2. Fair Value Measurements

12 Months Ended

Dec. 31, 2013

Notes to Financial Statements

Note 2 - Fair Value Measurements

We measure the fair value of financial assets and liabilities in accordance with GAAP, which defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements.

GAAP 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. GAAP 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. GAAP 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 – quoted prices for similar assets and liabilities in active markets or inputs that are observable.

Level 3 – inputs that are unobservable (for example the probability of a capital raise in a “binomial” methodology for valuation of a derivative liability directly related to the issuance of common stock warrants).

Derivative Instruments:

We do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain financial instruments and contracts, such as debt financing arrangements the issuance of preferred stock with detachable common stock warrants features that are either i) not afforded equity classification, ii) embody risks not clearly and closely related to host contracts, or iii) may be net-cash settled by the counterparty. These instruments are required to be carried as derivative liabilities, at fair value.

Our only derivative instruments are detachable (or “free-standing”) common stock purchase warrants issued in conjunction with debt or preferred stock. We estimate fair values of these derivatives (and related embedded beneficial conversion features) utilizing Level 2 inputs for all classes of warrants issued, other than one class, Series C Preferred Stock. Other than the Series C Preferred Stock warrants, we use the Black-Scholes option valuation technique as it embodies all of the requisite assumptions (including trading volatility, remaining term to maturity, market price, strike price, and risk free rates) necessary to fair value these instruments, for they do not contain material “down round protection” (otherwise referred to as “anti-dilution” and full ratchet provisions). For the warrants directly related to the Series C Preferred Stock, the warrant contracts do contain “Down Round Protections” and the “Black-Scholes” option valuation technique does not, in its valuation calculation, give effect for the additional value inherently attributable to the warrant having the “Down Round Protection” mechanisms in its contractual arrangement.  Valuation models and techniques have been developed and are widely accepted that take into account the additional value inherent in “Down Round Protection.” These widely accepted techniques include “Modified Binomial”, “Monte Carlo Simulation” and the “Lattice Model.” The “core” assumptions and inputs to the “Binomial” model are the same as for “Black-Scholes”, such as trading volatility, remaining term to maturity, market price, strike price, and risk free rates; all Level 2 inputs.  However, a key input to the “Binomial” model (in our case, the “Monte Carlo Simulation”, for which we engage an independent valuation firm to perform) is the probability of a future capital raise.  By definition, this input assumption does not meet the requirements for Level 1 or Level 2 outlined above; therefore, the entire fair value calculation for the Series C Common Stock Warrants is deemed to be Level 3. This input to the Monte Carlo Simulation model, was developed with significant input from management based on its knowledge of the business, current financial position and the strategic business plan with its best efforts.

Estimating fair values of these derivative financial instruments require the use of significant and subjective inputs that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, option-based techniques are volatile and sensitive to changes in our trading market price, the trading market price of various peer companies and other key assumptions such as the probability of a capital raise for the Monte Carlo Simulation described above. Since derivative financial instruments are initially and subsequently carried at fair value, our income will reflect this sensitivity of internal and external factors.

The key quantitative assumptions related to the Series C Common Stock Warrants, issued March 3, 2011 and expiring March 3, 2016, are as follows:

	December 31, 2013	December 31, 2012
Expected Life (Years)	2.2	3.2
Risk Free Rate	0.45%	0.39%
Volatility	29.31%	30.46%
Probability of a Capital Raise	4-8%	8-80%

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

Financial assets and liabilities measured at fair value on a recurring basis (for the Company, only derivative liabilities related to common stock purchase warrants, issued in directly in conjunction with debt and preferred stock issuances) are summarized below and disclosed on the balance sheet under Derivative liability:

	December 31, 2013
	Fair Value		Level 1	Level 2		Level 3
Derivative Liability – Common Stock Purchase Warrants:
Debentures	$	10,207		$	10,207
Series B Preferred Stock		24,277			24,277
Promissory Notes		85,824			85,824
Series D Preferred Stock		224,075			224,075
Series C Preferred Stock		382,610					382,610
Total	$	726,993		$	344,383	$	382,610
	December 31, 2012
	Fair Value		Level 1	Level 2		Level 3
Derivative Liability – Common Stock Purchase Warrants:
Debentures	$	85,350		$	85,350
Series B Preferred Stock		170,383			170,383
Promissory Notes		230,985			230,985
Series D Preferred Stock		496,840			496,840
Series C Preferred Stock		1,491,601					1,491,601
Total	$	2,475,159		$	983,558	$	1,491,601

The table below provides a summary of the changes in fair value of financial assets and liabilities (for the Company, only derivative liabilities related to common stock purchase warrants, issued in directly in conjunction with debt and preferred stock issuances) measured at fair value on a recurring basis for all derivatives, both level 2 and those using significant unobservable inputs (Level 3 – or only the common stock purchase warrants directly related to Series C Preferred Stock) for the years ended December 31, 2013 and 2012.:

	Fair Value Measurements Using
	Level 2 Inputs															Level 3 Inputs
	Derivative liability - Common Stock Purchase Warrants - Debentures			Derivative liability - Common Stock Purchase Warrants – Series B Preferred Stock			Derivative liability - Common Stock Purchase Warrants – Promissory Notes			Derivative liability - Common Stock Purchase Warrants – Series D Preferred Stock			Total Fair Value Measurements Using Level 2 Inputs			Derivative liability - Common Stock Purchase Warrants – Series C Preferred Stock			Grand Total Fair Value Measurements Using Both Level 2 and Level 3 Inputs
Balance December 31, 2011	$	26,200		$	67,666		$	-		$	-		$	93,866		$	869,261		$	963,127
Total unrealized (gains) or losses included in net income  or (loss)		59,150			102,717			110,305			-			272,172			622,340			894,512
Issuance of Convertible Promissory Notes Common Stock Purchase Warrants		--			--			120,680			--			120,680			--			120,680
Issuance of Series D Preferred Common Stock Purchase Warrants		--			--			--			496,840			496,840			--			496,840
Balance December 31, 2012	$	85,350		$	170,383		$	230,985		$	496,840		$	983,558		$	1,491,601		$	2,475,159
Total unrealized (gains) or losses included in net income  or (loss)		(75,143	)		(146,106	)		(145,161	)		(674,550	)		(1,040,960	)		(1,108,991	)		(2,149,951	)
Issuance of Series D Preferred Common Stock Purchase Warrants		--			--			--			401,785			401,785			--			401,785
Balance December 31, 2013	$	10,207		$	24,277		$	85,824		$	224,075		$	344,383		$	382,610		$	726,993