Note 7 - Derivative Liability

Derivative Liability - Conversion Option

The convertible revolving credit agreement (see Note 6) entered into during the year ended December 31, 2011 meets the definition of a hybrid instrument, as defined in ASC Topic 815 “Derivatives and Hedging”. The hybrid instrument is comprised of a (i) a debt instrument, as the host contract and (ii) an option to convert the debt outstanding under the revolving credit agreement into shares of our common stock, as an embedded derivative. The embedded derivative derives its value based on the underlying fair value of the shares of our common stock. The embedded derivative is not clearly and closely related to the underlying host debt instrument since the economic characteristics and risk associated with this derivative are based on the common stock fair value.

We determined the fair value of the embedded derivative and recorded it as a discount to the debt and a derivative liability on the date of issue. The discount is amortized to other expenses over the term of the revolving credit agreement and will be fully amortized at the maturity of the agreement on September 30, 2012. Upon conversion of the debt to equity, any remaining unamortized discount is charged to financing expense.

The embedded derivative does not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the embedded derivative are immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in the accompanying statements of operations. We recognized a gain of approximately $5,400 for the year ended December 31, 2011.

Derivative Liability - Warrants

The 10% convertible preferred stock (see Note 9) issued during the year ended December 31, 2011 meets the definition of a hybrid instrument, as defined in ASC Topic 815 “Derivatives and Hedging” (”ASC 815”). The hybrid instrument is comprised of a (i) a preferred stock, as the host contract, (ii) a warrant to purchase shares of our common stock if a certain revenue milestone is not achieved (the “Make Good Warrant”), as an embedded derivative liability and (iii) an option to convert the preferred stock into shares of our common stock (the “Conversion Option”). Since, at issuance the number of shares of common stock which the Make Good Warrant would be exercisable into, was not known, ASC 815 requires the fair value of the Make Good Warrants be recorded as a derivative liability at issuance and any change in fair value be recognized in current earnings. The Conversion Option derives its value based on the underlying fair value of the shares of our common stock as does the Preferred Stock, and therefore is clearly and closely related to the underlying host contract.

The Make Good Warrant derivative does not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the derivative are immediately recognized in earnings and classified as a gain or loss on the derivative financial instrument in the accompanying statements of operations. At the date of issuance in March and April 2011, we determined the fair value of the Make Good Warrant derivative to be insignificant and did not record a charge to Common Stock and a credit to the derivative liability. We determined the fair value of the derivative liability at each reporting period and accordingly recognized a loss on change in fair value of the derivative liability of approximately $2.4 million at September 30, 2011 and a gain in change of fair value of the derivative liability of approximately $0.5 million at December 31, 2011.

We are required to disclose the fair value measurements required by Accounting for Fair Value Measurements. The derivative liabilities recorded at fair value in the balance sheet as of December 31, 2011 are categorized based upon the level of judgment associated with the inputs used to measure its fair value. Hierarchical levels, defined by Fair Value Measurements are directly related to the amount of subjectivity associated with the inputs to fair valuation of the liability is as follows:

Level 1 —	Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;

Level 2 —	Inputs other than Level 1 inputs that are either directly or indirectly observable; and

Level 3 —	Unobservable inputs, for which little or no market data exist, therefore requiring an entity to develop its own assumptions.

The following table summarizes the financial liabilities measured at fair value on a recurring basis as of December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

							Liabilities
	Level 1		Level 2		Level 3		at fair value (as restated)
Derivative liability – conversion option	$	-	$	-	$	113,271	$	113,271
Derivative liability - warrants		-		-		1,875,463		1,875,463
Total	$	-	$	-	$	1,988,734	$	1,988,734

The following table is a reconciliation of the derivative liabilities for which Level 3 inputs were used in determining fair value:

	Derivative Liability – Conversion Option			Derivative Liability – Warrants (as restated)

Beginning balance as of January 1, 2011	$	-		$	-
Fair value of conversion feature		118,663			-
(Gain) loss in fair value		(5,392	)		1,875,463
Ending balance as of December 31, 2011	$	113,271		$	1,875,463

In accordance with Accounting for Derivative Instruments and Hedging, we calculated the fair value of the derivative liabilities using the Black–Scholes option pricing model and the following assumptions at December 31, 2011:

	Conversion Option			Warrants
Expected volatility		71	%		110	%
Expected life (months)		9
Expected life (years)					4
Risk free interest rate		0.11	%		0.60	%
Forfeiture rate		-			-
Dividend rate		-			-