Note 7 – Convertible Debentures and Derivatives

Debentures - Series B

On February 1, 2013, the Company raised gross proceeds of $6,000,000 which includes $4,000,000 from a family investment office and a charitable foundation controlled by Dr. Milton Boniuk, a member of the Company’s board of directors, through the issuance of our Series B Debentures. The investors purchased unsecured convertible debentures with a 4-year term. The debentures bore an interest rate of 8% p.a. payable quarterly in cash or the Holder at its option may elect to receive such coupon interest payment in shares of common stock and calculated on the date of issuance, using the average of the open and close prices of the Company’s common stock on the date such interest payment is due. For the years ended June 30, 2017 and 2016, the Company paid a total of $173,589 and $320,000, respectively, of coupon interest to Holders in cash and two additional Holders of the Company’s Series B Convertible Debentures elected to receive $107,178 and $160,000 respectively, of their coupon interest payment in shares of the Company’s common stock. The Board of Directors authorized the issuance of 97,909 and 101,558 shares of the Company’s common stock for the years ended June 30, 2017 and 2016, respectively. Additional interest was payable in restricted common stock of 571,429 shares at issuance, and on February 1, 2014 and 2015 and additional interest payable in 571,433 warrants on February 1, 2016. The investors could convert the principal of the debentures and any accrued interest into common stock at a fixed price of $3.50 per share. The Company could prepay the debentures, in which case the base interest rate would increase by a 7% prepayment penalty. The Company agreed to use its best efforts to register the interest shares and the shares issuable from the interest warrants under a “shelf” registration statement provided same is available, in accordance with the provisions of the Securities Act.

The Company estimated the fair value of the warrants granted to the holders of the Series B Debentures for additional interest on the date of grant using the Black-Scholes Option-Pricing Model with the following weighted-average assumptions:

Expected life (year)	3

Expected volatility	44.18	%

Expected annual rate of quarterly dividends	0.00	%

Risk-free rate(s)	1.01	%

The following table presents the balance of the Series B Debenture payable, net of discount at June 30, 2016. The Series B debentures matured on February 1, 2017, as described further below. The debt discount has been amortized to interest expense over the term of the debenture:

	June 30, 2016

Proceeds	$	6,000,000
Debt discount for bifurcated derivative		(2,735,310)
		3,264,690

Accumulated amortization of debt discount		2,210,047

Debenture payable - Series B, net	$	5,474,737

The debenture contained embedded derivatives that were not clearly and closely related to the host instrument. The embedded derivatives were bifurcated from the host debt instrument and treated as a liability.

The Company recognized amortization of this discount as an additional interest charge to “Discount on convertible debentures” for the years ended June 30, 2017, 2016 and 2015, in the amounts of $525,263, $774,155 and $663,014, respectively.

The single compound embedded derivative features valued include the:

Principal conversion feature at maturity based on fixed conversion price subject to standard adjustments.

Redemption additional interest and Redemption Warrants offering.

Additional Interest Shares and Interest Warrants.

The Company used a lattice model that values the compound embedded derivatives bifurcated from the Series B Convertible Debenture based on a probability weighted discounted cash flow model at January 31, 2017 and June 30, 2016.

The following assumptions were used for the valuation of the compound embedded derivative at January 31, 2017 and June 30, 2016:

The balance of the Series B Convertible Debenture was $6,000,000;

The underlying stock price was used as the fair value of the common stock. The warrant value with the $3.50 exercise price decreased due to the shorter term remaining and the difference between the exercise price and the stock price. The stock price decreased to $1.60 at June 30, 2016 which decreased the warrant value with the $3.50 exercise price;

The projected annual volatility was based on the Company historical volatility:

1 year

6/30/2016 83%

An event of default would occur 0% of the time, increasing 1.00% per month to a maximum of 10%;

The Company would redeem the debentures projected initially at 0% of the time and increase monthly by 1.0% to a maximum of 20.0% (from alternative financing being available for a Redemption event to occur);

The Holder would automatically convert the interest if the Company was not in default and its shares value would be equivalent to the cash value;

The Holder would automatically convert the debenture at maturity if the registration was effective and the Company was not in default.

The weighted cost of capital discount rate (based on the market value of the transaction at issuance) adjusted for changes in the risk free rate is 21.99%.

Even though the shares are restricted, the underlying assumption is that any restriction on resale will be removed either through registration or the passage of time at the time of issuance.

The fair value of the compound embedded derivatives of the Series B Convertible Debenture at January 31, 2017 and June 30, 2016 was $0 and $203,030 respectively.

The Company’s Series B Convertible Debenture, in the amount of $6 million, matured on January 31, 2017. On February 8, 2017, the Company entered into agreements with certain holders (the “Holders”) of the Company’s Series B Convertible Debentures (the “Debentures”). The Company and the Holders agreed to extinguish an aggregate of $5,027,178 of principal and interest attributable to the Company’s Series B Debentures, which were payable on January 31, 2017 (the “Maturity Date”) by converting into 4,359,652 newly-issued, restricted shares (the “Conversion Shares”) of the Company’s Common Stock. The number of shares attributable to the principal being converted was determined by dividing the $5,000,000 principal by $1.1533, the volume weighted average price (“VWAP”) of the Company’s stock price for the period from December 15, 2016 to January 30, 2017. The $5,000,000 of principal and $27,178 of accrued interest were converted into 4,335,386 and 24,266 shares of common stock, respectively. The principal balance of $1,000,000 not converted was paid in cash on February 8, 2017. The Company recognized a non-cash loss on extinguishment of debt of $332,524 on the extinguishment of the aforesaid principal attributable to the Series B Debentures into the Company’s Common Stock. The loss on extinguishment of debt resulted from the excess of the market value of the shares issued on February 8, 2017 of $1.23 per share or $5,332,524 in the aggregate, over the $5,000,000 face value of the debt extinguished.

Debenture - Series C

On July 2, 2014 (the “Closing Date”), the Company accepted a subscription in the amount of $5,000,000 for a 10% Coupon Series C Convertible Debenture (the “Debenture”) from Dr. Milton Boniuk, a member of the Company’s Board of Directors (the “Holder”). The Debenture is due on June 30, 2018 (the “Maturity Date”) and is convertible, at the sole option of the Holder, into restricted shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”) at the conversion price of $5.25 per share of Common Stock. The Debenture bears interest at the coupon rate of ten percent (10%) per annum, computed on an annual basis of a 365 day year, payable in quarterly installments on March 31, June 30, September 30 and December 31 of each calendar year until the Maturity Date. In accordance with the debenture agreement, the interest for the initial year of the debenture for a total of $500,000 was deferred, to be paid over the remainder of the term at $166,667 per year. The Holder at its option may choose to receive such coupon interest payment in shares of Common Stock calculated using the average of the open and close prices of the Company’s Common Stock on the date such interest payment is due. For the years ended June 30, 2017 and 2016, the Holder of the Company’s C Convertible Debenture elected to receive quarterly coupon interest of $375,000 and $125,000, respectively, of the deferred interest in restricted common shares of the Company. The Board of Directors authorized the issuance of 423,952 and 313,785 shares of the Company’s restricted $.001 par value common shares in payment of such coupon interest for the years ended June 30, 2017 and 2016, respectively. For both of the years ended June 30, 2017 and 2016, the Company paid cash interest of $166,667 on the Series C Debentures. The Company has the right, but not the obligation, to repay the Debenture prior to the Maturity Date (the “Redemption Payment”). If the closing bid price of the Common Stock is in excess of $5.25 when the Company notifies the Holder it has elected to prepay the Debenture (the “Redemption Date”), the Company must redeem the Debenture by delivering to the Holder 952,381 shares of Common Stock and any unpaid coupon interest in lieu of a cash Redemption Payment. If the Holder elects to receive the Redemption Payment in cash, or if the closing bid price of the Common Stock is less than $5.25, the Company shall pay to the Holder a Redemption Payment in cash equal to the principal amount of the Debenture, plus any accrued coupon interest, plus additional interest of 7% per annum for the period from the Closing Date to the Redemption Date and warrants to purchase 619,048 shares of Common Stock which shall expire in three years from the date of issuance at the exercise price of $6.05 per share of Common Stock. The Company cannot conclude that it has sufficient authorized and unissued shares to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding. This is due to the fact that the interest payments are payable in stock of the Company, at the option of the Holder, based on the current market price of the common stock on the date such payments are due. Therefore, the number of shares due as interest payments is essentially indeterminate and the Company cannot conclude that it has sufficient authorized and unissued shares to settle the conversion feature. Accordingly, the Company bifurcated the embedded features from the host contract and recorded them as a derivative liability at fair value. A debt discount was recognized in the same amount as the derivative liability associated with embedded features bifurcated from the Series C Convertible Debenture.

On July 2, 2014, in conjunction with the issuance of the Company’s Series C Convertible Debentures, the Company issued 187,000 shares of its Series A Convertible Preferred stock (the “Series A”) to Dr. Milton Boniuk, pursuant to the terms of the Debenture. Proceeds received in a financing transaction are allocated to the instruments issued prior to evaluating hybrid contracts for bifurcation of embedded derivatives. Since the Series A Convertible Preferred Stock is classified as equity, the proceeds allocated to the Preferred Stock are recorded at relative fair value. The fair value of the Series A was $1,645,606 at issuance and the relative fair value was calculated as $1,152,297. The remaining amount of the proceeds was allocated to the Debenture and a debt discount of $1,152,297 was recorded to offset the amount of the proceeds allocated to the Series A. Then, the embedded derivative was bifurcated at its fair value of $1,879,428 with the remaining balance allocated to the host instrument (Debenture). The total debt discount will be amortized over the term of the Debenture using the effective interest method.

The Company recognized amortization of this discount as an additional interest charge to “Discount on convertible debentures” in the amount of $822,485, $653,063 and $512,330 for the years ended June 30, 2017, 2016 and 2015 respectively.

The following represents the balance of the Debenture payable – Series C, net of discount at June 30, 2017 and June 30, 2016:

	June 30, 2017		June 30, 2016

Proceeds	$	5,000,000	$	5,000,000
Debt Discount:
Series A Preferred		(1,152,297)		(1,152,297)
Embedded derivative		(1,879,428)		(1,879,428)
		1,968,275		1,968,275

Accumulated amortization of debt discount		1,987,878		1,165,393

Debenture payable - Series C, net	$	3,956,153	$	3,133,668

The Company uses a lattice model that values the compound embedded derivatives of the Series C Convertible Debenture based on a probability weighted discounted cash flow model at June 30, 2017 and 2016.

The following assumptions were used for the valuation of the compound embedded derivative at June 30, 2017 and 2016:

·	The balance of the Series C Convertible Debenture as of June 30, 2017 and 2016 is $5,000,000;

The underlying stock price was used as the fair value of the common stock; The stock price decreased to $1.35 at June 30, 2017 and higher projected annual volatility decreased the warrant value with the $6.05 exercise price. The stock price decreased to $1.60 at June 30, 2016 which decreased the warrant value with the $6.05 exercise price;

·	The projected annual volatility was based on the Company historical volatility:

1 year

6/30/17 60%

6/30/16 83%

·	An event of default would occur 0% of the time, increasing 1.00% per month to a maximum of 10%;

·	The Company would redeem the debentures projected initially at 0% of the time and increase monthly by 1.0% to a maximum of 5.0% (from alternative financing being available for a Redemption event to occur);

·	The Holder would automatically convert the interest if the Company was not in default and its share value was equivalent to the cash value;

·	The Holder would automatically convert the debenture at maturity if the registration was effective and the Company was not in default.

·	The weighted cost of capital discount rate (based on the market value of the transaction at issuance) adjusted for changes in the risk free rate is 21.99%.

·	Even though the shares are restricted the underlying assumption is that any restriction on resale will be removed either through registration or the passage of time at the time of issuance.

The fair value of the compound embedded derivatives of the Series C Convertible Debenture at June 30, 2017 and 2016 was $32,213 and $343,673, respectively.