Quarterly report pursuant to Section 13 or 15(d)

Convertible Notes and Warrant Liabilities

v2.4.0.6
Convertible Notes and Warrant Liabilities
6 Months Ended
Jun. 30, 2012
Convertible Notes and Warrant Liabilities  
Convertible Notes and Warrant Liabilities

11.                               Convertible Notes and Warrant Liabilities

 

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 “Convertible Notes”) and warrants to purchase up to 40,000,000 shares of common stock, which expire February 22, 2016 (the “Investor Warrants”).  Under the terms of the Purchase Agreement, the Company had the opportunity to raise up to an additional $2 million from the Holders of the Convertible Notes in two separate $1 million tranches, based upon meeting certain operational milestones within certain periods of time.  The deadline for achieving the operational milestones for the first $1 million tranche expired in February 2012 without the Company achieving such milestones; however, as discussed below, 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 million tranche and completed such financing on July 2, 2012 (see Footnote 13 for additional disclosure on this financing).  The second $1 million tranche is due to the Company upon achievement of the applicable operational milestones at any time prior to February 22, 2014.

 

Convertible Notes

 

The Convertible Notes require payment of interest on the outstanding principal amount, in cash, at the rate of 5% per annum, payable quarterly on January 1, April 1, July 1, and October 1, beginning on the first such date following the Original Issue Date, on each conversion date (for the principal amount then being converted), on each optional redemption date (for the principal amount then being redeemed) and on the maturity date. 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 $0.10 per share (“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) 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 Volume Weighted Average Price (“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.  As of June 30, 2012, the Company has not elected to deliver such notice.

 

The Company is required to repay, in cash, any outstanding principal amount of the Convertible Notes on February 22, 2014 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.

 

Investor Warrants

 

On February 22, 2011, 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”). The following is a summary of the Warrants outstanding for the six months ending June 30, 2012:

 

 

 

Warrants

 

Exercise
Price

 

Beginning balance

 

40,000,000

 

$

0.15

 

Add: Adjustments (pursuant to warrants agreement)

 

 

n/a

 

Less: Exercised (prior to 3/31/2011)

 

 

n/a

 

Ending balance

 

40,000,000

 

$

0.15

 

 

The Warrants are exercisable in cash to purchase shares of the Company’s common stock (the “Warrant Shares”). The Exercise Price may be paid pursuant to a cashless exercise provision if the Warrant Shares have not been registered within six months after the Warrants are issued. 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) 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, 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.

 

Fair Value Measurements

 

The Company measures and reports fair value in accordance with Accounting Standards Codifications (“ASC”) 820 — Fair Value Measurements and Disclosures (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value investments.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, principal (or most advantageous) markets, and an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.

 

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques may require significant judgment and are primarily dependent upon the characteristics of the asset or liability, and the quality and availability of inputs. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and resulting measurement as follows:

 

Level 1

 

Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;

 

Level 2

 

Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities; and

 

Level 3

 

Unobservable inputs for the asset or liability that are supported by little or no market activity and that are significant to the fair values.

 

Fair value measurements are required to be disclosed by the Level within the fair value hierarchy in which the fair value measurements in their entirety fall. Fair value measurements using significant unobservable inputs (in Level 3 measurements) are subject to expanded disclosure requirements including a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following: (i) total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings, and a description of where those gains or losses included in earning are reported in the statement of income.

 

The following summarizes the Company’s assets and liabilities measured at fair value as of June 30, 2012:

 

 

 

 

 

Fair Value Measurements at Reporting Date Using:

 

 

 

 

 

Quoted
Prices

 

 

 

 

 

 

 

 

 

in Active

 

Significant

 

 

 

 

 

 

 

Markets for

 

Other

 

Significant

 

 

 

Balance as of

 

Identical

 

Observable

 

Unobservable

 

 

 

June 30,

 

Assets

 

Inputs

 

Inputs

 

Description

 

2012

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Convertible notes

 

$

8,920,000

 

$

 

$

 

$

8,920,000

 

Warrant liabilities

 

$

4,000,000

 

$

 

$

 

$

4,000,000

 

 

 

 

 

 

 

 

 

 

 

Total Liabilities

 

$

12,920,000

 

$

 

$

 

$

12,920,000

 

 

Accounting for the Convertible Notes and Investor Warrants

 

Investor Warrants

 

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 Investor Warrants 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. As a result, the Investor Warrants are recorded as a liability at fair value as of June 30, 2012 with changes in fair value recorded in the consolidated statement of operations.

 

Convertible Notes

 

The Company has determined that the 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 the February 22, 2011 financing.  As permitted under ASC 825-10-10 — Financial Instruments, as it relates to the fair value option, the Company has elected, as of February 22, 2011, to measure the 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 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.

 

Upon issuance of the Convertible Notes, the Company allocated the proceeds received to the Convertible Notes and Investor 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 Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $3,680,000 million. As of June 30, 2012, the Convertible Notes have been marked to fair value resulting in a derivative liability of $8,920,000 million. The net charge to other income (expense) was a loss of $354,000 and $3,461,000 in the three and six months ended June 30, 2012, respectively. The debt discount in the amount of $792,000 (resulting from the allocation of proceeds) is being amortized to interest expense using the effective interest method over the expected term of the Convertible Notes. The Company amortized $66,000 and $132,000 for the three and six months ended June 30, 2012, respectively which is a component of interest expense.

 

Upon issuance, the Company allocated $792,000 of the initial proceeds to the Investor Warrants and immediately marked them to fair value resulting in a derivative liability of $908,000. As of June 30, 2012, the Investor Warrants have been marked to fair value resulting in a derivative liability of $4,000,000. The charge to other income (expense) for the three and six months ended June 30, 2012 was expense of $0 and $2,400,000, respectively.

 

A summary of changes in the Convertible Notes and Investor Warrants is as follows:

 

 

 

Fair Value
of Convertible
Notes

 

Fair Value
of Warrant
Liabilities

 

Total

 

Allocation of initial proceeds

 

$

3,208,000

 

$

792,000

 

$

4,000,000

 

Initial fair value adjustment

 

$

469,000

 

$

116,000

 

$

585,000

 

February 22, 2011

 

$

3,677,000

 

$

908,000

 

$

4,585,000

 

Amortization of debt discount

 

$

91,000

 

$

 

$

91,000

 

Fair value adjustment

 

$

1,747,000

 

$

988,000

 

$

2,735,000

 

Balance June 30, 2011

 

$

5,515,000

 

$

1,896,000

 

$

7,411,000

 

Balance December 31, 2011

 

$

5,327,000

 

$

1,600,000

 

$

6,927,000

 

Amortization of debt discount

 

$

132,000

 

$

 

$

132,000

 

Fair value adjustment

 

$

3,461,000

 

$

2,400,000

 

$

5,861,000

 

Balance June 30, 2012

 

$

8,920,000

 

$

4,000,000

 

$

12,920,000

 

 

The Company records the fair value of Convertible Notes and Investor Warrants as a long term liability.

 

Financing Costs

 

Financing costs include costs associated with obtaining the February 22, 2011 financing.  Financing costs totaling $530,000 were recorded in other income (expense) in the six months ending June 30, 2011, $135,000 of which were recorded in prepaid expenses and other current assets at December 31, 2010 and expensed upon closing of the transaction.

 

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 and Convertible Notes are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.

 

Warrant Liabilities

 

A Black-Scholes-Merton option-pricing model, with dilution effects, was utilized to estimate the fair value of the Warrant Liabilities as of February 22, 2011, June 30, 2011, December 31, 2011 and June 30, 2012. This model is widely used in estimating value of European options dependent upon a non dividend-paying 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

 

February 22,
2011

 

June 30,
2011

 

December 31,
2011

 

June 30,
2012

 

Stock Price

 

$

0.0755

 

$

0.12

 

$

0.1075

 

$

0.20

 

Exercise Price

 

$

0.15

 

$

0.15

 

$

0.15

 

$

0.15

 

Expected Life (in years)

 

5.00

 

4.65

 

4.15

 

3.65

 

Stock Volatility

 

90

%

95

%

95

%

105

%

Risk-Free Rate

 

2.16

%

1.59

%

0.63

%

0.51

%

Dividend Rate

 

0

%

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

30,351,092

 

30,351,092

 

30,351,092

 

30,976,092

 

 

Convertible Notes

 

A binomial lattice model was utilized to estimate the fair value of the Convertible Notes. 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

 

February 22,
2011

 

June 30,
2011

 

December 31,
2011

 

June 30,
2012

 

Stock Price

 

$

0.0755

 

$

0.1200

 

$

0.1075

 

$

0.20

 

Exercise Price

 

$

0.10

 

$

0.10

 

$

0.10

 

$

0.10

 

Expected remaining term (in years)

 

3.00

 

2.65

 

2.15

 

1.65

 

Stock Volatility

 

95

%

100

%

100

%

110

%

Risk-Free Rate

 

1.22

%

0.68

%

0.27

%

0.29

%

Dividend Rate

 

0

%

0

%

0

%

0

%

Outstanding Shares of Common Stock

 

30,351,092

 

30,351,092

 

30,351,092

 

30,976,092

 

Effective discount rate

 

20.3

%

16.6

%

13.2

%

8.3

%

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 on the valuation date for the expected term;

 

·                  With respect to the Convertible Notes, the Company is expected to pay all accrued interest due to the Holders on each Interest Payment Date;

 

·                  With respect to the Convertible Notes, based upon management’s expectations for a change of control or fundamental transaction to occur prior to the maturity date of the 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.