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Securities Purchase Agreement
9 Months Ended
Sep. 30, 2011
Securities Purchase Agreement [Abstract] 
Securities Purchase Agreement
5. Securities Purchase Agreement
On May 24, 2010, the Company entered into a Securities Purchase Agreement by and among the Company and the purchasers named therein (the “Purchasers”). The Purchasers included institutional investors as well as the Company’s Chief Executive Officer, Chief Financial Officer and an additional Company employee. The total investment by these Company employees represented less than 3% of the proceeds received by the Company in the May 2010 Financing. Pursuant to the Securities Purchase Agreement, on May 26, 2010 (the “Closing Date” or “Closing”), for total consideration of $6,003,000, the Purchasers purchased (i) an aggregate of 289,704 shares of the Company’s Common Stock, par value $0.0001 per share, at a contractually stated price of $3.00 per share, and (ii) 5,134 shares of the Company’s Series C-11 Preferred, par value $0.0001 per share, at a contractually stated price of $1,000 per share. The Purchasers also received (i) Series D-11 Warrants to purchase 5,134 shares of the Company’s Series D-11 Preferred, par value $0.0001 per share, at an exercise price of $1,000 per share, which warrants may be exercised on a cashless basis, and (ii) Series C-21 Warrants to purchase 10,268 units, at an exercise price of $1,000 per unit, which warrants are exercisable only in cash, with each unit consisting of one share of the Company’s Series C-21 Preferred, par value $0.0001 per share, and an additional Series D-21 Warrant to purchase one share of the Company’s Series D-21 Preferred, par value $0.0001 per share, at an exercise price of $1,000 per share.
In March 2011, the Company entered into the Consent Agreement which amended the terms of the Securities Purchase Agreement. Under the Consent Agreement, the holders agreed to the following, among other changes: (i) a temporary suspension of dividends on Series C-11 Preferred and Series C-21 Preferred (ii) to provide an additional cash payment of approximately $236,000 in exchange for the right to receive Series C-21 Preferred upon the achievement of certain pre-specified results in the preclinical study of one of the Compounds (the “Preclinical Milestone”), (iii) to increase the warrants that must be exercised for cash from 10,268 to 10,646 units, (iv) the mandatory exercise of $7,452,000 of such warrants upon the achievement of the Preclinical Milestone, (v) the mandatory exercise of the remaining $3,194,000 of warrants upon the achievement of a future clinical milestone and (vi) an automatic one time downward conversion price adjustment following the Reverse Stock Split.
In June 2011, the Company entered into the Amendment Agreement which amended the terms of the Securities Purchase Agreement and the Consent Agreement. Under the Amendment Agreement, the Holders agreed to the following, among other changes: (i) a temporary waiver of dividends on Series C1 Preferred (ii) to provide additional working capital by July 29, 2011, in an amount to be determined, if the Requisite Holders (as defined in the Amendment Agreement) determined by July 22, 2011 that, as of such date, the Company was continuing to pursue a Strategic Transaction (as defined in the Amendment Agreement) (iii) to purchase up to all of the outstanding Series C1 Preferred and certain warrants held by current and former Company employees, including the executive officers, who will have the right to require the Holder to purchase these securities for a limited period of time following the employee’s termination of service with the Company.
In August 2011, the Company entered into a Second Amendment Agreement which extended the terms of the Amendment Agreement through October 31, 2011. Under the Second Amendment Agreement, the Holders agreed to the following, among other changes: (i) to continue a temporary waiver of dividends on Series C1 Preferred (ii) to provide additional working capital, in an amount to be determined, if the Requisite Holders (as defined in the Second Amendment Agreement) determine by September 2, 2011, and then again by September 26, 2011, that, as of such date, the Company was continuing to pursue a Strategic Transaction (as defined in the Second Amendment Agreement) (iii) to purchase up to all of the outstanding Series C1 Preferred and certain warrants held by current and former Company employees, including the executive officers, who will have the right to require the Holder to purchase these securities for a limited period of time following the employee’s termination of service with the Company. As of November 9, 2011, the Company is continuing its efforts to pursue a Strategic Transaction and is in the process of negotiating a third amendment to extend the terms of the Amendment Agreement.
Allocation of Proceeds
At the Closing Date, the estimated fair value of the Series C-21 Warrants for units, Series D-11 Warrants, and the embedded derivatives included within the Series C-11 Preferred exceeded the proceeds from the May 2010 Financing of $6,003,000 (see the valuations of these derivative liabilities under the heading, “Derivative Liabilities” below). As a result, all of the proceeds were allocated to these derivative liabilities and no proceeds remained for allocation to the Common Stock and Series C-11 Preferred issued in the financing.
Common Stock
Pursuant to Rule 144 under the Securities Act of 1933 the Purchasers were restricted from selling the Common Stock until November 2010, which was six months after the Closing Date.
Redeemable Preferred Stock
As of September 30, 2011, the Company’s Board of Directors is authorized to issue 8,000,000 shares of preferred stock, with a par value of $0.0001 per share, in one or more series, of which 11,000 are designated for Series C-11 Preferred, 22,000 are designated Series C-21 Preferred, 5,134 are designated Series D-11 Preferred, 10,868 are designated Series D-21 Preferred, and 12,000 are designated Series E Preferred. As of September 30, 2011, 5,140 shares of Series C-11 Preferred Stock are issued and outstanding. There were no shares of any other series of preferred stock issued and outstanding as of September 30, 2011.
Voting Rights
The holders of New Preferred Stock do not have voting rights other than for general protective rights required by the Delaware General Corporation Law or as set forth below.
Dividends
Cumulative dividends are payable on the Series C1 Preferred at an annual rate of 15% from the date of issuance through the date of conversion or redemption, payable semi-annually each November 25th and May 25th in shares of Series C1 Preferred. There is no limit to the number of shares of Series C1 Preferred that may be issued as dividends. Neither the Series D-11 Preferred nor the Series D-21 Preferred (if and when issued) is entitled to dividends.
As discussed in Note 1, the Company funded its confirmatory preclinical study of the RIL compounds in part through the Forfeited Dividend and is funding its current operations in part through the Waived Dividend. From June 1 through August 31, 2011, there was an accrual of five shares Series C1 Preferred payable to current and former Company employees who are holders of Series C1 Preferred. These holders waived their dividends as part of the Second Amendment Agreement effective after August 31, 2011.
Conversion Rights
The New Preferred Stock was convertible into common stock, initially at a rate of 667 shares of common stock for each share of New Preferred Stock, subject to certain limitations discussed below, at the election of the holders of New Preferred Stock. The conversion rate will be adjusted for certain events, such as stock splits, stock dividends, reclassifications and recapitalizations, and the New Preferred Stock is subject to full-ratchet anti-dilution protection such that if the Company issues or grants any warrants, rights, options to subscribe or purchase common stock or common stock equivalents (the “Options”) and the price per share for which the common stock issuable upon the exercise of such Options is below the effective conversion price of the New Preferred Stock at the time of such issuance, then the conversion rate of the New Preferred Stock automatically adjusts to increase the number of common shares into which it can convert. There are also limits on the amount of New Preferred Stock that can be converted and the timing of such conversions. In accordance with the Consent Agreement, after the Reverse Stock Split, the conversion ratio for the New Preferred Stock was adjusted based on the trading price of the Company’s common stock over a period of time after the Reverse Stock Split was implemented. Accordingly, effective May 7, 2011, each share of New Preferred Stock is now convertible into approximately 166,667 shares of common stock.
Effective with the Consent Agreement, in any week, each holder of New Preferred Stock may convert its amount of the outstanding New Preferred Stock held by the stockholder multiplied by the Conversion Cap (as defined in the Certificate of Designations for the Series C-11, C-21, D-11 and D-21 Preferred (the “Series C1/D1 Certificate”) for such week. Depending on the Closing Sales Prices (as defined in the Series C1/D1 Certificate), the Conversion Cap can range from 0% to 7.2%. Moreover, holders of New Preferred Stock may not convert if such conversion would result in the holder or any of its affiliates beneficially owning more than 9.999% of the Company’s then issued and outstanding shares of common stock. As of September 30, 2011, 433 shares of Series C-11 Preferred had been converted into common stock.
Upon certain redemption events, as set forth in the Securities Purchase Agreement, and as subsequently amended in the Consent Agreement, the conversion price of the New Preferred Stock decreases to 10% of the conversion price in effect immediately before such redemption event thereby increasing the number of common shares that would be issued for each share of New Preferred Stock by a factor of ten times.
Liquidation Preference
Upon a Liquidation Event (as defined in the Series C1/D1 Certificate), no other class or series of capital stock can receive any payment unless the Preferred Stock has first received a payment in an amount equal to $1,000 per share, plus all accrued and unpaid dividends, if applicable.
Redemption Rights
In the event that certain actions occur without the waiver or prior written consent of the holders of two-thirds of the then outstanding shares of New Preferred Stock (the “Requisite Holders”), such as the Company’s material breach of any material representation or warranty under the Securities Purchase Agreement, a suspension of the trading of the Company’s common stock, the failure to timely deliver shares on conversion of the New Preferred Stock, bankruptcy reorganization or the consummation of a Change of Control (as defined in the Series C1/D1 Certificate) among others, then the holders of the Series C1 Preferred shall have the right, upon the delivery of a notice to the Company by the Requisite Holders, to have such shares redeemed by the Company for an amount equal to the greater of $1,000 per share, plus accrued and unpaid dividends, or the fair market value of the underlying common stock issuable upon conversion of the Series C1 Preferred, which could include a greater number of shares pursuant to the conversion reset described above under the caption “Conversion Rights”. As of September 30, 2011 and through the date of this filing, none of these redemption actions have occurred to the Company’s knowledge.
Since the Company failed to consummate a Strategic Transaction (as defined in the Series C1/D1 Certificate) by February 26, 2011 (nine months from the May 26, 2010 Closing), the Series C1 Preferred may be redeemed upon the demand of the Requisite Holders. The redemption price would be equal to $1,000 per share, plus accrued and unpaid dividends. As of September 30, 2011, the redemption value was $5,140,000. This redemption feature terminates upon the consummation of a Strategic Transaction, which must be first approved by the Requisite Holders. The Requisite Holders may also waive this redemption feature. If the Requisite Holders fail to demand redemption of the Series C1 Preferred within two years from the date of a Redemption Event (as defined in the Series C1/D1 Certificate), then the redemption rights with respect to such Redemption Event shall be irrevocably waived by the preferred stockholders. The Requisite Holders have not elected to redeem through the date of the filing of this Report, nor have they waived this right.
Restrictions
So long as at least 1,000 shares of New Preferred Stock remain outstanding (or at least 3,000 shares of New Preferred Stock remain outstanding if the Series C-21 Warrants have been exercised), the Company may not take a variety of actions (such as altering the rights, powers, preferences or privileges of the New Preferred Stock so as to affect the New Preferred Stock adversely, amending any provision of the Company’s certificate of incorporation, entering into an agreement for a Strategic Transaction or Change of Control, consummating any financing or filing a registration statement with the Securities and Exchange Commission, or “SEC”) without the prior approval of the Requisite Holders. From May 2010 through April 2011, the Company had also agreed to certain limitations on its spending per month based on predetermined budgeted amounts.
Accounting Treatment
At the Closing Date, the Company issued 5,134 shares of Series C-11 Preferred and recorded the par value of $0.0001 per share with a corresponding reduction to paid-in capital, given that there was no allocated value from the proceeds to the Series C-11 Preferred.
In a separate transaction, in exchange for a first right of negotiation for a product candidate, the Company issued approximately 50 shares of Series C-11 Preferred convertible into approximately 8,333,000 shares of the Company’s common stock to a Purchaser on May 26, 2010. Using the present value of the face amount of the Series C-11 Preferred at Closing, these shares were valued at $12,000 and were fully charged to general and administrative expense during the three months ended June 30, 2010.
Under accounting guidance covering accounting for redeemable equity instruments, preferred securities that are redeemable for cash or other assets are to be classified outside of permanent equity (within the mezzanine section between liabilities and equity on the condensed consolidated balance sheets) if they are redeemable at the option of the holder or upon the occurrence of an event that is not solely within the control of the issuer. As there are redemption-triggering events related to the Series C1 Preferred that are not solely within the control of the Company, the Series C-11 Preferred was classified outside of permanent equity.
As of September 30, 2011, the outstanding Series C-11 Preferred is convertible into approximately 856,676,000 shares of common stock. The Company may be required to redeem the Series C-11 Preferred if a redemption event occurs, such as the failure to consummate a Strategic Transaction. Since the Company did not consummate a Strategic Transaction by February 26, 2011, the Series C-11 Preferred is currently redeemable and therefore the Company has adjusted the carrying value of the Series C-11 Preferred to the redemption value of such shares which, as of September 30, 2011, was $5,140,000.
As of December 31, 2010, accrued dividends on the Series C-11 Preferred were $6,000, which consisted of 79 shares of Series C-11 Preferred, or approximately 0.014 dividend shares per Series C-11 Preferred share outstanding, convertible into approximately 13,167,000 shares of common stock. Due to the forfeiture of dividends on the Company’s outstanding Series C1 Preferred for the period from November 26, 2010 to May 31, 2011 as discussed in Note 1, the accrued dividends of $6,000 as of December 31, 2010 were reversed.
As of September 30, 2011 accrued dividends on the Series C-11 Preferred were $501, which consisted of 5 shares of Series C-11 Preferred, payable to the current and former Company employees for the period June 1, 2011 to August 31, 2011. The accrued dividends are convertible into approximately 902,000 shares of common stock. Due to the waiver of dividends as discussed in Note 1, the dividends for current and former Company employees were waived from August 31, 2011 to October 31, 2011 and the dividends for the key investors were waived from June 1, 2011 to October 31, 2011.
Derivative Liabilities
The Series C-11 Preferred and the underlying securities of the Series C-21 Warrants for units and Series D-11 Warrants (Series C1 Preferred and Series D1 Preferred) contain conversion features. In addition, the Series C-11 Preferred and the underlying securities of the Series C-21 Warrants for units (Series C1 Preferred) are subject to redemption provisions that are outside of the control of the Company.
The Series C-21 Warrants and Series D-11 Warrants are exercisable starting on the issuance date and expire in three years from the date of issuance. The Series C-21 Warrants must be exercised in cash and beginning in June 2011, they are no longer subject to mandatory exercise terms. The Series D-11 Warrants may be exercised on a cashless basis and are not subject to mandatory exercise terms.
Accounting Treatment
The Company accounted for the conversion and redemption features embedded in the Series C-11 Preferred (the “Embedded Derivatives”) in accordance with accounting guidance covering derivatives. Under this accounting guidance, companies may be required to bifurcate conversion and redemption features embedded in redeemable convertible preferred stock from their host instruments and account for these embedded derivatives as free standing derivative financial instruments. If the underlying security of the embedded derivative requires net cash settlement in the event of circumstances that are not solely within the Company’s control, the embedded derivative should be classified as a liability, measured at fair value at issuance and adjusted to their current fair value at each period. As there are redemption triggering events for net cash settlement for Series C1 Preferred that are not solely within the Company’s control, and the conversion feature is a derivative, the Embedded Derivatives are classified as liabilities and are accounted for using fair value accounting at each reporting date (also see Note 3).
The Company accounted for the Series C-21 Warrants for units and Series D-11 Warrants in accordance with accounting guidance covering derivatives. If the underlying security of the warrant, a.) requires net cash settlement in the event of circumstances that are not solely within the Company’s control or if not, if they are b.) not indexed to the Company’s own stock, the warrants should be classified as liabilities, measured at fair value at issuance and adjusted to their current fair value at each period. As there are redemption triggering events for Series C1 Preferred that are not solely within the Company’s control, and the Series D1 Preferred are not indexed to the Company’s own stock, the Series C-21 Warrants for units and Series D-11 Warrants are classified as liabilities and are accounted for using fair value accounting at each reporting date. The Embedded Derivatives, Series C-21 Warrants for units and Series D-11 Warrants are collectively referred to as the “Derivative Liabilities”.
The estimated fair values of the Derivative Liabilities as of December 31, 2010 and September 30, 2011 are summarized as follows (in thousands):
                 
    Fair Value Measurements at  
    December 31,     September 30,  
    2010     2011  
Embedded Derivatives of Series C-11 Preferred (including dividends paid in Series C-11 Preferred in November 2010)
  $ 5,098     $ 3,163  
Embedded Derivatives of accrued dividends payable in Series C-11 Preferred
    72       3  
Series D-11 Warrants
    702       167  
Series C-21 Warrants for:
               
Series C-21 Preferred
    (1,175 )     (1,307 )
Series D-21 Warrants
    1,405       346  
 
           
 
  $ 6,102     $ 2,372  
 
           
The Derivative Liabilities were valued using binomial option pricing models with various assumptions detailed below. Due to the six month trading restriction on the unregistered shares of common stock issued or issuable from the conversion of Preferred Stock and the weekly conversion limitation on Preferred Stock as well as the uncertainty of the Company’s ability to continue as a going concern, the price per share of the Company’s common stock used in the binomial option pricing models for the Derivative Liabilities was discounted from the closing market prices of $2.60 and $0.003 on December 31, 2010 and September 30, 2011, respectively. The expected lives that were used to value each of the Derivative Liabilities were based on the individual characteristics of the underlying Preferred Stock, which impact the expected timing of conversion into common stock. In addition, the probabilities associated with the consummation of a Strategic Transaction and the clinical development of a drug candidate based on industry data were used in each of the binomial option pricing models. The models used to value the Series C-21 Warrants and Series D-11 Warrants are particularly sensitive to such probabilities, as well as to the closing price per share of the Company’s common stock. In addition, as noted above, the model included the effect of the automatic one-time downward conversion price adjustment following the Reverse Stock Split. To better estimate the fair value of the Derivative Liabilities at each reporting period, the binomial option pricing models and their inputs were refined based on information available to the Company. Such changes did not have a significant impact on amounts recorded in previous interim reporting periods.
At December 31, 2010, the total value of the Embedded Derivatives, including the estimated fair value of Embedded Derivatives related to the accrued dividends payable in Series C-11 Preferred of $72,000 was $5,170,000. At September 30, 2011, the total value of the Embedded Derivatives was $3,166,000, resulting in non-cash other income on the decrease in the estimated fair value of the Embedded Derivatives for the nine months ended September 30, 2011 of $1,620,000 (exclusive of the decrease in the liability of $315,000 due to the conversion of 433 shares of Series C-11 Preferred into common stock and the reversal of $72,000 for the December 31, 2010 accrued dividends that were forfeited and the accrued dividends of $3,000 as of September 30, 2011 for current and former Company employee holders of Series C-11 Preferred). Such decrease in value was primarily due to the significant decrease in the Company’s common stock price, and the updates to the assumptions used in the option pricing models.
The Embedded Derivatives were valued at December 31, 2010 and at September 30, 2011 using a binomial option pricing model, based on the value of the Series C-11 Preferred shares with and without embedded derivative features, with the following assumptions:
                 
    December 31,     September 30,  
    2010     2011  
Closing price per share of common stock
  $ 2.60     $ 0.003  
Conversion price per share
  $ 1.50     $ 0.006  
Volatility
    84.6 %     80.7 %
Risk-free interest rate
    2.19 %     0.96 %
Credit spread
    14.2 %     20.1 %
Remaining expected lives of underlying securities (years)
    6.3       5.0  
On December 31, 2010, the Series D-11 Warrants were recorded at estimated fair value of $702,000. On September 30, 2011, the Series D-11 Warrants were revalued at $167,000 resulting in non-cash other income on the decrease in the estimated fair value of the Series D-11 Warrants for the nine months ended September 30, 2011 of $535,000. Such decrease in value was primarily due to the significant decrease in the Company’s common stock price and the updates to the assumptions used in the option pricing models.
The Series D-11 Warrants were valued at December 31, 2010 and at September 30, 2011 using a binomial option pricing model with the following assumptions:
                 
    December 31,     September 30,  
    2010     2011  
Closing price per share of common stock
  $ 2.60     $ 0.003  
Conversion price per share
  $ 1.50     $ 0.006  
Volatility
    98.9 %     83.6 %
Risk-free interest rate
    1.02 %     0.38 %
Remaining expected lives of underlying securities (years)
    2.8       2.8  
On December 31, 2010, the Series C-21 Warrants (which consist of rights to purchase Series C-21 Preferred and Series D-21 Warrants) were recorded at an estimated fair value of $230,000. On September 30, 2011, the Series C-21 Warrants were revalued at a negative $961,000, resulting in non-cash other income on the decrease in the estimated fair value of the Series C-21 Warrants for the nine months ended September 30, 2011 of $1,191,000. Such decrease in value was primarily due to the significant decrease in the Company’s common stock price and the updates to the assumptions used in the option pricing models, offset by the increase in the Series C-21 Warrants by 378 units. The fair value of the rights to purchase Series C-21 Preferred was negative as of December 31, 2010 as the Series C-21 Warrants were mandatorily exercisable at a price that was greater than the fair value of the underlying instruments. The fair value of the rights to purchase Series C-21 Preferred was negative as of September 30, 2011 as it is assumed that upon a Strategic Transaction, Series C-21 Warrants will be exercised at a price that is greater than the fair value of the underlying instruments.
The portion of the Series C-21 Warrants that represent the rights to purchase Series C-21 Preferred were valued at December 31, 2010 and September 30, 2011 using a binomial option pricing model, discounted for the lack of dividends until the Series C-21 Warrants are exercised, with the following assumptions:
                 
    December 31,     September 30,  
    2010     2011  
Closing price per share of common stock
  $ 2.60     $ 0.003  
Conversion price per share
  $ 1.50     $ 0.006  
Volatility
    84.6 %     80.7 %
Risk-free interest rate
    2.19 %     0.96 %
Credit spread
    14.2 %     20.1 %
Remaining expected lives of underlying securities (years)
    6.3       5.0  
The Series D-21 Warrants were valued at December 31, 2010 and at September 30, 2011 using a binomial option pricing model with the same assumptions used in the valuation of the Series D-11 Warrants. The decrease in the value of the Series D-21 Warrants was primarily due to the significant decrease in the Company’s common stock price and the updates to the assumptions used in the option pricing models, offset by the increase in the Series D-21 Warrants by 378 units.