard. In May 2016, the FASB amended the guidance on collectability, noncash consideration, presentation of sales tax and transition in the new standard. In December 2016, the FASB issued ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers, which amends certain narrow aspects of the guidance issued in ASU 2014-09. The new standard will become effective starting on January 1, 2018. Early application is permitted to the original effective date of January 1, 2017. The Company will adopt the standard on January 1, 2018. The standard permits the use of either the modified retrospective method or full retrospective approach for all periods presented. The Company currently anticipates adopting the standard using the modified retrospective method. The Company is still in the process of completing its analysis on the impact this guidance will have on its consolidated financial statements and related disclosures.

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Note 2 — Net Loss Per Share

The following is the calculation of basic and diluted net (loss) income per share (in thousands, except per share data):

Basic net (loss) income per share is computed by dividing net (loss) income by the weighted average number of vested common shares outstanding during the period. Diluted net (loss) income per share is computed by giving effect to all potentially dilutive common shares, including outstanding stock options, unvested restricted stock units, warrants, and shares issuable under the Company’s Employee Stock Purchase Plan (“ESPP”), by applying the treasury stock method, if they have a dilutive effect. The following instruments were excluded from the computation of diluted net (loss) income per share because their effect would have been antidilutive (in thousands):

Note 3 — Supplemental Cash Flow Data

Supplemental cash flow data was as follows (in thousands):

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Note 4 — Research and Development Arrangements

Amgen Inc. (“Amgen”)

The Company and Amgen continue activities to discover, develop and commercialize novel small molecule therapeutics, including omecamtiv mecarbil, that activate cardiac muscle contractility for potential applications in the treatment of heart failure under the collaboration and option agreement between the Company and Amgen, as amended (the “Amgen Agreement”). The Company has recognized research and development revenue from Amgen for reimbursements of internal costs of certain full-time employee equivalents, supporting a collaborative research program directed to the discovery of next-generation cardiac sarcomere activator compounds and the development program for omecamtiv mecarbil, and other costs related to the research and development program.

 The Company provided notice to Amgen of its exercise of its option under the Amgen Agreement to fully co-invest $40.0 million in the Phase 3 development program of omecamtiv mecarbil in exchange for a total incremental royalty from Amgen of up to 4% on increasing worldwide sales of omecamtiv mecarbil outside Japan.

The Company made co-investment payments of $6.3 million and $13.8 million during the three and nine months ended September 30, 2017, respectively. Because these payments are contingent on Amgen continuing the Phase 3 development program of omecamtiv mecarbil and the benefit to be received in exchange for the payments is not sufficiently separable from the Amgen Agreement the Company reduced research and development revenues by the amount of these payments.

Revenue from Amgen was as follows (in thousands):

As of September 30, 2017, there was $10.0 million accounts receivables due from Amgen in connection with the development milestone describe below  and no accounts receivables due from Amgen as of December 31, 2016.

In September 2017, the Company recognized $10.0 million for a development milestone related to the start of GALACTIC-HF in Japan, the Phase 3 cardiovascular outcomes clinical trial of omecamtiv mecarbil which is being conducted by Amgen. Under the Amgen Agreement, the Company is eligible to receive over $300.0 million in additional development milestone payments which are based on various clinical milestones, including the initiation of certain clinical studies, the submission of an application for marketing authorization for a drug candidate to certain regulatory authorities and the receipt of such approvals. Additionally, the Company is eligible to receive up to $300.0 million in commercial milestone payments provided certain sales targets are met. Due to the nature of drug development, including the inherent risk of development and approval of drug candidates by regulatory authorities, it is not possible to estimate if and when these milestone payments could be achieved or become due. The achievement of each of these milestones is dependent solely upon the results of Amgen’s development and commercialization activities. 

In 2013, in conjunction with the Amgen Agreement, the Company sold 1,404,100 shares of its common stock to Amgen, subject to certain trading restrictions. Prior to April 1, 2017, the Company considered Amgen to be a related party, due in part to Amgen’s equity ownership percentage, and reported revenue under the Amgen Agreement to be revenues from a related party. Effective April 1, 2017, in part due to a decrease in Amgen’s equity ownership percentage, the Company no longer considers Amgen to be a related party.

Astellas Pharma Inc. (“Astellas”)

The Company and Astellas continue activities focused on the research, development, and commercialization of skeletal muscle activators, including CK-2127107, as novel drug candidates for diseases and medical conditions associated with muscle weakness under the Amended and Restated License and Collaboration Agreement dated December 22, 2014, as amended (the “Astellas Agreement”).

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The Company has recognized research and development revenue from Astellas for reimbursements of internal costs of certain full-time employee equivalents, supporting collaborative research and development programs, and of other costs related to those programs.

The Astellas Agreement expanded the existing exclusive license to include certain neuromuscular indications, such as spinal muscle atrophy (“SMA”), and Astellas paid the Company a $30 million non-refundable upfront license fee and a $15.0 million milestone payment relating to Astellas’ decision to advance CK-2127107 into Phase 2 clinical development. The Company determined that the license for the expanded SMA rights and the research and development services relating to the Astellas Agreement are a single unit of accounting as the license was determined to not have stand-alone value. Accordingly, the Company is recognizing this revenue over the research term of the Astellas Agreement using the proportional performance model.

In 2016, in connection with an amendment to the Astellas Agreement (the “2016 Astellas Amendment”), the 2016 Astellas Amendment futher expanded to include the development of CK-2127207 for the potential treatment of ALS, and Astellas paid the Company a $35.0 million non-refundable upfront amendment fee and an accelerated $15.0 million milestone payment for the initiation of the first Phase 2 clinical trial of CK-2127107 in ALS that was otherwise provided for in the Astellas Agreement, as if such milestone had been achieved upon the execution of the 2016 Astellas Amendment, and committed research and development consideration of $44.2 million (total consideration of $94.2 million), which the Company allocated between units of accounting for license fees and research and development services. The Company allocated $24.9 million of research and development consideration to the license and $19.3 million of the research and development consideration to research and development services, to be recognized as revenue as research and development services are performed.

The Company’s agreements with Astellas were further amended effective April 1, 2017 to adjust the payment mechanisms under these agreements because Astellas will also be incurring a portion of the development costs for ALS. This amendment had no effect on the accounting for these agreements.

Astellas’ Option on Tirasemtiv

In 2016, in connection with the 2016 Astellas Amendment, Astellas paid the Company a $15.0 million non-refundable option fee for an option for a global collaboration for the development and commercialization of tirasemtiv (the “Option on Tirasemtiv”). The Option on Tirasemtiv expires unless exercised following the receipt of the approval letter for tirasemtiv from the FDA.

Prior to Astellas’ exercise of the Option on Tirasemtiv, the Company will continue the development of tirasemtiv, including the conduct of VITALITY-ALS, at its own expense to support regulatory approval in the U.S., EU and certain other jurisdictions and will retain the final decision making authority on the development of tirasemtiv. Therefore, the Company concluded that there was no obligation related to any development services during the option period.

If Astellas exercises the Option on Tirasemtiv:

Contingent upon the successful development of tirasemtiv, the Company may receive from Astellas milestone payments up to $100.0 million for the initial indication and up to $50.0 million for each subsequent indication. If tirasemtiv is commercialized, Astellas will pay the Company royalties (at rates ranging from the mid-teens to twenty percent) on sales of tirasemtiv in Astellas’ territory, and the Company will pay Astellas royalties (at rates up to the mid-teens) on sales of tirasemtiv in the Company’s territory, in each case subject to various possible adjustments.

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The Company concluded that the Option on Tirasemtiv is a substantive option, and is therefore not considered a deliverable at the execution of the 2016 Astellas Amendment. The Company determined that the License on Tirasemtiv is contingent upon the exercise of the Option on Tirasemtiv, and is therefore not effective during the periods presented, since the option has not been exercised as of the latest balance sheet date. In addition, the Company did evaluate the consideration set to be received for the License on Tirasemtiv in relation to the fair value of the License on Tirasemtiv, and determined that it was not being provided at a significant incremental discount.

The Company further determined that the option fee of $15.0 million was deemed to be a prepayment towards the License on Tirasemtiv, and therefore deferred revenue recognition of the option fee either until the Option on Tirasemtiv is exercised or expires unexercised. Unless exercised, the Option on Tirasemtiv expires following the receipt of the approval letter for tirasemtiv from the FDA. If the Option on Tirasemtiv expires unexercised, the $15.0 million received would be added to the 2016 Astellas Amendment consideration, to be allocated to the units of accounting.

Revenue and deferred revenue from Astellas

Research and development revenue from Astellas was as follows (in thousands):

Deferred Revenue reflecting the unrecognized portion of the license fees, option fee and payment of expenses from Astellas was as follows (in thousands):

There were no accounts receivable due from Astellas at September 30, 2017 and December 31, 2016. 

Under the Astellas Agreement, additional research and early and late state development milestone payments which are based on various research and clinical milestones, including the initiation of certain clinical studies, the submission of an application for marketing authorization for a drug candidate to certain regulatory authorities and the commercial launch of collaboration products could total over $600.0 million, including up to $95.0 million relating to CK-2127107 in non-neuromuscular indications, and over $100.0 million related to CK-2127107 in each of spinal muscular atrophy (“SMA”), amyotrophic lateral sclerosis (“ALS”) and other neuromuscular indications. Additionally, $200.0 million in commercial milestones could be received under the Astellas Agreement provided certain sales targets are met. The achievement of each of the late stage development milestones and the commercialization milestones was determined to be dependent solely upon the results of Astellas’ development activities and therefore these potential milestone payments were not deemed to be substantive. The Company is eligible to receive up to $2.0 million in research milestone payments under the collaboration for each future potential drug candidate. The Company believes that each of the milestones related to research under the Astellas Agreement is substantive and can only be achieved with the Company’s past and current performance and each milestone will result in additional payments to the Company. Due to the nature of drug development, including the inherent risk of development and approval of drug candidates by regulatory authorities, it is not possible to estimate if and when these milestone payments could be achieved or become due.

In conjunction with the Astellas Agreement in December 2014, the Company also sold 2,040,816 shares of its common stock to Astellas at a price per share of $4.90 and an aggregate purchase price of $10.0 million, subject to certain trading restrictions. Prior to April 1, 2017, the Company considered Astellas to be a related party, due in part to Astellas’ equity ownership percentage, and reported revenue under the Astellas Agreement to be revenues from a related party. Effective April 1, 2017, in part due to a decrease in Astellas’ equity ownership percentage, the Company no longer considers Astellas to be a related party.

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Note 5 — Cash Equivalents and Investments

Cash Equivalents and Available for Sale Investments

The amortized cost and fair value of cash equivalents and available for sale investments at September 30, 2017 and December 31, 2016 were as follows (in thousands):

At September 30, 2017 there were no investments that had been in a continuous unrealized loss position for 12 months or longer.

Interest income was as follows (in thousands):

Note 6 — Fair Value Measurements

The Company follows the fair value accounting guidance to value its financial assets and liabilities. Fair value is defined as the price that would be received for assets when sold or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company utilizes market data or assumptions that the Company believes market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable.

The Company primarily applies the market approach for recurring fair value measurements and endeavors to utilize the best information reasonably available. Accordingly, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible, and considers the security issuers’ and the third-party insurers’ credit risk in its assessment of fair value.

The Company classifies the determined fair value based on the observability of those inputs. Fair value accounting guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). The three defined levels of the fair value hierarchy are as follows:

Level 1 — Observable inputs, such as quoted prices in active markets for identical assets or liabilities;

Level 2 — Inputs, other than the quoted prices in active markets, that are observable either directly or through corroboration with observable market data; and

Level 3 — Unobservable inputs, for which there is little or no market data for the assets or liabilities, such as internally-developed valuation models.

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Fair value of financial assets:

Financial assets measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016 are classified in the table below in one of the three categories described above (in thousands):

The valuation technique used to measure fair value for the Company’s Level 1 assets is a market approach, using prices and other relevant information generated by market transactions involving identical assets. When quoted market prices are not available for the specific security, then the Company estimates fair value by using benchmark yields, reported trades, broker/dealer quotes, and issuer spreads; these securities are classified as Level 2. As of September 30, 2017 and December 31, 2016, the Company had no financial assets measured at fair value on a recurring basis using significant Level 3 inputs. The carrying amount of the Company’s accounts receivable and accounts payable approximates fair value due to the short-term nature of these instruments.

Fair value of financial liabilities:

As of September 30, 2017 and December 31, 2016, the fair value of the long-term debt, payable in installments through year ended 2020, approximated its carrying value of $30.3 million and $29.9 million, respectively, because it is carried at a market observable interest rate, which are considered Level 2.