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 Topic 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 the Company’s 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, income will reflect this sensitivity of internal and external factors.

Items measured at fair value on a recurring basis include common stock warrants and a dilutive financing derivative liability (see Notes 6 and 8). 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
March 31, 2017
Liabilities
June 2016 offering warrant liability	$	-	$	-	$	245,000	$	245,000
Dilutive financing derivative liability		-		-		123,000		123,000
November 2016 offering warrant liability		-		-		1,961,000		1,961,000
Total liabilities	$	-	$	-	$	2,329,000	$	2,329,000

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

There were no transfers between Level 1, Level 2 or Level 3 of the fair value hierarchy for the three months ended March 31, 2017 or the year ended December 31, 2016.

The following table sets forth a summary of changes in the fair value of the Company's derivative and warrant liabilities, 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:



	June 2016		Dilutive Financing		November 2016		Total
	Offering		Derivative		Offering		Derivative
	Warrant Liability		Liability		Warrant Liability		Liabilities
Balance, December 31, 2016	$	274,000	$	126,000	$	2,043,000	$	2,443,000
Changes in estimated fair value		(29,000)		(3,000)		(82,000)		(114,000)
Balance, March 31, 2017	$	245,000	$	123,000	$	1,961,000	$	2,329,000

In connection with an issuance of warrants exercisable for an aggregate of 106,383 shares of common stock under a registered public offering, the Company incurred the June 2016 offering warrant liability (see Note 8). 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 assumptions used consisted of the following:



	March 31, 2017			December 31, 2016
Volatility		115	%		118	%
Expected term (years)		4.17			4.42
Risk-free interest rate		1.81	%		1.80	%
Dividend yield		0.00	%		0.00	%
Exercise price		$22.50			$22.50
Common stock closing price		$4.30			$4.40

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 (see Note 6). 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.

From April 8, 2016, the date of the Common Stock Issuance Agreement (“CSIA”) through December 31, 2016, the Company raised capital from the 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 75,020 shares in June 2016 to the parties of 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. As of December 31, 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 28,684 shares. This maximum number of shares did not change during the three months ended March 31, 2017. As of December 31, 2016, the dilutive financing liability was valued at $126,000, based on the closing market price of the Company’s common stock of $4.40 per share multiplied by the 28,684 shares available to be issued. As of the March 31, 2017, the dilutive financing liability was valued at $123,000, based on the closing market price of the Company’s common stock of $4.30 per share multiplied by the 28,684 shares available to be issued.

In connection with an issuance of warrants exercisable for an aggregate of 533,500 shares of common stock under a registered public offering, the Company incurred the November 2016 offering warrant liability (see Note 8). The fair value of the November 2016 offering warrant liability on the date of issuance and on each re-measurement date 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 warrants is considered a Level 3 measurement. The assumptions used consisted of the following:



	March 31, 2017		December 31, 2016
Volatility	112	%		112	%
Expected term (years)	4.64			4.89
Risk-free interest rate	1.85	%		1.91	%
Dividend yield	0.00	%		0.00	%
Exercise price (1)	$7.50			$7.50
Common stock closing price	$4.30			$4.40

(1) The exercise price of the November 2016 offering warrants will be adjusted downward due to events subsequent to March 31, 2017 (see Note 8).

As of March 31, 2017, all of the Company’s derivative liabilities were marked-to-market with the changes in fair value recorded as a component of change in fair value of derivative liabilities on the Company’s consolidated statements of operations.