3. Liabilities

Note Payable to an Affiliate

In September 2013, the Company issued a nine month unsecured note with a face value of $45,000 and 500,000 restricted shares of common stock to an affiliate of the Company in exchange for $54,325 in cash. The imputed annual rate of interest was calculated to be 18.4% and was repaid in nine equal monthly installments. Of the 500,000 shares issued, 312,500 shares were issued for debt issuance costs in an amount of $15,625 which was amortized as interest expense over the life of the note and 187,500 shares were issued for cash in an amount of $9,375.

Convertible Debentures

As of June 30, 2014, the Company has issued and outstanding Convertible Debentures (“Debentures”) with original terms of six months to one year, an interest rate ranging from 10-20% per year and an original issue discount of 5% which, at the option of the holder, may convert into common stock at an initial conversion price ranging from $0.045 to$0.099 per share. The Debentures were issued with detachable five year cashless Holders Warrants that allow the holders to purchase one share of stock for each two shares available under the converted Debentures at an exercise price ranging from $0.0745 to $0.1287 per share. In addition, the Company issued five year cashless Agent Warrants equal to 10% of the total number of shares issuable under the Debentures and Holders Warrants at an exercise price ranging from $0.0745 to $0.1287 per share. For debentures issued through June 30, 2013, at the option of the Debenture holder, the terms of the Debentures and Holders Warrants are subject to an exchange feature in the event that the Company issues securities with terms more favorable than those of the then outstanding Debentures and Holders Warrants. Debentures issued subsequent to June 30, 2013 do not contain such an exchange clause.

As of June 30, 2014 and December 31, 2013, the balances of the Debentures are as follows:

	June 30,		December 31,
	2014		2013

Balance at beginning of period	$	2,951,629	$	1,129,473
Issuance of debentures for cash		1,506,376		2,122,000
Original issue discount		44,737		111,685
Debentures surrendered in exchange transactions		-		(564,213)
Debentures issued in exchange transactions		-		626,368
Debentures converted to common stock		-		(473,684)
Convertible debt		4,502,742		2,951,629
Less unamortized costs of financing		1,002,608		644,518
Convertible debt, net of unamortized costs	$	3,500,134	$	2,307,111

Convertible debt in default	$	1,334,738	$	1,324,212

Derivative Liability

Since the Company issued Convertible Debentures which included Holders Warrants, Agent Warrants and a conversion option that includes a possible exchange feature in the event of a future financing on terms more favorable than those of the existing warrants and debentures, this results in the warrants and conversion feature of the debentures being recorded as a liability and measured at fair value. The Company measures these warrants and conversion feature using a combination of Black-Scholes option valuation models and Binomial Lattice option valuation models using similar assumptions to those described under “Stock-Based Compensation.” The time period over which the Company will be required to evaluate the fair value of the warrants is approximately five years and the time period over which the Company will be required to evaluate the fair value of the conversion feature is the lesser of six to twelve months or conversion.

The assumptions used in determining fair value represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change, including changes in the market value of the Company’s common stock, managements’ assessment of the probability of a more favorably priced future financing or significant fluctuations in the volatility of the trading market for the Company’s common stock, the Company’s fair value estimates could be materially different in the future.

The Company computes the fair value of the derivative liability at each reporting period and the change in the fair value is recorded as non-cash expense or non-cash income. The key component in the value of the derivative liability is the Company’s stock price, which is subject to significant fluctuation and is not under its control. The resulting effect on net loss is therefore subject to significant fluctuation and will continue to be so until the Company’s Debentures, which the convertible feature is associated with, are converted into common stock or paid in full with cash. Assuming all other fair value inputs remain constant, the Company will record non-cash expense when its stock price increases and non-cash income when its stock price decreases.

As of June 30, 2014 and December 31, 2013, the balances of the Derivative Liability are as follows:

			Conversion
	Warrants		Feature		Total

Balance at December 31, 2012	$	1,730,044	$	605,516	$	2,335,560
Liability on issuance of debt and warrants		762,111		929,156		1,691,267
Change in fair value at year end		(1,688,671)		(1,233,733)		(2,922,404)
Balance at December 31, 2013		803,484		300,939		1,104,423

Liability on issuance of debt and warrants		-		-		-
Change in fair value at period end		1,288,147		763,613		2,051,760
Balance at June 30, 2014	$	2,091,631	$	1,064,552	$	3,156,183

Debentures issued subsequent to June 30, 2013 did not contain an exchange provision and were accounted for using the equity method of valuing the note and warrant. For the six months ended June 30, 2014, $806,924 was recorded as additional paid-in capital.