Note 5: Derivative Liabilities and Fair Value Measurements

Accounting Standards Codification (“ASC”) 815 - Derivatives and Hedging provides guidance to determine what types of instruments, or embedded features in an instrument, are considered derivatives. This guidance can affect the accounting for convertible instruments that contain provisions to protect holders from a decline in the stock price, referred to as anti-dilution or down-round protection. Down-round provisions reduce the exercise price of a convertible instrument if a company either issues equity shares for a price that is lower than the exercise price of those instruments, or issues new convertible instruments that have a lower exercise price. The Company has determined that the warrant liability and related down-round provision related to the Secured Notes should be treated as derivatives. The Company is required to report derivatives at fair value and record the fluctuations in fair value in current operations.

The Company recognizes the derivative liabilities at their respective fair values at inception and on each reporting date. The Company values its financial assets and liabilities on a recurring basis and certain nonfinancial assets and nonfinancial liabilities on a nonrecurring basis based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, a fair value hierarchy that prioritizes observable and unobservable inputs is used to measure fair value into three broad levels, which are described below:

Level 1:	Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.

Level 2:	Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in inactive markets; or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data.

Level 3:	Unobservable inputs are used when little or no market data is available. The fair value hierarchy gives the lowest priority to Level 3 inputs.

In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as considers counterparty credit risk in its assessment of fair value.

The Company recognizes derivative liabilities at their respective fair values at inception and on each reporting date. The Company utilized the BOPM to develop its assumptions for determining the fair value of the Warrants and related anti-dilution features.

Key assumptions at March 31, 2015 for the warrants discussed in Note 4 include a volatility factor of 91.0%, a dividend yield of 0%, expected life of 3.25 years and a risk free interest rate of 0.92%.

The Company estimated the fair value of the warrants, including call options, to be $0.8974 per share and the down-round protection derivative for the same warrants was estimated at $0.5439. The number of liability classified Warrants outstanding as of March 31, 2015 and December 31,2014 were 575,164 and 647,312, respectively. As shown in the table below, carrying value of the Warrants with call options at March 31, 2015 was $516,152 and the carrying value of the down-round protection derivative for the same date was $312,832.

During the quarter ended March 31, 2015, a total of 72,150 warrants were exercised, reducing the fair value of warrants and derivative liabilities and increasing Additional Paid in Capital by $230,332.

The table below provides a reconciliation of beginning and ending balances for the liabilities measured at fair value using significant unobservable inputs (Level 3):

				Warrant
	Warrants			Derivative			Total
Balance: December 31, 2014	$	(1,809,949	)	$	(256,530	)	$	(2,066,479	)
Release of Warrant Liability Upon Exercise		201,739			28,593			230,332
Net Change in Fair Value		1,092,058			(84,895	)		1,007,163
Balance: March 31, 2015	$	(516,152	)	$	(312,832	)	$	(828,984	)

The derivative liabilities are considered Level 3 liabilities on the fair value hierarchy as the determination of fair values includes various assumptions about future activities and stock price and historical volatility inputs.

The following table describes the valuation techniques used to calculate fair values for assets in Level 3. There were no changes in the valuation techniques during the quarter ended March 31, 2015 and December 31, 2014.

Fair Value at

Valuation

Unobservable

3/31/2015

12/31/2014

Technique

Input

Range

Warrant Derivative and

Warrant Down-round

Protection Derivative

(combined)

828,984

2,066,479

Binomial

Option Pricing

Model

Probability of

common stock

issuance at

prices less than exercise prices stated in agreements

Probability of

reset provision

being waived

Significant unobservable inputs for the derivative liabilities include (1) the estimated probability of the occurrence of a down-round financing during the term over which the related warrants are exercisable, (2) the estimated magnitude of the down-round and (3) the probability of the reset provision being waived. These estimates which are unobservable in the market were utilized to value the anti-dilution features of the warrants as of March 31, 2015 and December 31, 2014.