NOTE 8 – Convertible Promissory Notes and Warrant Agreements

	As of March 31, 2018		As of December 31, 2017
2016 convertible promissory notes, net of discounts	$	1,578,239	$	1,543,652
2017 convertible promissory notes, net of discounts		753,637		504,465
Accrued interest		173,213		120,223
	$	2,505,089	$	2,168,340

2016 Convertible Promissory Notes

In November 2016 and as amended in June 2017, the Board authorized the Company to issue convertible promissory notes (the “Convertible Notes”) and common stock purchase warrants (the “Warrants”) for aggregate gross proceeds of up to $2.5 million and entered into subscription agreements with subscribers (the “2016 Private Placement”). The Company amended the Convertible Notes and Warrants again on November 20, 2017 to extend the maturity date of the Convertible Notes from November 21, 2017 to July 31, 2018 and to change the terms of the underlying Warrants that include the removal of down-round pricing protection provisions as described more fully below.

As of March 31, 2018, the Company issued a total of $1,625,120 of Convertible Notes and Warrants to investors. The Convertible Notes are unsecured. The Convertible Notes bear interest at a fixed rate of 8 percent per annum and require the Company to repay the principal and accrued and unpaid interest thereon at the earlier of July 31, 2018 or the consummation of the next equity or equity-linked round of financing resulting in more than $3.0 million in gross proceeds (a “Qualified Financing”). If a Qualified Financing occurs before July 31, 2018, the outstanding principal and accrued and unpaid interest on the Convertible Notes automatically converts into the securities issued by the Company in such financing based on the greater number of securities resulting from either the outstanding principal and accrued interest on the Convertible Notes divided by $1.80, or the outstanding principal and accrued interest on the Convertible Notes multiplied by 1.25, divided by the price paid per security in the Qualified Financing. If the Company fails to complete a Qualified Financing by July 31, 2018, the Convertible Notes will be immediately due and payable on such date.

If a change of control transaction or initial public offering occurs prior to a Qualified Financing, the Convertible Notes would, at the election of the holders of a majority of the outstanding principal of the Convertible Notes, either become payable on demand as of the closing date of such transaction, or become convertible into shares of common stock immediately prior to such transaction at a price per share equal to the lesser of the per share value as determined by the Board as if in connection with the granting of stock based compensation, or in a private sale to a third party in an arms-length transaction, or at the per share consideration to be paid in such transaction. Change of control means a merger or consolidation with another entity in which the Company’s stockholders do not own more than 50 percent of the outstanding voting power of the surviving entity or the disposition of all or substantially all of the assets of the Company.

Prior to the June 2017 amendment, the Warrants granted holders the option to purchase either (i) if exercised after conversion of the Convertible Notes, the number of shares equal to the number of shares received by the holders upon the conversion of the Convertible Notes, or (ii) if exercised prior to conversion of the Convertible Notes, the number of shares of common stock equal to the outstanding principal and accrued interest on the Convertible Note held by such warrant holder divided by $1.80. The Warrants were immediately exercisable on the date of issuance and expired on November 21, 2021. In June 2017, however, the Company amended the terms of the Warrants under the Convertible Notes to be exercisable only in the event of conversion of the outstanding principal and accrued interest on the related Convertible Notes. The amount of warrant shares to be issued are now contingent and are based on the number of shares of common stock received by the holder of the Convertible Notes upon conversion of such holder’s Convertible Notes, and at an exercise price equal to the same price per share of the securities issued in the Qualified Financing. The Warrants expire on November 21, 2021 in the event of a Qualified Financing or expire unissued if the notes have not been converted.

The Warrants were deemed to be a free-standing instrument and were accounted for as a liability given the variable number of shares issuable in connection with a possible change of control conversion event. A Monte Carlo simulation model was used to estimate the aggregate fair value of the Warrants. Input assumptions used were as follows: risk-free interest rate of 2.45 and 2.08 percent as of March 31, 2018 and December 31, 2017, respectively; expected volatility of 50 percent as of March 31, 2018 and December 31, 2017; expected life of 3.64 and 3.89 years as of March 31, 2018 and December 31, 2017, respectively; and expected dividend yield of 0 percent as of March 31, 2018 and December 31, 2017. The underlying stock price used in the analysis was on a non-marketable basis and was according to a separate independent third-party valuation analysis since there was no active trading market for the Company’s common stock. The Convertible Note proceeds assigned to the Warrants were zero and $182,693 during the three months ended March 31, 2018 and 2017, respectively, which represented their fair value at issuance, and were discounted from the Convertible Notes and reflected as a warrant liability. The discount was amortized to interest expense over the original term of the Convertible Notes using the straight-line method which approximates the effective interest method. The amortization expense was zero and $118,862 for the three months ended March 31, 2018 and 2017, respectively. The Company also recorded the fair value changes of the warrant liability associated with the Convertible Notes in the condensed consolidated statements of operations which amounted to a benefit of $(130,976) and $(215) for the three months ended March 31, 2018 and 2017, respectively.

The November 2017 amendment resulted in a substantial modification to the original Convertible Notes whereby the maturity date was extended, and the terms associated with the Warrants were revised. The fair value of the underlying convertible notes was $97,223 lower than the carrying value of the Convertible Notes on the date of the modification. The $97,223 difference was recorded as a discount to the debt and is being amortized over the amended term of the Convertible Notes. The amortization recorded during the three months ended March 31, 2018 and 2017 was $34,585 and zero, respectively.

At the time of their issuance, the Convertible Notes contained a 125% conversion premium in the event that a Qualified Financing occurs at a price under $2.25 per common share. The Company determined that the redemption feature under the Convertible Notes qualified as an embedded derivative and was separated from its debt host. The bifurcation of the embedded derivative from its debt host resulted in a discount to the Convertible Notes in the amount of zero and $72,732 during the three months ended March 31, 2018 and 2017, respectively. The discount was being amortized to interest expense over the original term of the Convertible Notes using the straight-line method which approximates the effective interest method. The amortization expense was zero and $47,318 for the three months ended March 31, 2018 and 2017, respectively. The embedded derivative is accounted for separately on a fair market value basis. The Company recorded the fair value changes of the premium debt conversion derivative associated with the Convertible Notes in the condensed consolidated statements of operations for an expense of $2,666 and $183 for the three months ended March 31, 2018 and 2017, respectively.

In connection with the Convertible Notes, the Company incurred issuance costs in the amount of $151,915, which included (i) a placement agent cash fee, which was $113,610 for the Convertible Notes issued through June 19, 2017 (ii) the obligation to issue a warrant to the placement agent (the “placement agent warrant”) which will have an exercise price of $2.00 per share of common stock and had a total fair value of $4,855 on date of Convertible Note issuance, and (iii) legal expenses of $33,450. The placement agent warrant is issuable at the time the private placement transaction closes which has not occurred as of March 31, 2018. The placement agent warrant will be immediately exercisable on the date of issuance and will expire five years following the date of issuance. The placement agent is to receive a placement agent warrant to purchase shares of common stock in an amount equal to 8% of the common stock (or common stock equivalents) purchased by investors in the private placement transaction. As of March 31, 2018 and December 31, 2017, the Company has an obligation to issue a placement agent warrant for the purchase of approximately 63,000 shares of common stock. The Company recorded an issuance cost discount to the Convertible Notes in the amount of zero and $16,645 during the three months ended March 31, 2018 and 2017, respectively, of which zero and $12,361 was amortized to interest expense during the three months ended March 31, 2018 and 2017, respectively. The balance of the issuance costs in the amount of zero and $15,803 was attributed to the Warrants and was immediately recorded as interest expense upon issuance during the three months ended March 31, 2018 and 2017, respectively.

2017 Convertible Notes

On October 4, 2017, the Company initially entered into a subscription agreement (with certain investors (the “Subscribers”), pursuant to which the Company, in a private placement (the “Private Placement”), agreed to issue and sell to the Subscribers 8% convertible promissory notes (each, a “Note” and collectively, the “2017 Convertible Notes”) and warrants (the “New Warrants”) to purchase shares of the Company’s capital stock in the event of a conversion event. The number of shares and pricing per share of the New Warrants are based on the underlying conversion event and are exercisable for five years commencing on the triggering conversion event. In November 2017, the Board approved an increase in the authorized subscription from $1,000,000 to $1,500,000. The subscription agreement and the 2017 Convertible Notes were amended on December 14, 2017 to move up the maturity date from October 4, 2022 to December 31, 2018, remove subordination provisions and simplify the conversion provision in the event of a qualified financing as described more fully below. In May 2018, the Board approved an increase in the authorized subscription from $1,500,000 to $2,000,000 and extended the offering period from five months to eight months.

The initial closing of the Private Placement was consummated on October 4, 2017, and the Company entered into additional subscription agreements and issued 2017 Convertible Notes in an aggregate principal amount of $1,140,000 to the Subscribers through March 31, 2018. The Company may conduct any number of additional closings so long as the final closing occurs on or before the eight-month anniversary of the initial closing date and the amount does not exceed $2,000,000 or a higher amount determined by the Board. See Note 13 – Subsequent Events for closings that occurred after March 31, 2018.

The 2017 Convertible Notes bear interest at a fixed rate of 8% per annum and require the Company to repay the principal and accrued and unpaid interest thereon on December 31, 2018 (the “2017 Convertible Notes Maturity Date”). If the Company consummates an equity round of financing resulting in more than $3 million in gross proceeds before December 31, 2018 (the “2017 Convertible Notes Qualified Financing”), the outstanding principal and accrued and unpaid interest on the 2017 Convertible Notes shall automatically convert into the securities issued by the Company in the 2017 Convertible Notes Qualified Financing equal to the outstanding principal and accrued interest on the 2017 Convertible Notes divided by 80% of the price per share of the securities issued by the Company in the 2017 Convertible Notes Qualified Financing. The New Warrants also become exercisable upon a 2017 Convertible Notes Qualified Financing for an amount of shares equal to the number of shares received by the holder in the 2017 Convertible Notes Qualified Financing at the same price per share of the securities issued in the 2017 Convertible Notes Qualified Financing.

Prior to the December 2017 amendment, if the Company had raised more than $3,000,000 in an equity financing before October 4, 2022, the outstanding principal and accrued and unpaid interest on the 2017 Convertible Notes would have automatically converted into the securities issued by the Company in such financing based on the greater number of such securities resulting from either (i) the outstanding principal and accrued interest on the 2017 Convertible Notes divided by $2.25 or (ii) the outstanding principal and accrued interest on the 2017 Convertible Notes multiplied by 1.25, divided by the price paid per security in such financing. The New Warrants would have also become exercisable in conjunction with the 2017 Convertible Notes Qualified Financing.

Lastly, if a change of control transaction occurs prior to the earlier of a 2017 Convertible Notes Qualified Financing or the 2017 Convertible Notes Maturity Date, the 2017 Convertible Notes would, at the election of the holders of a majority of the outstanding principal of the 2017 Convertible Notes, either become payable on demand as of the closing date of such transaction, or become convertible into shares of common stock immediately prior to such transaction at a price per share equal to the lesser of (i) the per share value of the common stock as determined by the Board as if in connection with the granting of stock based compensation or in a private sale to a third party in an arms-length transaction or (ii) at the per share consideration to be paid in such transaction. Change of control means a merger or consolidation with another entity in which the Company’s stockholders do not own more than 50% of the outstanding voting power of the surviving entity or the disposition of all or substantially all of the Company’s assets. The New Warrants also become exercisable upon a change of control transaction for an amount of shares equal to the number of shares received by the holder upon conversion in connection with such transaction at the same price per share that the 2017 Convertible Notes converted in the change of control transaction.

The December 2017 amendment resulted in a substantial modification to the original 2017 Convertible Notes whereby the maturity date was moved up to December 2018 from October 2022 and the terms associated with the embedded features were revised as described previously. The fair value of the underlying Convertible Notes was $27,371 lower than the face amount of the 2017 Convertible Notes. The $27,371 difference was recorded as a discount to the debt and is being amortized over the amended term of the 2017 Convertible Notes. The amortization recorded during the three months ended March 31, 2018 was $6,432.

The 2017 Convertible Notes contain a conversion discount in the event of a 2017 Convertible Notes Qualified Financing to equal the outstanding principal and accrued interest on the 2017 Convertible Notes divided by 80% of the price per share of the securities issued by the Company in the 2017 Convertible Notes Qualified Financing. The embedded feature qualified as an embedded derivative and was separated from its debt host. The bifurcation of the embedded derivative from its debt host resulted in a discount to the 2017 Convertible Notes in the amount of $91,298 for the convertible debt issued during the three months ended March 31, 2018. The discount is being amortized to interest expense over the term of the 2017 Convertible Notes using the straight-line method which approximates the effective interest method. The amortization expense was $27,021 for the three months ended March 31, 2018. The embedded derivative is accounted for separately on a fair market value basis. The Company recorded the fair value changes of the premium debt conversion derivative associated with all of the 2017 Convertible Notes in the condensed consolidated statements of operations which amounted to an expense of $1,323 for the three months ended March 31, 2018.

The New Warrants were deemed to be a free-standing instrument and were accounted for as a liability given the variable number of shares issuable in connection with a change of control conversion event. A Monte Carlo simulation model was used to estimate the aggregate fair value of the New Warrants. Input assumptions used were as follows: risk-free interest rate of 2.57 and 2.22 percent as of March 31, 2018 and December 31, 2017, respectively; expected volatility of 50 percent as of March 31, 2018 and December 31, 2017; expected life of 5.21 and 5.38 years as of March 31, 2018 and December 31, 2017, respectively; and expected dividend yield of 0 percent as of March 31, 2018 and December 31, 2017. The underlying stock price used in the analysis was on a non-marketable basis and was according to a separate independent third-party valuation analysis as there has been very limited trading with the Company’s common stock since the Acquisition on July 20, 2017. The 2017 Convertible Note proceeds assigned to the New Warrants were $238,864 during the three month period ended March 31, 2018, which represented their fair value at issuance and were discounted from the 2017 Convertible Notes and reflected as a warrant liability. The discount is being amortized to interest expense over the term of the 2017 Convertible Notes using the straight-line method which approximates the effective interest method. The amortization expense was $70,505 for the three month period ended March 31, 2018. The Company also recorded the fair value changes of the warrant liability associated with all of the 2017 Convertible Notes in the condensed consolidated statements of operations which amounted to an expense of $9,355 for the three months ended March 31, 2018.

In connection with the 2017 Convertible Notes, the Company incurred original cost of issuance in the amount of $5,283 which consisted of legal costs and was recorded as an issuance cost discount to the 2017 Convertible Notes, of which $375 was amortized to interest expense during the three months ended March 31, 2018.

2016 and 2017 Convertible Note Subscription Agreements

Pursuant to the subscription agreements entered into in connection with the 2016 Private Placement and the Private Placement, the Company is entitled to receive notice in the event a holder elects to sell or receives a bona fide offer for any portion of the Convertible Notes and associated Warrants or any portion of the 2017 Convertible Notes or New Warrants, as applicable, and the right to purchase the Convertible Notes and associated Warrants or the 2017 Convertible Notes and associated New Warrants on the same terms as the proposed sale or bona fide offer, as applicable, as long as the Company exercises that right within 15 days of receiving written notice. The Company has granted the subscribers indemnification rights with respect to its representations, warranties, covenants and agreements under the respective subscription agreements.