10. CONVERTIBLE NOTES PAYABLE AND FAIR VALUE MEASUREMENTS

12 Months Ended

Dec. 31, 2011

Convertible Notes Payable And Fair Value Measurements [Text Block]

10.	CONVERTIBLE NOTES PAYABLE AND FAIR VALUE MEASUREMENTS

Summary:

As of December 31, 2011, the following summarizes principal amounts owed under convertible notes:

	Amount		Discount		Convertible Notes Payable, net of discount
Pegasus Note	$	100,000	$	-	$	100,000
Gemini Master Fund – Second Amended Note and Note Five		1,190,308		614,114		576,194
Gemini Master Fund – Note 2010-3		65,635		33,863		31,772
Hickson Note		1,000,000		26,277		973,723
	$	2,355,943	$	674,254	$	1,681,689

As of December 31, 2010, the following summarizes principal amounts owed under convertible notes:

	Amount		Discount		Convertible Notes Payable, net of discount
Pegasus Note	$	100,000	$	-	$	100,000
Gemini Master Fund – Second Amended Note and Note Five		1,057,572		434,679		622,893
	$	1,157,572	$	434,679	$	722,893

Pegasus Note:

On December 19, 2009, the Company entered into a convertible promissory note for $100,000 to a new landlord in lieu of paying rent for one year for new office space. The interest is 10% per annum with the note principal and interest due December 18, 2010. However, if the Company receives greater than $1,000,000 of proceeds from debt or equity financing, 25% of the amount in excess of $1,000,000 shall be used to pay down the note. This note is subordinate to all existing senior indebtedness of the Company. This note is convertible at $0.33 per share. There was no beneficial conversion feature at the note date. On March 28, 2011, the Company entered into a revised agreement to extend the maturity date of the note to December 31, 2011. Further, throughout the time period of the current private offering, the lender agreed to waive the requirement that 25% of the amount of any financing in excess of $1,000,000 be used to pay down the note balance. As a result of this extension, the Company recorded $18,480 of embedded conversion option based effective interest in March 2011 which was recorded as debt discount and amortized over the remaining term of the note. Effective December 31, 2011, the Company entered into a further modification extending the term of the note to December 31, 2012. Per generally accepted accounting principles, this modification was treated as an extinguishment, but as the market price of the Company’s stock was below the conversion price at the time of the modification, there was no beneficial conversion feature that needed to be recorded. The balance of the note as of December 31, 2011 is $100,000 with accrued and unpaid interest amounting to $20,384.

Gemini Second Amended Note and Note Five:

At the end of 2009, the Company had outstanding a series of amended notes to Gemini Master Fund, Ltd (the “holder” or “lender”) amounting to $852,194. Interest under these notes was due on the first business day of each calendar quarter starting January 4, 2010, however, upon three days advance notice, the Company may elect to add such interest to the note principal balance effectively making the interest due at note maturity. With regard to the conversion feature of these notes, the conversion rights contain price protection whereby if the Company sold equity or converted existing instruments to common stock at a price less than the $0.33 conversion price, the conversion price will be adjusted downward to the sale price. Furthermore, if the Company issued new rights, warrants, options or other common stock equivalents at an exercise price less than the $0.33 conversion price, then the conversion price shall be adjusted downward to a new price based on a stipulated formula. The holder may not convert the debt if it results in the holder beneficially holding more than 9.9% of the Company common stock. The holder was subject to a lock-up agreement on the debt and underlying shares from October 30, 2009 through June 30, 2010. The note is secured by substantially all assets of the Company and its subsidiaries, and is unconditionally guaranteed by all the subsidiaries.

On January 20, 2010, the Company entered into a Second Amendment Agreement with Gemini Master Fund, LTD whereby certain terms of the First Amendment Agreement were modified. Under the Second Amendment Agreement the conversion price for all previous notes was reduced from $0.33 to $0.25 per share; the interest payment was extended from January 4, 2010 to April 1, 2010; and the beneficial ownership percentage was reduced from 9.9% to 4.9%. There was no accounting effect for the price reductions as the conversion prices were greater than the fair value of the common stock.

On February 12, 2010, the Company issued to Gemini Master Fund, LTD the Second Amended and Restated Secured Bridge Note in the amount of $811,792 consolidating all principal amounts outstanding at this date along with all accrued but unpaid interest. The terms of the note did not change. Prior to such issue, the Company paid down approximately $69,000 of the outstanding balance.

On March 10, 2010, the Company entered into a new secured note with Gemini Master Fund, LTD, Note No. 5, for $75,000. The new note bears interest at 12% per annum, payable in quarterly installments of the accrued and unpaid interest, beginning April 1, 2010, with the note maturing on December 31, 2010. In the event a quarterly payment is late, it incurs a late fee of 20%. The note carries a conversion feature whereby, the lender, at its option, may at any time convert this loan into common stock at $0.25 per share. There is no beneficial conversion value as the conversion price was deemed to be equal to or greater that the fair value of the common stock.

Prior to June 30, 2010, all shares underlying the Gemini Master Fund convertible debt were subject to a lock-up agreement as stated above, and the shares were not easily convertible to cash thus, the embedded conversion option did not need to be bifurcated and recorded as a fair value derivative due to the price protection provision in the notes. Subsequent to June 30, 2010, such lock-up provisions expired and as such, the Company has determined that the embedded conversion option met the definition of a derivative liability and thus must be bifurcated and recorded as a fair value derivative.

On July 1, 2010, the Company established an embedded conversion option liability of $868,591 for the above mentioned $886,792 of Gemini debt. The Company recorded a debt discount of $868,591 related to the fair value of the liability for the embedded conversion option. The fair value was determined using the Black-Scholes pricing model with the following assumptions: stock price $0.48, conversion price $0.25, expected term of six months based on the contractual term, volatility of 86% based on historical volatility, and a risk free interest rate of 0.2%. As of December 31, 2010, the Company amortized all $861,591 of debt discount to interest expense.

As of December 31, 2010, interest of $96,996 had accrued on the two Gemini Master Fund, LTD notes’. Further, on December 31, 2010, the Company entered into an extension agreement to extend the maturity date of the notes to December 31, 2011. As part of this agreement, all accrued but unpaid interest was capitalized into the note balance along with an extension fee of $73,784. Such extension fee, recorded as debt discount, was amortized to interest expense over the remaining term of the note. Additionally, as a result of the note modification, $360,895 of embedded conversion option based effective interest (due to the increase in the value of the embedded conversion option) was recorded as debt discount and was amortized over the remaining new term of the debt. This effective interest also increased the fair value of the derivative liability by the same $360,895 amount on the modification date. At December 31, 2010, the notes had a total balance outstanding of $1,057,572, and a net balance of $622,893. The interest on the note continued to accrue at a rate of 12%.

On December 31, 2011, the Company entered into a second extension and amendment agreement modifying certain terms of the notes. The interest rate was reduced to 10%; the conversion price was reduced from $0.25 to $0.20; and the term was extended to December 31, 2012. These changes were accounted for as a debt modification but not as a debt extinguishment. As a result of this transaction, the Company has recorded $614,114 of embedded conversion option based effective interest based on the increase in the fair value of the embedded conversion option due to the modification which is recorded as debt discount and will be amortized over the remaining term of the loan. Further, at the modification date, $132,736 of accrued interest was added to the loan balance. At December 31, 2011, the notes had a total balance of $1,190,308, and a net balance of $576,194.

Gemini Note 2010-3:

On April 22, 2010, the Company entered into a new non-secured note with Gemini Master Fund, LTD, Note No. 2010-3, for $50,000. This note bears interest at 12% per annum, payable in quarterly installments of the accrued and unpaid interest, beginning July 1, 2010, with the note originally maturing on August 20, 2010. In the event a quarterly payment is late, it incurs a late fee of 20%. On December 31, 2010, the Company entered into a revised agreement to extend the maturity date of the note to December 31, 2011. As a part of this agreement, all accrued and unpaid interest amounting to $4,247 was capitalized into the note balance along with an extension fee of $4,069. Such extension fee, recorded as debt discount, was amortized to interest expense over the remaining term of the note. At December 31, 2010, the note had a total balance outstanding of $58,315, and a balance, net of discount, of $54,247.

On December 31, 2011, the Company entered into an agreement to modify the terms of this note. As a result of this modification, the maturity date of the note was extended to December 31, 2012; the per annum interest rate of the note was lowered to 10%; and the note became convertible with a conversion feature whereby, the lender, at its option, may at any time convert this loan into common stock of the Company at $0.20 per share. All terms related to the conversion process are deemed to be the same terms as the other Gemini notes discussed above. All other terms of the original note remain the same. These changes were accounted for as a debt modification but not a debt extinguishment because the embedded conversion feature is bifurcated and treated as a derivative. As a result of this transaction, the Company has recorded $33,863 of embedded conversion option based effective interest based on the increase in the fair value of the embedded conversion option due to the modification which is recorded as debt discount and will be amortized over the remaining term of the loan. Further, at the modification date, $7,319 of accrued interest was added to the loan balance. At December 31, 2011, the note had a total balance of $65,635, and a net balance of $31,772.

Hickson Note:

On September 8, 2011, the Company entered into a convertible promissory note for $1,000,000 to a private individual. The interest is 9% per annum with the note principal and interest due December 31, 2012. This note is subordinate to all existing senior indebtedness of the Company. This note is convertible at $0.29 per share. As it relates to this note, the Company recorded $34,483 of beneficial conversion feature intrinsic value which is recorded as debt discount and is being amortized over the term of the note. As of December 31, 2011, this note had a total outstanding balance of $1,000,000 and a balance, net of discount, of $973,723. (See Note 16)

Fair Value Measurements – Derivative liability:

The accounting guidance for fair value measurements provides a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. Fair value is defined as the price that would be received for an asset or the exit price that would be paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. The accounting guidance established a fair value hierarchy which requires an entity to maximize the use of observable inputs, where available. 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. An asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

Assets and liabilities measured at fair value on a recurring and non-recurring basis consisted of the following at December 31, 2010 and 2011:

			Fair value Measurements at December 31, 2010
	Carrying Value at December 31, 2010		(Level 1)		(Level 2)		(Level 3)
Embedded Conversion Option Liability	$	963,931	$	-	$	-	$	963,931

			Fair value Measurements at December 31, 2011
	Carrying Value at December 31, 2011		(Level 1)		(Level 2)		(Level 3)
Embedded Conversion Option Liability	$	647,977	$	-	$	-	$	647,977

The following is a summary of activity of Level 3 liabilities for the period ended December 31, 2010 and 2011:

Balance at July 1, 2010	$	868,591
Increase in liability due to debt modification		360,895
Change in fair value		(265,555	)
Balance at December 31, 2010	$	963,931
Increase in liability due to debt modification		647,977
Change in fair value		(963,931	)
Balance December 31, 2011	$	647,977

Changes in fair value of the embedded conversion option liability are included in other income (expense) in the accompanying consolidated statements of operations.

The Company estimates the fair value of the embedded conversion liability utilizing the Black-Scholes pricing model, which is dependent upon several variables such as the expected term (based on contractual term), expected volatility of our stock price over the expected term (based on historical volatility), expected risk-free interest rate over the expected term, and the expected dividend yield rate over the expected term. The Company believes this valuation methodology is appropriate for estimating the fair value of the derivative liability. The following table summarizes the assumptions the Company utilized to estimate the fair value of the embedded conversion option at December 31, 2011 and 2010:

Assumptions	December 31, 2011	December 31, 2010
Expected term	1.0	1.0
Expected Volatility	107%	99%
Risk free rate	0.21%	0.21%
Dividend Yield	0.00%	0.00%

There were no changes in the valuation techniques during 2011. The weighted average interest rate for short term notes as of December 31, 2011 was 9.62%.