Note 7 - Convertible Debentures and Derivatives

Series B

On February 1, 2013, the Company raised gross proceeds of $6,000,000 which includes $4,000,000 from a family investment office and a charitable foundation controlled by Dr. Milton Boniuk, a member of the Company’s board of directors, through the issuance of our Series B Debentures. The investors purchased unsecured convertible debentures with a 4-year term. The debentures bear an interest rate of 8% p.a. payable quarterly in cash or the Holder at its option may elect to receive such coupon interest payment in shares of common stock and calculated on the date of issuance, using the average of the open and close prices of the Company’s common stock on the date such interest payment is due. For each of the three month periods ended December 31, 2016 and 2015, the Company paid a total of $40,000 of coupon interest to Holders in cash and two additional Holders of the Company’s Series B Convertible Debentures elected to receive their $80,000 of coupon interest payment in shares of the Company’s common stock. For each of the six month periods ended December 31, 2016 and 2015, the Company paid a total of $160,000 of coupon interest to Holders in cash and two of the Holders of the Company’s Series B Convertible Debentures elected to receive $80,000 of their coupon interest payment in shares of the Company’s common stock. The Board of Directors authorized the issuance of 73,733 and 66,666 shares of the Company’s common stock for the six month periods ended December 31, 2016 and 2015, respectively. Additional interest was payable in restricted common stock of 571,429 shares at issuance, and on February 1, 2014 and 2015 and additional interest payable in 571,433 warrants on February 1, 2016. The investors can convert the principal of the debentures and any accrued interest into common stock at a fixed price of $3.50 per share. The Company can prepay the debentures, in which case the base interest rate shall increase by a 7% prepayment penalty. The Company agreed to use its best efforts to register the interest shares and the shares issuable from the interest warrants under a “shelf” registration statement provided same is available, in accordance with the provisions of the Securities Act.

The following table presents the balance of the Series B Debenture payable, net of discount at December 31 and June 30, 2016. The debt discount is being amortized to interest expense over the term of the debenture:

	December 31,		June 30,
	2016		2016

Proceeds	$	6,000,000	$	6,000,000
Debt discount for bifurcated derivative		(2,735,310)		(2,735,310)
		3,264,690		3,264,690

Accumulated amortization of debt discount		2,646,145		2,210,047

Debenture payable - Series B, net	$	5,910,835	$	5,474,737

The Company recognized amortization of this discount as an additional interest charge to “Discount on convertible debentures” for the three month periods ended December 31, 2016 and 2015, in the amounts of $222,226 and $190,803, respectively, and for the six month periods ended December 31, 2016 and 2015, in the amounts of $436,098 and $374,430, respectively

The debenture contains embedded derivatives which are not clearly and closely related to the host instrument. The embedded derivatives were bifurcated from the host debt instrument and treated as a liability.

The single compound embedded derivative features valued include the:

Principal conversion feature at maturity based on fixed conversion price subject to standard adjustments.

Redemption additional interest and Redemption Warrants offering.

Additional Interest Shares and Interest Warrants.

The Company uses a lattice model that values the compound embedded derivatives bifurcated from the Series B Convertible Debenture based on a probability weighted discounted cash flow model at December 31, 2016 and June 30, 2016.

The following assumptions were used for the valuation of the compound embedded derivative at December 31, 2016 and June 30, 2016:

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The balance of the Series B Convertible Debenture as of December 31, 2016 and June 30, 2016 is $6,000,000;

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The underlying stock price was used as the fair value of the common stock. The stock price decreased to $1.07 at December 31, 2016. The warrant value with the $3.50 exercise price decreased due to the shorter term remaining and the difference between the exercise price and the stock price. The stock price decreased to $1.60 at June 30, 2016 which decreased the warrant value with the $3.50 exercise price;

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The projected annual volatility was based on the Company historical volatility:

1 year

12/31/2016 79%

6/30/2016 83%

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An event of default would occur 0% of the time, increasing 1.00% per month to a maximum of 10%;

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The Company would redeem the debentures projected initially at 0% of the time and increase monthly by 1.0% to a maximum of 20.0% (from alternative financing being available for a Redemption event to occur);

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The Holder would automatically convert the interest if the Company was not in default and its shares value would be equivalent to the cash value;

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The Holder would automatically convert the debenture at maturity if the registration was effective and the Company was not in default.

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The weighted cost of capital discount rate (based on the market value of the transaction at issuance) adjusted for changes in the risk free rate is 21.74%.

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Even though the shares are restricted, the underlying assumption is that any restriction on resale will be removed either through registration or the passage of time at the time of issuance.

The fair value of the compound embedded derivatives of the Series B Convertible Debenture at December 31, 2016 and June 30, 2016 was $28,284 and $203,030, respectively.

Series C

On July 2, 2014 (the “Closing Date”), the Company accepted a subscription in the amount of $5,000,000 for a 10% Coupon Series C Convertible Debenture (the “Debenture”) from Dr. Milton Boniuk, a member of the Company’s Board of Directors (the “Holder”). The Debenture is due on June 30, 2018 (the “Maturity Date”) and is convertible, at the sole option of the Holder, into restricted shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”) at the conversion price of $5.25 per share of Common Stock. The Debenture bears interest at the coupon rate of ten percent (10%) per annum, computed on an annual basis of a 365 day year, payable in quarterly installments on March 31, June 30, September 30 and December 31 of each calendar year until the Maturity Date. In accordance with the debenture agreement, the interest for the initial year of the debenture for a total of $500,000 shall be deferred and paid over the remainder of the term at $166,667 per year. The Holder at its option may choose to receive such coupon interest payment in shares of Common Stock calculated using the average of the open and close prices of the Company’s common stock on the date such interest payment is due. For each of the three-month periods ended December 31, 2016 and 2015, the Holder of the Company’s Series C Convertible Debentures elected to receive $125,000 of their coupon interest payment and $41,667 of deferred interest payment in shares of the Company’s common stock. For the six month periods ended December 31, 2016 and 2015 the Holder elected to receive $125,000 of its coupon interest payment and $41,667 of its deferred interest payment in cash and $125,000 of their coupon interest payment and $41,667 of deferred interest payment in shares of the Company’s Common Stock. The Board of Directors authorized the issuance of 153,610 and 138,889 shares of the Company’s Common Stock for the three-month periods ended December 31, 2016 and 2015, respectively. The Company has the right, but not the obligation, to repay the Debenture prior to the Maturity Date (the “Redemption Payment”). If the closing bid price of the Common Stock is in excess of $5.25 when the Company notifies the Holder it has elected to prepay the Debenture (the “Redemption Date”), the Company must redeem the Debenture by delivering to the Holder 952,381 shares of Common Stock and any unpaid coupon interest in lieu of a cash Redemption Payment. If the Holder elects to receive the Redemption Payment in cash, or if the closing bid price of the Common Stock is less than $5.25, the Company shall pay to the Holder a Redemption Payment in cash equal to the principal amount of the Debenture, plus any accrued coupon interest, plus additional interest of 7% per annum for the period from the Closing Date to the Redemption Date and warrants to purchase 619,048 shares of Common Stock which shall expire in three years from the date of issuance at the exercise price of $6.05 per share of Common Stock. The Company cannot conclude that it has sufficient authorized and unissued shares to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding. This is due to the fact that the interest payments are payable in stock of the Company, at the option of the Holder, based on the current market price of the common stock on the date such payments are due. Therefore, the number of shares due as interest payments is essentially indeterminate and the Company cannot conclude that it has sufficient authorized and unissued shares to settle the conversion feature. Accordingly, the Company bifurcated the embedded features from the host contract and recorded them as a derivative liability at fair value. A debt discount was recognized in the same amount as the derivative liability associated with embedded features bifurcated from the Series C Convertible Debenture.

On July 2, 2014, in conjunction with the issuance of the Company’s Series C Convertible Debentures, the Company issued 187,000 shares of its Series A Convertible Preferred stock (the “Series A”) to Dr. Milton Boniuk, pursuant to the terms of the Debenture. Proceeds received in a financing transaction are allocated to the instruments issued prior to evaluating hybrid contracts for bifurcation of embedded derivatives. Since the Series A Convertible Preferred Stock is classified as equity, the proceeds allocated to the Preferred Stock are recorded at relative fair value. The fair value of the Series A was $1,645,606 at issuance and the relative fair value was calculated as $1,152,297. The remaining amount of the proceeds was allocated to the Debenture and a debt discount of $1,152,297 was recorded to offset the amount of the proceeds allocated to the Series A. Then, the embedded derivative was bifurcated at its fair value of $1,879,428 with the remaining balance allocated to the host instrument (Debenture). The total debt discount will be amortized over the term of the Debenture using the effective interest method.

In November 2014, the FASB issued ASU 2014-16, “Derivatives and Hedging (Topic 815).” ASU 2014-16 addresses whether the host contract in a hybrid financial instrument issued in the form of a share should be accounted for as debt or equity. ASU 2014-16 is effective for annual periods beginning after December 15, 2015 and interim periods within those fiscal years. ASU 2014-16 did not have a material impact on the Company’s financial statements and disclosures.

In April 2015, the FASB issued ASU 2015-03, Interest - Imputation of Interest (Subtopic 835-30), “Simplifying the Presentation of Debt Issuance Costs,” which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This ASU requires retrospective adoption and will be effective for fiscal years beginning after December 15, 2015 and for interim periods within those fiscal years. This guidance does not have a material impact on our financial statements.

The Company recognized amortization of this discount as an additional interest charge to “Discount on convertible debentures” in the amount of $201,061 and $159,159 for the three month periods ended December 31, 2016 and 2015, respectively, and $390,651 and $309,240 for the six month periods ended December 31, 2016 and 2015 respectively.

The following represents the balance of the Debenture payable – Series C, net of discount at December 31, 2016 and June 30, 2016:

	December 31,		June 30,
	2016		2016

Proceeds	$	5,000,000	$	5,000,000
Debt Discount:
Series A Preferred		(1,152,297)		(1,152,297)
Embedded derivative		(1,879,428)		(1,879,428)
		1,968,275		1,968,275

Accumulated amortization of debt discount		1,556,044		1,165,393

Debenture payable - Series C, net	$	3,524,319	$	3,133,668

The Company uses a lattice model that values the compound embedded derivatives of the Series C Convertible Debenture based on a probability weighted discounted cash flow model at December 31, 2016 and June 30, 2016.

The following assumptions were used for the valuation of the compound embedded derivative at December 31 and June 30, 2016:

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The balance of the Series C Convertible Debenture as of December 31, 2016 and June 30, 2016 is $5,000,000;

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The underlying stock price was used as the fair value of the common stock; The stock price decreased to $1.07 at December 31, 2016 with lower projected annual volatility. The warrant value with the $6.05 exercise price decreased due the decreasing term remaining. The stock price decreased to $1.60 at June 30, 2016 which decreased the warrant value with the $6.05 exercise price;

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The projected annual volatility was based on the Company historical volatility:

1 year

12/31/16 79%

6/30/16 83%

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An event of default would occur 0% of the time, increasing 1.00% per month to a maximum of 10%;

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The Holder would automatically convert the interest if the Company was not in default and its share value was equivalent to the cash value;

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The Holder would automatically convert the debenture at maturity if the registration was effective and the Company was not in default.

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The weighted cost of capital discount rate (based on the market value of the transaction at issuance) adjusted for changes in the risk free rate is 21.74%.

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Even though the shares are restricted the underlying assumption is that any restriction on resale will be removed either through registration or the passage of time at the time of issuance.

The fair value of the compound embedded derivatives of the Series C Convertible Debenture at December 31, 2016 and June 30, 2016 was $104,957 and $343,673, respectively.