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DERIVATIVE WARRANT AND CONVERSION OPTION LIABILITY AND FAIR VALUE
 9 Months Ended
Sep. 30, 2013
Notes to Financial Statements  
DERIVATIVE WARRANT AND CONVERSION OPTION LIABILITY AND FAIR VALUE

Note 4: DERIVATIVE WARRANT AND CONVERSION OPTION LIABILITY AND FAIR VALUE

The Company has evaluated the application ASC 480-10 Distinguishing liabilities from equity, ASC 815-40 Contracts in an Entity’s Own Equity and ASC 718-10 Compensation – Stock Compensation to the issued and outstanding warrants to purchase common stock that were issued with the convertible notes, private placements, consulting agreements, and various debt settlements during 2009 through 2013. Based on the guidance, management concluded these instruments are required to be accounted for as derivatives either due to a ratchet down protection feature available on the exercise price (Note 5) or a holder’s right to put the warrants back to the Company for cash under certain conditions or a conversion option feature with conversion into variable number of shares. Under ASC 815-40-25, the Company records the fair value of these warrants and conversion options (derivatives) on its balance sheet, at fair value, with changes in the values reflected in the statements of operations as “Changes in fair value of derivative liabilities”. The fair value of the share purchase warrants are recorded on the balance sheet under ‘Derivative liability – warrants’ and the fair value of the conversion options are recorded on the balance sheet under ‘Derivative liability – conversion option’.

ASC 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820-10 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820-10 describes three levels of inputs that may be used to measure fair value: Level 1 – Quoted prices in active markets for identical assets or liabilities; Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and Level 3 – Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation. The Company’s Level 3 liabilities consist of the derivative liabilities associated with the warrants issued with the convertible notes during the year ended December 31, 2011. At December 31, 2012 and September 30, 2013, all of the Company’s derivative liabilities were categorized as Level 3 fair value liabilities. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

 

Level 3 Valuation Techniques

Financial liabilities are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial liabilities consist of the notes and warrants for which there is no current market for these securities such that the determination of fair value requires significant judgment or estimation.

Determining fair value of share purchase warrants and conversion options, given the Company’s stage of development and financial position, is highly subjective and identifying appropriate measurement criteria and models is subject to uncertainty. There are several generally accepted pricing models for warrants and options and derivative provisions. The Company has chosen to value the warrants and conversion option on the notes that contain ratchet down provisions using the Binomial model and Black-Scholes model under the following assumptions:

   December 31, 2012  September 30, 2013
     Expected Life (Years)  Risk free Rate   Dividend yield    Volatility   Expected Life (Years)  Risk free Rate   Dividend yield    Volatility 
 Share purchase warrants   0.08 to 3.78  0.02% to 0.36%   0.00%   199%  1.10 to 3.03  0.09% to 0.63%   0.00%   199%

 

   December 31, 2012  September 30, 2013
   Expected Life (Years)  Risk free Rate   Dividend yield    Volatility   Expected Life (Years)  Risk free Rate   Dividend yield    Volatility 
Conversion Option  0.003 to 0.89  0.05% to 0.19%   0.00%   100.88% to 141.21%   0.14 to 0.78  0.02% to 0.15%   0.00%   108% to 161.97% 

 

The foregoing assumptions are reviewed quarterly and are subject to change based primarily on management’s assessment of the probability of the events described occurring. Accordingly, changes to these assessments could materially affect the valuations.

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis

Financial assets and liabilities measured at fair value on a recurring basis are summarized below and disclosed on the balance sheet under Derivative liability – warrants and Derivative liability – conversion option:

      As of September 30, 2013   

 

 

 

 

     Fair Value Measurements   

 

 

 

 

 

  Carrying Value  Level 1  Level 2  Level 3  Total
Derivative liability - warrants  $89,195    —      —     $89,195   $89,195 
Derivative liability – conversion option   195,300    —      —      195,300    195,300 
Total  $284,495    —      —     $284,495   $284,495 

 

   As of December 31, 2012   

 

 

 

 

     Fair Value Measurements Using   

 

 

 

 

 

  Carrying Value  Level 1  Level 2  Level 3  Total
Derivative liability - warrants  $977,086    —      —     $977,086   $977,086 
Derivative liability – conversion option   867,575    —      —      867,575    867,575 
Total  $1,844,661    —      —     $1,844,661   $1,844,661 
                          

 

The table below provides a summary of the changes in fair value, including net transfers, in and/or out, of financial assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2013 and the year ended December 31, 2012:

 

 

 

 

 

  Fair Value Measurements Using Level 3 Inputs

 

 

   Derivative liability - warrants    Derivative liability – conversion option    Total 
Balance,  December 31, 2011  $1,317,834   $—     $1,317,834 
Additions during the year   300,000    737,700    1,037,700 
Total unrealized (gains) or losses included in net loss   (597,127)   129,875    (467,252)
Debt settlement   (43,621)   —      (43,621)
Transfers in and/or out of Level 3   —      —      —   
Balance,  December 31, 2012   977,086    867,575    1,844,661 
Additions during the period   200,000    363,300    563,300 
Total unrealized (gains) or losses included in net loss   (1,087,891)   (1,035,575)   (2,123,466)
Transfers in and/or out of Level 3   —      —      —   
Balance, September 30, 2013  $89,195   $195,300   $284,495 

 

The fair value of the warrants is determined using a Binomial option pricing model. The valuation of warrants is subjective and is affected by changes in inputs to the valuation model including the price per share of common stock, the historical volatility of the stock price, risk-free rates based on U.S. Treasury security yields, the expected term of the warrants and dividend yield. Changes in these assumptions can materially affect the fair value estimate. The Company could ultimately incur amounts to settle the warrant at a cash settlement value that is significantly different than the carrying value of the liability on the financial statements. The Company will continue to classify the fair value of the warrants as a liability until the warrants are exercised, expire, or are amended in a way that would no longer require these warrants to be classified as a liability. Changes in the fair value of the common stock warrants liability are recognized as a component of other income (expense) in the statement of operations.

The net cash settlement value at the time of any future Fundamental Transaction will depend upon the value of the following inputs at that time: the consideration value per share of the Company’s common stock, the volatility of the Company’s common stock, the remaining term of the warrant from announcement date, the risk-free interest rate based on U.S. Treasury security yields, and the Company’s dividend yield. The warrant requires use of a volatility assumption equal to the greater of 100% and the 100-day volatility function determined as of the trading day immediately following announcement of a Fundamental Transaction.