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CONVERTIBLE PREFERRED STOCK AND WARRANTS | 12 Months Ended
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Dec. 31, 2015
Notes to Financial Statements |
Note 9. CONVERTIBLE PREFERRED STOCK AND WARRANTS | 2013 Financing On December 13, 2013, the Company entered into a securities purchase agreement with certain investors for the private placement, for aggregate gross proceeds of $7,000,000, of 3,500,000 shares of the Company's newly-designated Series A 6% Convertible Preferred Stock (the "Series A Preferred Stock" – see Note 6) and warrants to purchase 5,250,000 shares of our common stock at an exercise price of $2.387 per share. The shares of Series A Preferred Stock, which had a stated liquidation value of $2.00, were convertible at any time, at the option of the holder, into shares of common stock on a one-for-one basis and vote with the shares of common stock on an as-converted basis. The holders of the Series A Preferred Stock could request redemption of their shares at their stated value of $2.00 per share, beginning on December 13, 2017. The Series A Preferred Stock accrued dividends at the rate of 6% per annum, whether or not declared by the Board of Directors. The Warrants could have been exercised at any time on or after June 13, 2014 and expire on June 13, 2019. They could have been exercised on a cashless basis and contain customary anti-dilution protection in the event of stock splits, stock dividends or similar events. In connection with the placement of the Series A Preferred Stock and warrants, we also issued warrants to purchase 525,000 shares of our common stock, with the same terms as the investor warrants, to the placement agent and paid cash fees to the placement agent of $420,000, equal to six percent of the purchase price paid by the investors in the offering. We also incurred other cash fees related to the offering of $202,145. The warrants contain a provision that may require net cash settlement in the event that there is a Fundamental Transaction (contractually defined as a merger, sale of substantially all assets, tender offer or share exchange). Because of this contingent redemption provision, the warrants require liability classification in accordance with FASB ASC 480-10, Distinguishing Liabilities from Equity and do not meet all of the established criteria for equity classification in FASB ASC 815-40, Derivatives and Hedging – Contracts in Entity's Own Equity. Accordingly, the warrants are recorded as derivative liabilities at fair value. Changes in the fair value of the warrants are charged or credited to income each period. The warrants issued to the investors and to the placement agent were valued using a trinomial lattice model, because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in the model included the market price of our common stock on the date of valuation, an expected dividend yield of zero, the remaining period to the expiration date of the warrants, expected volatility of our common stock over the remaining life of the warrants of 48.75% estimated based on a review of our historical volatility, and risk-free rates of return based on constant maturity rates published by the U.S. Federal Reserve, applicable to the remaining life of the warrants. At December 31, 2015 and December 31, 2014, the investor warrants were valued at $0 and $10,547,250, respectively, and the placement agent warrants were valued at $267,331 and $998,222, respectively. The aggregate change in value of the investor and placement agent warrants between December 13, 2015 and December 31, 2014 of $1,798,845 was recorded in income as a non-operating gain. The Company and the investors also executed a Registration Rights Agreement whereby the Company agreed to register the shares of common stock issuable upon conversion of the Series A Preferred Stock and upon exercise of the Warrants, as well as the common stock underlying the warrants issued to the placement agent. Pursuant to the terms of the Registration Rights Agreement, the Company agreed to file a registration statement within thirty days of the closing date and was required to obtain the effectiveness of such registration statement within ninety days of its filing. In the event that the required filing and effectiveness dates were not met or if the registration statement, once effective, failed to remain effective for a continuous period of 30 days or for a cumulative total of 60 days in any 12 month period, then the Company would have been required to pay to each investor an amount in cash, as liquidated damages and not as a penalty, equal to 1% of the aggregate purchase price paid by such investor for its Preferred Stock and Warrants; and on each monthly anniversary of each such event (if the applicable event has not been cured by such date) until the applicable event was cured, a further 1% of the purchase price, subject to a maximum payment of 10% of the purchase price. The required registration statement was filed on January 10, 2014 and became effective on January 28, 2014. Accordingly, the Company was not required to pay any liquidated damages to the investors, unless the registration statement failed to remain continuously effective for the periods specified by the Registration Rights Agreement. The Company does not presently anticipate being required to make any such payments. The gross proceeds of the offering of $7,000,000 were first allocated to the fair value of the warrants issued to the investors, with the balance of the proceeds allocated to the Series A Preferred Stock. The aggregate costs of the offering of $1,060,520, including the cash fees paid of $622,145 and the fair value of the placement agent warrants of $438,375, were allocated between the Series A Preferred Stock and the warrants based on the gross proceeds allocated to each instrument, as follows:
|  | Proceeds Allocated |  |  | Expenses Allocated |
Series A Preferred Stock |  | $ | 2,616,250 |  |  | $ | 396,369 |
Investor Warrants |  |  | 4,383,750 |  |  |  | 664,151 |
|  | $ | 7,000,000 |  |  | $ | 1,060,520 |
Because the warrants are recorded as a liability at fair value, the portion of the expenses allocated to the warrants was expensed and is included in other income (expense) section in our Statement of Operations. In accordance with FASB ASC 470-20-25-5, the company recognized a beneficial conversion feature related to the Series A Preferred Stock, The beneficial conversion feature, which was limited to $2,616,250, the proceeds initially allocated to the Series A Preferred Stock, was credited to additional paid-in capital. Because the Series A Preferred Stock is not mandatorily redeemable but can be immediately converted by the holder, the discount recognized by the allocation of proceeds to the beneficial conversion feature was immediately accreted and recognized as a dividend to the preferred shareholders, in accordance with FASB ASC 470-20-35-7c. Because the holders of the Series A Preferred Stock could have requested redemption on or after December 13, 2017, the preferred stock has conditions for its redemption that are not within the control of the Company. Accordingly, the carrying amount of the Series A Preferred Stock of $2,616,250, net of the expenses allocated to the preferred stock of $396,369, was recorded outside of stockholders' equity, as mezzanine equity, in accordance with FASB ASC 480-10-S99. The net carrying amount of the Series A Preferred Stock was accreted to its redemption value over the four year period to when the holders may request redemption, using an effective interest method. For the period ended December 31, 2015, additional accretion of $221,902 was recognized and the net carrying amount of the Series A Preferred Stock at December 31, 2015 was $0. The warrants contain a provision that may require net cash settlement in the event that there is a Fundamental Transaction (contractually defined as a merger, sale of substantially all assets, tender offer or share exchange). Because of this contingent redemption provision, the warrants require liability classification in accordance with FASB ASC 480-10, Distinguishing Liabilities from Equity and do not meet all of the established criteria for equity classification in FASB ASC 815-40, Derivatives and Hedging – Contracts in Entity's Own Equity. Accordingly, the warrants are recorded as derivative liabilities at fair value. Changes in the fair value of the warrants are charged or credited to income each period. The warrants are valued using a trinomial lattice model. Significant assumptions used in the model at December 31, 2014 included the market price of our common stock, an expected dividend yield of zero, the remaining period to the expiration date of the warrants, expected volatility of our common stock over the remaining life of the warrants of 48.75%, estimated based on a review of our historical volatility, and risk-free rates of return of 0.12% based on constant maturity rates published by the U.S. Federal Reserve, applicable to the remaining life of the warrants. We also take into consideration a probability assumption for anti-dilution. At December 31, 2015 and December 31, 2014, the fair value of the investor and placement agent warrants was approximately $0 and $1,067,954, respectively. On March 31, 2014, the Company entered into an agreement with an existing warrant holder pursuant to which the Company repurchased warrants exercisable into 142,857 shares of Common Stock for an aggregate purchase price of $420,571. Reconciliation of changes in fair value Certain assets and liabilities that are measured at fair value on a recurring basis are measured in accordance with FASB ASC Topic 820-10-05, Fair Value Measurements. FASB ASC Topic 820-10-05 defines fair value, establishes a framework for measuring fair value and expands the disclosure requirements regarding fair value measurements for financial assets and liabilities as well as for non-financial assets and liabilities that are recognized or disclosed at fair value on a recurring basis in the financial statements. The statement requires fair value measurement be classified and disclosed in one of the following three categories: Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity). Assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. Our derivative financial instruments that are measured at fair value on a recurring basis are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The following represents a reconciliation of the changes in fair value of warrants measured at fair value using Level 3 inputs during the year ended December 31, 2015:
(in $ thousands) |  | 2013 Investor Warrants |  |  | 2013 Placement Agent Warrants |  |  | 2010 Investor Warrants |  |  | 2010 Placement Agent Warrants |  |  | Total |
Balance, December 31, 2014 |  | $ | 10,546 |  |  | $ | 998 |  |  | $ | 1,065 |  |  | $ | 4 |  |  | $ | 12,613 |
Issuances |  |  | - |  |  |  | - |  |  |  | - |  |  |  | - |  |  |  | - |
Exchange of warrants (1) |  |  | (10,546 | ) |  |  | - |  |  |  | - |  |  |  | - |  |  |  | (10,546 | )
Exercise of warrants |  |  | - |  |  |  | - |  |  |  | (1,081 | ) |  |  | - |  |  |  | (1,081 | )
Change in fair value |  |  | - |  |  |  | (731 | ) |  |  | 16 |  |  |  | (4 | ) |  |  | (719 | )
Balance, December 31, 2015 (2) |  | $ | - |  |  | $ | 267 |  |  | $ | - |  |  | $ | - |  |  | $ | 267 |
(1) | Represents the fair value carrying amount of 3,500,000 Series A Preferred shares and 5,250,000 warrants exchanged for 3,588,139 shares of Series B Preferred stock exercisable into 7,176,298 shares of common stock.
(2) | The warrants are valued using a trinomial lattice valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in the model at December 31, 2015 included the market price of our common stock, an expected dividend yield of zero, the remaining period to the expiration date of the warrants, expected volatility of our common stock over the remaining life of the warrants of 48.59%, estimated based on a review of our historical volatility, and risk-free rates of return of 1.535% for the 2013 warrants based on constant maturity rates published by the U.S. Federal Reserve, applicable to the remaining life of the warrants. We also take into consideration a probability assumption for anti-dilution.

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