Securities Purchase Agreement

3 Months Ended

Mar. 31, 2012

Securities Purchase Agreement [Abstract]

Securities Purchase Agreement

6. 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 then Chief Executive Officer and Chief Financial Officer as well as an additional Company employee at that time. 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-1 Preferred, par value $0.0001 per share, at a contractually stated price of $1,000 per share. The Purchasers also received (i) Series D-1 Warrants to purchase 5,134 shares of the Company’s Series D-1 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-2 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-2 Preferred, par value $0.0001 per share, and an additional Series D-2 Warrant to purchase one share of the Company’s Series D-2 Preferred, par value $0.0001 per share, at an exercise price of $1,000 per share.

At the Closing Date, the estimated fair value of the Series C-2 Warrants for units, Series D-1 Warrants, and the embedded derivatives included within the Series C-1 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-1 Preferred issued in the financing.

As discussed in Note 1, in March 2011, the Company entered into the Consent Agreement that 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-1 ¹ Preferred and Series C-2 ¹ 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 2011 Reverse Stock Split.

The Company filed its Series C/D Certificate and Series E Certificate (collectively, the “Certificates”) with the State of Delaware on March 30, 2011. Each Certificate provided the holders with the following rights (the Series C/D Certificate was superseded by the Series C-1² /D-1² Certificate that was filed on January 20, 2012):

• The holders of New Preferred Stock and Series E Preferred Stock (collectively, the “C/D/E Preferred Stock”) did not have voting rights unless required by the Delaware General Corporation Law or as set forth below.

• Cumulative dividends were payable on the Series C-1 ¹ Stock and Series C-2 ¹ Stock (together referred to herein as the “Series C ¹ Preferred”) at a rate of 15% per annum and on the Series E Preferred Stock at a rate of 5% per annum, each accruing from the date of issuance through the date of conversion or redemption, payable semi-annually in shares of Series C-1 ¹ Stock, Series C-2 ¹ Stock and Series E Preferred Stock, respectively, but subject to the temporary suspension of dividends with respect to the Series C¹ Preferred, as described above. Neither the Series D-1¹ Stock nor the Series D-2 ¹ Stock was entitled to dividends.

• The C/D/E Preferred Stock was convertible into common stock, initially at a rate of 66,667 shares of common stock for each share of C/D/E Preferred Stock, subject to certain limitations discussed below, at the election of the holders of C/D/E Preferred Stock. The conversion rate was adjusted for certain events, such as stock splits, stock dividends, reclassifications and recapitalizations, and the New Preferred Stock was subject to full-ratchet anti-dilution protection such that any subsequent issuance of common stock below the effective conversion price of the C/D/E Preferred Stock at the time of such issuance automatically adjusts the conversion price of the C/D/E Preferred Stock to such lower price. There were also limits on the amount of C/D/E Preferred Stock that could be converted and the timing of such conversions. The New Preferred Stock could be converted starting the first Monday following the Closing of the asset purchase. The Series E Preferred Stock could not be converted until the first Monday following the achievement of the Preclinical Milestone under the Agreement.

• Upon a Liquidation Event (as defined in each Certificate), no other class or series of capital stock could receive any payment unless the New Preferred Stock has first received a payment in an amount equal to $1,000 per share, plus all accrued and unpaid dividends, if applicable. Once the New Preferred Stock received its liquidation payment, the Series E Preferred Stock was entitled to receive a payment in an amount equal to $1,000 per share, plus all accrued and unpaid dividends, if applicable.

• In the event that certain actions occurred without the 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 Agreement, a suspension of the trading of the Company’s common stock, the failure to timely deliver shares on conversion of the C/D/E Preferred Stock, or the consummation of a Change of Control (as defined in the Certificate of Designations), then the holders of the Series C ¹ Preferred had 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 C ¹ Preferred. The Series E Preferred Stock did not have similar redemption rights.

• Upon certain redemption events, such as the Company’s breach of covenants or material representations or warranties under the Purchase Agreement, the conversion price of the C/D/E Preferred Stock would decrease to 10% of the conversion price in effect immediately before such redemption event.

• So long as at least 1,000 shares of New Preferred Stock remained outstanding (or at least 3,000 shares of New Preferred Stock remained outstanding if the Cash Warrants had been fully 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 effect 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 (as each is defined in the Series C/D Certificate) and may not consummate any financing or file a registration statement with the Securities and Exchange Commission without the prior approval of the Requisite Holders. The Series E Preferred Stock did not have similar protective provisions.

In June 2011, the Company entered into the Amendment Agreement that 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 C-1 ¹ 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 C-1¹ Preferred and certain warrants held by then current and former Company employees, including the executive officers at that time, who would 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 that 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 C-1¹ 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 C-1 ¹ Preferred and certain warrants held by then current and former Company employees, including the executive officers at that time, 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.

Accounting Treatment

On May 26, 2010, the Company issued 5,134 shares of Series C-1² 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-1 ² Preferred.

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 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 C-1² Preferred that are not solely within the control of the Company, the Series C-1² Preferred was classified outside of permanent equity.

The Company may be required to redeem the Series C-1 ² Preferred if a redemption event occurs. Since the Company did not consummate a Strategic Transaction by February 26, 2011, the Series C-1² Preferred was currently redeemable and therefore the Company adjusted the carrying value of the Series C-1 ² Preferred to the redemption value of such shares. The carrying value at March 31, 2012, of $5,336,000, represents the redemption value of the Series C-1² Preferred plus accrued and unpaid dividends.

Derivative Liabilities

The Series C-1² Preferred and the underlying securities of the Series C-2² Warrants for units and Series D-1² Warrants contain conversion features. In addition, the Series C-1² Preferred and the underlying securities of the Series C-2² Warrants for units are subject to redemption provisions that are outside of the control of the Company.

The Series C-2 ² Warrants and Series D-1 ² Warrants are exercisable starting on the issuance date and expire three years from the date of issuance. The Series C-2² Warrants must be exercised in cash and beginning in June 2011, they are no longer subject to mandatory exercise terms. The Series D-1 ² Warrants may be exercised on a cashless basis and are not subject to mandatory exercise terms.

Accounting Treatment

The Company accounts for the conversion and redemption features embedded in the Series C-1 ² 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 C-1 ² 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 (see Note 3).

The Company accounts for the Series C-2² Warrants for units and Series D-1² 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 C-2 ² Preferred that are not solely within the Company’s control, and the Series D-1² Preferred are not indexed to the Company’s own stock, the Series C-2² Warrants for units and Series D-1² Warrants are classified as liabilities and are accounted for using fair value accounting at each reporting date. The Embedded Derivatives, Series C-2² Warrants for units and Series D-1 ² Warrants are collectively referred to as the “Derivative Liabilities”.

The estimated fair values of the Derivative Liabilities as of March 31, 2012 and December 31, 2011 are summarized as follows (in thousands):

	Fair Value Measurements at
	March 31, 2012		December 31, 2011
Embedded Derivatives of Series C-1 2 Preferred (including dividends paid in Series C-1 2 Preferred)	$	2,832	$	3,628
Embedded Derivatives of accrued dividends payable in Series C-1 2 Preferred		410		52
Series D-1 2 Warrants		411		2,539
Series C-2 2 Warrants for:
Series C-2 2 Preferred		1,837		3,785
Series D-2 2 Warrants		3,927		5,266
	$	9,417	$	15,270

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 $0.05 and $0.27 on March 31, 2012 and December 31, 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 successful 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-2² Warrants and Series D-1 ² Warrants are particularly sensitive to such probabilities, as well as to the closing price per share of the Company’s common stock. 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, 2011, the total value of the Embedded Derivatives was $3,680,000. At March 31, 2012, the total value of the Embedded Derivatives was $3,242,000, resulting in non-cash other income on the decrease in the estimated fair value of the Embedded Derivatives for the three months ended March 31, 2012 of $539,000 (exclusive of the increase in the liability of $101,000 due to the accrual of dividends). 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 March 31, 2012 and December 31, 2011 using a binomial option pricing model, based on the value of the Series C-1 ² Preferred shares with and without embedded derivative features, with the following assumptions:

	March 31, 2012			December 31, 2011
Closing price per share of common stock	$	0.05		$	0.27
Conversion price per share	$	0.005		$	0.60
Volatility		88.3	%		88.0	%
Risk-free interest rate		1.04	%		0.83	%
Credit spread		19.4	%		20.9	%
Remaining expected lives of underlying securities (years)		4.8			5.0

On December 31, 2011, the Series D-1² Warrants were recorded at estimated fair value of $2,539,000. On March 31, 2012, the Series D-1² Warrants were revalued at $411,000 resulting in non-cash other income on the decrease in the estimated fair value of the Series D-1 ² Warrants of $2,128,000. Such decrease in value was primarily due to the exercise of 4,021 Series D-1 ² Warrants and updates to the assumptions used in the option pricing models.

The Series D-1 ² Warrants were valued at March 31, 2012 and December 31, 2011 using a binomial option pricing model with the following assumptions:

	March 31, 2012			December 31, 2011
Closing price per share of common stock	$	0.05		$	0.27
Conversion price per share	$	0.005		$	0.60
Volatility		69.9	%		67.5	%
Risk-free interest rate		0.33	%		0.28	%
Remaining expected lives of underlying securities (years)		1.9			2.2
Probability of Strategic Transaction		N/A			70	%

On December 31, 2011, the Series C-2² Warrants (which consist of rights to purchase Series C-2² Preferred and Series D-2² Warrants) were recorded at an estimated fair value of $9,051,000. On March 31, 2012, the Series C-2² Warrants were revalued at $5,764,000, resulting in non-cash other income on the decrease in the estimated fair value of the Series C-2 ² Warrants of $3,287,000. Such decrease in value was primarily due to the removal of the mandatory redemption requirement upon successful completion of the Strategic Transaction, the extension of the term to cover the longer clinical trial period, and the updates to the assumptions used in the option pricing models.

The portion of the Series C-2 ² Warrants that represent the rights to purchase Series C-2 ² Preferred were valued at March 31, 2012 and December 31, 2011 using a binomial option pricing model. The pricing model determines the value of the Series C-2² Preferred at the warrant exercise date which is assumed to be at the end of the successful Phase 2 clinical trial and subtracts the value of the Series C-2 ² Preferred with the exercise price. The assumptions are:

	March 31, 2012			December 31, 2011
Closing price per share of common stock	$	0.05		$	0.27
Conversion price per share	$	0.005		$	0.60
Volatility		88.3	%		88.0	%
Risk-free interest rate		1.04	%		0.83	%
Credit spread		19.4	%		20.9	%
Remaining expected lives of underlying securities (years)		4.8			5.0
Time to exercise (months)		24			24

The Series D-2² Warrants were valued at March 31, 2012 and December 31, 2011 using a binomial option pricing model with the same assumptions used in the valuation of the Series D-1 ² Warrants. The decrease in the value of the Series D-2 ² Warrants was primarily due the updates to the assumptions used in the option pricing models.