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NOTE 4. 7% CONVERTIBLE PROMISSORY NOTES AND WARRANTS
9 Months Ended
Sep. 30, 2012
Notes to Financial Statements  
NOTE 4. 7% CONVERTIBLE PROMISSORY NOTES AND WARRANTS

 

NOTE 4.  7% SENIOR SECURED CONVERTIBLE PROMISSORY NOTES

 

On July 27, 2011 the Company completed an offering of $5,000,000 of its senior secured convertible promissory notes (the “Notes”). The Notes bear an interest of 7% per annum, originally scheduled to mature on November 30, 2011 and convertible into shares of the Company’s common stock at a conversion price of $1.25 per share, subject to adjustment. The Notes also contain a redemption feature whereby the Company can force conversion in the event its common stock trades at 200% of the conversion price for twenty consecutive trading days with a minimum daily trading volume of 100,000 shares. The terms of the Notes have been amended several times and had an extended maturity date to November 30, 2012, unless the holders of the Notes demand payment at any earlier date upon delivery of written notice.  The purchasers of the Notes also received five year, fully vested warrants to purchase 4,000,000 shares of common stock at $1.25 per share, subject to adjustment.  Net proceeds to the Company from the issuance of the Notes were $4,615,000 after placement and other direct closing costs.

 

The conversion price of the Notes and the exercise price of the warrants are subject to adjustment based upon the pricing of subsequent financings undertaken by the Company.  The Company has determined that this anti-dilution reset provision caused the conversion feature to be bifurcated from the Notes, treated as a derivative liability, and accounted for at its fair value.  Upon issuance, the Company determined the fair value of the beneficial conversion feature was $1,844,422 and recorded a corresponding discount to the Notes.  The Company has also determined that the anti-dilution reset provision of the warrants is subject to derivative liability treatment and is required to be accounted for at its fair value.  Upon issuance, the Company determined the fair value of the warrants was $3,616,870 and recorded a discount of $3,155,578 to the Notes, and recognized the remaining amount of $461,292 as private placement costs in the statement of operations.  The total discount to the Notes of $5,000,000 was amortized in full over the original maturity date of November 30, 2011.  See Note 7 for discussion on derivative liability.

 

In connection with this sale of Notes and warrants, the Company 1) incurred a placement fee of $350,000 (7% of gross proceeds of the offering), 2) issued five-year warrants to its placement agent to acquire 80,000 shares of common stock, and 3) paid $35,000 for legal and escrow services in connection with the issuance of these Notes and warrants.  The warrants issued to the placement agent are exercisable at $1.25 per share, may be exercised on a cashless basis, and contain anti-dilution protection.  The Company has determined that this anti-dilution reset provision of the warrants is subject to derivative liability treatment and is required to be accounted for at its fair value.  Upon issuance, the Company determined the fair value of the warrants was $74,018 and recorded a corresponding charge to private placement costs. The aggregate amount of the above costs was $459,018, and was considered as a cost of the private placement. Total private placement costs recorded for the issuance of convertible debentures was $920,310.

 

As of September 30, 2012, the entire $5,000,000 remains outstanding and $416,111 of accrued interest is recorded as part of Accrued Expenses in the accompanying condensed balance sheet.

 

As of the date of this Quarterly Report, the notes are in default.  Upon a default, the interest rate on the Notes increases to 15% per annum, and the holders of the Notes have the right to demand that the Company immediately redeem all of the Notes at a price that is the greater than the outstanding balance of the Notes.  In general, the investors may demand that the Notes be redeemed at a price equal to the greater of (i) 125% of the outstanding balance of the Notes, or (ii) an amount based on 135% of the greatest closing sale price of the Company’s common stock during the period beginning on the date of default until the redemption demand.  A default will also permit the holders of the Notes to pursue collection actions against the Company.  The Company has not received any demand for payment from the note holders and is currently in discussion with the note holders to cure the default.