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DERIVATIVE WARRANT LIABILITY AND FAIR VALUE
 12 Months Ended
Dec. 31, 2011
DERIVATIVE WARRANT LIABILITY AND FAIR VALUE

NOTE 4:   DERIVATIVE WARRANT LIABILITY AND FAIR VALUE

 

The Company has evaluated the application ASC 480-10 Distinguishing liabilities from equity, ASC 815-40 Contracts in an Entity’s Own Equity and ASC 718-10 Compensation – Stock Compensation to the issued and outstanding warrants to purchase common stock that were issued with the convertible notes, private placements, consulting agreements, and various debt settlements during 2009 through 2011. Based on the guidance, management concluded these instruments are required to be accounted for as derivatives either due to a ratchet down protection feature available on the exercise price (Note 5) or a holder’s right to put the warrants back to the Company for cash under certain conditions. Under ASC 815-40-25, the Company records the fair value of these warrants (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”. The fair value of the share purchase warrants are recorded on the balance sheet under ‘Derivative liabilities – warrants’.

 

ASC 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820-10 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820-10 describes three levels of inputs that may be used to measure fair value: Level 1 – Quoted prices in active markets for identical assets or liabilities; Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and Level 3 – Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation. The Company’s Level 3 liabilities consist of the derivative liabilities associated with the warrants issued with the convertible notes during the year ended December 31, 2010. At December 31, 2011, all of the Company’s derivative liabilities were categorized as Level 3 fair value liabilities. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

 

 

Level 3 Valuation Techniques

 

Financial liabilities are considered 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 fair value of share purchase 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 warrants and conversion option on the notes that contain ratchet down provisions using the Binomial model under the following assumptions:

 

    December 31, 2010     December 31, 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 %     1.00       0.11 %     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 %     -       -       -       -  
Share purchase warrants     1.40 to 2.00       0.29% to 1.02%       0.00 %     199 %     0.37 to 4.80       0.12% to 0.83%       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 December 31, 2011  
    Fair Value Measurements  
    Carrying
Value		     Level 1     Level 2     Level 3     Total  
Derivative liability - warrants   $ 1,317,834       -       -     $ 1,317,834     $ 1,317,834  
Derivative liability – conversion option     -       -       -       -       -  
Total   $ 1,317,834       -       -     $ 1,317,834     $ 1,317,834  

 

    As of December 31, 2010 (restated)  
    Fair Value Measurements Using  
    Carrying
Value		     Level 1     Level 2     Level 3     Total  
Derivative liability - warrants   $ 1,819,512       -       -     $ 1,819,512     $ 1,819,512  
Derivative liability – conversion option     175,389       -       -       175,389       175,389  
Total   $ 1,994,901       -       -     $ 1,994,901     $ 1,994,901  

 

 

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 year ended December 31, 2011 and 2010:

 

    Fair Value Measurements Using Level 3 Inputs  
    Derivative liability -
warrants		     Derivative liability –
conversion option		     Total  
Balance, December 31, 2009 (Restated)   $ 1,377,900     $ -     $ 1,377,900  
Additions during the year     3,334,281       785,400       4,119,681  
Total unrealized (gains) or losses included in net loss     (2,796,419 )     (610,011 )     (3,406,430 )
Debt settlement     (96,250 )     -       (96,250 )
Transfers in and/or out of Level 3     -       -       -  
Balance,  December 31, 2010 (Restated)     1,819,512       175,389       1,994,901  
Additions during the year     1,587,275       -       1,587,275  
Total unrealized (gains) or losses included in net loss     (631,631 )     (37,079 )     (668,710 )
Debt settlement     (1,457,322 )     (138,310 )     (1,595,632 )
Transfers in and/or out of Level 3     -       -       -  
Balance, December 31, 2011   $ 1,317,834     $ -     $ 1,317,834  

 

The fair value of the warrants is determined using a Binomial option pricing model. The valuation of warrants is subjective and is affected by changes in inputs to the valuation model including the price per share of our common stock, the historical volatility of the stock price, risk-free rates based on U.S. Treasury security yields, the expected term of the warrants and our dividend yield. Changes in these assumptions can materially affect the fair value estimate. We could ultimately incur amounts to settle the warrant at a cash settlement value that is significantly different than the carrying value of the liability on our financial statements. We will continue to classify the fair value of the warrants as a liability until the warrants are exercised, expire, or are amended in a way that would no longer require these warrants to be classified as a liability. Changes in the fair value of the common stock warrants liability are recognized as a component of other income (expense) in the statement of operations.

 

The net cash settlement value at the time of any future Fundamental Transaction will depend upon the value of the following inputs at that time: the consideration value per share of the Company’s common stock, the volatility of the Company’s common stock, the remaining term of the warrant from announcement date, the risk-free interest rate based on U.S. Treasury security yields, and the Company’s dividend yield. The warrant requires use of a volatility assumption equal to the greater of 100% and the 100-day volatility function determined as of the trading day immediately following announcement of a Fundamental Transaction. The fair value of the warrants is determined using a Black and Scholes option pricing model.