Note 7 - Derivative Liabilities

8% Convertible Promissory Notes – Conversion Option and Warrants

During the years ended December 31, 2013 and 2012, we issued 8% convertible promissory notes (the “8% Notes”) see Note 8 for further discussion. The 8% Notes met the definition of a hybrid instrument, as defined in the ASC Topic 815 “Derivatives and Hedging” (“ASC 815”). The hybrid instrument was composed of a debt instrument, as the host contract, and an option to convert the debt outstanding under the terms of the 8% Notes, into shares of our common stock. The 8% Notes were issued with a warrant to purchase shares of our common stock. Both the conversion option and the warrants are derivative liabilities. The conversion option derives its value based on the underlying fair value of the shares of our common stock which is not clearly and closely related to the underlying host debt instrument since the economic characteristics and risk associated with the conversion option derivative are based on the common stock fair value. The warrants do not qualify as equity under ASC 815. Accordingly, changes in the fair value of these warrant and conversion option liabilities are immediately recognized in operations and classified as a change in fair value in the statement of operations.

We determined the fair value of the conversion option and warrant derivative liabilities on the various dates of issuance and recorded these fair values as a discount to the debt and a derivative liability. The fair value of the conversion option derivative liability on the various dates of issuance and on December 31, 2013 aggregated approximately $1,945,200 and $12,400,000, respectively. The change in fair value during the years ended December 31, 2013 and 2012 of an increase of approximately $10,870,400 and a decrease of approximately $415,700, respectively was recorded as a change in fair value of derivative liability in the statement of operations. The fair value of the warrants derivative liability on the various dates of issuance and on December 31, 2013 aggregated approximately $777,400 and $4,790,000, respectively. The change in fair value during the years ended December 31, 2013 and 2012 of an increase of approximately $4,235,900 and a decrease of approximately $223,300, respectively was recorded as a change in fair value of derivative liability in the statement of operations.

The estimated fair values of the conversion option and the warrant derivative liabilities were computed by a third party using Monte Carlo simulations based on the following ranges for each assumption:

	At Issuances		December 31, 2013

Volatility	45% to 50.0	%	45.0	%
Risk-free interest rate	0.3% to 0.4	%	0.3	%
Dividend yield	0.0	%	0.0	%
Expected life	1.8 to 3.0 years		1.7 years

12% Convertible Revolving Credit Agreement – Conversion Option

The convertible revolving credit agreement (the “Revolving Agreement”) , see Note 7 for further discussion, entered into during the year ended December 31, 2011 met the definition of a hybrid instrument, as defined in ASC 815. 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 estimated the fair value of the embedded derivative on the date of issue using the Black-Scholes option pricing model with the following range of assumptions - (i) no dividend yield, (ii) an expected volatility of 71%, (iii) a risk-free interest rate of 0.11%, and (iv) an expected life of 10 months. We recorded this fair value as a discount to the debt and a derivative liability on the date of issue. This 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 change in fair value of derivative liability in the accompanying statements of operations.

For the year ended December 31, 2012, we recognized a gain on the change in fair value of this derivative liability of approximately $113,300 in our statement of operations. Since the Revolving Agreement was terminated during the year ended December 31, 2012, there was no derivative liability at December 31, 2012.

10% Convertible Preferred Stock – Warrants

The 10% convertible preferred stock (see Note 9 for further discussion), issued during the year ended December 31, 2011 meets the definition of a hybrid instrument, as defined in 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 determinable, pursuant to ASC 815 the fair value of the Make Good Warrants is recorded as a derivative liability at issuance and any change in fair value of the derivative liability is 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 did not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the derivative liability were immediately recognized in earnings and classified as a change in fair value of 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, when it became probable that the revenue milestone would not be met, we recorded the derivative liability at fair value of $1.9 million and recorded a charge to changes in fair value of derivative liability in our statement of operations. We estimated the initial fair value of this derivative liability by using the Black-Scholes option pricing model with the following assumptions - (i) no dividend yield, (ii) an expected volatility of 110%, (iii) a risk-free interest rate 0.6%, and (iv) an expected life of fifty-one months.

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 year ended December 31, 2012, we credited common stock for the issuance of these warrants at the fair value of the derivative liability of $1.9 million.

10% Convertible Debenture – Bonus Warrants

Effective January 14, 2011, the holders of our 10% convertible debentures (“Debentures”), see Note 8 for further discussion, 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 5% of the outstanding principal, divided by $0.90.

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. We estimated the initial fair value of this derivative liability by using the Black-Scholes option pricing model with the following assumptions - (i) no dividend yield, (ii) an expected volatility of 117%, (iii) a risk-free interest rate 1.0%, and (iv) an expected life of thirty-six months. This bonus warrant derivative liability did not qualify as a fair value or cash flow hedge under ASC 815 and accordingly, changes in the fair value of the derivative liability were immediately recognized in earnings and classified as a change in fair value of derivative liability in the accompanying statements of operations. During the year ended December 31, 2012, we recorded approximately $13,300 as a change in fair value of the derivative liability. Upon issuance of the bonus warrants during the year ended December 31, 2012, we credited additional paid-in capital for approximately $57,000. At December 31, 2012, all bonus warrants had been issued and therefore no derivative liabilities were recognized at December 31, 2012.

Placement Agent Warrants

We issued warrants to the placement agents for the sale of our 10% convertible preferred stock, to purchase 58,352 shares of 10% convertible preferred stock at $10 per share. Since the underlying 10% convertible preferred stock is redeemable by the holder after three years from the date of purchase, we recorded the fair value of the warrants at issuance, as a liability on our balance sheet and we re-measure this warrant liability at each reporting date, with changes in fair value recognized in earnings each reporting period. We estimated the fair value at December 31, 2013 of this derivative liability by using the Black-Scholes option pricing model with the following assumptions - (i) no dividend yield, (ii) an expected volatility of 90%, (iii) a risk-free interest rate 0.4%, and (iv) an expected life of approximately two and one-half years. The fair value of the warrant liability at December 31, 2013 and 2012 was approximately $296,200 and $81,700, respectively and we recognized the change in fair value of the warrant liability during the years ended December 31, 2013 and 2012 of a charge in our statement of operations of approximately $214,500 and a credit in our statement of operations of approximately $405,800, respectively.

Accounting for 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 December 31, 2013 and 2012 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 liability measured at fair value on a recurring basis as of December 31, 2013 and 2012, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

	As of December 31, 2013
							Derivative
							Liabilities at
	Level 1		Level 2		Level 3		Fair Value

8% Convertible promissory notes:
Conversion option	$	-	$	-	$	12,400,000	$	12,400,000
Warrants		-		-		4,790,000		4,790,000
Derivative liabilities - Current		-		-		17,190,000		17,190,000

Placement agent warrants - Non-current		-		-		296,194		296,194
Derivative liabilities - Total	$	-	$	-	$	17,486,194	$	17,486,194

	As of December 31, 2012
							Derivative
							Liabilities at
	Level 1		Level 2		Level 3		Fair Value

8% Convertible promissory notes:
Conversion option	$	-	$	-	$	610,000	$	610,000
Warrants		-		-		220,000		220,000
Derivative liabilities - Current		-		-		830,000		830,000

Placement agent warrants - Non-current		-		-		81,716		81,716
Derivative liabilities - Total	$	-	$	-	$	911,716	$	911,716

The following table is a reconciliation of the derivative liability for which Level 3 inputs were used in determining fair value during the years ended December 31, 2013 and 2012:

	For the Year Ended December 31, 2013
							Credited to
	Balance -		Fair Value of				Common Stock		Balance -
	January 1,		Derivative		Change in		Upon Issuance		December 31,
	2013		Liability		Fair Value		of Warrants		2013

8% Convertible promissory notes:
Conversion option	$	610,000	$	919,554	$	10,870,446	$	-	$	12,400,000
Warrants		220,000		334,059		4,235,941		-		4,790,000
Derivative liabilities - Current		830,000		1,253,613		15,106,387		-		17,190,000

Placement agent warrants - Non-current		81,716		-		214,478		-		296,194
Derivative liabilities - Total	$	911,716	$	1,253,613	$	15,320,865	$	-	$	17,486,194

	For the Year Ended December 31, 2012
							Credited to
	Balance -		Fair Value of				Common Stock		Balance -
	January 1,		Derivative		Change in		Upon Issuance		December 31,
	2012		Liability		Fair Value		of Warrants		2012

8% Convertible promissory notes:
Conversion option	$	-	$	1,025,691	$	(415,691)	$	-	$	610,000
Warrants		-		443,309		(223,309)		-		220,000
12% Convertible revolving credit agreement:
Conversion option		113,271		-		(113,271)		-		-
10% convertible preferred stock:
Warrants		1,875,463		-		-		(1,875,463)		-
10% convertible debentures:
Warrants		70,343		-		(13,309)		(57,034)		-
Derivative liabilities - Current		2,059,077		1,469,000		(765,580)		(1,932,497)		830,000

Placement agent warrants - Non-current		487,555		-		(405,839)		-		81,716
Derivative liabilities - Total	$	2,546,632	$	1,469,000	$	(1,171,419)	$	(1,932,497)	$	911,716