10-Q 1 form10q.htm PROSPER MARKETPLACE, INC 10-Q 6-30-2014

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 June 30, 2014

 
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. Yesx No ¨
Prosper Funding LLC Yesx 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. Yesx No ¨
Prosper Funding LLC Yesx 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

2

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  August 8, 2014
Prosper Marketplace, Inc.
 
14,464,398
($.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.
3

TABLE OF CONTENTS

 
Page No.
 
PART I. FINANCIAL INFORMATION
1
Item 1.
7
7
8
9
10
11
Schedule 1
 
32
33
34
35
Item 2.
46
Item 3.
69
Item 4.
70
PART II.
OTHER INFORMATION
 
Item 1.
71
Item 1A.
71
Item 2.
71
Item 3.
71
Item 4.
71
Item 5.
71
Item 6.
71
72
73

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. In this Quarterly Report, the unsecured, consumer loans originated through the platform are referred to as “Borrower Loans,” and the borrower payment dependent notes issued through the platform, whether issued by PMI or Prosper Funding, are referred to as “Notes.” 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 Notes, which, in addition to being speculative investments, are special, limited obligations that are not 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 Borrower Loans;

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

Prosper Funding and PMI’s ability to service the Borrower 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 and the effectiveness of the Registrants’ credit rating systems;

actions by some borrowers to defraud investor 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; 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 the Registrants’ Annual Report on Form 10-K, filed with the Securities and Exchange Commission (“SEC”) on March 31, 2014, as well as any subsequent quarterly reports on Form 10-Q, 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.
Item 1.
Condensed Consolidated Financial Statements

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

 
 
June 30,
2014
   
December 31,
2013 *
 
Assets
 
   
 
Cash and cash equivalents
 
$
76,802
   
$
18,339
 
Restricted cash
   
17,946
     
15,473
 
Accounts receivable
   
229
     
218
 
Loans held for investment
   
9,543
     
3,917
 
Borrower loans receivable at fair value
   
246,861
     
226,238
 
Property and equipment, net
   
4,200
     
3,396
 
Prepaid and other assets
   
2,870
     
708
 
Total Assets
 
$
358,451
   
$
268,289
 
 
               
Liabilities and Stockholders' Equity
               
Accounts payable and accrued liabilities
 
$
10,399
   
$
6,737
 
Class action settlement liability
   
8,000
     
10,000
 
Notes at fair value
   
246,511
     
226,794
 
Repurchase liability for unvested restricted stock awards
   
721
     
609
 
Repurchase and indemnification obligation
   
146
     
32
 
Total Liabilities
   
265,777
     
244,172
 
 
               
Commitments and contingencies (see Note 10)
               
 
               
Stockholders' Equity
               
Convertible preferred stock – Series A '13, A-1 '13, B '13 and C’14 ($0.01 par value; 32,155,022 and 27,274,068 shares authorized, issued and outstanding as of June 30, 2014 and December 31, 2013, respectively). (Aggregate liquidation preference of $166,247 and $96,172 as of June 30, 2014 and December 31, 2013, respectively).
   
322
     
273
 
Common stock ($0.01 par value; 47,928,883 shares authorized; 14,236,119 issued and outstanding as of June 30, 2014; and 41,487,465 shares authorized; 13,720,214 issued and outstanding as of December 31, 2013).
   
115
     
75
 
Additional paid-in capital
   
198,777
     
128,140
 
Less: treasury stock
   
(291
)
   
(291
)
Accumulated deficit
   
(106,249
)
   
(104,080
)
Total Stockholders' Equity
   
92,674
     
24,117
 
Total Liabilities and Stockholders' Equity
 
$
358,451
   
$
268,289
 

The number of shares issued and outstanding reflects a 10-for-1 reverse stock split effected by the Company on October 29, 2013.
 
 The accompanying notes are an integral part of these condensed consolidated financial statements.

* Derived from the Company’s audited consolidated financial statements.
Prosper Marketplace, Inc.
Condensed Consolidated Statements of Operations
(Unaudited)
(in thousands, except for share and per share amounts)

 
 
Three Months Ended
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
Revenues
 
   
   
   
 
Origination Fees
 
$
16,448
   
$
3,342
   
$
25,149
   
$
4,914
 
Interest Income on Borrower Loans
   
10,701
     
8,563
     
20,810
     
16,292
 
Interest Expense on Notes
   
(9,494
)
   
(8,127
)
   
(18,763
)
   
(15,453
)
Rebates & Promotions
   
(639
)
   
(387
)
   
(999
)
   
(662
)
Other Revenues
   
269
     
285
     
965
     
432
 
Total Revenues
   
17,285
     
3,676
     
27,162
     
5,523
 
 
Cost of Revenues
                               
Cost of Services
   
(767
)
   
(500
)
   
(1,293
)
   
(982
)
Provision for repurchase and indemnification obligation
   
(54
)
   
(50
)
   
(116
)
   
(177
)
Net Revenues
   
16,464
     
3,126
     
25,753
     
4,364
 
 
                               
Operating Expenses
                               
Compensation and Benefits
   
5,277
     
3,303
     
9,219
     
5,841
 
Marketing and Advertising
   
9,040
     
3,878
     
15,026
     
5,451
 
Depreciation and Amortization
   
380
     
208
     
743
     
413
 
General and Administrative
                               
Professional Services
   
364
     
694
     
541
     
1,382
 
Facilities and Maintenance
   
621
     
481
     
1,066
     
794
 
Class Action Settlement
   
-
     
10,000
     
-
     
10,000
 
Loss on impairment of Fixed Assets
   
-
     
61
     
215
     
62
 
Other
   
877
     
466
     
1,503
     
760
 
Total Operating Expenses
   
16,559
     
19,091
     
28,313
     
24,703
 
Loss Before Other Income and Expenses
   
(95
)
   
(15,965
)
   
(2,560
)
   
(20,339
)
 
                               
Other Income and Expenses
                               
Interest Income
   
1
     
-
     
2
     
-
 
Change in Fair Value of Borrower Loans, Loans Held for Investment and Notes, net
   
91
     
312
     
389
     
487
 
Total Other Income and Expenses
   
92
     
312
     
391
     
487
 
Loss Before Income Taxes
   
(3
)
   
(15,653
)
   
(2,169
)
   
(19,852
)
Provision For Income Taxes
   
-
     
-
     
-
     
-
 
Net Loss
 
$
(3
)
 
$
(15,653
)
 
$
(2,169
)
 
$
(19,852
)
 
                               
Net loss per share – basic and diluted
 
$
(0.00
)
 
$
(2.39
)
 
$
(0.25
)
 
$
(3.30
)
Weighted- average shares - basic and diluted net loss per share
   
9,155,199
     
6,553,785
     
8,794,337
     
6,020,281
 
 
The weighted average number of shares and the net loss per share reflect a 10-for-1 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 Statement of Stockholders' Equity
(Unaudited)
(in thousands, except for share and per share amounts)
 
 
 
Preferred Stock
   
Common Stock
   
Treasury Stock
   
Additional
   
   
 
 
 
   
   
   
   
   
   
Paid-In
   
Accumulated
   
 
 
 
Shares
   
Amount
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
Deficit
   
Total
 
 
 
   
   
   
   
   
   
   
   
 
Balance as of January 1, 2014
   
27,274,068
   
$
273
     
13,902,478
   
$
75
     
(182,264
)
 
$
(291
)
 
$
128,140
   
$
(104,080
)
 
$
24,117
 
Issuance of convertible preferred stock, Series C'14
   
4,880,954
     
49
     
-
     
-
     
-
     
-
     
69,909
     
-
     
69,958
 
Exercise of vested stock options
   
-
     
-
     
157,312
     
1
     
-
     
-
     
30
     
-
     
31
 
Exercise of nonvested stock options
   
-
     
-
     
351,750
     
-
     
-
     
-
     
-
             
-
 
Repurchase of restricted stock
   
-
     
-
     
(101,980
)
   
-
     
-
     
-
     
-
             
-
 
Restricted stock vested
   
-
     
-
     
38,451
     
38
                     
114
             
152
 
Exercise of warrants
                   
70,372
     
1
                     
84
             
85
 
Stock-based compensation expense
   
-
     
-
     
-
     
-
     
-
     
-
     
500
     
-
     
500
 
Net loss
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
(2,169
)
   
(2,169
)
Balance as of June 30, 2014
   
32,155,022
   
$
322
     
14,418,383
   
$
115
     
(182,264
)
 
$
(291
)
 
$
198,777
   
$
(106,249
)
 
$
92,674
 
 
The number of shares reflects a 10-for-1 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 Six Months Ended
June 30,
 
 
 
2014
   
2013
 
Cash flows from operating activities:
 
   
 
Net loss
 
$
(2,169
)
 
$
(19,852
)
Adjustments to reconcile net loss to net cash used in operating activities:
               
Change in fair value of borrower loans
   
958
     
4,082
 
Change in fair value of loans held for investment
   
3
     
3
 
Change in fair value of notes
   
(1,350
)
   
(4,573
)
Depreciation and amortization
   
743
     
413
 
Provision for repurchase and indemnification obligation
   
114
     
124
 
Stock-based compensation expense
   
500
     
92
 
Loss on impairment of fixed assets
   
215
     
62
 
Changes in operating assets and liabilities:
               
Restricted cash
   
(2,473
)
   
(1,339
)
Accounts receivable
   
(11
)
   
(40
)
Prepaid and other assets
   
(2,162
)
   
(851
)
Accounts payable and accrued liabilities
   
3,662
     
(95
)
Class action settlement liability payment
   
(2,000
)
   
10,000
 
Net cash used in operating activities
   
(3,970
)
   
(11,974
)
 
               
Cash flows from investing activities:
               
Origination of borrower loans held at fair value
   
(330,464
)
   
(74,875
)
Repayment of borrower loans held at fair value
   
65,648
     
50,568
 
Proceeds from sale of borrower loans held at fair value
   
243,235
     
 
Purchases of property and equipment
   
(1,762
)
   
(1,123
)
Maturities of short term investments
   
     
1,000
 
Repayments of loans held for investment at fair value and credit losses
   
312
     
64
 
Origination of loans held for investment at fair value
   
(111,927
)
   
(44
)
Proceeds from sale of loans held for investment at fair value
   
105,986
     
-
 
Net cash used in investing activities
   
(28,972
)
   
(24,410
)
 
Cash flows from financing activities:
               
Proceeds from issuance of notes held at fair value
   
86,713
     
74,875
 
Payment of notes held at fair value
   
(65,646
)
   
(50,291
)
Proceeds from issuance of convertible preferred stock
   
70,075
     
20,000
 
Principal repayment of notes payable
   
-
     
116
 
Proceeds from early exercise of stock options
   
276
     
 
Proceeds from exercise of vested stock options
   
31
         
Issuance costs of convertible preferred stock
   
(117
)
   
(101
)
Repurchase of restricted stock
   
(12
)
   
-
 
Proceeds from exercise of warrants
   
85
     
-
 
Net cash provided by financing activities
   
91,405
     
44,599
 
Net increase in cash and cash equivalents
   
58,463
     
8,215
 
Cash and cash equivalents at beginning of the period
   
18,339
     
2,300
 
Cash and cash equivalents at end of the period
 
$
76,802
   
$
10,515
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
Prosper Marketplace, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. Organization and Business

Prosper Marketplace, Inc. (“PMI” or “the Company”) was incorporated in the state of Delaware on March 22, 2005. PMI developed a peer-to-peer online credit platform (the “platform”) and prior to February 1, 2013, owned the proprietary technology that made operation of the platform possible. Prior to February 1, 2013, PMI also operated the platform, facilitated the origination of unsecured, consumer loans by WebBank, an FDIC-insured, Utah-chartered industrial bank, through the platform and issued and sold borrower payment dependent notes corresponding to those loans.

The platform is designed to allow investor members to invest money in borrower members in an open transparent marketplace, with the aim of allowing both investor members and borrower members to profit financially as well as socially. The Company believes peer-to-peer lending represents a new model of consumer lending, where individuals and institutions can earn the interest spread of a traditional consumer lender but must also assume the credit risk of a traditional lender. The platform was launched to the public in 2006 and had attracted over two million members and facilitated approximately $1.4 billion in Borrower Loans as of June 30, 2014.

A borrower member who wishes to obtain a loan through the platform must post a loan listing, or listing, on the platform. Listings are allocated to one of two investor member funding channels: (i) the first channel allows investor members to commit to purchase Notes, the payments of which are dependent on the payments made on the corresponding Borrower Loan (the “Note Channel”); and (ii) the second channel allows investor members to commit to purchase 100% of a Borrower Loan directly from the Company (the “Whole Loan Channel”).

On February 1, 2013, PMI transferred ownership of the platform, including all of the rights related to the operation of the platform, as well as all then-outstanding Borrower Loans, to its wholly-owned subsidiary, Prosper Funding LLC (“Prosper Funding” and, collectively with PMI, the “Company” or the “Registrants”). At that same time, Prosper Funding assumed all of PMI’s obligations with respect to all then-outstanding Notes.  Since February 1, 2013, all Notes issued and sold through the platform are issued and sold by Prosper Funding.  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. On February 1, 2013, Prosper Funding entered into an Administration Agreement with PMI in its capacity as licensee, corporate administrator, loan platform administrator and loan and note servicer, pursuant to which PMI provides certain back office support, loan platform administration and loan and note servicing to Prosper Funding.

Prosper Funding formed Prosper Asset Holdings LLC (“PAH”) in November 2013 as a limited liability company with the sole equity member being Prosper Funding. PAH was formed to purchase Borrower Loans from Prosper Funding and sell the Borrower Loans to third parties.
As reflected in the accompanying condensed consolidated financial statements, the Company has incurred net losses and negative cash flows from operations since inception.  An accumulated deficit of $106.2 million was incurred as of June 30, 2014.  At June 30, 2014, the Company had $76.8 million in cash and cash equivalents. Since its inception, the Company has financed its operations primarily through equity financing from various sources.  The Company believes that its current cash position, including the additional $51.4 million ($69.9 million raised in May 2014 net of $18.5 million spent in July 2014 on preferred share repurchases) through a new equity financing, is sufficient to meet its current liquidity needs. On May 1, 2014, the Company entered into a Series C Preferred Stock Purchase Agreement with certain new investors (collectively, the “Series C Share Purchasers”), pursuant to which the Company issued and sold to such Series C Share Purchasers 4,880,954 shares of the Company’s Series C Preferred Stock for an aggregate purchase price of $69.9 million, net of issuance costs. Refer to Note 13, Subsequent Events for additional information on the preferred share repurchases.

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, 2013. The balance sheet at December 31, 2013 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 and associated Notes, valuation of servicing rights, valuation allowance on deferred tax assets, repurchase and indemnification obligation, stock-based compensation expense, and contingent liabilities. The Company 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, the Company encounters two significant types of risk: credit and regulatory. Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalents, and restricted cash. The Company places cash, cash equivalents, and restricted cash 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.  The Company 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 Borrower Loan payments are not made, servicing income will be reduced.  A group of Notes corresponding to a particular Borrower Loan is wholly dependent on the repayment of such Borrower Loan. As a result, the Company does not bear the risk on such Borrower Loan.

The Company 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 Company's 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. 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.

Borrower Loans and Notes

Through the Note Channel, the Company issues Notes and purchases Borrower Loans from WebBank, and holds the Borrower Loans until maturity.  The obligation to repay a series of Notes funded through the Note Channel is conditioned upon the repayment of the associated Borrower Loan.  Borrower Loans and Notes funded through the Note Channel are carried on the Company’s condensed consolidated balance sheets as assets and liabilities, respectively.  The Company 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 the Company has elected the fair value option, but rather the Company 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 funded through the Note Channel 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.
Borrower Loans Sold Directly to Third Party Purchasers

For Borrower Loans sold to unrelated third party purchasers on a servicing retained basis through the Whole Loan Channel, a gain or loss is recorded on the sale date. In order to calculate the gain or loss, the Company first determines whether the terms of the servicing arrangement with the purchaser results in a net servicing asset (i.e., when contractual/expected servicing revenues adequately compensate the Company) or a net servicing liability (i.e., when contractual/expected servicing revenues do not adequately compensate the Company). When contractual/expected servicing revenues do not adequately compensate the Company, a portion of the gross proceeds of the Borrower Loans sold on a servicing retained basis through the Whole Loan Channel are allocated to the recording of a net servicing liability. Conversely, when contractual/expected servicing revenues provide more than adequate compensation to the Company, the excess servicing compensation is allocated to the gross proceeds of the Borrower Loans sold and results in the recording of a net servicing asset. The Company estimates the fair value of the loan servicing asset or liability considering the contractual servicing fee revenue, adequate compensation for the Company's servicing obligation, the current principal balances of the Borrower Loans and projected servicing revenues given projected defaults and prepayments (if significant) over the remaining lives of the Borrower Loans. The Company recorded a gain/(loss) on sale of whole loans of $(0.2) million and $0 for the three months ended June 30, 2014 and 2013, respectively, which was included in Other revenues on the condensed consolidated statements of operations. The Company recorded a gain/(loss) on sale of whole loans of $0.2 million and $0 for the six months ended June 30, 2014 and 2013, respectively, which was included in Other revenues on the condensed consolidated statements of operations. At June 30, 2014 and December 31, 2013, the Company recorded $0.7 million and $0.1 million as a servicing asset related to these loans, which is included in Borrower loans receivable at fair value on the condensed consolidated balance sheets.

Loans Held for Investment

Loans held for investment are primarily comprised of Borrower Loans held for short durations and are recorded at cost which approximates fair value. For Borrower Loans held long term, the fair value is estimated using discounted cash flow methodologies based upon a set of valuation assumptions similar to those of other Borrower Loans, which are set forth in Note 2— Fair Value Measurement.

Fair Value Measurement

The Company 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 on 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, Borrower loans receivable, Loans held for investment, Accounts payable and accrued liabilities, and Notes.  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.

The following tables present the assets and liabilities measured at fair value on a recurring basis at June 30, 2014 and December 31, 2013 (in thousands):

June 30, 2014
 
Level 1
   
Level 2
   
Level 3
   
Fair
Value
 
Assets
 
   
   
   
 
Borrower loans receivable
 
$
-
   
$
-
   
$
246,861
   
$
246,861
 
Restricted cash
   
16,573
     
1,373
     
-
     
17,946
 
Loans held for investment
   
-
     
-
     
9,543
     
9,543
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
246,511
   
$
246,511
 

December 31, 2013
 
Level 1
   
Level 2
   
Level 3
   
Fair
Value
 
Assets
 
   
   
   
 
Borrower loans receivable
 
$
-
   
$
-
   
$
226,238
   
$
226,238
 
Restricted cash
   
14,032
     
1,441
     
-
     
15,473
 
Loans held for investment
   
-
     
-
     
3,917
     
3,917
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
226,794
   
$
226,794
 

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 condensed consolidated 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.

Repurchase and Indemnification Obligation

Under the terms of the Notes, the Lender Registration Agreements between the Company and investor members who participate in the Note Channel, and the loan purchase agreements between the Company and investor members that participate in the Whole Loan Channel, the Company may, in certain circumstances, become obligated to repurchase a Note or Borrower Loan from a investor member or indemnify a investor member against loss on a Note. Generally, these circumstances include the occurrence of verifiable identity theft, the failure to properly follow loan listing or bidding protocols, or a violation of the applicable federal, state, or local lending laws. The indemnification and repurchase obligation is estimated based on historical experience. The Company accrues a provision for the repurchase and indemnification obligation when the Notes or Borrower Loans are issued. Indemnified or repurchased Notes and repurchased Borrower Loans associated with violations of federal, state, or local lending laws or verifiable identity theft 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

The Company earns an origination fee upon the successful closing of all Borrower Loans issued through the platform. WebBank charges the origination fee and the Company receives payments from WebBank equal to the origination fee as compensation for its loan origination activities on behalf of WebBank. The borrower receives an amount equal to the loan amount net of the loan origination fee. The loan origination fee is determined by the term and credit grade of the loan, and ranges from 1.00% to 5.00% of the original principal amount. Since the Company accounts for Borrower Loans, Loans held for investment and Notes at fair value, origination fees are not deferred but are recognized at origination of the Borrower Loan, and direct costs to originate Borrower Loans are recorded as expenses as incurred.

Interest Income on Borrower Loans Receivable and Interest Expense on Notes

The Company recognizes interest income on Borrower Loans funded through the Note Channel and interest expense on the corresponding Notes using the accrual method based on the stated interest rate to the extent the Company believes it to be collectable.  The following table summarizes the gross interest income and expense for the three and six months ended June 30, 2014 and 2013 (in thousands):

 
 
Three months ended June 30,
   
Six months ended June 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
 
 
   
   
   
 
Interest income on borrower loans
 
$
10,701
   
$
8,563
   
$
20,810
   
$
16,292
 
Interest expense on notes
   
(9,494
)
   
(8,127
)
   
(18,763
)
   
(15,453
)
Net interest income
 
$
1,207
   
$
436
   
$
2,047
   
$
839
 

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 $15.0 million and $5.5 million for the six months ended June 30, 2014 and 2013, 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 investor 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 Borrower Loan. Rebates and promotions have in the past been in the form of cash back and other incentives paid to borrower and investor members.
 
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 the Company 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 Company’s 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 June 30, 2014, there were outstanding convertible preferred stock, warrants and options convertible into 32,155,022, 148,438 and 4,338,461 common shares, respectively, which may dilute future earnings per share. At June 30, 2013, there were outstanding convertible preferred stock, warrants and options convertible into 138,681,720, 2,187,969 and 7,212,610 common shares, respectively, which may dilute future earnings per share. The weighted average number of shares and the loss per share reflect a 10-for-1 reverse stock split effected by the Company on October 29, 2013. By reporting a net loss for the three and six months ended June 30, 2014 and 2013, 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 Company’s 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.  The Company is currently not undergoing 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 statements of operations.
 
Recent Accounting Pronouncements
 
In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” The new guidance sets forth a new five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidance that have historically existed in U.S. GAAP. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The standard also requires more detailed disclosures and provides additional guidance for transactions that were not addressed completely in the prior accounting guidance. The standard will be effective for the Company in the first quarter of fiscal 2017. Early adoption is not permitted. The Company is currently assessing the potential impact on its financial statements from adopting this new guidance.
3. Borrower Loans and Notes Held at Fair Value

As observable market prices are not available for the Borrower Loans and Notes funded through the Note Channel, or for similar assets and liabilities, the Company believes such Borrower Loans and Notes should be considered Level 3 financial instruments under ASC Topic 820.  In a hypothetical transaction as of the measurement date, the Company believes that differences in the principal marketplace in which such Borrower Loans are originated and the principal marketplace in which it might offer such Borrower Loans for sale may result in differences between the originated amount of the Borrower Loans and their fair value as of the transaction date.  For Borrower Loans funded through the Note Channel, 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 series of Notes 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 funded through the Note Channel 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 investor members 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 funded through the Note Channel, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to Note holders.  Any unrealized gains or losses on such 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 a series of Notes is less than the interest rate earned on the corresponding Borrower Loan due to the servicing fee.  See further discussion in this note for a roll-forward and further discussion of the significant assumptions used to value Borrower Loans and Notes funded through the Note Channel.

The fair value of the Borrower Loans and Notes funded through the Note Channel is estimated using discounted cash flow methodologies based upon a set of valuation assumptions. The primary cash flow assumptions used to value such Borrower Loans and Notes include default rates derived from historical performance and discount rates applied to each credit grade based on the perceived credit risk of each credit grade. The obligation to pay principal and interest on any series of Notes 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 funded through the Note Channel, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to the Note holders.  The effective interest rate associated with a series of Notes will be less than the interest rate earned on the corresponding Borrower Loan due to the servicing fee.
Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at June 30, 2014 for Borrower Loans and Notes funded through the Note Channel are presented in the following table (in thousands):

 
 
Borrower Loans
   
Notes
 
Discount rate assumption:
   
9.43
%*
   
9.43
%*
Resulting fair value from:
               
100 basis point increase
 
$
239,501
   
$
236,585
 
200 basis point increase
   
236,564
     
233,668
 
Resulting fair value from:
               
100 basis point decrease
 
$
245,558
   
$
242,591
 
200 basis point decrease
   
248,688
     
245,689
 
 
               
 
               
Default rate assumption:
   
7.00
%*
   
7.00
%*
Resulting fair value from:
               
10% higher default rates
 
$
239,687
   
$
236,768
 
20% higher default rates
   
236,761
     
233,869
 
Resulting fair value from:
               
10% lower default rates
 
$
245,132
   
$
242,152
 
20% lower default rates
   
247,726
     
244,721
 

* Represents weighted average assumptions considering all credit grades.

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

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
 
 
Borrower
Loans
   
Notes
   
Loans Held
for
Investment
   
Total
 
Balance at January 1, 2013
 
$
166,900
   
$
(167,478
)
 
$
175
   
$
(403
)
Originations
   
74,875
     
(74,875
)
   
44
     
44
 
Principal repayments and credit losses
   
(50,568
)
   
50,291
     
(64
)
   
(341
)
Change in fair value on borrower loans and notes
   
(4,082
)
   
4,573
     
-
     
491
 
Change in fair value of loans held for investment
   
-
     
-
     
(3
)
   
(3
)
Balance at June 30, 2013
 
$
187,125
   
$
(187,489
)
 
$
152
   
$
(212
)

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
 
 
Borrower
Loans
   
Notes
   
Loans Held
for
Investment
   
Total
 
Balance at January 1, 2014
 
$
226,238
   
$
(226,794
)
 
$
3,917
   
$
3,361
 
Originations
   
330,464
     
(86,713
)
   
111,927
     
355,678
 
Principal repayments and credit losses
   
(65,648
)
   
65,646
     
(312
)
   
(314
)
Borrower loans sold to third parties
   
(243,235
)
   
-
     
(105,986
)
   
(349,221
)
Change in fair value on borrower loans and notes
   
(958
)
   
1,350
     
-
     
392
 
Change in fair value of loans held for investment
   
-
     
-
     
(3
)
   
(3
)
Balance at June 30, 2014
 
$
246,861
   
$
(246,511
)
 
$
9,543
   
$
9,893
 

The changes in fair value would directly impact the change in fair value on Borrower Loans, Loans held for investment and Notes in the condensed consolidated statements of operations.

Due to the recent origination of the Borrower Loans and Notes funded through the Note Channel, the change in fair value attributable to instrument-specific credit risk is immaterial.  Of the 92,110 Borrower Loans originated from July 13, 2009 to June 30, 2014, 254 Borrower Loans were 90 days or more delinquent, which related to an aggregate principal amount of $1.6 million and a fair value of $0.16 million as of June 30, 2014.
4.
Loans Held for Investment

Loans held for investment on the condensed consolidated balance sheets as of June 30, 2014 and December 31, 2013, was $9.5 million and $3.9 million, respectively. For the six months ended June 30, 2014 and 2013, a total of $111.9 million and $0.04 million of Borrower Loans originated through the platform as Loans held for investment. For the six months ended June 30, 2014 and 2013, $106.0 million and $0 of these Borrower Loans were sold to an unrelated third party through the Whole Loan Channel. When a Borrower Loan has been funded by the Company in whole, or in part, the portion of the borrower’s monthly loan payment that corresponds to the percentage of the Borrower 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 holding period of the Borrower Loan and are reported in the statements of operations as Origination fees.

The changes in Loans held for investment measured at fair value on a recurring basis are as follows (in thousands):

 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3) 
 
Loans Held
for
Investment
 
Balance at January 1, 2013
 
$
175
 
Originations
   
44
 
Principal repayments and credit losses
   
(64
)
Change in fair value of loans held for investment
   
(3
)
Balance at June 30, 2013
 
$
152
 

Balance at January 1, 2014
 
$
3,917
 
Originations
   
111,927
 
Principal repayments and credit losses
   
(312
)
Borrower loans sold to third parties
   
(105,986
)
Change in fair value of loans held for investment
   
(3
)
Balance at June 30, 2014
 
$
9,543
 

5. Repurchase and Indemnification Obligation

For the three months ended June 30, 2014 and 2013, the provision for repurchase and indemnification obligation was $0.05 million and $0.05 million, respectively. For the six months ended June 30, 2014 and 2013, the provision for repurchase and indemnification obligation was $0.1 million and $0.2 million, respectively. The balance of the Repurchase and indemnification obligation as of June 30, 2014 and December 31, 2013, was $0.15 million and $0.03 million, respectively.

6. Net Loss Per Share

The Company computes net loss per share 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 October 29, 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 convertible preferred stock was entitled to participate on an as-if-converted basis in distributions, when and if declared by the board of directors (“Board of Directors”), that were made to common stockholders and as a result these shares were considered participating securities. During the three months ended June 30, 2014, certain shares issued as a result of the early exercise of stock options, which are subject to a repurchase right 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 months ended June 30, 2014 and 2013, basic and diluted loss per share were the same, as the effect of potentially dilutive securities would have been anti-dilutive.

Basic and diluted net loss per share was calculated as follows (in thousands, except for share and per share amounts):

 
 
Three months ended
June 30,
   
Six months ended
June 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
Numerator:
 
   
   
   
 
Net loss applicable to common stockholders for basic and diluted EPS
 
$
(3
)
 
$
(15,653
)
 
$
(2,169
)
 
$
(19,852
)
Denominator:
                               
Weighted average shares used in computing basic and diluted net loss per share
   
9,155,199
     
6,553,785
     
8,794,337
     
6,020,281
 
Basic and diluted net loss per share
 
$
(0.00
)
 
$
(2.39
)
 
$
(0.25
)
 
$
(3.30
)

The number of shares reflect a 10-for-1 reverse stock split effected by the Company on October 29, 2013
Due to losses attributable to the Company’s 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:

 
Three and Six months ended June 30
 
 
2014
 
2013
 
Excluded Securities:
(shares)
 
(shares)
 
Convertible preferred stock issued and outstanding
   
32,155,022
     
13,868,172
 
Stock options issued and outstanding
   
4,338,461
     
721,261
 
Unvested stock options exercised
   
4,825,667
     
-
 
Warrants issued and outstanding
   
148,438
     
218,797
 
Total common stock equivalents excluded from diluted net loss per common share computation
   
41,467,588
     
14,808,230
 

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

7. Stockholders’ Equity

Preferred Stock

Under the Company's certificate of incorporation, preferred stock is issuable in series, and the Company’s Board of Directors is authorized to determine the rights, preferences, and terms of each series.

In January 2013, the Company 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 $19.8 million, net of issuance costs.  In connection with that sale, the Company issued 5,117,182 shares at par value $0.01 per share of Series A-1 (“Series A-1”) convertible preferred stock to the holders of shares of the Company’s preferred stock that was outstanding immediately prior to the sale (“Old Preferred Shares”) in consideration for such stockholders participating in the sale. In connection with the new Series A sale, Old Preferred Shares were converted into shares of common stock at a ratio of 1:1 if the holder of the Old Preferred Shares participated in the new Series A sale or at a 10:1 ratio if the holder of the Old Preferred Shares did not so participate. In addition, each such participating holder received a share of 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 $10.00 and converts into common stock at a ratio of 1,000,000:1.  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, the Company 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 $24.9 million, net of issuance costs.

In May 2014, the Company issued and sold 4,880,954 shares of new Series C (“Series C”) preferred stock in a private placement at a purchase price of $14.36 per share for approximately $69.9 million, net of issuance costs.  The purpose of this share issuance was to raise funds for the below tender offer and general operating needs.
On June 18, 2014, the Company issued a Tender Offer Statement to purchase up to 1,392,757 shares, in the aggregate, of its Series A Preferred Stock and Series B Preferred Stock, or such lesser number of shares as were properly tendered and not properly withdrawn, at a price equal to $14.36 per share, net to seller in cash. The offer, expired on July 16, 2014.  Refer to Note 13, Subsequent Events, below for more details.

Convertible
Preferred Stock
 
Par
Value
   
Authorized, Issued and
Outstanding shares as of June 30, 2014
   
Liquidation Preference
($,000s)
 
New Series A
 
$
0.01
     
13,868,152
   
$
20,000
 
Series A-1
   
0.01
     
5,117,182
     
51,172
 
New Series B
   
0.01
     
8,288,734
     
25,000
 
New Series C
   
0.01
     
4,880,954
     
70,075
 
 
           
32,155,022
   
$
166,247
 

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

Dividends

Dividends on shares of the new Series A, new Series B and new Series C 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 until any declared dividends on the new Series A preferred stock, new Series B preferred stock and new Series C preferred stock have been paid or set aside for payment to the new Series A preferred stockholders, new Series B preferred stockholders and new Series C preferred stockholders. After payment of any such dividends, any additional dividends or distributions will be distributed among all holders of common stock and preferred stock in proportion to the number of shares of common stock that would be held by each such holder if all shares of preferred stock were converted to common stock at the then effective conversion rate. To date, no dividends have been declared on any of the Company’s preferred stock or common stock, and there are no dividends in arrears at June 30, 2014.

Conversion

Under the terms of the Company’s amended and restated certificate of incorporation, the holders of preferred stock have the right to convert such preferred stock into common stock at any time. In addition, all preferred stock automatically converts into common stock (i) immediately prior to the closing of an IPO that values the Company at least at $750 million and that results in aggregate proceeds to the Company of at least $100 million 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 addition, if a holder of the new Series A preferred stock has converted any of the new Series A preferred stock, 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, the Company shall pay such holder cash in an amount equal to the fair market value of such fractional shares, as determined by the Board of Directors. At present, the new Series A preferred stock, new Series B preferred stock and the new Series C preferred stock converts into the Company common stock at a 1:1 ratio while the Series A-1 preferred stock converts into the Company common stock at a 1,000,000:1 ratio.
Liquidation Rights

Each holder of new Series A preferred stock, new Series B preferred stock and new Series C preferred stock is entitled to receive, on a pari passu basis, prior and in preference to any distribution of proceeds from a liquidation event to the holders of Series A-1 preferred stock or common stock, an amount per share for each share of new Series A preferred stock, new Series B preferred stock and new Series C preferred stock equal to the sum of the liquidation preference specified for such share and all declared but unpaid dividends, if any, on such share. After the payment or setting aside for payment to the holders of new Series A preferred stock, new Series B preferred stock and new Series C preferred stock, the holders of Series A-1 preferred stock are entitled to receive, prior and in preference to any distribution of proceeds to the holders of common stock an amount per share for each such share of Series A-1 preferred stock equal to the sum of the liquidation preference specified for such share and all declared but unpaid dividends, if any, on such share. After the payment or setting aside for payment to the holders of new Series A preferred stock, new Series B preferred stock, new Series C preferred stock and Series A-1 preferred stock, the entire remaining proceeds legally available for distribution will be distributed pro rata to the holders of new Series A preferred stock and common stock in proportion to the number of shares of common stock held by them assuming the new Series A preferred stock has been converted into shares of common stock at the then effective conversion rate, provided that the maximum aggregate amount per share of new Series A preferred stock which the holders of new Series A preferred stock shall be entitled to receive is three times the original issue price for the new Series A preferred stock. At present, the liquidation preferences are equal to $1.44215155 per share for the new Series A preferred stock, $10.00 per share for the Series A-1 preferred stock, $3.01613647 per share for the new Series B preferred stock and $14.356821052 per share for the new Series C preferred stock.

Voting

Each holder of shares of preferred stock is 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 has voting rights and powers equal to the voting rights and powers of the common stock.  The holders of preferred stock and the holders of common stock vote together as a single class (except with respect to certain matters that require separate votes or as required by law), and are entitled to notice of any stockholders’ meeting in accordance with the bylaws of the Company.

Authorized and Outstanding Shares:
 
The Company, through its amended and restated certificate of incorporation, is the sole issuer of common stock and related options and warrants. On October 29, 2013, the Company amended and restated its certificate of incorporation to effect a 10-for-1 reverse stock split. On May 15, 2014, the Company amended and restated its certificate of incorporation to effect an increase in authorized shares of stock.  The total number of shares of stock which the Company has the authority to issue is 80,083,905, consisting of 47,928,883 shares of common stock, $0.01 par value per share, and 32,155,022 shares of preferred stock, $0.01 par value per share, 13,868,152 of which are designated as new Series A preferred stock, 5,117,182 of which are designated as Series A-1 preferred stock and 8,288,734 of which are designated new Series B preferred stock and 4,880,954 of which are designated as Series C preferred stock.  As of June 30, 2014, 14,236,119 shares of common stock were issued and outstanding.  As of December 31, 2013, 13,720,214 shares of common stock were issued and outstanding.  Each holder of common stock is entitled to one vote for each share of common stock held.

Common Stock Issued for Services

Nonemployees

The Company did not grant any immediately vested common shares to nonemployees for services during the six months ended June 30, 2014. During the year ended December 31, 2013, the Company granted an immediately vested option to purchase 47,601 common shares to a nonemployee for services.
Common Stock Issued upon Exercise of Stock Options

During the six months ended June 30, 2014 and the year ended December 31, 2013, the Company issued 509,062 and 7,327,959 shares of common stock, respectively, upon the exercise of options for cash proceeds of $0.31 million and $0.86 million, respectively, of which 418,875 and 6,499,463 were unvested, respectively.   Certain options are eligible for exercise prior to vesting. These unvested options may be exercised for restricted shares of common stock that have the same vesting schedule as the options. The Company records a liability for the exercise of unvested shares, which is reclassified to common stock and additional paid-in capital as the shares vest.  Should the holder’s employment be terminated, the unvested restricted shares are subject to repurchase by the Company at the purchase price paid for such shares. At June 30, 2014 and December 31, 2013, there were 4,825,667 and 5,594,134 shares respectively of restricted stock outstanding that remain unvested and subject to the Company’s right of repurchase.
 
For the six months ended June 30, 2014, the Company repurchased 101,980 shares of restricted stock for $0.01 million, upon termination of employment of various employees.

The number of shares reflects a 10-for-1 reverse stock split effected by the Company on October 29, 2013.

Common Stock Issued upon Exercise of Stock Warrants

For the six months ended June 30, 2014 the Company issued 70,372 shares of common stock, upon the exercise of warrants for $1.20.

The number of shares reflects a 10-for-1 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 the Company’s common stock on the date of grant. Non-statutory stock options are granted to consultants, directors and employees who have more the $100,000 of incentive stock options that are first exercisable during the year in which the non-statutory stock options are granted.  Non-statutory stock options are granted at an exercise price not less than 100% of the fair value of the Company’s common stock on the date of grant. If options are granted to stockholders who hold 10% or more of the Company’s common stock on the option grant date, then the exercise price shall not be less than 110% of the fair value of the Company’s common stock on the date of grant. The fair value is based on a good faith estimate by the Board of Directors’ compensation committee 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.

In 2005, the Company’s stockholders approved the adoption of the 2005 Plan. On December 1, 2010, the Company’s stockholders approved the adoption of the Amended and Restated 2005 Stock Plan (as amended and restated, the “Plan”). Under the Plan, options to purchase up to 187,946 shares of common stock were reserved and may be granted to employees, directors, and consultants by the Board of Directors and stockholders to promote the success of the Company’s business. During 2011, the Board of Directors and stockholders of the Company increased the total number of options under the Plan by an additional 455,087 for a total of 1,353,966 available for grant. During 2012, the Board of Directors, either directly or through the compensation committee, and stockholders of the Company increased the total number of options under the Plan by an additional 170,000 for a total of 1,523,966, available for grant. During 2013, the Board of Directors, either directly or through the compensation committee, and stockholders of the Company 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. During the first six months of 2014, the Board of Directors, either directly or through the compensation committee, and stockholders of the Company increased the total number of options under the Plan by an additional 1,560,464 for a total of 14,195,255.
Option activity under the Plan is summarized as follows for the periods below:

 
     
Weighted-
 
 
 
Options Issued
   
Average Exercise
 
 
 
and Outstanding
   
Price
 
 
 
   
 
Balance as of January 1, 2014
   
938,585
   
$
1.39
 
Options granted (weighted average fair value of $0.30)
   
4,048,879
     
0.57
 
Options exercised - vested
   
(157,312
)
   
0.68
 
Options exercised - nonvested
   
(351,750
)
   
0.52
 
Options canceled
   
(139,941
)
   
2.36
 
Balance as of June 30, 2014
   
4,338,461
   
$
1.08
 
 
               
Options outstanding and exercisable at June 30, 2014
   
1,447,292
   
$
0.80
 

The share amounts and share prices reflect a 10-for-1 reverse stock split effected by the Company on October 29, 2013.

Other Information Regarding Stock Options

Additional information regarding the Company’s common stock options outstanding as of June 30, 2014 is as follows:

   
Options Outstanding
   
Options Exercisable
 
Range of
Exercise
Prices
   
Number
Outstanding
   
Weighted –
Avg.
Remaining
Life
   
Weighted –
Avg.
Exercise
Price
   
Number
Vested
   
Weighted -
Avg.
Exercise
Price
 
$
0.10 - $0.10
     
201,088
     
9.12
   
$
0.10
     
45,234
   
$
0.10
 
 
0.57 - 0.57
     
3,545,879
     
9.64
     
0.57
     
883,385
     
0.57
 
 
1.20 - 1.20
     
139,204
     
7.21
     
1.20
     
118,866
     
1.20
 
 
1.70 - 1.70
     
124,450
     
7.88
     
1.70
     
73,135
     
1.70
 
 
2.00 - 2.00
     
299,990
     
6.06
     
2.00
     
298,822
     
2.00
 
 
5.00 - 5.00
     
7,000
     
2.25
     
5.00
     
7,000
     
5.00
 
 
5.60 - 5.60
     
18,250
     
5.21
     
5.60
     
18,250
     
5.60
 
 
19.40 - 19.40
     
2,600
     
4.53
     
19.40
     
2,600
     
19.40
 
$
0.10 - $19.40
     
4,338,461
     
9.21
   
$
0.74
     
1,447,292
   
$
0.80
 

The number of options reflects a 10-for-1 reverse stock split effected by the Company on October 29, 2013.

The number of options outstanding, vested and expected to vest as of June 30, 2014 was 3,813,281 and the weighted-average remaining contractual life was 9.21 years.

No compensation expense is recognized for unvested shares that are forfeited upon termination of service, and the stock-based compensation expense for the six months ended June 30, 2014 and 2013 reflect the expenses that the Company expects to recognize after the consideration of estimated forfeitures.

The Company 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, the Company may be required to record adjustments to stock-based compensation expense in future periods.

The fair value of the Company’s stock option awards for the three and six months ended June 30, 2014 and 2013 was estimated at the date of grant using the Black-Scholes model with the following average assumptions:

 
 
Three Months ended
   
Six Months ended
 
 
 
June 30,
   
June 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
Volatility of common stock
   
73.31
%
  **
 
   
73.31
%
   
73.43
%
Risk-free interest rate
   
1.92
%
  **    
1.97
%
   
0.82
%
Expected life*
 
6.1 years
    **  
6.08 years
   
8.7 years
 
Dividend yield
   
0
%
  **    
0
%
   
0
%
Weighted-average fair value of grants
 
$
0.07
    **  
$
0.05
   
$
0.01
 

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

** No stock options were granted during the three months ended June 30, 2013.

The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility. Because the Company'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 reflected in the statements of operations for the six months ended June 30, 2014 and 2013 is $0.50 million and $0.08 million, respectively, and $0.24 million and $0.03 million for the three months ended June 30, 2014 and 2013. As of June 30, 2014, the unamortized stock-based compensation expense related to PMI employees’ unvested stock-based awards was approximately $1.0 million, which will be recognized over the remaining weighted-average vesting period of approximately 2.5 years.

9. Income Taxes

As part of the process of preparing the condensed consolidated financial statements, the Company 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 condensed consolidated balance sheets. The Company 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 three and six months ended June 30, 2014 and 2013, 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 are under non-cancelable operating leases that expire in December 2014 and August 2014, respectively.

Future minimum rental payments under these leases as of June 30, 2014 are as follows (in thousands):

2014
 
$
234
 
2015
 
 
187
 
2016
 
416
 
2017
 
 
425
 
2018
 
 
433
 
2019
 
 
442
 
2020
 
 
450
 
2021
 
 
225
 
Total future operating lease obligations
 
$
2,812
 

Rental expense under premises-operating lease arrangements was $0.2 million and $0.2 million for the three months ended June 30, 2014 and 2013, respectively.  Rental expense under premises-operating lease arrangements was $0.3 million and $0.3 million for the six months ended June 30, 2014 and 2013, respectively.

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

The Company 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 Notes.  The Company 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, the Company sold approximately $178.0 million of Borrower Loans to investor members through the old platform structure, whereby the Company assigned promissory notes directly to investor members. The Company did not register the offer and sale of the promissory notes corresponding to these Borrower Loans under the Securities Act or under the registration or qualification provisions of any state securities laws. The Company believes that 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, the Company would have failed to comply with the registration and qualification requirements of federal and state laws.

The Company’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, the Company and the North American Securities Administrators Association (“NASAA”) reached agreement on the terms of a model consent order between the Company and the states in which the Company offered promissory notes for sale prior to November 2008. The consent order involves payment by the Company of up to an aggregate of $1million in penalties, which have been allocated among the states based on the Company’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 million in exchange for its agreement to terminate, or refrain from initiating, any investigation of the Company’s promissory 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. The Company 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 the Company, subject to any applicable statute of limitations. As of June 30, 2014, the Company has entered into consent orders with 34 states and has paid an aggregate of $0.47 million in penalties to those states.

As of June 30, 2014 and December 31, 2013, the Company had accrued approximately $0.25 million  and $0.25 million, 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 million maximum fee pro-rata by state, using the Company’s promissory 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 a likelihood that the penalty will be claimed. In estimating the probability of a claim being made by a state, the Company 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 the Company; 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. The Company will continue to evaluate this accrual and related assumptions as new information becomes known.

In 2008, plaintiffs filed a class action lawsuit against the Company and certain of its executive officers and directors in the Superior Court of California, County of San Francisco, California. 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 the Company offered and sold unqualified and unregistered securities in violation of the California and federal securities laws. 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 class action litigation agreed to enter into a settlement to resolve all claims related thereto (the “Settlement”). In connection with the Settlement, the Company agreed to pay an aggregate amount of $10 million into a settlement fund, split into four annual installments of $2 million in 2014, $2 million in 2015, $3 million in 2016 and $3 million in 2017. The Settlement received final approval in a final order and judgment entered by the Superior Court on April 16, 2014. Pursuant to the final order and judgment, the claims in the class action were dismissed, and at the effective time of the Settlement (June 16, 2014), the defendants will have been released by the plaintiffs from all claims that were or could have been asserted concerning the issues alleged in the class action lawsuit. The reserve for the class action settlement liability is $8 million in the condensed consolidated balance sheet as of June 30, 2014.
 
On July 1, 2011, the Company and Greenwich entered into a Stipulated Order of Judgment pursuant to which the Company agreed to dismiss its remaining claims against Greenwich. On August 12, 2011, Greenwich filed a notice of appeal of the court's decision regarding Greenwich’s duty to defend up to $2 million.
11. Related Parties

Since the Company’s inception, it has engaged in various transactions with its directors, executive officers and holders of more than 5% of its voting securities, and immediate family members and other affiliates of its directors, executive officers and 5% stockholders.

Certain of the Company’s executive officers, directors who are not executive officers, and affiliates participate on the Company’s lending platform by placing bids and purchasing Notes and Borrower Loans.  The aggregate amount of Notes and Borrower Loans purchased and the income earned by parties deemed to be affiliates and related parties of the Company as of June 30, 2014 and 2013 are summarized below (amounts in thousands):
 
 
 
Related Party
 
Aggregate Amount of Notes
and Borrower Loans
Purchased June 30,
   
Income Earned on Notes
and Borrower Loans
six months ended June 30,
 
   
2014
   
2013
   
2014
   
2013
 
Executive officers and management
 
$
1,853
   
$
722
   
$
154
   
$
142
 
Directors
   
5,038
     
4,323
     
928
     
25
 
 
 
$
6,891
   
$
5,045
   
$
1,082
   
$
167
 

The Notes and Borrower Loans of parties deemed to be affiliates and related parties of the Company, 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 $0.40 million or 6% of principal and $0.31 million or 6% of principal has been charged off through June 30, 2014 and 2013, respectively. The Company has earned approximately $0.01 million in servicing fee revenue related to these Notes and Borrower Loans for the three months ended June 30, 2014 and 2013, respectively.

12. Post-retirement Benefit Plans

The Company 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.  The Company’s contributions to the plan are discretionary. During the six months ended June 30, 2014, the Company has contributed $0.19 million to the plan.

13. Subsequent Events

On June 18, 2014, the Company issued a Tender Offer Statement to purchase 1,392,757 shares, in the aggregate, of its Series A Preferred Stock and Series B Preferred Stock, or such lesser number of Shares as were properly tendered and not properly withdrawn, at a price equal to $14.36 per share, to the seller in cash. Upon closure of the tender offer on July 16, 2014, 156,508 shares of Series A Preferred Stock and 1,133,558 share of Series B Preferred Stock were purchased for a total price of $18.5 million.
 
On August 1, 2014, the Company executed an office lease for 47,905 square feet of office space located in San Francisco, California. The lease term is eight years three months with an anticipated commencement date on or about December 1, 2014.
Prosper Funding LLC
Condensed Consolidated Balance Sheets
(Unaudited)
(amounts in thousands)

 
 
June 30,
2014
   
December 31,
2013 *
 
Assets
 
   
 
Cash and cash equivalents
 
$
2,014
   
$
5,789
 
Restricted cash
   
14,270
     
12,299
 
Loans held for investment at fair value
   
9,543
     
3,917
 
Borrower loans receivable at fair value
   
246,861
     
226,238
 
Property and equipment, net
   
2,046
     
1,980
 
Other assets
   
19
     
14
 
Total Assets
 
$
274,753
   
$
250,237
 
 
               
Liabilities and Member’s Equity
               
Accounts payable and accrued liabilities
 
$
3,756
   
$
3,712
 
Notes at fair value
   
246,511
     
226,794
 
Repurchase and indemnification obligation
   
146
     
32
 
Related party payable
   
174
     
205
 
Total Liabilities
   
250,587
     
230,743
 
 
               
Member's Equity
               
Member's equity
   
16,076
     
16,076
 
Retained earnings
   
8,090
     
3,418
 
Total Member's Equity
   
24,166
     
19,494
 
Total Liabilities and Member's Equity
 
$
274,753
   
$
250,237
 

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

* Derived from the Company’s audited consolidated financial statements.
Prosper Funding LLC
Condensed Statements of Operations
(Unaudited)
(amounts in thousands)

 
 
Three months ended June 30,
   
Six months ended June 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
Revenues
 
   
   
   
 
Administration Fee Revenue - related party
 
$
6,898
   
$
1,528
   
$
10,951
   
$
2,135
 
Interest Income on Borrower Loans
   
10,517
     
8,563
     
20,567
     
13,636
 
Interest Expense on Notes
   
(9,494
)
   
(8,127
)
   
(18,763
)
   
(12,946
)
Other revenues (expenses)
   
(155
)
   
-
     
201
     
-
 
Total Revenues
   
7,766
     
1,964
     
12,956
     
2,825
 
 
                               
Cost of Revenues
                               
Cost of Services
   
(654
)
   
(338
)
   
(1,051
)
   
(563
)
Provision for repurchase and indemnification obligation
   
(56
)
   
(50
)
   
(118
)
   
(149
)
Net revenues
   
7,056
     
1,576
     
11,787
     
2,113
 
 
                               
Operating Expenses
                               
Administration Fee Expense - related party
   
4,234
     
631
     
6,840
     
1,012
 
Depreciation and Amortization
   
253
     
124
     
487
     
207
 
Professional Services
   
-
     
5
     
12
     
20
 
Other Operating Expenses
   
77
     
50
     
166
     
94
 
Total Operating Expenses
   
4,564
     
810
     
7,505
     
1,333
 
Income  Before Other Income and Expenses
   
2,492
     
766
     
4,282
     
780
 
 
                               
Other Income and Expenses
                               
Interest Income
   
1
     
-
     
1
     
-
 
Change in FV on Borrower Loans, Loans Held for Investment and Notes, net
   
91
     
312
     
389
     
487
 
Total Other Income and Expenses, net
   
92
     
312
     
390
     
487
 
 
                               
Income  Before Income Taxes
   
2,584
     
1,078
     
4,672
     
1,267
 
Provision For Income Taxes
   
-
     
-
     
-
     
-
 
Total Net Income
 
$
2,584
   
$
1,078
   
$
4,672
   
$
1,267
 

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

 
 
 
Six Months
Ended
June 30,
2014
   
Six Months
Ended
June 30,
2013
 
 
 
   
 
Cash flows from operating activities:
 
   
 
Net income
 
$
4,672
   
$
1,267
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Change in fair value of borrower loans
   
958
     
4,082
 
Change in fair value of loans held for investment
   
3
     
3
 
Change in fair value of notes
   
(1,350
)
   
(4,573
)
Depreciation and amortization
   
487
     
207
 
Provision for repurchase and indemnification obligation
   
114
     
124
 
Changes in operating assets and liabilities:
               
Restricted cash
   
(1,971
)
   
25
 
Other assets
   
(5
)
    -  
Accounts payable and accrued liabilities
   
44
     
430
 
Related party payable
   
(31
)
   
(71
)
Net cash provided by operating activities
   
2,921
     
1,494
 
 
               
Cash flows from investing activities:
               
Origination of borrower loans held at fair value
   
(330,464
)
   
(65,053
)
Repayments of borrower loans held at fair value
   
65,648
     
44,190
 
Proceeds from sale of borrower loans held at fair value
   
243,235
      -  
Purchases of property and equipment
   
(553
)
   
(509
)
Repayment of loans held for investment at fair value
   
312
     
49
 
Origination of loans held for investment at fair value
   
(111,927
)
   
(29
)
Proceeds from sale of loans held for investment at fair value
   
105,986
      -  
Net cash used in investing activities
   
(27,763
)
   
(21,352
)
 
               
Cash flows from financing activities:
               
Proceeds from issuance of notes held at fair value
   
86,713
     
65,053
 
Payment of notes held at fair value
   
(65,646
)
   
(43,565
)
Net cash included in transfer of assets from PMI
   
     
1,875
 
Net cash provided by financing activities
   
21,067
     
23,363
 
 
               
Net (decrease) increase in cash and cash equivalents
   
(3,775
)
   
3,505
 
Cash and cash equivalents at beginning of the period
   
5,789
     
5
 
Cash and cash equivalents at end of the period
 
$
2,014
   
$
3,510
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
Prosper Funding LLC
Notes to Condensed Consolidated Financial Statements
(Unaudited)

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 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 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 such Notes or 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.  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.

A borrower member who wishes to obtain a loan through the platform must post a loan listing, or listing, on the platform. Prosper Funding allocates listings to one of two investor member funding channels: (i) the first channel allows investor members to commit to purchase Notes, the payments of which are dependent on the payments made on the corresponding Borrower Loan (the “Note Channel”); and (ii) the second channel allows investor members to commit to purchase 100% of a Borrower Loan directly from the Company (the “Whole Loan Channel”).

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 June 30, 2014. 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.  WebBank does not have any obligation to purchasers of the Notes.

Prosper Funding formed Prosper Asset Holdings LLC (“PAH”) in November 2013 as a limited liability company with the sole equity member being Prosper Funding. PAH was formed to purchase Borrower Loans from Prosper Funding and sell the Borrower Loans to third parties.
2. Summary of Significant Accounting Policies

Basis of Presentation

Prosper Funding’s 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, 2013. The balance sheet at December 31, 2013 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 Prosper Funding and its wholly-owned subsidiary PAH. All intercompany balances and transactions between Prosper Funding and PAH have been eliminated in consolidation.

Use of Estimates

The preparation of Prosper Funding’s 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 condensed consolidated 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 and associated Notes, valuation of servicing rights, repurchase and indemnification obligation, valuation allowance on deferred tax assets, 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, and restricted cash. Prosper Funding places cash, cash equivalents, and restricted cash 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 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 Borrower Loan payments are not made, servicing income will be reduced.  A series of Notes corresponding to a particular Borrower Loan is wholly dependent on the repayment of such Borrower Loan. As a result, Prosper Funding does not bear the risk on such Borrower Loan.

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 consolidated 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 for loan funding and servicing activities.

Borrower Loans and Notes

Prosper Funding has adopted the provisions of ASC Topic 825, Financial Instrument.  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 records 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 funded through the Note Channel 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 Prosper Funding’s 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.  Prosper Funding has reported the aggregate fair value of the Borrower Loans and Notes funded through the Note Channel 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.

Borrower Loans Sold Directly to Third Party Purchasers

For Borrower Loans sold to unrelated third party purchasers on a servicing retained basis through the Whole Loan Channel, a gain or loss is recorded on the sale date. In order to calculate the gain or loss, Prosper Funding first determines whether the terms of the servicing arrangement with the purchaser results in a net servicing asset (i.e., when contractual/expected servicing revenues adequately compensate Prosper Funding) or a net servicing liability (i.e., when contractual/expected servicing revenues do not adequately compensate Prosper Funding). When contractual/expected servicing revenues do not adequately compensate Prosper Funding, a portion of the gross proceeds of the Borrower Loans sold on a servicing retained basis are allocated to the recording of a net servicing liability. Conversely, when contractual/expected servicing revenues provide more than adequate compensation to Prosper Funding, the excess servicing compensation is allocated to the gross proceeds of the Borrower Loans sold and results in the recording of a net servicing asset. Prosper Funding estimates the fair value of the loan servicing asset or liability considering the contractual servicing fee revenue, adequate compensation for Prosper Funding's servicing obligation, the current principal balances of the Borrower Loans sold through the Whole Loan Channel and projected servicing revenues given projected defaults and prepayments (if significant) over the remaining lives of such Borrower Loans. Prosper Funding recorded a gain on sale of whole loans of $(0.2) million and $0 for the three months ended June 30, 2014 and 2013, respectively, which was included in other revenues on the condensed consolidated statements of operations.  Prosper Funding recorded a gain/(loss) on sale of whole loans of $0.2 million and $0 for the six months ended June 30, 2014 and 2013, respectively, which was included in Other revenues on the condensed consolidated statements of operations.  At June 30, 2014 and December 31, 2013, Prosper Funding recorded $0.7 million and $0.1 million as a servicing asset related to these Borrower Loans, which is included in Borrower loans receivable at fair value on the condensed consolidated balance sheets.
Loans Held for Investment

Loans held for investment are primarily comprised of Borrower Loans held for short durations and are recorded at cost which approximates fair value. For Borrower Loans held long term, the fair value is estimated using discounted cash flow methodologies based upon a set of valuation assumptions similar to those of other Borrower Loans, which are set forth in Note 2— Fair Value Measurement.

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, Borrower loans receivable, Loans held for investment, Accounts payable and accrued liabilities, and Notes.  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.

The following tables present the assets and liabilities measured at fair value on a recurring basis at June 30, 2014 and December 31, 2013 (in thousands):

June 30, 2014
 
Level 1
   
Level 2
   
Level 3
   
Fair
Value
 
Assets
 
   
   
   
 
Borrower loans receivable
 
$
-
   
$
-
   
$
246,861
   
$
246,861
 
Certificates of deposit & restricted cash
   
12,998
     
1,272
     
-
     
14,270
 
Loans held for investment
   
-
     
-
     
9,543
     
9,543
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
246,511
   
$
246,511
 

December 31, 2013
 
Level 1
   
Level 2
   
Level 3
   
Fair
Value
 
Assets
 
   
   
   
 
Borrower loans receivable
 
$
-
   
$
-
   
$
226,238
   
$
226,238
 
Certificates of deposit & restricted cash
   
11,028
     
1,271
     
-
     
12,299
 
Loans held for investment
   
-
     
-
     
3,917
     
3,917
 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
226,794
   
$
226,794
 

Internal Use Software and Website Development

Prosper Funding accounts for internal use software costs, including website development costs, 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. 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.

Repurchase and Indemnification Obligation

Under the terms of the Notes, the Lender Registration Agreements between Prosper Funding and investor members who participate in the Note Channel, and the loan purchase agreements between Prosper Funding and investor members that participate in the Whole Loan Channel, Prosper Funding may, in certain circumstances, become obligated to repurchase a Note or Borrower Loan from a investor member or indemnify a investor member against loss on a Note. Generally, these circumstances include the occurrence of verifiable identity theft, the failure to properly follow loan listing or bidding protocols, or a violation of the applicable federal, state, or local lending laws. The indemnification and repurchase obligation is estimated based on historical experience. Prosper Funding accrues a provision for the repurchase and indemnification obligation when the Notes or Borrower Loans are issued. Indemnified or repurchased Notes and repurchased Borrower Loans associated with violations of federal, state, or local lending laws or verifiable identity theft 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.
 
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. The license fees are based on the number of listings that are posted to the platform.
 
Interest Income on Borrower Loans Receivable and Interest Expense on Notes

Prosper Funding recognizes interest income on Borrower Loans funded through the Note Channel and interest expense on the corresponding Notes using the accrual method based on the stated interest rate to the extent Prosper Funding believes it to be collectable.  Below is a table which summarizes the gross interest income and expense for the three months ended June 30, 2014 and 2013 (in thousands).

 
 
Three months ended June 30,
   
Six months ended June 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
 
 
   
   
   
 
Interest income on borrower loans
 
$
10,517
   
$
8,563
   
$
20,567
   
$
13,636
 
Interest expense on motes
   
(9,494
)
   
(8,127
)
   
(18,763
)
   
(12,946
)
Net interest income
 
$
1,023
   
$
436
   
$
1,804
   
$
690
 

Comprehensive Income

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

Recent Accounting Pronouncements

 In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” The new guidance sets forth a new five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidance that have historically existed in U.S. GAAP. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The standard also requires more detailed disclosures and provides additional guidance for transactions that were not addressed completely in the prior accounting guidance. The standard will be effective for the Company in the first quarter of fiscal 2017. Early adoption is not permitted. The Company is currently assessing the potential impact on its financial statements from adopting this new guidance.
3. Borrower Loans and Notes Held at Fair Value

As observable market prices are not available for the Borrower Loans and Notes funded through the Note Channel that Prosper Funding holds, or for similar assets and liabilities, Prosper Funding believes such 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 such Borrower Loans are originated and the principal marketplace in which it might offer such Borrower Loans for sale may result in differences between the originated amount of the Borrower Loans and their fair value as of the transaction date.  For Borrower Loans funded through the Note Channel, 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 series of Notes 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 funded through the Note Channel 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 investor members 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 funded through the Note Channel, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to Note holders.  Any unrealized gains or losses on such 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 a series of Notes is less than the interest rate earned on the corresponding Borrower Loan due to the servicing fee.  See further discussion in this note for a roll-forward and further discussion of the significant assumptions used to value Borrower Loans and Notes funded through the Note Channel.
The fair value of the Borrower Loans and Notes funded through the Note Channel is estimated using discounted cash flow methodologies based upon a set of valuation assumptions. The main assumptions used to value such Borrower Loans and Notes include prepayment rates derived from historical prepayment rates for each credit grade, default rates derived from historical performance, recovery rates and discount rates applied to each credit grade based on the perceived credit risk of each credit grade. The obligation to pay principal and interest on any series of Notes 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 funded through the Note Channel, adjusted for the servicing fee and the timing of borrower payments subsequently disbursed to the Note holders.  The effective interest rate associated with a series of Notes will be less than the interest rate earned on the corresponding Borrower Loan due to the 1.0% servicing fee.

Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at June 30, 2014 for Borrower Loans and Notes funded through the Note Channel are presented in the following table (in thousands):

 
 
Borrower Loans
   
Notes
 
Discount rate assumption:
   
9.43
%*
   
9.43
%*
Resulting fair value from:
               
100 basis point increase
 
$
239,501
   
$
236,585
 
200 basis point increase
   
236,564
     
233,668
 
Resulting fair value from:
               
100 basis point decrease
 
$
245,558
   
$
242,591
 
200 basis point decrease
   
248,688
     
245,689
 
 
               
Default rate assumption:
   
7.00
%*
   
7.00
%*
Resulting fair value from:
               
10% higher default rates
 
$
239,687
   
$
236,768
 
20% higher default rates
   
236,761
     
233,869
 
Resulting fair value from:
               
10% lower default rates
 
$
245,132
   
$
242,152
 
20% lower default rates
   
247,726
     
244,721
 

* Represents weighted average assumptions considering all credit grades.
The changes in Level 3 assets measured at fair value on a recurring basis are as follows (in thousands):

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
 
 
Borrower Loans
   
Notes
   
Loans
Held for
Investment
   
Total
 
Balance at January 1, 2013
 
$
-
   
$
-
   
$
-
   
$
-
 
Assets transferred on February 1, 2013
   
170,344
     
(170,574
)
   
175
     
(55
)
Originations
   
65,053
     
(65,053
)
   
29
     
29
 
Principal repayments and credit losses
   
(44,190
)
   
43,565
     
(49
)
   
(674
)
Change in fair value on borrower loans and notes
   
(4,082
)
   
4,573
     
-
     
491
 
Change in fair value of loans held for investment
   
-
     
-
     
(3
)
   
(3
)
Balance at June 30, 2013
 
$
187,125
   
$
(187,489
)
 
$
152
   
$
(212
)

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
 
 
Borrower Loans
   
Notes
   
Loans
Held for
Investment
   
Total
 
Balance at January 1, 2014
 
$
226,238
   
$
(226,794
)
 
$
3,917
   
$
3,361
 
Originations
   
330,464
     
(86,713
)
   
111,927
     
355,678
 
Principal repayments and credit losses
   
(65,648
)
   
65,646
     
(312
)
   
(314
)
Borrower loans sold to third parties
   
(243,235
)
   
-
     
(105,986
)
   
(349,221
Change in fair value on borrower loans and notes
   
(958
)
   
1,350
     
-
     
392
 
Change in fair value of loans held for investment
   
-
     
-
     
(3
)
   
(3
)
Balance at June 30, 2014
 
$
246,861
   
$
(246,511
)
 
$