10-Q 1 p10q093009.htm FORM 10-Q p10q093009.htm

 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)
     
þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2009

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

For the transition period from                       to                     

Commission File Number: 333-147019
 
 
PROSPER MARKETPLACE, INC.
(Exact name of registrant as specified in its charter)

Delaware
 
6199
 
73-1733867
(State or other jurisdiction of
 
(Primary Standard Industrial
 
(I.R.S. Employer
incorporation or organization)
 
Classification Code Number)
 
Identification Number)
 
111 Sutter Street, 22nd Floor
San Francisco, CA  94104
(415) 593-5400
(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)
 
 
Indicate by check mark whether the 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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ
 
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). Yes o  No o
 
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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
Accelerated filer o
Non-accelerated filer o(Do not check if a smaller reporting company)
Smaller reporting company þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of November 11, 2009, there were 4,455,509 shares of the registrant’s common stock outstanding.



 
 

 
 
 
Page No.
PART I. FINANCIAL INFORMATION
 
Item 1. Financial Statements
 
1
2
3
4
5
27
46
46
PART II. OTHER INFORMATION
 
47
47
51
51
52
53
   
   
   
   
   
   



Item 1. Interim Consolidated Financial Statements and Notes

Prosper Marketplace, Inc.
 Consolidated Balance Sheets
             
   
September 30,
   
December 31,
 
   
2009
   
2008
 
   
(Unaudited)
   
(Audited)
 
ASSETS
           
             
    Cash and cash equivalents
  $ 2,079,624     $ 9,839,758  
    Restricted cash
    1,751,769       1,429,011  
    Servicing rights
    32,888       67,685  
    Receivables
    6,254       -  
    Borrower Loans receivable at fair value
    1,647,315       -  
    Property and equipment, net of $1,810,696 and $1,570,848 accumulated depreciation and amortization as of September 30, 2009 and December 31, 2008, respectively
    696,489       859,103  
    Prepaid and other assets
    285,304       238,686  
    Intangible assets, net
    201,221       291,769  
                 
Total assets
  $ 6,700,864     $ 12,726,012  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
    Accounts payable
  $ 434,738     $ 431,744  
    Accrued liabilities
    987,128       1,186,984  
    Borrower Payment Dependent Notes at fair value
    1,619,655       -  
    Repurchase obligation
    22,940       80,000  
    Long-term debt, net of discount of $38,939 and $55,368 as of September 30, 2009 and December 31, 2008, respectively
    281,061       284,632  
                 
Total liabilities
    3,345,522       1,983,360  
                 
    Commitments and contingencies (see Note 11)
               
                 
Stockholders' Equity
               
    Convertible preferred stock – Series A ($0.001 par value; 4,023,999 shares authorized, issued and outstanding as of September 30, 2009 and December 31, 2008)
    4,024       4,024  
    Convertible preferred stock – Series B ($0.001 par value; 3,310,382 shares authorized, issued and outstanding as of September 30, 2009 and December 31, 2008)
    3,310       3,310  
    Convertible preferred stock – Series C ($0.001 par value; 2,063,558 shares authorized; issued and outstanding as of September 30, 2009 and December 31, 2008)
    2,064       2,064  
    Common stock ($0.001 par value; 16,000,000 shares authorized; 4,441,609 shares and 4,346,118 shares issued and outstanding as of September 30, 2009 and December 31, 2008, respectively)
    4,442       4,347  
    Additional paid-in capital
    41,285,903       40,946,853  
    Accumulated deficit
    (37,944,401 )     (30,217,946 )
Total stockholders' equity
    3,355,342       10,742,652  
                 
Total liabilities and stockholders' equity
  $ 6,700,864     $ 12,726,012  
                 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 

 
 
 
Prosper Marketplace, Inc.
Consolidated Statements of Operations
(Unaudited)
                         
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Operating income
                       
    Agency fees
  $ 67,348     $ 406,250     $ 68,273     $ 1,330,020  
    Loan servicing fees
    121,875       211,182       446,754       525,861  
    Interest income (expense) on Borrower Loans and Payment Dependent Notes, net
    2,659       -       2,659       -  
      191,882       617,432       517,686       1,855,881  
Cost of Revenues
                               
    Cost of services
    (152,428 )     (215,964 )     (376,803 )     (730,582 )
    Reduction (provision) for loan and Note repurchases
    1,767       (4,989 )     26,273       (33,893 )
Total revenues, net
    41,221       396,479       167,156       1,091,406  
                                 
Operating expenses
                               
    Compensation and benefits
    1,131,676       1,505,558       3,825,649       4,801,251  
    Marketing and advertising
    167,435       171,141       233,633       2,283,934  
    Depreciation and amortization
    150,315       209,472       447,791       601,695  
General and administrative
                               
    Professional services
    593,722       359,069       2,154,715       1,194,862  
    Facilities and maintenance
    160,868       177,075       500,468       521,164  
    Other
    126,297       113,088       824,635       420,575  
Total expenses
    2,330,313       2,535,403       7,986,891       9,823,481  
Loss before other income (expense)
    (2,289,092 )     (2,138,924 )     (7,819,735 )     (8,732,075 )
                                 
Other income (expense)
                               
    Interest income
    3,434       108,360       39,452       453,574  
    Change in fair value on Borrower Loans and Payment Dependent Notes, net
    39,133       -       39,133       -  
    Loss on impairment of fixed assets
    (1,189 )     -       (41,704 )     -  
    Other income
    9,576       2,324       56,399       2,939  
Total other income
    50,954       110,684       93,280       456,513  
                                 
Loss before income taxes
    (2,238,138 )     (2,028,240 )     (7,726,455 )     (8,275,562 )
Income taxes
    -       -       -       -  
 Net Loss
  $ (2,238,138 )   $ (2,028,240 )   $ (7,726,455 )   $ (8,275,562 )
                                 
                                 
 Net loss per share – basic and diluted
  $ (0.50 )   $ (0.48 )   $ (1.75 )   $ (2.07 )
                                 
 Weighted Average shares - basic and diluted net loss per share
    4,436,734       4,245,254       4,415,679       4,006,483  
                                 
The accompanying notes are an integral part of these consolidated financial statements.
 


 
Prosper Marketplace, Inc.
Consolidated Statements of Stockholders' Equity
 
 
Preferred Stock
 
Common Stock
 
Additional Paid-In
 
Accumulated
   
 
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
Deficit
 
Total
Balance as of January 1, 2008 (Audited)
   9,397,939
 
 $         9,398
 
      3,662,476
 
 $       3,663
 
 $      40,493,256
 
 $(19,378,703)
 
 $    21,127,614
                           
Issuance of common stock
       
           605,500
 
              605
 
                 71,330
     
               71,935
                           
Exercise of stock options
       
            54,529
 
                55
 
                 17,980
     
               18,035
                           
Compensation expense
               
                276,062
     
              276,062
                           
Net loss
                   
       (8,275,562)
 
          (8,275,562)
                           
Balance as of September, 2008 (Unaudited)
   9,397,939
 
 $         9,398
 
      4,322,505
 
 $       4,323
 
 $      40,858,628
 
 $(27,654,265)
 
 $    13,218,084
                           
                           
Balance as of January 1, 2009 (Audited)
   9,397,939
 
 $         9,398
 
      4,346,118
 
 $       4,347
 
 $      40,946,853
 
 $(30,217,946)
 
 $    10,742,652
                           
Issuance of common stock
       
              6,500
 
                 6
 
                   9,844
     
                 9,850
                           
Exercise of stock options
       
            88,991
 
                89
 
                 52,210
     
               52,299
                           
Compensation expense
               
                276,996
     
              276,996
                           
Net loss
                   
       (7,726,455)
 
          (7,726,455)
                           
Balance as of September 30, 2009 (Unaudited)
   9,397,939
 
 $         9,398
 
      4,441,609
 
 $       4,442
 
 $      41,285,903
 
 $(37,944,401)
 
 $      3,355,342
                           
The accompanying notes are an integral part of these consolidated financial statements.



 
Prosper Marketplace, Inc.
 
Consolidated Statements of Cash Flows
 
(Unaudited)
 
             
   
Nine Months Ended September 30,
 
   
2009
   
2008
 
             
Cash flows from operating activities:
           
Net loss
  $ (7,726,455 )   $ (8,275,562 )
Adjustments to reconcile net loss to net cash used in operating activities:
         
    Depreciation and amortization
    447,791       601,695  
    Loss on impairment of fixed assets
    41,703        
    Change in fair value of Borrower Loans
    464,288        
    Change in fair value of Borrower Payment Dependent Notes
    (503,421 )      
    Stock-based compensation expense
    286,846       347,997  
    Provision for loan and Note repurchases
    (26,273 )     33,893  
    Change in fair value of servicing rights
    34,797       (88,040 )
    Amortization of discount on long-term debt
    16,429       16,323  
Changes in operating assets and liabilities:
               
    Restricted cash
    (322,758 )     21,444  
    Loans receivable
    (6,254 )     352,107  
    Prepaid and other assets
    (46,618 )     (43,835 )
    Accounts payable and accrued liabilities
    (196,862 )     185,163  
    Loan and Note repurchases
    (30,787 )     (33,977 )
Net cash used in operating activities
    (7,567,574 )     (6,882,792 )
                 
Cash flows from investing activities:
               
Origination of Borrower Loans held at fair value
    (2,183,239 )      
Repayment of Borrower Loans held at fair value
    71,636        
Purchases of property and equipment
    (236,332 )     (420,282 )
Net cash used in investing activities
    (2,347,935 )     (420,282 )
                 
Cash flows from financing activities:
               
Proceeds from issuance of Notes held at fair value
    2,183,239        
Payment of Notes held at fair value
    (60,163 )      
Proceeds from issuance of common stock
    52,299       18,035  
Principal repayment of long-term debt
    (20,000 )     (20,000 )
Net cash provided by (used in) financing activities
    2,155,375       (1,965 )
                 
Net decrease in cash and cash equivalents
    (7,760,134 )     (7,305,039 )
Cash and cash equivalents at beginning of the year
    9,839,758       20,280,105  
Cash and cash equivalents at end of the period
  $ 2,079,624     $ 12,975,066  
                 
Supplemental disclosures of cash flow information
               
Cash paid during the year for:
               
Interest
  $     $  
Income taxes
  $     $  
                 
Supplemental disclosure of non-cash investing and financing activities:
               
    $     $  
                 
                 
The accompanying notes are an integral part of these consolidated financial statements.


 
PROSPER MARKETPLACE, INC.
 
Notes to Consolidated Financial Statements
(Unaudited)
 
1. Operations and Business
 
Prosper Marketplace, Inc. (Prosper, the Company, we, us, our) was incorporated in the state of Delaware on March 22, 2005. Prosper is an online marketplace for person-to-person lending. Prosper’s website provides an online marketplace for loans where people list and bid on loans with interest rates of return determined through Prosper’s online auction platform. Prosper’s lender members set the minimum interest rate that they are willing to earn and bid in increments of $25 to $25,000. Borrowers create loan listings from $1,000 up to $25,000 and set the maximum rate they are willing to pay on a loan. Prosper facilitates the lending and borrowing activities and acts as an agent to the lender by maintaining its online auction platform. Prosper also handles all ongoing loan administration tasks, including loan servicing and collections on behalf of the lenders. Prosper generates revenue by collecting one-time fees from borrowers on funded loans and from loan servicing fees paid by lender members.
 
All loans requested and obtained by Prosper borrower members through our platform are unsecured obligations of individual borrower members with a fixed interest rate and a loan term set at three years.  All borrower are funded by WebBank, an FDIC-insured, Utah-chartered industrial bank.  After funding a loan, WebBank assigns the loan to Prosper, without recourse to WebBank, in exchange for the principal amount of the borrower loan.  WebBank does not have any obligation to purchasers of the Notes.
 
On July 13, 2009, we implemented a new operating structure and began issuing Borrower Payment Dependent Notes (“Notes”).  The post registration operating structure resulted in Prosper purchasing loans from WebBank, and holding the loans until maturity.  Prosper issues new securities, the Notes, to the winning lenders.  Prosper’s obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan owned by Prosper.  As a result of these changes, borrower loans and the Notes originated on or after July 13, 2009 are carried on Prosper’s balance sheet as assets and liabilities, respectively.  Prosper has elected to carry the borrower loans and the Notes on its balance sheet at fair value.
 
As reflected in the accompanying financial statements, Prosper has incurred net losses and negative cash flows from operations since inception, and has an accumulated deficit of approximately $38.0 million as of September 30, 2009.  For the nine months ended September 30, 2009 the Company incurred a net loss of $7.7 million.  For the nine months ended September 30, 2009 the Company had negative cash flow from operations of $7.6 million. Since its inception, Prosper has financed its operations primarily through equity financing from various sources. The Company is dependent upon raising additional capital or debt financing to fund its current operating plan.  Failure to obtain sufficient debt and equity financings and, ultimately, to achieve profitable operations and positive cash flows from operations could adversely affect Prosper’s ability to achieve its business objectives and continue as a going concern.  Further, there can be no assurances as to the availability or terms upon which the required financing and capital might be available.

 
2. Significant Accounting Policies
 
Basis of Presentation
 
The accompanying consolidated financial statements include the accounts of Prosper and its wholly-owned subsidiary, Prosper Loans Marketplace, Inc.  Prosper Loans Marketplace, Inc. was incorporated on April 3, 2009 in the state of California but has not had significant operations. All significant intercompany transactions and balances have been eliminated.
 
The Company’s unaudited 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 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements.  The unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2008 contained in our Registration Statement on Form S-1.  Management believes these unaudited consolidated financial statements reflect all adjustments, including those of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.
 
 

 
Use of Estimates
 
The preparation of financial statements in conformity US GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the related disclosures at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. These include but are not limited to the following: valuation of borrower loans and associated member payment dependent notes, valuation of servicing rights valuation allowance on deferred tax assets, valuation and amortization periods of intangible assets, repurchase obligation, stock-based compensation expense, and contingent liabilities. Prosper bases its estimates on historical experience and on various other assumptions that Prosper 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 encounters two significant types of risk: credit and regulatory. Financial instruments that potentially subject Prosper 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. Prosper is exposed to credit risk in the event of default by these institutions to the extent the amount recorded on the balance sheet exceeds FDIC insured amounts. Prosper 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.
 
As previously described, beginning on July 13, 2009, loans originated by Prosper are carried on our balance sheet.  The loans are funded by the Notes and repayment of the Notes is wholly dependent on the repayment of the loan associated with a Note.  As a result, Prosper does not bear the risk associated with the repayment of principal on loans carried on its balance sheet.  A decrease in the value of the loans carried on Prosper’s balance sheet associated with increased credit risk is directly offset by a reduction in the value of the Notes Prosper issued in association with the loan. However, Prosper charges a servicing fee that is deducted from loan payments.  To the extent that loan payments are not made, Prosper’s servicing income will be reduced.  

Prosper 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’s financial position and results of operations (See Note 11 — Commitments and Contingencies — Securities Law Compliance).

Cash and Cash Equivalents
 
Prosper invests its excess cash primarily in money market funds and in highly liquid debt instruments of U.S. municipalities, and the U.S. government and its agencies. All highly liquid investments with stated maturities of three months or less from date of purchase are classified as cash equivalents. Cash equivalents are recorded at cost, which approximates fair value. Such deposits periodically exceed amounts insured by the FDIC.

Restricted Cash
 
Restricted cash consists primarily of an irrevocable letter of credit held by a financial institution in connection with the Company’s office lease and cash deposits required to support the Company’s ACH activities and secured corporate credit cards.
  


 
Servicing Rights
 
Prosper accounts for its servicing rights for loans originated prior to October 16, 2008 under the fair value measurement method of reporting in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 860-50, Servicing Assets and Liabilities (formerly, Statement of Financial Accounting Standards (SFAS) No. 156, Accounting for Servicing of Financial Assets – an Amendment of FAS 140). Under the fair value method, Prosper measures its servicing rights at fair value at each reporting date and reports changes in fair value in earnings in the period in which the changes occur.
 
Prosper estimates the fair value of the servicing rights using a discounted cash flow model to project future expected cash flows based upon a set of valuation assumptions Prosper believes market participants would use for similar rights. The primary assumptions Prosper uses to value its servicing rights include prepayment speeds, default rates, cost to service, profit margin, and discount rate. Prosper reviews these assumptions quarterly to ensure that they remain consistent with market conditions. Inaccurate assumptions in valuing servicing rights could affect Prosper’s results of operations.

Borrower Loans and Payment Dependent Notes
 
As of July 13, 2009, the Company implemented its new operating structure and began issuing Notes and purchasing loans from WebBank, and holding the loans until maturity.  Prosper’s obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan owned by Prosper.   As a result of these changes, borrower loans and the Notes are carried on our balance sheet as assets and liabilities, respectively.  In conjunction with our new operating structure, we adopted the provisions of ASC Topic 825, Financial Instruments (formerly, SFAS No. 159, The Fair Value Option for Financial Assets and Financial Measurements.  ASC Topic 825 permits companies to choose to measure certain financial instruments and certain other items at fair value on an instrument-by-instrument basis with unrealized gains and losses on items for which the fair value option has been elected reported in earnings.  The fair value election, with respect to an item, may not be revoked once an election is made.  In applying the provisions of ASC Topic 825, we will record assets and liabilities measured using the fair value option in a way that separates these reported fair values from the carrying values of similar assets and liabilities measured with a different measurement attribute.  We will report the aggregate fair value of the Notes and borrower loans as separate line items in the assets and liabilities sections of the balance sheet using the methods described in ASC Topic 820, Fair Value Measurements and Disclosures (formerly, SFAS No. 157, Fair Value Measurements) – See Fair Value Measurement. We did not apply the provisions of ASC Topic 825 to loans issued prior to July 13, 2009.
 
Prosper estimates the fair value of the Notes and borrower loans using discounted cash flow methodologies based upon a set of valuation assumptions. The main assumptions Prosper used to value the borrower loans and notes include prepayment rates derived off of historical prepayment rates for each credit score, default rates based off of historical performance, recovery rates and discount rates applied to each credit tranche based on the perceived credit risk of each credit grade. Our obligation to pay principal and interest on any Note is equal to the loan payments, if any, we receive on the corresponding borrower loan, net of our 1.0% servicing fee.  As such, the fair value of the Note is approximately equal to the fair value of the borrower loans, adjusted for the 1.0% servicing fee.  The effective interest rate associated with the Notes will be less than the interest rate earned on the borrower loans due to the 1.0% servicing fee.  

 

 
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. Depreciation and amortization are computed using the straight-line method based on the estimated useful lives of the assets, which range from three to seven years. Prosper capitalizes expenditures for replacements and betterments and expenses amounts for maintenance and repairs as they are incurred.  Depreciation and amortization commences once the asset is placed in service.
 
Internal Use Software and Website Development

Prosper accounts for internal use software costs, including website development costs, in accordance with ASC Topic 350-40, Internal Use Software and ASC Topic 350-50, Website Development Costs (formerly, Statement of Position (SOP) No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use and Emerging Issues Task Force (EITF) No. 00-02, Accounting for Website Development Costs). In accordance with ASC Topic 350-40 and 350-50, the costs to develop software for Prosper’s website and other internal uses are capitalized when management has authorized and committed project funding, preliminary development efforts are successfully completed, and it is probable that the project will be completed and the software will be used as intended. Capitalized software development costs primarily include software licenses acquired, fees paid to outside consultants, and salaries 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. The Company evaluates its software assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.  Recoverability of software assets to be held and used is measured by a comparison of the carrying amount of the asset to the future net undiscounted cash flows expected to be generated by the asset.  If such software assets are considered to be impaired, the impairment to be recognized is the excess of the carrying amount over the fair value of the software asset.
 
Intangible Assets
 
Prosper records the purchase of intangible assets not purchased in a business combination in accordance with ASC Topic 350 (formerly, SFAS No. 142, Goodwill and Other Intangible Assets). Prosper has an intangible asset resulting from the purchase of the “Prosper.com” domain name.  The intangible asset is amortized on a straight-line basis over five years.
 

 

Impairment of Long-Lived Assets Including Acquired Intangible Assets
 
In accordance with ASC Topic 360, Property Plant and Equipment (formerly, SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets), Prosper reviews property and equipment and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying values of those assets may not be recoverable.  Recoverability of assets to be held and used is measured by comparing the carrying value of the asset to future net undiscounted cash flows that the assets are expected to generate. If an asset is considered to be impaired, the impairment to be recognized equals the amount by which the asset’s carrying value exceeds its fair value. Fair value is estimated using discounted net cash flows.
 
During the first quarter of 2009, management made the decision to discontinue the development of one of its planned software development projects. The software asset previously capitalized in 2008 was deemed to be impaired in accordance with ASC Topic 360. An impairment charge of $40,515, encompassing the amount capitalized in 2008, is included as a component of other income (loss) in our Consolidated Statement of Operations for the nine months ended September 30, 2009.
 
Repurchase Obligation
 
Prosper is obligated to indemnify lenders and repurchase certain loans and Notes sold to lenders in the event of Prosper’s violation of applicable federal, state, or local lending laws, or verifiable identify theft. The amount of the loan repurchase obligation is estimated based on historical experience. Prosper accrues a provision for the repurchase obligation when the loans are funded. Repurchased loans and Notes associated with federal, state, or local lending laws, or verifiable identity thefts are written off at the time of repurchase.
 
Revenue Recognition
 
Prosper recognizes revenue in accordance with FASB ASC 605, Revenue Recognition (formally, Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial Statements).  Under FASB ASC 605, Prosper recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price of the services is fixed and determinable and collectability is reasonably assured.
 
Agency fees

Agency fees are a percentage of the amount borrowed varying by Prosper Rating and are recognized when the loan is funded to the borrower. Borrowers with a AA Prosper Rating are charged 0.5% with no minimum fee and borrowers with a Prosper Rating of A through HR are charged 3% or $50, whichever is greater. Prior to October 16, 2008, agency fees charged were the greater of 1% to 3% of the loan amount borrowed or $75.
 
Loan servicing fees

Loan servicing revenue includes monthly loan servicing fees and non-sufficient funds (NSF) fees. Loan servicing fees are accrued daily based on the current outstanding loan principal balance of the borrower loan but are not recognized until payment is received due to the uncertainty of collection of borrower loan payments. Servicing fees for a loan vary based on the credit grade of the borrower.  Prosper charges a NSF fee to borrowers on the first failed payment of each billing period.  NSF fees are charged to the customer and collected and recognized immediately.

 

 
Interest income (expense) on Borrower Loans Receivable & Payment Dependent Notes

We recognize interest income on our Borrower Loans using the accrual method based on the stated interest rate to the extent that we believe it to be collectable.  We record interest expense on the corresponding Note based on the contractual interest rate. Gross interest income earned and gross interest expense incurred were $13,266 and $10,607, respectively for the three and nine month periods ended September 30, 2009.
 
Advertising and Promotional Expenses
 
Under the provisions of ASC Topic 720, Other Expenses (formerly, SOP 93-7, Reporting on Advertising Costs), the costs of advertising are expensed as incurred. Advertising costs were approximately $167,000 and $171,000 for the three months ended September 30, 2009 and 2008, and $234,000 and $2,284,000 for the nine months ended September 30, 2009 and 2008, respectively..
 
Stock-Based Compensation
 
The Company accounts for its stock-based compensation for employees using fair-value-based accounting in accordance with ASC Topic 718, Compensation-Stock Compensation (formerly, SFAS No. 123R, Share-Based Payment.  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 is 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 and reduce the recognized stock-based compensation expense. The forfeitures were estimated based on historical experience. The Company estimated its annual forfeiture rate to be 23.1% and 21.3% for the nine months ended September 30, 2009 and 2008, respectively.
 
Prosper has granted options to purchase shares of common stock to nonemployees in exchange for services performed. Prosper accounts for stock options and restricted stock issued to nonemployees in accordance with the provisions of ASC Topic 505-50, Equity-Based Payments to Non-Employees (formerly, EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods, or Services), which requires that equity awards be recorded at their fair value.  Under ASC Topic 718 and 505-50, Prosper uses the Black-Scholes model to estimate the value of options granted to nonemployees at each vesting date to determine the appropriate charge to stock-based compensation. The volatility of common stock was based on comparative company volatility.


The fair value of stock option awards for the nine months ended September 30, 2009 and 2008 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,
 
2009
 
2008
 
2009
 
2008
Volatility of common stock
**
 
65.7%
 
63.8%
 
61.4%
Risk-free interest rate
**
 
3.2%
 
2.60%
 
2.9%
Expected life*
**
 
7.0 years
 
5.1 years
 
6.1 years
Dividend yield
**
 
0%
 
0%
 
0%
Weighted-average fair value of grants
**
 
$1.94
  
 $0.89
  
 $2.19

 
*For nonemployee stock option awards, the expected life is the contractual term of the award, which is generally ten years.
 
 
**No stock option awards were granted during the quarter ended September 30, 2009.

The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility. Because Prosper’s equity awards have characteristics significantly different from those of traded options, the changes in the subjective input assumptions can materially affect the fair value estimate.
 
Total stock-based compensation expense for employee and non-employee stock-option awards reflected in the Consolidated Statements of Operations is $93,404 and $112,251 for the three months ended September 30, 2009 and 2008 respectively, and $276,996 and $276,062 for the nine months ended September 30, 2009 and 2008, respectively. Total stock-based compensation expense for employee and non-employee stock awards reflected in the Consolidated Statements of Operations is $0 and $26,840 for the three months ended September 30, 2009 and 2008, respectively, and $9,850 and $79,435 for the nine months ended September 30, 2009 and 2008, respectively.  As of September 30, 2009, the unamortized stock-based compensation expense related to unvested stock-based awards was approximately $364,889, which will be recognized over the remaining vesting period of approximately 2.5 years.
 
Net Loss Per Share
 
Prosper computes net loss per share in accordance with ASC Topic 260 Earnings Per Share (formerly, SFAS No. 128, 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, 2009, there were outstanding convertible preferred stock and options convertible into 9,397,939 and 1,985,363 common shares, respectively, which may dilute future earnings per share. Due to the Company reporting a net loss for the three and nine months ended September 30, 2009 and 2008, there is no calculation of fully-diluted earnings per share as all common stock equivalents are anti-dilutive.
 


 
In June 2008, the FASB issued ASC Topic 260-45-60, Presentation-Earning Per Share-Other Presentation (formerly, FASB Staff Position No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities) which addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore need to be included in the earnings allocation in computing earnings per share under the two-class method. Management has evaluated the provisions of the ASC Topic 260-45-60 and has determined it has no impact on the Company based on its current capital structure.
 
Income Taxes
 
Prosper uses the liability method to account for 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, Income Taxes (formerly, FIN 48, Accounting for Uncertainty in Income Taxes) our policy to include interest and penalties related to gross unrecognized tax benefits within our provision for income taxes did not change.
 
Fair Value Measurement

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

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

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

Prosper determines the fair values of its financial instruments based on the fair value hierarchy established in that standard, 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.

The Company’s financial instruments consist principally of cash and cash equivalents, restricted cash, receivables, borrower loans, servicing rights, accounts payable and accrued liabilities, borrower payment dependent notes and long-term debt.  The estimated fair values of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities approximate their carrying values because of their short term nature.

The Company’s long-term debt is non-interest bearing and at inception was discounted at 8%.  The estimated fair value of the long-term debt is estimated to be $248,998 and $250,546 for the nine months ended September 30, 2009 and 2008, respectively, based on discounted cash flows and on the Company’s current incremental borrowing rate.

The following tables present the assets and liabilities measured at fair value on a recurring basis as of September 30, 2009 (unaudited) and December 31, 2008 (audited):

                                 
September 30, 2009  
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
                               
Servicing Rights
               
$
32,888
   
$
32,888
 
Borrower Loans Receivable
   
     
   
$
1,647,315
   
$
1,647,315
 
                                 
Liabilities
                               
Notes
                 
$
1,619,655
   
$
1,619,655
 
                                 


                                 
December 31, 2008  
Level 1 Inputs
   
Level 2 Inputs
   
Level 3 Inputs
   
Fair Value
 
Assets
                               
Servicing Rights
                 
$
67,685
   
$
67,685
 
Borrower Loans Receivable
   
     
     
     
 
                                 

As observable market prices are not available for the borrower loans and notes we hold, or for similar assets and liabilities, we believe the borrower loans and notes should be considered Level 3 financial instruments under ASC Topic 820.  In a hypothetical transaction as of the measurement date, the Company believes that differences in the principal marketplace in which the loans are originated and the principal marketplace in which the Company might offer those loans may result in differences between the originated amount of the loans and their fair value as of the transaction date.  The majority of unrealized loss incurred during the quarter is attributed to the difference in these principal marketplaces.  For borrower loans, the fair value is estimated using discounted cash flow methodologies based upon valuation assumptions including prepayment speeds, roll rates, recovery rates and discount rates based on the perceived credit risk within each credit grade.  Our obligation to pay principal and interest on any Note is equal to the loan payments, if any, we receive on the corresponding borrower loan, net of our 1.0% servicing fee.  As such, the fair value of the Note is approximately equal to the fair value of the borrower loans, adjusted for the 1.0% servicing fee.  Any unrealized gains or losses on the borrower loans and Notes for which the fair value option has been elected is recorded as a separate line item in the consolidated statement of operations.  The effective interest rate associated with the Notes will be less than the interest rate earned on the borrower loans due to the 1.0% servicing fee.  See Note 4 for a rollforward and further discussion of the significant assumptions used to value borrower loans and payment dependent notes.

Servicing rights related to loans originated prior to October 16, 2008 do not trade in an active open market with readily observable prices. Although sales of servicing assets do occur, the nature and character of the assets underlying those transactions are not similar to those held by the Company and, therefore, the precise terms and conditions typically seen in the marketplace would likely not be available to the Company. Accordingly, management determines the fair value of its servicing rights using a discounted cash flow model to project future expected cash flows based upon a set of valuation assumptions Prosper believes market participants would use for similar rights. The primary assumptions Prosper uses for valuing its servicing asset include prepayment speeds, default rates, cost to service, profit margin, and discount rate. Prosper reviews these assumptions to ensure that they remain consistent with the market conditions. Inaccurate assumptions in valuing the servicing rights could affect Prosper’s results of operations. Due to the nature of the valuation inputs, servicing assets are classified as Level 3. The change in the fair-value of servicing rights is included in cost of services in the consolidated statement of operations.  See Note 3 for a rollforward and further discussion of the significant assumptions used to value servicing rights.
 
 
 
 
New Accounting Pronouncements

In June 2009, the FASB issued ASC 102, Generally Accepted Accounting Principals (formerly, SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—A Replacement of FASB Statement No. 162 (“FASB Accounting Standards Codification”), which established the FASB Accounting Standards Codification (ASC) as the source of authoritative accounting principles recognized by the FASB to be applied in the preparation of financial statements in conformity with generally accepted accounting principles. The ASC explicitly recognizes rules and interpretative releases of the Securities and Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP for SEC registrants. The ASC is effective for financial statements issued for interim and annual reporting periods ending after September 15, 2009 The Company has adopted the ASC in the period ending September 30, 2009 and, as a result, has replaced references to standards that were issued prior to the Codification with new ASC references.  Our accounting policies were not affected by the conversion to ASC. However, references to specific accounting standards in the footnotes to our consolidated financial statements have been changed to refer to the appropriate section of ASC.

In April 2009, the FASB issued ASC Topic 825 Financial Instruments, (formerly, FSP SFAS No. 107-1 and APB No. 28-1, Interim Disclosures about Fair Value of Financial Instruments- an amendment of FASB Statement No. 107, Disclosures about Fair Values of Financial Instruments), to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. ASC Topic 825 also amends ASC Topic 270 Interim Reporting, to require those disclosures in summarized financial information at interim reporting periods.  ASC Topic 825 is effective for interim periods ending after June 15, 2009 and became effective for the Company in the second quarter of 2009. The adoption of ASC Topic 825 did not have a material impact on the Company’s results of operations, financial position or liquidity.
 
In May 2009, the FASB issued ASC Topic 855, Subsequent Events (formerly, SFAS 165, Subsequent Events),  which established general standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, ASC Topic 855 sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date.  ASC Topic 855 is effective for interim and annual periods ending after June 15, 2009 and became effective for the Company in the second quarter of 2009.
 


3. Servicing Rights
 
Prosper calculates the fair value of the servicing asset based on the following assumptions:
 
 
September 30,
 
       September 30,
 
2009
 
      2008
Unpaid principal loan balance under service
$41,907,000
 
$90,059,000
Servicing fees
0.0% - 1.0%
 
0.5% - 1.0%
Projected prepayment speed
1.20%
 
1.36%
Discount rate
25%
 
 25%


A rollforward of the servicing asset (liability) is summarized below:

   
Nine Months Ended,
Ended September 30,
 
   
2009
   
2008
 
Beginning of period balance:
 
$
67,685
   
$
(14,086
)
Change in fair value of servicing rights
   
(34,797
)
   
55,465
 
End of period balance:
 
$
32,888
   
$
41,379
 

No servicing rights were purchased or sold during the nine months ended September 30, 2009.

 
4. Borrower Loans and Notes Held at Fair Value

For Borrower Loans originated and Notes issued after July 13, 2009, we used the following average assumptions to determine the fair value as of September 30, 2009:
 
Monthly prepayment rate speed
1.43%
Recovery rate
2.56%
Discount rate *
26.42%
Weighted Average Default Rate
7.40%
 

* This is the weighted average discount rate among all of Prosper’s credit grades
 

The following table presents additional information about Borrower Loans and Notes measured at fair value on a recurring basis for the nine months ended September 30, 2009:
 
               
   
Borrower Loans
   
Notes
 
Fair value at December 31, 2008 (audited)
 
$
   
$
   
Originations
   
2,183,239
   
 
2,183,239
 
Principal repayments
   
(71,636
)
   
(60,163
)
Outstanding principal
   
2,111,603
     
2,123,076
 
Unrealized gains (losses) included in earnings
   
(464,288)
     
(503,421
)
Fair value at September 30, 2009 (unaudited)
 
$
1,647,315
   
$
1,619,655
 

 
 
 
Due to the recent origination of the Borrower Loans and Notes, the change in fair value attributable to instrument-specific credit risk is immaterial.  The Company had no originations of Borrower Loans or issuances of Notes prior to July 13, 2009.  As of September 30, 2009, the Company did not have any nonperforming loans and all loans were current.

Our obligation to pay principal and interest on any Note is equal to the loan payments, if any, we receive on the corresponding borrower loan, net of our 1.0% servicing fee.  As such, the fair value of the Note is approximately equal to the fair value of the borrower loans, adjusted for the 1.0% servicing fee..
 
 
5. Accrued Liabilities
 
As of September 30, 2009, and December 31, 2008, accrued liabilities consist of the following:
 
   
September 30,
   
December 31,
 
   
2009
   
2008
 
Professional Fees
 
$
779,442
   
$
936,070
 
Other
   
207,686
     
250,914
 
   
$
987,128
   
$
1,186,984
 

 
6. Repurchase Obligation
 
Changes in the repurchase obligation are summarized below:

   
Nine Months Ended
 
   
September 30,
 
   
2009
   
2008
 
Beginning of period balance:
 
$
80,000
   
$
100,151
 
Increase (reduction) in provision for repurchases
   
(26,273
)
   
33,893
 
Loans and Notes repurchased and immediately charged off (net of recoveries)
   
(30,787
)
   
(33,977
)
End of period balance:
 
$
22,940
   
$
100,067
 

 7. Net Loss Per Share
 
The Company computes net loss per share in accordance with ASC Topic 260. Under ASC Topic 260, basic net loss per share is computed by dividing net loss per share available to common stockholders by the weighted average number of common shares outstanding for the period and excludes the effects of any potentially dilutive securities. Diluted earnings per share, if presented, would include the dilution that would occur upon the exercise or conversion of all potentially dilutive securities into common stock using the “treasury stock” and/or “if converted” methods as applicable.

Basic and diluted loss per share was calculated as follows:
 
             
     
Three Months Ended
 September 30,
   
Nine Months Ended
September 30,
   
2009
   
2008
   
2009
   
2008
 
Numerator:
                       
Net loss
 
$
(2,238,138
)
 
$
(2,028,240
)
 
$
(7,726,455
)
 
$
(8,275,562
)
Denominator:
                               
Weighted average shares used in computing basic and diluted net loss per share
   
4,436,734
     
4,245,254
     
4,415,679
     
4,006,483
 
Basic and diluted net loss per share
 
$
(0.50
)
 
$
(0.48
)
 
$
(1.75
)
 
$
(2.07
)

Due to losses attributable to common shareholders for each of the periods below, the following potentially dilutive shares are excluded from the diluted net loss per share calculation because they were anti-dilutive under the treasury stock method, in accordance with ASC Topic 260:
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Excluded Securities:
                       
Weighted-average convertible preferred stock issued and outstanding
   
9,397,939
     
9,397,939
     
9,397,939
     
9,397,939
 
Weighted-average stock options issued and outstanding
   
1,985,363
     
1,721,272
     
1,653,185
     
1,646,859
 
Total weighted average common stock equivalents excluded from diluted net loss per common share computation
   
11,383,302
     
11,119,211
     
11,051,124
     
11,044,798
 
 
 
8. Stockholders’ Equity
 
Preferred Stock
 
Under Prosper’s articles of incorporation, preferred stock is issuable in series, and the Board of Directors is authorized to determine the rights, preferences, and terms of each series.
 
In April 2005, Prosper sold 4,023,999 shares of Series A convertible preferred stock (Series A) in a private placement for $7,464,450, net of issuance costs of $80,550. In February 2006, Prosper sold 3,310,382 shares of Series B convertible preferred stock (Series B) in a private placement for $12,412,302, net of issuance costs of $87,700. In June 2007, Prosper sold 2,063,558 shares of Series C convertible preferred stock (Series C) in a private placement for $19,919,009, net of issuance costs of $80,996.
 
 

Dividends
 
The holders of the Series A, Series B and Series C preferred stock are entitled to receive dividends at an annual rate of 8% per share for the preferred stock. Such dividends shall be payable only when, as, and if declared by the Board of Directors. To date, no dividends have been declared, and there are no dividends in arrears at September 30, 2009. No dividends will be paid on any common stock of Prosper until dividends on the Series A, Series B and Series C have been paid or declared and set apart during that fiscal year.
 
Conversion
 
Each share of Series A, Series B and Series C is automatically converted into shares of common stock at the Series A, Series B and Series C conversion price then in effect upon the earlier of (i) the date specified by vote or written consent or agreement of holders of 60% of the voting power of the shares of the Series A, Series B and Series C then outstanding, or (ii) immediately prior to the closing of the sale of Prosper’s common stock in a firm commitment, underwritten public offering registered under the Securities Act of 1933, as amended (the Securities Act), at a public offering price (before underwriters’ discounts and expenses) of at least two times the Original Series A, Series B and Series C Issue Price (as defined, per share as adjusted for any stock splits, stock dividends or other recapitalizations), and with gross proceeds to Prosper of at least $30,000,000.

Liquidation Rights
 
In the event of any liquidation, dissolution, or winding up of Prosper, whether voluntary or involuntary, the holders of the preferred stock are entitled to receive prior and in preference to any distribution of any of the proceeds of such Liquidation Event to holders of common stock, $1.875 for each share of Series A, $3.776 for each share of Series B, and $9.692 for each share of Series C (as adjusted for any stock dividends, combinations, or splits), plus all declared but unpaid dividends (if any) on each share of preferred stock. If upon the occurrence of such Liquidation Event, the assets and funds thus distributed among the holders of the Series A, Series B and Series C are insufficient to pay the preferential amount, then the entire assets and funds of Prosper legally available for distribution will be distributed ratably among the holders of the Series A, Series B and Series C in proportion to the preferential amount each such holder is otherwise entitled to receive.
 
Voting
 
Each holder of shares of the preferred stock shall be entitled to the number of votes equal to the number of shares of common stock into which such shares of preferred stock could be converted and shall have voting rights and powers equal to the voting rights and powers of the common stock (except as otherwise expressly provided herein or as required by law, voting together with the common stock as a single class) and shall be entitled to notice of any stockholders’ meeting in accordance with the Bylaws of Prosper. The holders of the preferred stock shall vote as one class with the holder of the common stock except with certain restrictions.

Each holder of common stock shall be entitled to one vote for each share of common stock held.
 
 
Common Stock
 
Prosper is authorized to issue up to 16,000,000 shares of common stock, $0.001 par value, of which 4,441,609 shares and 4,346,118 shares were issued and outstanding as of September 30, 2009, and December 31, 2008, respectively.
 
Common Stock Issued for Services

Employees

In March 2005, Prosper issued 4 million shares of common stock valued at $0.10 per share or $400,000 to the founders of the Company, of which 1 million shares were immediately vested and the remaining 3 million were to vest over 3.5 years for services rendered. The unvested shares are subject to a repurchase agreement if the founders leave the Company, whereby Prosper can choose to repurchase any unvested shares at the lesser price of $0.10 per share or the fair market value at the date service ceases.  A total of 600,000 shares vested during the nine months ended September 30, 2008, respectively. Total compensation expense of $60,000 was recognized for the nine months ended September 30, 2008. As of December 31, 2008, all founder shares of stock were fully vested or repurchased and retired.
 
During the nine months ended September 30, 2009 and 2008, the Company granted 0 and 4,000 fully vested common shares, respectively, to employees for services.  The 4,000 shares granted during the period ended September 30, 2008 were granted at $2.17 per share.  Expense of approximately $0 and $8,680 was recognized for the nine months ended September 30, 2009 and 2008, respectively.


 
 
Nonemployees

The Company granted 6,500 and 1,500 immediately vested common shares for the nine months ended September 30, 2009 and 2008, respectively.  2,000 shares issued in 2009 were valued at $0.56 per share, the remaining 4,500 shares issued in 2009 were valued at $1.94 per share and the 1,500 shares issued during 2008 were valued at $2.17 per share.  Expense of approximately $9,850 and $3,255 was recognized for the nine months ended September 30, 2009 and 2008, respectively.
 
Common Stock Issued upon Exercise of Stock Options
 
For the nine months ended September 30, 2009 and 2008, the Company issued 88,991 and 54,529 shares of common stock, respectively, upon the exercise of options for cash proceeds of $52,299 and $18,033, respectively.

 
9. Stock Option Plan and Other Stock Compensation
 
In 2005, Prosper’s stockholders approved the adoption of the 2005 Stock Option Plan (the Plan). Under the Plan, options to purchase up to 1,879,468 shares of common stock were reserved and may be granted to employees, directors, and consultants by the Board of Directors to promote the success of Prosper’s business. On January 31, 2008, the Board of Directors increased the total number of options under the Plan by 500,000 for a total of 2,379,468 options available for grant. On October 6, 2009, the Board of Directors increased the total number of options under the Plan by an additional 500,000 for a total of 2,879,468 options available for grant.
 
Incentive stock options are granted to employees at an exercise price not less than 100% of the fair value of Prosper’s common stock on the date of grant. Nonstatutory stock options are granted to consultants and directors at an exercise price not less than 85% of the fair value of Prosper’s common stock on the date of grant. If options are granted to stockholders who hold 10% or more of Prosper’s common stock on the option grant date, then the exercise price shall not be less than 110% of the fair value of Prosper’s common stock on the date of grant. The fair value is based on a good faith estimate by the Board of Directors at the
time of each grant. As there is no active trading market for these options, such estimates 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.
 

 

Option activity under the Option Plan is summarized as follows for the periods below:
 
 
Options Issued and Outstanding
 
Weighted-Average Exercise Price
Balance as of January 1, 2008 (audited)
1,608,025
 
$0.72
    Options granted (weighted average fair value of $2.19)
415,000
 
$2.17
    Options exercised
(54,529)
 
$0.33
    Options canceled
(207,659)
 
$1.58
Balance as of September 30, 2008 (unaudited)
1,760,837
 
$0.98
       
Balance as of January 1, 2009 (audited)
1,734,647
 
$1.14
    Options granted (weighted average fair value of $0.89 )
546,000
 
$0.89
    Options exercised
(88,991)
 
$0.59
    Options canceled
(206,293)
 
$1.44
Balance as of September 30, 2009 (unaudited)
1,985,363
 
$1.07
       
Options outstanding and exercisable at September 30, 2009
969,523
 
$0.92

 
 Other Information Regarding Stock Options
 
Additional information regarding common stock options outstanding as of September 30, 2009 is as follows:
 
     
Options Outstanding
     
Options Exercisable
 
Range of Exercise Prices
   
Number Outstanding
   
Weighted Avg. Remaining Life
   
Weighted Avg. Exercise Price
   
Intrinsic Value
     
Number Exercisable
   
Weighted Avg. Exercise Price
   
Intrinsic Value
 
$
0.25 - $0.25
     
291,658
     
5.85
    $
0.25
   
$
90,414
       
288,610
   
$
0.25
    $
89,469
 
$
0.50 - $0.50
     
506,617
     
7.17
   
 
0.50
   
 
30,397
       
363,275
   
 
0.50
   
 
21,797
 
$
0.56 - $0.56
     
415,000
     
9.72
     
0.56
     
       
     
0.56
     
 
$
1.94 - $1.94
     
533,963
     
9.26
     
1.94
     
       
227,435
     
1.94
     
 
$
2.17 - $2.17
     
238,125
     
8.52
     
2.17
     
       
90,203
     
2.17
     
 
       
1,985,363
     
8.23
   
$
1.06
   
$
120,811
       
969,523
   
$
0.86
   
$
111,266
 

The intrinsic value is calculated as the difference between the value of Prosper's common stock at September 30, 2009, which was $0.56 per share, and the exercise price of the options.  No compensation expense is recognized for unvested shares that are forfeited upon termination of service, and the stock-based compensation expense for the nine months ended September 30, 2009 and 2008 reflect the expenses that Prosper expects to recognize after the consideration of estimated forfeitures.
 
 
 
 
10. Income Taxes
 
As part of the process of preparing the Company’s 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 Company’s 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 deferred revenue or deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the accompanying balance sheet. 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, 2009 and 2008, Prosper has not incurred any income tax expense during those periods.  In addition, Prosper 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 and other commitments
 
Prosper leases its corporate office and co-location facility under noncancelable operating leases that expire in July 2011 and August 2011, respectively.  Prosper’s corporate office lease has the option to renew for an additional three years. Future minimum rental payments under these leases as of September 30, 2009 are as follows:
 
           Remaining three months ending December 31, 2009
 
$
107,012
 
   Years ending December 31:
       
      2010
   
431,864
 
      2011
   
265,513
 
   Total future operating lease obligations
 
$
804,389
 

 
Rental expense under premises-operating lease arrangements was approximately $106,248 and $315,690 for the three and nine months ended September 30, 2009, and $94,748 and $272,309 for the corresponding periods during 2008.
 
On April 14, 2008, the Company entered into an agreement with a Utah-chartered industrial bank whereby all loans originated through the Prosper marketplace resulting from listings posted on or after April 15, 2008 are made by WebBank under its bank charter. The arrangement allows for loans to be offered to borrowers at uniform nationwide terms. The Company is required to pay WebBank a monthly fee of $20,000.
 
 
 
Securities Law Compliance

From inception through October 16, 2008, the Company sold approximately $178.1 million of loans to unaffiliated lender members, and $1.0 million of loans to affiliated lender members through the Prosper platform whereby the Company assigned promissory notes directly to lender members. The Company did
not register the offer and sale of the promissory notes offered and sold through the Prosper platform under the Securities Act of 1933 or under the registration or qualification provisions of the state securities laws. The Company’s management believes that the question of whether or not the operation of the Prosper platform involved an offer or sale of a “security” involved a complicated factual and legal analysis and was uncertain. If the sales of promissory notes offered through the Company’s platform were viewed as a securities offering, the Company would have failed to comply with the registration and qualification requirements of federal and state laws and lender members who hold these promissory notes may be entitled to rescission of unpaid principal, plus statutory interest. Generally, the federal statute of limitations for noncompliance with the requirement to register securities under the Securities Act of 1933 is one year from the violation.

The Company’s decision to restructure its operations and cease sales of promissory notes offered through the platform effective October 16, 2008 limited this contingent liability to the period covering Prosper's activities prior to October 16, 2008, the date on which the Company ceased sales of promissory notes offered through the platform.
 
The Company has not recorded an accrued loss contingency in connection with the sale of promissory notes to lender members. Accounting for loss contingencies involves the existence of a condition, situation or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future event(s) occur or fail to occur. An estimated loss in connection with a loss contingency shall be recorded by a charge to current operations if both of the following conditions are met: first, the amount
can be reasonably estimated; and second, the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements.
 
The Company has assessed the contingent liability related to prior sales of loans on the platform and has determined that the occurrence of the contingency is reasonably possible but not probable and that contingent liability ranges from $0 in the event the company prevails to a maximum of $78.4 million which represents the remaining outstanding principal amount of $39.8 million and loans charged off of $38.6 million as of September 30, 2009.

On November 25, 2008, the Company signed a settlement agreement with the North American Securities Administrators Association (“NASAA”) to pay penalties not to exceed $1.0 million to the States in order to resolve matters relating to Prosper’s alleged unregistered offer and sale of securities. The $1.0 million penalty would be allocated among the states where Prosper conducts business, based on the loan sale transaction volume in each state. However, Prosper will not be required to pay any portion of the fine to those states which elect not to participate in the settlement. As of September 30, 2009 and December 31, 2008, the Company had accrued approximately $387,000 and $417,000, respectively, in connection with this contingent liability in accordance with ASC Topic 450, Contingencies (formerly, SFAS No. 5, Accounting for Contingencies). The methodology applied to estimate the accrual was to divide the $1,000,000 maximum fee pro-rata by state using the Company’s originations since inception. A weighting was then applied by state to assign a likelihood that the penalty will be claimed. In estimating the probability of a claim being made, we considered factors such as the nature of the settlement agreement, whether the states had given any indication of their concern regarding the sale of the promissory notes, and the probability of states opting out of the settlement to pursue their own litigation against the Company, whether penalty is sufficient to compensate these states for the cost of processing the settlement 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. Penalties will be paid promptly after a state reviews and agrees to the language of the consent order. There is no deadline for the states to decide whether to enforce the consent order. On April 21, 2009, the Company and NASAA finalized a template consent order, which NASAA is recommending that the states adopt in settling any state initiated matters with the Company. As of September 30, 2009, the Company has entered into 25 consent order agreements and has paid an aggregate of $325,320 in penalties.
 
 

 
On November 26, 2008, plaintiffs, Christian Hellum, William Barnwell and David Booth, individually and on behalf of all other plaintiffs similarly situated, filed a class action lawsuit against us, certain of our executive officers and our directors in the Superior Court of California, County of San Francisco, California.  The suit was brought on behalf of all loan note purchasers in our online lending platform from January 1, 2006 through October 14, 2008.  The lawsuit alleges that Prosper offered and sold unqualified and unregistered securities in violation of the California and federal securities laws.  The lawsuit seeks class certification, damages and the right of rescission against Prosper and the other named defendants, as well as treble damages against Prosper and the award of attorneys’ fees, experts’ fees and costs, and pre-judgment and post-judgment interest.
 
Some of the individual defendants filed a demurrer to the First Amended Complaint, which was heard on June 11, 2009 and sustained by the court with leave to amend until July 10, 2009.  The plaintiffs filed a Second Amended Complaint on July 10, 2009, to which the same individual defendants demurred.  On September 15, 2009, this demurrer was sustained by the court without leave to amend.
 
Prosper’s insurance carrier with respect to the class action lawsuit, Greenwich Insurance Company (“Greenwich”), has denied coverage.  On August 21, 2009, Prosper filed suit against Greenwich in the Superior Court of California, County of San Francisco, California.  The lawsuit seeks a declaration that Prosper is entitled to coverage under its policy with Greenwich for losses arising out of the class action lawsuit as well as damages and the award of attorneys’ fees and pre-judgment and post-judgment interest.

We intend to vigorously defend the class-action lawsuit and vigorously prosecute our suit against Greenwich.  We cannot, however, presently determine or estimate the final outcome of either lawsuit, and there can be no assurance that either matter will be finally resolved in our favor.  If the class-action lawsuit is not resolved in our favor, we might be obliged to pay damages, and might be subject to such equitable relief as a court may determine.  If our lawsuit against Greenwich is not resolved in our favor, we might not be able to recover any proceeds from Greenwich to offset any losses we incur in the class action lawsuit.
 
The lawsuits are in their preliminary stages and their probable outcomes cannot presently be determined, nor can the amount of damages or other costs that might be borne by Prosper be estimated.
 
 
 
 
12. Related Parties

Prosper’s executive officers, directors and certain affiliates participate on the Company’s lending platform by placing bids and purchasing loans originated from Prosper.  The aggregate amount of loans purchased and the income earned by these related parties as of September 30, 2009 and 2008 are summarized below:

 
Related Party
   
Aggregate Amount of Loans Purchased
   
Income Earned on Loans for the 9 months ended
 
     
September 30,
   
September 30,
   
September 30,
   
September 30,
 
     
2009
   
2008
   
2009
   
2008
 
Executive officers & management
   
$
452,292
   
$
440,904
   
$
5,413
   
$
13,170
 
Directors
     
447,974
     
411,607
     
10,552
     
19,543
 
Affiliate
     
167,259
     
167,259
     
1,878
     
6,314
 
     
$
1,067,525
   
$
1,019,770
   
$
17,843
   
$
39,027
 

The loans were obtained on the same terms and conditions as those obtained by other lenders. Of the total aggregate amount of loans purchased since inception approximately $133,000 or 12% and $29,000 or 3% of principal has been charged off through September 30, 2009 and September 30, 2008, respectively. Prosper earned approximately $1,058 and $1,941 in servicing fee revenue related to these loans for the nine months ended September 30, 2009 and 2008, respectively.

 
13. Postretirement Benefit Plans
 
Prosper 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. Prosper’s contributions to the plan are discretionary. Prosper has not made any contributions to the plan to date.
 
 
14. Subsequent Events

On November 10, 2009, Prosper Marketplace, Inc. and QED Fund I, L.P., a Delaware limited partnership (“QED”), entered into a Note and Warrant Purchase Agreement (the “Purchase Agreement”), pursuant to which, Prosper sold to QED a Convertible Promissory Note (the “Note”), dated as of November 10, 2009.  The Note is in the principal amount of $1,000,000.  Interest on the Note accrues at a per annum rate of 15.0%.  All principal and accrued interest under the Note are due in a single payment on November 10, 2011 (the “Maturity Date”).  On the Maturity Date and for 90 days after, QED may elect to convert all principal and accrued interest under the Note into shares of Prosper’s preferred stock.  If QED elects to convert the Note, and Prosper has consummated a preferred stock financing for an aggregate purchase price of $5,000,000 or more between November 10, 2009 and the date of QED’s election, the Note will convert into shares of the preferred stock sold pursuant to such financing at the per share purchase price for such financing.  If QED elects to convert the Note but Prosper has not consummated any such preferred stock financing, the Note will convert into shares of Prosper’s Series C Preferred Stock at the per share purchase price at which such shares were sold for Prosper’s Series C financing, which was consummated in June 2007.  Prosper’s obligations under the Note are unsecured. Within 30 days of the closing of the transactions contemplated by the Purchase Agreement, QED may elect to purchase an additional convertible promissory note from Prosper in the principal amount of $1,000,000, which note shall be convertible into shares of Prosper’s preferred stock on the same terms as the Note.

In connection with the transaction, Prosper also issued to QED a fully vested warrant to purchase 164,178 shares of Prosper’s Common Stock at an exercise price of $0.56 per share (the “Warrant”).
 
The Company has completed an evaluation of all subsequent events through November 13, 2009, which is the issuance date of our consolidated financial statements, and concluded no subsequent events occurred, other than the issuance of the Note and Warrant, that required recognition or disclosure.

 

 
Item 2.
FINANCIAL CONDITION AND RESULTS OF OPERATION

You should read the following discussion in conjunction with our financial statements and the related notes elsewhere in this quarterly report.  This discussion contains forward-looking statements that involve risks and uncertainties. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including but not limited to those discussed in Part II Item 1A “Risk Factors” and elsewhere in this quarterly report.
 
Overview

Prosper provides a peer-to-peer online credit auction platform that enables its borrower members to borrow money and its lender members to purchase Notes issued by Prosper, the proceeds of which facilitate the funding of specific loans made to borrowers.  Our platform enables our borrower members to request and obtain personal, unsecured loans by posting anonymous “listings” on the platform indicating the principal amount of the desired loan and the maximum interest rate the borrower is willing to pay.  We assign a Prosper Rating consisting of one of seven letter credit grades, based in part on the borrower’s credit score, to each borrower who requests a borrower loan.  Prosper borrower members’ Prosper Rating and credit score range, debt-to-income ratios and other credit data are displayed with their listings and are available for viewing by lender members on an anonymous basis.  Lender members access our platform and “bid” the amount they are willing to commit to the purchase of a Note that is dependent for payment on the corresponding borrower loan and the minimum yield percentage they are willing to receive, subject to a minimum yield percentage based on the Prosper Rating assigned to each listing. The highest yield percentage lender members may bid on a listing is the yield percentage that corresponds to the maximum interest rate set by the borrower.  The lowest yield percentage lender members may bid will be the minimum yield percentage set forth in the listing. The minimum yield percentage applicable to each listing is based on the Prosper Rating assigned to the listing and will be calculated by adding the national average certificate of deposit rate that matches the term of the borrower loan, as published by BankRate.com, to the minimum estimated loss rate associated with the Prosper Rating assigned to the listing, which is based on the historical performance of similar Prosper borrower loans. For listings with AA Prosper Ratings, an estimated loss rate of 1.0%, which represents the middle of the estimated loss rate range, is added to the national average certificate of deposit rate to determine the minimum yield percentage. By making a bid on a listing, a lender member is committing to purchase from Prosper a Note in the principal amount of the lender’s winning bid.  The lender members who purchase the Notes will designate that the sale proceeds be applied to facilitate the funding of a corresponding borrower loan listed on our platform.  Loans originated to borrower members are made by WebBank, an FDIC-insured, Utah-chartered industrial bank, and sold and assigned to Prosper.
 
All loans requested and obtained by Prosper borrower members through our platform are unsecured obligations of individual borrower members with a fixed interest rate and a loan term currently set at three years, although Prosper anticipates in the near future extending available loan terms to between three months to seven years.  With respect to loans resulting from listings posted by Prosper borrower members prior to April 15, 2008, Prosper is the originating lender for licensing and regulatory purposes.  All borrower loans resulting from listings posted on or after April 15, 2008 are funded by WebBank, an FDIC-insured, Utah-chartered industrial bank.  After funding a loan, WebBank assigns the loan to Prosper, without recourse to WebBank, in exchange for the principal amount of the borrower loan.  WebBank does not have any obligation to purchasers of the Notes.  For all borrower loans, listings are posted without our obtaining any documentation of the borrower’s ability to afford the loan.  In limited instances, we verify the income, employment, occupation or other information provided by Prosper borrower members in listings.  This verification is normally done after the listing has already been created and bidding is substantially completed and, therefore, the results of our verification are not reflected in the listings.
 
        Borrowers with AA Prosper Rating are charged 0.5% with no minimum fee and borrowers with a Prosper Rating of A through HR are charged 3% or $50, whichever is greater.  Prior to October 16, 2008, agency fees charged were the greater of 1% to 3% of the loan amount borrowed or $75.  Agency fees are charged by WebBank and Prosper receives amounts equal to the transaction fees as compensation for loan origination activities.  We also receive servicing fees at an annualized rate of 1.0% of the outstanding principal balance of a Prosper borrower member’s loan, which we deduct from each lender member’s share of borrower loan payments.
 
We incorporated in Delaware in March 2005 and launched our public website, www.prosper.com on February 13, 2006.  As of September 30, 2009, our platform has facilitated 29,598 borrower loans since its launch.

We have a limited operating history and have incurred net losses since our inception.  Our net loss was $2,238,138 and $2,028,240 for the three months ending September 30, 2009 and 2008, and the net loss for the nine months ending September 30, 2009 and 2008 was $7,726,455 and $8,275,562.  At this stage of our development, we have funded our operations primarily with proceeds from equity financings. Our decision to temporarily stop accepting lender members’ commitments, effective from October 16, 2008 until July 10, 2009, significantly slowed the ramp up of our operations, resulting in a negative impact on our cash flow and liquidity projections for the first nine months of fiscal 2009 due to a decrease in loan origination volume. On July 13, 2009, we began accepting new commitments from our lender members on our platform, as such we will generate increased revenue from borrower transaction fees and non-sufficient funds fees and lender members’ servicing fees.  Over time, we expect that the number of borrowers and lender members and the volume of borrower loans originated through our platform will increase.

Our operating plan calls for a continuation of the current strategy of increasing transaction volume to increase revenue until we reach profitability and become cash-flow positive, which we do not expect to occur before 2010.

We have made significant changes to the operation of our lending platform that became effective on July 10, 2009.  Our historical financial results and this discussion reflect the structure of our lending platform and our operations both prior to and after July 10, 2009.  For a discussion of the effect of our new structure on our financial statements, see “Borrower Loans and Payment Dependent Notes” under Critical Accounting Policies and Estimates below.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and consolidated results of operations is based on our financial statements, which we have prepared in accordance with U.S. generally accepted accounting principles.  The preparation of financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and the related disclosures.  Prosper bases its estimates on historical experience and on various other assumptions that Prosper believes to be reasonable under the circumstances.  Actual results could differ from those estimates.  Our significant accounting policies are more fully described in Note 2 to our consolidated financial statements included elsewhere in this quarterly report.

Critical accounting policies are those policies that we believe present the most complex or subjective measurements and have the most potential to impact our financial position and operating results.  While all decisions regarding accounting policies are important, we believe that the following policies could be considered critical.  These critical policies relate to Borrower Loans and Payment Dependent Notes, servicing rights, repurchase obligation, fair value measurement, revenue recognition and stock-based compensation.



 
Borrower Loans and Payment Dependent Notes

On July 13, 2009, we implemented our new operating structure and began issuing Notes.  The post registration operating structure resulted in Prosper purchasing loans from WebBank, and holding the loans until maturity.  Prosper issues new securities, the Notes, to the winning lenders.  Prosper’s obligation to repay the Notes is conditioned upon the repayment of the associated borrower loan owned by Prosper.  As a result of these changes, Prosper carries the borrower loans and the Notes on its balance sheet as assets and liabilities, respectively.
 
In conjunction with our new operating structure effective July 13, 2009 we adopted the provisions of Financial Accounting Standards Board Accounting Standards Codification (ASC) Topic 825 (formerly, Statement of Financial Accounting Standard (SFAS) No. 159, The Fair Value Option for Financial Assets and Financial Measurements).  ASC Topic 825 permits companies to choose to measure certain financial instruments and certain other items at fair value.  The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings.  We applied the provisions of ASC Topic 825 to the Borrower Loans and Notes issued subsequent to July 13, 2009 on an instrument by instrument basis.  We did not apply the provisions of ASC Topic 825 to loans issued prior July 13, 2009.  The aggregate fair value of the Notes and borrower loans are reported as separate line items in the assets and liabilities sections of the balance sheet using the methods described in ASC Topic 820 Fair Value Measurements and Disclosures (formerly, SFAS No. 157, Fair Value Measurements).

The following table presents additional information about Borrower Loans and Notes measured at fair value on a recurring basis for the nine months ended September 30, 2009:

                 
   
Borrower Loans
   
Notes
 
Fair value at December 31, 2008 (audited)
 
$
     
$
   
Originations
   
2,183,239
   
 
2,183,239
 
Principal repayments
   
(71,636
)
   
(60,163
)
Outstanding principal
   
2,111,603
     
2,123,076
 
Realized and unrealized gains (losses) included in earnings
   
(464,288)
     
(503,421
)
Fair value at September 30, 2009 (unaudited)
 
$
1,647,315
   
$
1,619,655
 

We determine the fair value of the Notes and borrower loans in accordance with the fair value hierarchy established in ASC Topic 820, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  As observable market prices are not available for the borrower loans and notes we hold or for similar assets and liabilities, we believe the Borrower Loans and Notes should be considered Level 3 financial instruments under ASC Topic 820.  ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  In a hypothetical transaction as of the measurement date, the Company believes that differences in the principal marketplace in which the loans are originated and the principal marketplace in which the Company might offer those loans may result in differences between the originated amount of the loans and their fair value as of the transaction date.  The majority of unrealized loss incurred during the quarter is attributed to the difference in these principal marketplaces.  Changes in fair value of the Notes and borrower loans subject to the provisions of ASC Topic 820 are recognized in earnings, and fees and costs associated with the origination or acquisition of borrower loans are recognized as incurred.  Prosper estimates the fair value of the Notes and borrower loans using a discounted cash flow methodology based upon a set of valuation assumptions Prosper believes market participants would use for similar assets and liabilities. The main assumptions used to value the borrower loans and notes include default rates, discount rates applied to each credit tranche/grade, prepayment rates, and recovery rates.
For Borrower Loans and Notes issued after July 13, 2009, we used the following average assumptions to determine the fair value as of September 30, 2009:
 
Monthly prepayment rate speed
1.43%
Recovery rate
2.56%
Discount rate *
26.42%
Weighted Average Default Rate
7.40%
 
* This is the weighted average discount rate among all of Prosper’s credit grades

Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at September 30, 2009 for Borrower Loans and Payment Dependent Notes are presented in the following table:
 
($ thousands)
 
Borrower Loans
       
Payment Dependent Notes
 
Discount rate assumption:
    26.42 %         26.42 %
  Decrease in fair value and income (loss) to earnings from:
                   
    100 basis point increase
  $ (19,521 )       $ 19,250  
    200 basis point increase
  $ (38,670 )       $ 38,160  
                     
  Increase in fair value and income (loss) to earnings from:
                   
    100 basis point decrease
  $ 19,870         $ (19,600 )
    200 basis point decrease
  $ 40,102         $ (39,550 )
                     
Default rate assumption:
    7.40 %         7.40 %
  Decrease in fair value and income (loss) to earnings from:
                   
     10% higher default rates
  $ (9,825 )       $ 10,309  
     20% higher default rates
  $ (19,476 )       $ 20,436  
                     
  Increase in fair value  and income (loss) to earnings from:
                   
     10% lower default rates
  $ 10,004         $ (10,496 )
     20% lower default rates
  $ 20,193         $ (21,186 )
 
Overall, if the fair value of the Borrower Loans decrease or increase due to any changes in our assumptions, there will also be a corresponding decrease or increase in the fair value of the linked Payment Dependent Notes. As a result, the effect on Prosper’s earnings of adverse changes in key assumptions is mitigated. However, the impact of these changes in fair value could have a material adverse impact on lender member's investments in the Payment Dependent Notes.
 
As we receive scheduled payments of principal and interest on the borrower loans we will in turn make principal and interest payments on the Notes.  These principal payments will reduce the carrying value of the borrower loans and Notes.  If we do not receive payments on the borrower loans, we are not obligated to and will not make payments on the Notes.  The fair value of the Note is approximately equal to the fair value of the borrower loan, less the 1.0% service fee.  If the fair value of the borrower loan decreases due to our expectation of both the rate of default of the loan and the amount of loss in the event of default, there will also be a corresponding decrease in the fair value of the Note (an unrealized gain related to the Note and an unrealized loss related to the borrower loan).


We do not record a specific allowance account related to the Borrower Loans and Notes in which we have elected the fair value option, but rather estimate the fair value of the Borrower Loans and Notes using discounted cash flow methodologies adjusted for Prosper’s historical loss and recovery rates. Due to the recent origination of the Borrower Loans and Notes, the change in fair value attributable to instrument-specific credit risk is immaterial.  The Company had no originations of Borrower Loans or issuances of Notes prior to July 13, 2009. As of September 30, 2009, the Company did not have any nonperforming loans and all loans were current.
 
        We recognize interest income on our Borrower Loans using the accrual method based on the stated interest rate to the extent that we believe it to be collectable.  We record interest expense on the corresponding Note based on the contractual interest rate.
 
The origination of Notes and scheduled principal payments are shown as financing activities on the statement of cash flow.  

Servicing Rights

Prosper accounts for its servicing rights under the fair value measurement method of reporting in accordance with ASC Topic 860, Transfer and Servicing (formerly, SFAS No. 156, Accounting for Servicing of Financial Assets – an Amendment of FAS 140).  Under the fair value method, Prosper measures servicing rights at fair value at each reporting date and reports changes in fair value in earnings in the period in which the changes occur.

Prosper estimates the fair value of the servicing rights as it relates to loans originated prior to July 13, 2009, using a discounted cash flow model to project future expected cash flows based upon a set of valuation assumptions Prosper believes market participants would use for similar rights.  The primary assumptions Prosper uses for valuing its servicing rights include prepayment speeds, default rates, cost to service, profit margin, and discount rate.  Prosper reviews these assumptions to ensure that they remain consistent with the market conditions.  Inaccurate assumptions in valuing servicing rights could affect Prosper’s results of operations.  The significant assumptions used in the calculation of servicing rights are discussed in detail in Note 3 to our consolidated financial statements.

Repurchase Obligation

Prosper is obligated to indemnify the lenders and repurchase the Notes sold to the lenders in the event of violation of the applicable federal/state/local lending laws or verifiable identify theft.  Prosper’s limited operating history, the lack of industry comparables and the potential to impact financial performance make the Repurchase Obligation a critical accounting policy.
 
Prosper accrues a provision for the repurchase obligation when the Notes are funded to the lender in an amount considered appropriate to reserve for its repurchase obligation related to the Notes sold to the lenders in the event of violation of the applicable federal/state/local lending laws or verifiable identify theft.  The repurchase obligation is evaluated at least once a quarter and represents an estimate based on the rate of historical repurchases as a percentage of originations (which generally occur within six to nine months of origination).  The repurchase obligation includes a judgmental management adjustment  due to our limited operating history, changes in current economic conditions, the risk of new and as yet undetected fraud schemes, origination unit and dollar volumes, and the lack of industry comparables.
 
At September 30, 2009 and December 31, 2008, we have recorded a repurchase obligation of $22,940 and $80,000, respectively.  For the three months ended September 30, 2009 and 2008, we have repurchased loans and Notes of $6,211 net of recoveries, and $4,923, net of recoveries, respectively, and for the nine months ended September 30, 2009 and 2008 we have repurchased loans and Notes of approximately $30,787, net of recoveries and $33,977, net of recoveries, respectively, due to identity theft and legal and regulatory requirements.  Since the latter part of 2007, Prosper has been successful at identifying and preventing a number of fraud attempts involving a series of fraudulent loan requests as our risk indicators and related operational controls in this area have significantly improved.    The overall decrease is due in large part by the Company’s increased efforts in identifying and preventing various fraud schemes combined with the fact that we were not actively originating loans from October 16, 2008 till July 13, 2009.  Although we believe our fraud controls have resulted in a lower incidence of fraud in 2009, our controls are largely based on experience from past fraud attempts. Accordingly, future repurchase and repayment obligations could vary significantly from our estimates.
 
 
Fair Value Measurement

Prosper adopted ASC Topic 820 on January 1, 2008.  ASC Topic 820 provides a framework for measuring the fair value of assets and liabilities.  ASC 820 Topic 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.

Prosper determines the fair values of its financial instruments based on the fair value hierarchy established in that standard, 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.

For additional information and discussion, see Note 2, Note 3 and Note 4 to the consolidated financial statements.

Revenue Recognition

Prosper recognizes revenue in accordance with ASC Topic 605, Revenue Recognition (formerly, Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial Statements).  Under ASC Topic 605, Prosper recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price of the services is fixed and determinable and collectibility is reasonably assured.

Agency Fees

Borrowers with an AA Prosper Rating are charged 0.5% with no minimum fee and borrowers with a Prosper Rating of A through HR are charged 3% or $50, whichever is greater.  Prior to October 16, 2008, agency fees charged were the greater of 1% to 3% of the loan amount borrowed or $75.  Agency fees are charged by WebBank and Prosper receives amounts equal to the transaction fees as compensation for loan origination activities.  

Servicing Fees
  
Loan servicing revenue includes loan servicing fees and non-sufficient funds fees.  Loan servicing fees are accrued daily based on the current outstanding loan principal balance of (a) borrower loan(s), but are not recognized until payment is received due to uncertainty of collection of borrower loan payments.  Currently, Prosper charges servicing fees at an annualized rate of 1.0% of the outstanding principal balance of a Prosper borrower member’s loan, which we deduct from each lender member’s share of borrower loan payments.

Prosper charges a non-sufficient funds fee to borrowers on the first failed payment of each billing period.  Non-sufficient funds fees are charged to the borrower and collected and recognized immediately.


Interest Income (expense) on Borrower Loans Receivable & Payment Dependent Notes

       We recognize interest income on our Borrower Loans using the accrual method based on the stated interest rate to the extent that we believe it to be collectable.  We record interest expense on the corresponding Note based on the contractual interest rate.
 
Stock-Based Compensation

The Company accounts for its stock-based compensation for employees using fair-value-based accounting in accordance with ASC Topic 718, Compensation – Stock Compensation (formerly, SFAS No. 123R, Share-Based Payment).  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 is expected to vest is amortized 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 and reduce the recognized stock-based compensation expense.  The forfeitures were estimated based on historical experience.  The significant assumptions used in the calculation of stock based compensation are discussed in detail in Note 2 to our consolidated financial statements included elsewhere in this quarterly report.

Prosper has granted options to purchase shares of common stock to non-employees in exchange for services performed.  Prosper accounts for stock options, restricted stock, and warrants issued to non-employees in accordance with the provisions of ASC 505-50, Equity-Based payments to Non-Employees (formerly, EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods, or Services) which requires that equity awards be recorded at their fair value.  Under ASC Topic 718 and 505, we use the Black-Scholes model to estimate the value of options granted to non-employees at each vesting date to determine the appropriate charge to stock-based compensation.  The volatility of common stock was based on comparative company volatility.  The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility.  Because Prosper’s equity awards have characteristics significantly different from those of traded options, the changes in the subjective input assumptions can materially affect the fair value estimate.



Results of Operations
 
Our results of operations for the three months and nine months ended September 30, 2009 and 2008, together with the percentage change between years, are set forth below.
                             
Prosper Marketplace, Inc.
MD&A Table
(Unaudited)
                                                                           
               
   
Three Months Ended September 30,
   
Change from prior period
     
Nine Months Ended September 30,
   
Change from prior period
 
   
2009
         
2008
           
2009
         
2008
       
    $    
As % of sales
    $    
As % of sales
   
$ Increase / (Decrease)
   
%
      $    
As % of sales
    $    
As % of sales
   
$ Increase / (Decrease)
   
%
 
 Operating income
                                                                                 
Agency fees
  $ 67,348           $ 406,250           $ (338,902 )     (83 %)     $ 68,273           $ 1,330,020           $ (1,261,747 )     (95 %)
Loan servicing fees
    121,875             211,182             (89,307 )     (42 %)       446,754             525,861             (79,107 )     (15 %)
Interest income (expense) on Borrower  
    Loans and Borrower Payment Dependent
    Notes, net
    2,659             -             2,659       n/a         2,659             -             2,659       n/a  
      191,882             617,432                               517,686             1,855,881                        
 Cost of Revenues
                                                                                         
Cost of services
    (152,428 )     (79 %)     (215,964 )     (35 %)     63,536       (29 %)       (376,803 )     (73 %)     (730,582 )     (39 %)     353,779       (48 %)
Reduction (provision) for loan and Note  
    repurchases
    1,767       1 %     (4,989 )     (1 %)     6,756       (135 %)       26,273       5 %     (33,893 )     (2 %)     60,166       (178 %)
 Total revenues, net
    41,221               396,479                                 167,156               1,091,406                          
                                                                                                   
 Operating expenses
                                                                                                 
Compensation and benefits
    1,131,676       590 %     1,505,558       244 %     (373,882 )     (25 %)       3,825,649       739 %     4,801,251       259 %     (975,602 )     (20 %)
Marketing and advertising
    167,435       87 %     171,141       28 %     (3,706 )     (2 %)       233,633       45 %     2,283,934       123 %     (2,050,301 )     (90 %)
Depreciation and amortization
    150,315       78 %     209,472       34 %     (59,157 )     (28 %)       447,791       86 %     601,695       32 %     (153,904 )     (26 %)
 General and administrative