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DERIVATIVE LIABILITIES AND FAIR VALUE
9 Months Ended
Sep. 30, 2011
DERIVATIVE LIABILITIES AND FAIR VALUE
NOTE 4: DERIVATIVE LIABILITIES AND FAIR VALUE
 
The Company has evaluated the application of ASC 815 Derivatives and Hedging (formerly SFAS No. 133) and ASC 815-40 Contracts in an Entity’s Own Equity to the issued and outstanding warrants to purchase common stock that were issued with the May 2010 secured convertible notes and those issued as finders’ fees. Based on the guidance in ASC 815 and ASC 815-40-25, the Company concluded these instruments were required to be accounted for as derivatives due to a ratchet down protection feature available on the exercise price. Under ASC 815-40-25, the Company records the fair value of these derivatives on its balance sheet at fair value with changes in the values reflected in the statements of operations as “Changes in fair value of derivative liabilities”. These derivative instruments are disclosed on the balance sheet under ‘Derivative liabilities – warrants’.
 
Level 3 Valuation Techniques
 
Financial liabilities are considered as Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial liabilities consist of the notes and warrants for which there is no current market for these securities such that the determination of fair value requires significant judgment or estimation.
 
Determining the fair value of the derivative liability of warrants and conversion options, given the Company’s stage of development and financial position, is highly subjective and identifying appropriate measurement criteria and models is subject to uncertainty. There are several generally accepted pricing models for warrants and options and derivative provisions. The Company has chosen to value the conversion option on the notes and the warrants, both of which contain ratchet down provisions using the Binomial option pricing model under the following assumptions:
 
   
December 31, 2010
    
September 30, 2011
  
   
Expected Life (Years)
    
Risk free Rate
    
Dividend yield
    
Volatility
    
Expected Life (Years)
    
Risk free Rate
    
Dividend yield
    
Volatility
  
Series A Warrants
     2.0       2.00 %     0.00 %     199 %     1.25       0.13 %     0.00 %     199 %
Series B Warrants
     0.4       0.40 %     0.00 %     199 %     -       -       -       -  
Series C Warrants
     -       -       -       -       -       -       -       -  
Conversion Option
     0.4       0.40 %     0.00 %     199 %     -       -       -       -  
 


 
 
The Series C Warrants were contingently exercisable following the exercise of the Series B Warrants. The Series B and Series C Warrants expired on May 19, 2011.
 
The foregoing assumptions are reviewed quarterly and are subject to change based primarily on management’s assessment of the probability of the events described occurring. Accordingly, changes to these assessments could materially affect the valuations.
 
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
Financial assets and liabilities measured at fair value on a recurring basis are summarized below and disclosed on the balance sheet under Derivative liability – warrants and Derivative liability – conversion option:
 

   
As of September 30, 2011
  
         
Fair Value Measurements
        
   
Carrying Value
    
Level 1
    
Level 2
    
Level 3
    
Total
  
Derivative liability - warrants
   $ 48,500       -       -     $ 48,500     $ 48,500  
Derivative liability – conversion option
     -       -       -       -       -  
Total
   $ 48,500       -       -     $ 48,500     $ 48,500  
 

   
As of December 31, 2010
  
         
Fair Value Measurements
        
   
Carrying Value
    
Level 1
    
Level 2
    
Level 3
    
Total
  
Derivative liability - warrants
   $ 1,225,125       -       -     $ 1,225,125     $ 1,225,125  
Derivative liability – conversion option
     175,389       -       -       175,389       175,389  
Total
   $ 1,400,514       -       -     $ 1,400,514     $ 1,400,514  
 
The table below provides a summary of the changes in fair value, including net transfers, in and/or out, of financial assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2011:
 
   Fair Value Measurements Using Level 3 Inputs  
   
Derivative liability - warrants
    
Derivative liability – conversion option
    
Total
  
Beginning balance as of date of issuance, May 24, 2010
   $ 2,270,125     $ 785,400     $ 3,055,525  
Total unrealized gains or losses included in net loss
     (1,045,000 )     (610,011 )     (1,655,011 )
Transfers in and/or out of Level 3
     -       -       -  
Balance as of December 31, 2010
     1,225,125       175,389       1,400,514  
Total unrealized gains or (losses) included in net loss
     365,950       (88,832 )     277,118  
Debt settlement
     (1,542,575 )     (86,557 )     (1,629,132 )
Transfers in and/or out of Level 3
     -       -       -  
Ending balance at September 30, 2011
   $ 48,500     $ -     $ 48,500