NOTE 15. - WARRANT EXCHANGE PROGRAM AND WARRANTS FOR COMMON STOCK

During the fourth quarter of 2013, the Company initiated a warrant exchange program (the “Warrant Exchange Program”) with existing warrant holders. As a result of the Warrant Exchange Program, the Company had 10,653,469 outstanding warrants remaining at December 31, 2013, a reduction from 19,616,308, as of September 30, 2013. The Company estimated the total cost of inducement to be $3,736,313 and this expense was recorded as an Other expense on the Company’s Consolidated Statements of Operations. Of the remaining outstanding warrants at December 31, 2013, 3,921,381 warrants contained anti-dilution features that provide for adjustments to the exercise price and number of warrants outstanding if the Company issues shares of common stock of 22nd Century Group at a price that is less than the respective warrant exercise prices. These provisions require that such warrants be classified as derivatives for accounting purposes, which means they are reported as a liability and adjusted to fair value at each balance sheet date.

In March 2014, the Company entered into warrant amendments with existing warrant holders (the “Warrant Amendments”) with the goal of further reducing the Company’s warrant liability. To that end, the Company offered financial inducements to certain non-management warrant holders to (i) exercise their warrants on a cash basis, (ii) exercise their warrants on a cashless basis, or (iii) agree to have the anti-dilution feature removed from their warrants in exchange for a reduction in the exercise price contained in their respective warrants. The warrant holders also had the option to maintain the terms and conditions of their original warrant. Management elected to have the anti-dilution feature removed from their warrants without inducement. As a result of the Warrant Amendments, subsequent warrant exercises, and additional warrants issued during 2015 and 2014, there were a total of 130,178 and 129,809 warrants containing anti-dilution features that remained outstanding at December 31, 2015 and December 31, 2014, respectively. The Company calculated the cost of inducement as the difference between the fair value of the warrants immediately after the Warrant Amendments closed, less the fair value of the warrants immediately prior to the closing of the Warrant Amendments.

The Company estimated the total cost of inducement to be $144,548 for the year ended December 31, 2014. This expense was recorded as an Other expense on the Company’s Consolidated Statements of Operations, and as an increase to the derivative warrant liability that was subsequently reversed into capital.

Pursuant to the registered direct offering that closed on June 2, 2015, and discussed in Note 3, the Company issued 3,000,000 warrants with an exercise price of $1.25 per share. These warrants have a term of sixty-six (66) months, are not exercisable for six months immediately following the date of issuance, do not contain an anti-dilution feature, and had a fair value of approximately $2,067,000 at issuance.

As discussed in Note 6, the Company issued warrants to Crede on September 29, 2014, in connection with a previous joint venture and Consulting Agreement, whereby Crede was to provide consulting services to 22nd Century Asia with respect to the Company’s efforts to sell its proprietary tobacco products in the Asian market. The terms and conditions relating to the warrants issued to Crede are discussed in detail in Note 6.

Outstanding warrants at December 31, 2015 consist of the following:

	Number of		Exercise
Warrant Description	Warrants		Price		Expiration

January 2011 PPO $3.00 warrants		2,817,952	$	2.2029	January 25, 2016
January 2011 PPO $3.00 warrants		653,869	$	2.0000	January 25, 2016
January 2011 PPO $3.00 warrants		3,062,665	$	1.9600	January 25, 2016
January 2011 PPO $1.50 warrants		252,965	$	1.2672	January 25, 2016
January 2011 PPO $1.50 warrants ⁽¹⁾		37,546	$	1.1900	January 25, 2016
January 2011 PPO $1.50 warrants		62,329	$	1.2018	January 25, 2016
January 2011 PPO $1.50 warrants		10,831	$	1.1718	January 25, 2016
December 2011 convertible NP warrants		172,730	$	1.1984	February 8, 2017
December 2011 convertible NP warrants		802,215	$	1.3816	February 6, 2018
May 2012 PPO warrants		401,700	$	0.6000	May 15, 2017
November 2012 PPO warrants		925,100	$	0.6000	November 9, 2017
August 2012 convertible NP warrants ⁽¹⁾		92,632	$	0.9520	August 8, 2018
August 2012 convertible NP warrants		92,244	$	0.9060	August 8, 2018
Crede Tranche 1A Warrants ⁽²⁾		1,250,000	$	3.3600	September 29, 2016
Crede Tranche 1B Warrants		1,000,000	$	2.5951	September 29, 2016
Crede Tranche 2 Warrants ⁽³⁾		1,000,000	$	3.3736	September 29, 2019
Crede Tranche 3 Warrants ⁽³⁾		1,000,000	$	3.3736	September 29, 2019
Registered direct offering Warrants		3,000,000	$	1.2500	December 2, 2020

Total warrants outstanding ^(4),(5),(6)		16,634,778

	(1)	Includes anti-dilution features.
	(2)	Include Exchange Rights (see Note 6 for detailed discussion).
	(3)	Exercisable only upon attainment of certain revenue milestones that are no longer achievable due to the termination of the joint venture agreement; accordingly these warrants cannot have a dilutive effect on the Company’s common stock because such warrants cannot be exercised (see Note 6 for detailed discussion).
	(4)	Includes 1,453,812 warrants (8.7%) held by officers and directors that have had the anti-dilution feature removed.
	(5)	Includes 2,272,198 warrants (13.7%) held by a former officer and director that have had the anti-dilution feature removed.

(6)	On January 25, 2016, 6,831,115 warrants expired unexercised.

The Company estimates the value of warrant liability upon issuance of the warrants and at each balance sheet date using the binomial lattice model to allocate total enterprise value to the warrants and other securities in the Company’s capital structure. 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.

As a result of the Exchange Rights contained in the Tranche 1A Warrants, the financial instrument is considered a liability in accordance with FASB Accounting Standards Codification Topic 480 - “Distinguishing Liabilities from Equity” (“ASC 480”). More specifically, ASC 480 requires a financial instrument to be classified as a liability if such financial instrument contains a conditional obligation that the issuer must or may settle by issuing a variable number of its equity securities if, at inception, the monetary value of the obligation is based on a known fixed monetary amount.

The following table is a roll-forward summary of the warrant liability:

Fair value at December 31, 2012	$	4,173,140
Fair value of warrant liability upon conversion of remaining December 14, 2011 Notes - Q1 2013		1,445,091
Fair value of warrant liability upon issuance - Q1 2013		6,022,319
Fair value of warrant liability upon issuance - Q2 2013		711,675
Fair value of warrant liability upon issuance - Q3 2013		1,622,069
Fair value of warrant liability upon conversion of August 9, 2012 Notes - Q3 2013		731,662
Fair value of warrant liability upon reduction of exercise price of Series A and Series C warrants - Q3 2013		626,328
Reclassification of warrant liability to equity upon exercise of warrants - Q2 2013		(204,513)
Reclassification of warrant liability to equity upon exercise of warrants - Q3 2013		(6,542,904)
Reclassification of warrant liability to equity upon exercise of warrants - Q4 2013		(7,712,170)
Cost of inducement from Warrant Exchange Program - Q4 2013		3,274,313
Reclassification of warrant liability to equity resulting from Warrant Exchange Program - Q4 2013		(19,639,465)
Loss as a result of change in fair value		19,271,977
Fair value at December 31, 2013	$	3,779,522
Reclassification of warrant liability to equity resulting from Warrant Amendments - Q1 2014		(7,367,915)
Cost of inducement from Warrant Amendments - Q1 2014		144,548
Fair value of warrant liability resulting from issuance of Crede Tranche 1A Warrants - Q3 2014		2,810,000
Loss as a result of change in fair value		3,676,691
Fair value at December 31, 2014	$	3,042,846
Gain as a result of change in fair value		(144,550)
Fair value at December 31, 2015	$	2,898,296

The aggregate net (gain) loss as a result of the Company’s warrant liability for the years ended December 31, 2015, 2014 and 2013 amounted to ($144,500), $3,676,691 and $19,271,977, respectively, which is included in Other income (expense) as part of Warrant liability gain (loss) - net in the accompanying Consolidated Statements of Operations. The loss for the year ended December 31, 2013, also includes a charge to Other income (expense) in the amount of $4,330,734 as a result of (i) warrant liabilities issued in connection with the Series A-1 Preferred Stock in excess of net proceeds raised in the amount of $3,987,655 in January 2013, and (ii) warrant liabilities issued in connection with the July 2013 issuance of 1,101,034 Series C Warrants in excess of the sum of the net process received upon exercise and the reclassification of the warrant liability to capital, in the amount of $343,079. Warrant liabilities issued during the year ended December 31, 2013, in connection with the December 14, 2011 convertible notes and the August 9, 2012 convertible notes converted to common stock in excess of the conversion amount by $17,386 and $509,062, respectively, were recorded as additional interest expense.

FASB ASC 820 - “Fair Value Measurements and Disclosures” 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; and
	·	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’s or a financial 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 which are classified within Level 3 of the valuation hierarchy. Significant unobservable inputs that are used in the fair value measurement of the Company’s derivative warrant liabilities include volatility. Significant increases (decreases) in the volatility input would result in a significantly higher (lower) fair value measurement.

The following table summarizes the Company’s warrant activity since December 31, 2012:

	Number of Warrants

Warrants outstanding at December 31, 2012		12,972,664
Warrants issued		11,570,274
Warrants issued as part of Warrant Exchange Program		138,666
Additional warrants due to anti-dilution provisions		1,665,400
Warrants exercised during 2013		(9,831,414)
Warrants exercised as part of Warrant Exchange Program		(5,862,121)
Warrants outstanding at December 31, 2013		10,653,469
Warrants issued in conjunction with consulting agreement (see Note 6)		4,250,000
Warrants exercised during 2014		(1,247,443)
Additional warrants due to anti-dilution provisions		18,383
Warrants outstanding at December 31, 2014		13,674,409
Warrants issued in conjunction with registered direct offering		3,000,000
Warrants exercised during 2015		(40,000)
Additional warrants due to anti-dilution provisions		369
Warrants outstanding at December 31, 2015		16,634,778
Composition of outstanding warrants:
Warrants containing anti-dilution feature		130,178	(1)
Warrants without anti-dilution feature		16,504,600	(2)
		16,634,778

	(1)	37,546 of such warrants expired unexercised on January 25, 2016.
	(2)	Include 1,250,000 warrants containing Exchange Rights (see Note 6 for detailed discussion), and 6,793,569 of such warrants expired unexercised on January 25, 2016.