Quarterly report pursuant to sections 13 or 15(d)

Convertible Promissory Notes and Derivative Liability

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Convertible Promissory Notes and Derivative Liability
6 Months Ended
Jun. 30, 2011
Notes to Financial Statements  
Convertible Promissory Notes and Derivative Liability

In March, April, and July 2008, the Company issued convertible notes to three investors for aggregate proceeds of $155,000. Principal and interest on these convertible notes, accrued at the rate of 10% per annum, were due and payable in August and September 2009, the maturity dates, unless earlier converted into equity securities of the Company. Principal and unpaid accrued interest was convertible into equity securities of the Company automatically at the closing of the Company’s next equity financing to outside investors in which gross aggregate proceeds exceed $1,000,000 (“Next Equity Financing”), at the price per share received by the outside investors. Since the Next Equity Financing did not occur on or before the maturity date, the principal and unpaid accrued interest were converted at the option of the Company into 488,354 shares of Series 1 convertible preferred stock at a price per share of $0.40 in October 2010. In addition, the Company issued warrants to the note holders equal to 50% of the principal of the note which provides for the note holders to purchase an aggregate of 193,750 shares of Series 1 preferred stock at an exercise price of $0.40 per share. Concurrent with the merger on May 25, 2011, the 488,354 shares of preferred stock were converted into 3,032,348 shares of common stock and the warrant now provides for the note holders to purchase an aggregate of 1,203,056 of common stock at an exercise price of $.06 per share.

 

In November 2008, the Company issued a convertible note to an investor for proceeds of $172,548. Principal and interest on these convertible notes, accrued at the rate of 10% per annum, were due and payable in December 2009, unless earlier converted into equity securities of the Company. Contemporaneously with the closing of any equity financing of the Company having aggregate proceeds of at least $500,000 (“Qualified Financing”), the investor had the option to receive payment on the outstanding principal and unpaid accrued interest, or to convert the outstanding principal and unpaid accrued interest into preferred stock of the Company at the price per share paid by the purchasers in the Qualified Financing. If no Qualified Financing occurred on or before the maturity date, the investor had the option to receive payment on the outstanding principal and unpaid accrued interest, or to convert the outstanding principal and unpaid accrued interest into the Company’s common stock at a price per share of $0.50. In addition, the Company issued warrants to the investor to purchase a number of shares of stock issued to investors in the Qualified Financing equivalent to 70% of the principal amount of the note divided by the price per share of the stock sold in the Qualified Financing). On June 1, 2010, the Company and the investor entered into a settlement agreement to cancel the $172,548 convertible note, related accrued interest of $26,793 and warrants fair valued at $65,082 on the date of cancellation, for a cash payment of $100,000, resulting in a gain of $164,423 recorded in the statement of operations as other income (expense).

 

In August, November, and December 2010, the Company issued convertible promissory notes to certain investors for aggregate proceeds of $32,527. Principal and interest on these convertible notes, accrued at the rate of 5% per annum, are due and payable two years from the issuance dates, unless earlier converted into equity securities of the Company. Principal and unpaid accrued interest shall be converted automatically or at the investor’s option into equity securities of the Company at the closing of the Company’s next equity financing to outside investors in which gross aggregate proceeds exceed $1,000,000 (“Next Equity Financing”), at the price per share received by the outside investors. If the Next Equity Financing does not occur on or before the maturity date, the principal and unpaid accrued interest can be converted at the option of the Company into shares of capital stock of the Company. In addition, the Company issued warrants to the note holders to purchase a number of shares of capital stock issued to investors in the Next Equity Financing equivalent to 5% or 20% of the principal amount of the notes divided by the price per share of the stock sold in the Next Equity Financing.

 

On December 13, 2010, the Company issued a convertible note to an investor for proceeds of $100,000. Principal and interest, accrued at the rate of 5% per annum, are due and payable on December 13, 2012, unless earlier converted into equity securities of the Company. Principal and unpaid accrued interest shall be automatically converted into equity securities of the Company at the closing of the Company’s Next Equity Financing, based on a conversion price equal to one-third of the price per share of the stock sold to outside investors in the Next Equity Financing. If the Next Equity Financing does not occur on or before the maturity date, the principal and unpaid accrued interest can be converted at the option of the Company into shares of the most recently closed Company equity financing, based on a conversion price equal to one-third of the price per share of the most recently closed Company equity financing.

 

On December 28, 2010, the Company entered into an agreement to issue senior secured convertible promissory notes to certain investors up to an aggregate amount of $250,000 and on that date, issued a convertible promissory note to an investor for proceeds of $125,000. Principal and interest, accrued at the rate of 5% per annum, are due and payable on December 6, 2011, unless earlier converted into equity securities of the Company. Principal and unpaid accrued interest shall be automatically converted into equity securities of the Company at the closing of the Company’s next equity financing in which gross aggregate proceeds to the Company exceed $5,500,000 to outside investors and the Company registers its stock for sale pursuant to the Securities and Exchange Act of 1934. The conversion price shall be equal to one-third of the price per share of this financing. If this financing does not occur on or before the maturity date, the principal and unpaid accrued interest can be converted at the option of the holders of a majority of the aggregate principal amount of the senior secured convertible promissory notes, into common stock of the Company.

 

During the six months ended June 30, 2011, the Company issued convertible promissory notes to an existing investors for aggregate proceeds of $21,250. Principal and interest on these convertible notes, accrued at the rate of 5% per annum, are due and payable two years from the issuance dates, unless earlier converted into equity securities of the Company. Principal and unpaid accrued interest shall be converted automatically or at the investor’s option into equity securities of the Company at the closing of the Company’s next equity financing to outside investors in which gross aggregate proceeds exceed $1,000,000 (“Next Equity Financing”), at the price per share received by the outside investors. If the Next Equity Financing does not occur on or before the maturity date, the principal and unpaid accrued interest can be converted at the option of the Company into shares of capital stock of the Company In addition, the Company issued warrants to the note holders to purchase a number of shares of capital stock issued to investors in the Next Equity Financing equivalent to 5% of the principal amount of the notes divided by the price per share of the stock sold in the Next Equity Financing.

 

During the six months ended June 30, 2011, the Company issued convertible notes to a series of investors for total proceeds of $505,000. Principal and interest, accrued at the rate of 5% per annum, are due and payable on various dates in either December 2011, April 2013 or June 2013, unless earlier converted into equity securities of the Company. Principal and unpaid accrued interest shall be automatically converted into equity securities of the Company at the closing of the Company’s Next Equity Financing, based on a conversion price equal to one-third of the price per share of the stock sold to outside investors in the Next Equity Financing. If the Next Equity Financing does not occur on or before the maturity date, the principal and unpaid accrued interest can be converted at the option of the Company into shares of the most recently closed Company equity financing, based on a conversion price equal to one-third of the price per share of the most recently closed Company equity financing

 

At June 30, 2011, total future minimum payments under the Convertible Notes are as follows:

2011 $535,000 
2012  132,527 
2013  116,250 
     
Total minimum payments  783,777 
     
Less: Debt discount resulting from warrant and derivative liabilities  (305,258)
     
Total  478,519 
     
Current portion of convertible promissory notes  (370,435)
     
Convertible promissory notes – net of current portion $108,084 

  

All of Company’s convertible notes contain embedded derivatives wherein their automatic conversion, which is contingent upon a future equity raise, can accelerate the realization of the expected payout for each note. This feature creates the possibility of a greater than expected return for the note holder and thus a higher than expected liability for the Company. The value of this feature was estimated for each note using the probability expected return method, in which the payout of distinct potential early conversion scenarios was discounted to the present using the expected IRR of the note and compared with the present value of the note if held to maturity. Probabilities were applied to the value of early conversion in each scenario to arrive at a probability weighted value of the early conversion feature.

 

As of June 30, 2011 and December 31, 2010, the fair value of the derivative liability was $360,791 and $287,547, respectively. The changes in fair value for the three month periods ended June 30, 2011 and June 30, 2010 of $122,194 and $ -0-, respectively, and for the six month periods ended June 30, 2011 and June 30, 2010 and the period from January 14, 2008 (date of inception) to June 30, 2011 of $160,454, $ -0- and $163,750, respectively, have been recorded in the accompanying statements of operations as a component of other income (expense).