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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 81510054. The embedded derivative feature includes the warrants attached to the Notes. Pursuant to Paragraph 81510054, 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 probabilityweighted cash flow approach, recorded at fair value at the date of issuance; and markedtomarket 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 8154015 of the FASB Accounting Standard Codification (“Section 8154015”) (formerly FASB Emerging Issues Task Force (“EITF”) Issue No. 075: Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock (“EITF 075”)). Section 8154015 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
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.
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 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 8154015 became effective:
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 paidin capital upon issuance. Upon the adoption of Section 8154015, 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 paidin 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:
The fair value of the embedded derivative warrants is markedtomarket at each balance sheet date after January 1, 2009, the date when Section 8154015 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:
Warrants Activities
The table below summarizes the Company’s derivative warrant activity through June 30, 2012:
