Note 7 - Convertible Debentures and Derivatives

Debentures - Series B

The Series B debentures matured on February 1, 2017. For the three-month period ended September 30, 2016, the Company paid $120,000, of coupon interest to the Holders in cash.

The debt discount has been amortized to interest expense over the term of the debenture. The Company recognized amortization of the discount as an additional interest charge to “Discount on convertible debentures” for the three months ended September 30, 2016, in the amount of $213,872. The debenture contained embedded derivatives that were 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 fair value of the compound embedded derivatives of the Series B Convertible Debenture at September 30, 2016 was $120,123. For the three months ended September 30, 2016 the change in fair value was $(82,907), which is included in the change in fair value of derivatives on the statement of operations.

Debenture - 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 was deferred, to be 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 September 30, 2017 and 2016, 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 cash. 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.

The Company recognized amortization of this discount as an additional interest charge to “Discount on convertible debentures” in the amount of $239,351 and $189,590 for the three month periods ended September 30, 2017 and 2016, respectively.

The following represents the balance of the Debenture payable – Series C, net of discount at September 30, 2017 and June 30, 2017:

	September 30,		June 30,
	2017		2017

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		2,227,229		1,987,878

Debenture payable - Series C, net	$	4,195,504	$	3,956,153

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 September 30, 2017 and June 30, 2017.

The following assumptions were used for the valuation of the compound embedded derivative at September 30 and June 30, 2017:

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The balance of the Series C Convertible Debenture as of September 30, 2017 and June 30, 2017 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 $1.14 at September 30, 2017 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 $1.35 at June 30, 2017 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
9/30/17	53	%
6/30/17	60	%

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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 21.99%.

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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 September 30, 2017 and June 30, 2017 was $20,094 and $32,213, respectively.