Fair Value Measurements

6 Months Ended

Jun. 30, 2014

5. Fair Value Measurements

Accounting guidance on fair value measurements and disclosures defines fair value, establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system, and defines required disclosures. It clarifies that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts business.

The Company's balance sheet contains derivative and warrant liabilities that are recorded at fair value on a recurring basis. The three-level valuation hierarchy for disclosure of fair value is as follows:

Level 1: uses quoted market prices in active markets for identical assets or liabilities.

Level 2: uses observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: uses unobservable inputs that are not corroborated by market data.

The fair value of the Company’s recorded derivative and warrant liabilities is determined based on unobservable inputs that are not corroborated by market data, which require a Level 3 classification. A Binomial Lattice option valuation model was used to determine the fair value with similar assumptions to those described under “Stock-Based Compensation”. The Company records derivative and warrant liabilities on the condensed consolidated balance sheets at fair value with changes in fair value recorded in the condensed consolidated statements of operation.

The following table presents the balances of liabilities measured at fair value on a recurring basis by level as of June 30, 2014:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
	Identical Assets		Inputs		Inputs
	(Level 1)		(Level 2)		(Level 3)		Total

As of June 30, 2014
Derivative liability	$	-	$	-	$	1,064,552	$	1,064,552
Warrant liability		-		-		2,091,631		2,091,631
Total	$	-	$	-	$	3,156,183	$	3,156,183

The following table presents changes in the liabilities with significant unobservable inputs (Level 3) for the nine months ended June 30, 2014:

	Warrant		Derivative		Total
	Liability		Liability		Liability
Balance December 31, 2013	$	803,484	$	300,939	$	1,104,423

Liability on issuance of debt and warrants		-		-		-

Change in estimated fair value (1)		1,288,147		763,613		2,051,760

Elimination of liability on conversion		-		-		-

Balance June 30, 2014	$	2,091,631	$	1,064,552	$	3,156,183

(1) Included in the Condensed Statements of Operation on the line “Change in fair value of derivative and warrant liabilities.”

Management used the following inputs to value the Derivative and Warrant Liabilities for the six months ended June 30, 2014:

	Derivative Liability	Warrant Liability
Expected term	6 months - 1 year	5 years
Exercise price	$0.045 - $0.099	$0.075 - $0.1287
Expected volatility	238% to 242%	189% to 190%
Expected dividends	None	None
Risk-free interest rate	0.11% to 0.13%	1.62% to 1.73%
Forfeitures	None	None

In computing the fair value of the derivative and warrant liability at June 30, 2014 for instruments under the Binomial Lattice option-pricing model, management estimated a 50% probability of a down round financing event at a price of $0.036 and a 20% to 80% probability that existing note holders with exchange privileges would exchange their existing debentures and warrants for new debentures and warrants.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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