4. CONVERTIBLE NOTES PAYABLE AND FAIR VALUE MEASUREMENTS

9 Months Ended

Sep. 30, 2012

Convertible Notes Payable And Fair Value Measurements

CONVERTIBLE NOTES PAYABLE AND FAIR VALUE MEASUREMENTS

Summary – Short Term Convertible Debt:

As of September 30, 2012, the following summarizes amounts owed under short-term convertible notes:

					Convertible
					Notes Payable,
	Amount		Discount		net of discount
Pegasus Note	$	100,000	$	–	$	100,000
Gemini Master Fund – Second Amended Note and Note Five	$	1,190,307	$	153,529	$	1,036,778
Gemini Master Fund – Note 2010-3	$	65,635	$	8,466	$	57,169
	$	1,355,942	$	161,995	$	1,193,947

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 originally 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 then 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 September 30, 2012 is $100,000 with accrued and unpaid interest amounting to $27,836 which is included in accrued expenses in the accompanying unaudited balance sheet. The interest on the note continues to accrue at a rate of 10%.

 Gemini Second Amended Note and Note Five

Prior to and as of December 31, 2010, the Company had entered into a series of convertible notes payable and modifications of such convertible notes amounting to a combined balance of $1,057,572. Interest under these notes was due on the first business day of each calendar quarter, 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. 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. With regard to this conversion feature, 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 $0.25 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 $0.25 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 4.9% of the Company common stock. These notes bear interest at a rate of 12% per annum. These notes were to become due on December 31, 2011.

Prior to June 30, 2010 all shares underlying the Gemini Master Fund convertible debt were subject to a lock-up agreement, 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, which state the conversion price of the notes will be adjusted downward to match any lower price for which the Company issues subsequent shares. Subsequent to June 30, 2010, such lock-up provisions expired and as such, the Company 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 Gemini debt and as of December 31, 2010, the Company had amortized all $868,591 of such debt discount to interest expense.

As of December 31, 2010, as a result of the note modification at this time, $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 then remaining term of the debt. This effective interest also increased the fair value of the derivative liability by the same $360,895 amount as of this date.

On December 31, 2011, the Company entered into a further 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 is being 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 September 30, 2012, the notes had a total balance of $1,190,307, a net balance of $1,036,778, and accrued interest of $91,523 which is included in accrued expenses in the accompanying unaudited balance sheet.

Gemini Note 2010-3

On April 22, 2010, the Company entered into a separate 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 then remaining term of the note.

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 is being 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 September 30, 2012, the note had a total balance of $65,635, a net balance of $57,169, and accrued interest of $5,047 which is included in accrued expenses in the accompanying unaudited balance sheet.

Fair Value Measurements – Derivative liability:

The accounting standard 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 standard 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 input 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 September 30, 2012:

	Carrying Value at		Fair value Measurements at September 30, 2012
	September 30, 2012		(Level 1)		(Level 2)		(Level 3)
Embedded Conversion Option Liability	$	108,999	$	–	$	–	$	108,999

The following is a summary of activity of Level 3 liabilities for the period ended September 30, 2012:

Balance December 31, 2011	$	647,977
Change in Fair Value	$	(538,978	)
Balance September 30, 2012	$	108,999

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

 The Company estimates the fair value of the embedded conversion option 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 September 30, 2012:

Assumptions
Expected term	0.25
Expected Volatility	108.31%
Risk free rate	0.21%
Dividend Yield	0.00%

There were no changes in the valuation techniques during the three and nine month periods ended September 30, 2012.