4. Fair Value of Financial Assets and Liabilities – Derivative Instruments

ASC Topic 820, Fair Value Measurement (ASC 820), establishes a fair value hierarchy for instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability, and are developed based on the best information available in the circumstances.

ASC 820 identifies fair value as the exchange price, or exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As a basis for considering market participant assumptions in fair value measurements, ASC 820 establishes a three-tier fair value hierarchy that distinguishes among the following:


		Level 1—Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.
		Level 2—Valuations based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and models for which all significant inputs are observable, either directly or indirectly.
		Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

The Company estimates fair values of derivative instruments utilizing Level 3 inputs, which is based on the lowest level of any input that is significant to the fair value measurement. The Company uses the Monte Carlo and Black Scholes valuation technique for derivatives which embodies all of the requisite assumptions (including trading volatility, remaining term to maturity, market price, strike price, risk free rates) necessary to determine fair value of these instruments.

The Company’s derivative liabilities are marked-to-market with the changes in fair value recorded as a component of change in fair value of derivative liabilities in the Company’s consolidated statements of operations. Estimating fair values of derivative financial instruments, including Level 3 instruments, requires the use of significant and subjective inputs that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, option-based techniques are volatile and sensitive to changes in our trading market price, the trading market price of various peer companies and other key assumptions. Since derivative financial instruments are initially and subsequently carried at fair value, our income will reflect this sensitivity of internal and external factors.

Items measured at fair value on a recurring basis include common stock warrants, and embedded derivatives related to the Company’s redeemable convertible preferred stock, and a dilutive financing derivative liability established on April 8, 2016. During the periods presented, the Company has not changed the manner in which it values liabilities that are measured at fair value using Level 3 inputs. The following fair value hierarchy table presents information about each major category of the Company's financial liabilities measured at fair value on a recurring basis:



	Quoted Prices in
	Active Markets		Significant Other		Significant
	for Identical		Observable Inputs		Unobservable
	Items (Level 1)		(Level 2)		Inputs (Level 3)		Total
December 31, 2016
Liabilities
June 2016 offering warrant liability	$	-	$	-	$	274,000	$	274,000
Dilutive financing derivative liability		-		-		126,000		126,000
November 2016 offering warrant liability		-		-		2,043,000		2,043,000
Total liabilities	$	-	$	-	$	2,443,000	$	2,443,000

December 31, 2015
Liabilities
Series B preferred stock derivative liability	$	-	$	-	$	1,493,000	$	1,493,000
2011 Warrant liability		-		-		6,000		6,000
Total liabilities	$	-	$	-	$	1,499,000	$	1,499,000

There were no transfers between Level 1, Level 2 or Level 3 of the fair value hierarchy for the years ended December 31, 2016 and 2015.

The following table sets forth a summary of changes in the fair value of the Company's Series B redeemable convertible preferred stock derivative, warrant liabilities and dilutive financing liability, which represents a recurring measurement that is classified within Level 3 of the fair value hierarchy, wherein fair value is estimated using significant unobservable inputs.


					Series B Preferred		Dilutive Financing
	2011 Warrant		June 2016 Offering		Stock Derivative		Derivative		November 2016 Offering
	Liability		Warrant Liability		Liability		Liability		Warrant Liability
Balance, December 31, 2015	$	6,000	$	-	$	1,493,000	$	-	$	-
Creation of derivative or warrant liability		-		1,816,000		-		2,282,000		2,929,000
Changes in estimated fair value		(6,000)		(1,542,000)		(1,493,000)		(611,000)		(886,000)
Payout from liability		-		-		-		(1,545,000)		-
Balance, December 31, 2016	$	-	$	274,000	$	-	$	126,000	$	2,043,000

The fair value of the November 2016 offering warrant liability on the date of issuance and on December 31, 2016 was estimated using the Monte Carlo valuation model. This method of valuation involves using inputs such as the fair value of the Company’s common stock, stock price volatility, contractual term of the warrants, risk–free interest rates and dividend yields. Due to the nature of these inputs, the valuation of the warrant is considered a Level 3 measurement. The following assumptions were used on November 22, 2016 (issuance date) and December 31, 2016:


	December 31, 2016			November 22, 2016
Volatility		112	%		116	%
Expected term (years)		4.89			5.00
Risk-free interest rate		1.91	%		1.77	%
Dividend yield		0.00	%		0.00	%
Exercise price		$0.75			$0.75
Common stock closing price		$0.44			$0.62

The fair value of the June 2016 offering warrant liability on the date of issuance and on each re-measurement date was estimated using the Black-Scholes valuation model. This method of valuation involves using inputs such as the fair value of the Company’s common stock, stock price volatility, risk–free interest rates and dividend yields. Due to the nature of these inputs, the valuation of the warrants is considered a Level 3 measurement. The following assumptions were used on June 3, 2016 (issuance date) and December 31, 2016:



	December 31, 2016			June 3, 2016
Volatility		118	%		123	%
Expected term (years)		4.42			5.00
Risk-free interest rate		1.80	%		1.23	%
Dividend yield		0.00	%		0.00	%
Exercise price		$2.25			$2.25
Common stock closing price		$0.44			$2.06

The dilutive financing derivative liability was recorded on the accompanying consolidated balance sheet at its initial value on April 8, 2016 and is marked-to-market at each balance sheet date until the liability is relieved. The fair value of the dilutive financing derivative liability on each measurement date is estimated using the Monte Carlo valuation model. For this liability, the Company develops its own assumptions that do not have observable inputs or available market data to support the fair value. This method of valuation involves using inputs such as the fair value of the Company’s common stock, stock price volatility, expected future financings, risk–free interest rates and dividend yields. Due to the nature of these inputs, the valuation of future potential dilutive financings is considered a Level 3 measurement. The following assumptions were used to value the dilutive financing derivative liability from the inception date of April 8, 2016 through September 30, 2016:



Volatility	108 to 121	%
Expected term (years), weighted average	1.75 to 2.23
Risk-free interest rate	0.58 to 0.79	%
Dividend yield	0.00	%
Stock price dilutive limit	$2.35 to $4.05
Common stock closing price	$1.52 to $3.68

From April 8, 2016, the date of the Common Stock Issuance Agreement (“CSIA”) through December 31, 2016, the Company raised capital from issuance of common stock and related warrants for gross proceeds of approximately $9.0 million that were dilutive in accordance with the provisions of the CSIA agreement. The Company issued 750,206 shares in June 2016 to the parties to the CSIA and the Company became obligated to issue additional common shares to the parties to the CSIA in connection with a financing transaction completed by the Company in November 2016. The maximum number of shares that the Company could issue under the rules of the NYSE MKT and the terms of the CSIA agreement was 286,846 shares as of December 31, 2016. As of the balance sheet date, the dilutive financing liability was valued at $126,000, based on the closing market price of the Company’s common stock of $0.44 per share multiplied by the 286,846 shares available to be issued.

The fair value of the Series B preferred stock derivative liability on each measurement date is estimated using the Monte Carlo valuation model. For this liability, the Company developed its own assumptions that do not have observable inputs or available market data to support the fair value. This method of valuation involves using inputs such as the fair value of the Company’s common stock, stock price volatility, the expected term of the Series B redeemable convertible preferred stock, risk–free interest rates and dividend yields. Due to the nature of these inputs, the valuation of the Series B redeemable convertible preferred stock conversion liability is considered a Level 3 measurement. On April 8, 2016, all outstanding Series B preferred stock was converted into common stock, and the remaining Series B preferred stock derivative liability balance of $91,000 was reversed and recorded as a gain in derivative liability on the Company’s consolidated statements of operations in the second quarter of 2016. The following assumptions were used at December 31, 2015:




Volatility	108 to 117	%
Expected term (years), weighted average	0.50 to 2.50
Risk-free interest rate	0.49 to 1.19	%
Dividend yield	0.00	%
Exercise price	$7.00
Common stock closing price	$3.98