Note 4. Common Stock Options and Warrants

9 Months Ended

Sep. 30, 2011

Disclosure of Compensation Related Costs, Share-based Payments [Text Block]

4. Common Stock Options and Warrants.  The Board granted 100,000 options with a 2-year term and $0.075 exercise price to a consultant on March 8, 2011 with a fair value of $7,280.  One quarter of the options (fair value $1,820) vest each quarter during 2011.

The Company previously issued 447,999 warrants that contained an embedded derivative, which is accounted for as a derivative liability. The binomial Black-Scholes pricing model was used to calculate the fair value of these warrants on September 30, 2011.  In the binomial model, the most likely price which will trigger the anti-dilution ratchet and the most likely price that will not trigger the anti-dilution ratchet are given estimated probabilities of occurrence.  The probability of private placement issuances triggering a reset equal to a stock price of $0.03 per share was estimated as 75%.  The reset stock price was set at $0.03 since this was the lowest quarterly closing price for the period October 1, 2009, through September 30, 2011.  The lowest closing price for January 1, 2011 through September 30, 2011, was $0.042.  The stock price closed at $0.08 on December, 31, 2010, $0.09 on March 31, 2011, $0.06 on June 30, 2011, and $0.05 on September 30, 2011.  The probability was estimated at 75% because during the 3rd and 4th quarter of 2010 and the 1st quarter of 2011 the Company sold convertible preferred stock with $0.10 per share common stock share conversion price although the market price of the common stock was below $0.10 per share.  In addition, the Company may sell “Exempt Issuances” below $0.10 to Directors, Officers, and Consultants, under a stock purchase plan approved by a majority of the outside directors without triggering a reset.  The Company sold exempt issuances of stock below $0.10 per share to directors, officers, and consultants during the fourth quarter of 2010.  No such exempt issuances have been sold during the nine months ended September 30, 2011.  The probability of not triggering the reset at $0.10 per share was estimated as 25%.  Valuation consists of 75% of the Black-Scholes value of the warrants for a reset occurrence at $0.03 per share and 25% of the Black-Scholes value of the warrants on September 30, 2011.  The Black-Scholes option-pricing model was utilized with the following assumptions:  dividend yield 0.0%; expected volatility of 181.70%; risk-free interest rate of 0.25% (2 year U.S. treasury rate on September 30, 2011) and expected life of 1.27 years.  The valuation for the 447,999 warrants was $46,261 on September 30, 2011.  For the quarter ended September 30, 2011, the change in fair value of the derivative instrument was recorded as a $7,445 derivative gain and the derivative liabilities account continued to decrease as follows: from $60,395 on March 31, 2011 to $53,706 on June 30, 2011 and to $46,261 on September 30, 2011.

The Company entered into two Securities Purchase Agreements each consisting of a secured convertible debenture (the Note) and a warrant (Warrant) issued on April 15, 2011 and May 24, 2011 (Valuation Dates).  The instruments were valued on issue date(s) and at the end of the third fiscal quarter, September 30, 2011.

The instruments are:

1. $63,000 Convertible Note at the greater/lesser (see definition below) of the 55% of market price and $0.04 fixed conversion price; an annual interest rate of 14%; redemption at 150% to 180 days and 100% to 240 days; and a maturity date of April 14, 2012; 787,500 Warrants for a period of 3 years at $0.04 per share. The loan is in default, which requires interest to be accrued at 10%.

2. $40,000 Convertible Note at the greater/lesser (see definition below) of the 55% of market price and $0.04 fixed conversion price; an annual interest rate of 14%; redemption at 150% to 180 days and 100% to 240 days; and a maturity date of May 31, 2012; 500,000 Warrants for a period of 3 years at $0.04 per share.

The conversion price and time frame are defined and explained for both Convertible Notes as follows:

The Variable Conversion Price is defined as 55% multiplied by the Market Price (45% discount).  The Market Price is defined as the average of the lowest three trading prices (closing price per OTCBB) for the Common Stock during the ten trading day period ending on the latest complete trading day prior to the Conversion Date (date notice sent to Borrower via facsimile).

The Fixed Conversion Price is defined as $0.04 per share of Common Stock.

The First Period:  Beginning on the date of the note and ending on the 240th day following the date of the note, providing that no default has occurred, the (Conversion) Price is to be the greater of the Variable Conversion Price and the Fixed Conversion Price.

The Second Period:  This period is defined as (a) following the occurrence of a default or (b) anytime after the 240th day following the date of the note, the (Conversion) Price is to be the lesser of the Variable Conversion Price and the Fixed Conversion Price.

The basis for determination and valuation are

● FASB ASC 820 Fair Value Measurements and Disclosures

● FASB ASC 815 Derivatives and Hedging

Management determined that the variable conversion prices of the notes constituted an embedded derivative.

The embedded derivatives were bundled and valued as a single, compound embedded derivative separated from the debt host and treated as a liability.  The single compound embedded derivative features are

1. The conversion feature with the variable and fixed conversion prices

2. The redemption features

The embedded conversion features in the Notes’ conversion and redemption features were accounted for as a derivative liability.  The Warrants’ were valued as a liability and discount to the note, due to the unknown number of shares to be issued upon conversion of the debt, causing a lack of sufficient authorized shares to be available to settle the warrants. The derivative liabilities will be marked-to-market each quarter with the change in fair value recorded in the income statement.

The fair values for the derivatives within the Convertible Notes at the dates of issuance and at the end of the third fiscal quarter are:

	4/15/2011	5/24/2011	6/30/2011	9/30/2011
Notional Amount	63,000	40,000	103,000	103,000
Note Balance	63,000	40,000	105,438	109,123
Derivative Value (Notes)	50,410	32,414	81,066	101,517
Mark to Market (Notes)	-	-	(1,758)	20,451

The fair values for the derivatives within the Warrants at the dates of issuance and at the end of the third fiscal quarter are:

	4/15/2011	5/24/2011	6/30/2011	9/30/11
Warrants	787,500	500,000	1,287,500	1,287,500
Warrants Value	28,940	17,757	27,180	24,128
Mark to Market Warrants	-	-	(19,517)	(3,052)

At each issuance date of the Note, the initial loan and valuation of the embedded derivative was recorded.  The net cash received was recorded.  There was an upfront payment of legal expenses made to the Holder’s attorney for each note.  That amount was recorded as a deferred financing cost.  The notional amount was recorded as a liability with that same amount recorded as debt discount. The debt discount and deferred financing costs are being amortized over the life of the notes using the effective interest method. An additional expense of $26,521 was recorded as derivative expense for the excess of inception date derivative values over the face value of the notes.

Quarterly the Convertible Embedded Derivative(s) and the Warrant values are marked-to-market. The convertible Term Note Discount and the Deferred Financing Costs are amortized quarterly.