CONVERTIBLE NOTES PAYABLE AND DERIVATIVE LIABILITY

3 Months Ended

Mar. 31, 2013

CONVERTIBLE NOTES PAYABLE AND DERIVATIVE LIABILITY

7. CONVERTIBLE NOTES PAYABLE AND DERIVATIVE LIABILITY

On December 7, 2012, the Company issued convertible notes, (the “2012 Convertible Notes”). The 2012 Convertible Notes are, at the holders’ option, redeemable in cash upon maturity at December 31, 2014 or convertible into shares of common stock at a current conversion price of $2.59 per share, which price is subject to adjustment upon certain dilutive issuances of common stock. The 2012 Convertible Notes bear interest at 7% per annum, which is payable quarterly at the Company’s option in cash or, if the Company’s net cash balance is less than $3.0 million at the time of payment, in shares of common stock. If paid in shares of common stock, then the price of the stock issued is determined as 95% of the five-day weighted average of the market price of the common stock prior to the time of payment.

The fair value of the 2012 Convertible Notes is determined based on a discounted cash flow model using a risk adjusted annual interest rate of 16%, which represents a Level 3 measurement within the fair value hierarchy given that this is an unobservable input. The fair value of these notes at March 31, 2013 approximates the book value.

The 2012 Convertible Notes have an anti-dilution provision that results in an embedded conversion feature that has been accounted for as a derivative. The Company valued the derivative using a Black-Scholes valuation model and the following inputs: stock price on the day of issuance $1.93, 70% volatility, the term of the notes payable (2 years) and the risk-free interest rate of 0.25%. These unobservable inputs represent a Level 3 measurement within the fair value hierarchy. The estimated fair value of the conversion feature is revalued on a quarterly basis and any resulting increases or decreases in the estimated fair value are recorded as adjustments to other (expense) income. The fair value at March 31, 2013 was revalued using the same inputs, with the exception of the stock price which was $2.68 and the term, which was 1.75 years at March 31, 2013. The estimated fair value of the conversion feature as of March 31, 2013 and December 31, 2012 was $1.5 million and $0.9 million, respectively, which has been recorded as a derivative liability in the condensed consolidated balance sheet.

During the three month period ended March 31, 2013, the Company issued 38,873 common shares upon the conversion of $100,000 of the principal balance of the note into common stock, $0.03 million of the derivative liability was re-classified as additional paid in capital upon conversion, and $0.01 million of the debt discount was charged to interest expense in the statement of operations.

The Company’s notes payable at March 31, 2013 and December 31, 2012 consisted of the following (in thousands):

	MARCH 31, 2013			DECEMBER 31, 2012
2012 Convertible Notes	$	4,000		$	4,000
Less: Conversions to common stock		(100	)		—
		3,900			4,000
Less: Unamortized debt discount		(506	)		(587	)
		3,394			3,413
Less: Current portion		—			—
Notes payable- long term	$	3,394		$	3,413

The Company recognized total interest expense of $0.1 million during each of the three months ended March 31, 2013 and 2012.