10-Q 1 form10q.htm PROSPER MARKETPLACE, INC 10-Q 9-30-2014

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 September 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  November 10, 2014
Prosper Marketplace, Inc.
 
14,430,808
($.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
Prosper Marketplace Inc.
 
7
8
9
10
11
Prosper Funding LLC
 
34
35
36
37
Item 2.
50
Item 3.
77
Item 4.
77
PART II.
OTHER INFORMATION
 
Item 1.
78
Item 1A.
78
Item 2.
78
Item 3.
78
Item 4.
78
Item 5.
79
Item 6.
87
88
89
 
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,” “expect,” “project,” “estimate,” “intend,” “anticipate,” “plan,” “continue” or similar expressions.  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)

 
 
September 30,
2014
   
December 31,
2013 *
 
Assets
       
Cash and cash equivalents
 
$
53,267
   
$
18,339
 
Restricted cash
   
16,951
     
15,473
 
Accounts receivable
   
921
     
218
 
Loans held for sale at fair value
   
16,350
     
3,917
 
Borrower loans receivable at fair value
   
253,068
     
226,094
 
Property and equipment, net
   
6,293
     
3,396
 
Prepaid and other assets
   
5,106
     
968
 
Total Assets
 
$
351,956
   
$
268,405
 
                 
Liabilities, Convertible Preferred Stock and Stockholders' Equity (Deficit)
               
Accounts payable and accrued liabilities
 
$
13,311
   
$
7,076
 
Class action settlement liability
   
7,830
     
9,739
 
Notes at fair value
   
252,911
     
226,794
 
Repurchase liability for unvested restricted stock awards
   
837
     
559
 
Repurchase and indemnification obligation
   
157
     
32
 
Total Liabilities
   
275,046
     
244,200
 
                 
Commitments and contingencies (see Note 11)
               
                 
Convertible preferred stock – Series A '13, A-1 '13, B '13 and C’14 ($0.01 par value; 32,155,022 authorized, 30,699,957 issued and outstanding as of September 30, 2014, and 27,274,068 shares  authorized, issued and outstanding as of December 31, 2013 ). (Aggregate liquidation preference of $160,952 and $96,172 as of September 30, 2014 and December 31, 2013, respectively).
   
111,443
     
45,118
 
                 
Stockholders' Equity (Deficit)
               
                 
Common stock ($0.01 par value; 47,928,883 shares authorized; 14,398,864 issued and outstanding as of September 30, 2014; and 41,487,465 shares authorized; 13,588,803 issued and outstanding as of December 31, 2013).
   
94
     
75
 
Additional paid-in capital
   
84,428
     
83,345
 
Less: treasury stock
   
(291
)
   
(291
)
Accumulated deficit
   
(118,764
)
   
(104,042
)
Total Stockholders' Equity (Deficit)
   
(34,533
)
   
(20,913
)
Total Liabilities, Convertible Preferred Stock and Stockholders' Equity (Deficit)
 
$
351,956
   
$
268,405
 

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.

* Please see note 14
 
Prosper Marketplace, Inc.
Condensed Consolidated Statements of Operations
(Unaudited)
(in thousands, except for share and per share amounts)
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues
               
Operating Revenues
               
Origination Fees, net
 
$
22,233
   
$
4,038
     
46,849
     
8,488
 
Servicing Fees, net
   
1,749
     
83
     
3,044
     
70
 
Other Revenues
   
1,147
     
378
     
2,090
     
810
 
Total Operating Revenues
   
25,129
     
4,499
     
51,983
     
9,368
 
Interest Income
                               
Interest income on borrower loans
   
10,705
     
8,799
     
30,995
     
24,785
 
Interest expense on notes
   
(9,850
)
   
(8,435
)
   
(28,613
)
   
(23,770
)
Net Interest income
   
855
     
364
     
2,382
     
1,015
 
Change in Fair Value of Borrower Loans, Loans Held for Sale and Notes, net
   
59
     
91
     
448
     
579
 
Total Net Revenues
   
26,043
     
4,954
     
54,813
     
10,962
 
                                 
Expenses
                               
Cost of Services
   
1,408
     
450
     
3,275
     
1,609
 
Compensation and Benefits
   
6,260
     
3,259
     
16,327
     
9,101
 
Marketing and Advertising
   
10,717
     
4,675
     
25,743
     
10,126
 
Depreciation and Amortization
   
462
     
229
     
1,201
     
643
 
Professional Services
   
582
     
399
     
1,169
     
1,781
 
Facilities and Maintenance
   
1,441
     
530
     
2,604
     
1,323
 
Class Action Settlement
   
-
     
-
     
-
     
10,000
 
Loss on Impairment of Fixed Assets
   
-
     
-
     
215
     
62
 
Other
   
2,449
     
375
     
4,097
     
1,132
 
Total Expenses
   
23,319
     
9,917
     
54,631
     
35,777
 
Net Income (Loss)
 
$
2,724
   
$
(4,963
)
   
182
     
(24,815
)
 
                         
Excess return to preferred shareholders on repurchase
   
(14,892
)
   
-
     
(14,892
)
   
-
 
Net Loss Available to Common Shareholders    
(12,168
)
   
(4,963
)
   
(14,710
)
   
(24,815
)
Net loss per share – basic and diluted
 
$
(1.31
)
   
(0.72
)
   
(1.68
)
   
(4.05
)
Weighted-average shares - basic and diluted net loss per share
   
9,280,334
     
6,927,648
     
8,740,785
     
6,119,987
 


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 Convertible Preferred Stock and Stockholders' Equity (Deficit)
(Unaudited)
(in thousands, except for share and per share amounts)
 
   
Convertible 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
   
$
45,118
     
13,588,803
   
$
75
     
(182,264
)
 
$
(291
)
 
$
83,345
   
$
(104,042
)
 
$
(20,913
)
Issuance of Convertible Preferred Stock, Series C'14
   
4,880,954
     
69,958
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Exercise of Vested Stock Options
   
-
     
-
     
56,323
     
1
     
-
     
-
     
71
     
-
     
72
 
Exercise of Nonvested Stock Options
   
-
     
-
     
796,828
     
-
     
-
     
-
     
-
     
-
     
-
 
Repurchase of Restricted Stock
   
-
     
-
     
(116,018
)
   
-
     
-
     
-
     
-
     
(12
)
   
(12
)
Restricted Stock Vested
   
-
     
-
     
-
     
17
     
-
     
-
     
147
     
-
     
164
 
Exercise of Warrants
   
-
     
-
     
72,928
     
1
     
-
     
-
     
88
     
-
     
89
 
Stock-based Compensation Expense
   
-
     
-
     
-
     
-
     
-
     
-
     
777
     
-
     
777
 
Repurchase of Preferred Stock
   
(1,455,065
)
   
(3,633
)
   
-
     
-
     
-
     
-
     
-
     
(14,892
)
   
(14,892
)
Net Income
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
182
     
182
 
Balance as of September 30, 2014
   
30,699,957
   
$
111,443
     
14,398,864
   
$
94
     
(182,264
)
 
$
(291
)
 
$
84,428
   
$
(118,764
)
 
$
(34,533
)
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
Prosper Marketplace, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(in thousands, except for share and per share amounts)

 
For the Nine Months Ended September 30,
 
   
2014
   
2013*
 
Cash Flows from Operating Activities:
       
Net Income (Loss)
 
$
182
   
$
(24,815
)
Adjustments to Reconcile Net Income (Loss) to Net Cash Used in Operating Activities:
               
Change in Fair Value of Borrower Loans
   
14,916
     
15,614
 
Change in Fair Value of Loans Held For Sale
   
11
     
3
 
Change in Fair Value of Notes
   
(15,375
)
   
(16,195
)
Depreciation and Amortization
   
1,201
     
643
 
Provision for Repurchase and Indemnification Obligation
   
125
     
20
 
Change in Servicing Rights
(803 ) -
Stock-based Compensation Expense
   
777
     
184
 
Loss on Impairment of Fixed Assets
   
215
     
62
 
Class Action Settlement Liability
   
(1,909
)
   
10,000
 
Changes in Operating Assets and Liabilities:
               
Restricted Cash Except for those Related to Investing Activities
   
-
     
(2,000
)
Accounts Receivable
   
(703
)
   
(122
)
Prepaid and Other Assets
   
(2,543
)
   
(305
)
Loans Held for Sale at Fair Value
   
(12,444
)
   
35
 
Accounts Payable and Accrued Liabilities
   
4,281
     
(421
)
Net Cash Used in Operating Activities
   
(12,069
)
   
(17,297
)
                 
Cash Flows from Investing Activities:
               
Origination of Borrower Loans Held at Fair Value
   
(823,841
)
   
(199,135
)
Repayment of Borrower Loans Held at Fair Value
   
88,944
     
65,504
 
Proceeds from Sale of Borrower Loans Held at Fair Value
   
693,007
     
80,786
 
Purchases of Property and Equipment
   
(3,151
)
   
(2,334
)
Maturities of Short Term Investments
   
     
1,000
 
Changes in Restricted Cash Related to Investing Activities
   
(1,478
)
   
(334
)
Net Cash Used in Investing Activities
   
(46,519
)
   
(54,513
)
                 
Cash Flows From Financing Activities:
               
Proceeds from Issuance of Notes Held at Fair Value
   
130,828
     
118,349
 
Payment of Notes Held at Fair Value
   
(89,336
)
   
(65,167
)
Proceeds from Issuance of Convertible Preferred Stock, Net
   
69,958
     
44,775
 
Proceeds from Early Exercise of Stock Options
   
454
     
650
 
Proceeds from Exercise of Vested Stock Options
   
72
     
207
 
Repurchase of Restricted Stock
   
(24
)
   
(4
)
Repurchase of Preferred Stock
   
(18,525
)
   
 
Proceeds from Exercise of Warrants
   
89
     
 
                 
Net Cash Provided by Financing Activities
   
93,516
     
98,810
 
                 
Net Increase in Cash and Cash Equivalents
   
34,928
     
27,000
 
Cash and Cash Equivalents at Beginning of the Period
   
18,339
     
2,300
 
Cash and Cash Equivalents at End of the Period
 
$
53,267
   
$
29,300
 
                 
Cash Paid for Interest
 
$
28,976
   
$
23,725
 
Non-Cash Investing Activity-Accrual for Property and Equipment Net
 
$
1,162
   
$
-
 

 The accompanying notes are an integral part of these condensed consolidated financial statements.
 
* Please see Note 14
 
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 consumer lender.

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”).

As of September 30, 2014, the platform is open to investors in 31 states and the District of Columbia. Additionally, as of September 30, 2014 the platform is open to borrowers in 47 states and the District of Columbia.  Currently our platform is not offered internationally.

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 generated income in the current period, however before the current quarter the Company had incurred net losses and negative cash flows from operations since inception.  There is an accumulated deficit of $118.8 million as of September 30, 2014.  At September 30, 2014, the Company had $53.3 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) raised through a new equity financing, is sufficient to meet its liquidity needs over the next year.
 
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, consisting of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

The accompanying interim condensed consolidated financial statements include the accounts of PMI and its wholly-owned subsidiary, Prosper Funding. All intercompany balances 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, including contingent liabilities 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, Borrower Loans held for sale, valuation of servicing rights, valuation allowance on deferred tax assets, repurchase and indemnification obligation, stock-based compensation expense, and contingent liabilities. 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 11—Commitments and Contingencies—Securities Law Compliance).

Reclassifications
 
During the nine months ended September 30, 2014, the Company changed the presentation of its revenues in the statement of operations.   A new line called “Servicing Fees” was created and the servicing fees related to whole loans that were previously included in interest income were reclassified to this new line.   Furthermore, the “Rebates and Promotions” line was removed, with the amounts in that line reclassified to the “Servicing Fees” or “Origination Fees” lines based on the underlying transactions.  Also, the “Change in Fair Value of Borrower Loans, Loans Held for Sale and Notes, Net” was moved into the total revenues subtotal.     Lastly, the subtotals were realigned to reflect the new presentation.   Management believes these changes make the income statement more useful for the readers of the financial statements and comparable with the Company’s competitors.
 
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 plus accrued interest, 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 long term leases, 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.  Management believes that the fair value option is more meaningful for the reader of the financial statements and it allows both the Borrower Loans and Notes to be valued using the same methodology.  The fair value election, with respect to an item, may not be revoked once an election is made.  A specific allowance account is not recorded relating to the Borrower Loans 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 expected payment, loss and recovery rates.
 
Servicing Asset/Liability
 
The Company records servicing assets and liabilities at their estimated fair values when the Company sells Borrower Loans to unrelated third-party buyers. The gain or loss on a loan sale is recorded in “Other Revenue” while the fair value of the servicing rights, which is based on the degree to which the contractual loan servicing fee is above or below an estimated market loan servicing fee is recorded in servicing assets or liabilities. Servicing assets and liabilities are recorded in “Prepaid and Other Assets” and “Accrued Expenses and Other Liabilities,” respectively, on the condensed consolidated balance sheets. The initial fair value of servicing assets or liabilities are amortized in proportion to and over the period of estimated servicing income or loss and are reported in “Servicing Fees” on the condensed consolidated statement of operations.
 
The Company uses a discounted cash flow model to estimate the fair value of the loan servicing assets or liabilities which considers the contractual projected servicing fee revenue that the Company earns on the loans, estimated market servicing fees to service such loans, prepayment rates, default rates and the current principal balances of the loans.

The Company periodically assesses servicing assets accounted for using the amortization method for impairment. Impairment occurs when the current fair value of the servicing assets falls below the asset’s carrying value (carrying value is the amortized cost reduced by any related valuation allowance). If servicing assets are impaired, the impairment is recognized in current-period earnings and the carrying value of the assets is adjusted through a valuation allowance. If the value of impaired servicing assets subsequently increases, the Company recognizes the increase in value in current-period earnings and adjusts the carrying value of the servicing assets through a reduction in the valuation allowance to adjust the carrying value only to the extent of the valuation allowance.
 
Loans Held for Sale

Loans held for sale are primarily comprised of Borrower Loans held for short durations and are recorded at fair value. 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. 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 sale, 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 September 30, 2014 and December 31, 2013 (in thousands):

September 30, 2014
 
Level 1
   
Level 2
   
Level 3
   
Fair
Value
 
Assets
               
Borrower loans receivable
 
$
-
   
$
-
   
$
253,068
   
$
253,068
 
Restricted cash
   
15,577
     
1,374
     
-
     
16,951
 
Loans held for sale
   
-
     
-
     
16,350
     
16,350
 
Total assets
 
$
15,577
   
$
1,374
   
$
269,418
   
$
286,369
 
                                 
Liabilities
                               
Notes
 
$
-
   
$
-
   
$
252,911
   
$
252,911
 

December 31, 2013
 
Level 1
   
Level 2
   
Level 3
   
Fair
Value
 
Assets
               
Borrower loans receivable
 
$
-
   
$
-
   
$
226,094
   
$
226,094
 
Restricted cash
   
14,032
     
1,441
     
-
     
15,473
 
Loans held for sale
   
-
     
-
     
3,917
     
3,917
 
Total assets
 
$
14,032
   
$
1,441
   
$
230,011
   
$
245,484
 
                                 
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 for maintenance and repairs as incurred.

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 Liability for Unvested Restricted Stock Awards

Under the terms of the Company’s stock option plan certain options issued to employees can be exercised before they have vested by the employee.  When this occurs the Company records a liability for the unvested portion of the exercise.  If the employee’s employment is terminated before all of the shares become vested the Company may repurchase the unvested shares at the original exercise price. The liability is released into Equity as the shares become vested.   The related shares are considered to be restricted shares and are excluded from the basic earnings per share calculation.         
 
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 an investor member or indemnify an 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 fair value of the indemnification and repurchase obligation is estimated based on historical experience. The Company recognizes a liability 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 primarily results from fees earned. Fees include loan origination fees paid by borrowers and servicing fees paid by investors. We also have other smaller sources of revenue reported as other revenue, this includes referral fees and gains on whole loan sales.
 
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 and Loans held for sale 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.

Service Fees 

Investors in whole loans typically pay the Company a servicing fee which is currently generally set at 1% per annum of the outstanding principal balance of the corresponding loan prior to applying the current payment. The servicing fee compensates the Company for the costs we incur in servicing the related loan, including managing payments from borrowers, payments to investors and maintaining investors’ account portfolios. Prosper records servicing fees paid by note holders and borrower loan holders as a component of operating revenue when received. The amortization of servicing rights is also included in this line.
             
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. 
 
Cost of Services

Cost of Services includes costs that are directly related to the origination and servicing of Borrower Loans such as verification fees and fees from WebBank for processing loan payments. 
 
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 $25.7 million and $10.1 million for the nine months ended September 30, 2014 and 2013, respectively.
 
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.

Net Loss Per Share

Net loss per share is computed in accordance with ASC Topic 260, Earnings Per Share. Under ASC Topic 260, basic net loss per share is computed by dividing net loss per share available to common shareholders by the weighted average number of common shares outstanding for the period and excludes the effects of any potentially dilutive securities. Diluted earnings per share, if presented, would include the dilution that would occur upon the exercise or conversion of all potentially dilutive securities into common stock using the “treasury stock” and/or “if converted” methods as applicable. At September 30, 2014, there were outstanding convertible preferred stock, warrants, restricted stock and options convertible into 30,699,957, 220,882, 4,768,109 and 4,540,101 common shares, respectively, which may dilute future earnings per share. At September 30, 2013, there were outstanding convertible preferred stock, warrants, restricted stock and options convertible into 22,156,922, 218,797, 6,461,797 and 979,483 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 available to common stockholders for the three and nine months ended September 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.

In August 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-15, "Presentation of Financial Statements - Going Concern (Subtopic 205-40); Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern," which requires management of a company to evaluate whether there is substantial doubt about the company's ability to continue as a going concern. This ASU is effective for the annual reporting period ending after December 15, 2016, and for interim and annual reporting periods thereafter, with early adoption 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.

At September 30, 2014 and December 31, 2013, borrower loans, notes and loans held for sale (in thousands) were: 

   
Borrower Loans
   
Notes
   
Loans Held for Sale
 
   
September 30, 2014
   
December 31, 2013
   
September 30, 2014
   
December 31, 2013
   
September 30, 2014
   
December 31, 2013
 
Aggregate principal balance outstanding
 
$
256,026
   
$
225,953
   
$
(258,947
)
 
$
(229,271
)
 
$
16,360
   
$
3,915
 
Fair value adjustments
   
(2,958
)
   
141
     
6,036
     
2,477
     
(10
)
   
2
 
Fair value
 
$
253,068
   
$
226,094
   
$
(252,911
)
 
$
(226,794
)
 
$
16,350
   
$
3,917
 
 
Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at September 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:
   
9.36
%*
   
9.36
%*
Resulting fair value from:
               
100 basis point increase
 
$
247,738
   
$
244,736
 
200 basis point increase
   
244,715
     
241,743
 
Resulting fair value from:
               
100 basis point decrease
 
$
253,975
   
$
250,912
 
200 basis point decrease
   
257,188
     
254,085
 
                 
                 
Default rate assumption:
   
7.40
%*
   
7.40
%*
Resulting fair value from:
               
10% higher default rates
 
$
247,275
   
$
244,275
 
20% higher default rates
   
244,418
     
241,452
 
Resulting fair value from:
               
10% lower default rates
 
$
253,729
   
$
250,663
 
20% lower default rates
   
256,584
     
253,493
 

* 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
Sale
   
Total
 
Balance at January 1, 2013
 
$
166,900
     
(167,478
)    
175
     
(403
Originations
   
199,135
     
(118,349
)
   
71
     
80,857
 
Principal repayments
   
(65,504
)
   
65,167
     
(106
)
   
(443
)
Borrower loans sold to third parties (80,786 ) - - (80,786 )
Change in fair value on borrower loans and notes
   
(15,614
)
   
16,195
     
-
     
581
 
Change in fair value of loans held for sale
   
-
     
-
     
(3
)
   
(3
)
Balance at September 30, 2013
 
$
204,131
     
(204,465
)
   
137
     
(197
)
 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
   
Borrower
Loans
   
Notes
   
Loans Held
for
Sale
   
Total
 
Balance at January 1, 2014
 
$
226,094
   
$
(226,794
)
 
$
3,917
   
$
3,217
 
Originations
   
823,841
     
(130,828
)
   
229,679
     
922,692
 
Principal repayments
   
(88,944
)
   
89,336
     
(899
)
   
(507
)
Borrower loans sold to third parties
   
(693,007
)
   
-
     
(216,336
)
   
(909,343
)
Change in fair value on borrower loans and notes
   
(14,916
)
   
15,375
     
-
     
459
 
Change in fair value of loans held for sale
                   
(11
)
   
(11
)
Balance at September 30, 2014
 
$
253,068
   
$
(252,911
)
 
$
16,350
   
$
16,507
 
 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
   
Borrower
Loans
   
Notes
   
Loans Held
for
Sale
   
Total
 
Balance July 1, 2013
 
$
187,124
   
$
(187,489
)
 
$
153
   
$
(212
)
Originations
   
94,098
     
(43,475
)
   
25
     
50,648
 
Principal repayments
   
(22,778
)
   
22,718
     
(41
)
   
(101
)
Borrower loans sold to third parties (50,623 ) - - (50,623 )
Change in fair value on borrower loans and notes
   
(3,690
)
   
3,781
     
-
     
91
 
Balance at September 30, 2013
 
$
204,131
   
$
(204,465
)
 
$
137
   
$
(197
)
 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
   
Borrower
Loans
   
Notes
   
Loans Held
for
Sale
   
Total
 
Balance July 1, 2014
 
$
246,203
   
$
(246,511
)
 
$
9,543
   
$
9,235
 
Originations
   
372,027
     
(44,115
)
   
117,752
     
445,664
 
Principal repayments
   
(31,226
)
   
31,620
     
(586
)
   
(192
)
Borrower loans sold to third parties
   
(327,909
)
   
-
     
(110,350
)
   
(438,259
)
Change in fair value on borrower loans and notes
   
(6,027
)
   
6,095
     
-
     
68
 
Change in fair value of loans held for sale
                   
(9
)
   
(9
)
Balance at September 30, 2014
 
$
253,068
   
$
(252,911
)
 
$
16,350
   
$
16,507
 

The changes in fair value would directly impact the change in fair value on Borrower Loans, Loans held for sale and Notes in the condensed consolidated statements of operations.  The majority of fair value adjustments included in earnings is attributable to changes in estimated instrument-specific future credit losses.

As September 30, 2014 the Borrower Loans that were 90 days or more delinquent, had an aggregate principal amount of $1.5 million and a fair value of $0.14 million.
 
4.
Loan Servicing Note:
 
The Company initially records servicing assets and liabilities at their estimated fair values when the Company sells whole loans to unrelated third-party whole loan buyers.   The initial fair value of such servicing assets or liabilities is amortized in proportion to and over the period of estimated servicing income or loss.

Fair value
 
Discounted cash flow – Discounted cash flow valuation techniques generally consist of developing an estimate of future cash flows that are expected to occur over the life of a financial instrument and then discounting those cash flows at a rate of return that results in the fair value amount.
 
Significant unobservable inputs presented in the table below are those that the Company considers significant to the estimated fair values of the Level 3 servicing assets and liabilities. The Company considers unobservable inputs to be significant, if by their exclusion, the estimated fair value of the Level 3 asset or liability would be impacted by a significant percentage change, or based on qualitative factors such as the nature of the instrument and significance of the unobservable inputs relative to other inputs used within the valuation. The following is a description of the significant unobservable inputs provided in the table.
 
Market servicing rate – The Company estimates adequate servicing compensation rates of what a market participant would earn to service the loans that the Company sells to third parties. This rate is calculated on the loan balance on a per annum basis.  The Company estimated these market servicing rates based on observable market rates for other loan types in the industry, adjusted for the unique loan attributes that are present in the specific loans that the Company sells and services and information from a backup service provider.
 
Discount rate – The discount rate is a rate of return used to discount future expected cash flows to arrive at a present value, which represents the fair value of the loan servicing rights. The discount rates for the projected net cash flows of loan servicing rights are our estimates of the rates of return that investors in servicing rights for unsecured consumer credit obligations would require for the various credit grades of the underlying loans. Discount rates for servicing rights on existing loans are adjusted to reflect the time value of money. A risk premium component is implicitly included in the discount rates to reflect the amount of compensation market participants require due to the uncertainty inherent in the instruments’ cash flows resulting from risks such as credit and liquidity.
Default Rate – The default rate presented is an annualized, average estimate considering all loan categories, and represents an aggregate of conditional default rate curves for each credit grade or loan category. Each point on a particular loan category’s curve represents the percentage of principal expected to default per period based on the term and age of the underlying loans. The assumption regarding defaults directly reduces servicing revenues because the amount of servicing revenues received is based on the amount of outstanding principal each period. In addition, defaults also reduce the expected terms of the loans, which are used to project future servicing revenues.
    
Significant Unobservable Inputs
 
The following table presents quantitative information about the significant unobservable inputs used for our servicing asset/liability fair value measurements at September 30, 2014 and December 31, 2013:
 
   
Weighted Average
 
Unobservable Input
 
September 30, 2014
   
December 31, 2013
 
Discount rate
   
9.6
%**
   
9.9
%**
Default rate
   
5.5
%**
   
5.6
%**
Market servicing rate
   
0.65
%
   
0.65
%
 
** Represents weighted average or aggregate assumptions considering all credit grades.
 
Servicing asset/liability activity:
 
 
The following tables present additional information about Level 3 servicing assets and liabilities being amortized for the three and nine months ended September 30, 2014 (in thousands).  There were no servicing assets or liabilities recorded at September 30, 2013.
 
 
 
Three Months Ended
September 30, 2014
 
 
 
Servicing
Assets
   
Servicing
Liabilities
 
Amortized cost at June 30, 2014
 
$
968
   
$
857
 
Additions
   
1,044
     
414
 
Less: Amortization
   
(157
)
   
(140
)
Amortized cost at September 30, 2014
 
$
1,855
   
$
1,131
 
 
 
 
Nine Months Ended
September 30, 2014
 
 
 
Servicing
Assets
   
Servicing
Liabilities
 
Amortized cost at December 31, 2013
 
$
260
   
$
339
 
Additions
   
1,873
     
1,064
 
Less: Amortization
   
(278
)
   
(272
)
Amortized cost at September 30, 2014
 
$
1,855
   
$
1,131
 
 
5. Loans Held for Sale

Loans held for sale on the condensed consolidated balance sheets as of September 30, 2014 and December 31, 2013, was $16.4 million and $3.9 million, respectively. For the nine months ended September 30, 2014 and 2013, a total of $229.7 million and $0.07 million of Borrower Loans was originated through the platform as Loans held for sale. For the nine months ended September 30, 2014 and 2013, $216.3 million and $0 of these Borrower Loans were sold to unrelated third parties 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.
 
6. Repurchase and Indemnification Obligation

For the three months ended September 30, 2014 and 2013, the liability for repurchase and indemnification obligation was $0.03 million and $0.01 million, respectively. For the nine months ended September 30, 2014 and 2013, the liability for repurchase and indemnification obligations was $0.14 million and $0.02 million, respectively.   The expense was included in the cost of services line in the Statement of Operations.  The balance of the Repurchase and indemnification obligation as of September 30, 2014 and December 31, 2013, was $0.16 million and $0.03 million, respectively.
 
7.
Net Loss Per Share Available to Common Stockholders
 
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 September 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 available to common stockholders for the three and nine months ended September 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.
 
The adjustment from net income (loss) to net loss available to common shareholders represents the excess over cost paid to certain preferred shareholders upon repurchase of their preferred shares as described below in Note 8 Convertible Preferred Stock and Stockholders' Equity (Deficit). The weighted average shares used in calculating basic and diluted net loss per share excludes shares that are disclosed as outstanding shares in the Condensed Consolidated Balance Sheet and Condensed Consolidated Statement of Stockholders' Equity because such shares are restricted as they were associated with options that were early exercised and continue to remain unvested.
 
Basic and diluted net loss per share was calculated as follows (in thousands, except for share and per share amounts):
 
   
Three months ended
September 30,
   
Nine months ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Numerator:
               
Net loss available to common stockholders for basic and diluted EPS
 
$
(12,168
)
 
$
(4,963
)
 
$
(14,710
)
 
$
(24,815
)
Denominator:
                               
Weighted average shares used in computing basic and diluted net loss per share
   
9,280,334
     
6,927,648
     
8,740,785
     
6,119,987
 
Basic and diluted net loss per share
 
$
(1.31
)
 
$
(0.72
)
 
$
(1.68
)
 
$
(4.05
)
 
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 or if converted method, in accordance with ASC Topic 260:

 
Three and Nine months ended September 30
 
2014
2013
Excluded Securities:
(shares)
(shares)
Convertible preferred stock issued and outstanding
   
30,699,957
     
22,156,922
 
Stock options issued and outstanding
   
4,540,101
     
979,483
 
Unvested stock options exercised
   
4,768,109
     
6,461,797
 
Warrants issued and outstanding
   
220,882
     
218,797
 
Total common stock equivalents excluded from diluted net loss per common share computation
   
40,229,049
     
29,816,999
 

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

8. Convertible Preferred Stock and Stockholders’ Equity (Deficit)

Convertible 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, at a price equal to $14.36 per share. 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.
 
Convertible
Preferred Stock
 
Par
Value
   
Authorized, Issued and
Outstanding shares as of September 30, 2014
   
Liquidation Preference
($,000s)
 
New Series A
 
$
0.01
     
13,711,644
   
$
19,774
 
Series A-1
   
0.01
     
4,952,183
     
49,522
 
New Series B
   
0.01
     
7,155,176
     
21,581
 
New Series C
   
0.01
     
4,880,954
     
70,075
 
 
           
30,699,957
   
$
160,952
 

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 September 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
   
The Company’s convertible preferred stock has been classified as temporary equity on the accompanying balance sheets in accordance with authoritative guidance. The preferred stock is not redeemable; however, upon in the event of a voluntary or involuntary liquidation, dissolution, change in control or winding up of the Company, holders of the convertible preferred stock may have the right to receive its liquidation preference under the terms of the Company’s certificate of incorporation.
 
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 September 30, 2014, 14,216,600 shares of common stock were issued and outstanding.  As of December 31, 2013, 13,406,539 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 nine months ended September 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 nine months ended September 30, 2014 and the year ended December 31, 2013, the Company issued 853,151 and 7,327,959 shares of common stock, respectively, upon the exercise of options for cash proceeds of $0.53 million and $0.86 million, respectively, of which 796,828 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 September 30, 2014 and December 31, 2013, there were 4,768,109 and 5,594,134 shares respectively of restricted stock outstanding that remain unvested and subject to the Company’s right of repurchase.
 
For the nine months ended September 30, 2014, the Company repurchased 116,018 shares of restricted stock for $0.02 million, upon termination of employment of various employees.
 
Common Stock Issued upon Exercise of Stock Warrants

For the nine months ended September 30, 2014 the Company issued 72,928 shares of common stock, upon the exercise of warrants.
 
9. 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 incentive stock options that the underlying stock has a fair value greater than $100,000 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. 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.
 
 The activity of options that were early exercised under the plan as for the period below:
 
   
Early exercised
options, unvested
   
Weighted average
exercise price
 
Balance as of January 1, 2014
   
5,594,134
     
0.11
 
Exercise of non-vested stock options
   
796,828
     
0.57
 
Repurchase of restricted stock
   
(111,095
)
   
(0.10
)
Restricted stock vested
   
(1,511,758
)
   
(0.11
)
Balance as of Sept  30, 2014
   
4,768,109
     
0.18
 

Option activity under the Plan is summarized as follows for the period below:

 
 
 
Options Issued
and Outstanding
   
Weighted-
Average Exercise
Price
 
 
       
Balance as of January 1, 2014
   
938,585
   
$
1.39
 
Options granted (weighted average fair value of $0.30)
   
4,669,091
     
1.24
 
Options exercised – vested
   
(56,323
)
   
1.28
 
Options exercised – nonvested
   
(796,828
)
   
0.57
 
Options forfeited
   
(214,424
)
   
3.53
 
Balance as of September 30, 2014
   
4,540,101
   
$
0.91
 
                 
Options outstanding and exercisable at September 30, 2014
   
1,891,438
   
$
1.40
 

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 September 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
     
170,728
     
8.87
   
$
0.10
     
60,113
   
$
0.10
 
 
0.57 - 0.57
     
3,203,051
     
9.37
     
0.57
     
1,339,911
     
0.57
 
 
1.20 – 1.20
     
133,334
     
6.96
     
1.20
     
117,435
     
1.20
 
 
1.70 – 1.70
     
99,593
     
7.65
     
1.70
     
61,049
     
1.70
 
 
2.00 – 2.00
     
287,933
     
5.82
     
2.00
     
287,680
     
2.00
 
 
5.00 - 5.00
     
7,000
     
2.00
     
5.00
     
7,000
     
5.00
 
 
5.60 - 5.60
     
18,250
     
4.96
     
5.60
     
18,250
     
5.60
 
 
5.65-5.65
     
620,212
     
9.87
     
5.65
     
-
     
5.65
 
$
0.10 - $5.65
     
4,540,101
     
9.06
   
$
1.41
     
1,891,438
   
$
1.40
 

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 September 30, 2014 was 3,990,512 and the weighted-average remaining contractual life was 9.06 years.
 
No compensation expense is recognized for unvested shares that are forfeited upon termination of service, and the stock-based compensation expense for the nine months ended September 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 nine months ended September 30, 2014 and 2013 was estimated at the date of grant using the Black-Scholes model with the following average assumptions:

 
Three Months ended
September 30,
 
Nine Months ended
September 30,
 
 
2014
   
2013
 
2014
 
2013
 
Volatility of common stock
   
67.47
%
   
69.57
%
   
69.42
%
   
69.56
%
Risk-free interest rate
   
1.92
%
   
1.39
%
   
1.91
%
   
1.90
%
Expected life*
5.9 years
   
5.8 years
 
5.9 years
 
5.8 years
 
Dividend yield
   
0
%
   
0
%
   
0
%
   
0
%
Weighted-average fair value of grants
 
$
3.46
   
$
0.10
   
$
0.76
   
$
0.01
 

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

The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility, as a result 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 nine months ended September 30, 2014 and 2013 is $0.76 million and $0.18 million, respectively, and $0.27 million and $0.10 million for the three months ended September 30, 2014 and 2013. This expense is included in the Compensation and Benefits line in the Statements of Operations. As of September 30, 2014, the unamortized stock-based compensation expense related to PMI employees’ unvested stock-based awards was approximately $2.4 million, which will be recognized over the remaining weighted-average vesting period of approximately 3.3 years.

10. 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 nine months ended September 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.

11. Commitments and Contingencies

Future Minimum Lease Payments

During the period the Company signed new leases for the new corporate headquarters at 221 Main Street in San Francisco California and for the co-location facility are under non-cancelable operating leases that expire in February 2023 and August 2015, respectively.  The Company also signed a new lease for office space in Phoenix Arizona under an operating lease that expires in June 2022. 

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

Remaining three months of 2014
 
$
139
 
2015
   
2,459
 
2016
   
3,757
 
2017
   
3,866
 
2018
   
3,978
 
2019
   
4,093
 
Thereafter
   
12,981
 
Total future operating lease obligations
 
$
31,273
 

Rental expense under premises-operating lease arrangements was $0.7 million and $0.2 million for the three months ended September 30, 2014 and 2013, respectively.  Rental expense under premises-operating lease arrangements was $1.0 million and $0.5 million for the nine months ended September 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 September 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 September 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 $7.8 million in the condensed consolidated balance sheet as of September 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. This appeal was dismissed On October 22, 2012. 
 
12. 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 September 30, 2014 and 2013 are summarized below (amounts in thousands):

 
 
Related Party
Aggregate Amount of Notes
and Borrower Loans
Purchased September 30,
Income Earned on Notes
and Borrower Loans
nine months ended September 30,
 
2014
2013
2014
2013
Executive officers and management
 
$
2,100
   
$
806
   
$
83
   
$
30
 
Directors
   
5,198
     
4,578
     
81
     
204
 
   
$
7,298
   
$
5,384
   
$
164
   
$
234
 

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 $0.41 million or 6% of principal and $0.36 million or 7% of principal has been charged off through September 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 September 30, 2014 and 2013.
 
13. 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 nine months ended September 30, 2014, the Company has contributed $0.38 million to the plan.
 
14.
Prior Period Adjustments
   
Subsequent to the issuance of our condensed consolidated financial statements for the period ended June 30, 2014, Prosper Marketplace discovered an error in its estimates of net service income which resulted in an overstatement of net loan servicing rights as of December 31, 2013 and an overstatement of the gain recognized on the sale of loans which was included in other revenues in the fourth quarter of 2013 by approximately $223.  Furthermore, the Company inappropriately netted loan servicing liabilities against its loan servicing assets.  This resulted in a $223 overstatement of the loan servicing assets, which were originally included in “Borrower Loans Receivable at Fair Value” for $144.  The Company corrected this error by reclassifying the adjusted gross serving assets of $260 to “Prepaid and Other Assets and recognized the servicing liabilities of $339 in “Accounts Payable and Other Liabilities.

The Company also discovered an error related to measurement of the Class Action Settlement Liability.  Upon the courts preliminary approval of the settlement during the quarter ended December 31, 2013, this liability became payable at fixed future dates so the Company should have recognized the liability based on the present value of the future payments rather than the gross amount of such future payments.  This error resulted in an overstatement of the Class Action Settlement Liability and the Class Action Settlement expense recognized as of and for the year end December 31, 2013 of $261.

Additionally, the Company discovered that the Convertible Preferred Stock was incorrectly classified within permanent stockholders’ equity in its consolidated balance sheet as of December 31, 2013.  Since the Convertible Preferred Stockholders are entitled to receive their liquidation preference upon a change-in-control transaction the Convertible Preferred Stock should be classified as temporary equity.  This resulted in a $45,118 reclassification of the Convertible Preferred Stock from permanent equity to temporary equity as of December 31, 2013.
 

Lastly, the Company discovered the following classification errors within its Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2013:

· Changes in Restricted Cash were inappropriately classified as changes in cash flows from operating activities rather than changes in cash flows from investing activities.
· Cash flows from the purchase and sale of Loans held for sale was inappropriately classified within cash flows from investing activities rather than cash flows from operating activities.
· A portion of the change in fair value of Borrower Loans and Notes was inappropriately reflected as a cash flow from investing and financing activities, respectively, rather than an adjustment to reconcile net income to net cash used in operating activities.
·
The proceeds from sale of borrower loans held at fair value were netted against origination of borrower loans at fair value.
 
The aggregate impact of these errors were an understatement of cash flows from operating activities of $369; an overstatement of cash flows from investing activities of $12,080; and an $11,711understatement of cash flows from financing activities for the nine months ended September 30, 2013.
 
Finally, the Company corrected the number of outstanding common shares on the face of the balance sheet and in the Statements of Stockholders’ Equity as a result of an error in the calculation of restricted shares repurchased.  The number of common shares outstanding at December 31, 2013 was previously stated as 13,902,478 and has been corrected to 13,588,803.

The Company evaluated these errors and determined that they were immaterial to the previously issued financial statements and therefore, amendment of previously filed reports was not required. However, in order to provide consistency in the consolidated financial statements, corrections for these immaterial amounts are reflected in the Company’s accompanying Consolidated Balance Sheet as of December 31, 2013 and Consolidated Statement of Cash Flows for the nine months ended September 30, 2013.  The impact of the corrections on specific line items in the Consolidated Balance Sheet as of December 31, 2013 and the Condensed Consolidated Cash Flows for the nine months ended September 30, 2013 are presented below (in thousands):
 
Condensed Consolidated Statements of Cash Flows - Nine months ended September 30, 2013

   
As previously
reported
   
Adjustments
   
As corrected
 
Net income (loss)
 
$
(24,815
)
 
$
-
   
$
(24,815
)
Change in fair value of Borrower Loans
   
3,903
     
11,711
     
15,614
 
Change in fair value of Notes
   
(4,484
)
   
(11,711
)
   
(16,195
)
Restricted cash except for those related to investing activities
   
(2,334
   
334
     
(2,000
)
Loans held for sale at fair value
   
-
     
35
     
35
 
Net cash used in operating activities
   
(17,666
)
   
369
     
(17,297
)
Origination of Borrower Loans held at fair value
   
(118,349
)
   
(80,786
   
(199,135
)
Repayment of Borrower Loans held at fair value
   
77,215
     
(11,711
)
   
65,504
 
Proceeds from sale of Borrower Loans Held at Fair Value - 80,786 80,786
Repayment of Loans held for investment at fair value
   
106
     
(106
)
   
-
 
Origination of Loans held for investment at fair value
   
(71
)
   
71
     
-
 
Changes in restricted cash related to investing activities
   
-
     
(334
)
   
(334
)
Net cash used in investing activities
   
(42,433
)
   
(12,080
)
   
(54,513
)
Payment of Notes held at fair value
   
(76,878
)
   
11,711
     
(65,167
)
Net cash provided by financing activities
   
87,099
     
11,711
     
98,810
 

 
Condensed Consolidated Balance Sheet - December 31, 2013

   
As previously
reported
   
Adjustments
   
As corrected
 
Borrower Loans Receivable at Fair Value
 
$
226,238
   
$
(144
)
 
$
226,094
 
Prepaid and Other Assets
   
708
     
260
     
968
 
Total Assets
   
268,289
     
116
     
268,405
 
Accounts Payable and Accrued Liabilities
   
6,737
     
339
     
7,076
 
Class Action Settlement Liability 10,000 (261 ) 9,739
Repurchase Liability for Unvested Restricted Stock Awards 609 (50 ) 559
Total Liabilities
   
244,172
     
28
     
244,200
 
Convertible Preferred Stock
   
-
     
45,118
     
45,118
 
Convertible Preferred Stock
   
273
     
(273
)
   
-
 
Additional Paid in Capital
   
128,140
     
(44,795
)
   
83,345
 
Accumulated Deficit
   
(104,080
)
    38
 
   
(104,042
)
Total Stockholders' Equity (Deficit)
   
24,117
     
(45,030
)
   
(20,913
)
Total Liabilities, Convertible Preferred Stock and Stockholders' Equity (Deficit)
 
$
268,289
   
$
116
   
$
268,405
 
 
Prosper Funding LLC
Condensed Consolidated Balance Sheets
(Unaudited)
(amounts in thousands)

 
 
September 30,
2014
   
December 31,
2013 *
 
Assets
       
Cash and cash equivalents
 
$
2,862
   
$
5,789
 
Restricted cash
   
8,721
     
12,299
 
Loans held for sale at fair value
   
16,350
     
3,917
 
Borrower loans receivable at fair value
   
253,068
     
226,094
 
Property and equipment, net
   
2,048
     
1,980
 
Related party receivable
   
73
     
-
 
Other assets
   
1,450
     
255
 
Total Assets
 
$
284,572
   
$
250,334
 
                 
Liabilities and Member’s Equity
               
Accounts payable and accrued liabilities
 
$
4,684
   
$
4,026
 
Notes at fair value
   
252,911
     
226,794
 
Repurchase and indemnification obligation
   
157
     
32
 
Related party payable
   
-
     
205
 
Total Liabilities
   
257,752
     
231,057
 
                 
Member's Equity
               
Member's equity
   
15,877
     
16,082
 
Retained earnings
   
10,943
     
3,195
 
Total Member's Equity
   
26,820
     
19,277
 
Total Liabilities and Member's Equity
 
$
284,572
   
$
250,334
 

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

* Please see Note 8
 
Prosper Funding LLC
Condensed Consolidated Statements of Operations
(Unaudited)
(amounts in thousands)

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues
               
Operating Revenues
               
Administration Fee Revenue
 
$
8,574
   
$
2,042
   
$
19,525
   
$
4,178
 
Servicing Income, net
   
1,574
     
89
   
$
2,965
     
106
 
Other Revenues
   
635
     
-
     
814
     
-
 
Total Operating Revenues
   
10,783
     
2,131
     
23,304
     
4,284
 
Interest Income on Borrower Loans
   
10,724
     
8,892
     
31,014
     
22,391
 
Interest Expense on Notes
   
(9,850
)
   
(8,435
)
   
(28,613
)
   
(21,262
)
Net Interest Income
   
874
     
457
     
2,401
     
1,129
 
Change in Fair Value on Borrower Loans, Loans Held for Sale and Notes, net
   
59
     
91
     
448
     
578
 
Total Net Revenues
   
11,716
     
2,679
     
26,153
     
5,991
 
                                 
Expenses
                               
Cost of Services
   
958
     
292
     
2,297
     
1,004
 
Administration Fee Expense
   
6,836
     
1,520
     
15,018
     
2,534
 
Depreciation and Amortization
   
273
     
148
     
761
     
355
 
Professional Services
   
1
     
6
     
16
     
26
 
Other Operating Expenses
   
128
     
63
     
313
     
157
 
Total  Expenses
   
8,196
     
2,029
     
18,405
     
4,076
 
Total Net Income
 
$
3,520
   
$
650
   
$
7,748
   
$
1,915
 

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)

   
For the Nine Months Ended September 30,
 
   
2014
   
2013*
 
         
Cash flows from operating activities:
       
Net Income
 
$
7,748
   
$
1,915
 
Adjustments to reconcile net income to net cash  provided by (used in) operating activities:
               
Change in fair value of Borrower Loans
   
14,916
     
(16,195
)
Change in fair value of Loans held for sale
   
11
     
3
 
Change in fair value of Notes
   
(15,375
)
   
15,614
 
Initial Gain and Amortization of Servicing Rights
(808 )
Depreciation and amortization
   
761
     
355
 
Provision for repurchase and indemnification obligation
   
125
     
20
 
Changes in operating assets and liabilities:
               
Receivables and other assets
   
(21
)
   
 
Loans held for sale at fair value
   
(12,444
)
   
35
 
Accounts payable and accrued liabilities
   
87
     
533
 
Net Intercompany Payable/Receivable
   
(278
)
   
518
 
Net cash (used in) provided by operating activities
   
(5,278
)
   
2,798
 
                 
Cash flows from investing activities:
               
Origination of Borrower Loans held at fair value
   
(823,841
)
   
(189,313
)
Repayment of Borrower Loans held at fair value
   
88,944
     
59,126
 
Proceeds from sale of borrower loans held at fair value
   
693,007
     
80,786
 
Purchases of property and equipment
   
(829
)
   
(1,227
)
Change in restricted cash
   
3,578
     
(969
)
Net cash used in investing activities
   
(39,141
)
   
(51,597
)
                 
Cash flows from financing activities:
               
Proceeds from issuance of Notes held at fair value
   
130,828
     
108,527
 
Payment of Notes held at fair value
   
(89,336
)
   
(58,441
)
Net cash included in transfer of assets from PMI
     –      
1,875
 
Net cash provided by financing activities
   
41,492
     
51,961
 
                 
Net (decrease) increase in cash and cash equivalents
   
(2,927
)
   
3,162
 
Cash and cash equivalents at beginning of the period
   
5,789
     
5
 
Cash and cash equivalents at end of the period
 
$
2,862
   
$
3,167
 
                 
Cash paid for interest
 
$
28,976
   
$
23,725
 
Non - Cash Financing Activity, Distribution to Parent $ (205 ) $ -


The accompanying notes are an integral part of these condensed consolidated financial statements.
 
*Please see Note 8
 
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 September 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.

As of September 30, 2014, the platform is open to investors in 31 states and the District of Columbia. Additionally, as of September 30, 2014 the platform is open to borrowers in 47 states and the District of Columbia.  Currently our platform is not offered internationally.
 
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, consisting of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

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.
 
Reclassifications
 
During the nine months ended September 30, 2014, the Company changed the presentation of its revenues in the statement of operations.   A new line called “Servicing Fees” was created and the servicing fees related to whole loans that were previously included in interest income were reclassified to this new line.   Also, the “Change in Fair Value of Borrower Loans, Loans Held for Sale and Notes, Net” was moved into the total revenues subtotal. Lastly, the subtotals were realigned to reflect the new presentation.   These changes had no impact to net income and are reflected in the “Reclassifications” column in the table below. Management believes these changes make the income statement more useful for the readers of the financial statements and comparable with the Company’s competitors.
 
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.  Prosper Funding does not record a specific allowance account related to the Borrower Loans 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.
 
Servicing Asset/Liability

The Company records servicing assets and liabilities at their estimated fair values when the Company sells Borrower Loans to unrelated third-party buyers. The gain or loss on a loan sale is recorded in “Other Revenue” while the while the fair value of the servicing rights, which is based on the degree to which the contractual loan servicing fee is above or below an estimated market loan servicing fee is recorded as an offset in servicing assets or liabilities. Servicing assets and liabilities are recorded in “Prepaid and Other Assets” and “Accrued Expenses and Other Liabilities,” respectively, on the condensed consolidated balance sheets. The initial fair value of servicing assets or liabilities are amortized in proportion to and over the period of estimated servicing income or loss and are reported in “Servicing Fees” on the condensed consolidated statement of operations.
 
The Company uses a discounted cash flow model to estimate the fair value of the loan servicing assets or liabilities which considers the contractual projected servicing fee revenue that the Company earns on the loans, estimated market servicing fees to service such loans, prepayment rates, default rates and the current principal balances of the loans.

The Company periodically assesses servicing assets accounted for using the amortization method for impairment. Impairment occurs when the current fair value of the servicing assets falls below the asset’s carrying value (carrying value is the amortized cost reduced by any related valuation allowance). If servicing assets are impaired, the impairment is recognized in current-period earnings and the carrying value of the assets is adjusted through a valuation allowance. If the value of impaired servicing assets subsequently increases, the Company recognizes the increase in value in current-period earnings and adjusts the carrying value of the servicing assets through a reduction in the valuation allowance to adjust the carrying value only to the extent of the valuation allowance.
 
Loans Held for Sale

Loans held for sale are primarily comprised of Borrower Loans held for short durations and are recorded at cost plus accrued interest 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. 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 va