Note 7 - Derivative Liabilities

Conversion Option

The convertible revolving credit agreement, see Note 6 (the “Agreement”) entered into during the year ended December 31, 2011 met the definition of a hybrid instrument, as defined in ASC Topic 815 “Derivatives and Hedging”. The hybrid instrument was 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. As disclosed in Note 5, the discount was amortized to other expenses over the initial term of the Agreement and the unamortized discount at repayment of principal of the Agreement was charged to our statement of operations during the three months ended June 30, 2012.

The embedded derivative did not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the embedded derivative were immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in the accompanying statements of operations. For the three and six months ended June 30, 2012, we recognized a gain on the change in fair value of this derivative liability of $127,071 and $113,271, respectively.

Upon termination of the Agreement during the three months ended June 30, 2012, the fair value of the derivative liability of $127,071 was charged to our statement of operations.

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 to be issued if a certain revenue milestone was 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 liability does not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the derivative liability are immediately recognized in earnings and classified as a gain or loss on the derivative liability 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. Subsequently in 2011, since it became probable that the revenue milestone would not be met, we recorded the derivative liability at fair value of $1.9 million. Since we did not achieve the revenue milestone for the year ended December 31, 2011, we were required to issue the Make Good Warrants, and accordingly once issued, the derivative liability associated with the Make Good Warrants was satisfied and the related derivative liability was reduced to zero. During the three months ended March 31, 2012, we credited Common Stock for the issuance of these warrants for the fair value of the derivative liability of approximately $1.9 million.

Bonus Warrants

Effective January 14, 2011, the holders of our Debentures, agreed to extend the maturity dates to June 30, 2012 and to the elimination of the prohibition of paying dividends or distributions on any of our equity securities. In addition to other amendments, we agreed that for each calendar month after the original maturity dates that these Debentures remained outstanding, we would issue a bonus warrant exercisable for three years for a number of shares of our common stock equal to the 5% of the outstanding principal, divided by $0.90. These bonus warrants are exercisable at $0.90 per share.

Since it was probable that we would issue the bonus warrants which were part of the reacquisition costs of the new debt, at each month-end through the amended maturity date, we calculated the fair value of the bonus warrants using the Black-Scholes pricing model and recorded a derivative liability of approximately $797,000 on the date of amendment and recognized the amount as a loss in our statement of operations during the three months ended March 31, 2011, the period of amendment. The bonus warrant derivative liability does not qualify as a fair value or cash flow hedge under ASC 815, accordingly, changes in the fair value of the derivative liability are immediately recognized in earnings and classified as a gain or loss on the derivative liability in the accompanying statements of operations. During the three and six months ended June 30, 2012, we recorded approximately $2,500 and $13,300, respectively of the gain in the fair value of the derivative liability. Upon issuance of the bonus warrants during the six months ended June 30, 2012 and year ended December 31, 2011, we credited additional paid-in capital for approximately $57,000, and $234,700, respectively.

Fair Value Measurements

We are required to disclose the fair value measurements required by Accounting for Fair Value Measurements. The derivative liability recorded at fair value in the balance sheet as of June 30, 2012 and December 31, 2011 is categorized based upon the level of judgment associated with the inputs used to measure its fair value. Hierarchical levels, defined by Accounting for 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 June 30, 2012 and December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

	As of June 30, 2012
	Level 1		Level 2		Level 3		Liabilities at Fair Value
Placement agent warrants		-		-		140,458		140,458
Total	$	-	$	-	$	140,458	$	140,458

	As of December 31, 2011 (Restated)
	Level 1		Level 2		Level 3		Liabilities at Fair Value
Derivative liability – conversion option	$	-	$	-	$	113,271	$	113,271
Derivative liability – warrants		-		-		1,875,463		1,875,463
Derivative liability – bonus warrants		-		-		70,343		70,343
Placement agent warrants		-		-		487,555		487,555
Total	$	-	$	-	$	2,546,632	$	2,546,632

The following tables are a reconciliation of the derivative liability for which Level 3 inputs were used in determining fair value:

	Conversion Option			Warrants			Bonus Warrants			Placement Agent Warrants

Beginning balance as of January 1, 2012	$	113,271		$	1,875,463		$	70,343		$	487,555
Change in fair value		(113,271	)		-			(13,309	)		(347,097	)
Credited to common stock upon issuance of warrants		-			(1,875,463	)		(57,034	)		-
Ending balance as of June 30, 2012	$	-		$	-		$	-		$	140,458

	Conversion Option			Warrants		Bonus Warrants			Placement Agent Warrants

Beginning balance as of January 1, 2011	$	-		$	-	$	-		$	-
Fair value of derivative liability		118,663			-		797,185			487,555
Change in fair value		(5,392	)		1,875,463		(492,111	)		-
Credited to common stock upon issuance of warrants		-			-		(234,731	)		-
Ending balance as of December 31, 2011	$	113,271		$	1,875,463	$	70,343		$	487,555