WARRANTS FOR COMMON STOCK

12 Months Ended

Dec. 31, 2011

WARRANTS FOR COMMON STOCK

NOTE 10. - WARRANTS FOR COMMON STOCK

Prior to December 31, 2010, 22nd Century Ltd granted warrants to purchase common shares of 22nd Century Group in connection with borrowings as an additional incentive for providing financing to the Company and as additional compensation to officers, consultants and advisors. The warrants were granted with a conversion price of less than $.0001, and the number of warrants issued was negotiated based on the agreement at the time of the grant. These warrants had been issued for terms of two to five years. All of these warrants were exercised prior to December 31, 2010.

In connection with the January 25, 2011 Private Placement and Merger, the Company issued 8,651,978 five year warrants (“January 25, 2011 Warrants”) to purchase shares of common stock of 22nd Century Group as follows: 5,000,000 with an exercise price of $3.00 per share, and 3,651,978 with an exercise price of $1.50 per share. These warrants contain “down round” provisions which provide for adjustments to the exercise price if the Company issues common shares of stock of 22nd Century Group at a price that is less than the respective warrant exercise prices. This provision is a guarantee of value which requires that these warrants be classified as derivatives for accounting purposes which means they are reported as a liability and marked to market at each balance sheet date.  The original amount of the warrant liability related to the 5,000,000 $3.00 warrants was $1,550,000 and was recorded as a reduction of equity on January 25, 2011; the original amount of the warrant liability related to the 3,651,978 $1.50 warrants is $1,511,750, and, because it was recorded as a liability, the portion of proceeds from the Private Placement that was recorded as contributed capital was reduced accordingly. As of December 31, 2011 there are 3,651,978 January 25, 2011 Warrants with an exercise price of $1.50 and 5,000,000 January 25, 2011 Warrants with an exercise price of $3.00.

The Company estimated the initial value of the warrant liability at January 25, 2011 using the binomial lattice model to allocate total enterprise value to the warrants and other securities in the Company’s capital structure based upon the enterprise value implied in the January 25, 2011 Private Placement. Consideration was also given to the impact of expected future capital raises and issuances of securities under the Company’s 2010 Equity Investment Plan (“EIP”). Volatility was estimated based on historical observed equity volatilities and implied (forward) or expected volatilities for a sample group of guideline companies and consideration of recent market trends. The fair value of this warrant liability as of December 31, 2011 was estimated to be $550,000 which was determined using the binomial lattice model with updated for the factors used in the initial valuation performed as of January 25, 2011, principally: the equity value of the Company, the remaining exercise period and the decrease in the risk free interest rate.  As a result a gain of $2,511,750 was recorded as other income in the statement of operations during 2011. The following table is a roll-forward of the warrant liability from the initial valuation:

Fair value of warrant liability as of January 25, 2011	$	3,061,750
Gain as a result of change in fair value		(2,511,750	)
Fair value at December 31, 2011	$	550,000

ASC 820 establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows.

· Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.

· Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument.

· Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value.

A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The warrant liability is measured at fair value using certain estimated factors such as volatility and probability and are classified within Level 3 of the valuation hierarchy.

The following table summarizes the warrant activity since December 31, 2009:

	Number of Warrants
Warrants outstanding at December 31, 2009		1,688,076
Warrants issued during 2010		3,116,447
Warrants exercised during 2010		(4,804,523	)
Warrants outstanding at December 31, 2010		-
January 25, 2011 Warrants issued		8,651,978
Warrants exercised during 2011		-
Warrants outstanding at December 31, 2011		8,651,978
Warrants exercisable at December 31, 2011		8,651,978