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4. Fair Value

9 Months Ended

Sep. 30, 2014

Warrants:

The balance sheet caption derivative liabilities includes warrants, issued in connection with the 2005 Laurus Financing Arrangement, and the 2006 Omnibus Amendment and Waiver Agreement with Laurus. These derivative financial instruments are indexed to an aggregate of 758,333 shares of the Company’s common stock as of September 30, 2014 and December 31, 2013 and are carried at fair value. The balance at September 30, 2014 was $62,714 compared to $122,698 at December 31, 2013.

The valuation of the derivative warrant liabilities is determined using a Black Scholes Merton Model. Freestanding derivative instruments, consisting of warrants and options that arose from the Laurus financing are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in the Black Scholes models as of September 30, 2014 included conversion or strike price of $0.09; historical volatility factor of 177% based upon forward terms of instruments, and a risk free rate of 2.22% and remaining life 7.98 years.

In accordance with FASB ASC 820, “Fair Value Measurements and Disclosures”, the following table represents the Company’s fair value hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013:

Convertible Notes:

	Level 3		Total
September 30, 2014:

Derivative Instrument	$	694,694	$	694,694

		Level 3		Total
December 31, 2013:

Derivative Instrument	$	–	$	–

Level 3 financial instruments consist of certain embedded conversion features. The fair value of these embedded conversion features that have exercise reset features are estimated using a Monte Carlo valuation model. The Company adopted the disclosure requirements of ASU 2011-04, “Fair Value Measurements,” during the quarter ended September 30, 2014. The unobservable input used by the Company was the estimation of the likelihood of a reset occurring on the embedded conversion feature of the Convertible Notes. These estimates of the likelihood of completing an equity raise that would meet the criteria to trigger the reset provisions are based on numerous factors, including the remaining term of the financial instruments and the Company’s overall financial condition.

The following table summarizes the changes in fair value of the Company’s Level 3 financial instruments for the period ended September 30, 2014.

	September 30, 2014
Beginning Balance	$	122,698
Initial recognition - Derivative liability of embedded conversion feature of the Convertible Notes		1,223,923

Change in fair value		(589,214	)

Ending Balance	$	757,407

Changes in the unobservable input values would likely cause material changes in the fair value of the Company’s Level 3 financial instruments. The significant unobservable input used in the fair value measurement is the estimation of the likelihood of the occurrence of a change to the conversion price based on the contractual terms of the financial instruments. A significant increase (decrease) in this likelihood would result in a higher (lower) fair value measurement.