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4. CONVERTIBLE NOTES PAYABLE AND FAIR VALUE MEASUREMENTS
9 Months Ended
Sep. 30, 2011
Fair Value, Measurement Inputs, Disclosure [Table Text Block]
4.    CONVERTIBLE NOTES PAYABLE AND FAIR VALUE MEASUREMENTS

Summary – Short Term Convertible Debt:

As of September 30, 2011, the following summarizes amounts owed under short-term convertible notes:

 
 
Amount
   
Discount
   
Convertible Notes Payable,
net of discount
 
Pegasus Note
  $ 100,000     $ 6,160     $ 93,840  
Gemini Master Fund – Second Amended Note
  $ 968,855     $ 99,544     $ 869,311  
Gemini Master Fund –Note Five
  $ 88,717     $ 9,126     $ 79,591  
    $ 1,157,572     $ 114,830     $ 1,042,742  

Pegasus Note

On December 19, 2009, the Company entered into a convertible promissory note for $100,000 to a new landlord in lieu of paying rent for one year for new office space.  The interest is 10% per annum with the note principal and interest due December 18, 2010.  However, if the Company receives greater than $100,000 of proceeds from debt or equity financing, 25% of the amount in excess of $100,000 shall be used to pay down the note.  This note is subordinate to all existing senior indebtedness of the Company.  This note is convertible at $0.33 per share.  There was no beneficial conversion feature at the note date.  On March 28, 2011, the Company entered into a revised agreement to extend the maturity date of the note to December 31, 2011. Further, throughout the time period of the current private offering, the lender agreed to waive the requirement that 25% of the amount of any financing in excess of $100,000 be used to pay down the note balance.  As a result of this extension, the Company recorded $18,480 of embedded conversion option based effective interest in March 2011 which represents the increase in fair value of the embedded conversion option at the extension date, and is recorded as debt discount and is being amortized over the remaining term of the note. As of September 30, 2011, this note had a total outstanding balance of $100,000 and a balance, net of discount, of $93,840.  The interest on the note continues to accrue at a rate of 10%.

Gemini Note

On January 20, 2010, the Company entered into a Second Amendment Agreement with Gemini Master Fund, LTD whereby certain terms of the First Amendment Agreement were modified.  Under the Second Amendment Agreement the conversion price for all previous notes was reduced from $0.33 to $0.25 per share; the interest payment was extended from January 4, 2010 to April 1, 2010; and the beneficial ownership percentage was reduced from 9.9% to 4.9%.  There was no accounting effect for the price reductions as the conversion prices were greater than the fair value of the common stock.

On February 12, 2010, the Company issued to Gemini Master Fund, LTD the Second Amended and Restated Secured Bridge Note in the amount of $811,792 consolidating all principal amounts outstanding at this date along with all accrued but unpaid interest.  The terms of the note did not change. Prior to such issue, the Company paid down approximately $69,000 of the outstanding balance.

On March 10, 2010, the Company entered into a new secured note with Gemini Master Fund, LTD, Note No. 5, for $75,000.  The new note bears interest at 12% per annum, payable in quarterly installments of the accrued and unpaid interest, beginning April 1, 2010, with the note maturing on December 31, 2010. In the event a quarterly payment is late, it incurs a late fee of 20%.  The note carries a conversion feature whereby, the lender, at its option, may at any time convert this loan into common stock at $0.25 per share.  There is no beneficial conversion value as the conversion price was deemed to be equal to or greater that the fair value of the common stock.

Prior to June 30, 2010 all shares underlying the Gemini Master Fund convertible debt were subject to a lock-up agreement, and the shares were not easily convertible to cash thus, the embedded conversion option did not need to be bifurcated and recorded as a fair value derivative due to the price protection provision in the notes, which state the conversion price of the notes will be adjusted downward to match any lower price for which the Company issues subsequent shares.  Subsequent to June 30, 2010, such lock-up provisions expired and as such, the Company has determined that the embedded conversion option met the definition of a derivative liability and thus must be bifurcated and recorded as a fair value derivative.

On July 1, 2010 the Company established an embedded conversion option liability of $868,591 for the above mentioned $886,792 of Gemini debt.  The Company recorded a debt discount of $868,591 related to the fair value of the liability for the embedded conversion option.  The fair value was determined using the Black-Scholes pricing model with the following assumptions:  stock price $0.48, conversion price $0.25, expected term of six months based on the contractual term, volatility of 86% based on historical volatility, and a risk free interest rate of 0.2%.  As of December 31, 2010, the Company amortized all $868,591 of such debt discount to interest expense.

As of December 31, 2010, interest of $96,996 had accrued on the two Gemini Master Fund, LTD notes.  Further, on December 31, 2010, the Company entered into an extension agreement to extend the maturity date of the notes to December 31, 2011.  As part of this agreement, all accrued but unpaid interest totaling $96,996 was capitalized into the note balances along with an extension fee of $73,784. Such extension fee, recorded as additional debt discount, is being amortized to interest expense over the remaining term of the note.  Additionally, as a result of the note modification, $360,895 of embedded conversion option based effective interest (due to the increase in the value of the embedded conversion option) was recorded as additional debt discount and is being amortized over the remaining new term of the debt.  This effective interest also increased the fair value of the derivative liability by the same $360,895 amount on the modification date.  At September 30, 2011, the notes had a total balance outstanding of $1,057,572, and a net balance of $948,902.  The interest on the note continues to accrue at a rate of 12%.

Summary – Long Term Convertible Debt:

On September 8, 2011, the Company entered into a convertible promissory note for $1,000,000 to a private individual.  The interest is 9% per annum with the note principal and interest due December 31, 2012.  This note is subordinate to all existing senior indebtedness of the Company.  This note is convertible at $0.29 per share.  As it relates to this note, the Company recorded $34,483 of embedded conversion option based effective interest which represents the increase in fair value of the embedded conversion option at the note date, and is recorded as debt discount and is being amortized over the term of the note. As of September 30, 2011, this note had a total outstanding balance of $1,000,000 and a balance, net of discount, of $967,101.

Fair Value Measurements – Derivative liability:

  The accounting standard for fair value measurements provides a framework for measuring fair value and requires expanded disclosures regarding fair value measurements.  Fair value is defined as the price that would be received for an asset or the exit price that would be paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date.  The accounting standard established a fair value hierarchy which requires an entity to maximize the use of observable inputs, where available.  This hierarchy prioritizes the inputs into three broad levels as follows.  Level 1 input are quoted prices (unadjusted) in active markets for identical assets or liabilities.  Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument.  Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value.  An asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

Assets and liabilities measured at fair value on a recurring and non-recurring basis consisted of the following at September 30, 2011:

         
Fair value Measurements at September 30, 2011
 
   
Carrying Value at
September 30, 2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Embedded Conversion Option Liability
  $ 234,193     $ -     $ -     $ 234,193  

The following is a summary of activity of Level 3 liabilities for the period ended September 30, 2011:

Balance December 31, 2010
  $ 963,931  
Change in Fair Value
  $ (729,738 )
Balance September 30, 2011
  $ 234,193  

Changes in fair value of the embedded conversion option liability are included in other income (expense) in the accompanying unaudited consolidated statements of operations.

The Company estimates the fair value of the embedded conversion option liability utilizing the Black-Scholes pricing model, which is dependent upon several variables such as the expected term (based on contractual term), expected volatility of our stock price over the expected term (based on historical volatility), expected risk-free interest rate over the expected term, and the expected dividend yield rate over the expected term.  The Company believes this valuation methodology is appropriate for estimating the fair value of the derivative liability.  The following table summarizes the assumptions the Company utilized to estimate the fair value of the embedded conversion option at September 30, 2011:

Assumptions  
Expected Volatility 0.25
Expected term 99.6%
Risk free rate 0.2%
Dividend Yield 0.00%

There were no changes in the valuation techniques during the three and nine month periods ended September 30, 2011.