DERIVATIVE LIABILITY

12 Months Ended

Dec. 31, 2013

Notes to Financial Statements

DERIVATIVE LIABILITY

NOTE 21 – DERIVATIVE LIABILITY

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 year ended December 31, 2013, the Company issued a 10% Convertible Note (see “NOTE 17 – 10% SENIOR CONVERTIBLE NOTE”) in the principal amount of $156,000. As of December 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 December 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.

On the date of issuance, 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. During the first quarter of fiscal year 2013, BME converted, on three separate dates, all of the principal and accrued interest into 6,270,413 shares of the Company’s common stock. The Company revalued the derivative liability as of each conversion, which resulted in the Company recording non-cash charges to change in fair value of derivative totaling $169,753 during the year ended December 31, 2013. As of December 31, 2013, the Company had no derivative liability with regard to this note.

On May 1, 2013, the Company issued warrants to GMF (see “NOTE 23 – STOCKHOLDERS’ DEFICIT”) entitling GMF to purchase, at their discretion, 5,000,000 shares of the Company’s common stock. 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 19 – 7% CONVERTIBLE NOTE”).

The Company originally 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 year ended December 31, 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 October 11, 2013, Gemini Master Fund exercised the 5,000,000 warrants via a cashless exercise (see “NOTE 23 – STOCKHOLDERS’ DEFICIT”). At the time of exercise the Company revalued the derivative liability 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 same criteria used when valued at September 31, 2013), and determined that there had been no change in the fair value of the derivative liability since September 30, 2013. Accordingly, the Company reclassified the $312,500 derivative liability to additional paid-in capital on October 11, 2013. As of December 31, 2013, the Company no longer had a derivative liability related to these warrants.

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 19 – 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 price 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 09.30.13			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
Conversion price per share	$	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 year ended December 31, 2013.

On December 19, 2013, the Holder of the original 7% Convertible Note converted the remaining principal of $50,000 and accrued and unpaid interest of $11,349, which totals $61,349, into 2,453,945 shares of the Company’s common stock at a per share conversion price of $0.025. At the time of conversion the Company revalued the derivative liability of this note using the weighted-average Black-Scholes-Merton option pricing model with the following assumptions; (i) dividend yield of 0%; (ii) expected volatility of 21%; (iii) risk free rate of 0.01%, (iv) expected term of 1 day, (v) market value share price of $0.133, and (vi) per share conversion price of $0.025. This resulted in a derivative value of $265,026 as of December 19, 2013, which represents an increase in the fair value of the derivative of $166,455 as compared to the $98,571 derivative value as of September 30, 2013. Accordingly, the Company recorded a $166,455 non-cash change in the fair value of the derivative while also reclassifying the $265,026 derivative liability to additional paid-in capital as of December 19, 2013. As of December 31, 2013, there was no longer a derivative liability associated with the original $750,000 7% Convertible Note.

On October 11, 2013, the Company issued an additional $850,000 of 7% convertible notes to four Holders. As previously stated, due to the “reset” clause in these 7% Notes relating to the conversion price, the Company has determined that the conversion feature is considered a beneficial conversion feature and thereby creates a derivative liability for the Company. On the date of issuance, the Company calculated the value of the derivative liability 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 25.09%; (iii) risk free rate of 0.23%, (iv) expected term of 1 year, (v) market value share price of $0.063, and (vi) per share conversion price of $0.025. Based upon this model, the Company determined an initial derivative liability value of $1,292,000, which it recorded as a derivative liability as of the date of issuance while also recording a $442,000 non-cash interest expense and an $850,000 debt discount on its balance sheet in relation to the beneficial conversion feature (BCF) of these notes.

On December 31, 2013, the Company revalued the derivative liability associated with the $850,000 of 7% convertible notes 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 45.04%; (iii) risk free rate of 0.01%, (iv) expected term of 1 year, (v) market value share price of $0.151, and (vi) per share conversion price of $0.025. This resulted in a derivative value of 4,284,000 as of December 31, 2013, which represents an increase of $2,992,000 from the $1,292,000 value as of October 11, 2013. As a result, the Company recorded a $2,992,000 non-cash change in the fair value of the derivative expense while also increasing the related derivative liability to $4,284,000 as of December 31, 2013.

On December 20, 2013, the Company issued an additional $1,000,000 of 7% convertible notes to two Holders. As previously stated, due to the “reset” clause in these 7% Notes relating to the conversion price, the Company has determined that the conversion feature is considered a beneficial conversion feature and thereby creates a derivative liability for the Company. On the date of issuance, the Company calculated the value of the derivative liability 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 45.04%; (iii) risk free rate of 0.02%, (iv) expected term of 1 year, (v) market value share price of $0.14, and (vi) per share conversion price of $0.025. Based upon this model, the Company determined an initial derivative liability value of $4,600,000, which it recorded as a derivative liability as of the date of issuance while also recording a $3,600,000 non-cash interest expense and an $1,000,000 debt discount on its balance sheet in relation to the beneficial conversion feature (BCF) of these notes.

On December 31, 2013, the Company revalued the derivative liability associated with the $1,000,000 of 7% convertible notes 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 45.04%; (iii) risk free rate of 0.01%, (iv) expected term of 1 year, (v) market value share price of $0.151, and (vi) per share conversion price of $0.025. This resulted in a derivative value of 5,040,000 as of December 31, 2013, which represents an increase of $440,000 from the $4,600,000 value as of December 20, 2013. As a result, the Company recorded a $440,000 non-cash change in the fair value of the derivative expense while also increasing the related derivative liability to $5,040,000 as of December 31, 2013.

As of December 31, 2013, the Company had recorded a derivative liability in the amount of $9,324,000 as detailed below:

Derivative value of $850,000 7% Convertible Notes	$	4,284,000
Derivative value of $1,000,000 7% Convertible Notes		5,040,000
	$	9,324,000