DERIVATIVE LIABILITY

9 Months Ended

Sep. 30, 2013

Notes to Financial Statements

DERIVATIVE LIABILITY

NOTE 9 – DERIVATIVE LIABILITY

In April 2008, the FASB issued a pronouncement that provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in the pronouncement on accounting for derivatives. This pronouncement was effective for financial statements issued for fiscal years beginning after December 15, 2008. The adoption of these requirements can affect the accounting for warrants and many convertible instruments with provisions that protect holders from a decline in the stock price (or “down-round” provisions). For example, warrants or conversion features with such provisions are no longer recorded in equity. Down-round provisions reduce the exercise price of a warrant or convertible instrument if a company either issues equity shares for a price that is lower than the exercise price of those instruments or issues new warrants or convertible instruments that have a lower exercise price.

During fiscal year 2012, which ended December 31, 2012, the Company issued the 6% Notes and the Company determined that the conversion feature in these 6% Notes created a derivative liability. The derivative liability was initially valued using the weighted-average Black-Scholes-Merton option pricing model, which approximates the Monte Carlo and other binomial valuation techniques, with the following assumptions; (i) dividend yield of 0%; (ii) expected volatility of 74%; (iii) risk free rate of 0.04% and (iv) expected term of 3.08 years. Based upon this model, the Company determined an initial value of $592,326. On December 31, 2012, the Company determined there was no longer a derivative liability related to these 6% Notes and fully expensed the value of the initial derivative liability as of December 31, 2012.

During the three month period ended March 31, 2013, the Company issued a 10% Convertible Note (see “NOTE 14 – 10% SENIOR CONVERTIBLE NOTE”) in the principal amount of $156,000. As of March 31, 2013 the entire balance of the 10% Convertible Note had been converted into 6,270,413 shares of the Company’s common stock. The Company determined that the conversion feature was considered a beneficial conversion feature and determined its value on the date of conversion to be $156,000. Accordingly, the beneficial conversion feature has been accounted for as a valuation discount to the 10% Convertible Note and was fully amortized as of March 31, 2013 via effective interest method, with the Company recording $156,000 non-cash interest expense and $2,750 non-cash loss on extinguishment of debt. The Company had no derivative liability with regard to this note as of March 31, 2013.

During the three month period ended March 31, 2013, the Company evaluated the conversion feature of the 10% Convertible Note and determined that there was a derivative liability. The derivative liability was initially valued using the Black-Scholes option pricing model, with the following assumptions; (i) dividend yield of 0%; (ii) expected volatility of 309%; (iii) risk free rate of 0.11% and (iv) expected term of 0.5 years. Based upon this model, the Company determined an initial value of $158,745. The Company fully expensed as of March 31, 2013 as a $169,753 non-cash charge to change in fair value of derivative liability. As of March 31, 2013, BME had converted all of the principal and accrued interest into 6,270,413 shares of the Company’s common stock. The Company determined there was no longer a derivative liability related to this 10% Convertible Note.

During the nine months ended September 30, 2013, the Company issued warrants to GMF (see “NOTE 18 – STOCKHOLDERS’ EQUITY/DEFICIT”) entitling GMF to purchase, at their discretion, 5,000,000 shares of the Company’s common stock. The warrants were issued on May 1, 2013 in connection with the $280,000 OID Bridge Note that was also issued on May 1, 2013. The warrants have a five-year term with an original exercise price of $0.05 per share. The warrants vest immediately and are exercisable in whole, or in part, at any time and from time to time on or after the issue date and on or before the termination date. Per the terms of the Common Stock Purchase Warrant (the “Warrant Agreement”) between the Company and GMF, the exercise price was reset on June 4, 2013 to $0.035 per share due to the Company’s sale/issuance of shares at $0.035 per share under its Subscription Agreement. On September 5, 2013, the exercise price was reset again to $0.02156 per share as a result of the Company issuing shares of its common stock at said per share price in relation to a debt conversion related to the Company’s 7% Convertible Notes (see ”NOTE 16 – 7% CONVERTIBLE NOTE”).

On June 30, 2013, the Company valued the warrants at $250,000 using the Black-Scholes option pricing model using the following assumptions: (i) dividend yield of 0%; (ii) expected volatility of 240%; (iii) risk free rate of 0.04% and (iv) expected term of 5 years. The Company fully expensed the entire $250,000 as a non-cash charge to “warrants issued expense” during the three month period ended June 30, 2013.

On September 30, 2013, the Company valued the warrants at $312,500 using the Black-Scholes option pricing model using the following assumptions: (i) dividend yield of 0%; (ii) expected volatility of 230%; (iii) risk free rate of 0.02% and (iv) expected term of 4.5 years. The Company fully expensed the $62,500 increase in the value of the warrants as a non-cash charge to “change in fair value of derivative”.

On August 29, 2013, the Company issued a 7% Convertible Note (the “7% Note”) to W-Net Fund I, L.P. (the “Holder”), a Delaware limited partnership, in exchange for the Revolving Promissory Note originally issued on June 7, 2013 by the Company to the Holder and amended on August 6, 2013 (the “Exchanged Note”) (see ”NOTE 16 – 7% CONVERTIBLE NOTE”). Per the terms of the 7% Note, the Holder can, at its sole discretion, convert the outstanding and unpaid principal and interest into fully paid and nonassessable shares of the Company’s common stock. The conversion price for the period of time from the date of this 7% Note through and including September 30, 2014 is the lesser of (a) $0.025 per share and (b) seventy percent (70%) of the average of the three (3) lowest daily volume weighted average closing prices occurring during the twenty (20) consecutive trading days immediately preceding the applicable conversion date on which the Holder elects to convert all or part of this 7% Note, subject to adjustment as provided in this 7% Note. The conversion price is $0.025 per share for the period of October 1, 2014 through the maturity date of September 30, 2015, subject to adjustment as provided in this 7% Note.

On September 5, 2013, the Holder converted $550,000 of principal into 25,510,204 shares of the Company’s common stock at a conversion price of $0.02156 per share. On September 17, 2013, the Holder converted $150,000 of principal into 6,957,328 shares of the Company’s common stock at a conversion price of $0.02156 per share. As of September 30, 2013, there was $50,000 of principal outstanding in relation to the 7% Note.

The Company has determined that the 7% Note is a derivative liability due to the “reset” clause associated with the conversion price. On August 29, 2013, which represents the date that the Revolving Promissory Note was exchanged for the 7% Convertible Note, the Company valued the derivative liability of the 7% Note using the Black Scholes option pricing model using the assumptions detailed below. Also, as a result of the above mentioned conversions, the Company has valued the derivative liability of the 7% Note in three portions:

	1st Conversion			2nd Conversion			Outstanding 09.05.13			Total
Original principal amount	$	550,000		$	150,000		$	50,000		$	750,000
Conversion Date		09.05.13			09.17.13
Conversion price per share	$	0.02156		$	0.02156		$	0.02156
Amount converted	$	550,000		$	150,000					$	700,000
Shares		25,510,204			6,957,328			2,319,109
Stock price 08.29.13	$	0.04		$	0.04		$	0.04
Volatility		21.0	%		21.0	%		21.0	%
Risk free rate		0.02	%		0.02	%		0.02	%
Per share derivative value	$	0.018		$	0.018		$	0.018
Derivative value 08.29.13	$	469,388		$	128,015		$	42,671		$	640,074

Accordingly, on August 29, 2013, the Company recorded a derivative liability of $640,074 in relation to the 7% Note while also recording a corresponding $640,074 non-cash “loss on extinguishment of debt”. The Company also determined that the exchange of the Revolving Promissory Note for the 7% Convertible Note created a beneficial conversion feature, the value of which was determined to be $109,926 ($750,000 – $640,074). Accordingly, the Company recorded a $109,926 non-cash “loss on extinguishment of debt” and a corresponding $109,926 increase to “additional paid-in capital”.

On both September 5th and 17th, 2013, the above mentioned dates of conversion, the Company revalued the converted portion of the derivative liability, which was originally valued at $597,403 ($469,388+$128,015), using the Black-Scholes option pricing model and the assumptions detailed below:

	1st Conversion			2nd Conversion			Total
Original principal amount	$	550,000		$	150,000		$	700,000
Conversion Date		09.05.13			09.17.13
Conversion price per share	$	0.02156		$	0.02156
Amount converted	$	550,000		$	150,000		$	700,000
Shares		25,510,204			6,957,328
Stock price on date of conversion	$	0.03000		$	0.05000
Volatility		21.0	%		21.0	%
Risk free rate		0.02	%		0.02	%
Per share derivative value	$	0.0084		$	0.028
Derivative value on conversion date	$	214,286		$	197,588		$	411,874

The resulting $411,874 derivative value attributed to the $700,000 of converted debt resulted in a $185,529 reduction in the original $597,403 value recorded on August 29, 2013. As a result, the Company recorded a $185,529 reduction in the value of the derivative liability and a corresponding $185,529 non-cash gain to “change in fair value of derivative” during the three months ending September 30, 2013. The remaining $411,874 derivative liability ($597,403 - $185,529) related to the $700,000 converted on September 5th and 17th 2013 was reclassified from a “derivative liability” to “additional paid-in capital” as of September 30, 2013.

On September 30, 2013, the Company revalued the derivative liability related to the $50,000 of outstanding principal related to the 7% Note. The Company used the Black-Scholes option pricing model using the following assumptions: (i) dividend yield of 0%; (ii) expected volatility of 21%; (iii) risk free rate of 0.02% and (iv) expected term of 6 months. This resulted in a value of $98,571 as of September 30, 2013, an increase of $55,900 from the $42,671 as of August 29, 2013. The Company fully expensed the $55,900 as a non-cash charge to “change in fair value of derivative” during the three-month period ended September 30, 2013.

As of September 30, 2013, the Company had a total derivative liability of $411,071, of which $312,500 was in relation to the warrants and $98,571 in relation to the 7% Note.