(3) Union Capital Financing

6 Months Ended

Sep. 30, 2011

Discussion of Hybrid Instruments and Embedded Derivatives [Text Block]

(3)	Union Capital Financing
	Overview:
	On December 15, 2009, the Company consummated a $5.0 million financing led by an investment vehicle organized by Union Capital Corporation (“UCC”). In the financing, the Company issued $2.5 million in aggregate principal amount of the Senior Notes, $2.5 million in aggregate stated value of Series D Preferred Stock initially convertible into 5,319,149 shares of Common Stock, and Warrants to purchase 2,456,272 shares of Common Stock (“Warrants”). As a condition to its participation in the financing, UCC required that certain of our directors, officers and employees (“Management Buyers”) collectively purchase $735,000 of the financial instruments on the same terms and conditions as the lead investor. Aggregate amounts above are inclusive of Management Buyers amounts. See Note 4 for terms of the Senior Notes.
	The shares of Series D Preferred Stock issued in the financing have a stated value of $1.00 per share, and are convertible into Common Stock at an initial conversion price of $0.47.  The conversion price of the Series D Preferred Stock is subject to full ratchet anti-dilution provisions for 18 months following issuance and weighted-average anti-dilution provisions thereafter. Generally, this means that if the Company sells non-exempt securities below the conversion price, the holders’ conversion price will be adjusted downwards. Holders of the Series D Preferred Stock are not entitled to special dividends but will be entitled to be paid upon a liquidation, redemption or change of control, the stated value of such shares plus the greater of (a) a 14% accreting liquidation preference, compounding annually, and (b) 3% of the volume weighted average price of the Common Stock outstanding on a fully-diluted basis (excluding the shares issued upon conversion of the Series D Preferred Stock) for the 20 days preceding the event.  A consolidation or merger, a sale of all or substantially all of the Company’s assets, and a sale of 50% or more of Common Stock would be treated as a change of control for this purpose.
	After December 15, 2015, holders of the Series D Preferred Stock can require the Company to redeem the Series D Preferred Stock for cash at its stated value plus any accretion thereon (“Put Derivative”).  In addition, the Company may be required to redeem the Series D Preferred Stock for cash earlier upon the occurrence of a “Triggering Event.” Triggering Events include (i) a failure to timely deliver shares of Common Stock upon conversion of Series D Preferred Stock, (ii) failure to pay amounts due to the holders (after notice and a cure period), (iii) a bankruptcy event with respect to the Company or any of its subsidiaries, (iv) default under other indebtedness in excess of certain amounts, and (v) a breach of representations, warranties or covenants in the documents entered into in connection with the financing.  Upon a Triggering Event or failure to redeem the Series D Preferred Stock, the accretion rate on the Series D Preferred Stock will increase to 16.5% per annum.  The Company may also be required to pay penalties upon a failure to timely deliver shares of Common Stock upon conversion of Series D Preferred Stock.
	The Series D Preferred Stock votes together with the Common Stock on an as-converted basis, and the vote of a majority of the shares of the Series D Preferred Stock is required to approve, among other things, (i) any issuance of capital stock senior to or pari passu with the Series D Preferred Stock; (ii) any increase in the number of authorized shares of Series D Preferred Stock; (iii) any dividends or payments on equity securities; (iv) any amendment to the Company’s Certificate of Incorporation, By-laws or other governing documents that would result in an adverse change to the rights, preferences, or privileges of the Series D Preferred Stock; (v) any material deviation from the annual budget approved by the Board of Directors; and (vi) entering into any material contract not contemplated by the annual budget approved by the Board of Directors.
	So long as at least 25% of the shares of Series D Preferred Stock issued at closing are outstanding, the holders of the Series D Preferred Stock as a class will have the right to designate two members of the Company’s Board of Directors, and so long as at least 15% but less than 25% of the shares of Series D Preferred Stock issued at the closing are outstanding, the holders of the Series D Preferred Stock will have the right to designate one member of the Board of Directors.  Additionally, the holders of Series D Preferred Stock have the right to designate two non-voting observers to our Board of Directors.
	The Warrants to purchase 2,456,272 shares of Common Stock issued in the financing have an exercise price of $0.001 per share, subject to adjustment solely for recapitalizations. The Warrants may also be exercised on a cashless basis under a formula that explicitly limits the number of issuable common shares. The exercise period for the Warrants commences 180 days following December 15, 2009 and ends December 15, 2015.

At the request of the holders of a majority of the shares of Common Stock issuable upon conversion of the Series D Preferred Stock and exercise of the Warrants, if ever, the Company will be required to file a registration statement with the SEC to register the resale of such shares of Common Stock under the Securities Act of 1933, as amended.

Upon closing of the financing, UCC became entitled to a closing fee of $325,000, half of which was paid upon the closing and the balance of which was paid in six monthly installments following the closing. The Company also reimbursed UCC for its fees and expenses in the amount of $250,000. Additionally, the Company entered into a management consulting agreement with Union Capital under which Union Capital provides the Company with management advisory services and the Company pays Union Capital a fee of $125,000 per year for such services.  Such fee will be reduced to $62,500 per year if the holders of the Series D Preferred Stock no longer have the right to nominate two directors and Union Capital no longer owns at least 40% of the Common Stock purchased by it at closing (assuming conversion of Series D Preferred Stock and exercise of Warrants held by it). The management consulting agreement will terminate when the holders of the Series D Preferred Stock no longer have the right to nominate any directors and Union Capital no longer owns at least 20% of the Common Stock purchased by it at closing (assuming conversion of Series Preferred D Stock and exercise of Warrants held by it).

Accounting for the December 2009 Financing:

Current accounting standards require analysis of each of the financial instruments issued in the December 2009 financing for purposes of classification and measurement in our financial statements.

The Series D Preferred Stock is a hybrid financial instrument.  Due to the redemption feature and the associated participation feature that behaves similarly to a coupon on indebtedness, the Company determined that the embedded conversion feature and other features that have risks associated with debt require bifurcation and classification in liabilities as a compound embedded derivative financial instrument. The conversion feature, along with certain other features that have risks of equity, required bifurcation and classification in their compound form in liabilities as a derivative financial instrument. Derivative financial instruments are required to be measured at fair value both at inception and an ongoing basis. As more fully discussed below, the Company has used the Monte Carlo simulation technique to value the compound embedded derivative, because that model affords the flexibility to incorporate all of the assumptions that market participants would likely consider in determining the value for purposes of trading the hybrid contract. Further, due to the redemption feature, the Company is required to carry the host Series D Preferred Stock outside of stockholders’ equity and the discount resulting from the initial allocation requires accretion through charges to retained earnings, using the effective method, over the period from issuance to the redemption date.

The Company evaluated the terms and conditions of the Senior Notes under the guidance of ASC 815, Derivatives and Hedging. The terms of the Notes that qualify as a derivative instrument are (i) a written put option which allows the holders of the Notes to accelerate interest and principal (effectively forcing an early redemption of the Notes) in the event of certain events of default, including a change of control of the Company, and (ii) the holders’ right to increase the interest rate on the Notes by 4% per year in the event of a suspension from trading of the Company’s Common Stock or an event of default.  Pursuant to ASC 815-15-25-40, put options that can accelerate repayment of principal meet the requisite criteria of a derivative financial instrument. In addition, as addressed in ASC 815-15-25-41, for a contingently exercisable put to be considered clearly and closely related to the relevant instrument and not constitute a separate derivative financial instrument, it can be indexed only to interest or credit risk. In this instance, the put instruments embedded in the Notes are indexed to events that are not related to interest or credit risk, namely, a change of control of the Company, and suspension of trading of the Company’s Common Stock.  Accordingly, these features are not considered clearly and closely related to the Note, and bifurcation is necessary.

The Company determined that the Warrants should be classified as stockholders’ equity. The principal concepts underlying accounting for warrants provide a series of conditions, related to the potential for net cash settlement, which must be met in order to achieve equity classification. Our conclusion is that the Warrants are indexed to the Company’s common stock and meet all of the conditions for equity classification. The Company measured the fair value of the Warrants on the inception date to provide a basis for allocating the net proceeds to the various financial instruments issued in the December 2009 financing. As more fully discussed below, the Company used the Black-Scholes-Merton valuation technique, because that method embodies, in its view, all of the assumptions that market participants would consider in determining the fair value of the Warrants for purposes of a sale or exchange.  The allocated value of the Warrants was recorded to Additional Paid-in Capital.

The financial instruments sold to the Management Buyers, were recognized as compensation expense in the amount by which the fair value of the share-linked financial instruments (i.e. Series D Preferred Stock and Warrants) exceeded the proceeds that the Company received. The financial instruments subject to allocation are the Senior Notes, Series D Preferred Stock, Compound Embedded Derivatives (“CED”) and the Warrants. Other than the compensatory amounts, current accounting concepts generally provide that the allocation is, first, to those instruments that are required to be recorded at fair value; that is, the CED; and the remainder based upon relative fair values.

The following table provides the components of the allocation and the related fair values of the subject financial instruments:

			Allocation
	Fair Values		UCC			Management Buyers			Total
Proceeds:
Gross proceeds			$	4,265,000		$	735,000		$	5,000,000
Closing costs				(325,000	)		—			(325,000	)
Reimbursement of investor costs				(250,000	)					(250,000	)
Net proceeds			$	3,690,000		$	735,000		$	4,425,000
Allocation:
Series D Preferred Stock	$	2,670,578	$	1,127,574		$	233,098		$	1,360,672
Senior Notes	$	2,536,015		1,070,519			363,293			1,433,812
Compound Embedded Derivatives (CED):
Series D Preferred Stock	$	1,116,595		949,106			167,489			1,116,595
Senior Notes	$	28,049		23,842			4,207			28,049
Warrants	$	1,225,680		518,959			183,852			702,811
Compensation Expense				—			(216,939	)		(216,939	)
			$	3,690,000		$	735,000		$	4,425,000

Closing costs of $325,000 were paid directly to the lead investor. The Company agreed to reimburse UCC $250,000 for out-of-pocket expenses of which $150,000 was paid upon signing of the purchase agreement in November 2009, and the remainder paid at closing. As required by current accounting standards, financing costs paid directly to an investor or creditor are reflected in the allocation as original issue discount to the financial instruments.

Fair Value Considerations:

The Company has adopted the authoritative guidance on “Fair Value Measurements.”  The guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not adjusted for transaction costs.  The guidance also establishes a fair value hierarchy that prioritizes the inputs to the valuation techniques used to measure fair value into three broad levels giving the highest priority to quoted prices in active markets for identical asset or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3) as described below:

Level 1 Inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible by the Company.

Level 2 Inputs – Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly.

Level 3 Inputs – Unobservable inputs for the asset or liability including significant assumptions of the Company and other market participants.

The Company’s Senior Notes, Warrant derivative liability, Put option derivative and Series D Preferred Stock are classified within Level 3 of the fair value hierarchy as they are valued using unobservable inputs including significant assumptions of the Company and other market participants.

The following tables present the Company’s instruments that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy.

	Fair Value Measurements as of March 31, 2011
	Total		Level 1		Level 2		Level 3
Instruments:
Senior Notes	$	2,500,000	$	—	$	—	$	2,500,000
Warrants		2,837,143		—		—		2,837,143
Put Derivative		5,272		—		—		5,272
Series D Preferred Stock		2,003,085		—		—		2,003,085
Total Instruments	$	7,345,500	$	—	$	—	$	7,345,500

	Fair Value Measurements as of September 30, 2011
	Total		Level 1		Level 2		Level 3
Instruments:
Senior Notes	$	2,500,000	$	—	$	—	$	2,500,000
Warrants		2,409,574		—		—		2,409,574
Put Derivative		2,574		—		—		2,574
Series D Preferred Stock		2,300,008		—		—		2,300,008
Total Instruments	$	7,212,156	$	—	$	—	$	7,212,156

The following table presents the changes in Level 3 Instruments measured at fair value on a recurring basis for the three months ended September 30, 2011 and 2010:

	Total			Senior Notes		Warrants			Put Derivative			Series D Preferred Stock
Balances at, June 30, 2010	$	3,986,778		$	1,586,041	$	761,981		$	11,940		$	1,626,816
Fair value adjustments		1,652,404			—		1,658,191			(5,787	)		—
Discount amortization		75,096			75,096		—			—			—
Accretion		125,108			—		—			—			125,108
Balances at, September 30, 2010	$	5,839,386		$	1,661,137	$	2,420,172		$	6,153		$	1,751,924
Balances at, June 30, 2011	$	7,314,575		$	2,500,000	$	2,680,150		$	4,280		$	2,130,145
Fair value adjustments		(272,282	)		—		(270,576	)		(1,706	)		—
Discount amortization		—			—		—			—			—
Accretion		169,863			—		—			—			169,863
Balances at, September 30, 2011	$	7,212,156		$	2,500,000	$	2,409,574		$	2,574		$	2,300,008

The following table presents the changes in Level 3 Instruments measured at fair value on a recurring basis for the six months ended September 30, 2011 and 2010:

	Total			Senior Notes		Warrants			Put Derivative			Series D Preferred Stock
Balances at, March 31, 2010	$	3,978,080		$	1,514,340	$	849,211		$	110,940		$	1,503,589
Fair value adjustments		1,466,174			—		1,570,961			(104,787	)		—
Discount amortization		146,797			146,797		—			—			—
Accretion		248,335			—		—			—			248,335
Balances at, September 30, 2010	$	5,839,386		$	1,661,137	$	2,420,172		$	6,153		$	1,751,924
Balances at, March 31, 2011	$	7,345,500		$	2,500,000	$	2,837,143		$	5,272		$	2,003,085
Fair value adjustments		(430,267	)		—		(427,569	)		(2,698	)		—
Discount amortization		—			—		—			—			—
Accretion		296,923			—		—			—			296,923
Balances at, September 30, 2011	$	7,212,156		$	2,500,000	$	2,409,574		$	2,574		$	2,300,008

The fair value adjustments recorded for Warrants and Put Derivative are reported separately in the Statement of Operations, the discount amortization on Senior Notes is reported in interest expense, and accretion on Series D Preferred Stock is recorded to the accumulated deficit.