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Derivative Liabilities

9 Months Ended

Sep. 30, 2012

Note 6 - Derivative Liabilities

8% Convertible Promissory Notes – Conversion Option and Warrant

During the three months ended September 30, 2012, we issued 8% convertible promissory notes (the “8% Notes”) see Note 7. The 8% Notes met the definition of a hybrid instrument, as defined in the ASC Topic 815 “Derivatives and Hedging” (“ASC 815”). The hybrid instrument was composed of a debt instrument, as the host contract, and an option to convert the debt outstanding under the terms of the 8% Notes, into shares of our common stock. The 8% Notes were issued with a warrant to purchase shares of our common stock. Both the conversion option and the warrants are derivative liabilities. The conversion option derives its value based on the underlying fair value of the shares of our common stock which is not clearly and closely related to the underlying host debt instrument since the economic characteristics and risk associated with the conversion option derivative are based on the common stock fair value. The warrants do not qualify as equity under ASC 815. Accordingly, changes in the fair value of these warrant and conversion option liabilities are immediately recognized in earnings and classified as a change in fair value in the statement of operations.

We determined the fair value of the conversion option and warrant derivative liabilities on the dates of issuance and recorded these fair values as a discount to the debt and a derivative liability. This debt discount is amortized to other expenses in our statement of operations over the initial term of the 8% Notes.

The fair value of the conversion option derivative liability on the dates of issuance and on September 30, 2012 was approximately $982,900 and $720,000, respectively. The decrease in fair value of approximately $262,900 was recorded as a change in derivative liability in the statement of operations during the three months ended September 30, 2012.

The fair value of the warrants derivative liability on the dates of issuance and on September 30, 2012 was approximately $427,900 and $300,000, respectively. The decrease in fair value of approximately $127,900 was recorded as a change in derivative liability in the statement of operations.

The estimated fair values of the conversion option and the warrant derivative liabilities, were computed by a third party using Monte Carlo simulation models based on the following assumptions:

	At Issuances			September 30, 2012

Volatility		50.0	%		50.0	%
Risk-free interest rate		0.4	%		0.3	%
Dividend yield		0.0	%		0.0	%
Expected life		3.0 years			2.9 years

Convertible Revolving Credit Agreement – Conversion Option

The convertible revolving credit agreement, see Note 5 (the “Agreement”) entered into during the year ended December 31, 2011 met the definition of a hybrid instrument, as defined in ASC 815. The hybrid instrument was comprised of a (i) a debt instrument, as the host contract and (ii) an option to convert the debt outstanding under the revolving credit agreement into shares of our common stock, as an embedded derivative. The embedded derivative derives its value based on the underlying fair value of the shares of our common stock. The embedded derivative is not clearly and closely related to the underlying host debt instrument since the economic characteristics and risk associated with this derivative are based on the common stock fair value.

We determined the fair value of the embedded derivative and recorded it as a discount to the debt and a derivative liability on the date of issue. The discount was amortized to other expenses over the initial term of the Agreement and the unamortized discount at repayment of principal and termination of the Agreement during the three months ended June 30, 2012 was charged to our statement of operations.

The embedded derivative did not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the embedded derivative were immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in the accompanying statements of operations. For the nine months ended September 30, 2012, we recognized a gain on the change in fair value of this derivative liability of approximately $113,300 in our statement of operations.

10% Convertible Preferred Stock – Warrants

The 10% convertible preferred stock (see Note 8) issued during the year ended December 31, 2011 meets the definition of a hybrid instrument, as defined in ASC 815. The hybrid instrument is comprised of a (i) a preferred stock, as the host contract, (ii) a warrant to purchase shares of our common stock to be issued if a certain revenue milestone was not achieved (the “Make Good Warrant”), as an embedded derivative liability and (iii) an option to convert the preferred stock into shares of our common stock (the “Conversion Option”). Since, at issuance the number of shares of common stock which the Make Good Warrant would be exercisable into, was not known, ASC 815 requires the fair value of the Make Good Warrants be recorded as a derivative liability at issuance and any change in fair value be recognized in current earnings. The Conversion Option derives its value based on the underlying fair value of the shares of our common stock as does the Preferred Stock, and therefore is clearly and closely related to the underlying host contract.

The Make Good Warrant derivative liability does not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the derivative liability are immediately recognized in earnings and classified as a gain or loss on the derivative liability in the accompanying statements of operations. At the date of issuance in March and April 2011, we determined the fair value of the Make Good Warrant derivative to be insignificant and did not record a charge to Common Stock and a credit to the derivative liability. Subsequently in 2011, when it became probable that the revenue milestone would not be met, we recorded the derivative liability at fair value of $1.9 million. Since we did not achieve the revenue milestone for the year ended December 31, 2011, we were required to issue the Make Good Warrants, and accordingly once issued, the derivative liability associated with the Make Good Warrants was satisfied and the related derivative liability was reduced to zero. During the three months ended March 31, 2012, we credited Common Stock for the issuance of these warrants for the fair value of the derivative liability of approximately $1.9 million.

10% Convertible Debenture – Bonus Warrants

Effective January 14, 2011, the holders of our 10% convertible debentures (“Debentures”), agreed to extend the maturity dates to June 30, 2012 and to the elimination of the prohibition of paying dividends or distributions on any of our equity securities. In addition to other amendments, we agreed that for each calendar month after the original maturity dates that these Debentures remained outstanding, we would issue a bonus warrant exercisable for three years for a number of shares of our common stock equal to the 5% of the outstanding principal, divided by $0.90. These bonus warrants are exercisable at $0.90 per share.

Since it was probable that we would issue the bonus warrants which were part of the reacquisition costs of the new debt, at each month-end through the amended maturity date, we calculated the fair value of the bonus warrants using the Black-Scholes pricing model and recorded a derivative liability of approximately $797,000 on the date of amendment and recognized the amount as a loss in our statement of operations during the three months ended March 31, 2011, the period of amendment. The bonus warrant derivative liability does not qualify as a fair value or cash flow hedge under ASC 815 and accordingly, changes in the fair value of the derivative liability are immediately recognized in earnings and classified as a gain or loss on the derivative liability in the accompanying statements of operations. During the nine months ended September 30, 2012, we recorded approximately $13,300 of gain in the fair value of the derivative liability. Upon issuance of the bonus warrants during the nine months ended September 30, 2012, we credited additional paid-in capital for approximately $57,000.

Placement Agent Warrants

We issued warrants to the placement agents for the sale of our 10% convertible redeemable preferred stock, to purchase 58,352 shares of 10% convertible preferred stock at $10 per share. Since the underlying 10% convertible preferred stock is redeemable by the holder after three years from the date of purchase, we recorded the fair value of the warrants at issuance, as a liability on our balance sheet and we re-measure this warrant liability at each reporting date, with changes in fair value recognized in earnings each reporting period. The fair value of the warrant liability at September 30, 2012 was approximately $85,600, and we recognized a charge to our statement of operations for the change in fair value of the warrant liability during the three and nine months ended September 30, 2012 of approximately $54,900 and $402,000, respectively.

Fair Value Measurements

We are required to disclose the fair value measurements required by Accounting for Fair Value Measurements. The derivative liability recorded at fair value in the balance sheet as of September 30, 2012 and December 31, 2011 is categorized based upon the level of judgment associated with the inputs used to measure its fair value. Hierarchical levels, defined by Accounting for Fair Value Measurements are directly related to the amount of subjectivity associated with the inputs to fair valuation of the liability is as follows:

Level 1 -

Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;

Level 2 -

Inputs other than Level 1 inputs that are either directly or indirectly observable; and

Level 3 -

Unobservable inputs, for which little or no market data exist, therefore requiring an entity to develop its own assumptions.

The following table summarizes the financial liabilities measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

	As of September 30, 2012
	Level 1		Level 2		Level 3		Liabilities at Fair Value
Derivative liability – 8% convertible promissory notes – conversion option	$	-	$	-	$	720,000	$	720,000
Derivative liability – 8% convertible promissory notes – warrants		-		-		300,000		300,000
Placement agent warrants		-		-		85,594		85,594
Total	$	-	$	-	$	1,105,594	$	1,105,594

	As of December 31, 2011 (Restated)
	Level 1		Level 2		Level 3		Liabilities at Fair Value
Derivative liability – conversion option	$	-	$	-	$	113,271	$	113,271
Derivative liability – warrants		-		-		1,875,463		1,875,463
Derivative liability – bonus warrants		-		-		70,343		70,343
Placement agent warrants		-		-		487,555		487,555
Total	$	-	$	-	$	2,546,632	$	2,546,632

The following tables are a reconciliation of the derivative liability for which Level 3 inputs were used in determining fair value:

	8% Note
	Conversion Option			Warrants			Conversion Option			Warrants			Bonus Warrants			Placement Agent Warrants

Beginning balance as of January 1, 2012	$	-		$	-		$	113,271		$	1,875,463		$	70,343		$	487,555
Fair value of derivative liability		982,932			427,888			-			-			-			-
Change in fair value		(262,932	)		(127,888	)		(113,271	)		-			(13,309	)		(401,961	)
Credited to common stock upon issuance of warrants		-			-			-			(1,875,463	)		(57,034	)		-
Ending balance as of September 30, 2012	$	720,000		$	300,000		$	-		$	-		$	-		$	85,594

	Conversion Option			Warrants		Bonus Warrants			Placement Agent Warrants

Beginning balance as of January 1, 2011	$	-		$	-	$	-		$	-
Fair value of derivative liability		118,663			-		797,185			487,555
Change in fair value		(5,392	)		1,875,463		(492,111	)		-
Credited to common stock upon issuance of warrants		-			-		(234,731	)		-
Ending balance as of December 31, 2011	$	113,271		$	1,875,463	$	70,343		$	487,555