Note 7 - 10% Convertible Redeemable Preferred Stock

The components of our Preferred Stock, classified as temporary equity in our balance sheet, are summarized as follows:

	September 30,		December 31,
	2013		2012
10% convertible preferred stock - face value	$	7,021,230	$	7,060,230
Unamortized discount		(452,914)		(1,137,618)
10% convertible preferred stock, net of discount	$	6,568,316	$	5,922,612

During the year ended December 31, 2011, we designated 880,000 shares of preferred stock as 10% convertible redeemable preferred stock (the “Preferred Stock”). The Preferred Stock has a stated value (the “Stated Value”) of $10.00 per share. The Preferred Stock and any dividends thereon may be converted into shares of our common stock at any time by the holder at a conversion rate of $1.00 per share, as adjusted (the “Conversion Rate”). The holders of the Preferred Stock are entitled to receive dividends at the rate of ten percent per annum payable quarterly. Dividends shall not be declared, paid or set aside for any series or other class of stock ranking junior to the Preferred Stock, until all dividends have been paid in full on the Preferred Stock. The dividends on the Preferred Stock are payable, at our option, in cash, if permissible, or in shares of common stock. The Preferred Stock is not subject to any anti-dilution provisions other than for stock splits and stock dividends or other similar transactions. The holders of the Preferred Stock shall have the right to vote with our stockholders in any matter. The number of votes that may be cast by a holder of our Preferred Stock shall equal the Stated Value of the Preferred Stock purchased divided by the Conversion Rate. The Preferred Stock shall be redeemable for cash by the holder any time after the three-year anniversary from the initial purchase. The Preferred Stock may be converted by us, provided that the variable weighted average price of our common stock has closed at $4.00 per share or greater for sixty consecutive trading days and during such sixty-day period, the shares of common stock issuable upon conversion of the Preferred Stock have either been registered for resale or are issuable without restriction pursuant to Rule 144 of the Securities Act of 1933, as amended.

The Preferred Stock when issued was a hybrid instrument comprised of (i) a preferred stock, (ii) an option to convert the preferred stock into shares of our common stock (the “Conversion Option”) and (iii) a warrant to purchase shares of our common stock to be issued if a certain revenue milestone (the “Revenue Milestone”) was not achieved (the “Make Good Warrant”), as an embedded derivative liability. 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 preferred stock. Since, at issuance the number of shares of common stock which the Make Good Warrant would be exercisable into, was not determinable, and since the fair value of the Make Good Warrants was deemed improbable, we did not record a derivative liability. See Note 6 for further discussion on these derivative liabilities.

Since our Revenue Milestone for the twelve months ended December 31, 2011 was not achieved (i) the Conversion Rate was reduced to $1.00, and (ii) each holder received a Make Good Warrant to purchase a number of shares of our common stock equal to fifty percent of the number of shares of common stock issuable upon conversion of the Preferred Stock at the Conversion Rate. The Make Good Warrants expire December 31, 2015, have an initial exercise price of $1.00 per share and provide for cashless exercise at any time the underlying shares of common stock have not been registered for resale under the Securities Act of 1933 or are issuable without restriction pursuant to Rule 144 of the Securities Act.

During March and April 2011, we sold 759,773 shares of Preferred Stock at a price per share of $10, for gross proceeds of $7,597,730. We paid commissions, legal fees and other expenses of issuance of approximately $828,300, which has been recorded as a discount and deducted from the face value of the Preferred Stock. At issuance of the Preferred Stock, we attributed a conversion option to the Preferred Stock based upon the difference between the Conversion Rate at the time of issuance and the closing price of our common stock on the date of issuance, which was recorded as a discount and deducted from the face value of the Preferred Stock. Pursuant to the Make Good adjustment of the Conversion Rate to $1.00, at December 31, 2011 the conversion option was recalculated as if the $1.00 Conversion Rate was in effect at issuance which amounted to $2.1 million, and the amortization of the related discount was adjusted for the year ended December 31, 2011. These discounts are amortized over three years consistent with the initial redemption terms, as a charge to additional paid-in capital, due to our deficit in retained earnings. During the three and nine months ended September 30, 2013, we amortized $228,946 and $684,704, respectively to additional paid-in capital. For the corresponding periods in 2012 we amortized $268,425 and $811,452, respectively to additional paid-in capital. At September 30, 2013, the unamortized Preferred Stock discount balance was $452,914.

During the nine months ended September 30, 2013 and the year ended December 31, 2012, we issued 39,000 and 462,500 shares of our common stock, respectively upon conversion of 3,900 and 46,250 shares of our Preferred Stock, respectively.

The Preferred Stock outstanding at September 30, 2013, was convertible into 7.0 million shares of our common stock.

Since the Preferred Stock at September 30, 2013 may ultimately be redeemed at the option of the holder, the carrying value of the Preferred Stock, net of unamortized discount has been classified as temporary equity.

Our dividend payable on September 30, 2013 was paid with 347,039 shares of common stock in lieu of cash, which were issued subsequent to September 30, 2013, and with a value of $176,990.

Placement Agent Warrants

We issued warrants to the placement agents for the sale of our Preferred Stock, to purchase 58,352 shares of Preferred Stock at $10 per share. Since at issuance, the number of shares of common stock which these warrants would be exercisable into was not determinable, we recorded the fair value of the warrants at issuance, as a liability on our balance sheet and we re-value this warrant liability at each reporting date, with changes in fair value recognized in earnings each reporting period. See Note 5 for further discussion of derivative liabilities.