Note 5 - Derivative Liabilities

8% Convertible Promissory Notes (2012) – Conversion Option and Warrants

Prior to, and through April 8, 2014, we issued 8% convertible promissory notes (the “8% Notes (2012)”). See Note 8 for further discussion. The 8% Notes (2012) 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 (2012), into shares of our common stock. The 8% Notes (2012) 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 earnings and classified as a change in fair value in the statement of operations.

During the three months ended June 30, 2014, we offered all warrant holders the right to exchange their warrants for their fair value, as calculated using the Black-Scholes option pricing model, for shares of common stock. All warrants associated with the 8% Notes (2012) were exchanged for shares of common stock resulting in no derivative liability for the warrants at and after June 30, 2014.

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 aggregate fair value of all the conversion options on March 31, 2015 was $381,000. The $1.6 million decrease in the fair value of this derivative liability during the three months ended March 31, 2015 was recorded as a change in derivative liability in the statement of operations.

12% Convertible Promissory Notes – Conversion Option

During the three months ended September 30, 2014, we issued 12% convertible promissory notes (the “12% Notes”). See Note 8 for further discussion. The 12% 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 12% Notes, into shares of our common stock. The conversion option is a derivative liability. 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. Accordingly, changes in the fair value of the conversion option liabilities are immediately recognized in earnings and classified as a change in fair value in the statement of operations.

We determined the fair value of the conversion option derivative liability on the date of issuance and recorded the fair value as a discount to the debt and a derivative liability. The fair value of the conversion option on March 31, 2015 was $158,000. The $89,000 increase in the fair value of this derivative liability during the three months ended March 31, 2015 was recorded as a change in derivative liability in the statement of operations.

The estimated fair values of the derivative liabilities associated with the 8% Notes (2012) and the 12% Notes, for the conversion options and warrants issued through and as of March 31, 2015 were computed by a third party using Monte Carlo simulations based on the following ranges for each assumption:

	At Issuances			March 31, 2015

Volatility		40.0% to 45.0	%		35.0	%
Risk-free interest rate		0.11% to 0.3	%		0.03% to 0.10	%
Dividend yield		0.0	%		0.0	%
Expected life		1.1 to 1.6 years			0.3 to 0.4 years

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 March 31, 2015 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 85%, (iii) a risk-free interest rate 0.5%, and (iv) an expected life of approximately 1 year. The fair value of the warrant liability at March 31, 2015 and December 31, 2014 was $52,720.

Accounting for Fair Value Measurements

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 March 31, 2015 and December 31, 2014 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 March 31, 2015 and December 31, 2014, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

	As of March 31, 2015
							Derivative
							Liabilities at
	Level 1		Level 2		Level 3		Fair Value
8% Convertible promissory notes:
Conversion option	$	-	$	-	$	381,000	$	381,000
12% Convertible promissory notes:
Conversion option		-		-		158,000		158,000
Derivative liabilities - Current		-		-		539,000		539,000
Placement agent warrants - Non-current		-		-		52,720		52,720
Derivative liabilities - Total	$	-	$	-	$	591,720	$	591,720

	As of December 31, 2014
							Derivative
							Liabilities at
	Level 1		Level 2		Level 3		Fair Value
8% Convertible promissory notes:
Conversion option	$	-	$	-	$	1,984,000	$	1,984,000
12% Convertible promissory notes:
Conversion option		-		-		69,000		69,000
Derivative liabilities - Current		-		-		2,053,000		2,053,000
Placement agent warrants - Non-current		-		-		52,720		52,720
Derivative liabilities - Total	$	-	$	-	$	2,105,720	$	2,105,720