Derivative Liability

6 Months Ended

Jun. 30, 2014

Derivative Liability [Abstract]

Derivative Liability

Note 6.  Derivative Liability

As described in Note 7, Debt, Warrants and Preferred Stock Issuance of our Annual Report, we issued a total of 23,711,052 warrants on December 31, 2012.  Pursuant to ASC 815, the reset provision contained in the warrants qualifies the warrants for derivative accounting.  In addition, the derivative liability must be marked-to-market each reporting period and the change in its fair value will be recorded in our statement of income. On the date of the issuance, the fair value of the derivative liability was $474,203, which was calculated using the Black-Scholes model based upon the following assumptions: expected volatility of 419.44%, discount rate of 0.36%, expected term of three years and no dividends.

$427,450 of the fair value was attributable to warrants issued to Water Tech as additional consideration for the $310,000 note discussed above.  As the fair value of the warrants was higher than the face value of the note, a debt discount of $310,000 was recorded on the note with the additional $117,450 of fair value recorded as a loss on derivative liability during the year ended December 31, 2012.  The entire debt discount was amortized during the first quarter of 2013.  The remaining $46,753 of the fair value of the warrants was attributable to warrants issued to the Investor as additional consideration for the $50,000 note discussed above.  The fair value was recorded as a debt discount on the note and was fully amortized during the year ended December 31, 2012.

During the year ended December 31, 2013, Water Tech exercised 19,035,638 warrants on a cashless basis, which had a fair value of $1,332,360 on the date of exercise, and received 18,790,174 restricted shares of our common stock as a result. The fair value was extinguished to additional paid-in capital on our consolidated balance sheets. At June 30, 2014 and December 31, 2013, the total fair value of the remaining outstanding warrants was $275,367 and $163,299.  The total change in fair value, less the warrant exercise, was $112,068, which was recognized as a loss on our consolidated statements of operations.

We measure fair value in accordance with a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 Measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy are described below:

Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical unrestricted assets or liabilities;

Level 2 – Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and

Level 3 – Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity).

The following table sets forth our financial assets and liabilities measured at fair value by level within the fair value hierarchy as of December 31, 2013 and June 30, 2014, respectively. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

	Level 1		Level 2		Level 3		Total
Derivative liabilities	$	-	$	-	$	163,299	$	163,299

	Level 1		Level 2		Level 3		Total
Derivative liabilities	$	-	$	-	$	275,367	$	275,367

The following table presents a roll-forward of the derivative liability measured at fair value by level within the fair value hierarchy as of December 31, 2013 and June 30, 2014, respectively.  Derivative liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Beginning derivative liability at December 31, 2013	$	163,299
Mark-to-market loss		112,068
Ending derivative liability at June 30, 2014	$	275,367

As described in Note 5. Debt and Preferred Stock Issuance, on February 8, 2014 we issued to a certain investor 500 shares of our Series A Preferred Stock as part of the sale of the Units.  Even though we identified conversion features embedded within Series A Preferred Stock, we have determined that the features associated with the embedded conversion option should not be accounted for at fair value as a derivative liability.