10. DERIVATIVE LIABILITY

Secured Convertible Notes Conversion Option

In 2012, the Company issued notes that are convertible into shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”) at a conversion price of $0.20 per share (the “Conversion Price.”) The conversion feature was bifurcated from the Notes due to a down round provision in the terms of the conversion feature and accounted for as a derivative liability in the accompanying condensed balance sheet.

The Company recorded the conversion feature as a liability based upon its fair value on each reporting date.

The table below summarizes the fair values of the Company’s financial liabilities:

	Fair Value at
	September 30,		Fair Value Measurement Using
	2013		Level 1		Level 2		Level 3
Derivative liability – Conversion Feature	$	32,000		-		-	$	32,000
	$	32,000		-		-	$	32,000

The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial liabilities (Derivative liability – Conversion Feature) for the nine months ended September 30, 2013:

	September 30,
	2013
Balance at December 31, 2012	$	49,000
Additions to derivative instruments		-
Change in fair market value of Conversion Feature		(17,000)
Balance at September 30, 2013	$	32,000

The Company computed the fair value of the conversion feature using the Black-Scholes model.

The following are the key assumptions used in connection with this computation:

		September 30, 2013

Number of shares		625,000
Conversion Price		.20
Volatility		123.00 – 125.62%
Risk-free interest rate		2%
Expected dividend yield		0%
Life of Notes		18 months

Warrant Liability

In connection with the issuance of the Notes, the Company issued warrants to purchase up to 2,625,000 shares of Common Stock (the “Warrants”). The Warrants are exercisable for a 36 month period of time since the date of issuance and have an exercise price of $0.20 per share (the “Exercise Price”).

The Warrants provide for anti-dilution protection in the event that any shares of Common Stock, or securities convertible into Common Stock, are issued at less than the Exercise Price. The Company accounts for the Warrants as derivative liabilities in the accompanying condensed balance sheet.

The Company computed the value of the warrants using the Black-Scholes model.

The following are the key assumptions used in connection with this computation:

		September 30, 2013
Number of shares		2,625,000
Conversion Price		.20
Volatility		120.60-126.70%
Risk-free interest rate		2%
Expected dividend yield		0%
Life of Warrants		15 - 18 months

The Company recognizes their derivative financial instruments as assets or liabilities in the financial statements and measures them at fair value with changes in fair value reflected as current period income or loss.

The table below summarizes the fair values of the Company’s financial liabilities:

	Fair Value at
	September 30,		Fair Value Measurement Using
	2013		Level 1		Level 2		Level 3
Derivative liability – Warrants	$	131,000		-		-	$	131,000
	$	131,000		-		-	$	131,000

The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial liabilities Derivative Liability - Warrant for the nine months ended September 30, 2013:

	September 30,
	2013
Balance at December 31, 2012	$	178,000
Canceled warrants		(19,000)
Change in fair market value of Warrants		(28,000)

Balance at September 30, 2013	$	131,000