Note 7 - Derivative Liabilities

8% Convertible Promissory Notes – Conversion Option and Warrants

Prior to, and through April 8, 2014, we issued 8% convertible promissory notes (the “8% Notes”). See Note 8 for further discussion. 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 various dates of issuance and recorded these fair values as a discount to the debt and a derivative liability. The fair value of the conversion option derivative liability on the various dates of issuance and on December 31, 2014 aggregated approximately $6,332,400 and $1,984,000, respectively. The change in fair value during the years ended December 31, 2014 and 2013 of a decrease of approximately $14,803,100 and an increase of approximately $10,870,400, respectively was recorded as a change in fair value of derivative liability in the statement of operations. The fair value of the warrants derivative liability on the various dates of issuance aggregated approximately $1,168,700. During the year ended December 31, 2014, we offered all warrant holders the right to exchange their warrants for their fair value, as calculated using the Black-Scholes option pricing model, for shares of common stock. All warrants associated with the 8% Notes were exchanged for shares of common stock resulting in no derivative liability for the warrants at December 31, 2014. The change in fair value during the years ended December 31, 2014 and 2013 of a decrease of approximately $5,181,400 and an increase of approximately $4,235,900, respectively was recorded as a change in fair value of derivative liability in the statement of operations. The fair value of common stock issued in exchange for warrants tendered exceeded the fair value of the warrant liability which resulted in (i) compensation expense of $19.1 million for all warrant holders considered affiliates which was recorded as a component of general and administrative expenses and (ii) approximately $883,400 of other expense for warrant holders not considered affiliates classified as fair value of common stock issued in excess of fair value of warrants tendered for the year ended December 31, 2014.

12% Convertible Promissory Notes – Conversion Option

During the year ended December 31, 2014, we issued 12% convertible promissory notes (the “12% Notes”). See Note 8 for further discussion. The 12% 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 12% Notes, into shares of our common stock. The conversion option is a derivative liability. 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. Accordingly, changes in the fair value of the 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 derivative liability on the date of issuance and recorded the fair value of $157,000 as a discount to the debt and a derivative liability. The aggregate fair value of the conversion option on December 31, 2014 was $69,000. The $88,000 decrease in the fair value of this derivative liability during the year ended December 31, 2014 was recorded as a change in derivative liability in the statement of operations.

The estimated fair values of the derivative liabilities associated with the 8% Notes and the 12% Notes, for the conversion options and warrants issued through and as of December 31, 2014 were computed by a third party using Monte Carlo simulations based on the following ranges for each assumption:

			December 31,
	At Issuances		2014

Volatility	40.0% to 45.0	%	35.0	%
Risk-free interest rate	0.11% to 0.3	%	0.4% to 0.14	%
Dividend yield	0.0	%	0.0	%
Expected life	1.1 to 1.6 years		0.25 to 0.65 years

Placement Agent Warrants

We issued warrants to the placement agents for the sale of our 10% convertible 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. We estimated the fair value at December 31, 2014 of this derivative liability by using the Black-Scholes option pricing model with the following assumptions - (i) no dividend yield, (ii) an expected volatility of 85%, (iii) a risk-free interest rate 0.47%, and (iv) an expected life of approximately one and one-half years. The fair value of the warrant liability at December 31, 2014 and 2013 was approximately $52,700 and $296,200, respectively and we recognized the change in fair value of the warrant liability during the years ended December 31, 2014 and 2013 of a credit in our statement of operations of approximately $243,500 and a charge in our statement of operations of approximately $214,500, respectively.

Accounting for 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 December 31, 2014 and 2013 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 tables summarize the financial liability measured at fair value on a recurring basis as of December 31, 2014 and 2013, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

	As of December 31, 2014
							Derivative
							Liabilities at
	Level 1		Level 2		Level 3		Fair Value

8% Convertible promissory notes:
Conversion option	$	-	$	-	$	1,984,000	$	1,984,000
12% Convertible promissory notes:
Conversion option		-		-		69,000		69,000
Derivative liabilities - Current		-		-		2,053,000		2,053,000
Placement agent warrants - Non-current		-		-		52,720		52,720
Derivative liabilities - Total	$	-	$	-	$	2,105,720	$	2,105,720

	As of December 31, 2013
							Derivative
							Liabilities at
	Level 1		Level 2		Level 3		Fair Value

8% Convertible promissory notes:
Conversion option	$	-	$	-	$	12,400,000	$	12,400,000
Warrants		-		-		4,790,000		4,790,000
Derivative liabilities - Current		-		-		17,190,000		17,190,000
Placement agent warrants - Non-current		-		-		296,194		296,194
Derivative liabilities - Total	$	-	$	-	$	17,486,194	$	17,486,194

The following tables are a reconciliation of the derivative liability for which Level 3 inputs were used in determining fair value during the years ended December 31, 2014 and 2013:

	For the Year Ended December 31, 2014
			Fair Value
	Balance -		of				Balance -
	January 1,		Derivative		Change in		December 31,
	2014		Liability		Fair Value		2014

8% Convertible promissory notes:
Conversion option	$	12,400,000	$	4,387,139	$	(14,803,139)	$	1,984,000
Warrants		4,790,000		391,365		(5,181,365)		-
12% Convertible promissory notes:
Conversion option		-		157,000		(88,000)		69,000
Derivative liabilities - Current		17,190,000		4,935,504		(20,072,504)		2,053,000
Placement agent warrants - Non-current		296,194		-		(243,474)		52,720
Derivative liabilities - Total	$	17,486,194	$	4,935,504	$	(20,315,978)	$	2,105,720

	For the Year Ended December 31, 2013
			Fair Value
	Balance -		of				Balance -
	January 1,		Derivative		Change in		December 31,
	2013		Liability		Fair Value		2013

8% Convertible promissory notes:
Conversion option	$	610,000	$	919,554	$	10,870,446	$	12,400,000
Warrants		220,000		334,059		4,235,941		4,790,000
Derivative liabilities - Current		830,000		1,253,613		15,106,387		17,190,000
Placement agent warrants - Non-current		81,716		-		214,478		296,194
Derivative liabilities - Total	$	911,716	$	1,253,613	$	15,320,865	$	17,486,194