Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the quarterly period ended September 30, 2013.

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the transition period from                    to                   

 

Commission File Number: 1-11388

 

PLC SYSTEMS INC.

(Exact Name of Registrant as Specified in Its Charter)

 

Yukon Territory, Canada

 

04-3153858

(State or Other Jurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer Identification No.)

 

 

 

459 Fortune Boulevard, Milford, Massachusetts

 

01757

(Address of Principal Executive Offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (508) 541-8800

 

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  x  No  o

 

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  x  No  o

 

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.

 

Large accelerated filer o

 

Accelerated filer o

Non-accelerated filer o

 

Smaller reporting company x

(Do not check if a smaller reporting company)

 

 

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at November 6, 2013

Common Stock, no par value

 

161,414,862

 

 

 



Table of Contents

 

PLC SYSTEMS INC.

 

Index

 

Part I.

Financial Information:

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

Condensed Consolidated Balance Sheets (unaudited)

3

 

 

 

 

 

 

Condensed Consolidated Statements of Operations (unaudited)

4

 

 

 

 

 

 

Condensed Consolidated Statements of Comprehensive Loss (unaudited)

5

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows (unaudited)

6

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements (unaudited)

7

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

28

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

35

 

 

 

 

 

Item 4.

Controls and Procedures

35

 

 

 

 

Part II.

Other Information:

 

 

 

 

 

Item 1A.

Risk Factors

36

 

 

 

 

 

Item 6.

Exhibits

36

 

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Table of Contents

 

Part I.        Financial Information

 

Item 1.       Financial Statements

 

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

 

 

September 30,
2013

 

December 31,
2012

 

ASSETS

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

1,404

 

$

258

 

Restricted cash

 

250

 

 

Accounts receivable, net of allowance of $2 at September 30, 2013 and December 31, 2012, respectively

 

488

 

402

 

Inventories

 

145

 

182

 

Prepaid expenses and other current assets

 

144

 

178

 

Total current assets

 

2,431

 

1,020

 

Equipment, furniture and leasehold improvements, net

 

50

 

67

 

Other assets

 

4

 

4

 

Total assets

 

2,485

 

$

1,091

 

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

443

 

$

377

 

Accrued compensation

 

41

 

78

 

Accrued other

 

331

 

368

 

Deferred revenue

 

13

 

317

 

Total current liabilities

 

828

 

1,140

 

Convertible notes

 

5,793

 

8,098

 

Warrant and option liabilities

 

6,452

 

3,800

 

Commitments and contingencies (Note 7)

 

 

 

 

 

Stockholders’ deficit:

 

 

 

 

 

Common stock, no par value, unlimited shares authorized, 125,000 shares issued and outstanding; 37,538 unissued and reserved at September 30, 2013; and 32,434 shares issued and outstanding at December 31, 2012

 

97,263

 

93,893

 

Additional paid in capital

 

 

1,540

 

Accumulated deficit

 

(107,586

)

(107,114

)

Accumulated other comprehensive loss

 

(265

)

(266

)

Total stockholders’ deficit

 

(10,588

)

(11,947

)

Total liabilities and stockholders’ deficit

 

$

2,485

 

$

1,091

 

 

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

 

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Table of Contents

 

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

348

 

$

212

 

$

1,069

 

$

595

 

Cost of revenues

 

124

 

84

 

438

 

308

 

Gross profit

 

224

 

128

 

631

 

287

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

945

 

674

 

2,595

 

1,899

 

Research and development

 

549

 

549

 

1,661

 

1,618

 

Total operating expenses

 

1,494

 

1,223

 

4,256

 

3,517

 

Loss from operations

 

(1,270

)

(1,095

)

(3,625

)

(3,230

)

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest expense

 

(63

)

(137

)

(264

)

(369

)

Foreign currency transaction gains (losses)

 

16

 

17

 

9

 

2

 

Financing costs associated with convertible notes

 

 

(80

)

 

(80

)

Change in fair value of warrant and option liabilities

 

1,078

 

(1,117

)

3,192

 

(3,517

)

Change in fair value of convertible notes

 

1,620

 

(757

)

3,485

 

(4,218

)

Loss on extinguishment of convertible notes

 

(1,991

)

 

(3,274

)

 

Other income

 

1

 

4

 

4

 

24

 

Total other income (expense)

 

661

 

(2,070

)

3,152

 

(8,158

)

Net loss

 

$

(609

)

$

(3,165

)

$

(473

)

$

(11,388

)

Net loss per weighted average share, basic

 

$

(0.01

)

$

(0.10

)

$

(0.01

)

$

(0.37

)

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

76,902

 

30,397

 

60,923

 

30,912

 

 

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

 

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Table of Contents

 

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(In thousands, except per share data)

(Unaudited)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Net loss

 

$

(609

)

$

(3,165

)

$

(473

)

$

(11,388

)

Other comprehensive income (loss)

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

(9

)

2

 

1

 

(17

)

Other comprehensive income (loss)

 

(9

)

2

 

1

 

(17

)

Comprehensive loss

 

$

(618

)

$

(3,163

)

$

(472

)

$

(11,405

)

 

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

 

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Table of Contents

 

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2013

 

2012

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(473

)

$

(11,388

)

Depreciation and amortization

 

39

 

31

 

Stock-based compensation expense

 

158

 

433

 

Change in fair value of warrant and liabilities

 

(3,192

)

3,517

 

Change in fair value of convertible notes

 

(3,485

)

4,218

 

Financing costs associated with convertible notes

 

 

80

 

Loss on extinguishment of convertible notes

 

3,274

 

 

Non-cash interest expense

 

158

 

215

 

Change in assets and liabilities:

 

 

 

 

 

Restricted cash

 

(250

)

 

Accounts receivable

 

(87

)

59

 

Inventories

 

15

 

3

 

Prepaid expenses and other current assets

 

36

 

12

 

Accounts payable

 

66

 

82

 

Deferred revenue

 

(312

)

109

 

Accrued liabilities

 

(137

)

65

 

Net cash flows used in operating activities

 

(4,190

)

(2,564

)

Cash flows used for investing activities:

 

 

 

 

 

Purchase of equipment, furniture, and leasehold improvements

 

 

(74

)

Net cash flow used for investing activities

 

 

(74

)

Cash flows from financing activities:

 

 

 

 

 

Net proceeds from sale of common stock and warrants

 

5,079

 

 

Net proceeds from issuance of convertible notes and warrants

 

250

 

920

 

Net cash provided by financing activities

 

5,329

 

920

 

Effect of exchange rate changes on cash and cash equivalents

 

7

 

(144

)

Net (decrease) increase in cash and cash equivalents

 

1,146

 

(1,862

)

Cash and cash equivalents at beginning of period

 

258

 

2,585

 

Cash and cash equivalents at end of period

 

$

1,404

 

$

723

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid for interest

 

$

112

 

$

154

 

Supplemental disclosure of non-cash financing activities:

 

 

 

 

 

Cashless exercise of warrants

 

$

2,655

 

$

 

Cashless conversion of convertible notes

 

$

883

 

$

 

 

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

 

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PLC SYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

September 30, 2013

 

1.                                      Business and Liquidity

 

PLC Systems Inc. (“PLC” or the “Company”) is a medical device company specializing in innovative technologies for the cardiac and vascular markets. Over the past five years, the Company has begun initial commercialization outside the United States of its product, RenalGuard®, which currently represents the Company’s key strategic growth initiative and primary business focus.  The RenalGuard System consists of a proprietary console and accompanying single-use sets and is designed to reduce the potentially toxic effects that contrast media can have on the kidneys when it is administered to patients during certain medical imaging procedures. The Company conducts business operations as one operating segment.

 

For the nine months ended September 30, 2013, the Company incurred a loss from operations of approximately $3,625,000 and used cash in operations of approximately $4,190,000.  As of September 30, 2013, cash and cash equivalents were $1,404,000.  Management expects that quarterly losses from operations and negative cash flows will continue during 2013.  These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

 

Based upon the current financial condition of the Company and the expectation of continued quarterly losses from operations during 2013, management is currently investigating ways to raise additional capital that can be completed in the next several months. The Company believes that its existing resources, based on its currently projected financial results, are sufficient to fund operations through the first quarter of 2014. Based upon current and anticipated revenue projections from foreign sales of our RenalGuard product, and the anticipated costs of its U.S. clinical trial, we expect that we will need to raise additional capital during the first quarter of 2014. The Company was able to raise an additional $1,750,000 of capital in September 2013, and $4,040,000 in capital in February 2013, through the completion of equity financings. (see Note 9 — Sale of Common Stock).  Where possible, the Company has taken certain reductions in its discretionary spending. The Company will continue to review its other expense areas to determine whether additional reductions in discretionary spending can be achieved.

 

2.                                      Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.  These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

 

The preparation of financial statements in accordance with GAAP requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure 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.

 

3.                                      Inventories

 

Inventories are stated at the lower of cost (computed on a first-in, first-out method) or market value and include allocations of labor and overhead.  As of September 30, 2013 and December 31, 2012, inventories consisted of the following (in thousands):

 

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Table of Contents

 

 

 

September 30,
2013

 

December 31,
2012

 

Raw materials

 

$

145

 

$

143

 

Finished goods

 

 

39

 

 

 

$

145

 

$

182

 

 

4.                                      Stock-Based Compensation

 

Stock Option Plans

 

In May 2005, the Company’s shareholders approved the 2005 Stock Incentive Plan (the “2005 Plan”).  Incentive stock options are issuable only to employees of the Company, while non-qualified stock options may be issued to non-employee directors, consultants and others, as well as to employees.  Under the 2005 Plan, the per share exercise price of incentive stock options may not be less than the fair market value of the common stock on the date the option is granted.  The 2005 Plan provides that the Company may not grant non-qualified stock options at an exercise price less than 85% of the fair market value of the Company’s common stock.

 

In June 2013, the Company’s shareholders approved the 2013 Stock Incentive Plan (the “2013 Plan”). The 2013 Plan allows for an additional 11,382,600 incentive stock options which may be issued to non-employee directors, consultants and others, as well as to employees. Under the 2013 Plan, the per share exercise price of incentive stock options may not be less than the fair market value of the common stock on the date the option is granted.  The 2013 Plan provides that the Company may not grant non-qualified stock options at an exercise price less than 85% of the fair market value of the Company’s common stock.

 

The Company grants stock options to its non-employee directors.  New non-employee directors receive an initial grant of an option to purchase shares of the Company’s common stock that generally vest in quarterly installments over three years.  Once the initial grant has fully vested, non-employee directors (other than the Chairman of the Board) receive an annual grant of an option to purchase additional shares of the Company’s common stock that generally will vest in four equal quarterly installments. The Chairman of the Board receives an annual grant of an option to purchase 45,000 shares of the Company’s common stock that generally vests in four equal quarterly installments. All such options have an exercise price equal to the fair market value of the Company’s common stock on the date of grant.

 

During the three months ended September 30, 2013, the Company granted options to employees to purchase 5,050,000 shares of the Company’s common stock, which vest ratably over a three year period. Certain of these grants were issued to former employees to replace 502,000 options that were cancelled during the three months ended September 30, 2013. These grants were accounted for as modifications of previously issued stock options during the quarter. Additionally, the Company granted 589,000 options to non-employee directors that vest quarterly over a one year period.

 

During the year ended December 31, 2012, the Company granted options to employees to purchase 355,000 shares of the Company’s common stock, which vest ratably over a three year period and granted options to purchase 112,500 shares of the Company’s common stock to non-employee directors that vest quarterly over one year.

 

During the year ended December 31, 2011, the Company granted options to purchase 565,000 shares of the Company’s common stock to employees with performance-based vesting.  Management determined that as of June 30, 2012, it was probable that the performance conditions associated with the performance-based vesting were to be met in July 2012 with the closing of the second tranche convertible notes. Therefore, the related expense was recorded in the nine months ending
September 30, 2012.

 

During the year ended December 31, 2012, the Company issued an aggregate of 2,083,338 shares of restricted common stock to Garden State Securities, Inc. and JFS Investments, Inc. in exchange for certain investor relations and related consulting services provided to the Company.  During the nine months ended September 30, 2013, the Company issued an aggregate of 416,668 shares of common stock resulting in $56,250 of compensation expense.  These shares vested immediately but are restricted from being sold for a period of six months from the date of issuance.  The contract with Garden State

 

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Securities, Inc. and JFS Investments, Inc. terminated in February 2013. No further stock issuances will occur under this agreement.

 

As of September 30, 2013, there were 1,819,000 shares of common stock available to be granted under the 2005 Plan, and 5,743,000 shares of common stock available to be granted under the 2013 Plan.

 

The following is a summary of option activity under all plans (in thousands, except per option data):

 

 

 

Number
of Options

 

Weighted
Average
Exercise
Price

 

Average
Remaining
Contractual
Life (Years)

 

Aggregate
Intrinsic
Value

 

Outstanding, December 31, 2012

 

5,592

 

$

0.21

 

3.2

 

$

6,500

 

Granted

 

5,639

 

0.09

 

 

 

 

 

Exercised

 

 

 

 

 

 

 

Cancelled

 

(502

)

0.16

 

 

 

 

 

Forfeited

 

(643

)

0.10

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding, September 30, 2013

 

10,086

 

0.15

 

6.1

 

$

0

 

Exercisable, September 30, 2013

 

5,528

 

0.20

 

2.4

 

$

0

 

 

Stock-Based Compensation Expense

 

The Company recorded compensation expense related to stock options of $76,000 and $102,000 in the three and nine months ended September 30, 2013, respectively, as compared to $12,000 and $65,000 in the three and nine months ended September 30, 2012, respectively.  The Company also recorded compensation expense of $0 and $56,000 related to the issuance of restricted common shares during the three and nine months ended September 30, 2013, respectively, as compared to $123,000 and $368,000 in the three and nine months ended September 30, 2012, respectively.  As of September 30, 2013, the Company had $401,000 of total unrecognized compensation cost related to its unvested options, which is expected to be recognized over a weighted average period of 1.93 years.

 

The weighted average fair value of options issued, as estimated using the Black-Scholes model, was $0.08 and $0.16 during the nine months ended September 30, 2013 and 2012, respectively.  The assumptions used were as follows:

 

 

 

Grants Issued in:

 

 

 

2013

 

2012

 

Expected life (years)

 

3.00-6.00

 

5.00-6.00

 

Risk free rate

 

0.73-1.67%

 

0.19-0.69%

 

Volatility

 

195.75-217.52%

 

204.1-216.2%

 

Expected dividend yield

 

None

 

None

 

Value of options granted

 

$0.07-0.09

 

$0.12-0.17

 

 

Stock Purchase Plan

 

The Company has a 2000 Employee Stock Purchase Plan (the “Purchase Plan”) for all eligible employees whereby shares of the Company’s common stock may be purchased at six-month intervals at 95% of the average of the closing bid and ask prices of the Company’s common stock on the last business day of the relevant plan period.  Employees may purchase shares having a value not exceeding 10% of their gross compensation during an offering period, subject to certain additional limitations.  There was no activity during the three and nine months ended September 30, 2013 or 2012.  At September 30, 2013, 294,461 shares were reserved for future issuance under the Purchase Plan.

 

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5.                                      Revenue Recognition

 

The Company recognizes revenue when the following basic revenue recognition criteria have been met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the price to the buyer is fixed or determinable; and (4) collectability is reasonably assured.  Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the price to the buyer charged for products delivered or services rendered and collectability of the sales price. The Company assesses credit worthiness of customers based upon prior history with the customer and assessment of financial condition. The Company’s shipping terms are customarily Free On Board (“FOB”) shipping point. The Company records revenue at the time of shipment if all other revenue recognition criteria have been met. As of September 30, 2013, the Company had deferred $13,000 of revenue related to shipments prior to March 31, 2013 to its distributor in Italy, Artech, because not all revenue recognition criteria were met.  The Company expects this revenue to be recognized during the fourth quarter of 2013.

 

6.                                      Loss per Share

 

In the three and nine months ended September 30, 2012, basic loss per share has been computed using only the weighted average number of common shares outstanding during the period without giving effect to any potential future issuances of common stock related to stock option programs, Rights To Shares Agreement (see Note 9), investor warrants or convertible notes, since their inclusion would be antidilutive.

 

For the three and nine months ended September 30, 2013, 248,336,287 shares attributable to outstanding warrants, convertible notes, the Rights To Shares Agreements and stock options were excluded from the calculation of diluted earnings per share because the effect would have been antidilutive.

 

7.                                      Total Comprehensive Income (Loss)

 

Total comprehensive loss for the three and nine months ended September 30, 2013 was $618,000 and $472,000 as compared to a comprehensive loss of $3,163,000 and $11,405,000 in the three and nine months ended September 30, 2012, respectively.  Comprehensive income (loss) is comprised of the net income/loss plus the increase/decrease in currency translation adjustment.

 

8.                                      Warranty and Preventative Maintenance Costs

 

The Company warranties its products against manufacturing defects under normal use and service during the warranty period.  The Company evaluates the estimated future unrecoverable costs of warranty and preventative maintenance services for its installed base of products on a quarterly basis and adjusts its warranty reserve accordingly.  The Company considers all available evidence, including historical experience and information obtained from supplier audits.  There was no warranty liability recorded at September 30, 2013 or December 31, 2012.

 

9.                                      Sale of Common Stock

 

September 2013 Financing

 

On September 18, 2013 the Company entered into a Securities Purchase Agreement (the “September SPA”) with a number of accredited investors, whereby the Company sold an aggregate of 29,166,668 shares of common stock at $0.06 per share (the “September Purchase Price”) and issued warrants to purchase an additional 29,166,668 shares of common stock (the “September Investor Warrants”) with gross proceeds to the Company of $1,750,000. After payment of the placement agent fees and other expenses, the Company received net proceeds of approximately $1,575,329.  As part of the fee for its placement agent services, the Company also issued Palladium Capital Advisors a warrant to purchase 1,485,333 shares of common stock (together with the September Investor Warrants, the “September 2013 Warrants”) on the same terms and conditions as the investors under the September SPA.  The shares of common stock sold in the offering are subject to certain piggyback registration rights as well as certain other protections, including price protection, as discussed below.

 

The September SPA provides that for a period of 24 months after the later of (i) September 18, 2013, or (ii) the public announcement of FDA approval for RenalGuard for sale in the United States, and so long as the investors hold the shares purchased pursuant to the September SPA, if the Company issues or sells any shares of common stock or any common stock

 

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equivalent at a price less than the September Purchase Price (a “Share Dilutive Issuance”), the Company shall issue additional shares of common stock so that total amount paid by the investor to acquire the shares, divided by the number of shares held by the investor pursuant to the September SPA, plus the additional shares issued as a result of a Share Dilutive Issuance, equals the price per share paid in the Share Dilutive Issuance.  This provision also extends to any common shares that are issued pursuant to an exercise of the September 2013 Warrants.

 

In conjunction with the September 2013 SPA, the Company entered into a Right To Shares Agreement with one of the investors.  Pursuant to this agreement, in lieu of issuing 16,666,667 of the common shares purchased by the investor, the Company shall be obligated to issue, and the investor has the right to up to 16,666,667 shares of the Company’s common stock.  No additional consideration will be paid upon the issuance of the shares and the subscription amount has been paid in full by the investor and is non-refundable.  The Company is obligated to deliver the shares to the investor within 3 days of the investor’s request for the share issuance.  If the Company fails to deliver the shares within 3 days of the request, under certain circumstances defined in the Right To Shares Agreement, the Company may be obligated to reimburse the investor in cash for losses that the investor incurs as a result of not having access to the shares (the “Buy-In Shares”).  As of September 30, 2013, the Company has reserved, but not issued 16,666,667 shares of common stock pursuant to the Right To Shares Agreement.

 

The September SPA also provides the investors with the option, for a period through June 18, 2014, to purchase on the same terms and with the same rights as the September 2013 SPA up to one-half of the shares of common stock purchased by the purchaser at the initial closing (“September 2013 SPA Option”). The investors would also receive a warrant for every option share exercised with the same terms as the warrants issued in the September SPA. To date, no shares have been purchased under the September 2013 SPA Option.  The following is a summary of the September 2013 SPA Option for the:

 

September 2013 SPA Option

 

Shares

 

Exercise
Price

 

Beginning balance at September 18, 2013

 

14,583,334

 

$

0.06

 

 

 

 

 

 

 

Ending balance at September 30, 2013

 

14,583,334

 

$

0.06

 

 

The September 2013 Warrants have a term of five-years and are immediately exercisable for an aggregate 30,625,001 shares of common stock purchased at an exercise price of $0.08 per share.  The exercise price of the September 2013 Warrants shall be adjusted in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then exercise price. The September 2013 Warrants may be exercised on a cashless basis if at any time there is no effective registration statement within 180 days after the closing date of the private placement covering the resale of the shares of common stock underlying the September 2013 Warrants. The September 2013 Warrants contain limitations on the holder’s ability to exercise the September 2013 Warrants in the event such exercise causes the holder to beneficially own in excess of 4.99% of the Company’s issued and outstanding common stock, subject to a discretionary increase in such limitation by the holder to 9.99% upon 61 days’ notice.  To date, none of the September 2013 Warrants have been exercised.  The following is a summary of the September 2013 Warrants for the nine months ending September 30, 2013:

 

The September 2013 Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at September 18, 2013

 

30,625,001

 

$

0.08

 

Add: Adjustments

 

 

n/a

 

Ending balance at September 30, 2013

 

30,625,001

 

$

0.08

 

 

In June 2008, the FASB issued ASC 815-40-15 (formerly EITF 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock), which was effective for the Company in 2009. This issued guidance requires that derivative instruments be evaluated for certain contingencies and anti-dilution provisions that would affect their equity classification as a derivative under ASC 815, Derivatives and Hedging (ASC 815) and requires the instruments to be

 

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classified as liabilities and reported at fair value.

 

Upon issuance, the September 2013 Warrants and the September 2013 SPA Option were not considered indexed to the Company’s own stock and therefore are required to be accounted for as freestanding derivative instruments and classified as a liability.  A Monte Carlo simulation was used to estimate the fair value of the September 2013 Warrants and September 2013 SPA Option resulting in grant date fair values of $1,807,000 and $1,166,000, respectively (see Note 11 — Fair Value Measurements). As of September 30, 2013, the September 2013 Warrants have been marked to fair value resulting in a derivative liability of $1,574,000. The impact to other income for the change in fair value of the September 2013 Warrants for the three months ended September 30, 2013 was a gain of $233,000. As of September 30, 2013, the September 2013 SPA Options have been marked to fair value resulting in a derivative liability of $875,000. The impact to other income for the change in fair value of the September 2013 SPA Option for the three months ended September 30, 2013 was a gain of $291,000.

 

The Company also assessed the provisions of the Buy-In Share feature of the Rights To Shares Agreement as an embedded derivative pursuant to ASC 815-15, Embedded Derivatives, and has concluded that the feature meets the definition of a derivative and is not clearly and closely related to the Rights To Shares equity host agreement.  The Buy-In Shares feature has been bifurcated from the Rights To Shares agreement and accounted for separately. The value of this feature was nominal as of the issuance date and September 30, 2013.

 

Allocation of SPA Proceeds

 

The Company first allocated the proceeds of the September SPA to the fair value of the September 2013 Warrants and September 2013 SPA Option.  When the issuance costs were considered, the aggregate fair value of the September 2013 Warrants and September 2013 SPA Option exceeded the net proceeds of the September SPA.  The Company first recorded the difference as a reduction of additional paid in capital to the extent available, with the reminder accounted for as a reduction in common stock.

 

February 2013 Financing

 

On February 22, 2013, the Company entered into a Securities Purchase Agreement (the “February SPA”) with a number of accredited investors, whereby the Company sold an aggregate of 26,933,333 shares of common stock at $0.15 per share (the “February Purchase Price”) and issued warrants to purchase an additional 26,933,333 shares of common stock (the “February Investor Warrants”) with gross proceeds to the Company of $4,040,000. After payment of the placement agent fees and other expenses, the Company received net proceeds of approximately $3,504,000.  As part of the fee for its placement agent services, the Company also issued Palladium Capital Advisors a warrant to purchase 1,885,333 shares of common stock (together with the Investor Warrant, the “February 2013 Warrants”) on the same terms and conditions as the investors under the February SPA.  The shares of common stock sold in the offering are subject to certain piggyback registration rights as well as certain other protections, including price protection, as discussed below.

 

The February SPA provides that for a period of 24 months after the later of (i) February 22, 2013, or (ii) the public announcement of FDA approval for RenalGuard for sale in the United States, and so long as the investors hold the shares purchased pursuant to the February SPA; in the event that the Company issues or sells any shares of common stock or any common stock equivalent at a price less than the Purchase Price (a “Share Dilutive Issuance”), the Company shall issue additional shares of common stock so that total amount paid by the investor to acquire the shares, divided by the number of shares held by the investor pursuant to the February SPA, plus the additional shares issued as a result of a Share Dilutive Issuance, equals the price per share paid in the Share Dilutive Issuance.  This provision also extends to any common shares that are issued pursuant to an exercise of the February 2013 Warrants.  As required under the terms of the February SPA, in connection with the September SPA, the Company issued to the investors in the February 2013 Financing an additional 40,400,001 shares of Common Stock due to these anti-dilutive provisions being triggered by the lower purchase price for shares issued in the September SPA.

 

In conjunction with the February SPA, the Company entered into a Right To Shares Agreement with one of the investors.  Pursuant to this agreement, in lieu of issuing 7,000,000 of the common shares purchased by the investor, the Company shall be obligated to issue, and the investor has the right to up to 7,000,000 shares of the Company’s common stock.  No additional consideration will be paid upon the issuance of the shares and the subscription amount has been paid in full by

 

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the investor and is non-refundable.  The Company is obligated to deliver the shares to the investor within 3 days of the investor’s request for the share issuance.  If the Company fails to deliver the shares within 3 days of the request, under certain circumstances defined in the Right To Shares Agreement, the Company may be obligated to reimburse the investor in cash for losses that the investor incurs as a result of not having access to the shares (the “Buy-In Shares”).  As of September 30, 2013, the Company has reserved, but not issued 19,000,000 shares of common stock pursuant to the Right To Shares Agreement.

 

The February SPA also provides the investors with the option, for a period through November 21, 2013, to purchase on the same terms and with the same rights as the February 2013 SPA up to one-half of the shares of common stock purchased by the purchaser at the initial closing (“February 2013 SPA Option”). The investors would also receive a warrant for every option share exercised with the same terms as the warrant issued in the February SPA.  To date, no shares have been purchased under the February 2013 SPA Option.  The following is a summary of the February 2013 SPA Option for the nine months ending September 30, 2013:

 

February 2013 SPA Option

 

Shares

 

Exercise
Price

 

Beginning balance at February 22, 2013

 

13,466,667

 

$

0.15

 

Ending balance at September 30, 2013

 

13,466,667

 

$

0.15

 

 

The February 2013 Warrants have a term of five-years and were immediately exercisable for an aggregate 28,818,666 shares of common stock purchased at an exercise price of $0.20 per share.  The exercise price of the 2013 Warrants shall be adjusted in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then exercise price. Due to the September SPA, certain anti-dilution rights were triggered, resulting in the issuance of an additional 43,228,001 warrants at a price of $0.08 .All previously issued warrants related to the February 2013 financing have been repriced to $0.08. The February 2013 Warrants may be exercised on a cashless basis if at any time there is no effective registration statement within 180 days after the closing date of the private placement covering the resale of the shares of common stock underlying the February 2013 Warrants. The February 2013 Warrants contain limitations on the holder’s ability to exercise the February 2013 Warrant in the event such exercise causes the holder to beneficially own in excess of 4.99% of the Company’s issued and outstanding common stock, subject to a discretionary increase in such limitation by the holder to 9.99% upon 61 days’ notice.  The following is a summary of the February 2013 Warrants for the nine months ending September 30, 2013:

 

The February 2013 Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at February 22, 2013

 

28,818,666

 

$

0.20

 

Add: Anti-dilution adjustment

 

43,228,001

 

0.08

 

Ending balance at September 30, 2013

 

72,046,667

 

$

0.08

 

 

In June 2008, the FASB issued ASC 815-40-15 (formerly EITF 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock), which was effective for the Company in 2009. This issued guidance requires that derivative instruments be evaluated for certain contingencies and anti-dilution provisions that would affect their equity classification as a derivative under ASC 815, Derivatives and Hedging (ASC 815) and requires the instruments to be classified as liabilities and reported at fair value.

 

Upon issuance, the February 2013 Warrants and February 2013 SPA Option were not considered indexed to the Company’s own stock and therefore are required to be accounted for as freestanding derivative instruments and classified as a liability.  A Monte Carlo simulation was used to estimate the fair value of the February 2013 Warrants and February 2013 SPA Option resulting in grant date fair values of $2,759,000 and $1,211,000, respectively (see Note 11 — Fair Value Measurements). As of September 30, 2013, the February 2013 Warrants have been marked to fair value resulting in a derivative liability of $3,182,000. The impact to other income for the change in fair value of the February 2013 Warrants for the three and nine months ended September 30, 2013 was a loss of $1,165,000 and $423,000 respectively. As of September 30, 2013, the February 2013 SPA Options have been marked to fair value resulting in a derivative liability of $0. The impact to other income for the change in fair value of the February 2013 SPA Option for the three and nine months ended September 30,

 

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2013 was a gain of $404,000 and a gain of $1,211,000, respectively.

 

The Company also assessed the provisions of the Buy-In Share feature of the Rights To Shares Agreement as an embedded derivative pursuant to ASC 815-15, Embedded Derivatives, and has concluded that the feature meets the definition of a derivative and is not clearly and closely related to the Rights To Shares equity host agreement.  The Buy-In Shares feature has been bifurcated from the Rights To Shares agreement and accounted for separately. The value of this feature was nominal as of the issuance date and September 30, 2013.

 

Allocation of SPA Proceeds

 

The Company first allocated the proceeds of the February SPA to the fair value of the February 2013 Warrants and February 2013 SPA Option.  When the issuance costs were considered, the aggregate fair value of the February 2013 Warrants and February 2013 SPA Option exceeded exceeded the net proceeds of the February SPA.  The Company recorded the difference as a reduction of additional paid in capital.

 

The SPA requires the Company to use $1,000,000 of the proceeds received from the February SPA for investor relations.  The Company engaged an investor relations firm and made an initial payment of $500,000 on the date of the February SPA closing. During the quarter ended September 30, 2013 the Company paid an additional $250,000. The remaining $250,000 will be paid during the quarter ended December 31, 2013.  The Company has recorded the cash held in escrow as restricted cash on the balance sheet. The Company is amortizing the investor relations payments over the one-year estimated period of performance for the investor relations services.

 

10.                               Convertible Notes and Warrants

 

Features of the Convertible Notes and Investor Warrants

 

On February 22, 2011 (the “Original Issue Date”), the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) and a 5% Senior Secured Convertible Debenture Agreement (the “Note Agreement”) with GCP IV LLC (the “Investors” or “Holders”) pursuant to which the Company agreed to issue and sell in a private placement to the Investors an aggregate principal amount of $4,000,000 of convertible notes due February 22, 2014 (the “2011 Convertible Notes”) and warrants to purchase 40,000,000 shares of common stock at $0.15 per share (the “2011 Warrants”).  Under the terms of the Purchase Agreement, the Company had the opportunity to raise up to an additional $2,000,000 from the Holders in two separate $1,000,000 tranches, based upon meeting certain operational milestones within certain periods of time.  The deadline for achieving the operational milestones for the first $1,000,000 tranche expired in February 2012 without the Company achieving such milestones; however, the Investors agreed to waive both the deadline and the achievement of these milestones as a condition for the investment of the first additional $1,000,000 tranche (the “2012 Convertible Notes”) and issuance of warrants to purchase 10,000,000 shares of common stock at $0.15 per share and 10,000,000 shares of common stock at $0.25 per share (the “2012 Warrants”)   which was completed on July 2, 2012.  On January 16, 2013 the Company entered into an amendment and waiver to the Purchase Agreement to provide for the issuance of an additional $250,000 of 5% Senior Secured Convertible Debentures (the “Third Tranche Convertible Notes”) maturing on January 16, 2016 and warrants exercisable for a period of five years to purchase up to 2,500,000 shares of common stock at an exercise price of $0.15 per share (the “Third Tranche Warrants”).

 

The convertible notes and warrants and the Purchase Agreement covering both are secured by a security interest in all assets of the Company and its subsidiaries and all such obligations are guaranteed jointly and severally by the Company’s subsidiaries. The convertible notes also contain non-financial covenants which limit the Company and its subsidiaries from incurring subsequent indebtedness, incurring liens, and amending organizational documents, repurchasing or repaying other debt, paying cash dividends and entering into affiliate transactions.

 

On February 22, 2013, simultaneous with the closing of the February SPA, the Company entered into an Amendment and Waiver Agreement (the “February Amendment and Waiver Agreement”) with the Holder under which the Holder agreed to (a) increase the number of shares exercisable under the 2011 and 2012 Warrants from an aggregate 50,000,000 shares to 81,578,946 shares and to modify both the exercise price and the Volume Weighted Average Price (“VWAP price”) of the 2011 and 2012  Warrants to $0.098 and $0.155, respectively, (b)  return to the Company for forfeiture the remaining warrants previously issued to purchase an aggregate 12,500,000 shares of common stock, (c)  extend the due date for the 2012 Convertible Notes from February 22, 2014 to June 30, 2015, (d) until February 22, 2014, without the prior written consent

 

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from the majority of the investors under the February SPA, forbear from declaring any Event of Default (as defined in the original debenture, and (e) relinquish its right to purchase up to an additional $750,000 in debentures under the terms of the original Purchase Agreement.  The terms of the individual tranches of convertible notes and warrants issued pursuant to this agreement and the impact of the Amendment and Waiver Agreement are discussed below.

 

On September 18, 2013, simultaneous with the closing of the September SPA, the company entered into an Amendment and Waiver Agreement (“the September Amendment and Waiver Agreement”) under which the holders of the term debentures have agreed to (a) extend the payment due date for the interest on the debentures to June 30, 2015, modify the conversion price for the debentures to $0.06, and set the VWAP Price of the warrants originally issued in 2011 and 2012 to $0.3705.

 

2011 Convertible Notes

 

The September Amendment and Waiver of the Convertible Notes extends the payment due date for the interest on the debentures to June 30, 2015. Interest is calculated on the basis of a 360-day year and accrues daily commencing on the Original Issue Date until payment in full of the outstanding principal, together with all accrued and unpaid interest, liquidated damages and other amounts that may become due in connection with the Convertible Notes, has been made.

 

The Holders may convert the outstanding principal amount of the Convertible Notes into shares of the Company’s common stock at the conversion price of $0.06 per share (“Conversion Price”) as per the September 2013 Amendment and Waiver. The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

At any time after February 2012, and upon entering into a change of control transaction or Fundamental Transaction, as defined in the Debenture Agreement, the Company may deliver a notice to the Holders of its irrevocable election to redeem all of the then outstanding principal of the Convertible Notes for cash in an amount equal to the sum of (a) the greater of (i) the outstanding amount of the Convertible Notes divided by the Conversion Price on the date of the mandatory default amount, as defined in the Purchase Agreement, is either (A) demanded or (B) paid in full, whichever has a lower conversion price, multiplied by the VWAP of the date of the mandatory default amount is either (x) demanded or otherwise due or (y) paid in full, whichever has higher VWAP, plus all accrued and unpaid interest, or (ii) 130% of the outstanding principal amount of the Notes, plus 100% of accrued and unpaid interest, and (b) all other amounts, costs, expenses and liquidated damages due under the various agreements covering issuance of the Convertible Notes. Such amount would include the liquidated damages due under the default provision of the Purchase Agreement.

 

Due to the February 2013 Amendment and Waiver agreement, the Company is required to repay, in cash, any outstanding principal amount of the Convertible Notes on June 30, 2015 and is not permitted, except upon entering into a change of control transaction or fundamental transaction as noted above, to prepay any portion of the principal amount without prior written consent of the Holders.

 

2011 Warrants

 

On February 22, 2011, in connection with the issuance of the 2011 Convertible Notes, the Company issued warrants for the purchase of up to 40,000,000 shares of common stock at the exercise price of $0.15 per share and with an expiration date of February 22, 2016 (the “Warrants”). On February 22, 2013, as per the terms of the Amendment and Waiver Agreement, the Company canceled the original warrants and re-issued new warrants for the purchase of up to 65,263,156 shares of common stock at an exercise price of $0.098 per share.

 

The 2011 Warrants are exercisable by a cashless exercise to purchase shares of the Company’s common stock (the “Warrant Shares”). The Exercise Price of the Warrants shall be adjusted in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Exercise Price.

 

In connection with a Fundamental Transaction, as defined in the Purchase Agreement, that is an all-cash transaction,

 

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the Company shall have the right to purchase from the Holders all, but not less than all, of the unexercised portion of the Warrants by paying in cash to the Holders an amount equal to 30% of the Exercise Price multiplied by the number of shares of Common Stock for which the Warrants are exercisable immediately prior to such change of control transaction.

 

During the nine months ended September 30, 2013, 47,322,376 of the 2011 Warrants were exercised pursuant to the cashless exercise provisions resulting in the issuance of 19,608,926 shares of common stock.

 

The following is a summary of the 2011 Warrants outstanding for the nine months ending September 30, 2013:

 

 

 

2011 Warrants

 

Exercise
Price

 

Beginning balance — December 31, 2012

 

40,000,000

 

$

0.15

 

Less: Canceled

 

(40,000,000

)

0.15

 

Add: Issued

 

65,263,156

 

0.098

 

Less: Exercised

 

(47,322,376

)

0.098

 

Ending Balance — September 30, 2013

 

17,940,780

 

$

0.098

 

 

2012 Convertible Notes

 

The 2012 Convertible Notes contains the same terms as the 2011 Convertible Notes and require payment of interest at the rate of 5% per annum, payable upon the maturation of the debenture and mature on July 2, 2015. The Second Tranche Convertible Notes provide the Investors the option at any time prior to the repayment of the notes to convert any portion of the outstanding Second Tranche balance into fully-paid and non-assessable restricted shares of common stock of the Company at an initial conversion price of $0.06 per share (the “Conversion Price”). The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

The Second Tranche Convertible Notes may be redeemed at the option of the Company on the same terms as the Convertible Notes only in connection with a change of control or other fundamental transaction of the Company and subject to the satisfaction of other conditions including, without limitation, that the shares issuable upon conversion of the debentures are freely tradable and that there is no event of default.

 

2012 Warrants

 

On July 2, 2012, in conjunction with the issuance of the 2012 Convertible Notes, the Company issued warrants for the purchase of up to 20,000,000 shares of common stock with five year terms.  The warrants were issued to allow the Investors to purchase up to 10,000,000 shares of common stock at an initial purchase price of $0.15 per share and the remaining 10,000,000 shares of common stock at an initial purchase price of $0.25 per share. The terms of the 2012 Warrants are identical to those of the 2011 Warrants, except that the 2012 Warrants are exercisable for a period of five years from the date of issuance and contain different exercise prices. On February 22, 2013, as per the terms of the Amendment and Waiver Agreement, the Company canceled the original warrants and re-issued new warrants for the purchase of up to 16,315,790 shares of common stock at an initial purchase price of $0.098.  During the nine months ended September 30, 2013, 9,250,535 of the 2012 Warrants were exercised pursuant to the cashless exercise provisions resulting in the issuance of 3,401,809 shares of common stock.

 

The following is a summary of the 2012 Warrants outstanding at September 30, 2013:

 

$0.15 Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at December 31, 2012

 

10,000,000

 

$

0.15

 

Less: Canceled

 

(10,000,000

)

0.15

 

Add: Issued

 

16,315,790

 

0.098

 

Less: Exercised

 

(9,250,535

)

0.098

 

Ending balance at September 30, 2013

 

7,065,255

 

$

0.098

 

 

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$0.25 Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at December 31, 2012

 

10,000,000

 

$

0.25

 

Less: Canceled

 

(10,000,000

)

0.25

 

Ending balance at September 30, 2013

 

 

$

 

 

Third Tranche Convertible Notes

 

The Third Tranche Convertible Notes, which were issued on January 16, 2013, contain the same terms as the 2011 and 2012 Convertible Notes and require payment of interest at the rate of 5% per annum, payable upon the maturation of the debenture on January 16, 2016.  The Third Tranche Convertible Notes provide the Investors the option at any time prior to the repayment of the notes to convert any portion of the outstanding Third Tranche balance into fully-paid and non-assessable restricted shares of common stock of the Company at an initial conversion price of $0.06 per share (the “Conversion Price”). The Conversion Price is subject to adjustment in the event of (a) stock splits, stock dividends, combinations, reclassifications, mergers, consolidations, distributions of assets or evidence of indebtedness, sales or transfers of substantially all assets, share exchanges or similar events, and (b) certain dilutive issuances of (i) common stock or (ii) common stock equivalents at an effective price per share that is lower than the then Conversion Price.

 

The Third Tranche Convertible Notes may be redeemed at the option of the Company on the same terms as the 2011 and 2012 Convertible Notes only in connection with a change of control or other fundamental transaction of the Company and subject to the satisfaction of other conditions including, without limitation, that the shares issuable upon conversion of the debentures are freely tradable and that there is no event of default.

 

Third Tranche Warrants

 

On January 16, 2013, in connection with the Third Tranche Convertible Notes, the Company issued warrants for the purchase of up to 2,500,000 shares of common stock with five year terms.  The warrants were issued to allow the Investors to purchase up to 2,500,000 shares of common stock at an initial purchase price of $0.15 per share. On February 22, 2013, per the terms of the Amendment and Waiver Agreement, the Third Tranche Warrants were canceled. The following is a summary of the 2012 Warrants outstanding for the nine months ending September 30, 2013:

 

Third Tranche Warrants

 

Warrants

 

Exercise
Price

 

Beginning balance at December 31, 2012

 

 

$

 

Add: Issued

 

2,500,000

 

$

0.15

 

Less: Canceled warrants

 

(2,500,000

)

0.15

 

Ending balance at September 30, 2013

 

 

$

 

 

Accounting for the 2011 Convertible Notes, 2012 Convertible Notes, Third Tranche Convertible Notes, 2011 Warrants, 2012 Warrants, and Third Tranche Warrants

 

2011 Convertible Notes, 2012 Convertible Notes, and Third Tranche Convertible Notes

 

The Company has determined that the 2011 Convertible Notes, 2012 Convertible Notes and Third Tranche Convertible Notes constitute a hybrid instrument that has the characteristics of a debt host contract containing several embedded derivative features that would require bifurcation and separate accounting as a derivative instrument pursuant to the provisions of ASC 815. The Company has identified all of the derivatives associated with each convertible note.  As permitted under ASC 825-10-10 — Financial Instruments, as it relates to the fair value option, the Company has elected, as of the original issuance date of each convertible note, to measure the 2011 Convertible Notes, 2012 Convertible Notes, and the Third Tranche Convertible Notes in their entirety at fair value with changes in fair value recognized in the Consolidated Statement of Operations as either a gain or loss until the notes are settled.  As such, the Company has appropriately valued the embedded derivatives as a single

 

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hybrid contract together with the convertible notes. This election was made by the Company after determining the aggregate fair value of the convertible notes to be more meaningful in the context of the Company’s financial statements than if separate fair values were assigned to each of the multiple embedded instruments contained in the convertible notes.

 

Pursuant to the guidance of ASC 815-40-15 (formerly EITF 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock), the 2011 Warrants, 2012 Warrants and Third Tranche Warrants were not considered indexed to the Company’s own stock.  As a result these instruments have been account for as freestanding derivative instruments and classified as a liability recorded at fair value at each reporting period.

 

The February 2013 Amendment and Waiver Agreement triggered a greater than 10% change in the present value of cash flows of the convertible notes and associated warrants.  As a result, the Company has treated the Amendment and Waiver Agreement as a debt extinguishment where the carrying value of the convertible notes and warrants prior to the amendment were removed from the Company’s books and the fair value of the amended convertible notes and warrants was recorded.  The resulting difference in value was recorded as a $1,283,000 loss on the extinguishment of debt.  The impact to each of the convertible notes and associated warrants is discussed below.

 

The September 2013 Amendment and Waiver Agreement triggered a greater than 10% change in the present value of cash flows of the convertible notes.  As a result, the Company has treated the Amendment and Waiver Agreement as a debt extinguishment where the carrying value of the convertible notes prior to the amendment were removed from the Company’s books and the fair value of the amended convertible notes was recorded.  The resulting difference in value was recorded as a $1,991,000 loss on the extinguishment of debt.  The impact to each of the convertible note tranches is discussed below.

 

2011 Convertible Notes and 2011 Warrants

 

Upon issuance of the 2011 Convertible Notes, the Company allocated the proceeds received to the 2011 Convertible Notes and 2011 Warrants on a relative fair value basis. As a result of such allocation, the Company determined the initial carrying value of the Notes to be $3,208,000. The debt discount in the amount of $792,000 (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the 2011 Convertible Notes.  The carrying value of the 2011 Convertible Notes has been adjusted to fair value each reporting period.  During the three and nine months ended September 30, 2012, the Company amortized $67,000 and $198,000 of the debt discount and recorded a $747,000 gain and a $2,715,000 loss in the adjustment to the fair value of the notes as a component of other income (expense), respectively.

 

The Company has accounted for the February 2013 Amendment and Waiver Agreement as an extinguishment of debt at February 22, 2013.  The fair value of the 2011 Convertible Notes prior to the extinguishment was replaced by the fair value of the amended 2011 Convertible Notes, resulting in a fair value of $6,070,000 as of February 22, 2013.  In connection with the extinguishment of the debt as of February 22, 2013, the Company had amortized $38,000 of the debt discount and wrote off the remaining debt discount of $265,000.

 

The Company has accounted for the September 2013 Amendment and Waiver Agreement as an extinguishment of debt at September 18, 2013.  The fair value of the 2011 Convertible Notes prior to the extinguishment was replaced by the fair value of the amended 2011 Convertible Notes, resulting in a fair value of $4,920,000 as of September 18, 2013. As of September 30, 2013, the 2011 Convertible Notes have been marked to fair value resulting in a derivative liability of $4,190,000.  The impact to other income (expense) for the loss on extinguishment and adjustments to fair value for the three and nine months ended September 30, 2013 was a gain of $1,227,000 and $1,475,000 respectively.

 

During the three and nine months ended September 30, 2013, certain holders of the 2011 Convertible Notes converted $456,000 and $756,000, respectively, of convertible note principal into 6,427,000 and 9,427,000 shares of common stock, respectively. The conversions resulted in the reclassification of $433,000 and $833,000, respectively, in conversion date fair value of the shares as a component of the common stock balance in stockholders’ equity within the balance sheet.

 

As a result of the February 2013 Amendment and Waiver Agreement the carrying value of the 2011 Warrants was adjusted at February 22, 2013 to reflect the revised terms.  As of September 30, 2013, the 2011 Warrants have been marked to fair value resulting in a derivative liability of $538,000.  The impact to other income (expense) for the change in fair value of

 

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the 2011 Warrants for the three and nine months ended September 30, 2013 was a gain of $857,000 and a loss of $955,000 respectively.

 

During the three and nine months ended September 30, 2013, certain holders of the 2011 Warrants exercised warrants to purchase 18,236,853 and 47,322,376, respectively,  shares of common stock pursuant to the cashless exercise provisions resulting in the issuance of 8,913,000 and 19,609,000, respectively, shares of the Company’s common stock.  The cashless exercise resulted in the reclassification of $652,000 and $2,405,000, respectively, in the exercise date fair value of the 2011 Warrants exercised as a component of the common stock balance within stockholders’ equity in the balance sheet.

 

2012 Convertible Notes and 2012 Warrants

 

Upon issuance of the 2012 Convertible Notes, the Company allocated the proceeds received to the Second Tranche Convertible Notes and 2012 Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Second Tranche Convertible Notes to be $417,000.  The debt discount in the amount of $583,000 (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the 2012 Convertible Notes. The carrying value of the 2012 Convertible Notes has been adjusted to fair value each reporting period.  During the three and nine months ended September 30, 2012 the Company amortized $17,000 of the debt discount and recorded a loss of $1,502,000 in fair value adjustment as a component of other income (expense), respectively.

 

The Company has accounted for the February 2013 Amendment and Waiver Agreement as an extinguishment of debt at February 22, 2013.  The fair value of the 2012 Convertible Notes prior to the extinguishment was replaced by the fair value of the amended 2012 Convertible Notes, resulting in a fair value of $1,516,000 as of February 22, 2013.

 

The Company has accounted for the September 2013 Amendment and Waiver Agreement as an extinguishment of debt at September 18, 2013.  The fair value of the 2012 Convertible Notes prior to the extinguishment was replaced by the fair value of the amended 2012 Convertible Notes, resulting in a fair value of $1,390,000 as of September 18, 2013. As of September 30, 2013, the 2012 Convertible Notes have been marked to fair value resulting in a derivative liability of $1,290,000.  The impact to other income (expense) for the loss on extinguishment and adjustments to fair value was a loss of $110,000 and a gain of $353,000 for the three and nine months ended September 30, 2013, respectively.

 

As a result of the February 2013 Amendment and Waiver Agreement the carrying value of the 2012 Warrants was adjusted at February 22, 2013 to reflect the revised terms.  As of September 30, 2013, the 2012 Warrants have been marked to fair value resulting in a derivative liability of $283,000. The impact to other income (expense) for the three and nine months ended September 30, 2013 was a gain of $458,000 and $1,279,000 respectively.

 

During the three months ended September 30, 2013, certain holders of the 2012 Warrants exercised warrants to purchase 9,250,535 shares of common stock pursuant to the cashless exercise provisions resulting in the issuance of 3,401,809 shares of the Company’s common stock.  The cashless exercise resulted in the reclassification of $238,000 in the exercise date fair value of the 2012 Warrants exercised as a component of common stock in stockholders’ equity.

 

Third Tranche Convertible Notes and Third Tranche Warrants

 

Upon issuance of the Third Tranche Convertible Notes in January 2013, the Company allocated the proceeds received to the Third Tranche Convertible Notes and Third Tranche Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Third Tranche Convertible Notes to be $142,000.  The Third Tranche Convertible Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $394,000. The debt discount in the amount of $108,000 (resulting from the allocation of proceeds) was being amortized to interest expense using the effective interest method over the expected term of the Convertible Notes.

 

The Company has accounted for the February 2013 Amendment and Waiver Agreement as an extinguishment of debt at February 22, 2013.  The fair value of the Third Tranche Convertible Notes prior to the extinguishment was replaced by the fair value of the amended Third Tranche Convertible Notes, resulting in a fair value of $386,000 as of February 22, 2013.

 

The Company has accounted for the September 2013 Amendment and Waiver Agreement as an extinguishment of

 

19



Table of Contents

 

debt at September 18, 2013.  The fair value of the Third Tranche Convertible Notes prior to the extinguishment was replaced by the fair value of the amended Third Tranche Convertible Notes, resulting in a fair value of $361,000 as of September 18, 2013.  As of September 30, 2013, the Third Tranche Convertible Notes have been marked to fair value resulting in a derivative liability of $313,000.  The impact to other income (expense) for the loss on extinguishment and adjustments to fair value was a loss of $18,000 and a gain of $83,000 for the three and nine months ended September 30, 2013, respectively.

 

Upon issuance of the Third Tranche Warrants, the Company allocated $108,000 of the initial proceeds to the Third Tranche Warrants and immediately marked them to fair value resulting in a derivative liability of $300,000.  As of September 30, 2013, the Third Tranche Warrants have been canceled as per the terms of the February 2013 Amendment and Waiver Agreement. The impact to other income (expense) for the three and nine months ended September 30, 2013 was a gain of $0 and $108,000, respectively.

 

11.                               Fair Value Measurements

 

The following summarizes the Company’s assets and liabilities measured at fair value as of December 31, 2012:

 

 

 

 

 

Fair Value Measurements at Reporting Date Using:

 

 

 

 

 

Quoted
Prices

 

 

 

 

 

 

 

 

 

in Active

 

Significant

 

 

 

 

 

 

 

Markets for

 

Other

 

Significant

 

 

 

Balance as of

 

Identical

 

Observable

 

Unobservable

 

 

 

December 31,

 

Assets

 

Inputs

 

Inputs

 

Description

 

2012

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Convertible notes

 

$

8,098,000

 

$

 

$

 

$

8,098,000

 

Warrant liabilities

 

$

3,800,000

 

$

 

$

 

$

3,800,000

 

Total Liabilities

 

$

11,898,000

 

$

 

$

 

$

11,898,000

 

 

The following summarizes the Company’s assets and liabilities measured at fair value as of September 30, 2013:

 

 

 

 

 

Fair Value Measurements at Reporting Date Using:

 

 

 

 

 

Quoted
Prices

 

 

 

 

 

 

 

 

 

in Active

 

Significant

 

 

 

 

 

 

 

Markets for

 

Other

 

Significant

 

 

 

Balance as of

 

Identical

 

Observable

 

Unobservable

 

 

 

September 30,

 

Assets

 

Inputs

 

Inputs

 

Description

 

2013

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Convertible notes

 

$

5,793,000

 

$

 

$

 

$

5,793,000

 

Warrant liabilities

 

$

6,452,000

 

$

 

$

 

$

6,452,000

 

Total Liabilities

 

$

12,245,000

 

$

 

$

 

$

12,245,000

 

 

A summary of changes in the Convertible Notes, Second Tranche Convertible Notes, Third Tranche Convertible Notes, Investor Warrants, 2012 Warrants, Third Tranche Warrants, and the 2013 Warrants and Additional 2013 Warrants as of September 30, 2012, December 31, 2012, February 22, 2013, September 18, 2013 and September 30, 2013 is as follows:

 

20



Table of Contents

 

 

 

Fair Value
of 2011
Convertible
Notes

 

Fair Value of
2011
Warrant
Liabilities

 

Fair Value of
2012
Convertible
Notes

 

Fair Value of
2012
Warrant
Liabilities

 

Fair Value of
Third
Tranche
Convertible
Notes

 

Fair Value of
Third
Tranche
Warrant
Liabilities

 

February
2013
Warrants

 

February
2013 SPA
Option

 

September
2013
Warrants

 

September
2013 SPA
Options

 

Total

 

Balance December 31, 2011

 

$

5,327,000

 

$

1,600,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

6,927,000

 

Amortization of debt discount

 

$

198,000

 

$

 

$

17,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

215,000

 

Allocation of initial proceeds

 

$

 

$

 

$

417,000

 

$

583,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

1,000,000

 

Fair value adjustment

 

$

2,715,000

 

$

1,600,000

 

$

1,502,000

 

$

1,917,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

7,734,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance September 30, 2012

 

$

8,240,000

 

$

3,200,000

 

$

1,936,000

 

$

2,500,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

15,876,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance December 31, 2012

 

$

6,510,000

 

$

2,000,000

 

$

1,588,000

 

$

1,800,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

11,898,000

 

Allocation of initial proceeds

 

$

 

$

 

$

 

$

 

$

142,000

 

$

108,000

 

$

 

$

 

$

 

$

 

$

250,000

 

Initial fair value adjustment

 

$

 

$

 

$

 

$

 

$

252,000

 

$

192,000

 

$

 

$

 

$

 

$

 

$

444,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

January 16, 2013

 

$

6,510,000

 

$

2,000,000

 

$

1,588,000

 

$

1,800,000

 

$

394,000

 

$

300,000

 

$

 

$

 

$

 

$

 

$

12,592,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of debt discount

 

$

38,000

 

$

 

$

55,000

 

$

 

$

2,000

 

$

 

$

 

$

 

$

 

$

 

$

95,000

 

Fair value adjustment

 

$

(370,000

)

$

 

$

(72,000

)

$

 

$

(8,000

)

$

 

$

 

$

 

$

 

$

 

$

(450,000

)

Carrying value of old debt at modification

 

$

(6,178,000

)

$

 

$

(1,571,000

)

$

 

$

(388,000

)

$

 

$

 

$

 

$

 

$

 

$

(8,137,000

)

Fair value of new debt at modification

 

$

6,070,000

 

$

 

$

1,516,000

 

$

 

$

386,000

 

$

 

$

 

$

 

$

 

$

 

$

7,972,000

 

Modification of warrants

 

$

 

$

1,916,000

 

$

 

$

632,000

 

$

 

$

 

$

 

$

 

$

 

$

 

$

2,548,000

 

Cancellation/retirement of warrants

 

$

 

$

 

$

 

$

(800,000

)

$

 

$

(300,000

)

$

 

$

 

$

 

$

 

$

(1,100,000

)

Fair value of instruments at issuance

 

$

 

$

 

$

 

$

 

$

 

$

 

$

2,759,000

 

$

1,211,000

 

$

 

$

 

$

3,970,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

February 22, 2013

 

$

6,070,000

 

$

3,916,000

 

$

1,516,000

 

$

1,632,000

 

$

386,000

 

$

 

$

2,759,000

 

$

1,211,000

 

$

 

$

 

$

17,490,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value adjustment

 

$

(2,041,000

)

$

(716,000

)

$

(536,000

)

$

(970,000

)

$

(136,000

)

$

 

$

(742,000

)

$

(807,000

)

$

 

$

 

$

(5,948,000

)

Carrying value of old debt at modification

 

$

(3,450,000

)

$

 

$

(980,000

)

$

 

$

(250,000

)

$

 

$

 

$

 

$

 

$

 

$

(4,680,000

)

Fair value of new debt at modification

 

$

4,920,000

 

$

 

$

1,390,000

 

$

 

$

361,000

 

$

 

$

 

$

 

$

 

$

 

$

6,671,000

 

Conversion of debentures and warrants

 

$

(579,000

)

$

(2,152,000

)

$

 

$

(238,000

)

$

 

$

 

$

 

$

 

$

 

$

 

$

(2,969,000

)

Fair value of instruments at issuance

 

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

1,807,000

 

$

1,166,000

 

$

2,973,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 18, 2013

 

$

4,920,000

 

$

1,048,000

 

$

1,390,000

 

$

424,000

 

$

361,000

 

$

 

$

2,017,000

 

$

404,000

 

$

1,807,000

 

$

1,166,000

 

$

13,537,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Conversion of debentures and warrants

 

$

(304,000

)

$

(265,000

)

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

 

$

(569,000

)

Fair value adjustment

 

$

(426,000

)

$

(245,000

)

$

(100,000

)

$

(141,000

)

$

(48,000

)

$

 

$

1,165,000

 

$

(404,000

)

$

(233,000

)

$

(291,000

)

$

(723,000

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2013

 

$

4,190,000

 

$

538,000

 

$

1,290,000

 

$

283,000

 

$

313,000

 

$

 

$

3,182,000

 

$

 

$

1,574,000

 

$

875,000

 

$

12,245,000

 

 

21



Table of Contents

 

Valuation — Methodology and Significant Inputs Assumptions

 

Fair values for the Company’s derivatives and financial instruments are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates.  Such amounts and the recognition of such amounts are subject to significant estimates that may change in the future. The methods and significant inputs and assumptions utilized in estimating the fair value of the warrant liabilities, 2013 SPA Options and Convertible Notes as of the December 31, 2012 balance sheet date, February 22, 2013 Amendment and Waiver Agreement date, September 18, 2013 Amendment and Waiver agreement, and the September 30, 2013 balance sheet date are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one significant unobservable input.

 

2011 Warrants

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was utilized to estimate the fair value of the 2011 Warrants as of December 31, 2012, February 22, 2013, and September 30, 2013. This model is widely used in estimating value of European options dependent upon a non-paying dividend stock and fixed inputs. This model is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:

 

Input

 

December 31,
2012

 

February 22,
2013

 

September 30,
2013

 

Stock Price

 

$

0.15

 

$

0.14

 

$

0.065

 

Exercise Price

 

$

0.15

 

$

0.15

 

$

0.098

 

Expected Life (in years)

 

3.15

 

3.00

 

2.40

 

Stock Volatility

 

100

%

100

%

100

%

Risk-Free Rate

 

0.39

%

0.40

%

0.24

%

Dividend Rate

 

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

59,576,097

 

160,666,475

 

 

2012 Warrants

 

$0.15 Warrants

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was also utilized to estimate the fair value of the $0.15 Warrants as of December 31, 2012, February 22, 2013, and September 30, 2013.

 

Input

 

December 31,
2012

 

February 22,
2013

 

September 30,
2013

 

Stock Price

 

$

0.15

 

$

0.14

 

$

0.065

 

Exercise Price

 

$

0.15

 

$

0.15

 

$

0.0098

 

Expected Life (in years)

 

4.50

 

4.38

 

3.76

 

Stock Volatility

 

100

%

100

%

100

%

Risk-Free Rate

 

0.63

%

0.70

%

0.92

%

Dividend Rate

 

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

59,576,097

 

160,666,475

 

 

$0.25 Warrants

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was also utilized to estimate the fair value of the $0.25 Warrants as December 31, 2012.  These warrants were canceled on February 22, 2013.

 

22



Table of Contents

 

Input

 

December 31, 2012

 

Stock Price

 

$

0.15

 

Exercise Price

 

$

0.25

 

Expected Life (in years)

 

4.50

 

Stock Volatility

 

100

%

Risk-Free Rate

 

0.63

%

Dividend Rate

 

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

 

Third Tranche Warrants

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was also utilized to estimate the fair value of the Third Tranche Warrants as of January 16, 2013. These warrants were canceled on February 22, 2013.

 

Input

 

January 16,
2013

 

Stock Price

 

$

0.15

 

Exercise Price

 

$

0.15

 

Expected Life (in years)

 

5

 

Stock Volatility

 

110

%

Risk-Free Rate

 

0.75

%

Dividend Rate

 

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

 

February 2013 Warrants

 

A Monte Carlo simulation mode was utilized to estimate the fair value of the February 2013 warrants as of February 22, 2013 and September 30, 2013.

 

Input

 

February 22,
2013

 

September 30,
2013

 

Stock Price

 

$

0.12

 

$

0.058

 

Exercise Price

 

$

0.20

 

$

0.08

 

Expected Life (in years)

 

5

 

4.40

 

Stock Volatility

 

110

%

110

%

Risk-Free Rate

 

0.84

%

1.16

%

Number of Steps

 

100,000

 

100,000

 

Outstanding Shares of Common Stock

 

59,576,097

 

160,666,475

 

 

February 2013 SPA Option

 

The February 2013 SPA option, upon exercise, allows the investor to purchase one share of common stock and one common stock warrant. The option was valued using multiple valuation models, including a Black-Scholes-Merton option-pricing model, with dilution effects, to estimate the fair value of the option to purchase the common share, and a Monte Carlo simulation to determine the estimated fair value of the warrant that would be issued at the time of exercise. These models were used to estimate the fair value of the option at February 22, 2013 and September 30, 2013.

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was also utilized to estimate the fair value of the February 2013 SPA Option as of February 22, 2013 and September 30, 2013.

 

23



Table of Contents

 

Input

 

February 22,
2013

 

September 30,
2013

 

Stock Price

 

$

0.14

 

$

0.065

 

Exercise Price

 

$

0.15

 

$

0.015

 

Expected Life (in years)

 

0.75

 

0.142

 

Stock Volatility

 

110

%

110

%

Risk-Free Rate

 

0.15

%

0.03

%

Dividend Rate

 

0

%

0

%

Outstanding Shares of Common Stock

 

73,042,764

 

160,666,475

 

 

A Monte Carlo simulation model was also utilized to estimate the fair value of the February 2013 SPA Option as of February 22, 2013 and September 30, 2013.

 

Input

 

February 22,
2013

 

September 30,
2013

 

Stock Price (simulated)

 

$

0.10

 

$

0.065

 

Exercise Price

 

$

0.20

 

$

0.20

 

Expected Life (in years)

 

5.00

 

0.142

 

Stock Volatility

 

110

%

110

%

Risk-Free Rate

 

1.158

%

1.475

%

Number of Steps

 

10,000

 

10,000

 

 

September 2013 Warrants

 

A Monte Carlo simulation mode was utilized to estimate the fair value of the September 2013 warrants as of September 18, 2013 and September 30, 2013.

 

Input

 

September 18,
2013

 

September 30,
2013

 

Stock Price

 

$

0.071

 

$

0.062

 

Exercise Price

 

$

0.08

 

$

0.08

 

Expected Life (in years)

 

5

 

4.97

 

Stock Volatility

 

110

%

110

%

Risk-Free Rate

 

1.43

%

1.38

%

Number of Steps

 

100,000

 

100,000

 

 

September 2013 SPA Option

 

The September 2013 SPA option, upon exercise, allows the investor to purchase one share of common stock and one common stock warrant. The option was valued using multiple valuation models, including a Black-Scholes-Merton option-pricing model, with dilution effects, to estimate the fair value of the option to purchase the common share, and a Monte Carlo simulation to determine the estimated fair value of the warrant that would be issued at the time of exercise. These models were used to estimate the fair value of the option at September 18, 2013 and September 30, 2013.

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was also utilized to estimate the fair value of the September 2013 SPA Option as of September 18, 2013 and September 30, 2013.

 

24



Table of Contents

 

Input

 

September 18,
2013

 

September 30,
2013

 

Stock Price

 

$

0.075

 

$

0.065

 

Exercise Price

 

$

0.06

 

$

0.06

 

Expected Life (in years)

 

0.748

 

0.715

 

Stock Volatility

 

110

%

110

%

Risk-Free Rate

 

0.07

%

0.07

%

Dividend Rate

 

0

%

0

%

Outstanding Shares of Common Stock

 

143,997,066

 

160,666,475

 

 

A Monte Carlo simulation model was also utilized to estimate the fair value of the 2013 SPA Option as of September 18, 2013 and September 30, 2013.

 

Input

 

September 18,
2013

 

September 30,
2013

 

Stock Price (simulated)

 

$

0.075

 

$

0.065

 

Exercise Price

 

$

0.06

 

$

0.06

 

Expected Life (in years)

 

.7480

 

0.715

 

Stock Volatility

 

110

%

110

%

Risk-Free Rate

 

0.07

%

0.07

%

Number of Steps

 

10,000

 

10,000

 

 

2011 Convertible Notes

 

A binomial lattice model was utilized to estimate the fair value of the Convertible Notes as of December 31, 2012, February 22, 2012, September 18, 2013 and September 30, 2013. The binomial model considers the key features of the Convertible Notes, as noted above, and is subject to the significant assumptions discussed below. First, a discrete simulation of the Company’s stock price, without effects of dilution due to the conversion feature, was conducted at each node and throughout the expected life of the instrument. Second, a discrete simulation of the Company’s stock price, with effects of dilution due to the conversion feature, was conducted at each node and throughout the expected life of the instrument. Third, based upon the simulated stock price with dilution effect, an analysis of the higher position of a conversion position, redemption position, or holding position (i.e. fair value of the respective future nodes value discounted using the applicable discount rate) was conducted relative to each node until a final fair value of the instrument is conducted at the node representing the measurement date. This model requires the following key inputs with respect to the Company and/or instrument:

 

Input

 

December 31,
2012

 

February 22,
2013

 

September 18
2013

 

September 30,
2013

 

Stock Price

 

$

0.15

 

$

0.14

 

$

0.075

 

$

0.065

 

Strike Price

 

$

0.10

 

$

0.10

 

$

0.06

 

$

0.06

 

Expected remaining term (in years)

 

1.15

 

2.35

 

1.78

 

1.75

 

Stock Volatility

 

105

%

100

%

100

%

100

%

Risk-Free Rate

 

0.17

%

0.32

%

0.38

%

0.27

%

Dividend Rate

 

0

%

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

59,576,097

 

143,997,066

 

160,666,475

 

Effective discount rate

 

13.1

%

13.2

%

16.4

%

16.4

%

Probability of forced redemption

 

20

%

20

%

20

%

20

%

 

2012 Convertible Notes

 

A binomial lattice model was also utilized to estimate the fair value of the 2012 Convertible Notes as of December 31, 2012, February 22, 2012 and September 30, 2013. This model requires the following key inputs with respect to the Company and/or instrument:

 

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Table of Contents

 

Input

 

December 31,
2012

 

February 22,
2013

 

September 18
2013

 

September 30,
2013

 

Stock Price

 

$

0.15

 

$

0.14

 

$

0.075

 

$

0.065

 

Exercise Price

 

$

0.10

 

$

0.10

 

$

0.06

 

$

0.06

 

Expected remaining term (in years)

 

2.50

 

2.35

 

1.79

 

1.75

 

Stock Volatility

 

100

%

100

%

100

%

100

%

Risk-Free Rate

 

0.31

%

0.32

%

0.38

%

0.26

%

Dividend Rate

 

0

%

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

59,576,097

 

143,997,066

 

160,666,475

 

Effective discount rate

 

13.2

%

13.2

%

16.4

%

16.4

%

Probability of forced redemption

 

20

%

20

%

20

%

20

%

 

Third Tranche Convertible Notes

 

A binomial lattice model was also utilized to estimate the fair value of the Tranche Three Convertible Notes as of January 16, 2012, February 22, 2012 and September 30, 2013. This model requires the following key inputs with respect to the Company and/or instrument:

 

Input

 

January 16,
2013

 

February 22,
2013

 

September 18
2013

 

September 30,
2013

 

Stock Price

 

$

0.15

 

$

0.14

 

$

0.075

 

$

0.065

 

Exercise Price

 

$

0.10

 

$

0.10

 

$

0.06

 

$

0.06

 

Expected remaining term (in years)

 

3

 

2.90

 

2.33

 

2.30

 

Stock Volatility

 

100

%

100

%

100

%

100

%

Risk-Free Rate

 

0.36

%

0.39

%

0.56

%

0.42

%

Dividend Rate

 

0

%

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

32,434,430

 

59,576,097

 

143,997,066

 

160,666,475

 

Effective discount rate

 

13.2

%

13.2

%

13.3

%

13.3

%

Probability of forced redemption

 

20

%

20

%

20

%

20

%

 

The following are significant assumptions utilized in developing the inputs:

 

·                  The Company’s common stock shares are traded on the OTC Bulletin Board and, accordingly, the stock price input is based upon bid prices as of the valuation dates due to the extremely thin trading volume, broker-driven market (vs. exchange market) and the wide bid/ask spread as of the valuation date;

 

·                  The expected future stock prices of the Company’s stock were modeled to include the effect of dilution upon conversion of the instruments to shares of common stock;

 

·                  Stock volatility was estimated by considering (i) the annualized monthly volatility of the Company’s stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instruments (monthly data set is more relevant given the extremely thin trading volume of the Company’s common stock) and (ii) the annualized daily volatility of comparable companies’ stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instrument. Historic prices of the Company and comparable companies’ common stock were used to estimate volatility as the Company did not have traded options as of the valuation dates;

 

·                  Based upon the Company’s historical operations and management’s expectations for the foreseeable future, the Company’s stock was assumed to be a non-dividend-paying stock;

 

·                  The risk-free interest rate is based on the U.S. Treasury Yield curve in effect as of the valuation date for the expected term;

 

·                  With respect to the 2011 Convertible Notes, 2012 Convertible Notes and Third Tranche Convertible Notes, the

 

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Table of Contents

 

Company is expected to pay all accrued interest due to the Holders on each Interest Payment Date;

 

·                  With respect to the 2011 Convertible Notes, 2012 Convertible Notes and Third Tranche Convertible Notes, based upon management’s expectations for a change of control or fundamental transaction to occur prior to the maturity date of the 2011 Convertible Notes, 2012 Convertible Notes and Third Tranche Convertible Notes, a low probability of a forced redemption;

 

·                  Upon a change of control redemption, the change of control redemption amount shall equal to the sum of:

 

I.                the greater of:

 

(i)            the outstanding amount of the debt divided by the Conversion Price on the date of the mandatory default amount is either (A) demanded or (B) paid in full, whichever has a lower conversion price, multiplied by the VWAP of the date of the mandatory default amount is either (x) demanded or otherwise due or (y) paid in full, whichever has higher VWAP, plus all accrued and unpaid interest, or

(ii)           130% of the outstanding principal amount of the debt, plus 100% of accrued and unpaid interest, and

 

II.           all other amounts, costs, expenses and liquidated damages due under the various agreements covering issuance of the debt.

 

Additionally, it is assumed that no amounts are due pursuant to clause (II) above in any period and that the stock price at each respective node represents a reasonable approximation of the VWAP requirements.

 

The changes in fair value between reporting periods are related to the changes in the price of the Company’s common stock as of the measurement dates, the volatility of the Company’s common stock during the remaining term of the instrument, changes in the conversion price and effective discount rate.

 

12.                               Commitments

 

Lease Commitments

 

The Company leases its corporate office under an operating lease agreement that expires in August 2014. In addition to the minimum lease payments, the agreement requires payment of the Company’s pro-rata share of property taxes and building operating expenses.

 

As of September 30, 2013, future minimum lease payments are estimated to be as follows (in thousands):

 

Year

 

Future Minimum
Lease Payments

 

2013

 

$