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v2.4.0.6
Derivative Warrant Liability
12 Months Ended
Jun. 30, 2012
Notes to Financial Statements  
Note 8 - Derivative Warrant Liability

The notes payable are hybrid instruments which contain an embedded derivative feature which would individually warrant separate accounting as a derivative instrument under Paragraph 815-10-05-4.  The embedded derivative feature includes the warrants attached to the Notes.  Pursuant to Paragraph 815-10-05-4, the value of the embedded derivative liability have been bifurcated from the debt host contract and recorded as a derivative liability resulting in a reduction of the initial carrying amount (as unamortized discount) of the notes, which are amortized as debt discount to be presented in other (income) expenses in the statements of operations using the effective interest method over the life of the notes.

 

The compound embedded derivatives within the notes have been valued using a layered discounted probability-weighted cash flow approach, recorded at fair value at the date of issuance; and marked-to-market at each reporting period end date with changes in fair value recorded in the Company’s statements of operations as “change in the fair value of derivative instrument”.

 

Warrants Issued on May 18, 2007

 

Description of Warrants

 

In connection with the sale of Notes, the Company issued (i) warrants to purchase 500,000 shares of common stock to the Notes holders and (ii) a warrant to purchase 83,111 shares of common stock to the broker, or 583,111 common shares in aggregate (“2007 Warrants”) with an exercise price of $0.18 per share, which expired on May 18, 2012, all of which have been earned upon issuance.

 

Derivative Analysis

 

The exercise price of the 2007 warrants and the number of shares issuable upon exercise was subject to reset adjustment in the event of stock splits, stock dividends, recapitalization, most favored nation clause and similar corporate events.  Pursuant to the most favored nation provision of the 2007 Notes Offering, if the Company issues any common stock or securities other than the excepted issuances,  to any person or entity at a purchase or exercise price per share less than the share purchase price of the 2007 warrant exercise price without the consent of the subscriber holding purchased notes, warrants or warrant shares of the 2007 Notes Offering, then the subscriber shall have the right to apply the lowest such purchase price or exercise price of the offering or sale of such new securities to the purchase price of the purchased shares then held by the subscriber (and, if necessary, the Company will issue additional shares), the reset adjustments are also referred to as full reset adjustments.

 

Because these warrants had full reset adjustments tied to future issuances of equity securities by the Company, they were subject to derivative liability treatment under Section 815-40-15 of the FASB Accounting Standard Codification (“Section 815-40-15”) (formerly FASB Emerging Issues Task Force (“EITF”) Issue No. 07-5: Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock (“EITF 07-5”)). Section 815-40-15 became effective for the Company on January 1, 2009 and as of that date the Warrants issued in the 2007 Notes Offering have been measured at fair value using a Binomial pricing model at each reporting period end date with gains and losses from the change in fair value of derivative liabilities recognized on the statements of operations.

 

Valuation of Derivative Liability

 

(a)   Valuation Methodology

 

The Company’s 2007 warrants do not trade in an active securities market, as such, the Company developed a lattice model that values the derivative liability of the warrants based on a probability weighted discounted cash flow model. This model is based on future projections of the various potential outcomes. The features that were analyzed and incorporated into the model included the exercise feature and the full ratchet reset.

 

Based on these features, there are two primary events that can occur; the Holder exercises the Warrants or the Warrants are held to expiration. The model analyzed the underlying economic factors that influenced which of these events would occur, when they were likely to occur, and the specific terms that would be in effect at the time (i.e. stock price, exercise price, volatility, etc.). Projections were then made on these underlying factors which led to a set of potential scenarios. As the result of the large Warrant overhang we accounted for the dilution affects, volatility and market cap to adjust the projections.

 

Probabilities were assigned to each of these scenarios based on management projections. This led to a cash flow projection and a probability associated with that cash flow. A discounted weighted average cash flow over the various scenarios was completed to determine the value of the derivative warrant liability.

 

(b)   Valuation Assumptions

 

The Company’s 2007 derivative warrants were valued at each period ending date using the Cox, Ross & Rubenstein Binomial Lattice Model with the following assumptions:

 

· The underlying stock price was used as the fair value of the common stock on period end date;

 

· The stock price would fluctuate with the Company’s projected volatility. The projected volatility curve for each valuation period was based on its historical volatility;

 

· The Holder would exercise the warrant at maturity if the stock price was above the exercise price;

 

· Reset events projected to occur are based on no future projected capital needs;

 

· The Holder would exercise the warrant as they become exercisable at target prices of $0.18 per common share for the 2007 Notes Offering, and lowering such target as the warrants approached maturity;

 

· The probability weighted cash flows are discounted using the risk free interest rates.

 

· Expected volatility: Due to limited to no trading volume, the Company selected comparables to determine expected volatility. The Company analyzed companies in the comparable industry and selected early staged, similarly capitalized companies. The Company performed an analysis of the comparable companies’ volatility and utilized the average of the comparable companies’ volatility as its expected volatility.

 

· The risk-free interest rate is based on a yield curve of U.S treasury interest rates on the date of valuation based on the contractual life of the warrants

 

· Expected annual rate of quarterly dividends is based on the Company’s dividend history and anticipated dividend policy.

 

(c)   Fair Value of Derivative Warrants

 

The fair value of the 2007 derivative warrants was computed using the Cox, Ross & Rubenstein Binomial Lattice Model with the following assumptions at December 31, 2008, the date when Section 815-40-15 became effective:

 

   

December 31,

2008

 
         
Expected life (year)     3.38  
         
Expected volatility     91.00 %
         
Expected annual rate of quarterly dividends     0.00 %
         
Risk-free interest rate     1.55 %

 

The Company initially classified the warrants to purchase 583,111 shares of its common stock issued in connection with its 2007 Notes Offering as additional paid-in capital upon issuance.  Upon the adoption of Section 815-40-15, these warrants are no longer deemed to be indexed to the Company’s own stock and were reclassified from equity to a derivative warrant liability.  The difference between the fair value of the 2007 warrants estimated on December 31, 2008 and the relative fair value of the 2007 warrants estimated on the date of grant was immaterial.  On January 1, 2009, the Company reclassified $52,887, the amount originally classified as additional paid-in capital upon issuance of the warrants on May 18, 2007, to the derivative warrant liability.  On May 18, 2012, all of the 2007  warrants unexercised and expired.

 

The fair value of the 2007 derivative warrants was computed using the Cox, Ross & Rubenstein Binomial Lattice Model with the following assumptions:

 

   

June 30,

2011

 
         
Expected life (year)     0.88  
         
Expected volatility     87.43 %
         
Expected annual rate of quarterly dividends     0.00 %
         
Risk-free interest rate     0.88 %

 

The fair value of the embedded derivative warrants is marked-to-market at each balance sheet date after January 1, 2009, the date when Section 815-40-15 became effective, and the change in the fair value of the embedded derivative warrants is recorded in the statements of operations as change in the fair value of derivative liability in other income or expense.

 

The table below provides a summary of the fair value of the derivative warrant liability and the changes in the fair value of the derivative warrants, including net transfers in and/or out, of derivative warrants measured at fair value on a recurring basis using significant unobservable inputs (level 3) at June 30, 2012 and for the interim period then ended:

 

    Fair Value Measurement Using Level 3 Inputs  
    Derivative warrants Assets (Liability)     Total  
             
Balance, December 31, 2008, the date when Section 815-40-15 became effective   $ (52,887 )   $ (52,887 )
                 
Total gains or losses (realized/unrealized) included in:                
                 
Net income (loss)     (759 )     (759 )
                 
Other comprehensive income (loss)     -       -  
                 
Purchases, issuances and settlements     -       -  
                 
Transfers in and/or out of Level 3     -       -  
                 
Balance, June 30, 2009     (53,646 )     (53,646 )
                 
Total gains or losses (realized/unrealized) included in:                
                 
Net income (loss)     9,504       9,504  
                 
Other comprehensive income (loss)     -       -  
                 
Purchases, issuances and settlements     -       -  
                 
Transfers in and/or out of Level 3     -       -  
                 
Balance, June 30, 2010     (44,142 )     (44,142 )
                 
Total gains or losses (realized/unrealized) included in:                
                 
Net income (loss)     12,946       12,946  
                 
Other comprehensive income (loss)     -       -  
                 
Purchases, issuances and settlements     -       -  
                 
Transfers in and/or out of Level 3     -       -  
                 
Balance, June 30, 2011     (31,196 )     (31,196 )
                 
Total gains or losses (realized/unrealized) included in:                
                 
Net income (loss)     31,196       31,196  
                 
Other comprehensive income (loss)     -       -  
                 
Purchases, issuances and settlements     -       -  
                 
Transfers in and/or out of Level 3     -       -  
                 
Balance, June 30, 2012   $ -     $ -  

 

Warrants Activities

 

The table below summarizes the Company’s derivative warrant activity through June 30, 2012:

 

    2007 Warrant Activities    

APIC

Reclassification of Derivative Liability

   

(Gain) Loss

Change in Fair Value of Derivative Liability

 
    Derivative Shares    

Non-derivative

 Shares

    Total Warrant Shares     Fair Value of Derivative Warrants          
                                     
Derivative warrants at December 31, 2008     583,111       -       583,111     $ (52,887 )   $ -     $ -  
                                                 
Exercise of warrants     (-     -       (-     -       (-     -  
                                                 
Exercise of warrants – Cashless     (-     -       (-     -       (-     -  
                                                 
Total warrant exercised     (-     -       (-     -       (-     -  
                                                 
Extinguishment of warrant liability resulting from waiver of anti-dilution     (-     -       (-     -       (-     -  
                                                 
Derivative warrants remaining     583,111       -       583,111       (52,887     -       -  
                                                 
Mark to market     -       -               (759 )     -       759  
                                                 
Derivative warrants at June 30, 2009     583,111       -       583,111       (53,646     -       759  
                                                 
Exercise of warrants     (-     -       (-     -       (-     -  
                                                 
Exercise of warrants – Cashless     (-     -       (-     -       (-     -  
                                                 
Total warrant exercised     (-     -       (-     -       (-     -  
                                                 
Extinguishment of warrant liability resulting from waiver of anti-dilution     (-     -       (-     -       (-     -  
                                                 
Derivative warrants remaining     583,111       -       583,111       (53,646     -       -  
                                                 
Mark to market     -       -               9,504       -       (9,504
                                                 
Derivative warrants at June 30, 2010     583,111       -       583,111       (44,142     -       -  
                                                 
Mark to market     -       -               12,946       -       (12,946
                                                 
Derivative warrants at June 30, 2011     583,111       -       583,111       (31,196     -       -  
                                                 
Mark to market (warrants expired)     (583,111 )     -       (583,111     31,196       -       31,196  
                                                 
Derivative warrants at June 30, 2012     -       -       -     $ -     $ -     $ -