Convertible Notes

6 Months Ended

Jun. 30, 2011

Note 5 — Convertible Notes

In connection with the reverse merger, $1,048,863 of the Company’s outstanding convertible notes, which were issued in 2010, and $26,770 of accrued interest, converted into 358,559 shares of common stock on February 11, 2011.

The carrying values of our secured convertible notes consist of the following as of June 30, 2011:


Secured Convertible Notes	June 30, 2011
$2,000,000 face value secured convertible notes due January 24, 2012	$	136,259
$500,000 face value secured convertible notes due January 24, 2012		244,155
$2,500,000 face value secured convertible notes due April 24, 2012		72,357

	$	452,771

$2,000,000 Merkin Secured Convertible Note

On January 24, 2011, we issued a $2,000,000 face value Secured Convertible Note, due January 24, 2012, to Dr. Richard Merkin (the “Merkin Note”) for net proceeds of $2,000,000. The Merkin Note is secured pari passu by all of our assets with our other $4,500,000 of outstanding convertible notes and accrues interest at 10% per annum, payable in cash at maturity. However, the principal amount, plus accrued interest, may be converted at the option of the holder at any time during the term to maturity into a fixed number of 10,538,583 shares of our common stock, subject to adjustment solely for capital reorganization events. The Merkin Note also embodies certain traditional default provisions that are linked to credit or interest risks, such as bankruptcy proceedings, liquidation events and corporate existence. In addition, the holder is entitled to designate one member of our Board of Directors while the Merkin Note is outstanding or the holder owns at least 1,000,000 shares of our common stock. We have concluded that the embedded conversion option is not indexed to our stock because it did not pass the criteria of equity classification. Therefore, the embedded conversion option is subject to classification in our financial statements in liabilities at fair value both at inception and subsequently.

Concurrent with the issuance of the Merkin Note, we entered into an agreement with the Dr. Merkin that provides for a guaranteed post-conversion sales value of $3.00 per converted share with a monetary obligation not to exceed a fixed amount of $15,000,000, following conversion of the Merkin Note, if ever, without expiration. The fixed monetary amount is settled solely by our issuance of additional shares of our common stock. The number of shares necessary to settle this contingent obligation is dependent upon future values of our common stock at times the holder chooses to sell converted shares, if the holder in fact converts. Thus the number of shares necessary to settle is not determinable. We have concluded that this arrangement is an embedded financial instrument subject to bifurcation and classification in our financial statements in liabilities at fair value both at inception and subsequently.

On April 20, 2011, we entered into an amendment with Dr. Richard Merkin. The Amendment added an automatic conversion feature in which the Merkin Note and all accrued interest converts automatically into 10,538,583 shares of our common stock upon our completion of a Qualified Financing (defined as the Company’s sale of securities in a transaction or series of transactions of at least $10,000,000). Dr. Merkin also agreed to the deletion of the majority of the negative covenants in the note. In exchange for these modifications, we agreed to pay Dr. Merkin a fee of $2,000,000 upon the completion of a Qualified Financing. We analyzed the modification under applicable accounting standards. We determined that extinguishment accounting was applicable because the change in cash flows as a result of the amendment was substantial because it was greater than ten percent (10%). As a result of the modification, we recorded a loss on debt extinguishment of $2,000,000 with the offsetting charge to accrued liabilities for the future payment of $2,000,000 to Dr. Merkin.

$500,000 COR Secured Convertible Note

On March 11, 2011, we issued a $500,000 face value Secured Convertible Note, due January 24, 2012, to COR Capital, LLC (the “COR Note”) for net proceeds of $500,000. The COR Note is secured pari passu by all of our assets with our other $6,000,000 of outstanding convertible notes and accrues interest at 10% per annum, payable in cash at maturity. However, the principal amount, plus accrued interest, may be converted at the option of the holder at any time during the term to maturity into shares of our common stock at a conversion price of $3.00 per share subject to adjustment for capital reorganization events and subsequent sales by the Company of shares of its common stock at a price per share below $3.60. The COR Note also embodies certain traditional default provisions that are linked to credit or interest risks, such as bankruptcy proceedings, liquidation events and corporate existence. We have concluded that the embedded conversion option is not indexed to our stock due to the down-round protection features afforded to the holder. Therefore, the embedded conversion option is subject to classification in our financial statement in liabilities at fair value both at inception and subsequently.

Concurrent with the issuance of the COR Note, we entered into an agreement with the holder that provides for a guaranteed post-conversion sales value of $3.00 per converted share with a monetary obligation not to exceed a fixed amount of $600,000, following conversion of the COR Note, if ever, without expiration. The fixed monetary amount is settled solely by our issuance of additional shares of our common stock. The number of shares necessary to settle this contingent obligation is dependent upon future values of our common stock at times the holder chooses to sell converted shares, if the holder in fact converts, and is, therefore, not determinable. We have concluded that this arrangement is an embedded financial instrument subject to bifurcation and classification in our financial statements in liabilities at fair value both at inception and subsequently.

On April 20, 2011, we entered into a waiver agreement with COR Capital, LLC. As consideration for consenting to the amendment to the Merkin Note, we issued to COR Capital LLC a warrant to purchase up to $200,000 of the our common stock. The warrant’s purchase price per share is equal to the conversion price per share of the COR Note. The COR warrant expires on April 20, 2012. We analyzed the modification under applicable accounting standards. We determined that extinguishment accounting was not applicable because the change in cash flows as a result of the amendment was not substantial. We have concluded that the warrants issued as consideration for the waiver did not meet the criteria for equity classification. Accordingly, our analysis resulted in the conclusion that this warrant requires classification in our financial statements in liabilities at fair value both at inception and subsequently.

$2,500,000 Hexagon Secured Convertible Note

On April 25, 2011, we issued a $2,500,000 face value Secured Convertible Note, due April 24, 2012, to Hexagon Investments, LLC (the “Hexagon Note”) for net proceeds of $2,500,000. The Hexagon Note is secured pari passu by all of our assets with our other $4,000,000 of outstanding convertible notes and accrues interest at 10% per annum, payable in cash at maturity. However, the principal amount, plus accrued interest, may be converted at the option of the holder at any time during the term to maturity into shares of our common stock at a conversion price of $3.00 per share subject to adjustment for capital reorganization events. Additionally, if we enter into a Qualified Financing prior to the maturity date, the note will automatically convert into shares of our common stock at a conversion price of the lesser of $3.00 or 80% of the per share price of the Qualified Financing if that Qualified Financing is less than $3.60 per share. The Hexagon Note also embodies certain traditional default provisions that are linked to credit or interest risks, such as bankruptcy proceedings, liquidation events and corporate existence. We have concluded that the embedded conversion option is not indexed to our stock because it did not meet the criteria for equity classification. Therefore, the embedded conversion option is subject to classification in our financial statements in liabilities at fair value both at inception and subsequently.

In connection with the issuance of the Hexagon Note, we issued Hexagon two warrants to purchase our common stock. The first warrant is exercisable until April 25, 2013, for a market value as of the exercise date of up to $2,000,000 of shares at an exercise price per share equal to the conversion price per share of the Hexagon Note. The second warrant is exercisable until April 25, 2014, for up to $7,500,000 of shares at the same exercise price per share. We have concluded that these warrants did not meet the criteria for equity classification. Accordingly, our analysis resulted in the conclusion that these warrants require classification in our financial statements in liabilities at fair value both at inception and subsequently.

Accounting for the Merkin, COR and Hexagon Secured Convertible Notes

We have evaluated the terms and conditions of the Merkin, COR and Hexagon secured convertible notes. Because the economic characteristics and risks of the equity-linked conversion options are not clearly and closely related to a debt-type host, the conversion features require classification and measurement as derivative financial instruments. The other embedded derivative features (down-round protection feature of the COR Note, automatic conversion provision of the Hexagon Note and the make whole provisions of the Merkin Note, COR Note, and Hexagon Note) were also not considered clearly and closely related to the host debt instruments. Further, these features individually were not afforded the exemption normally available to derivatives indexed to a company’s own stock. Accordingly, our evaluation resulted in the conclusion that this compound derivative financial instrument requires bifurcation and liability classification, at fair value. The compound derivative financial instrument consists of (i) the embedded conversion features and the (ii) down-round protection features. Current standards contemplate that the classification of financial instruments requires evaluation at each report date.

The following table reports the allocation of the purchase on the financing dates:


	Merkin Note:			COR Note:			Hexagon Note
	$2,000,000 Face			$500,000 Face			$2,500,000 Face
Secured Convertible Notes	Value			Value			Value
Proceeds	$	(2,000,000	)	$	(500,000	)	$	(2,500,000	)
Compound embedded derivative		10,068,182			332,539			459,989
Warrant derivative liability		—			—			3,954,333
Day-one derivative loss		(8,068,182	)		—			(1,914,322	)

Carrying value	$	—		$	167,461		$	—

The carrying value of the secured convertible notes at December 31, 2010 was $0 and the carrying value at June 30, 2011 was $452,771.

Discounts (premiums) on the convertible notes arise from (i) the allocation of basis to other instruments issued in the transaction, (ii) fees paid directly to the creditor and (iii) initial recognition at fair value, which is lower than face value. Discounts (premiums) are amortized through charges (credits) to interest expense over the term of the debt agreement. Amortization of debt discounts (premiums) amounted to $285,310 during the period from August 5, 2010 (Inception) to June 30, 2011.