10-Q 1 form10q.htm PROSPER MARKETPLACE INC 10-Q 9-30-2013

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

 
FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013
 
 
Commission
File Number
 
Exact Name of Registrant as Specified in its Charter,
State or Other Jurisdiction of Incorporation,
Address of Principal Executive Offices, Zip Code
and Telephone Number (Including Area Code)
 
I.R.S. Employer
Identification Number
 
 
 
333-147019,
333-182599, and
333-179941-01
 
PROSPER MARKETPLACE, INC.
a Delaware corporation
101 Second Street, 15th Floor
San Francisco, CA 94105
Telephone: (415)593-5400
 
73-1733867
 
 
333-179941
 
PROSPER FUNDING LLC
a Delaware limited liability company
101 Second Street, 15th Floor
San Francisco, CA 94105
Telephone: (415)593-5479
 
45-4526070
 
Indicate by check mark whether each registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.

Prosper Marketplace, Inc.
Yes x No ¨
Prosper Funding LLC
Yes x No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Prosper Marketplace, Inc.
Yes x No ¨
Prosper Funding LLC
Yes x No ¨
 


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 
 
Large
Accelerated
Filer
 
Accelerated
Filer
 
Non-
Accelerated
Filer
 
Smaller
Reporting
Company
 
Prosper Marketplace, Inc.
 
o
 
o
 
o
 
x
 
Prosper Funding LLC
 
o
 
o
 
o
 
x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Prosper Marketplace, Inc.
Yes ¨ No x
Prosper Funding LLC
Yes ¨ No x


Prosper Funding LLC meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this Form 10-Q with the reduced disclosure format specified in General Instruction H(2) of Form 10-Q.

 
Registrant
 
Number of Shares of Common
Stock of the Registrant
Outstanding at  November 11, 2013
Prosper Marketplace, Inc.
 
13,751,076
($.01 par value)
Prosper Funding LLC
 
None

THIS COMBINED FORM 10-Q IS SEPARATELY FILED BY PROSPER MARKETPLACE, INC. AND PROSPER FUNDING LLC.  INFORMATION CONTAINED HEREIN RELATING TO ANY INDIVIDUAL REGISTRANT IS FILED BY SUCH REGISTRANT ON ITS OWN BEHALF. EACH REGISTRANT MAKES NO REPRESENTATION AS TO INFORMATION RELATING TO THE OTHER REGISTRANT.

TABLE OF CONTENTS
 
 
Page No.
i
1
 
Condensed Consolidated
 
1
2
3
4
5
Schedule 1
Condensed
 
20
21
22
23
Item 2.    
Management’s Discussion and Analysis of Financial Condition and Results of Operations
30
Item 3.    
Quantitative and Qualitative Disclosures About Market Risk
49
Item 4.    
Controls and Procedures
49
PART II.
OTHER INFORMATION
 
Item 1.    
Legal Proceedings
50
Item 1A.
Risk Factors
50
Item 2.    
Unregistered "Sale" of Equity Securities and Use of Proceeds
50
Item 3.    
Defaults upon Senior Securities
50
Item 4.    
Mine Safety Disclosures
50
Item 5.    
Other Information
50
Item 6.  
Exhibits
50
51
52

Forward-Looking Statements

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements include all statements that do not relate solely to historical or current facts, and can generally be identified by the use of words such as “may,” “believe,” “will,” “expect,” “project,” “estimate,” “intend,” “anticipate,” “plan,” “continue” or similar expressions. In particular, information appearing under “Prosper Marketplace, Inc. Notes to Condensed Consolidated Financial Statements,” “Prosper Funding LLC Notes to Condensed Financial Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” includes forward-looking statements. Forward-looking statements inherently involve many risks and uncertainties that could cause actual results to differ materially from those projected in these statements. Where, in any forward-looking statement, Prosper Funding LLC (“Prosper Funding”) or Prosper Marketplace, Inc. (“PMI” and, collectively with Prosper Funding, the “Registrants”) expresses an expectation or belief as to future results or events, such expectation or belief is based on the current plans and expectations of Prosper Funding and PMI’s respective managements, expressed in good faith and is believed to have a reasonable basis.  Nevertheless, there can be no assurance that the expectation or belief will result or be achieved or accomplished. The following include some but not all of the factors that could cause actual results or events to differ materially from those anticipated:

  · the performance of the Borrower Payment Dependent Notes or “Notes”, which, in addition to being speculative investments, are special, limited obligations that are not secured, guaranteed or insured;

  · Prosper Funding’s ability to make payments on the Notes, including in the event that borrowers fail to make payments on the corresponding loans;

  · the reliability of the information about borrowers that is supplied by borrowers;

  · Prosper Funding and PMI’s ability to service the loans, and their ability or the ability of a third party debt collector to pursue collection against any borrower, including in the event of fraud or identity theft;

  · credit risks posed by the credit worthiness of borrowers, the lack of a maximum debt-to-income ratio for borrowers, and the effectiveness of the Registrants’ credit rating systems;

  · actions by some borrowers to defraud lender members and risks associated with identity theft;

  · Prosper Funding and PMI’s limited operational history and lack of significant historical performance data about borrower performance;

  · the impact of current economic conditions on the performance of the Notes and loss rates of the Notes;

  · payments by borrowers on the loans in light of the facts that the loans do not impose restrictions on borrowers and do not include cross-default provisions;

  · Prosper Funding and PMI’s compliance with applicable local, state and federal law, including the Investment Advisers Act of 1940, the Investment Company Act of 1940 and other laws;

  · potential efforts by state regulators or litigants to characterize Prosper Funding or PMI, rather than WebBank, as the lender of the loans originated through the platform;

  · the application of federal and state bankruptcy and insolvency laws to borrowers and to Prosper Funding and PMI;

  · the impact of borrower delinquencies, defaults and prepayments on the returns on the Notes;

  · the lack of a public trading market for the Notes and any inability to resell the Notes on the Note Trader platform;

  · the federal income tax treatment of an investment in the Notes and the PMI Management Rights;
  · Prosper Funding and PMI’s ability to prevent security breaches, disruptions in service, and comparable events that could compromise the personal and confidential information held on their data systems, reduce the attractiveness of the platform or adversely impact their ability to service loans;

  · the resolution of any litigation involving PMI, including any state or federal securities litigation; and

  · Prosper Funding’s ability to compete successfully in the peer-to-peer and consumer lending industry.

There may be other factors that may cause actual results to differ materially from the forward-looking statements in this Quarterly Report on Form 10-Q.  Prosper Funding and PMI can give no assurances that any of the events anticipated by the forward-looking statements will occur or, if any of them does, what impact they will have on Prosper Funding or PMI’s results of operations and financial condition. You should carefully read the factors described in the “Risk Factors” section of our Annual Report on Form 10-K for a description of certain risks that could, among other things, cause Prosper Funding and PMI’s actual results to differ from these forward-looking statements.

All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q and are expressly qualified in their entirety by the cautionary statements included in this Quarterly Report on Form 10-Q. Prosper Funding and PMI undertake no obligation to update or revise forward-looking statements that may be made to reflect events or circumstances that arise after the date made or to reflect the occurrence of unanticipated events, other than as required by law.

WHERE YOU CAN FIND MORE INFORMATION

The Registrants file annual, quarterly and current reports and other information with the SEC. You can inspect, read and copy these reports and other information at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You can obtain information regarding the operation of the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that makes available reports, proxy statements and other information regarding issuers that file electronically.
PART I. Financial Information
Item 1.
Condensed Consolidated Financial Statements

Prosper Marketplace, Inc.
Condensed Consolidated Balance Sheets
(Unaudited)
(in thousands, except for share and per share amounts)

 
 
September 30,
2013
   
December 31,
2012
 
Assets
 
   
 
Cash and Cash Equivalents
 
$
29,300
   
$
2,300
 
Restricted Cash
   
8,283
     
5,949
 
Short Term Investments
   
-
     
1,000
 
Accounts Receivable
   
214
     
92
 
Loans Held for Investment at Fair Value
   
137
     
175
 
Borrower Loans Receivable at Fair Value
   
204,131
     
166,900
 
Property and Equipment, net
   
3,159
     
1,530
 
Prepaid and Other Assets
   
681
     
376
 
Total Assets
 
$
245,905
   
$
178,322
 
 
               
Liabilities and Stockholders' Equity
               
Accounts Payable and Accrued Liabilities
 
$
4,345
   
$
4,766
 
Class Action Settlement Liability
   
10,000
     
-
 
Notes at Fair Value
   
204,465
     
167,478
 
Repurchase Liability for Unvested Restricted Stock Awards 
646
-
Loan Loss Reserve
   
61
     
41
 
Total Liabilities
    219,517      
172,285
 
 
               
Commitments and Contingencies (see Note 10)
               
 
               
Stockholders' Equity
               
Convertible preferred stock – Series A-F, $0.01 par value; zero and 7,195,813 shares authorized, issued and outstanding as of September 30, 2013 and December 31, 2012, respectively. Aggregate liquidation preference of zero and $51,172 as of September 30, 2013 and December 31, 2012, respectively.
   
-
     
72
 
Convertible preferred stock – Series A '13, A-1 '13 and B '13, $0.01 par value; 27,274,068 and zero shares authorized, issued and outstanding as of September 30, 2013 and December 31, 2012, respectively. Aggregate liquidation preferences of $96,172 and zero as of September 30, 2013 and December 31, 2012, respectively.
   
273
     
-
 
Common stock – $0.01 par value; 41,487,465 shares authorized; 13,799,063 issued and outstanding as of September 30, 2013; and 8,263,000 shares authorized; 300,674 issued and outstanding as of December 31, 2012.
   
75
     
5
 
Additional Paid - in Capital
   
128,045
     
83,150
 
Less: Treasury Stock
   
(291
)
   
(291
)
Accumulated Deficit
   
(101,714
)
   
(76,899
)
Total Stockholders' Equity
   
26,388
     
6,037
 
Total Liabilities and Stockholders' Equity
 
$
245,905
   
$
178,322
 
 
The number of shares issued and outstanding reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
Prosper Marketplace, Inc.
Condensed Consolidated Statements of Operations
(Unaudited)
(in thousands, except for share and per share amounts)
 
 
 
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Revenues
 
   
   
   
 
Origination Fees
  $
4,409
    $
2,083
    $
9,323
    $
5,223
 
Interest Income on Borrower Loans
   
9,039
     
5,027
     
25,348
     
15,437
 
Interest Expense on Notes
   
(8,435
)
   
(4,716
)
   
(23,888
)
   
(14,618
)
Rebates and Promotions
   
(471
)
   
(455
)
   
(1,133
)
   
(1,004
)
Total Revenues
   
4,542
     
1,939
     
9,650
     
5,038
 
 
                               
Cost of Revenues
                               
Cost of Services
   
(508
)
   
(375
)
   
(1,490
)
   
(1,056
)
Reversal of (Provision for) Loan Losses
   
58
     
(5
)
   
(119
)
   
(17
)
Net Revenues
   
4,092
     
1,559
     
8,041
     
3,965
 
 
                               
Expenses
                               
Compensation and Benefits
   
3,224
     
2,778
     
8,999
     
7,584
 
Marketing and Advertising
   
4,676
     
1,578
     
10,126
     
3,980
 
Depreciation and Amortization
   
228
     
167
     
643
     
493
 
Professional Services
   
399
     
863
     
1,781
     
2,496
 
Facilities and Maintenance
   
530
     
302
     
1,323
     
927
 
Class Action Settlement
   
-
     
-
     
10,000
     
-
 
Other
   
410
     
320
     
1,235
     
1,170
 
Total Expenses
   
9,467
     
6,008
     
34,107
     
16,650
 
Loss Before Other Income and Expenses
   
(5,375
)
   
(4,449
)
   
(26,066
)
   
(12,685
)
 
                               
Other Income and Expenses
                               
Interest Income
   
1
     
1
     
1
     
6
 
Change in Fair Value on Borrower Loans, Loans Held for Investment and Notes, net
   
91
     
316
     
578
     
836
 
Loss on Impairment of Fixed Assets
   
-
     
-
     
(62
)
   
-
 
Other Income
   
320
     
145
     
734
     
235
 
Total Other Income and Expenses
   
412
     
462
     
1,251
     
1,077
 
 
                               
Loss Before Income Taxes
   
(4,963
)
   
(3,987
)
   
(24,815
)
   
(11,608
)
Provision or Income Taxes
   
-
     
-
     
-
     
-
 
Net Loss
  $
(4,963
)
  $
(3,987
)
  $
(24,815
)
  $
(11,608
)
 
                               
Net loss per share – basic and diluted
  $
(0.72
)
  $
(13.70
)
  $
(4.05
)
  $
(40.05
)
Weighted – average shares - basic and diluted net loss per share
    6,927,648       290,979       6,119,987      
289,823
 

The weighted average number of shares and the net loss per share reflect a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
Prosper Marketplace, Inc.
Condensed Consolidated Statements of Stockholders' Equity
(Unaudited)
(in thousands, except for share and per share amounts)
 
 
 
Preferred Stock
   
Common Stock
   
Treasury Stock
   
   
   
 
 
 
Shares
   
Amount
   
Shares
   
Amount
   
Shares
   
Amount
   
Additional
Paid In
Capital
   
Accumulated
Deficit
   
Total
 
 
 
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 
Balance as of January 1, 2013
   
7,195,813
   
$
72
     
482,938
   
$
5
     
(182,264
)
 
$
(291
)
 
$
83,150
   
$
(76,899
)
 
$
6,037
 
Issuance of convertible preferred stock, Series A'13, net of issuance costs
   
13,868,152
   
 
139
     
-
     
-
     
-
     
-
     
19,705
     
-
     
19,844
 
Issuance of convertible preferred stock, Series A-1'13
   
5,117,182
     
51
     
-
     
-
     
-
     
-
     
-
     
-
     
51
 
Issuance of convertible preferred stock, Series B'13, net of issuance costs
    8,288,734      
83
     
-
     
-
     
-
     
-
     
24,797
     
-
     
24,880
 
Conversion of Preferred Series A-F
   
(7,195,813
)
   
(72
)
   
6,191,270
     
62
     
-
     
-
     
10
     
-
     
-
 
Exercise of vested stock options
   
-
     
-
      824,502      
8
     
-
     
-
      199      
-
     
207
 
Exercise of nonvested  stock options
   
-
     
-
      6,499,459      
-
      -       -      
-
      -      
-
 
Repurchase of restricted stock
   
-
     
-
      (37,662
)
   
-
     
-
     
-
     
-
 
   
-
     
-
 
Exercise of common stock warrants
   
-
     
-
     
820
     
-
     
-
     
-
     
-
     
-
     
-
 
Compensation expense
   
-
     
-
     
-
     
-
     
-
     
-
     
184
     
-
     
184
 
Net loss
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
(24,815
)
   
(24,815
)
Balance as of September 30, 2013
    27,274,068    
$
273
      13,961,327    
$
75
      (182,264
)
 
$
(291
)
 
$
128,045
   
$
(101,714
)
 
$
26,388
 

The number of shares reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
Prosper Marketplace, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(in thousands, except for share and per share amounts)
 
 
 
For the Nine Months Ended September 30,
 
 
 
2013
   
2012
 
Cash Flows from Operating Activities:
 
   
 
Net loss
 
$
(24,815
)
 
$
(11,608
)
Adjustments to Reconcile net loss to net cash used in Operating Activities:
         
Change in Fair Value of Borrower Loans
   
3,903
     
(2,913
)
Change in Fair Value of Notes
   
(4,484
)
   
2,063
 
Depreciation and Amortization
   
643
     
493
 
Change in Loan loss Reserve
   
20
     
13
 
Stock-based Compensation Expense
   
184
     
262
 
Loss on Impairment of Fixed Assets
   
62
     
 
Change in Fair Value of Loans Held for Investment
   
3
     
14
 
Issuance of Common Stock Warrants
   
     
53
 
Changes in Operating Assets and Liabilities:
               
Class action Settlement Liability
   
10,000
     
 
Restricted Cash
   
(2,334
)
   
(1,000
)
Receivables
   
(122
)
   
(64
)
Prepaid and Other Assets
   
(305
)
   
(188
)
Accounts Payable and Accrued Liabilities
   
(421
)
   
1,215
 
Net Cash used in Operating Activities
   
(17,666
)
   
(11,660
)
 
               
Cash flows from investing activities:
               
Origination of Borrower Loans Held at Fair Value
   
(118,349
)
   
(116,148
)
Repayment of Borrower Loans Held at Fair Value
   
77,215
     
46,277
 
Purchases of Property and Equipment
   
(2,334
)
   
(553
)
Maturities of Short term Investments
   
1,000
     
8,998
 
Repayment of Loans Held for Investment at Fair Value
   
106
     
94
 
Origination of Loans Held for Investment at Fair Value
   
(71
)
   
(164
)
Purchases of Short – term Investments
   
     
(3,000
)
Net Cash used in Investing Activities
   
(42,433
)
   
(64,496
)
 
               
Cash Flows from Financing Activities:
               
Proceeds from Issuance of Notes Held at Fair Value
   
118,349
     
116,148
 
Payment of Notes Held at Fair Value
   
(76,878
)
   
(45,193
)
Proceeds from Issuance of Convertible Preferred Stock
   
45,000
     
 
Proceeds from Early Exercise of Stock Options 650
Proceeds from Exercise of Vested Stock Options
207
19
Repurchase of restricted stock
   
(4
   
 
Issuance Costs of Convertible Preferred Stock
   
(225
)
   
 
Net Cash provided by Financing Activities
   
87,099
     
70,974
 
 
               
Net Increase (decrease) in Cash and Cash Equivalents
   
27,000
     
(5,182
)
Cash and Cash Equivalents at beginning of the period
   
2,300
     
9,216
 
Cash and Cash Equivalents at end of the period
 
$
29,300
   
$
4,034
 
 
               
Supplemental Disclosure of Cash Flow Information:
               
Cash Paid for Interest
 
$
23,844
   
$
14,151
 

The accompanying notes are an integral part of these condensed consolidated financial statements.
Prosper Marketplace, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(in thousands, except for share and per share amounts)

1.
Organization and Business

Prosper Marketplace, Inc. (“PMI”) was incorporated in the state of Delaware on March 22, 2005. PMI developed and operated a peer-to-peer online credit platform (the “platform”) that permitted its borrower members to apply for loans and lender members to purchase notes (“Notes”) issued by PMI, the proceeds of which facilitated the funding of specific loans to borrowers. On February 1, 2013, PMI transferred ownership of the platform, including all of the rights related to the operation of the platform, to its wholly-owned subsidiary, Prosper Funding LLC (“Prosper Funding” and, collectively with PMI (“PMI Group”). Since February 1, 2013, all Notes issued and sold through the platform are issued and sold by Prosper Funding.  Pursuant to the Loan Account Program Agreement between PMI and WebBank, dated as of September 14, 2010, PMI manages the operation of the platform, as agent of WebBank, in connection with the submission of loan applications by potential borrowers, the making of related loans by WebBank and the funding of such loans by WebBank. On February 1, 2013, Prosper Funding LLC entered into an Administration Agreement with PMI in its capacity as licensee, corporate administrator, loan platform administrator and loan and note servicer in which PMI provides certain back office support, loan platform administration and loan and note servicing to Prosper Funding.  

The platform enables borrower members to request and obtain personal, unsecured loans by posting anonymous “listings” on the platform. Loan terms are subject to minimum and maximum loan amounts determined by the borrower’s credit bureau score and Prosper score, at interest rates set by PMI. PMI sets the interest rates for borrower loans based on Prosper Ratings, as well as additional factors, such as estimated loss rate, loan terms, general economic environment, previous Prosper loans and competitive conditions. As of September 30, 2013, borrowers could create loan listings from $2 up to $35.

All loans requested and obtained through the platform are unsecured obligations of individual borrower members with a fixed interest rate and loan terms set at three or five years as of September 30, 2013. All loans made through the platform are funded by WebBank, an FDIC-insured, Utah chartered industrial bank. After funding a loan, WebBank sells the loan to PMI (prior to February 1, 2013) or Prosper Funding (on or after February 1, 2013), without recourse to WebBank, in exchange for the principal amount of the loan (the “Borrower Loans”). WebBank does not have any obligation to purchasers of the Notes.

As reflected in the accompanying condensed consolidated financial statements, net losses and negative cash flows were incurred from operations since inception.  An accumulated deficit of $101,714 was incurred as of September 30, 2013.  At September 30, 2013, $29,300 in cash and cash equivalents was being held. Since its inception, operations have been financed primarily through equity financing from various sources and is dependent upon raising additional capital or debt financing to fund its current operating plan.  Failure to obtain sufficient debt and equity financings and, ultimately, to achieve profitable operations and positive cash flows from operations could adversely affect the ability to achieve its business objectives and continue as a going concern.  Further, there can be no assurances as to the availability or terms upon which the required financing and capital might be available.  On January 15, 2013, PMI entered into The Series A Preferred Stock Purchase Agreement with certain new investors and certain of its existing investors (each, a “Series A Share Purchaser” and, collectively, the “Series A Share Purchasers”), pursuant to which PMI issued and sold to such Series A Share Purchasers, either directly or through certain of their respective affiliates, 13,868,152 shares of PMI’s Series A preferred stock and 5,117,182 of Series A-1 preferred stock for an aggregate purchase price of $19,844, net of issuance costs.  On September 23, 2013, PMI entered into The Series B Preferred Stock Purchase Agreement with certain new investors and certain of its existing investors (each, a “Series B Share Purchaser” and, collectively, the “Series B Share Purchasers”), pursuant to which PMI issued and sold to such Series B Share Purchasers, either directly or through certain of their respective affiliates, 8,288,734 shares of PMI’s Series B preferred stock for an aggregate purchase price of $24,880, net of issuance costs.  See Note 7, Stockholders’ Equity, for additional information.
 
2.
Summary of Significant Accounting Policies

Basis of Presentation

The unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) and disclosure requirements for interim financial information and the requirements of Rule 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. The unaudited interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2012. The balance sheet at December 31, 2012 has been derived from the audited financial statements at that date. Management believes these unaudited interim condensed consolidated financial statements reflect all adjustments, including those of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year of any other interim period.
The accompanying interim condensed consolidated financial statements include the accounts of PMI and its wholly-owned subsidiary Prosper Funding. All intercompany balances and transactions between Prosper Funding and PMI have been eliminated in consolidation.

Use of Estimates

The preparation of the interim condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the related disclosures at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. These estimates, judgments and assumptions include but are not limited to the following: valuation of borrower loans receivable and associated member payment dependent notes, valuation allowance on deferred tax assets, provision for loan losses, stock-based compensation expense, and contingent liabilities. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from those estimates.

Certain Risks and Concentrations

In the normal course of its business, two significant types of risk are encountered: credit and regulatory. Financial instruments that potentially subject significant concentrations of credit risk consist primarily of cash, cash equivalents, restricted cash and short term investments. Cash, cash equivalents, restricted cash and short term investments are placed with high-quality financial institutions and is exposed to credit risk in the event of default by these institutions to the extent the amount recorded on the balance sheet exceeds federally insured amounts. Periodic evaluations of the relative credit standing of these financial institutions are performed and no credit losses have been sustained from instruments held at these financial institutions.

To the extent that loan payments are not made, servicing income will be reduced.  Borrower Loans are funded by the Notes and repayment of said Notes is wholly dependent on the repayment of the Borrower Loans associated with the Notes.  As a result, PMI Group does not bear the risk associated with the repayment of principal on loans carried on its condensed consolidated balance sheet.

The PMI Group is subject to various regulatory requirements. The failure to appropriately identify and address these regulatory requirements could result in certain discretionary actions by regulators that could have a material effect on the consolidated financial position and results of operations (See Note 10—Commitments and Contingencies—Securities Law Compliance).

Cash and Cash Equivalents

All highly liquid investments with stated maturities of three months or less from date of purchase are classified as cash equivalents. Cash equivalents are recorded at cost, which approximates fair value. Such deposits periodically exceed amounts insured by the FDIC.  Cash and cash equivalents include various unrestricted deposits with highly rated financial institutions in checking, money market and short-term certificate of deposit accounts.

Restricted Cash

Restricted cash consists primarily of cash deposits held as collateral as required for loan funding and servicing activities.

Short – Term Investments

Short term investments consist of highly liquid instruments with original maturity periods greater than three months and less than 12 months.
Borrower Loans and Notes

PMI Group issues Notes and purchases Borrower Loans from WebBank, and holds the Borrower Loans until maturity.  The obligation to repay the Notes is conditioned upon the repayment of the associated Borrower Loans.  Borrower Loans and Notes are carried on PMI Group's condensed consolidated balance sheets as assets and liabilities, respectively.  PMI Group has adopted the provisions of ASC Topic 825, Financial Instruments.  ASC Topic 825 permits companies to choose to measure certain financial instruments and certain other items at fair value on an instrument-by-instrument basis with unrealized gains and losses on items for which the fair value option has been elected reported in earnings.  The fair value election, with respect to an item, may not be revoked once an election is made.  In applying the provisions of ASC Topic 825, the recorded assets and liabilities are measured using the fair value option in a way that separates these reported fair values from the carrying values of similar assets and liabilities measured with a different measurement attribute.  A specific allowance account is not recorded relating to the Borrower Loans and Notes in which it has elected the fair value option, but rather estimates the fair value of such Borrower Loans and Notes using discounted cash flow methodologies adjusted for the historical payment, loss and recovery rates. An account is considered to be a loss, or charged-off, when it reaches more than 120 days past due.  The aggregate fair value of the Borrower Loans and Notes are reported as separate line items in the assets and liabilities sections of the accompanying balance sheets using the methods described in ASC Topic 820, Fair Value Measurements and Disclosures—See Fair Value Measurement.

Fair Value Measurement

PMI Group adopted ASC Topic 820, Fair Value Measurements and Disclosures, on January 1, 2008, which provides a framework for measuring the fair value of assets and liabilities. ASC Topic 820 also provides guidance regarding a fair value hierarchy, which prioritizes information used to measure fair value and the effect of fair value measurements on earnings and provides for enhanced disclosures determined by the level within the hierarchy of information used in the valuation. ASC Topic 820 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances.

ASC Topic 820 defines fair value in terms of the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The price used to measure the fair value is not adjusted for transaction costs while the cost basis of certain financial instruments may include initial transaction costs. Under ASC Topic 820, the fair value measurement also assumes that the transaction to sell an asset occurs in the principal market for the asset or, in the absence of a principal market, the most advantageous market for the asset. The principal market is the market in which the reporting entity would sell or transfer the asset with the greatest volume and level of activity for the asset. In determining the principal market for an asset or liability under ASC Topic 820, it is assumed that the reporting entity has access to the market as of the measurement date. If no market for the asset exists or if the reporting entity does not have access to the principal market, the reporting entity should use a hypothetical market.

Under ASC Topic 820, assets and liabilities carried at fair value in the balance sheets are classified among three levels based on the observability of the inputs used to determine fair value:

Level 1 — The valuation is based on quoted prices in active markets for identical instruments.

Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 — The valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques, which incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument or valuations that require significant management judgment or estimation.

Fair value of financial instruments are determined based on the fair value hierarchy established in ASC Topic 820, which requires an entity to maximize the use of quoted prices and observable inputs and to minimize the use of unobservable inputs when measuring fair value. Various valuation techniques are utilized, depending on the nature of the financial instrument, including the use of market prices for identical or similar instruments, or discounted cash flow models. When possible, active and observable market data for identical or similar financial instruments are utilized. Alternatively, fair value is determined using assumptions that management believes a market participant would use in pricing the asset or liability.

Financial instruments consist principally of cash and cash equivalents, restricted cash, short term investments, Borrower Loans receivable, accounts payable and accrued liabilities, Notes and long-term debt.  The estimated fair values of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities approximate their carrying values because of their short term nature.

Borrower Loans and Notes are accounted for on a fair value basis.
 
The following tables present the assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012:
 
September 30, 2013
 
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
 
   
   
   
 
Borrower Loans Receivable
 
$
-
   
$
-
   
$
204,131
   
$
204,131
 
Certificates of Deposit
   
-
   
 
1,438
     
-
   
 
1,438
 
Loans Held for Investment
   
-
     
-
     
137
     
137
 
Liabilities
   
-
     
-
     
-
     
-
 
Notes
 
 
-
   
 
-
   
 
204,465
   
 
204,465
 
 
December 31, 2012
 
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
               
Short – Term Investments
 
$
1,000
   
$
-
   
$
-
   
$
1,000
 
Certificates of Deposit
   
-
   
 
1,618
     
-
   
 
1,618
 
Borrower Loans Receivable
   
-
     
-
     
166,900
     
166,900
 
Borrower Loans Held for Investment
   
-
     
-
     
175
     
175
 
Liabilities
                               
Notes
 
 
-
   
 
-
   
 
167,478
   
 
167,478
 
 
Short term investments consist of United States Treasuries with original maturity periods greater than three months and less than 12 months. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that PMI Group has the ability to access. PMI Group classifies United States Treasuries as Level 1 assets which it intends to hold until maturity.
 
Property and Equipment

Property and equipment consists of computer equipment, office furniture and equipment, and software purchased or developed for internal use. Property and equipment are stated at cost, less accumulated depreciation and amortization, and are computed using the straight-line method based upon estimated useful lives of the assets, which range from three to seven years, commencing once the asset is placed in service. Expenditures are capitalized for replacements and betterments and recognized as expense amounts for maintenance and repairs as incurred.

Earned Vacations

The Company has a flexible vacation plan for its employees under which employees are entitled to take vacations for such periods of time that do not interfere with the orderly performance of their job responsibilities. Accordingly, no accrual for unpaid vacation pay has been included in the financial statements.

Internal Use Software and Website Development

Internal use software costs and website development costs are accounted for, in accordance with ASC Topic 350-40, Internal Use Software, and ASC Topic 350-50, Website Development Costs. In accordance with ASC Topic 350-40 and 350-50, the costs to develop software for the website and other internal uses are capitalized when management has authorized and committed project funding, preliminary development efforts are successfully completed, and it is probable that the project will be completed and the software will be used as intended. Capitalized software development costs primarily include software licenses acquired, fees paid to outside consultants, and salaries and payroll related costs for employees directly involved in the development efforts.

Costs incurred prior to meeting these criteria, together with costs incurred for training and maintenance, are expensed. Costs incurred for upgrades and enhancements that are considered to be probable to result in additional functionality are capitalized. Capitalized costs are included in property and equipment and amortized to expense using the straight-line method over their expected lives. Software assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.  Recoverability of software assets to be held and used is measured by a comparison of the carrying amount of the asset to the future net undiscounted cash flows expected to be generated by the asset.  If such software assets are considered to be impaired, the impairment to be recognized is the excess of the carrying amount over the fair value of the software asset.

Loan Loss Reserve

PMI Group is obligated to indemnify lenders and or repurchase certain Notes sold to the lenders in the event of violation of applicable federal, state, or local lending laws or verifiable identify theft. The loan loss reserve is estimated based on historical experience and is accrued when the Notes are issued. Indemnified or repurchased Notes are written off at the time of repurchase or at the time an indemnification payment is made.

Revenue Recognition

Revenue is recognized in accordance with ASC Topic 605, Revenue Recognition. Under ASC Topic 605, revenue is recognized when persuasive evidence of an arrangement exists, services have been rendered, the price of the services is fixed and determinable, and collectability is reasonably assured.

Origination Fees

Borrowers pay an origination fee upon the successful closing of a loan. The origination fee is deducted and retained from the loan amount prior to disbursing the net amount to the borrower member. The loan origination fee is determined by the term and credit grade of the loan, and ranges from 1.00% to 4.95% of the original principal amount.  Origination fees are not deferred but are recognized at origination of the loan, and direct costs to originate loans are recorded as expenses as incurred since Borrower Loans, Borrower Loans held for investment and Notes are accounted for at fair value.

Loan Servicing Fees

Loan servicing fees are accrued daily based on the current outstanding loan principal balance of the Borrower Loans but are not recognized until payment is received due to the uncertainty of collection of borrower loan payments.

Interest Income on Borrower Loans Receivable and Interest Expense on Notes
 
Interest income on Borrower Loans is recognized using the accrual method based on the stated interest rate to the extent that is believed it to be collectable.  Interest expense is recorded on the corresponding Notes based on the contractual interest rate.  Below is a table that summarizes the gross interest income and expense for the three and nine months ended September 30, 2013 and 2012.

 
 
Three months ended
September 30,
   
Nine months ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Interest Income on Borrower Loans
 
$
9,039
   
$
5,027
   
$
25,348
   
$
15,437
 
Interest Expense on Notes
   
(8,435
)
   
(4,716
)
   
(23,888
)
   
(14,618
)
Net Interest Income
 
$
604
   
$
311
   
$
1,460
   
$
819
 

Marketing and Advertising Expense

Under the provisions of ASC Topic 720, Other Expenses, the costs of advertising are expensed as incurred. Marketing and advertising costs were $4,676 and $1,578 for the three months ended September 30, 2013 and 2012, respectively. Marketing and advertising costs were $10,126 and $3,980 for the nine months ended September 30, 2013 and 2012, respectively.

Rebate and Promotional Expenses

Rebates and promotions are accounted for in accordance with ASC Topic 605, Revenue Recognition.  From time to time rebates and promotions are offered to borrower and lender members.  These rebates and promotions are recorded as an offset to revenue if a particular rebate or promotion is earned upon the origination of the loan. Rebates and promotions have in the past been in the form of cash back and other incentives paid to lenders and borrowers.

Stock-Based Compensation

Stock-based compensation for employees is accounted for using fair-value-based accounting in accordance with ASC Topic 718, Stock Compensation.  ASC Topic 718 requires companies to estimate the fair value of stock-based awards on the date of grant using an option-pricing model. The stock-based compensation related to awards that are expected to vest is amortized using the straight line method over the vesting term of the stock-based award, which is generally four years. Expected forfeitures of unvested options are estimated at the time of grant such that expense is recorded only for those stock-based awards that are expected to vest.

Options have been granted to purchase shares of common stock to nonemployees in exchange for services performed which it accounts for in accordance with the provisions of ASC Topic 505-50, Equity-Based Payments to Non-Employees. Because ASC Topic 505 requires that nonemployee equity awards be recorded at their fair value, the Black-Scholes model is used to estimate the fair value of options granted to nonemployees at each vesting date until performance is complete to determine the appropriate charge for the services provided. The volatility of the common stock was based on comparative company volatility.

Net Loss Per Share

Net loss per share is computed in accordance with ASC Topic 260, Earnings Per Share. Under ASC Topic 260, basic net loss per share is computed by dividing net loss per share available to common shareholders by the weighted average number of common shares outstanding for the period and excludes the effects of any potentially dilutive securities. Diluted earnings per share, if presented, would include the dilution that would occur upon the exercise or conversion of all potentially dilutive securities into common stock using the “treasury stock” and/or “if converted” methods as applicable. At September 30, 2013, there were outstanding convertible preferred stock, warrants and options convertible into 22,156,922,  218,797 and 979,483 common shares, respectively, which may dilute future earnings per share. At September 30, 2012, there were outstanding convertible preferred stock, warrants and options convertible into 7,195,770, 260,971 and 1,291,420 common shares, respectively, which may dilute future earnings per share. The weighted average number of shares and the loss per share reflect a 1-for-10 reverse stock split effected by the Company on October 29, 2013. By reporting a net loss for the three and nine months ended September 30, 2013 and 2012, potentially dilutive securities are excluded from the computation of net loss per share, as their effect would be antidilutive.
 
Income Taxes

The asset and liability method is used to account for income taxes as codified in ASC Topic 740, Income Taxes. Under this method, deferred income tax assets and liabilities are based on the differences between the financial statements and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
Under ASC Topic 740, the policy to include interest and penalties related to gross unrecognized tax benefits within its provision for income taxes did not change.  U.S. Federal, California and other state income tax returns are filed.  PMI Group are currently not undergoing to any income tax examinations. Due to the net operating loss, generally all tax years remain open.

Comprehensive Income

There is no comprehensive income (loss) other than the net income (loss) disclosed in the condensed consolidated statement of operations.

Recent Accounting Pronouncements

We do not expect the adoption of recently issued accounting pronouncements to have a material impact on our results of operations, financial position or cash flows.

3.
Borrower Loans and Notes Held at Fair Value

The following tables present the assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012:
 
September 30, 2013
 
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
 
   
   
   
 
Borrower Loans Receivable
 
$
-
   
$
-
   
$
204,131
   
$
204,131
 
Loans Held for Investment
   
-
     
-
     
137
     
137
 
Liabilities
   
-
     
-
     
-
     
-
 
Notes
 
 
-
   
 
-
   
 
204,465
   
 
204,465
 
 
December 31, 2012
 
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
               
Short – Term Investments
 
$
1,000
   
$
-
   
$
-
   
$
1,000
 
Borrower Loans Receivable
   
-
     
-
     
166,900
     
166,900
 
Borrower Loans Held for Investment
   
-
     
-
     
175
     
175
 
Liabilities
                               
Notes
 
 
-
   
 
-
   
 
167,478
   
 
167,478
 
 
As observable market prices are not available for the Borrower Loans and Notes the PMI Group holds, or for similar assets and liabilities, the PMI Group believes the Borrower Loans and Notes should be considered Level 3 financial instruments under ASC Topic 820.  In a hypothetical transaction as of the measurement date, PMI Group believes that differences in the principal marketplace in which the loans are originated and the principal marketplace in which it might offer those loans may result in differences between the originated amount of the loans and their fair value as of the transaction date.  For Borrower Loans, the fair value is estimated using discounted cash flow methodologies based upon valuation assumptions including prepayment speeds, roll rates, recovery rates and discount rates based on the perceived credit risk within each credit grade.

The obligation to pay principal and interest on any Note is equal to the loan payments, if any, that are received on the corresponding Borrower Loan, net of its servicing fee.  The fair value election for Notes and Borrower Loans allows both the assets and the related liabilities to receive similar accounting treatment for expected losses which is consistent with the subsequent cash flows to lenders that are dependent upon borrower payments.  As such, the fair value of the Notes is approximately equal to the fair value of the Borrower Loans, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to Note holders.  Any unrealized gains or losses on the Borrower Loans and Notes for which the fair value option has been elected is recorded as a separate line item in the statement of operations.  The effective interest rate associated with the Notes is less than the interest rate earned on the Borrower Loans due to the servicing fee.  See further in this note for a roll-forward and further discussion of the significant assumptions used to value Borrower Loans and Notes.
The fair value of the Notes and Borrower Loans are estimated using discounted cash flow methodologies based upon a set of valuation assumptions. The main assumptions used to value the Borrower Loans and Notes include prepayment rates derived from historical prepayment rates for each credit score, default rates derived from historical performance, recovery rates and discount rates applied to each credit tranche based on the perceived credit risk of each credit grade. The obligation to pay principal and interest on any Note is equal to the loan payments, if any, received on the corresponding Borrower Loan, net of the servicing fee.  As such, the fair value of the Notes is approximately equal to the fair value of the Borrower Loans, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to the Note holders.  The effective interest rate associated with the Notes will be less than the interest rate earned on the Borrower Loans due to the servicing fee.

For Borrower Loans originated and Notes, the following average assumptions to determine the fair value as of September 30:

 
2013
 
2012
Monthly prepayment rate speed
1.50%
 
1.60%
Recovery rate
2.50%
 
5.39%
Discount rate *
10.00%
 
9.97%

*
This is the average discount rate among all of the credit grades

Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at September 30, 2013 for Borrower Loans and Notes are presented in the following table:

 
 
Borrower Loans
   
Notes
 
Discount rate assumption:
   
10.00
%
   
10.00
%
Resulting fair value from:
               
100 basis point increase
 
$
202,015
   
$
199,663
 
200 basis point increase
   
199,623
     
197,271
 
Resulting fair value from:
               
100 basis point decrease
 
$
206,953
   
$
204,550
 
200 basis point decrease
   
209,509
     
207,074
 
 
               
 
               
Default rate assumption:
               
Resulting fair value from:
               
10% higher default rates
 
$
202,295
   
$
199,926
 
20% higher default rates
   
199,450
     
197,127
 
Resulting fair value from:
               
10% lower default rates
 
$
206,651
   
$
204,234
 
20% lower default rates
   
208,796
     
206,364
 

The changes in Level 3 assets measured at fair value on a recurring basis are as follows:

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)  
 
 
Borrower Loans
   
Notes
   
Loans Held for
Investment
   
Total
 
Balance at January 1, 2012
 
$
75,763
   
$
(76,160
)
 
$
137
   
$
(260
)
Originations
   
153,175
     
(153,175
)
   
182
     
182
 
Principal repayments and credit losses
   
(66,840
)
   
65,690
     
(133
)
   
(1,283
)
Change in fair value on Borrower Loans and Notes
   
4,802
     
(3,833
)
   
-
     
969
 
Change in fair value of loans held for investment
   
-
     
-
     
(11
)
   
(11
)
Balance at December 31, 2012
 
$
166,900
   
$
(167,478
)
 
$
175
   
$
(403
)
Originations
   
118,349
     
(118,349
)
   
71
     
71
 
Principal repayments and credit losses
   
(77,215
)
   
76,878
     
(106
)
   
(443
)
Change in fair value on Borrower Loans and Notes
   
(3,903
)
   
4,484
     
-
     
581
 
Change in fair value of loans held for investment
   
-
     
-
     
(3
)
   
(3
)
Balance at September 30, 2013
 
$
204,131
   
$
(204,465
)
 
$
137
   
$
(197
)
 
Due to the recent origination of the Borrower Loans and Notes, the change in fair value attributable to instrument-specific credit risk is immaterial.  There were no outstanding Borrower Loans or Notes originated or issued prior to July 13, 2009.  Of the Borrower Loans originated from July 13, 2009 to September 30, 2013, 285 loans, which were 90 days or more delinquent, totaled an aggregate principal amount of $1,489 and a fair value of $144 as of September 30, 2013.  From July 13, 2009 to September 30, 2012, 214 loans, which were 90 days or more delinquent, totaled an aggregate principal amount of $1,061 and a fair value of $165.

No other assets or other liabilities were carried at fair value as of September 30, 2013 and December 31, 2012.

4.
Loans Held for Investment at Fair Value

As of September 30, 2013, a total of $137 of Borrower Loans originated through the platform is presented as Loans Held for Investment in the accompanying condensed consolidated balance sheets. When a borrower member loan has been funded in whole, or in part, the portion of the borrower’s monthly loan payment that corresponds to the percentage of the loan that is funded is retained. In these cases, interest income is recorded on these Borrower Loans.
 
Origination fees earned from Borrower Loans funded are initially deferred and subsequently amortized ratably over the term of the Borrower Loan and are reported in the statement of operations as Origination fees.

The fair value of the Borrower Loans held for investment is estimated using the discounted cash flow methodologies based upon a set of valuation assumptions similar to those of all the Borrower Loans, which are set forth in Note 3, as they have similar characteristics and the PMI Group expects these Borrower Loans to behave in a comparable manner.  The valuation assumptions used to value these Borrower Loans include prepayment rates, default rates and recovery rates derived from historical loan performance data and discount rates based on credit grade applied to each Borrower Loan.

The fair value adjustment on these Borrower Loans held for investment was zero and $3, which is included in earnings for the three and nine months ended September 30, 2013.  As of September 30, 2013, $225 in payments was received on these Borrower Loans.  As of September 30, 2013, there was $37 in Borrower Loans held for investment that were charged-off.

5.
Loan Loss Reserve

For the three and nine months ended September 30, 2013, the reversal of (provision for) loan losses was $58 and ($119), respectively.  For the three and nine months ended September 30, 2012, the provision for loan losses was ($5) and ($17), respectively.  The balance of the loan loss reserve as of September 30, 2013 and December 31, 2012, was $61 and $41, respectively.

6.
Net Loss Per Share
 
Net loss per share is computed in accordance with ASC Topic 260. Under ASC Topic 260, basic net loss per share is computed by dividing net loss per share available to common stockholders by the weighted average number of common shares outstanding for the period and excludes the effects of any potentially dilutive securities. Diluted earnings per share, if presented, would include the dilution that would occur upon the exercise or conversion of all potentially dilutive securities into common stock using the “treasury stock” and/or “if converted” methods as applicable. The weighted average number of shares and the loss per share reflect a 10-for-1 reverse stock split effected by the Company on October29, 2013.
 
The Company uses the two-class method to compute net loss per share because the Company has issued securities, other than common stock, that contractually entitle the holders to participate in dividends and earnings of the Company. The two-class method requires earnings for the period to be allocated between common stock and participating securities based upon their respective rights to receive distributed and undistributed earnings. Prior to their conversion to common shares, each series of the Company’s Preferred Stock was entitled to participate on an as-if-converted basis in distributions, when and if declared by the board of directors, that were made to common stockholders and as a result these shares were considered participating securities. During the nine months ended September 2013, certain shares issued as a result of the early exercise of stock options, which are subject to repurchase by the Company, were entitled to receive non-forfeitable dividends during the vesting period and as a result were considered participating securities.

Under the two-class method, for periods with net income, basic net income per common share is computed by dividing the net income attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period. Net income attributable to common stockholders is computed by subtracting from net income the portion of current year earnings that the participating securities would have been entitled to receive pursuant to their dividend rights had all of the year’s earnings been distributed. No such adjustment to earnings is made during periods with a net loss, as the holders of the participating securities have no obligation to fund losses. Diluted net loss per common share is computed under the two-class method by using the weighted average number of shares of common stock outstanding, plus, for periods with net income attributable to common stockholders, the potential dilutive effects of stock options and warrants. In addition, the Company analyzes the potential dilutive effect of the outstanding participating securities under the “if-converted” method when calculating diluted earnings per share, in which it is assumed that the outstanding participating securities convert into common stock at the beginning of the period. The Company reports the more dilutive of the approaches (two class or “if-converted”) as its diluted net income per share during the period. Due to net losses for the three and nine months ended September 30, 2013 and 2012, basic and diluted loss per share were the same, as the effect of potentially dilutive securities would have been anti-dilutive.
Due to losses attributable to common shareholders for each of the periods below, the following potentially dilutive shares are excluded from the diluted net loss per share calculation because they were anti-dilutive under the treasury stock method, in accordance with ASC Topic 260:

 
 
Nine Months ended September 30,
 
 
 
2013
   
2012
 
Excluded Securities:
 
(shares)
   
(shares)
 
Convertible preferred stock issued and outstanding
   
22,156,922
     
7,195,770
 
Stock options issued and outstanding
    979,483       1,291,420  
Unvested stock options exercised
   
6,461,797
     
-
 
Warrants  issued and outstanding
   
218,797
     
260,971
 
Total common stock equivalents excluded from diluted net loss per common share computation
   
29,816,999
      8,748,161  

The number of shares issued and outstanding reflect a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
7.
Stockholders’ Equity

Preferred Stock

Under PMI's certificate of incorporation, preferred stock is issuable in series, and PMI’s board of directors (the “Board of Directors”) is authorized to determine the rights, preferences, and terms of each series.

In January 2013, PMI issued and sold 13,868,152 shares of new Series A (“Series A”) preferred stock in a private placement at a purchase price of $1.44 per share for $19,844, net of issuance costs.  In connection with that sale, PMI issued 5,117,182 shares at par value $0.01 per share of Series A-1 (“Series A-1”) convertible preferred stock to certain previous holders of PMI’s original Series A, Series B, Series C, Series D, Series E and Series F preferred stock who participated in the sale. Upon issuance of the new Series A and Series A-1 preferred stock, all of PMI’s preferred stock existing prior to such issuance was converted into PMI common stock at a 1:1 ratio if the holder of the preferred stock participated in the new Series A preferred stock sale or at a 10:1 ratio if the holder of the preferred stock did not so participate.  These securities were sold in reliance on the exemption from the registration requirements of the Securities Act set forth in Section 4(2) of the Securities Act and Regulation D promulgated thereunder regarding sales by an issuer not involving a public offering.  In September 2013, PMI issued and sold 8,288,734 shares of new Series B (“Series B”) preferred stock in a private placement at a purchase price of $3.02 per share for approximately $24,880, net of issuance costs.

Convertible
Preferred Stock
 
Par Value
   
Authorized, Issued and
Outstanding shares as of
September 30, 2013
   
Balance September
30, 2013
   
Liquidation Preference
 
Series A '13
 
$
0.01
      13,868,152      
139
   
$
20,000
 
Series A-1 '13
   
0.01
      5,117,182      
51
     
51,172
 
Series B '13
   
0.01
      8,288,734      
83
     
25,000
 
  27,274,068 $ 273 $ 96,172
 
The number of shares issued and outstanding reflect a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
Convertible
Preferred Stock
 
Par Value
   
Authorized, Issued and
Outstanding shares as of
September 30, 2013
   
Balance September
30, 2013
   
Authorized, Issued and
Outstanding shares as of
December 31, 2012
   
Balance December
31, 2012
 
Series A
 
$
0.01
     
-
   
$
-
      402,400          
Series B
   
0.01
     
-
     
-
      331,038          
Series C
   
0.01
     
-
     
-
      206,356          
Series D
   
0.01
     
-
     
-
      2,034,070          
Series E
   
0.01
     
-
     
-
      2,322,275          
Series E-1
   
0.01
     
-
     
-
      1,000,000          
Series F
   
0.01
     
-
     
-
      899,674          
 
           
-
   
$
-
      7,195,813    
$
72
 
 
Dividends

Dividends on shares of the new Series A and Series B preferred stock are payable only when, as, and if declared by the Board of Directors.  No dividends will be paid with respect to the common stock or Series A-1 preferred stock or Series B preferred stock until any declared dividends on the Series A preferred stock and Series B preferred stock have been paid or set aside for payment to the Series A preferred stock holders and the Series B preferred stock holders.  Holders of Series A-1 preferred stock and Series B preferred stock are not entitled to receive dividends in preference and priority to, or on a pari passu basis with, the other preferred stock or the common stock. To date, no dividends have been declared on any of PMI’s preferred stock or common stock, and there are no dividends in arrears at September 30, 2013.

The holders of PMI’s Series D, Series E and Series F preferred stock were entitled to receive an annual dividend per share in an amount equal to 8% times the liquidation preference for such share, payable in preference and priority to any declaration or payment of any distribution on common stock in such calendar year.  The right to receive dividends on shares of PMI’s Series D, Series E and Series F preferred stock was cumulative from and after the date of issuance of such shares and were payable only when, as, and if declared by the Board of Directors.  Holders of PMI’s Series E-1 preferred stock were not entitled to receive dividends in preference and priority to, or on a pari passu basis with, the other preferred stock or the common stock. Dividends on shares of PMI’s Series E-1 preferred stock were payable only when, as, and if declared by the Board of Directors.  All shares of PMI’s Series D, E, E-1 and F preferred stock were converted to common stock in connection with the January 2013 sale of PMI’s new Series A and A-1 preferred stock.

Conversion

On January 15, 2013, PMI entered into an equity financing transaction where shares of PMI’s preferred stock that were outstanding immediately prior to the financing (“Old Preferred Shares”) were converted into shares of PMI common stock. For holders of Old Preferred Shares who participated in the financing in proportion to their pro rata ownership interest in PMI, their Old Preferred Shares converted into common shares at a ratio of 1:1. In addition, each such participating holder received a share of PMI’s new Series A-1 preferred stock for every dollar of liquidation preference associated with an Old Preferred Share held by such holder. Each share of Series A-1 preferred stock has a liquidation preference of $1.00 and converts into common stock at a ratio of 1,000,000:1.

Under the terms of PMI’s new Series A preferred stock (the “Shares”), the holders of such Shares have the right to convert the Shares into common stock at any time. In addition, the Shares automatically convert into common stock (i) immediately prior to the closing of an IPO that values PMI at least at $200,000 and that results in aggregate proceeds to PMI of at least $40,000 or (ii) upon a written request from the holders of at least 70% of the voting power of the outstanding preferred stock (on an as-converted basis). In addition, if a holder of the Shares has converted any of the Shares, then all of such holder’s shares of Series A-1 preferred stock also will be converted upon a liquidation event. In lieu of any fractional shares of common stock to which a holder would otherwise be entitled, PMI shall pay such holder cash in an amount equal to the fair market value of such fractional shares, as determined by PMI’s Board of Directors. At present, the new Series A preferred stock converts into PMI common stock at a 1:1 ratio while the Series A-1 preferred stock converts into PMI common stock at a 1,000,000:1 ratio.

On September 23, 2013, PMI entered into an equity financing transaction with certain new investors and certain of its existing investors (each, a “Series B Share Purchaser” and, collectively, the “Series B Share Purchasers”), pursuant to which, PMI issued and sold to such Series B Share Purchasers (either directly or through certain of their respective affiliates) 8,288,734 shares of PMI’s Series B Preferred Stock (the “Shares”) for an aggregate purchase price of $24,880, net of issuance costs. Under the terms of the Shares, the Share Purchasers have the right to convert the Shares into common stock at any time. In addition, the Shares automatically convert into common stock (i) immediately prior to the closing of an IPO that values PMI at least at $200,000 and that results in aggregate proceeds to PMI of at least $40,000 or (ii) upon a written request from the holders of at least 60% of the voting power of the outstanding Preferred Stock (on an as-converted basis) including at least 14% of the voting power of the outstanding Series A-1 Preferred Stock. In lieu of any fractional shares of common stock to which a holder would otherwise be entitled, PMI shall pay such holder cash in an amount equal to the fair market value of such fractional shares, as determined by PMI’s Board of Directors (the “Board”). At present, the Series B Preferred Stock converts into PMI common stock at a 1:1 ratio.
Liquidation Rights

PMI issued 5,117,182 shares at the par value $0.01 per share of Series A-1 convertible preferred stock to certain previous holders of PMI’s preferred stock who participated in the new Series A preferred stock sale. The Series A-1 shares established certain liquidation rights, have no voting rights and are convertible into one share of PMI common stock for every one million shares of Series A-1 preferred stock. PMI allocated the fair value of the shares of Series A-1 preferred stock at the par value of $0.01 per share from the proceeds of new Series A preferred stock. Upon issuance of PMI’s new Series A and Series A-1 preferred stock, all of PMI’s preferred stock existing prior to such issuance was converted into PMI common stock at a 1:1 ratio if the holder of the preferred stock participated in the new Series A preferred stock sale or at a 10:1 ratio if the holder of the preferred stock did not so participate.
 
The number of shares reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
Voting

Each holder of shares of preferred stock shall be entitled to the number of votes equal to the number of shares of common stock into which such shares of preferred stock could be converted and shall have voting rights and powers equal to the voting rights and powers of the common stock (except as otherwise expressly provided in PMI’s Amended and Restated Certificate of Incorporation or as required by law), voting together with the common stock as a single class, and shall be entitled to notice of any stockholders’ meeting in accordance with the Bylaws of PMI. The holders of preferred stock shall vote as one class with the holders of the common stock except with respect to certain matters that require separate votes.

Common Stock

PMI, through its certificate of incorporation, is the sole issuer of common stock and related options and warrants. PMI was authorized to issue up to 41,487,465 shares of common stock, $0.01 par value, of which 13,799,063 shares were issued and outstanding as of September 30, 2013.  As of December 31, 2012, there were 8,263,000 shares of common stock authorized, $0.01 par value, of which 482,938 shares were issued and outstanding.  Each holder of common stock shall be entitled to one vote for each share of common stock held.
 
On October 29, 2013, the Company amended and restated its Certificate of Incorporation to effect a 1-for-10 reverse stock split. The total number of shares of stock which the Company shall have the authority to issue is 68,761,533, consisting of 41,487,465 shares of Common Stock, $0.01 par value per share, and 27,274,068 Preferred Stock, $0.01 par value per share, 13,868,152 of which are designated as "Series A Preferred Stock," 5,117,182 of which are designated as "Series B Preferred Stock." Each tens shares of Common Stock issued and outstanding immediately prior to the effective date shall be combined and converted into one share of Common Stock; each ten shares of Series A Preferred Stock, Series A-1 Preferred Stock, Series B Preferred Stock, issued and outstanding immediately prior to the effective date, shall be combined and converted into one share of Series A Preferred Stock, Series A-1 Preferred Stock Series B Preferred Stock, respectively. No fractional shares shall be issued in connection with the reverse stock split and stockholders who otherwise would be entitled to receive fractional shares of Common Stock or Preferred Stock will be entitled to receive cash in lieu of such fractional shares.
 
Common Stock Issued upon Exercise of Stock Options

For the nine months ended September 30, 2013 and 2012, PMI issued 7,286,299 and 13,388 shares of common stock, respectively, upon the exercise of options for cash proceeds of $8 and $19, respectively, of which 6,499,459 and zero were unvested, respectively. Certain options are eligible for exercise prior to vesting. Shares issued as a result of early exercise may be subject to repurchase by the Company upon termination of employment or services, at the lesser of the price paid or the fair value of the shares on the repurchase date. At September 30, 2013 and 2012, there were zero shares of common stock outstanding subject to the Company’s right of repurchase. The Company recorded a liability for the exercise of unvested shares, which will be reclassified to common stock and additional paid-in capital as the shares vest.
 
For the nine months ended September 30, 2013, the Company repurchased 37,662 shares of restricted stock upon termination of employment of various employees. For the nine months ended September 30, 2012, there were no repurchases of restricted stock.
 
The number of shares reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
Common Stock Issued upon Exercise of Stock Warrants

For the nine months ended September 30, 2013 PMI issued 820 shares of common stock upon the exercise of warrants for $0.01 per share. The number of shares reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
8.
Stock Option Plan and Compensation

Incentive stock options are granted to employees at an exercise price not less than 100% of the fair value of PMI’s common stock on the date of grant. Non-statutory stock options are granted to consultants and directors at an exercise price not less than 85% of the fair value of PMI’s common stock on the date of grant. If options are granted to stockholders who hold 10% or more of PMI’s common stock on the option grant date, then the exercise price shall not be less than 110% of the fair value of PMI’s common stock on the date of grant. The fair value is based on a good faith estimate by the Board of Directors at the time of each grant. As there is no active trading market for these options, such estimate may ultimately differ from valuations completed by an independent party. The options generally vest over four years, which is the same as the performance period. In no event are options exercisable more than ten years after the date of grant.

At December 31, 2012, there were 1,523,966 stock options available for grant under the 2005 Stock Option Plan (the “Plan”). During the first nine months of 2013, the Board of Directors increased the total number of options under the plan by an additional 11,110,825 for a total of 12,634,791 available for grant.
Option activity under the Option Plan is summarized as follows for the periods below:
 
The share amounts and share prices reflect a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
 
Options Issued
   
Weighted-
 
 
and Outstanding
   
Average Exercise
 
 
 
   
Price
 
 
 
   
 
Balance as of January 1, 2012
   
1,208,762
   
$
2.10
 
Options granted (weighted – average fair value of $0.11)
   
288,796
     
1.70
 
Options exercised
   
(13,389
)
   
1.40
 
Options canceled
   
(192,749
)
   
2.20
 
Balance as of September 30, 2012
   
1,291,420
   
$
2.00
 
 
               
Balance as of January 1, 2013
   
1,173,816
   
$
2.00
 
Options granted (weighted – average fair value of $0.01)
   
7,912,949
     
0.10
 
Options exercised - vested
   
(967,128
)
   
0.20
 
Options exercised - nonvested
   
(6,356,845
)
   
0.10
 
Options canceled
   
(783,309
)
   
1.80
 
Balance as of Sept 30, 2013
   
979,483
   
$
1.90
 
 
               
Options outstanding and exercisable at Sept 30, 2013
   
561,241
   
$
1.30
 
 
The number of options reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.

Other Information Regarding Stock Options

Additional information regarding PMI common stock options outstanding as of September 30, 2013 is as follows:
 
   
Options Outstanding
   
 
   
 
   
Options Exercisable
   
 
 
Range of Exercise
Prices
   
Number Outstanding
   
Weighted –
Avg.
Remaining
Life
   
Weighted –
Avg.
Exercise
Price
   
Intrinsic
Value
   
Number
Vested
   
Weighted -
Avg.
Exercise
Price
   
Intrinsic
Value
 
$0.10 - $0.10
     
302,196
     
9.87
    $
0.10
   
$
-
     
51,925
    $ 0.10    
$
-
 
$1.20 - $1.20
     
171,187
     
7.96
     
1.20
     
-
     
119,216
      1.20      
-
 
$1.70 - $1.70
     
172,173
     
8.64
     
1.70
     
-
     
66,930
      1.70      
-
 
$2.00 - $2.00
     
300,077
     
6.81
     
2.00
     
-
     
289,320
      2.00      
-
 
$2.50 - $2.50
     
1,500
     
1.8
     
2.50
     
-
     
1,500
      2.50      
-
 
$5.00 - $5.00
     
11,000
     
2.92
     
5.00
     
-
     
11,000
      5.00      
-
 
$5.60 - $5.60
     
18,250
     
5.96
     
5.60
     
-
     
18,250
      5.60      
-
 
$19.40 - $19.40
     
3,100
     
5.3
     
19.40
     
-
     
3,100
      19.40      
-
 
$0.10 - $19.40
     
979,483
     
8.21
   
$
1.40
   
$
-
     
561,241
    $ 1.30    
$
-
 

The number of options reflects a 1-for-10 reverse stock split effected by the Company on October 29, 2013.
 
The intrinsic value is calculated as the difference between the value of PMI's common stock at September 30, 2013, which was $0.01 per share, and the exercise price of the options.

No compensation expense is recognized for unvested shares that are forfeited upon termination of service, and the stock-based compensation expense for the three and nine months ended September 30, 2013 and 2012 reflect the expenses that PMI expects to recognize after the consideration of estimated forfeitures.
PMI estimates its forfeiture rate based on an analysis of its actual forfeitures and will continue to evaluate the adequacy of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior, and other factors. The impact from a forfeiture rate adjustment will be recognized in full in the period of adjustment, and if the actual number of future forfeitures differs from that estimate, PMI may be required to record adjustments to stock-based compensation expense in future periods.

The fair value of PMI stock option awards for the three and nine months ended September 30, 2013 and 2012 was estimated at the date of grant using the Black-Scholes model with the following average assumptions:

 
 
Three months ended
September 30,
   
Nine months ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Volatility of common stock
   
69.57
%
   
75.00
%
   
69.56
%
   
76.20
%
Risk-free interest rate
   
1.39
%
   
0.72
%
   
1.90
%
   
0.86
%
Expected life*
 
5.8 years
   
5.1 years
   
5.8 years
   
5.0 years
 
Dividend yield
   
0
%
   
0
%
   
0
%
   
0
%
Weighted-average fair value of grants
 
$
0.01
   
$
0.10
   
$
0.01
   
$
0.10
 

*For nonemployee stock option awards, the expected life is the contractual term of the award, which is generally ten years.

The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility. Because PMI's equity awards have characteristics significantly different from those of traded options, the changes in the subjective input assumptions can materially affect the fair value estimate.

Total stock-based compensation expense for PMI employees reflected in the statements of operations for the nine months ended September 30, 2013 and 2012 is approximately $184 and $272, respectively, and $100 and $103 for the three months ended September 30, 2013 and 2012.  As of September 30, 2013, the unamortized stock-based compensation expense related to PMI employees’ unvested stock-based awards was approximately $322, which will be recognized over the remaining weighted average vesting period of approximately 3.0 years.

9.
Income Taxes

As part of the process of preparing the condensed consolidated financial statements, PMI Group is required to estimate its income taxes in each of the jurisdictions in which it operates. This process involves determining the income tax expense (benefit) together with calculating the deferred income tax expense (benefit) related to temporary differences resulting from differing treatment of items, such as fair value of loans or deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the accompanying balance sheet. PMI Group must then assess the likelihood that the deferred tax assets will be recovered through the generation of future taxable income.

Due to the book and tax net losses incurred during the nine months ended September 30, 2013 and 2012, zero income tax expense has been incurred during those periods. In addition, substantial historical losses have been incurred and the company has maintained a full valuation allowance against its net deferred tax assets because the realization of those deferred tax assets is dependent upon future earnings, and the amount and timing of those earnings, if any is uncertain.

10.
Commitments and Contingencies

Future Minimum Lease Payments

The corporate office and co-location facility is under non-cancelable operating leases that expire in December 2014 and August 2014, respectively.

Future minimum rental payments under these leases as of September 30, 2013 are as follows:

2013
 
$
132
 
2014
   
502
 
Total future operating lease obligations
 
$
634
 

Rental expense under premises-operating lease arrangements was $165 and $502 for the three and nine months ended September 30, 2013 and $134 and $398 for the corresponding periods during 2012, respectively.

PMI Group amended and restated an agreement with WebBank, an FDIC-insured Utah-chartered industrial bank, under which all loans originated through the platform are made by WebBank under its bank charter. The arrangement allows for loans to be offered to borrowers at uniform nationwide terms. PMI Group is required to pay the greater of a monthly minimum fee or a fee calculated based on a certain percentage of monthly loan origination volume.

PMI Group has an agreement with a third party broker-dealer in which the third party agreed to operate and maintain the Note Trader Platform for the secondary trading of PMI Group Notes.  PMI Group is required to pay the third party broker-dealer an agreed upon monthly fee which equals the difference between the minimum monthly fee and the transaction fees collected by the third party provider during that month.

Securities Law Compliance

From inception through October 16, 2008, PMI sold approximately $178,000 of borrower loans to lender members through the old platform structure, whereby PMI assigned promissory notes directly to lender members. PMI did not register the offer and sale of the promissory notes corresponding to these loans under the Securities Act or under the registration or qualification provisions of any state securities laws. The question of whether or not the operation of the platform during this period constituted an offer or sale of “securities” involved a complicated factual and legal analysis and was uncertain. If the sales of promissory notes offered through the platform during this period were viewed as a securities offering, PMI would have failed to comply with the registration and qualification requirements of federal and state laws and lender members who hold these promissory notes may be entitled to rescission of unpaid principal, plus statutory interest. Generally, the federal statute of limitations for noncompliance with the requirement to register securities under the Securities Act is one year from the violation, although the statute of limitations period under various state laws may be for a longer period of time.

PMI’s decision to restructure the platform and cease sales of promissory notes offered through the platform effective October 16, 2008 limited this contingent liability to the period covering its activities prior to October 16, 2008.

On April 21, 2009, PMI and the North American Securities Administrators Association (“NASAA”) reached agreement on the terms of a model consent order between PMI and the states in which PMI offered loan notes for sale prior to November 2008. The consent order involves payment by PMI of up to an aggregate of $1,000 in penalties, which have been allocated among the states based on PMI’s promissory note sale transaction volume in each state prior to November 2008. A state that enters into a consent order receives its portion of the $1,000 in exchange for its agreement to terminate, or refrain from initiating, any investigation of PMI’s note sale activities prior to November 2008.  Penalties are paid promptly after a state enters into a consent order. NASAA has recommended that each state enter into a consent order.  However, no state is obliged to do so, and there is no deadline by which a state must make its decision. PMI is not required to pay any portion of the penalty to those states that do not elect to enter into a consent order. If a state does not enter into a consent order, it is free to pursue its own remedies against PMI, subject to any applicable statute of limitations. As of September 30, 2013, PMI Group has entered into consent orders with thirty-four states and has paid an aggregate of $466 in penalties to those states.

As of September 30, 2013 and December 31, 2012, PMI Group had accrued approximately $248 and $248, respectively, in connection with the contingent liability associated with the states that have not entered into consent orders, in accordance with ASC Topic 450, Contingencies. The methodology applied to estimate the accrual was to divide the $1,000 maximum fee pro-rata by state, using PMI’s note sales from inception through November 2008. A weighting was then applied by state to each state that has not entered into a consent order, assigning likelihood that the penalty will be claimed. In estimating the probability of a claim being made by a state, PMI Group considered factors such as the standard terms of the consent orders; whether the state ever gave any indication of concern regarding the sale of promissory notes through the platform; the probability of a state electing not to enter into a consent order in order to pursue its own litigation against PMI; whether the penalty is sufficient to compensate a state for the cost of processing the settlement consent order; and finally the impact that current economic conditions have had on state governments.  PMI Group will continue to evaluate this accrual and related assumptions as new information becomes known.

In 2008 plaintiffs filed a class action lawsuit (“Hellum Litigation”) against PMI and certain of its executive officers and directors in the Superior Court of California, County of San Francisco, California (“Superior Court”).  The suit was brought on behalf of all promissory note purchasers on the platform from January 1, 2006 through October 14, 2008.  The lawsuit alleged that PMI offered and sold unqualified and unregistered securities in violation of the California and federal securities laws.  The lawsuit sought class certification, damages and the right of rescission against PMI and the other named defendants, as well as treble damages against PMI and the award of attorneys’ fees, experts’ fees and costs, and pre-judgment and post-judgment interest.
On July 19, 2013, solely to avoid the costs, risks and uncertainties inherent in litigation, and without admitting any liability or wrongdoing, the parties to the Hellum Litigation pending before the Superior Court, entered into a Stipulation and Agreement of Compromise, Settlement, and Release (the “Settlement”) setting forth an agreement to settle all claims related thereto. In connection with the Settlement, PMI agreed to pay the plaintiffs, and took the charge on the income statement, an aggregate amount of $10,000, payable according to the following schedule: (i) $2,000 within 10 days of entry of an order by the Court granting preliminary approval of the settlement (“Preliminary Approval”); (ii) $2,000 on the one-year anniversary of Preliminary Approval; (iii) $3,000 on the two-year anniversary of Preliminary Approval; and (iv) $3,000 on the three-year anniversary of Preliminary Approval. The settlement is subject to final approval by the Superior Court. Subject to satisfaction of the conditions set forth in the Settlement, the defendants will be released by the plaintiffs from all claims concerning or arising out of the offering of promissory notes on the platform from January 1, 2006 through October 14, 2008.

As a result of the Settlement, PMI recorded the Settlement in the condensed consolidated statement of operations and a reserve for class action settlement liability of $10,000 in the condensed consolidated balance sheet as of September 30, 2013.

11.
Related Parties

PMI Group’s executive officers, directors who are not executive officers, and certain affiliates participate on PMI Group’s lending platform by placing bids and purchasing Notes.  The aggregate amount of Notes and Borrower Loans purchased and the income earned by parties deemed to be affiliates and related parties of PMI Group as of September 30, 2013 and 2012 are summarized below:

Related Party
 
Aggregate Amount of Borrower Loans and Notes
Purchased September 30,
   
Income Earned on Borrower Loans and
Notes for the nine months ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Executive officers and management
 
$
806
   
$
227
   
$
30
   
$
13
 
Directors
   
4,578
     
3,127
     
204
     
223
 
 
 
$
5,384
   
$
3,354
   
$
234
   
$
236
 

The Notes and Borrower Loans were obtained on terms and conditions that were not more favorable than those obtained by other Note and Borrower Loan purchasers. Of the total aggregate amount of Notes and Borrower Loans purchased since inception approximately $359 or 7% and $148 or 4% of principal has been charged off through September 30, 2013 and 2012, respectively. The revenue earned is approximately $14 and $12 in servicing fee revenue related to these Notes and Borrower Loans for the nine months ended September 30, 2013 and 2012, respectively.

12.
Post-retirement Benefit Plans

PMI has a 401(k) plan that covers all employees meeting certain eligibility requirements. The 401(k) plan is designed to provide tax-deferred retirement benefits in accordance with the provisions of Section 401(k) of the Internal Revenue Code. Eligible employees may defer up to 90% of eligible compensation up to the annual maximum as determined by the Internal Revenue Service.  PMI’s contributions to the plan are discretionary. PMI has not made any contributions to the plan to date.

13.
Subsequent Events
 
On October 29, 2013, the Company amended and restated its Certificate of Incorporation to effect a 1-for-10 reverse stock split. The total number of shares of stock which the Company shall have the authority to issue is 68,761,533, consisting of 41,487,465 shares of Common Stock, $0.01 par value per share, and 27,274,068 Preferred Stock, $0.01 par value per share, 13,868,152 of which are designated as "Series A Preferred Stock," 5,117,182 of which are designated as "Series B Preferred Stock." Each tens shares of Common Stock issued and outstanding immediately prior to the effective date shall be combined and converted into one share of Common Stock; each ten sahres of Series A Preferred Stock, Series A-1 Preferred Stock, Series B Preferred Stock, issued and outstanding immediately prior to the effective date, shall be combined and converted into one share of Series A Preferred Stock, Series A-1 Preferred Stock Series B Preferred Stock, respectively. No fractional shares shall be issued in connection with the reverse stock split and stockholders who otherwise would be entitled to recieve fractional shares of Common Stock or Preferred Stock will be entitled to receive cash in lieu of such fractional shares.
Schedule I

Prosper Funding LLC
Condensed Balance Sheets
(Unaudited)
(amounts in thousands)

 
 
September 30,
2013
   
December 31,
2012
 
Assets
 
   
 
Cash and Cash Equivalents
 
$
3,167
   
$
5
 
Restricted Cash
   
5,113
     
-
 
Loans Held for Investment at Fair Value
   
137
     
-
 
Borrower Loans Receivable at Fair Value
   
204,131
     
-
 
Property and Equipment, net
   
1,593
     
-
 
Total Assets
 
$
214,141
   
$
5
 
 
               
Liabilities and Stockholders' Equity
               
Accounts Payable and Accrued Liabilities
 
$
1,312
   
$
-
 
Notes at Fair Value
   
204,465
     
-
 
Loan Loss Reserve
   
61
     
-
 
Intercompany Payable
   
518
     
-
 
Total Liabilities
   
206,356
     
-
 
 
               
Member's Equity
               
Member's Equity
   
6,075
     
210
 
Retained Earnings (Accumulated Deficit)
   
1,710
     
(205
)
Total Member's Equity
   
7,785
     
5
 
Total Liabilities and Member's Equity
 
$
214,141
   
$
5
 

The accompanying notes are an integral part of these condensed financial statements.
Prosper Funding LLC
Condensed Statements of Operations
(Unaudited)
(amounts in thousands)

 
 
Three months ended September 30,
   
Nine months ended
September 30,
   
From February  17,
2012 (date of
inception) to
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Revenues
 
   
   
   
 
Administration Fee Revenue - Related Party
 
$
2,042
   
$
-
   
$
4,178
   
$
-
 
Interest Income on Borrower Loans
   
9,039
     
-
     
22,687
     
-
 
Interest Expense on Notes
   
(8,435
)
   
-
     
(21,380
)
   
-
 
Total Revenues
   
2,646
     
-
     
5,485
     
-
 
 
                               
Cost of Revenues
                               
Cost of Services
   
(357
)
   
-
     
(920
)
   
-
 
Reversal of (Provision for) Loan Losses
   
66
     
-
     
(83
)
   
-
 
Net revenues
   
2,355
     
-
     
4,482
     
-
 
 
                               
Expenses
                               
Administration Fee Expense - Related Party
   
1,521
     
-
     
2,534
     
-
 
Depreciation and Amortization
   
149
     
-
      355      
-
 
Professional Services
   
6
     
8
     
26
     
90
 
Other
   
62
     
19
     
157
     
78
 
Total Expenses
   
1,738
     
27
     
3,072
     
168
 
Income (Loss) Before Other Income and Expenses
   
617
     
(27
)
   
1,410
     
(168
)
 
                               
Other Income and Expenses
                               
Change in Fair Value of Borrower Loans, Loans Held for Investment and Notes, net
   
91
     
-
     
578
     
-
 
Other Expense
   
(58
)
   
-
     
(73
)
   
-
 
Total Other Income and Expenses, net
   
33
     
-
     
505
     
-
 
 
                               
Income (Loss) Before Income Taxes
 
 
650
   
 
(27
)
 
 
1,915
   
 
(168
)
Provision For Income Taxes
   
-
     
-
     
-
     
-
 
Total Net Income (Loss)
 
$
650
   
$
(27
)
 
$
1,915
   
$
(168
)

The accompanying notes are an integral part of these condensed financial statements.
Prosper Funding LLC
Condensed Statements of Cash Flows
(Unaudited)
(amounts in thousands)
 
 
 
 
Nine Months Ended
September 30, 2013
   
From February 17,
2012 (date of
inception) to
September 30, 2012
 
 
 
   
 
Cash flows from operating activities:
 
   
 
Net Income (loss)
 
$
1,915
   
$
(168
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
               
Change in fair value of Notes
   
(4,484
)
   
 
Change in fair value of Borrower Loans
   
3,903
     
 
Depreciation and amortization
   
355
     
 
Loan loss reserve
   
20
     
 
Change in fair value of Loans held for investment
   
3
     
 
Changes in operating assets and liabilities:
               
Restricted cash
   
(969
)
   
 
Accounts payable and accrued liabilities
   
533
     
 
Net Intercompany Payable
   
518
     
 
Net cash provided by (used in) operating activities
   
1,794
     
(168
)
 
               
Cash flows from investing activities:
               
Origination of Borrower Loans held at fair value
   
(108,527
)
   
 
Repayment of Borrower Loans held at fair value
   
70,837
     
 
Purchases of property and equipment
   
(1,227
)
   
 
Repayment of Loans held for investment at fair value
   
106
     
 
Origination of Loans held for investment at fair value
   
(71
)
   
 
Net cash used in investing activities
   
(38,882
)
   
 
 
               
Cash flows from financing activities:
               
Proceeds from issuance of Notes held at fair value
   
108,527
     
 
Payment of Notes held at fair value
   
(70,152
)
   
 
Net cash included in transfer of assets from PMI
   
1,875
     
 
Proceeds from Member's equity
   
     
173
 
Net cash provided by financing activities
   
40,250
     
173
 
 
               
Net increase in cash and cash equivalents
   
3,162
     
5
 
Cash and cash equivalents at beginning of the period
   
5
     
 
Cash and cash equivalents at end of the period
 
$
3,167
   
$
5
 
 
               
Supplemental disclosure of cash flow information:
               
Cash paid for interest
 
$
20,344
   
$
-
 

The accompanying notes are an integral part of these condensed financial statements.

Prosper Funding LLC
Notes to Condensed Financial Statements
(Unaudited)
(amounts in thousands)

1.
Organization and Business

Prosper Funding LLC (“Prosper Funding”) was formed in the state of Delaware in February 2012 as a limited liability company with the sole equity member being Prosper Marketplace, Inc. (“PMI”).

Prosper Funding was formed by PMI to hold borrower loans and issue borrower payment dependent notes through the platform.  Although Prosper Funding is consolidated with PMI for accounting and tax purposes, Prosper Funding has been organized and is operated in a manner that is intended to minimize the likelihood that it would be substantively consolidated with PMI in a bankruptcy proceeding.  Prosper Funding’s intention is to minimize the likelihood that its assets would be subject to claims by PMI’s creditors if PMI were to file for bankruptcy, as well as to minimize the likelihood that Prosper Funding will become subject to bankruptcy proceedings directly.  Prosper Funding seeks to achieve this by placing certain restrictions on its activities and implementing certain formal procedures designed to expressly reinforce its status as a distinct corporate entity from PMI.

On January 22, 2013, PMI entered into an asset transfer agreement with Prosper Funding (the “Asset Transfer Agreement”), pursuant to which PMI transferred substantially all of its remaining assets to Prosper Funding, including (i) all outstanding notes issued by PMI under the Indenture dated June 15, 2009 between PMI and Wells Fargo Bank, as trustee, (ii) all borrower loans held by PMI, (iii) all lender/borrower/group leader registration agreements related to the notes or the borrower loans, and (iv) all documents and information related to the foregoing, effective February 1, 2013.

Prosper Funding commenced operations as of February 1, 2013 when PMI transferred ownership of the platform, including all of the rights related to the operation of the platform, to Prosper Funding. Since February 1, 2013, all notes issued and sold through the platform are issued, sold and serviced by Prosper Funding (together with the notes transferred from PMI, the “Notes”).  Pursuant to a Loan Account Program Agreement between PMI and WebBank, PMI manages the operation of the platform, as agent of WebBank, in connection with the submission of loan applications by potential borrowers, the making of related loans by WebBank and the funding of such loans by WebBank. Pursuant to an Administration Agreement between Prosper Funding and PMI, PMI manages all other aspects of the platform on behalf of Prosper Funding.

All loans requested and obtained through the platform are unsecured obligations of individual borrower members with a fixed interest rate and loan terms set at three or five years as of September 30, 2013. All loans made through the platform are funded by WebBank, an FDIC-insured, Utah chartered industrial bank.  After funding a loan, WebBank sells the loan to Prosper Funding, without recourse to WebBank, in exchange for the principal amount of the loan (together with the borrower loans transferred from PMI, the “Borrower Loans”).  WebBank does not have any obligation to purchasers of the Notes.

2.
Summary of Significant Accounting Policies

Basis of Presentation

Prosper Funding’s unaudited interim condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) and disclosure requirements for interim financial information and the requirements of Rule 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. The unaudited interim condensed financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2012. The balance sheet at December 31, 2012 has been derived from the audited financial statements at that date. Management believes these unaudited interim condensed financial statements reflect all adjustments, including those of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.
Use of Estimates

The preparation of Prosper Funding’s condensed financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the related disclosures at the date of the condensed financial statements and the reported amounts of revenues and expenses during the reporting periods. These estimates, judgments and assumptions include but are not limited to the following: valuation of Borrower Loans receivable and associated Notes, valuation allowance on deferred tax assets, provision for loan loss and contingent liabilities. Prosper Funding bases its estimates on historical experience from all Borrower Loans, and on various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from those estimates.

Certain Risks and Concentrations

In the normal course of its business, Prosper Funding encounters two significant types of risk: credit and regulatory. Financial instruments that potentially subject Prosper Funding to significant concentrations of credit risk consist primarily of cash, cash equivalents, restricted cash and short term investments. Prosper Funding places cash, cash equivalents, restricted cash and short term investments with high-quality financial institutions and is exposed to credit risk in the event of default by these institutions to the extent the amount recorded on the balance sheet exceeds federally insured amounts. Prosper Funding also performs periodic evaluations of the relative credit standing of these financial institutions and has not sustained any credit losses from instruments held at these financial institutions.

To the extent that loan payments are not made, servicing income will be reduced.  Borrower Loans were funded by the Notes and repayment of said Notes is wholly dependent on the repayment of the Borrower Loans associated with the Notes.  As a result, PMI Group does not bear the risk associated with the repayment of principal on loans carried on its condensed consolidated balance sheet.

Prosper Funding is subject to various regulatory requirements. The failure to appropriately identify and address these regulatory requirements could result in certain discretionary actions by regulators that could have a material effect on Prosper Funding's financial position and results of operations.

Cash and Cash Equivalents

Cash equivalents are recorded at cost, which approximates fair value. Such deposits periodically exceed amounts insured by the FDIC.

Restricted Cash

Restricted cash consists primarily of cash deposits held as collateral as required to secure operating activities.

Borrower Loans and Notes

Prosper Funding has adopted the provisions of ASC Topic 825, Financial Instruments.  ASC Topic 825 permits companies to choose to measure certain financial instruments and certain other items at fair value on an instrument-by-instrument basis with unrealized gains and losses on items for which the fair value option has been elected reported in earnings.  The fair value election, with respect to an item, may not be revoked once an election is made.  In applying the provisions of ASC Topic 825, Prosper Funding has recorded assets and liabilities measured using the fair value option in a way that separates these reported fair values from the carrying values of similar assets and liabilities measured with a different measurement attribute.  Prosper Funding does not record a specific allowance account related to the Borrower Loans and Notes in which it has elected the fair value option, but rather estimates the fair value of the Borrower Loans and Notes using discounted cash flow methodologies adjusted for historical payment, loss and recovery rates of Borrower Loans. An account is considered to be a loss, or charged-off, when it reaches more than 120 days past due.  Prosper Funding has reported the aggregate fair value of the  Borrower Loans and Notes as separate line items in the assets and liabilities sections of the accompanying balance sheets using the methods described in ASC Topic 820, Fair Value Measurements and Disclosures—See Fair Value Measurement.

Prosper Funding purchases Borrower Loans from WebBank and, if issuing Notes to lender members to fund its purchase of Borrower Loans, holds the Borrower Loans until maturity, except as may otherwise be determined in connection with the servicing of any Borrower Loan.   Prosper Funding’s obligation to repay the Notes is conditioned upon the repayment of the associated Borrower Loan owned by Prosper Funding.  Prosper Funding carries the Borrower Loans and Notes on its balance sheet as assets and liabilities, respectively.  Prosper Funding also purchases Borrower Loans from WebBank and immediately sells them to certain qualified lender members.
Fair Value Measurement

Prosper Funding follows ASC Topic 820, Fair Value Measurements and Disclosures, which provides guidance regarding a fair value hierarchy, which prioritizes information used to measure fair value and the effect of fair value measurements on earnings and provides for enhanced disclosures determined by the level within the hierarchy of information used in the valuation. ASC Topic 820 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances.

ASC Topic 820 defines fair value in terms of the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The price used to measure the fair value is not adjusted for transaction costs while the cost basis of certain financial instruments may include initial transaction costs. Under ASC Topic 820, the fair value measurement also assumes that the transaction to sell an asset occurs in the principal market for the asset or, in the absence of a principal market, the most advantageous market for the asset. The principal market is the market in which the reporting entity would sell or transfer the asset with the greatest volume and level of activity for the asset. In determining the principal market for an asset or liability under ASC Topic 820, it is assumed that the reporting entity has access to the market as of the measurement date. If no market for the asset exists or if the reporting entity does not have access to the principal market, the reporting entity should use a hypothetical market.

Under ASC Topic 820, assets and liabilities carried at fair value in the balance sheets are classified among three levels based on the observability of the inputs used to determine fair value:

Level 1 — The valuation is based on quoted prices in active markets for identical instruments.

Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 — The valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques, which incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument or valuations that require significant management judgment or estimation.

Fair value of financial instruments are determined based on the fair value hierarchy established in ASC Topic 820, which requires an entity to maximize the use of quoted prices and observable inputs and to minimize the use of unobservable inputs when measuring fair value. Various valuation techniques are utilized, depending on the nature of the financial instrument, including the use of market prices for identical or similar instruments, or discounted cash flow models. When possible, active and observable market data for identical or similar financial instruments are utilized. Alternatively, fair value is determined using assumptions that management believes a market participant would use in pricing the asset or liability.

Financial instruments consist principally of cash and cash equivalents, restricted cash, short term investments, Borrower Loans receivable, accounts payable and accrued liabilities, Notes and long-term debt.  The estimated fair values of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities approximate their carrying values because of their short term nature.

Borrower Loans Notes, cash equivalents and restricted cash are accounted for on a fair value basis.

The following table presents the assets & liabilities measured at fair value on a recurring basis at September 30, 2013, and December 31, 2012:
 
September 30, 2013
 
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
 
   
   
   
 
Borrower Loans receivable
 
$
-
   
$
-
   
$
204,131
   
$
204,131
 
Certificates of Deposit
   
-
     
1,269
     
-
     
1,269
 
Loans held for investment
   
-
     
-
     
137
     
137
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
204,465
   
$
204,465
 
 
                               
December 31, 2012
                               
Assets
 
$
-
   
$
-
   
$
-
   
$
-
 
Borrower Loans receivable
                               
Certificates of Deposit
   
-
     
-
     
-
     
-
 
Borrower Loans held for investment
   
-
     
-
     
-
     
-
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
-
   
$
-
 
 
Internal Use Software and Website Development

Internal use software costs and website development costs are accounted for in accordance with ASC Topic 350-40, Internal Use Software, and ASC Topic 350-50, Website Development Costs. In accordance with ASC Topic 350-40 and 350-50, the costs to develop software for Prosper Funding's website and other internal uses are capitalized when management has authorized and committed project funding, preliminary development efforts are successfully completed, and it is probable that the project will be completed and the software will be used as intended. Capitalized software development costs primarily include software licenses acquired, fees paid to outside consultants, salaries and payroll related costs for PMI employees directly involved in the development efforts.
Costs incurred prior to meeting these criteria, together with costs incurred for training and maintenance, are expensed. Costs incurred for upgrades and enhancements that are considered to be probable to result in additional functionality are capitalized. Capitalized costs are included in property and equipment and amortized to expense using the straight-line method over their expected lives. Prosper Funding evaluates its software assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.  Recoverability of software assets to be held and used is measured by a comparison of the carrying amount of the asset to the future net undiscounted cash flows expected to be generated by the asset.  If such software assets are considered to be impaired, the impairment to be recognized is the excess of the carrying amount over the fair value of the software asset.

 Loan Loss Reserve

Prosper Funding is obligated to indemnify lenders and or repurchase certain Notes sold to the lenders in the event of violation of applicable federal, state, or local lending laws, or verifiable identify theft. The loan loss reserve is estimated based on historical experience and is accrued when the Notes are issued. Indemnified or repurchased Notes are written off at the time of repurchase or at the time an indemnification payment is made.

Revenue Recognition

Revenue is recognized in accordance with ASC Topic 605, Revenue Recognition.  Revenue is recognized when persuasive evidence of an arrangement exists, services have been rendered, the price of the services is fixed and determinable, and collectability is reasonably assured.

Administration Agreement License Fees

Prosper Funding primarily generates revenues through license fees it earns through an Administration Agreement with PMI.  The Administration Agreement contains a license granted by Prosper Funding to PMI that entitles PMI to use the platform for and in relation to: (i) PMI’s performance of its duties and obligations under the Administration Agreement relating to corporate administration, loan platform services, loan and note servicing and marketing, and (ii) PMI’s performance of its duties and obligations to WebBank in relation to loan origination and funding.

Loan Servicing Fees

Loan servicing fees are accrued daily based on the current outstanding loan principal balance of the Borrower Loan but are not recognized until payment is received due to the uncertainty of collection of borrower loan payments.

Interest Income on Borrower Loans Receivable and Interest Expense on Notes

Interest income on Borrower Loans is recognized using the accrual method based on the stated interest rate to the extent that is believed it to be collectable.  Interest expense is recorded on the corresponding Notes based on the contractual interest rate.  Below is a table that summarizes the gross interest income and expense for the three and nine months ended September 30, 2013 and 2012.

 
 
Three months ended
September 30,
   
Nine months ended
September 30,
   
From February
17, 2012 (date of
inception) to
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Interest Income on Borrower Loans
 
$
9,039
   
$
-
   
$
22,687
   
$
-
 
Interest Expense on Notes
   
(8,435
)
   
-
     
(21,380
)
   
-
 
Net Interest Income (Expense) on Loans & Notes
 
$
604
   
$
-
   
$
1,307
   
$
-
 

Comprehensive Income

There is no comprehensive income (loss) other than the net income (loss) disclosed in the condensed statement of operations.

Recent Accounting Pronouncements

We do not expect the adoption of recently issued accounting pronouncements to have a material impact on our results of operations, financial position or cash flows.
3.
Borrower Loans and Notes Held at Fair Value

The following tables present the assets and liabilities measured at fair value on a recurring basis at September 30, 2013.

September 30, 2013
 
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
 
   
   
   
 
Borrower Loans receivable
 
$
-
   
$
-
   
$
204,131
   
$
204,131
 
Loans held for investment
   
-
     
-
     
137
     
137
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
204,465
   
$
204,465
 

As observable market prices are not available for the Borrower Loans and Notes Prosper Funding holds, or for similar assets and liabilities, the Prosper Funding believes the Borrower Loans and Notes should be considered Level 3 financial instruments under ASC Topic 820.  In a hypothetical transaction as of the measurement date, Prosper Funding believes that differences in the principal marketplace in which the loans are originated and the principal marketplace in which it might offer those loans may result in differences between the originated amount of the loans and their fair value as of the transaction date.  For Borrower Loans, the fair value is estimated using discounted cash flow methodologies based upon valuation assumptions including prepayment speeds, roll rates, recovery rates and discount rates based on the perceived credit risk within each credit grade.

The obligation to pay principal and interest on any Note is equal to the loan payments, if any, that are received on the corresponding Borrower Loan, net of its servicing fee.  The fair value election for Notes and Borrower Loans allows both the assets and the related liabilities to receive similar accounting treatment for expected losses which is consistent with the subsequent cash flows to lenders that are dependent upon borrower payments.  As such, the fair value of the Notes is approximately equal to the fair value of the Borrower Loans, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to Note holders.  Any unrealized gains or losses on the Borrower Loans and Notes for which the fair value option has been elected is recorded as a separate line item in the statement of operations.  The effective interest rate associated with the Notes is less than the interest rate earned on the Borrower Loans due to the servicing fee.  See further in this note for a roll-forward and further discussion of the significant assumptions used to value Borrower Loans and Notes.

The fair value of the Notes and Borrower Loans are estimated using discounted cash flow methodologies based upon a set of valuation assumptions. The main assumptions used to value the Borrower Loans and Notes include prepayment rates derived from historical prepayment rates for each credit score, default rates derived from historical performance, recovery rates and discount rates applied to each credit tranche based on the perceived credit risk of each credit grade. The obligation to pay principal and interest on any Note is equal to the loan payments, if any, received on the corresponding Borrower Loan, net of the servicing fee.  As such, the fair value of the Notes is approximately equal to the fair value of the Borrower Loans, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to the Note holders.  The effective interest rate associated with the Notes will be less than the interest rate earned on the Borrower Loans due to the servicing fee.

For Borrower Loans originated and Notes, the following average assumptions were used to determine the fair value as of September 30, 2013:

 
 
2013
 
Monthly prepayment rate speed
   
1.50
%
Recovery rate
   
2.50
%
Discount rate *
   
10.00
%

*
This is the average discount rate among all of the credit grades

Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at September 30, 2013 for Borrower Loans and Notes are presented in the following table:

 
 
Borrower Loans
   
Notes
 
Discount rate assumption:
   
10.00
%
   
10.00
%
Resulting fair value from:
               
100 basis point increase
 
$
202,015
   
$
199,663
 
200 basis point increase
   
199,623
     
197,271
 
Resulting fair value from:
               
100 basis point decrease
 
$
206,953
   
$
204,550
 
200 basis point decrease
   
209,509
     
207,074
 
 
Default rate assumption:
 
   
 
Resulting fair value from:
 
   
 
10% higher default rates
 
$
202,295
   
$
199,926
 
20% higher default rates
   
199,450
     
197,127
 
Resulting fair value from:
               
10% lower default rates
 
$
206,651
   
$
204,234
 
20% lower default rates